The Cambridge International AS & A Level Accounting series consists of a Student’s Book,
Boost eBook and Workbook.
Cambridge International
AS & A Level Accounting
Second Edition
Cambridge International
AS & A Level Accounting
Second Edition Boost eBook
Cambridge International
AS & A Level Accounting
Workbook
9781398317536
9781398317260
9781398317543
To explore the entire series, visit www.hoddereducation.com/cambridge-alevel-accounting
Use this skills-based workbook throughout the
course to practise and develop independent
learning by answering a range of questions and
activities that are clearly linked to the content
of the Student’s Book.
●
Ensure students practise key skills and
accounting concepts with write-in space to
keep track of answers
●
Enable students to regularly identify and
address gaps in learning
●
Encourage students to learn at home by
setting targeted homework assignments on
specific topics covered in the workbook
Cambridge
International AS & A Level
Accounting
Second edition
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Cambridge
International AS & A Level
Accounting
Second edition
Ian Harrison
David Horner
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Contents
Introduction
5
AS LEVEL
1 Financial accounting
1.1
1.2
1.3
1.4
1.5
1.6
Types of business entity
1.1.1 Types of business entity and the advantages and
disadvantages of each type
The accounting system
1.2.1 The accounting system
Accounting for non-current assets
1.3.1 Capital and revenue income and expenditure
1.3.2 Changing asset values
Reconciliation and verification
1.4.1 Reconciliation and verification
1.4.2 Trial balance
1.4.3 Bank reconciliation statements
1.4.4 Control accounts
Preparation of financial statements
1.5.1 Adjustments to draft financial statements
1.5.2 Sole traders
1.5.3 Partnerships
1.5.4 Limited companies
Analysis and communication of accounting information to
stakeholders
1.6.1 Users of accounting information
1.6.2 Calculation and evaluation of ratios
2 Cost and management accounting
2.1
2.2
Costs and cost behaviour
2.1.1 Materials and labour
Traditional costing methods
2.2.1 Costing applications
2.2.2 Absorption costing
2.2.3 Marginal costing
2.2.4 Cost–volume–profit analysis
11
11
11
19
19
65
65
66
81
81
82
92
102
121
121
140
160
169
192
192
196
208
208
208
219
219
222
237
258
A LEVEL
3 Financial accounting
3.1
Preparation of financial statements
3.1.1 Financial statements
3.1.2 Partnerships
3.1.3 Clubs and societies
262
262
263
263
297
3
Contents
3.2
3.3
3.4
3.5
3.1.4 Manufacturing businesses
3.1.5 Limited companies
Regulatory and ethical considerations
3.2.1 International Accounting Standards
3.2.2 Ethical considerations
3.2.3 Auditing and stewardship of limited companies
Business acquisition and merger
3.3.1 Business acquisition and merger
Computerised accounting systems
3.4.1 Computerised accounting systems
Analysis and communication of accounting information
3.5.1 Analysis and communication of accounting information
4 Cost and management accounting
4.1
4.2
4.3
4.4
4
Activity based costing (ABC)
4.1.1 Activity based costing
Standard costing
4.2.1 Standard costing
Budgeting and budgetary control
4.3.1 Budgeting and budgetary control
Investment appraisal
4.4.1 Investment appraisal
310
332
354
354
361
365
370
370
386
386
388
388
396
396
396
404
404
421
421
451
451
Examination-style questions
Multiple-choice questions
AS Level
A Level
472
472
478
485
Answers to calculation self-test questions
494
Glossary
495
Index
502
Introduction
Aims
This book has been written for students of Cambridge International AS & A Level
Accounting (9706) for examination from 2023. It fully covers the syllabus content,
provides guidance to support students throughout the course and helps them to
prepare for examination.
Assessment
The information in this section is taken from the Cambridge International AS &
A Level Accounting (9706) syllabus for examination from 2023. Students should
always refer to the appropriate syllabus document for the year of examination to
confirm the details and for more information.
The syllabus document is available on the Cambridge International website at:
www.cambridgeinternational.org.
There are four examination papers:
Paper 1 Multiple Choice
Paper 2 Fundamentals Paper 3 Financial
of Accounting
Accounting
Paper 4 Cost and
Management Accounting
Duration
1 hour
1 hours 45 minutes
1 hours 30 minutes
1 hour
Marks
30 marks
90 marks
75 marks
50 marks
72% of AS
36% of A Level
30% of A Level
20% of A Level
Percentage of 28% of AS
overall marks 14% of A Level
Question
format
30 multiple-choice questions 4 structured questions
based on Sections 1&2
based on Sections
1 and 2
3 structured questions 2 structured questions
based on Section 3
based on Section 4
How to use this book
The content is organised into 17 chapters, corresponding to the syllabus. The content
is in the same order as the syllabus.
AS Level topics
A Level topics
Financial accounting
1.1 Types of business entity
1.2 The accounting system
1.3 Accounting for non-current assets
1.4 Reconciliation and verification
1.5 Preparation of financial statements
1.6 Analysis and communication of
accounting information
3.1 Preparation of financial statements
3.2 Regulatory and ethical considerations
3.3 Business acquisition and merger
3.4 Computerised accounting systems
3.5 Analysis and communication of
accounting information
Cost and management accounting
2.1 Costs and cost behaviour
2.2 Traditional costing methods
4.1 Activity based costing (ABC)
4.2 Standard costing
4.3 Budgeting and budgetary control
4.4 Investment appraisal
5
IntroduCtIon
Features
Learning outcomes
Each chapter opens with a list of the topics that will be covered.
Learning outcomes
By the end of this chapter you should have an understanding of:
l the different types of business entities: sole trader, partnership, limited
companies and their legal structure
l the advantages and disadvantages of each type of business entity
l sources of finance and funding for these types of business entities, including
finance only available for limited companies.
Chapter introduction
A short introduction to the chapter and its focus.
Introduction
There are a number of different types of business entity, or business
organisation. Businesses can operate in a number of markets, selling different
types of goods or services. Some will be small-scale businesses selling
to a local area, while some will be enormous organisations that operate
across international borders (multinational corporations). In this section, the
differences in types of business entity are judged in terms of differences in their
legal structure, i.e. how the law treats each type of business organisation.
All businesses need money to finance their operations. Each type of business will
have different needs for finance. There are many different sources from which a
business can obtain finance, such as banks. The methods of finance, i.e. the type
of lending available – will, in part, depend on the type of business entity.
Learning link
Numerous topics in Accounting are connected. This feature states where relevant
material is covered elsewhere in the book.
Learning link
Cash discounts are
covered in Chapter 1.2
and are given to
businesses that settle
their amounts owing
quickly with suppliers.
Study tip
Advice that students will find useful when learning a new topic or revising.
STUDY TIP
It is important to
understand what is
the most appropriate
type of structure for
a business entity.
Ensure you know
the advantages and
disadvantages of each
type of business entity.
6
Worked example
A formal question or task followed by a full worked example of the appropriate
accounting procedure.
WORKED EXAMPLE
The following transactions took place in February:
February 3: paid rent $400 by cheque
February 7: paid Gary $67 by cheque
February 9: paid wages $832 by cheque.
Required
Enter the transactions in a cash book.
Answer
Cash book
Cash
Bank
Cash
Bank
$
Feb 3
Rent
400
Feb 7
Gary
67
Feb 9
Wages
832
Example
A demonstration of a concept in the text.
EXAMPLE
Lara has extracted a trial balance. The totals of the debit and credit columns do
not agree.
Lara inserts a suspense account to make the trial balance
balance
Debit
column total
Credit
column total
$
$
123 456
132 546
9 090
132 546
132 546
Evaluation
These scenarios are examples of how business decisions can be evaluated based on some
given information. They are made up of a scenario and some ideas for good answers.
Chapter summary
At the end of each chapter, there is a list of the main points from the chapter that you
should have a good understanding of.
Self-test questions
Short questions at the end of each chapter to help recap and confirm knowledge and
understanding of the concepts covered. Answers to these questions can be found within
the chapter. However, the answers to calculation questions can be found at the end of
the book on page 494.
7
IntroduCtIon
SELF-TEST QUESTIONS
1 Why are results converted into ratios?
2 What do profitability ratios tell us?
3 Give an example of a profitability ratio.
4 What do liquidity ratios tell us?
5 Give an example of a liquidity ratio.
6 Give the formula for calculating the profit margin.
7 Give the formula for calculating inventory turnover.
8 How is average inventory calculated?
9 Bima makes a gross profit ratio of 54 per cent. Is this good or bad?
10 Mary’s average collection period is 42 days; her average payment period is
19 days. Explain whether or not this is a good or a bad policy.
11 Identify two limitations of using ratios as an evaluation of performance.
Examination-style questions
The textbook concludes with:
» one set of multiple-choice questions written in an examination style
» one set of examination-style questions covering the AS Level topics
» one set of examination-style questions covering the A Level topics.
All of these will help with preparation for examination.
Glossary
Non-current assets Assets that will be used by the business for more than one
accounting year.
Additional support
The accompanying Workbook provides additional opportunity for practice. This write-in
workbook is designed to be used throughout the course.
8
Command words
Command word What it means
Advise
write down a suggested course of action in a given situation
Allocate
charge overheads that can be directly attributed to a specific cost
centre to that centre
Analyse
examine in detail to show meaning, identify elements and the
relationship between them
Apportion
charge overheads that cannot be directly attributable to a cost centre,
to other centres using that overhead, on an appropriate basis
Assess
make an informed judgement
Calculate
work out from given facts, figures or information
Comment
give an informed opinion
Compare
identify/comment on similarities and/or differences
Define
give precise meaning
Describe
state the points of a topic/give characteristics and main features
Discuss
write about issue(s) or topic(s) in depth in a structured way
Evaluate
judge or calculate the quality, importance, amount, or value of
something
Explain
set out purposes or reasons/make the relationships between things
evident/provide why and/or how and support with relevant evidence
Identify
name/select/recognise
Justify
support a case with evidence/argument
Prepare
present information in a suitable format
Reapportion
recharge overheads from non-production cost centres on an appropriate
basis
Reconcile
process two sets of figures to confirm their agreement
State
express in clear terms
Suggest
apply knowledge and understanding to situations where there are
a range of valid responses in order to make proposals/put forward
considerations
The information in this section is taken from the Cambridge International syllabus for
examination from 2023. You should always refer to the appropriate syllabus document
for the year of your examination to confirm the details and for more information.
The syllabus document is available on the Cambridge International website at
www.cambridgeinternational.org
9
IntroduCtIon
Key concepts
The syllabus is built around five fundamental concepts that should be applied to all
accounting transactions. They are:
» A true and fair view: Financial statements are designed to give a true and fair
view of the financial position, performance and changes in financial position of
the business to internal and external stakeholders.
» Duality: Duality in accounting recognises that every financial transaction has a
double (or dual) effect on the position of a business as recorded in the accounts.
» Consistency: Consistency in the treatment of financial transactions enables the
performance of a business to be compared meaningfully over different time periods.
» Business entity: A business is a separate legal entity from the owner of a
business. The accounting records must relate only to the business and not to the
personal assets and spending of the owner.
» Money measurement: Financial accounts only include items and transactions that
can be expressed in terms of money. For example, the purchase of raw material is
recorded in the accounts whereas staff creativity is not.
» Planning and control: Management accounting provides a framework for a business
to plan and control its finances and enables informed decision-making.
These key concepts will dictate the way that you study accounting. They underpin the
work that you will study during your course. You should find that they provide themes
that run through all the accounting topics that you study.
Answers
Answers to questions in the student textbook and workbook are available at:
hoddereducation.com/cambridgeextras
10
1 Financial accounting (AS Level)
1.1
Types of business entity
By the end of this chapter you should have an understanding of:
l the different types of business entities: sole trader, partnership, limited
companies and their legal structure
l the advantages and disadvantages of each type of business entity
l sources of finance and funding for these types of business entities, including
finance only available for limited companies.
Introduction
There are a number of different types of business entity, or business
organisation. Businesses can operate in a number of markets, selling different
types of goods or services. Some will be small-scale businesses selling
to a local area, while some will be enormous organisations that operate
across international borders (multinational corporations). In this section, the
differences in types of business entity are judged in terms of differences in their
legal structure, i.e. how the law treats each type of business organisation.
All businesses need money to finance their operations. Each type of business will
have different needs for finance. There are many different sources from which a
business can obtain finance, such as banks. The methods of finance, i.e. the type
of lending available – will, in part, depend on the type of business entity.
1.1.1 Types of business entity and the advantages
and disadvantages of each type
The different types of business entity
1.1.1 Types of business entity and the advantages and disadvantages of each type
Learning outcomes
There are a number of ways we can classify the different types of business entity.
These include the type of producer – manufacturer, trader or service provider. They
also include the scale of the business – measured by its size (usually measured in
terms of sales, output or market capitalisation, if a public limited company). However,
another common way of classifying businesses is in terms of their legal structure.
Based on the legal classification, there are four main types of business entity.
Sole trader
When people decide to set up their own business, they are likely to set up as a sole
trader. This is the simplest form of business entity. It can be set up relatively quickly
and easily. Although others can be employed by the sole trader, the business is owned
and controlled by one person. This one person runs the business and makes all the
major decisions.
This type of business entity is very common and is the most likely format used by any
entrepreneur when initially setting up a business. However, being a sole trader is not
without its disadvantages. The main advantages and disadvantages of operating as a
sole trader are summarised in Table 1.1.1.
11
▼ Table 1.1.1 Advantages and disadvantages of operating as a sole trader
1.1 types of busIness entIty
1.1
Learning link
The contents of a
partnership agreement
are covered in more
detail in Chapter 1.5.
Advantages
Disadvantages
The sole trader has complete control over
how the business is run.
The sole trader has unlimited liability for
the debts of the business.
Setting up as a sole trader is usually
straightforward – with the minimum
of legal formalities.
Being a sole trader may involve long hours
of work as the sole trader has no one with
whom to share the burden of work.
The financial results of the business do not
need to be shared publicly.
Illness or other reasons for absence may
affect the running of the business.
The profits of the business belong (less any
tax) to the sole trader and are not shared
with anyone else.
It can be difficult to raise finance when
needed.
Expansion of a business usually involves raising extra finance. Raising the necessary
finance is very difficult without involving other people. This generally means that
if sole traders need significant external finance, they are faced with the choice of
converting the business into either a partnership or a limited liability company.
Partnership
STUDY TIP
Although there is
no maximum to the
number of partners,
most partnerships will
normally have a small
number of partners –
unlikely to be bigger
than four.
STUDY TIP
If there is no
partnership agreement
then you must apply
the rules contained in
the 1890 Partnership
Act or equivalent
legislation in your
country.
A sole trader may wish to expand or bring in more expertise to the business. As a
result, the most appropriate type of business entity may be a partnership. This is a
business owned and controlled by two or more partners. There is no upper limit on the
number of partners allowed. Here, we are specifically considering the entity known as
a general partnership. (A limited liability partnership is another type of partnership
but this will not be studied for this course. Any reference in this book to partnerships
is to general partnerships.)
It is usual for a partnership to have a written partnership agreement, also known as
a deed of partnership. This will reduce the possibility of any disputes arising. This
agreement covers issues such as:
»
»
»
»
the duties of the individual partners
the amount of capital to be subscribed by each of the partners
the ways that profits are to be shared
the financial arrangements if there are any changes to the structure of the
partnership.
If there is no agreement, in the UK, the Partnership Act of 1890 lays down the
following rules that must apply:
»
»
»
»
»
No partner should be entitled to interest on capital.
No partner is entitled to a salary.
No partner is to be charged interest on drawings.
Residual profits or losses are to be shared equally.
Any loan made to the partnership by a partner will carry interest at the rate of five
per cent per annum.
There may be similar legislation that applies in your country.
As a type of business entity, the partnership has a number of advantages compared
with sole traders and limited companies. There are also disadvantages, and these are
summarised in Table 1.1.2.
12
▼ Table 1.1.2 Advantages and disadvantages of a partnership
Disadvantages
Partnerships have access to more capital than a sole trader
from the increased contributions from a greater number of
co-owners.
Partnerships still have unlimited liability meaning they are
responsible for business debts.
Partners can specialise in different aspects of business
management allowing business operations to match the
expertise of each partner.
Disagreements may be more frequent if they do not agree
on how the business should be run.
Illness and holidays can be covered by other partners if
needed.
Profits will be shared between partners, which may seem
unfair if a partner believes they deserve a higher proportion
of the profits.
Compared with a limited company, a partnership may still
find it difficult to borrow money.
Learning link
The financial
statements of
partnerships involve
new features that
are not covered until
Section 3.1.2.
Both sole traders and partnerships are relatively simple forms of business entity. In
terms of their legal structure, the law does not make any distinction between the
business and the owner(s) of that business. This means the owners – either the sole
trader or each partner – have unlimited liability. This is not the same for the next type
of business entity – the limited company.
Limited company
A limited company can be a very small business or a giant multinational business
with branches and/or subsidiary companies trading throughout the world.
The majority of businesses are sole traders or partnerships. The major drawback
of these two types of business is that their owner(s) have unlimited liability.
As we have seen, sole traders are responsible for all debts incurred by them in the
course of running the business. For example, if Moona, a sole trader, runs up business
debts of $25 000, she may have to settle these debts from her private savings or she
may have to sell her house or car to clear the debts. Moona has unlimited liability.
Similarly, if the business partnership of Clint and Dyke has debts of $30 000, both
partners are ‘jointly and severally responsible’ for the debts of the business and
between them they may have to raise the money privately to pay off the amount that
is owed. Clint and Dyke have unlimited liability.
However, Blinva plc (public limited company) has debts of $345 000. Jemma, a
shareholder in the company (she owns 500 ordinary shares of $1 each), could not be
asked to contribute further funds in order to help pay off the debts of the company.
She could lose her investment but that is all she would lose. Her personal possessions
are safe. Jemma has limited liability.
1.1
1.1.1 Types of business entity and the advantages and disadvantages of each type
Advantages
So, unlimited liability means that the owners of a business have responsibility for all
the debts incurred by their business.
In the vast majority of cases, unlimited liability is of little significance. However, if
a business is making losses on a regular basis then the continuing existence of the
business may well be in doubt. So, a major drawback of being a sole trader or a partner
in a business is unlimited liability for the owners.
As a consequence of unlimited liability, there is another major drawback for unlimited
businesses. There are fewer opportunities to find extra capital that may be necessary
for an expansion programme. Prospective investors may not wish to take the risk of
losing their personal possessions as well as their investment.
Because shareholders have limited liability, prospective investors do not risk losing
their private assets (e.g. personal possessions such as their home) when investing in
limited companies. This is one reason why limited companies find it easier to attract
funding.
13
1.1 types of busIness entIty
1.1
Compared with both sole traders and partnerships, limited companies are quite
different as a type of business entity. The main differences are summarised here:
» At least one shareholder – but with no maximum number.
» All shareholders have limited liability.
» Limited companies pay corporation tax on their profits, whereas sole traders and
partners are likely to pay income tax rather than corporation tax as the business
does not exist separately from its owners as individuals.
» Shareholders delegate the running of the company to the directors.
» Directors are elected by shareholders to run the company.
In some countries, there are multiple types of limited company. A common distinction
is made between public limited companies and private limited companies. The main
differences between these two types of company is summarised in Table 1.1.3.
▼ Table 1.1.3 The main features of private limited companies and public limited companies
Private limited company
‘Ltd’ or ‘Limited’ appears after company name
Minimum of one shareholder to the limit of share capital
and at least one director
Share trading restricted
No stock market listing
Public limited company
‘plc’ or ‘public limited company’ appears after company name
Minimum of two shareholders to the limit of share capital and
at least two directors
No restriction to share trading
Usually listed on recognised stock market
Private limited companies do not sell their shares to the general public, so if a private
limited company wishes to raise additional finance through a share issue, the directors
must find other individuals who might be willing to invest in the company. This is
why many private limited companies are often family businesses with members of the
family or close friends of the family owning all the shares.
On the other hand, if the directors of a public limited company wish to raise additional
finance, the directors may well advertise the fact in the financial sections of daily
newspapers in order that the public at large may subscribe to the offer.
The advantages of limited liability status and the ability to raise large amounts of
finance are offset by certain legal obligations:
» Annual financial statements must usually be audited by professionally qualified
personnel. (This is not the case with partnerships or with sole traders.)
» Annual returns must be completed and filed with the Registrar of Companies. These
returns may be inspected by the general public. The financial statements included as
part of the annual return lack much of the detail that could be used by a competitor.
» Companies are usually regulated by government legislation and/or agencies.
» Copies of the company’s annual audited financial statements must be sent to each
shareholder and debenture holder.
Setting up a limited company has a number of benefits compared with setting up as
a sole trader or as a partnership. Table 1.1.4 summarises the main advantages and
disadvantages of operating as a limited company.
▼ Table 1.1.4 Main advantages and disadvantages of operating as a limited company
Advantages of limited companies
Access to more capital (especially if a public limited
company)
Limited liability
The business can continue even after the founders retire or
even die – assuming multiple shareholders exist
Disadvantages of limited companies
More disclosure of financial records (especially if a public
limited company)
More complex to set up
Expensive to set up (as a public limited company)
Potential loss of control to other shareholders (mainly for
public limited companies)
Increased media scrutiny (for public limited companies)
14
Remember
STUDY TIP
It is important to
understand what is
the most appropriate
type of structure for
a business entity.
Ensure you know
the advantages and
disadvantages of each
type of business entity.
Learning link
Share capital is covered
in Chapter 1.5.
» Private companies have more control over the business as shares cannot be publicly
traded.
» Private companies have less access to large sums of capital.
» Private companies have fewer disclosure issues (most information can remain
private).
A majority of companies are private so the need to access large sums of capital is not
an issue for most businesses.
Sources and methods of finance
Businesses will need funds to finance their operations. There are many sources of
finance available. These refer to the places a business can obtain money. The methods
of finance used are the particular way in which a business accesses money. For
example, a bank may be a source of finance for a business but banks offer different
methods of finance for businesses, such as bank loans and overdrafts.
A common way to examine the different sources and methods of finance available for
a business is to classify them into short-term and long-term methods and sources.
It is also possible to classify finance as internal – i.e. from within the business, or
external – i.e. from outside the business.
Internal and external sources and methods of finance
As well as dividing between short-term and long-term finance, it is common to divide
finance between internal and external sources of finance (Table 1.1.5).
▼ Table 1.1.5 Internal and external sources of finance
Short-term
Internal sources and methods
of finance
External sources and methods
of finance
Owner’s money
Bank overdraft
Short-term bank loan
Trade credit
Payment by instalments
Long-term
Owner’s money
Rental/leasing
Retained earnings
Long-term bank loan
1.1
1.1.1 Types of business entity and the advantages and disadvantages of each type
Liability means
responsibility for
the company’s debt.
Liabilities are the name
given to types of debts
borrowed by businesses.
These are covered in
Chapter 1.5.
The advantages and disadvantages of operating as a private rather than public limited
company include:
Debentures (*)
Share issue (*)
Learning link
What working capital
is and how it can be
managed is explored in
many different chapters
of this book, including
1.4, 1.5, 1.6 and 2.1.
Note
* These sources are available only to limited companies.
Short-term internal financing is also known as management of working capital, that
is, managing the elements that make up current assets. These are explored later in
the book. Efficient management of the components of current assets means that
limited companies will need to borrow less to finance their day-to-day operations. If a
company is inefficient in its working capital management, it may have to borrow short
term to finance inventory, trade receivables and cash needs.
If a business is not generating enough cash through normal trading activities, then it
may have to borrow through a bank overdraft or short-term bank loan.
15
Loans (secured and unsecured)
Bank loans are amounts of money borrowed from the bank. They are paid back over
a specified period of time and interest is charged on the loan, which will be paid in
addition to the repayments. Interest rates on bank loans can be fixed or variable.
1.1
Although bank loans are often a long-term method of finance (i.e. beyond one year), it
is possible to obtain a bank loan for a shorter period of time.
Banks can lend money in the form of secured or unsecured bank loans.
1.1 types of busIness entIty
A secured bank loan requires the business to offer security (also known as collateral)
in the form of a business asset that the bank can take for itself if the business fails
to keep up repayments. Even though a bank may hold the title to non-current assets
as security, the loan does not give the bank any say or rights in the everyday running
of the business. An unsecured loan is where the bank lends money but the business
offers no asset as security. As a result, the unsecured loan is a bigger risk for the
bank. Consequently, interest rates on secured loans are usually lower than those on
unsecured loans owing to the lower risk taken on by the bank. It is also possible that
a secured loan may be the only way a business can persuade a bank to lend it money.
Bank overdrafts
A short-term method of obtaining finance is through a bank overdraft. A bank
overdraft facility is a good way to overcome the irregular cash flows experienced by
many businesses. It is in the best interests of managers to agree an overdraft limit
in case they need to use this source of finance. This is wise because the interest rate
charged on an unauthorised overdraft is usually much higher than if an agreement had
been reached before the overdraft is required.
The rates of interest charged on overdrafts tend to be greater than those charged on
longer term borrowings. This is why businesses are likely to use overdrafts only in the
short term (although many businesses have a permanent overdraft facility).
Providers of overdrafts do not require security on the loan and, therefore, the level of
risk for the provider is greater than that incurred with a loan. This is why the rate of
interest charged is greater than that charged on a loan.
Overdraft facilities are dependent on the management of a business convincing the
bank that cash shortages are of a temporary nature.
In addition to overdrafts and bank loans, there are other external sources of finance
available:
Payment by instalments
Learning link
Substance over form is
an accounting concept
covered in Section 1.2.1.
A business may purchase non-current assets by regular instalments (sometimes known
as a hire purchase agreement). This means that the cost of the asset is spread over
several years. Although ownership of the asset rests with the hire purchase company
until the final payment is made, the purchaser will show the asset on its statement
of financial position. (This is an application of substance over form.) The amount still
outstanding on the agreement will be shown as a liability.
Rental/leasing as an alternative to purchase
A way of raising long-term finance may be for a business to lease (or rent) non-current
assets rather than purchase them. Once again, this action will conserve cash in the
short term. However, the business does not own the asset. The rental charges are
shown in the statement of profit or loss as an expense.
Trade credit
Trade credit is where a business takes ownership of purchases (usually of goods or raw
materials) but does not pay for these until some time later (usually 1–3 months’ time).
16
This form of financing must be used with caution. If trade payables (or credit
suppliers) feel that their credit terms are being abused, they may revert to requiring
that their supplies of goods and services are purchased on a cash basis only, or that
any beneficial credit facilities are withdrawn.
Learning link
In addition to the methods covered so far, businesses can also aim to use internal
financing. This is where the business uses retained earnings. These are the profits of
the business that have not been taken out by the owners or given to the shareholders.
Other short-term sources of finance include selling off any assets that are no longer
needed by the business. This can prove very expensive if the asset then needs to be
replaced at a later date.
The business can also use debt factoring. Debt factoring involves the sales ledger
being administered by a debt factoring company. The debt factoring company buys
the business’s debts, at a discount, paying an advance based on the total amount
to be collected. The debt factoring company then collects the debts when they
fall due.
In the long term, businesses normally rely on a combination of retained earnings
(assuming they exist) or bank loans. Mortgages, a special type of long-term bank loan
secured on the value of property, are used to buy any business premises.
Learning link
The methods of finance
available for limited
companies will also be
covered in Section 1.5.4.
Sources of finance for limited companies
The sources of finance mentioned so far are potentially available for all types of
business organisation. However, there are two more sources that are available only for
limited companies.
Share capital
This is where a company sells shares (in effect, selling the chance to become a partowner of the business) to investors who may wish to gain some measure of control
over the company, or benefit from the rising profits of the company. There are three
main methods of raising capital available to a public limited company:
» by a public issue, which requires new shareholders to purchase the shares
» by placing, which involves underwriters making shares available to financial
institutions of their choosing (this method is often used by companies coming to
the market for the first time)
» by a rights issue of shares, which is an issue to existing shareholders in some
proportion to their existing holding.
1.1.1 Types of business entity and the advantages and disadvantages of each type
Cash discounts are
covered in Chapter 1.2
and are given to
businesses that settle
their amounts owing
to suppliers within a
specified time period.
1.1
For a private limited company, selling shares is likely to involve inviting people/
investors already known to the business (e.g. family and friends) to invest money into
the company and provide finance as needed. All these share issues provide finance
that can be used in whatever way the directors feel is appropriate to the needs of the
company.
Debentures
Many companies raise additional finance by issuing debentures. A debenture is
acknowledgement of a loan to a company. The loan is generally secured against the
company’s assets.
The lenders are paid a fixed rate of interest whether the company is profitable or not;
interest is paid half-yearly and is a charge against profits, unlike dividends. Debenture
holders are not owners of a company, but people or institutions to whom the company
owes money. The amount of debentures issued will appear on the statement of
financial position as a non-current liability (i.e. long-term debt).
17
1.1 types of busIness entIty
1.1
SUMMARY
After reading this chapter, you should:
» know about the main types of business entity
» understand the advantages and disadvantages of operating as each type of
business entity
» know about the different sources and methods of finance
» be able to select an appropriate source of finance for a particular type of
business entity and scenario
» understand the sources of finance available for a limited company.
SELF-TEST QUESTIONS
1 A sole trader has limited liability. True/False?
2 Partners have unlimited liability. True/False?
3 Explain two advantages of being in partnership.
4 List four rules that apply if a partnership does not have a partnership agreement.
5 Explain why the owners of a partnership might turn their business into a private
limited company.
6 What is meant by ‘limited liability’?
7 Directors are the owners of a limited company. True/False?
8 Explain why shareholders appoint directors to run a limited company.
9 Explain two reasons why a company might need to raise finance.
10 A company wishes to purchase more land in order to extend its manufacturing
base. The finance director believes that he should negotiate an overdraft facility
with the company’s bankers. Do you consider his action to be reasonable?
11 Identify two problems that might occur if a company embarks on a marketing
policy that is aimed at doubling sales revenue.
12 Explain the difference between a bank overdraft and a bank loan.
13 Explain how a company might benefit from issuing ordinary shares rather than
issuing debentures.
14 Explain how company directors might be able to predict the need for additional
finance in the future.
Calculation question (answer on page 494)
15 A business obtains a loan of $50 000. Interest on the loan is 5%. The loan is paid
back in one lump sum after six months with interest charged on the period it is
taken for. Calculate the total interest paid on the loan.
18
1.2
The accounting system
By the end of this chapter, you should have an understanding of:
l the principles of double-entry accounting for recording business transactions
l the accounting equation
l the role of books of prime entry in recording business transactions
l the preparation of ledger accounts
l the purpose of a trial balance
l the advantages and disadvantages of maintaining full accounting records
l accounting concepts that underpin the preparation of accounts
l the uses of computerised accounting systems and their advantages and
disadvantages
l ensuring security of data in computerised accounting systems.
1.2.1 The accounting system
Learning outcomes
Introduction
Businesses will be involved in many transactions of a financial nature. Some
businesses will have thousands of these to record in any one day. It is important
that we have a robust system of recording these transactions. Being able to
locate, identify and understand the nature of these transactions is vital to ensure
effective business decision-making. There are a number of systems in place
to facilitate this. The double-entry system of recording transactions and the
use of books of prime entry provide an effective method of recording financial
transactions. Increasingly, many businesses are now using software to maintain
their financial records on computers. However, this is not always appropriate for
businesses.
1.2.1 The accounting system
The principles of the double-entry system to record business
transactions
There are two main ways in which the managers of businesses record their financial
transactions. They use either:
» a single-entry system of recording transactions
» a double-entry system of recording transactions.
Single-entry systems generally record each business transaction once, as a single
entry. Only very small businesses, and other forms of organisations (such as small
charities or clubs) are likely to use this method of recording transactions.
The double-entry system provides the accountant with information needed in order to
prepare the financial statements of a business, which are covered later in this book.
19
As the name implies, double-entry bookkeeping recognises there are two sides to
every business transaction. For example, the following transactions can be seen from
two sides:
1.2
1.2 the aCCountIng system
STUDY TIP
Like all areas of
study, accounting
has its own jargon.
Whenever a new word
or term is introduced,
an explanation or
definition will be given.
Make sure you read
and understand what
these terms mean
and how they are used
in accounting.
I fill my car with $20 of fuel.
» I receive the fuel.
» The filling station attendant puts the fuel into my vehicle.
I buy a pair of soccer boots costing $13.
» I receive the boots.
» The sports shop ‘gives’ me the boots.
There are two more aspects to each of these transactions:
When I give the filling station attendant my $20
» she receives the cash
» I ‘give’ the cash.
When I give the shop assistant my $13
» he receives the cash
» I ‘give’ the cash.
All financial transactions involving the business are recorded in a format called a
ledger account or an account.
You would find each account on a separate page in the ledger. In fact, if a great many
transactions of a similar nature are undertaken, an account may spread over several
pages.
For the sake of convenience, this one book (the ledger) is divided into several smaller
books. You can imagine that large businesses like the Toyota Motor Corporation or
McDonald’s could not possibly keep all their financial records in one book.
Initially, to make our task a little simpler, we shall keep all our records together. When
the other books are introduced, you will see that it does make sense to split the ledger
into several different parts.
An account looks like a ‘T’ shape, like this:
Each account has two sides.
» The left side is known as the debit side.
» The right side is known as the credit side.
An account
Debit
The debit side of an account is always the
receiving side or the side that shows gains
in value.
Debit is often abbreviated to Dr.
Credit
The credit side of an account is always the
giving or losing side – the side that shows
value given.
Credit is often abbreviated to Cr.
An account
Receives
or
Gains
20
Gives
or
Loses
An account in the ledger would be headed like this:
1.2
‘Name of account’
Note
There should always be a heading; if the account shown is not a personal account, the
heading should include the word ‘account’.
1.2.1 The accounting system
It is vital to remember that every time you enter something on the debit side (left
side) of an account you must enter an equivalent amount on the credit side (right
side) of another account.
Practise applying this rule to questions and examples until you are comfortable
dealing with them.
WORKED EXAMPLE 1
Bola owns a business selling meat. During one week the following financial
transactions take place:
1 Bola purchases meat $210 from Scragg, a meat wholesaler. She will pay for
the meat in two weeks’ time.
2 Bola’s cash sales for the week amount to $742.
3 Bola supplies meat to the Grand Hotel $217.
4 Bola pays the rent for her shop $75 in cash.
5 Bola pays her telephone bill $43 in cash.
Required
Enter the transactions in Bola’s ledger.
Answer
1 Bola receives meat … and Scragg ‘gives’ the meat …
Purchases
Scragg
$
Scragg
$
210
Purchases
210
2 Bola ‘gives’ (sells) some meat … and she receives cash …
Sales
Cash
$
Cash
742
$
Sales
742
3 Bola ‘gives’ meat … and the Grand Hotel receives the meat …
Sales
Grand Hotel
$
Grand Hotel
217
$
Sales
217
21
4 Bola receives the use of her premises … and she ‘gives’ (pays) cash …
1.2
Rent
Cash
$
1.2 the aCCountIng system
Cash
$
75
Rent
75
l Bola pays money to a landlord for the use of his building.
l Bola receives/gains the use of the premises.
l In cases like this, think of the cash entry first and then put in the second
entry.
5 Bola receives the use of her telephone … and she gives cash ….
Telephone
Cash
$
Cash
$
43
Telephone
43
l Bola gives the telephone company cash for the service they provide to her.
l Bola receives/gains the use of the telephone.
If you are uncertain about the telephone account, ask whether Bola has gained cash
or ‘lost’ cash. You know that Bola has paid cash to the telephone company so the cash
has to be a credit entry (right side); the other entry has to be a debit entry (left side)
according to the rules of double entry.
Treatment of similar transactions
If there are a number of similar transactions that need to be recorded, we enter them
all in one account.
WORKED EXAMPLE 2
Greta Teer owns and runs a store selling newspapers, magazines and candies.
The following transactions took place over the past few days:
1 On 1 May 2021, cash sales of newspapers amounted to $68.
2 On 3 May 2021, cash sales of candies amounted to $151.
3 On 7 May 2021, Greta purchased candies for $135, paying cash to her
wholesaler.
4 On 11 May 2021, she paid $160 cash for business rates.
5 On 15 May 2021, Greta sold four boxes of potato chips to a local club for cash
$30.
Required
Enter the transactions in Greta’s ledger.
Answer
Sales
$
$
May 1
Cash
68
May 1
Sales
May 3
Cash 151
May 3
Sales
May 15 Cash
22
Cash
$
30
May 15 Sales
$
68 May 7 Purchases 135
151 May 11 Business 160
rates
30
Purchases
$
May 7 Cash
Business rates
$
135
$
$
1.2
May 11 Cash 160
Note
All the transactions involving cash have been entered in one cash account. All
the sales transactions have also been entered in one account.
WORKED EXAMPLE 3
Sven Drax owns and runs a hotel. He supplies the following information:
1 He purchases for cash $127 fruit and vegetables for the hotel restaurant.
2 Sven purchases petrol $45 for the hotel minibus using cash.
3 He pays for a family holiday $1500 paying with a business cheque.
4 He pays $2178 cash takings into the bank account.
1.2.1 The accounting system
As well as keeping money in the business, the owners of businesses will bank
money and will pay many bills by cheque, direct debit and electronic transfers. So,
as well as having a cash account in the ledger, the business would also keep a bank
account to record transactions using the business bank account.
Required
Enter the transactions in the hotel ledger.
Answer
Purchases
Bank
$
$
$
127
2 178
415
1 500
Motor expenses
Cash
$
$
45
127
45
Sales (or takings)
Drawings
$
$
2 178
1 500
Note
The cheque paid out to the holiday company is drawings – it is not a business
expense.
23
1.2 the aCCountIng system
1.2
STUDY TIP
Although the sales
ledger contains
all the accounts of
credit customers,
and the purchases
ledger contains
all the accounts of
credit suppliers, the
sales and purchases
accounts are found in
the general ledger.
The division of the ledger
All accounts are entered in one book called the ledger. Because the number of
accounts could run into many hundreds, it is more convenient to split the ledger into a
number of different books. The ledger is made more manageable by grouping together
similar accounts. We put:
» credit customers’ accounts together in one ledger – the sales ledger.
» credit suppliers’ accounts together in one ledger – the purchases ledger.
» all other accounts in another ledger – the general ledger.
The location of some accounts is not necessarily obvious:
» The sales account is found in the general ledger and not the sales ledger. The sales
ledger is reserved for the personal accounts of credit customers only.
» The purchases account is found in the general ledger and not in the purchases
ledger. The purchases ledger is reserved for the personal accounts of credit
suppliers only.
These transactions appear in the general ledger.
WORKED EXAMPLE 4
1 Nadhim purchases goods for resale $73; he pays cash.
2 He sells goods $19 for cash.
Required
State the double-entry needed to record each transaction.
Answer
Debits
Credits
1
Purchases account
Cash account
2
Cash account
Sales account
Any sale or purchase made for immediate settlement (i.e. paying or receiving money
immediately and not on credit) will be recorded in the cash or bank account – which is
found in the general ledger.
We will return to double-entry accounts later on in this chapter.
The concept of recording both sides of every transaction is fundamental to the
double-entry system of record keeping. It is also present in another important aspect
of accounting, known as the accounting equation.
WORKED EXAMPLE 5
Siobhan Murphy provides the following information for the past few days:
1 Siobhan purchases a non-current asset $1450 from Adil on credit.
2 She sells goods $77 to Fiona, who pays by cheque.
3 She purchases goods for resale $510 from Zainab on credit.
4 She purchases goods for resale $65 from Joan for cash.
Required
Enter the transactions in Siobhan’s ledger. (Indicate in which ledger each
account would be found.)
24
Answer
1.2
General ledger
Non-current assets
$
1 450
Sales
77
Purchases
$
510
65
Cash
$
1.2.1 The accounting system
$
65
Bank
$
77
Adil
$
1 450
Purchases ledger
Zainab
$
510
Note
l Customers’ accounts and suppliers’ accounts appear in the sales ledger
and in the purchases ledger respectively – but only if the transactions are
on credit.
l Accounts that are not personal accounts are found in the general ledger.
l All debit entries have a corresponding credit entry.
l All credit entries have a corresponding debit entry.
The accounting equation
The accounting equation continues the theme that runs through the principle of
double-entry bookkeeping – that there are two sides to each transaction.
The accounting equation is based on this and appears as follows:
Assets = Capital + Liabilities
The accounting equation recognises that the assets owned by a business are always
equal to the claims against the business.
The left-hand side of the accounting equation shows, in monetary terms, the assets
that are owned by an organisation. The right-hand side of the equation shows how
these resources have been financed with funds provided by the owner and others.
25
1.2 the aCCountIng system
1.2
Assets used in a business could include premises, machinery, vehicles and computers.
For example, assets used in a tennis club might include the tennis courts and rollers.
The liabilities owed by a business could include a loan, and money owed to the
suppliers of goods and services. For example, the liabilities of a local garage might
include money owed to the Honda motor company for spare parts; to the supplier of
electricity; to the supplier of office stationery, and so on. The liabilities of a tennis club
could include money owed to a local builder for repairs to the clubhouse; money owed
to the suppliers of tennis balls; money owed to the ground staff for wages not yet paid.
Both assets and liabilities are divided into two categories: current and non-current.
We will cover this later.
A statement of financial position lists all the assets that are owned by the organisation
and lists all the liabilities that are owed at one moment in time. A statement of financial
position can be prepared for a business, a club or any other organisation. You can even
prepare your own personal statement showing your financial position. The only difference
between your personal statement of financial position and that of, say, Microsoft, is the
type of assets owned and the magnitude of the figures used.
All statements of financial position must ‘balance’. This means that the total of assets
held must equal the total of capital plus liabilities.
EXAMPLE
A statement of financial position for Rollo’s general store may look as follows:
$
ASSETS
Premises
45 000
Van
16 000
Shop fittings
18 000
Inventory
Trade receivables
Bank
1 670
140
900
Total assets
81 710
CAPITAL
43 820
LIABILITIES
Loan used to buy premises
25 000
Bank loan owed on van
12 000
Trade payables
Total capital and liabilities
From this we can see that Rollo’s
business is worth $43 820. The business
has assets totalling $81 710, while the
business debts amount to $37 890. If
Rollo decided to stop trading he would
sell his assets, settle his debts and take
$43 820 out of the business.
Another way of expressing the difference
between the value of the business assets
and its liabilities is by using the term
capital; that is, all assets less all external
liabilities.
Here, $43 820 is the amount the business
‘owes’ the owner. It is the amount Rollo
has tied up (invested) in the business,
on the date the statement of financial
position was prepared. This is Rollo’s
capital.
890
81 710
Note: This assumes that the business assets could be sold for the value shown in the
statement of financial position. In reality, the assets may be sold for more or less than
the values shown in the statement; we will consider this at a later stage in your studies.
Given the accounting equation is always true then if we know the value of two
components in the equation we can calculate the value of the other component. For
instance, we can ascertain the value of the assets of the business if we know the
26
Learning link
Chapter 1.5 has
more detail on the
construction of the
statement of financial
position.
value of the capital and liabilities. If we know the assets and liabilities of a business,
we can use the equation to calculate the value of capital.
We will return to the statement of financial position when looking at the financial
statements of business entities in Chapter 1.5.
1.2
The role of books of prime entry in the recording of
business transactions
Before entries are made in the double-entry system of accounting, there is a
further stage of recording financial transactions. This is where transactions are first
recorded – the books of prime entry. There are six books of prime entry and they are:
1 the sales journal
2 the sales returns journal
3 the purchases journal
4 the purchases returns journal
5 the cash book
6 the general journal
1.2.1 The accounting system
The books of prime entry
Sales
journal
Purchases
journal
The double-entry system
Sales
returns
journal
Cash book
General journal
Purchases
returns
journal
▲ Figure 1.2.1 The six books of prime entry
All transactions are first entered in a book of prime entry.
Each book of prime entry is made up of a list of similar types of transaction. The items
are listed in the book until it is worthwhile to post the list to the ledger. Some of this
may sound confusing; but when you have seen how the books work, things will become
clear.
STUDY TIP
As long as you
remember the left side
is debit and the right
side is credit, you can
leave Dr/Cr out when
writing the ledger
accounts.
All transactions must be entered in one of the books of prime entry before they can be
entered in the ledger.
The cash book is both a book of prime entry and part of the double entry system.
» The books of prime entry are used as a convenient way of entering transactions
into the double-entry system.
» It is less efficient to make entries into the ledgers as they arise. It is too timeconsuming and that means it is generally more costly.
» It is better to collect the entries and categorise them into bundles of similar types
and then to post from these books in bulk.
27
Sales journal
1.2
When goods are sold the supplier sends a sales invoice to the customer. The sales
invoice itemises the goods that have been sold and the price of those goods.
A copy of this invoice is retained by the seller.
1.2 the aCCountIng system
The copy of the sales invoice is the source document from which the sales journal is
written.
The copies of the sales invoices sent to customers are used to prepare a list of the
credit sales made.
When it is convenient (this could be daily, weekly or monthly depending on the volume
of sales made by the business), the list is totalled and the total is posted to the credit
side of the sales account in the general ledger because the goods have been received
by the customer.
Each individual customer’s ledger account in the sales ledger is debited with the value
of goods sold to them (indicating that the customer has received the goods).
ur
Arth
td Cratchit &
c
Scratchit
es plEmily Smith L
Bain
.00
$ 547
Sales ledger
Arthur Baines plc
$
547.00
$ 912.50
$ 18.27
Sales journal
Arthur Baines plc
$
547.00
Emily Smith Ltd
912.50
Cratchit & Scratchit
Emily Smith Ltd
$
912.50
Cratchit & Scratchit
$
18.27
Source
documents
18.27
1 477.77
The system
General ledger
Sales
$
1 477.77
▲ Figure 1.2.2 The sales journal
28
Book of
prime entry
Note: The sales journal is
not an account; it is
only used to gain
entry into the accounts.
Sales returns journal
Sales that are not acceptable are returned by the customer and a credit note is sent to
the customer.
1.2
A copy of the credit note will be retained and this is the source document from which
the sales returns journal is prepared.
Note
» The goods that have been returned are not debited to the sales account.
» Each individual entry in the sales returns journal is posted to the credit of
the customer who returned the goods (they have ‘given’ the goods back to the
supplier).
Copy credit notes
Source document
1.2.1 The accounting system
When convenient, the list is added and the total is posted to the debit of the sales
returns account (the goods have been received). Figure 1.2.3 shows the effect of a
return from D. Jones for goods previously sold on credit for $46.
Sales returns journal
Book of
prime entry
General ledger
Sales ledger
D. Jones
$
46
Sales returns
$
D. Jones 46
The system
▲ Figure 1.2.3 The sales returns journal
Purchases journal
The purchases journal is also known as the purchases day book.
When a purchases invoice is received from a supplier of goods it shows the goods that
have been purchased and the price charged. The details are listed in the purchases
journal.
The purchases journal is a list of credit purchases made. The source documents are
the purchase invoices received.
When it is convenient (this could be daily, weekly or monthly depending on the volume
of purchases made by the business), the list of purchases is totalled and the total is
posted to the debit side of the purchases account in the general ledger because the
goods have been received.
Each individual supplier’s ledger account in the purchases ledger is credited with the
value of goods purchased (showing that the supplier has ‘given’ the goods).
29
1.2
Mary
d olightly plc
p LtP.
G
Picku
1.2 the aCCountIng system
$
Purchases ledger
Mary Pickup Ltd
$
125.70
0
125.7
Garth & Ic
$ 76.40
Geor
ge Ti
mms
Source
documents
$ 1 261.00
$ 99.1
0
Purchases journal
$
125.70
Mary Pickup Ltd
76.40
P. Golightly plc
Garth & Icks
P. Golightly plc
ks
1 261.00
George Timms
$
76.40
Book of
prime entry
99.10
1 562.20
Garth & Icks
$
1 261.00
The system
General ledger
George Timms
$
99.10
Purchases
$
1 562.20
Note: The purchases
journal is not an
account; it is used to
gain entry into
the accounts.
▲ Figure 1.2.4 The purchases journal
Purchases returns journal
Sometimes, goods that have been purchased turn out to be faulty, the wrong colour,
the wrong size or not useful in some other way. These goods will be returned to the
supplier. The supplier in due course will send a credit note.
These credit notes are the source documents from which the purchases returns
journal is prepared.
The purchases returns journal is a list of all the credit notes received from suppliers.
When it is convenient, the list is added and the total is posted to the credit of the
purchases returns account (the returns have been sent back to the supplier).
Note
» The goods that have been returned are not posted to the credit side of the
purchases account.
» Each individual entry in the purchases returns journal is then posted to the debit
of the respective supplier’s account in the purchases ledger (the suppliers receive
the goods).
30
Remember
Source document
1.2
Purchases returns journal
Book of
prime entry
Purchases ledger
General ledger
F. Bloggs
Purchases returns
$
28
$
F. Bloggs 28
The system
▲ Figure 1.2.5 The purchases returns journal
Cash book
The cash book records any transaction concerning money – both payments and receipts.
1.2.1 The accounting system
» A ledger is a book
of double-entry
accounts grouped
together according
to type of account.
» An account is part
of the double-entry
system and records
transactions of a
similar type.
» A journal is a book
of prime entry –
a place where
transactions are
recorded first before
being entered in
the double-entry
accounts.
Credit notes
You will have noticed in the section on double-entry accounts that the cash and bank
accounts were used frequently and as a result became very full with entries.
Generally, the cash and bank accounts are used more frequently than any other
accounts. This means that it is sensible to remove these two accounts from the
general ledger and keep them apart from the other accounts. The cash and bank
accounts are kept separately in one book – the cash book. The cash book is the
combination of the cash account and bank account of the business. It does not appear
in a ledger but remains a separate book of prime entry.
Because it is such an important and sensitive area of the business, all cash and bank
transactions are usually the responsibility of one senior or well-qualified person – the
cashier.
The cash book is both part of the double-entry system and also a book of prime entry
(the only book of prime entry that fulfils this dual function).
Recording cash and bank payments in a cash book
The accounts in the cash book work on double-entry principles like all other accounts.
» The debit (or receiving) side is found on the left.
» The credit (or giving) side is on the right.
The only differences in the layout of the cash book are that the debit entries are
distanced from the credit entries by extra columns and information; and that the debit
entries, generally, take up the whole of the left page while the credit entries take up
the whole of the right page.
31
The layout is the same on both sides of the cash book:
1.2
EXAMPLE
The debit side of the cash book looks like this:
Cash book
1.2 the aCCountIng system
Cash
Bank
The credit side of the cash book looks like this:
Cash book
Cash
Bank
Cash
Bank
(7)
(8)
The whole cash book looks like this:
Cash book
(1)
(2)
Cash
Bank
(3)
(4)
(5)
(6)
l Columns (1) and (5) give the date the transaction occurred.
l Columns (2) and (6) identify the account where the corresponding entry can
l
l
l
l
be found.
All cash received is entered in Column (3).
All monies paid into the business bank account are recorded in Column (4).
All cash payments made are entered in Column (7).
All payments made by cheque, electronic transfer, and so on, are recorded in
Column (8).
WORKED EXAMPLE 6
The following transactions took place in the first week of September:
September 1: paid R. Serth $34 cash
September 2: paid T. Horse $167 cash
September 3: paid V. Dole $78 cash.
Required
Enter the transactions in a cash book.
Answer
Cash book
Cash
Cr
Bank
Cash
$
32
Sep 1
R. Serth
34
Sep 2
T. Horse
167
Sep 3
V. Dole
78
Bank
WORKED EXAMPLE 7
1.2
The following transactions took place in February:
February 3: paid rent $400 by cheque
February 7: paid Gary $67 by cheque
February 9: paid wages $832 by cheque.
Answer
Cash book
Cash
Bank
Cash
Bank
$
Feb 3
Rent
400
Feb 7
Gary
67
Feb 9
Wages
832
1.2.1 The accounting system
Required
Enter the transactions in a cash book.
Recording the receipt of cash and cheques in a cash book
WORKED EXAMPLE 8
The following transactions took place during May:
May 4: cash received from Nigel $213
May 5: cash received from Harry $92
May 9: cash received from Hilary $729.
Required
Enter the transactions in a cash book.
Answer
Cash book
Cash
Bank
Cash
Bank
$
May 4
Nigel
213
May 5
Harry
92
May 9
Hilary
729
33
1.2 the aCCountIng system
1.2
WORKED EXAMPLE 9
The following transactions took place during January:
January 2: cheque received from Steve $249
January 3: cash sales banked $851
January 11: cheque received from Mustaf $29.
Required
Enter the transactions in a cash book.
Answer
Cash book
Cash
Bank
Cash
Bank
$
Jan 2
Steve
249
Jan 3
Cash sales
851
Jan 11
Mustaf
29
Once you have mastered the method of recording debit entries and credit entries, you
then need to combine the two.
WORKED EXAMPLE 10
The following transactions took place during April:
April 2: cash received from Xavier, a customer, $458
April 4: motor repairs $530 paid using cash
April 6: cash received from Milly, a customer, $77
April 7: rent $210 paid using cash
April 9: insurance premium $156 paid using cash
April 12: cash sales $743.
Required
Enter the transactions in a cash book.
Answer
Cash book
Cash
Bank
Cash
$
34
$
Apr 2
Xavier
458
Apr 4
Motor expenses
530
Apr 6
Milly
77
Apr 7
Rent
210
Apr 12
Cash sales
743
Apr 9
Insurance
156
Bank
WORKED EXAMPLE 11
1.2
Required
Enter the transactions in a cash book.
Answer
Cash book
Cash
Bank
Cash
Bank
$
$
Oct 6
Rent
450 Oct 3
Oct 9
Sales
2 187 Oct 17
Oct 11
Bliff
639
Oct 12
Box
93
Price
350
Business rates
219
1.2.1 The accounting system
The following transactions took place in October:
October 3: paid Price, a supplier, $350 by cheque
October 6: a cheque for $450 received, an overpayment of rent
October 9: takings paid into bank $2187
October 11: Bliff, a customer, paid by cheque $639
October 12: a cheque received from Box $93 paid into the bank
October 17: business rates $219 paid by cheque.
Cash payments and cash receipts are put in the same book as cheque payments and
monies paid into the bank.
WORKED EXAMPLE 12
The following transactions have taken place:
November 1: cheque from Norman, a customer, $288 paid into bank
November 2: motor expenses paid by cheque $311
November 5: Matthew draws a cheque for private use $150
November 10: cash sales $2390
November 15: motor fuel purchased with cash $42
November 21: cheque paid into bank for insurance refund $273
November 29: paid wages in cash $1309
November 30: cash sales $5630, paid directly into bank.
Required
Enter the transactions in a cash book.
Answer
Cash book
Cash
$
Nov 1
Norman
Nov 10 Sales
Nov 21 Insurance
Nov 30 Sales
Bank
$
288 Nov 2
2 390
Nov 5
Cash
Bank
$
$
Motor expenses
311
Drawings
150
273 Nov 15 Motor expenses
5 630 Nov 29 Wages
42
1 309
35
1.2 the aCCountIng system
1.2
STUDY TIP
Drawings represent
cash, inventory or
services taken out of
the business by the
owner – usually for
private use. Although
it can be seen as the
opposite of introducing
capital, there is a
separate account
maintained for any
drawings.
Source documents used to write up a cash book
The source documents used to write up a cash book are:
Debit side
Credit side
Copy receipts
Receipts
Till rolls
Cheque book counterfoils
Bank paying-in book counterfoils
A further source of information to be used to write up the cash book is a copy of the
details (recorded by the bank) of transactions made using the business bank account –
but more of this source later.
‘Balancing’ a cash book
At the end of an appropriate length of time, a cash book should be balanced. The time
when balancing takes place will generally depend on the size of the business and the
number of transactions that are included in the cash book. In effect we are balancing
two separate accounts – the cash account part of the cash book and the bank account
part of the cash book.
Both of the balances in a cash book should be verified.
» How could you verify the cash balance brought down?
» How could you verify the bank balance brought down?
The balance brought down in the cash column should agree with the cash in hand at
that date.
The bank balance in the cash book can be verified by reference to the bank statement.
The balances are brought down to start the ‘new’ time period.
A balancing figure is an amount that needs to be included in the debit side or credit
side of an account to make the debit side equal to the credit side. The amount used to
balance a cash book column is then used to ‘start’ the next time period.
Remember the cash balance will always be brought down as a debit. The bank balance
brought down could be either a debit or a credit balance.
WORKED EXAMPLE 13
The cash book of Grey is shown:
Cash book
Cash
Bank
$
Nov 1
Reid
Nov 6
Sales
Nov 8
Gong
Nov 14 Potts
Cash
$
$
1 439 Nov 4
1 270
Bank
Nov 7
Wages
Hunt
428
73
451 Nov 11 Rent
349 Nov 16 Trig
$
600
38
Required
Balance the cash and bank columns of the cash book on 16 November and carry
any balances down.
36
Answer
Always bring
balances down. This
is important, so make
sure you get in the
practice of doing so.
Cash
Bank
$
Reid
Nov 6
Sales
Nov 8
Gong
$
1 439 Nov 4
1 270
Nov 7
$
Wages
428
Hunt
73
451 Nov 11 Rent
600
349 Nov 16 Trig
STUDY TIP
Nov 16 Balances c/d
Nov 17 Balances b/d
Bank
1 270
2 239
1 159
1 211
38
1 159
1 211
1 270
2 239
Note
Make sure that all four totals are on the same line. Balance the cash columns first;
then balance the bank columns. Do not try to do them both at the same time.
1.2.1 The accounting system
Nov 1
Cash
$
Nov 14 Potts
In ledger accounts, use
‘Balance c/d’ (carried
down) for the balances
above the total. Use
‘Balance b/d’ (brought
down) for the balances
below the total.
1.2
Cash book
STUDY TIP
Contra entries in a cash book
Clearly, it is unsafe to keep large amounts of cash and cheques on the business
premises for prolonged periods of time. The cashier will arrange for the monies received
to be taken to a bank and deposited when the amount in the till or safe warrants it.
WORKED EXAMPLE 14
The following is an extract from the cash book of Grant:
Cash book
Cash Bank
Cash Bank
$
Jul 4
Cash sales
Bradley
4 397
$
Jul 5
Purchases
48
74
Grant has more than $4000 cash on his premises – this represents a security
risk. He pays $4000 into the business bank account on 5 July.
Talk yourself through this transaction.
Grant takes $4000 from the till … the cash column ‘loses’ $4000. The credit
side of the cash book will contain this entry:
Cash
Bank
$
Jul 5
Bank
4 000
Note
l the date of the transaction
l the particulars telling where the ‘corresponding’ entry is to be found (in the
bank column)
l $4000 in the cash column shows that cash has been ‘lost’.
37
1.2
Grant takes the money to the bank and the bank receives the money. The debit
side of the cash book will contain this entry:
Cash
Bank
$
1.2 the aCCountIng system
Jul 5
Cash
4 000
Note
l the date of the transaction
l the particulars telling where the ‘corresponding’ entry is to be found (in the
cash column)
l $4000 in the bank column shows that money has been received into the
bank account.
The effect on the business is the same as the effect on your finances that would occur
if you removed a five-dollar bill from one pocket and put it into another pocket.
Another common contra entry in the cash book is the withdrawal of cash from the
bank for use in the business. This transaction often occurs when cash wages need to
be paid and the business has insufficient cash in the safe to make up the necessary
wage packets. In fact, for security reasons, many larger businesses now pay wages and
salaries directly into staff bank accounts so that large amounts of cash do not need to
be transported from the bank and then kept on the business’s premises.
WORKED EXAMPLE 15
The following is an extract from the cash book of Diego:
Cash book
Cash
Bank
Cash
Bank
$
Aug 12
Robson
4 574
Aug 16
Nkomo
5 490
$
Aug 11
Machinery
2 350
Wages amounting to $4529 have to be paid in cash on 18 August. Diego
withdraws this sum from the bank on 17 August.
If we talk ourselves through the process, the entries become clear:
Diego goes to the bank and withdraws $4529.
Cash
Bank
$
Aug 17
Cash
4 529
He returns to his business premises and puts the cash in the safe:
Cash
Bank
$
Aug 17
Bank
4 529
Many larger businesses now keep a cheque payments book and a cash receipts
and lodgement book. This is certainly the case where the bulk of transactions are
conducted through the bank account.
38
Types of discounts
There are two types of discount available to businesses: trade discount and cash
discount.
1.2
EXAMPLE
A customer owes
$100.
A retailer may
indicate that if the
debt is settled before
the month end, a
cash discount of 5%
will be allowed.
The credit customer
pays before the
month end, so only
$95 needs to be paid
– $100 less $5 cash
discount.
Both the receipt
of the money and
the cash discount
are recorded by
the retailer and the
customer.
Recording cash discounts allowed
The ledger accounts necessary to record cash discount allowed to credit customers are
shown below:
WORKED EXAMPLE 16
On 1 August Yung has three credit customers. Her settlement terms allow
a cash discount of 5% to customers who settle their debts before the end of
August. (For illustrative purposes only, Yung does not keep a cash book.)
Credit customer
Amount owed
Georgi
1.2.1 The accounting system
» Trade discounts are reductions in the price of goods charged by a manufacturer
or distributor to another business. Trade discounts are not recorded in the doubleentry books of account.
» Cash discounts are a reduction in the price charged for goods when a credit
customer settles their debt within a time given by the supplier. Cash discounts
are available to encourage trade receivables to settle debts promptly. These are
recorded in the double-entry books of account.
Date of payment by cheque
$2 800 23 August
Ahmed
$80 17 September
Fatima
$360 29 August
Required
Prepare the ledger accounts to record the settling of the debts due.
Answer
Aug 1
Aug 1
Aug 1
Aug 23
Aug 29
Sep 17
Balance b/d
Sales ledger
Georgi
$
2 800 Aug 23
Balance b/d
Ahmed
$
80 Sep 17
Balance b/d
Fatima
$
360 Aug 29
Georgi
Fatima
Ahmed
Bank
Discount allowed
Bank
Bank
Discount allowed
$
2 660
140
$
80
$
342
18
General ledger
Bank account
$
2 660
342
80
39
Discount allowed account
1.2 the aCCountIng system
1.2
$
Aug 23
Georgi
140
Aug 29
Fatima
18
You can see that discount allowed is credited to the customer’s account, thus reducing
the amount to be paid in settlement. It is debited to the discount allowed account in
the general ledger. Ahmed did not qualify for a discount – he did not pay before the
end of August.
Recording cash discount received
WORKED EXAMPLE 17
Yung has three credit suppliers (trade payables) on 1 August (for illustrative
purposes only, Yung does not keep a cash book).
Supplier
Amount owed
Hameed & Co.
BTQ plc
Carot Ltd
Cash discount available if payment
made before 31 August
$
%
400
2
7 400
5
200
3
Yung settled the amounts she owed by cheque on 26 August.
Required
The ledger accounts in Yung’s books of account recording the payments made
by her.
Answer
Purchases ledger
Hameed & Co.
$
Aug 26
Bank
Discount received
392
$
Aug 1
Balance b/d
400
8
BTQ plc
$
Aug 26
Bank
Discount received
7 030
$
Aug 1
Balance b/d
7 400
370
Carot Ltd
$
Aug 26
Bank
Discount received
40
194
6
$
Aug 1
Balance b/d
200
General ledger
1.2
Bank
$
Aug 26
Hameed & Co.
BTQ plc
Carot Ltd
392
7 030
194
$
Aug 26
Hameed & Co.
BTQ plc
Carot Ltd
8
370
6
1.2.1 The accounting system
Discount received
You can see that discount received is debited to the supplier’s account, thus reducing
the amount that Yung has to pay in settlement. The discounts are credited to the
discount received account in the general ledger.
To summarise:
» Discount allowed is debited to the discount allowed account in the general ledger
and is credited to the customer’s account in the sales ledger.
» Discount received is credited to the discount received account in the general ledger
and is debited to the supplier’s account in the purchases ledger.
Entering cash discounts in the general ledger
To prepare the discount accounts in the general ledger in the way outlined above
means that all the accounts in the sales ledger must be scrutinised and all the
accounts in the purchases ledger must also be examined and lists must be made of
all the discounts allowed and discounts received in order to post them to the general
ledger. This could be a huge task. We simplify our work by adding an extra column to
those already found in the cash book.
We have already used a ‘two-column’ cash book (cash columns and bank columns). The
principles used still hold good. We introduce a third column on the debit and credit
sides for discounts, so that we now have a ‘three-column’ cash book.
The three-column cash book headings look like this:
Discounts Cash Bank
allowed
Discounts Cash Bank
received
The discount columns are memorandum columns only; they record the discounts but
are not yet part of the double-entry system. This is a much more efficient way of
collecting the information necessary to write up the discount accounts in the general
ledger rather than examining every account in the sales ledger and every account in
the purchases ledger.
41
1.2 the aCCountIng system
1.2
The entries to record the previous transactions in Yung’s cash book would look
like this:
EXAMPLE
Aug 23
Aug 29
Sep 17
Geogi
Fatima
Ahmed
Balance c/d
Discount
$
140
18
Cash
158
Cash book
Bank
$
2 660
Aug 26
342
80
4 534
7 616
Sep 18
Hameed & Co.
BTQ plc
Carot Ltd
Discount
$
8
370
6
Cash
384
Balance b/d
Bank
$
392
7 030
194
7 616
4 534
The cash and bank columns in the cash book are balanced as they were in the cash
book of Grey earlier in this chapter.
Note
» It is important to note that the discount columns are totalled. They are not compared
and balanced since there is no connection between the entries in the two columns. One
column refers to customers’ accounts; the other column refers to suppliers’ accounts.
» The discount columns are memorandum columns only – they are not part of the
double-entry system.
The totals of the discount columns are then posted to the respective discount allowed
and discount received accounts in the general ledger.
The purchases ledger accounts and the sales ledger accounts are the same as
previously shown. However, the discount accounts would look like this.
EXAMPLE
General ledger
Discount allowed
$
Sep 17
Cash book
158
Discount received
$
Sep 17
Cash book
384
Note
» The totals are used; the individual discounts are not shown.
» Notice also that two separate accounts are used.
General journal
Most business transactions typically involve the purchase and sale of goods and
their respective returns or a movement in money, either as cash or involving a bank
transaction. Each type of transaction is recorded in the appropriate book of prime
entry: credit sales and purchases, their respective returns and payments and receipts
of money – either as cash or through the business bank account. However, there are
some transactions that could not be categorised and recorded in the books of prime
entry covered so far.
42
The general journal is used to record transactions that are not covered by the other
five books of prime entry. These, by definition, are likely to be transactions that will
not occur frequently.
1.2
There is no stipulation for what counts as a general journal transaction other than it is
one that does not meet the requirements for entry into the other books of prime entry.
The layout of the general journal is different from the other day books covered so far.
EXAMPLE
Debit
The date of the
entries
The account to
be debited
Credit
Amount to be
debited
The account to
be credited
Amount to be
credited
A description of why the transaction was necessary (the narrative)
1.2.1 The accounting system
General journal
After the two entries have been entered in the general journal, an explanation of why
the transaction was necessary is required. This is referred to as the narrative.
The general journal can be used for any transaction not covered by the other books of
prime entry, but is often used to record:
» the purchase or sale of non-current assets on credit
» the transactions of a business start-up (i.e. the ledger account entries when a
business begins)
» the transactions required to record the closing down of a business
» correction of errors
» inter-ledger transfers
» conversion of a business to a different type of legal structure.
Source documents will provide information for making entries in the general journal.
For purchases and sales of non-current assets on credit, invoices can still be used.
However, there are other types of source documents that will provide information and
these will be covered as we progress through the textbook.
WORKED EXAMPLE 18
On 23 April 2021, Tamara purchased on credit an xtr/397 machine from Dextel
and Co. for $12 600.
Required
Prepare the entry in Tamara’s general journal to record the transaction.
Answer
General journal
2021
Apr 23
Machinery account
Dextel Ltd
Debit
Credit
$
$
12 600
12 600
Purchase of Machine xtr/397 on credit from Dextel Ltd
Remember the use of the narrative explaining why entries in the ledgers are necessary.
43
WORKED EXAMPLE 19
1.2
On 6 September 2021, Hussain sold vehicle P341 FTX to Greg’s garage for $230.
Greg will settle the debt on 31 October 2021.
Required
Prepare the entry in Hussain’s general journal to record the transaction.
1.2 the aCCountIng system
Answer
General journal
2021
Sep 6
Greg’s garage
Debit
Credit
$
$
230
Vehicles disposal account
230
Sale of vehicle P341 FTX on credit to Greg’s garage
WORKED EXAMPLE 20
Marlene started in business on 1 January 2021 by paying $14 000 into her
business bank account.
STUDY TIP
If you find it difficult
to prepare journal
entries, try to prepare
‘T’ accounts as you did
in Section 1.2.1. Then
from the accounts
prepare the journal.
In reality, the journal
should be done first as
it is the book of prime
entry.
Required
Prepare the entry in Marlene’s general journal to record the transaction.
Answer
General journal
2021
Jan 1
Bank account
Debit
Credit
$
$
14 000
Capital account
14 000
Capital introduced by Marlene in the form of money into the business bank account
WORKED EXAMPLE 21
On 2 August 2021, Jared purchases, on credit, a new machine for his business
costing $5400 from Factre Ltd.
Required
Prepare the entries in Jared’s general journal to record the transaction.
Workings
If you are unsure how to tackle this question, prepare the ‘T’ accounts.
Jared gains a machine. Factre Ltd ‘loses’ the machine.
Machinery
44
Factre Ltd
$
$
5 400
5 400
Which account has been debited? Which account has been credited?
1.2
If you can do this, then you can prepare the general journal.
Answer
General journal
2021
Machinery account
Credit
$
$
5 400
Factre Ltd
5 400
Purchase of new machine on credit from Factre Ltd
Preparation of ledger accounts
Making detailed entries in ledger accounts
Up to now, we have used ‘T’ accounts to record the two sides of a transaction. This is
useful and it will give us the information that we require. However, it would be more
useful if the ‘T’ accounts gave us more details of each transaction.
1.2.1 The accounting system
Aug 2
Debit
» It would be useful to know when the transaction took place.
» It would also be useful to be able to follow the whole transaction through to its
completion, especially when a problem occurs in the system.
These problems are rectified as follows.
Each entry should be preceded by:
» the date of the transaction
» a description stating where the corresponding entry can be located
Entries in the ledger account for sales and purchases may look like the examples
shown below.
A credit sale is made on 7 April to Rogers for $217.
The transaction took place on 7 April. The debit entry is made in the account of
Rogers, who now owes the business $217 for the sale made to him.
Rogers
$
Apr 7
Sales
$
217
The ‘opposite’ entry (the credit entry) is in the sales account:
Sales
$
$
Apr 7
Rogers
217
45
Credit purchases are made on 12 September from Joffer for $416.
The transaction took place on 12 September. The debit entry is made in the account of
Purchases as the business has gained the asset of inventory at a cost of $416.
1.2
Purchases
$
1.2 the aCCountIng system
Sep 12
Joffer
$
416
The ‘opposite’ entry (the credit entry) is in the account of Joffer as the business now
owes Joffer the total of $416 in respect of purchases made on credit.
Joffer
$
$
Sep 12
STUDY TIP
When preparing a
ledger account, you
must ensure you
include all the details.
However, when you are
working things out, you
may use ‘T’ accounts
because this is faster.
STUDY TIP
Try jotting down
your workings using
‘T’ accounts. When you
gain confidence in their
use you will find that
you can use them as
a revision tool and for
solving problems.
416
Using the books of prime entry
The information shown in ledger accounts is derived from one of the books of
prime entry.
WORKED EXAMPLE 22
The following transactions took place during the first week in October:
1 1 October: purchased goods for resale on credit from Arkimed plc $120
2 1 October: sold goods on credit to Morris & Co. $600
3 2 October: purchased vehicle on credit from Pooley Motors plc $17 400
4 4 October: sold goods on credit to Nelson plc $315
5 4 October: purchased goods for resale on credit from Bjorn & Co. $450
6 4 October: purchased goods for resale on credit from Darth & Son $170
7 7 October: sold goods on credit to Olivia Ltd $1340
8 7 October: returned damaged goods $38 to Arkimed plc
9 7 October: purchased goods for resale on credit from Charlene $320.
Required
a Identify the source document that has been used in each case to write up the
book of prime entry.
b Write up the appropriate books of prime entry.
c Enter the transactions in each ledger account.
Answer
a Purchase invoices:
Transactions 1, 3, 5, 6, 9
Copy sales invoices: Transactions 2, 4, 7
Credit note:
46
Purchases
Transaction 8
Purchases journal
b
1.2
$
Oct 1
Arkimed plc
120
Oct 4
Bjorn & Co.
450
Oct 7
Darth & Son
170
Charlene
320
1.2.1 The accounting system
1 060
Sales journal
Oct 1
Oct 4
Oct 7
Morris & Co.
Nelson plc
Olivia Ltd
$
600
315
1 340
2 255
Purchases returns journal
$
Oct 7
Arkimed
38
General journal
Oct 2
Vehicles
Dr
Cr
$
$
17 400
Pooley Mtrs plc
17 400
Purchase of vehicle from Pooley Motors plc
c
Oct 7
Purchases returns
Purchases ledger
Arkimed plc
$
38 Oct 1
Purchases
$
120
Bjorn & Co.
Oct 4
Purchases
$
450
Purchases
$
170
Purchases
$
320
Darth & Son
Oct 4
Charlene
Oct 7
47
Sales
Sales ledger
Morris & Co.
$
600
Sales
Nelson plc
$
315
Sales
Olivia Ltd
$
1 340
1.2
Oct 1
1.2 the aCCountIng system
Oct 4
Oct 7
Oct 7
Sundry trade
payables
General ledger
Purchases
$
1 060
Sales
$
Oct 7
Sundry trade
receivables
2 255
Purchases returns
$
Oct 7
Oct 2
Pooley Motors plc
Sundry trade
payables
38
Vehicles
$
17 400
Pooley Motors plc
Oct 2
Vehicles
$
17 400
The cash book is a book of prime entry. It contains the business cash account and the
business bank account.
WORKED EXAMPLE 23
The following transactions took place during December:
1 December: paid rent using cash $250
2 December: paid insurance by bank transfer $110
6 December: paid wages using cash $1782
13 December: paid wages using cash $1780
17 December: paid insurance premium by cheque $240
20 December: paid wages using cash $1780
48
27 December: paid wages using cash $1781
1.2
31 December: paid rent by bank transfer $250.
Required
Enter the transactions in an appropriate book of prime entry.
Answer
Cash
Bank
Cash
Bank
$
$
$
$
Dec 1
Rent
250
Dec 2
Insurance
Dec 6
Wages
1 782
Dec 13
Wages
1 780
Dec 17
Insurance
Dec 20
Wages
1 780
Dec 27
Wages
1 781
Dec 31
Rent
110
240
1.2.1 The accounting system
Cash book
250
Entering transactions in the books of prime entry and then the ledgers requires care
and precision. An entry is made in the books of prime entry followed by the correct
double entry in the ledger accounts.
Balancing a ledger account
We have seen that every time we make a debit entry into our double-entry system we
must also make a credit entry. If we follow this rule, then the total of all debit entries
in the system must equal the sum of all credit entries.
A trial balance is a summary of all the entries in the double-entry system. It checks
that each transaction has been entered once on the debit side of an account and once
on the credit side of another account.
WORKED EXAMPLE 24
STUDY TIP
Cash
The cash and bank
columns of the cash
book are balanced
in the same way that
ledger accounts are
balanced.
$
Sales
23 Purchases
Rent received
41
Capital
16
$
45
The debit side of the account adds to $80.
The credit side adds to $45.
To make the account balance we need to insert $35 into the credit side. This is
shown as the balancing figure (balance c/d).
49
The account now looks like this:
1.2
Cash
$
$
Sales
23 Purchases
45
Rent received
41 Balance c/d
35
Capital
16
1.2 the aCCountIng system
80
80
The account balances.
This process makes it look as though the debit entries were exactly the same
amounts as the credit entries, but this is not true.
The debit side totalled $35 more than the credit side. We need to reflect this
when we start the account again. We carry the balance down.
We start anew with an opening balance of $35 on the debit side:
Cash
$
$
Sales
23 Purchases
45
Rent received
41 Balance c/d
35
Capital
16
80
Balance b/d
80
35
The rules of double-entry are that for every debit entry in the system there must be a
corresponding credit entry. We have done just that. We inserted a credit entry to make
the account balance.
Our debit entry starts us off again:
WORKED EXAMPLE 25
The following accounts are given:
Romir
$
$
Sales
23 Cash
21
Sales
44 Sales returns
12
Cash
15
Dickins
$
Cash
Discounts received
Purchases returns
$
23 Purchases
45
9 Purchases
60
20
Plunkett
$
Sales
50
109 Cash
Sales
27
Sales
18
$
99
Required
Balance the accounts and carry down any balances.
1.2
Answer
Romir
$
$
23 Cash
21
Sales
44 Sales returns
12
Cash
15
Balance c/d
19
67
Balance b/d
67
19
Dickins
$
Cash
Discounts received
$
23 Purchases
45
9 Purchases
60
Purchases returns
20
Balance c/d
53
105
1.2.1 The accounting system
Sales
105
Balance b/d
53
Plunkett
$
Sales
109 Cash
Sales
27 Balance c/d
Sales
18
154
Balance b/d
$
99
55
154
55
When a balance is described as a debit balance or a credit balance, we are
describing the balance required to start the account in the next time period; the
balance that has been brought down.
In the example above:
l Romir’s account has a debit balance of $19
l Dickins’s account has a credit balance of $53
l Plunkett’s account has a debit balance of $55.
The purpose of a trial balance
The purpose of a trial balance is to check the accuracy of the double entry in the
ledgers. A list of all the balances extracted from the ledgers is prepared by balancing
all the ledger accounts and carrying down any outstanding balances on each account.
All the debit balances are listed under a column headed debit and each credit balance
is listed in a column headed credit.
51
1.2
The debit column is totalled; the credit column is totalled. The two columns should
have the same total. This list is called a trial balance.
If we extract a trial balance, and the two sides total to the same figure, we can say
with some certainty that every debit has a corresponding credit.
1.2 the aCCountIng system
If the trial balance totals do not agree, then we can say with some certainty that
there are some errors in the double-entry system.
Here are a couple of simple double-entry examples using ‘T’ accounts, followed by a
very simple trial balance.
WORKED EXAMPLE 26
The following transactions are for Geraint’s business:
1 Geraint purchased goods for resale $153 from Buvcu on credit.
2 He sold goods $29 to Sangita on credit.
3 Geraint sold goods for cash $296.
4 He paid motor expenses $68 paying cash.
Required
Enter the transactions in Geraint’s ledger. Carry down any balances and check
the accuracy of the entries by extracting a trial balance.
Answer
Purchases
$
153
Buvcu
$
153
Sales
$
29
296
Cash
$
296
Purchases
$
68
Trial balance
Debit
$
153
Buvcu
Sales
Sangita
Cash
Motor expenses
29
228
68
478
Sangita
$
29
Motor expenses
$
68
Credit
$
The account shows a debit balance; the
trial balance shows a debit balance.
153 The account shows a credit balance; the
trial balance shows a credit balance.
325 Sales have credit entries totalling $325;
the trial balance shows this balance.
The account shows a debit balance; the
trial balance shows a debit balance.
The debit side is greater; the trial balance
shows the debit balancing figure.
The account shows a debit balance; the
trial balance shows a debit balance.
478
The trial balance has shown that we have entered our transactions correctly.
52
WORKED EXAMPLE 27
1.2
The following accounts have been extracted from a ledger:
Cash
Bank
$
$
$
42
100
365
534
534
458
912
141
12
Rent
1.2.1 The accounting system
$
69
Wages
$
$
100
458
Sales
Purchases
$
$
42
141
365
69
912
12
Required
Balance the ledger accounts. Carry down any balances and extract a trial
balance to check the accuracy of the entries in the ledger.
Answer
Cash
Bank
$
$
$
$
42
100
365
534
534
458
912
141
576
12
69
6
533
576
6
1 277
533
Rent
Wages
$
$
100
458
Sales
$
1 319
1 319
1 277
Purchases
$
$
$
42
141
365
69
912
12
222
1 319
222
222
1 319
222
53
Trial balance
1.2 the aCCountIng system
1.2
Debit
Credit
$
$
Cash
6
Bank
533
Rent
100
Wages
458
Sales
Purchases
1 319
222
1 319
1 319
A trial balance is made up of the balances extracted from the ledger. It summarises
the balances in all the ledgers.
If you consider the few trial balances that have been prepared a pattern has started to
emerge.
Debit balances
» Assets are always debit balances. Examples in the worked example above are cash
and bank balances (an asset).
» Expenses are always debit balances. Examples above are the balance on the rent
account; the balance on the wages account; the balance on the purchases account.
STUDY TIP
You can learn where
balances are entered
on a trial balance by
using a mnemonic.
For example: Do All
Elephants Chase Large
Italian Buffaloes.
Perhaps you can devise
your own mnemonics
to help you remember
key facts.
Credit balances
» Incomes and benefits are always credit balances. An example above is the balance
on the sales account.
» Liabilities are always credit balances. From the first worked example, an example is
the trade payable (credit supplier) named Bucvu.
A trial balance will show balances thus:
Debit balances
Credit balances
Assets
Liabilities
Expenses
Incomes
WORKED EXAMPLE 28
The following is a list of account headings found in Tayyiba’s ledger.
Place a tick in the appropriate columns to show the category into which each item
falls. Indicate whether a balance on the account would appear in the debit or credit
column of her trial balance.
Account name
Wages
Premises
Biko, a credit supplier
Advertising
Sales
Bank overdraft
54
Asset
Expense
Liability
Income
Debit
Credit
Answer
l
l
l
l
l
l
1.2
Wages: Expense/Debit
Premises: Asset/Debit
Biko: Liability/Credit
Advertising: Expense/Debit
Sales: Income/Credit
Bank overdraft: Liability/Credit
The following balances have been extracted from the ledgers of Laksumana on
30 April 2021:
buildings $120 000; fixtures and fittings $45 000; van $14 500; motor expenses
$4160; rent $7000; business rates $2400; insurance $2100; cash in hand $120;
balance at bank $3670; trade receivables $850; trade payables $1200; sales
$260 000; purchases $140 000; capital $78 600.
1.2.1 The accounting system
WORKED EXAMPLE 29
Required
Prepare a trial balance at 30 April 2021 for Laksumana.
Answer
Laksumana
Trial balance at 30 April 2021
Debit
$
Buildings
120 000
Fixtures and Fittings
45 000
Van
14 500
Rent
7 000
Business rates
2 400
Insurance
2 100
Motor expenses
4 160
Cash in hand
120
Balance at bank
3 670
Trade receivables
850
Trade payables
Sales
Purchases
140 000
Capital
339 800
Credit
$
1 200
260 000
78 600
339 800
Note
» The debit and credit column totals are the same. So we can say with some certainty
that whoever did the double-entry book-keeping probably made a debit entry for
every credit entry. (‘Probably’ means that there could be some missing debit and/or
credits of the same total value – these are known as compensating errors, which
will be discussed later.)
» The debit column of the trial balance contains only assets and expenses; the credit
column of the trial balance contains only liabilities and incomes or benefits.
55
Uses of the trial balance
The trial balance has only one function and that is to check the arithmetic accuracy of
the double-entry system.
1.2
Another use of the trial balance is to assist with the production of the financial
statements of the business – the statement of profit or loss and the statement of
financial position.
1.2 the aCCountIng system
Learning link
See Section 1.4.2.for
more on the six types
of error.
Limitations of using a trial balance as a control system
The trial balance has certain limitations. Even if the trial balance totals do agree, that
is no guarantee that there are no mistakes in the system. There are six types of errors
that can be made that would not necessarily stop the trial balance totals from agreeing.
The advantages and disadvantages of maintaining full
accounting records
It is possible to calculate the profits (or losses) of a business without keeping
full accounting records. This approach is more likely to be popular with very small
organisations (such as clubs and other charities). However, there are a number of
limitations in relying on not maintaining a full set of records (or, as some organisations
do, maintaining only incomplete records):
» Any expenditure that only appears in the cash book of the business will not normally
show the separation of expenditure on day-to-day running expenses and expenditure
on assets. This is an important distinction, for when a business wants to calculate
the level of profit for the period, assets would not normally be deducted as expenses.
» The double-entry bookkeeping system has a number of built-in checks, making it
easier to spot mistakes (though mistakes still occur). Single-entry bookkeeping and
incomplete records have no self-checking mechanism.
» Attempting to control the level of expenditure requires detailed records of where
a business spends money. This is not easy unless there are separate records (i.e.
separate ledger accounts) maintained for each type of expense.
» A lack of full accounting records makes theft from the business by employees more
likely. Obviously, a one-person organisation will not face this problem.
In reality, the tax authorities of a national government will probably want more
detailed record keeping. There is no statutory requirement that sole traders or
partnerships should maintain a full set of accounting records. However, to satisfy the
authorities, most traders do keep a record of all cash and bank transactions. They
also keep all source documents received and copies of those sent, including purchases
invoices, copies of sales invoices, bank statements, cheque book counterfoils, paying
in counterfoils, till rolls, invoices from the utilities (gas, electricity, water), and so on.
The accounting concepts underpinning the preparation
of accounts
Over the years, accounting has evolved rules that all accountants use when preparing
the financial statements of a business. These rules are referred to as accounting
concepts or accounting principles. Some of these principles are enshrined in law
and also in International Financial Reporting Standards (IFRS) and International
Accounting Standards (IAS) laid down by major accounting bodies.
The application of these rules by all accountants means that the users of the financial
statements can rely on the information they contain, safe in the knowledge that a set
of financial statements prepared in Kingston, Kuala Lumpur, Karachi or Kalol for any
type of business have been prepared using the same ground rules.
The concepts are an important topic: they underpin all of the work done by
accountants. Make sure that you are familiar with them.
56
Business entity
The concept of the business entity states that only the expenses and revenues
relating to the business are recorded in the business books of account. Transactions
involving the private affairs of the owner are not part of the business and should not
be included in the business books.
1.2
The owner’s private electricity bills or private food bills should not be included as
business expenditure.
Historic cost
Traditionally, financial statements have been prepared using historic cost. This means
that all income, expenditure, assets and liabilities are recorded at the price paid for
them at the date of the transaction. Unfortunately, as time goes by, the value of
assets is understated and profits are overstated, especially in times of inflation.
Some of the advantages of using historic cost are that it is:
»
»
»
»
»
objective
easily understood
easily applied to the double-entry system
easy for external auditors to verify all transactions
recognised by tax authorities.
1.2.1 The accounting system
If the business cheque book is used to pay the proprietor’s private mortgage payments
the amount should be included in the drawings account.
Some of the disadvantages of using historic cost include:
» overstated profits due to failure to adjust for increased costs of replacing
inventory or replacement of non-current assets
» understatement of non-current asset values, hence understatement of capital
employed (this can be overcome by revaluing the assets).
Property, plant and equipment should be valued at cost in a statement of financial
position. Cost includes the actual purchase price plus all other costs involved in
bringing the asset to the location where it is to be used together with costs of making
sure that the asset can perform its intended use. The asset is shown at historical
cost less accumulated depreciation. Non-current assets may be shown on a statement
of financial position at a revalued amount if the fair value can be measured reliably.
The company must revalue all assets in a particular class. If a company has seven
different factories, it cannot revalue just one of those factories. Future depreciation is
calculated and provided on the revalued amount.
Money measurement
Only transactions that can be measured in monetary terms should be included in the
business books of account. It is extremely difficult to put a value on:
»
»
»
»
managerial efficiency and expertise
the skill and efficiency of the workforce
good customer relations
good after-sales service.
Going concern
Unless we have knowledge to the contrary, we assume that the business will continue to
trade in its present form for the foreseeable future. This means that we value all business
assets at cost, not at what they would fetch if sold (but see IAS 16 in Chapter 3.2). If the
business is going to continue, the assets will not be sold so sale value is irrelevant.
International Accounting Standard 1 (IAS 1) names the going concern concept as a
fundamental accounting concept.
57
Consistency
The concept of consistency requires that once a method of treating information has
been established the method should continue to be used in subsequent years’ financial
statements.
1.2
The application of this concept can be seen in Chapter 1.3 when methods of providing
for depreciation of non-current assets are considered.
1.2 the aCCountIng system
If information is treated differently each year then inter-year results cannot be
compared. Trends cannot be determined.
Prudence
Prudence requires that revenues and profits are only included in the accounts when
they are realised or their realisation is reasonably certain. This prevents profits
from being overstated. If year end gross profit is overstated, then the profit for the
year will also be overstated. If profits are overstated, a trader may withdraw more
resources (money and goods) from the business than is wise.
This could lead to a position where assets could not be replaced when necessary or
that trade payables could not be paid when due. However, the concept of prudence
allows provision to be made for all known expenses or losses when they become
known. For example, if damages were awarded against the business in a court case,
the business could make a provision on the estimated amount that it might have to
pay out in compensation.
Realisation
EXAMPLE
Fiona is an engineer.
She is fairly certain
that, in July, Jack will
sign a contract to
purchase machinery
valued at $18 000.
The $18 000 should
not be included in
Fiona’s financial
statements until the
title to the machinery
has passed to Jack.
The realisation concept states that profits are normally recognised when the title to
the goods passes to the customer, not necessarily when money changes hands. This
concept is an extension of the matching/accruals concept (see page 59).
When goods are sent to a customer on sale or return, a sale does not take place until
the potential customer indicates that they wish to purchase the goods. Goods sent on
a sale or return basis remain as inventory in the ‘sender’s’ books of account.
Duality
Every financial transaction has a twofold effect on the position of the business as
recorded in the books of account. The assets of a business are always equal to the
liabilities. This effect is recognisable in the accounting equation (see Section 1.2.1)
and in the double-entry book-keeping system. For example, when an asset is
purchased either another asset is reduced or a liability is incurred.
Materiality
The concept of materiality recognises that some types of expenditure are less
important in a business context than others. So, absolute precision in the recording of
these transactions is not absolutely essential. However, if the inclusion or exclusion of
information in a financial statement would mislead the users of that information, then
the information is material.
To spend much time in deciding how to treat a transaction of little consequence in the
financial statements is detrimental to the well-being of the business – it would be a
waste of time and resources.
Capital expenditure is spending on non-current assets or their improvement. Revenue
expenditure is spending on the normal running costs of a business. Non-current assets
are used in a business for more than one accounting year. If we apply the matching
concept we should spread the cost of a non-current asset over the years it is used to
generate the profits.
58
EXAMPLE
A business purchases a ruler. The ruler costs
$0.45. It estimated that the ruler should last for
three years. Technically, the ruler is a non-current
asset and should therefore be classified as capital
expenditure. To do this would be rather silly for
such a trivial amount. The $0.45 would be treated as
revenue expenditure and would be debited to either
general expenses or office expenses.
This treatment is not going to have a significant
impact on profits or the valuation of capital on
a statement of financial position – the absolute
accuracy of its treatment is not material.
The matching/accruals
concept underpins
many concepts
covered in the
calculation of profits
and construction of
financial statements.
It is important that accounting transactions and accounting records are based on
objective, verifiable information that can be checked as actually occurring rather than
subjective interpretation. Any subjective value provided by anyone connected to the
business may well be biased and not provide a realistic account of the transaction.
Some estimates are allowable, such as estimating the number of years of an asset’s life
for the purpose of calculating the annual depreciation or deciding whether an item of
expenditure is material or not, but where objective values exist, these should be used.
1.2.1 The accounting system
Objectivity
STUDY TIP
1.2
Matching/Accruals
The matching concept is sometimes known as the accruals concept.
As accountants, we are concerned with the value of resources used by the business
and the benefits derived from the use of those resources by the business in any one
financial year. The value of the resources used in any year may be different from the
price paid to acquire the resources.
WORKED EXAMPLE 30
Juanita has a financial year end on 31 December 2021. The following amounts
have been paid during the year ended 31 December 2021:
$
Wages
48 000
Rent
5 500
Business rates
1 800
Insurance
2 100
Motor expenses
14 300
l Wages due to workers for work completed in the week 24–31 December
l
l
l
l
2021, but unpaid, amount to $970.
Rent $500, for December 2021, was paid on 19 January 2022.
Business rates have been paid for the period ending 31 March 2022. $450
relates to 1 January – 31 March 2022.
Insurance includes a premium $300 for the period 1 January – 28 February
2022.
Motor expenses do not include $236 paid on 27 January 2022 for a vehicle
service completed on 15 December 2021.
Required
Calculate the amounts to be included in a statement of profit or loss for the year
ended 31 December 2021 in respect of wages, rent, business rates, insurance
and motor expenses.
59
Answer
1.2
l Wages: $48 970
Juanita has used $48 970 skills and expertise of her workers during the year
even though she has only paid them $48 000.
l Rent: $6000
1.2 the aCCountIng system
Juanita has had the use of premises worth $6000 to her; even though she
had only paid $5500.
l Business rates: $1350
STUDY TIP
Accruals is used in
two separate ways –
as a concept (here)
and also to refer to
amounts unpaid but
owing as explained in
Chapter 1.5.
Juanita has used local government facilities valued at $1350 for the year.
She has also paid $450 for the use of facilities in the following year – we are
not, at the moment, interested in the figures relating to next year.
l Insurance: $1800
The payment of $2100 includes $300 for insurance cover next year. This
means that only $1800 refers to this year.
l Motor expenses: $14 536
The service was completed in the year ended 31 December 2021 even though
it was not paid for until the following year.
Substance over form
This principle ensures that financial statements observe the commercial substance
of transactions rather than just their legal form. In most transactions commercial
substance is the same as the legal form, but occasionally the accounting treatment
is not a true reflection of the legal position.
For example, when a non-current asset is purchased using hire purchase, the asset
legally remains the property of the seller until the final instalment has been paid.
However, from a business accounting point of view, the asset can be regarded as
belonging to the purchaser. This means it will appear as an asset on the statement of
financial position.
The use of computerised accounting systems in recording
financial transactions
The business world is becoming increasingly competitive with each passing year and
changing at a pace never before seen. Businesses today are competing in a global
economy and to cope with these pressures managers need to take full advantage of all
aspects of information technology. It has been said that ‘information is one of the
most important resources’ that managers have. This information includes records of the
activities of all stakeholders – customers, suppliers and staff – and how the business
deals with them through its activities that involve inventory, payroll, etc. Customers
and suppliers expect a business to be efficient. Managers need to react to stakeholder
requirements quickly and efficiently, so reaction time is of the essence. Information
technology (IT) makes relevant and detailed data available at the click of a mouse.
Nearly all managers of businesses that use a double-entry system of recording
financial transactions will use a computer in some, if not all, parts of their business.
As the use of computers has increased in all kinds and sizes of business, the use of
handwritten entries in the accounting system has steadily decreased; paper documents
have given way to onscreen documents and computer printouts.
The underlying system of accounting remains unaltered but the speed at which
information is processed and made available to users has greatly increased. In any
accounting system all transactions have a ‘knock on effect’; all transactions are
interrelated and interdependent and an efficient computerised accounting system will
provide useful feedback to management and staff.
60
A good IT system of computerised accounting will allow all levels of management to:
»
»
»
»
create plans
put those plans into practice
control activities
evaluate outcomes so that adjustments to the business can be made and any errors
can be rectified quickly.
Spreadsheets
A spreadsheet is a table of cells (boxes) arranged in rows and columns in which text
and figures are entered. The computer works out any calculations that need to be
made. Managers and staff at all levels can use spreadsheets for a variety of tasks.
The major advantage of using a spreadsheet is that if any figures are adjusted all other
figures affected are changed automatically. For example, ‘What would happen to all
other parts of the business if sales were to increase by seven per cent?’ Changing this
one variable would stimulate automatic recalculation of changes in all related areas.
1.2.1 The accounting system
A computerised accounting system provides managers with instant and up-to-date
reliable information in real time that can be used to plan and control the business,
allowing prompt decision-making. Information obtained from the computerised
accounting system can be used to help guide and control business policy.
1.2
The advantages and disadvantages of introducing
a computerised accounting system
Senior managers
Senior managers use the accounting information for strategic planning purposes. They
will use the system to access regular updated trial balances, statements of profit or
loss and statements of financial position, enabling them to see whether strategic
plans are on track or if adjustments need to be made. They can also make use of
budgeting programs which allow them to consider ‘what if …’ changes to strategy.
A computerised system with its automatic updating of all records means that all
general ledger accounts show the current position, enabling managers to judge
whether strategic goals are being achieved. If they are not, then modifications to
strategy can take place very quickly.
Quick access to general ledger accounts makes changes to asset management (both
non-current and liquid) more appropriate in a fast-changing economic climate. The
progress of individual projects is easily monitored. Senior management can use
spreadsheets to prepare strategic budgets and to prepare statements of profit or loss
and statements of financial position, etc.
Middle managers
Middle managers use the computerised accounting system to control the business
and ensure that the business as a whole is achieving the goals that will contribute to
and help achieve overall strategic goals. They will use the system to monitor trade
receivables and inventories and to gain up-to-date information regarding all aspects
of human resource management, including payroll and vacation times. All aspects of
the business bank account are readily available, including receipts from customers and
payments to settle trade payables. Information regarding the computerised accounting
system’s compliance with IASs can be programmed into the system. Spreadsheets can
be used for monitoring cash flow forecasts, enabling overdraft facilities to be arranged
if necessary, while payroll issues can also be resolved by use of spreadsheets.
Administrative staff
Administrative staff will use a computerised system to record all accounting methods
used and to enable instant scrutiny of any part of the accounting system. Spreadsheets
can be used to produce invoices, calculate costs and prepare customer quotes, etc.
61
Advantages of introducing a computerised accounting system
1.2 the aCCountIng system
1.2
» Speed: Data entry into the system can be carried out much more quickly than
if done manually. One entry can be processed into a multitude of different areas.
For example, one entry can be made that will simultaneously update a customer’s
account, sales account in the general ledger and inventory records.
» Accuracy: Provided that the original entry is correct there are fewer areas where
an error can be made since only one entry is necessary to provide the data that
is replicated throughout the system.
» Automatic document production: Fast and accurate invoices and credit notes are
produced and processed in the appropriate sections of the system.
» Availability of information: Accounting records are automatically updated once
information is keyed in. This information is then readily available to anyone within
the organisation who requires it.
» Taxation returns: Information required by tax authorities is available at the touch
of a button.
» Legibility: Data are always legible, whether shown on screen or as a printout. This
reduces the possibility of errors caused by poor handwriting.
» Efficiency: Time saved may mean that staff resources can be put to better use in
other areas of the business.
» Staff motivation: Since staff require training to acquire the necessary skills to
use a computerised accounting system, their career and promotion prospects are
enhanced, both within their current role and for future employment. Some staff
may benefit from increased responsibility, job satisfaction and pay.
Disadvantages of introducing a computerised accounting system
» Hardware costs: The initial costs of installing a computerised accounting system
can be expensive. Once the decision has been made to install a system, the
hardware will inevitably need to be updated and replaced on a regular basis,
leading to further costs.
» Software costs: Accounting software needs to be kept up to date. Investment in
software therefore requires a long-term financial commitment.
» Staff training: Staff will need training to use the software and training updates
each time the system is modified.
» Opposition from staff: Some staff may feel demotivated at the prospect of using
a computerised system. Other members of staff may fear that the introduction of
a new system will lead to staff redundancies, which could include them. Changing
to a computerised system can cause disruption in the workplace and changes to
existing working practices may make staff feel uneasy.
» Inputting errors: Staff can become complacent because inputting into the system
becomes more repetitive and therefore they may lose concentration which can lead
to input errors.
» Damage to health: There are many cases of reported health hazards to staff
working long hours at a computer terminal. The health issues range from repetitive
strain injuries through to backache and headaches.
» Back-up requirements: All work entered into the computerised accounting system
must be backed up regularly in case there is a failure of the system. Much work
has to be printed out on paper as a back-up, so hard copies might require further
expenditure on secure storage facilities.
» Security breaches: There is always a chance of a breach in security – where an
unauthorised person or organisation accesses the information that is meant to
be stored securely. This may be part of an attempt to commit fraud or to access
confidential information. This clearly is not a desirable state and measures must be
taken to minimise this risk.
62
The ways in which the security of data can be ensured
within a computerised accounting system
As mentioned, there is a risk of unauthorised access to the information stored
electronically. Some might argue that a computerised system makes staff fraud simpler
to achieve. A computer system that communicates with outside agencies such as
customers, suppliers and government agencies means there is always the danger of
infection from software viruses.
To prevent this from occurring, an organisation must ensure that it uses robust anti-virus
protection and firewalls will need to be put in place to protect sensitive and important
data. It should store only data that is necessary to store – this is based on changes in
legislation – and irrelevant personal data should never be stored by an organisation.
1.2.1 The accounting system
There are a number of things that can be done to ensure that no one accesses
confidential data. A system of passwords will ensure that only those with the ‘correct’
level of access can view data. Data encryption will be important as well to ensure
that sensitive information cannot be leaked outside the business (or to those within
who are not allowed to access the data). Clearly, there are risks that data might be
accessed by those looking to profit from the confidential information.
1.2
EVALUATION
A partnership consists of three partners who have been
in business together for more than ten years. They
are considering expanding the business by opening
up separate offices – each managed by one partner in
other parts of the country. Until now, they have always
maintained handwritten accounting records. One of
the partners believes that they should now purchase
software that would enable them to computerise their
accounting records. The other partner disagrees.
Which partner would you agree with?
A strong answer is likely to include:
l The move to different offices – which are not
nearby – is likely to support the need for using
software, as remote access is likely to be
necessary for each partner to see other parts of
the business.
l An expanding business will be generating an
increase in the number of the transactions. Using
software makes it easier to maintain the increase
in volume of records needed.
However, there are potential difficulties and
problems in such a decision:
l There is a risk of a security breach – this is unlikely
to be between each partner given how long they
have worked together (though not impossible), but
having new locations and potential new employees
may make a security breach more likely.
l The cost of an investment may be high – but
if the business is expanding then this may be
affordable.
Overall, it is probably a wise decision given that
most businesses will be moving to computerise
their records (if they have yet to do so). An expanding
business might find it increasingly difficult to
maintain written records.
SUMMARY
After reading this chapter, you should:
» know how to record transactions in the doubleentry accounts
» understand the benefits of maintaining a doubleentry system compared with a single-entry
accounting system
» understand the systems used to record different
categories of transactions
» be able to make entries into books of prime entry
» be able to prepare and maintain a cash book –
including the recording of discounts
» know how to balance off ledger accounts and
produce a trial balance
» understand the benefits of preparing a trial
balance as well as its limitations
» know about the concepts that set out the
guidelines (and rules) for how accounts are to be
maintained
» understand the case for and against using
computer software to maintain accounting
records.
63
SELF-TEST QUESTIONS
1.2
1 Define the term ‘account’.
2 In which account would goods purchased for resale be entered?
1.2 the aCCountIng system
3 Denzil pays the rent on his factory with $300 cash. The entries to record this
transaction are debit rent account $300; credit cash account $300. True/False?
4 Bradley pays the telephone bill $120 cash. The entries to record this transaction
are debit cash account $120; credit telephone account $120. True/False?
5 What is meant by the term ‘liability’?
6 What is meant by the term ‘trade payables’?
7 What is meant by the term ‘trade receivables’?
8 In which column would a cash sale be entered?
9 Explain the term ‘cash discount’.
10 Explain the term ‘trade discount’.
11 Name the source document used to prepare the purchases journal.
12 Name the source document used to prepare the sales returns journal.
13 Which two accounts are prepared from the entries in the purchases returns
journal?
14 How is trade discount entered in the books of prime entry?
15 The debit side of a ledger account totals $242; the credit side totals $200. What is
the balance on the account?
16 In which ledger would you expect to find the account of Gisele, a supplier of goods
on credit?
17 Lopez says, ‘If we delay paying $45 000 for the purchase of a non-current asset
until a couple of weeks after our financial year-end our recorded profits will
increase by that amount.’ Is Lopez correct in his treatment of the purchase?
18 Why is there a need to be consistent in the treatment of accounting information?
Calculation questions (answers on page 494)
19 Credit purchases of $400 are made from Foster, who allows a trade discount of
10% and a 5% cash discount if payment is made within two weeks. If payment is
made within two weeks, calculate the amount the business should pay Foster in
full settlement.
20 The following items were taken from a trial balance:
Capital
$45 000
Drawings
$18 000
Machinery
$9 000
Sales
$26 000
Purchases
$15 700
Bank overdraft
$2 400
Calculate the total of the debit balances from these entries.
64
1.3
Accounting for non-current assets
By the end of this chapter you should have an understanding of:
l the difference between the treatment of capital and revenue income and
capital and revenue expenditure
l the effect on profit/loss and asset value of the incorrect treatment of capital
and revenue expenditure
l factors that cause the value of non-current assets to depreciate
l the purpose of accounting for depreciation of non-current assets and the
associated application of relevant accounting concepts
l how to calculate depreciation using the reducing balance and straight-line
methods
l the most appropriate method of calculating depreciation
l how to measure the value of non-current assets by the cost model or the
revaluation model
l how to prepare ledger accounts and journal entries for non-current assets,
depreciation and disposal
l how to calculate profit or loss on disposal of a non-current asset
l how to record the effect of a charge for depreciation in the statement of profit
or loss and statement of financial position.
1.3.1 Capital and revenue income and expenditure
Learning outcomes
Introduction
All businesses spend money. However, the types of spending undertaken by
businesses need to be considered carefully. A distinction is made between
spending on ‘running’ the business on a daily basis and spending on long-term
items that will add value to the business.
When calculating profits, we normally only subtract from the income the
expenditure on those costs incurred in running the business. However, the
expenditure on adding value to the business must still be accounted for and this
is done through the process of depreciation. Treatment of incomes follows the
same logic, as well as what happens if a business chooses to sell a non-current
asset. These topics are covered in this chapter.
1.3.1 Capital and revenue income and expenditure
The difference between the treatment of capital and revenue
income, and capital and revenue expenditure
A business purchases resources to be used in the generation of profits. Some of the
resources are used up in one year.
» Goods purchased for resale will be used in one year.
» Petrol purchased for a delivery vehicle will be used in one year.
» The work provided by staff is used in one year.
65
Each of the expenses described here can be classified as revenue expenditure. The
benefits derived from revenue expenditure will be earned in the year and the expense
is entered in the statement of profit or loss for the year in question.
1.3
Other resources will be used over a number of years. These are non-current assets. Just
like the resources listed above, a non-current asset is an item that has been purchased
by a business in order to generate profits for the business. However, a non-current
asset will be used by the business for more than one financial year. Non-current assets
will yield benefits to the business over a prolonged period of time.
1.3 aCCountIng for non-Current assets
» Premises will be used for more than one year.
» A delivery van will be used for more than one year.
» Machinery will be used for more than one year.
Expenditure on non-current assets, such as those items listed here, is classified
as capital expenditure. Since the benefits derived from capital expenditure will
continue to be earned over a number of years it seems sensible to charge part of the
cost of the non-current assets over those years.
Revenues and expenses are recorded in nominal accounts in the general ledger.
Non-current assets are recorded in real accounts in the general ledger.
Capital and revenue income
Incomes can be classified in the same way as expenditure. Capital receipts and
capital income are those that are not generated for a particular period of time
(this means they are ‘one-off’ incomes rather than incomes being earned for a
particular period of trading). Examples of capital receipts would include:
Remember
Although it includes
the word ‘revenue’,
revenue expenditure
still involves spending
money, not receiving it!
» income generated from sales of non-current assets
» income from share issues
» income from loans taken by the business.
Revenue incomes and revenue receipts are the incomes received by the organisation
that belong to a particular period of time. Sales income (of goods or services produced
by the organisation) would be the main example of revenue income. Other examples of
revenue income would include rent received and commission received.
The effect on profit/loss and asset value of the incorrect
treatment of capital and revenue expenditure
Mistaken classification of expenditure – either capital or revenue expenditure – can
occur and will potentially impact on the following:
» Profit calculations will be incorrect – the reported profits will be higher or lower
than the correct value.
» Asset values will be incorrect – and the statement of financial position will not be
correct – though it may still balance.
Learning link
Errors of principle are
covered in Section 1.4.2.
For example, if a purchase of a motor vehicle to be used within the business is treated
as revenue expenditure then revenue expenditure will be higher than the correct level.
This means reported profits will be lower than expected. Furthermore, the value of
non-current assets will be lower on the statement of financial position. This mistaken
classification of expenditure is known as an error of principle.
1.3.2 Changing asset values
We know that capital expenditure involves the purchase of non-current assets, such
as premises, plant, machinery and equipment. It also includes any associated costs,
66
Learning link
The statement of
financial position is
covered in Chapter 1.5.
such as delivery or installation charges that are connected with getting the asset
ready for use.
Non-current assets are likely to be used within the business for a long period of
time (at least beyond the end of the current financial year). They will appear on the
statement of financial position (covered later). However, one of the issues we need
to deal with first is how to value these non-current assets.
1.3
All non-current assets (except land) have a finite life. The UK Companies Act 1985 says
that all assets with a finite life should be depreciated.
Of course, land should not be depreciated, because land has an infinite life.
So, the total cost of a non-current asset is never charged to the statement of profit or
loss for the year in which it was purchased. The cost is spread over all the years that it
is used in order to reflect in the statement of profit or loss the cost of using the asset
in that particular financial year.
WORKED
EXAMPLE 1
Donna purchased a
non-current asset for
$20 000. She sold it
three years later for
$2 000.
Required
Calculate the cost
of using the asset
(the amount of
depreciation) for the
three years.
Answer
The cost of using the
non-current asset
(i.e. the depreciation)
is $18 000 ($20 000 –
$2000).
When a non-current asset is purchased and later sold, the amount that is not
recovered is called depreciation.
1.3.2 Changing asset values
» A machine will eventually cease to produce the goods for which it was purchased.
» A delivery vehicle will eventually cease to be useful for the delivery of goods.
This means that the actual depreciation can only be accurately calculated when the
non-current asset is no longer being used.
The annual depreciation charge is therefore an estimate made based on experience.
If we know the cost and can make an estimate of how long the non-current asset will
be useful and how much it might be worth at the end of its life, we can calculate the
amount of depreciation that will take place over the lifetime of the non-current asset.
We need to apportion this lifetime cost into each of the years that the non-current
asset was used.
Factors that cause the value of non-current assets
to depreciate
When determining the useful life of a non-current asset the following factors should
be considered:
» physical deterioration based on expected wear and tear: this will depend on the
type of use that the asset is employed in, how well the asset is maintained and
how well any repairs are carried out
» economic factors such as the necessary output and the potential capacity of
the asset
» the introduction of new technology making the asset obsolete
» obsolescence due to a change in demand for the product the asset produces
» a change in demand which makes the asset incapable of producing the quantity
(or quality) of product required
» the age of the asset
» legal or other limits placed on the asset; for example, when an asset is acquired
under a leasing agreement the lessor may place restrictions on the use of the asset.
There are many methods of dividing the lifetime depreciation charge. We shall
consider the following three methods:
» straight-line method
» reducing balance method
» revaluation method.
67
When a method of calculating the provision for depreciation has been decided upon,
it should be used consistently so that the results shown in the financial statements
of different years can be compared.
1.3
1.3 aCCountIng for non-Current assets
The purpose of accounting for depreciation of non-current
assets and the associated application of relevant accounting
concepts
Through the process of charging depreciation each year for a non-current asset, we
will also change the value of the non-current asset on the statement of financial
position. The net value of these assets will be gradually reduced each year by the
charge made for deprecation in that period.
In this way, the depreciation charge means the asset’s value is more realistic – as its
value will fall over the lifetime of the non-current asset. This can be seen as a further
application of the prudence concept (where we do not overstate the value of assets
held by the business).
Learning link
The prudence and
matching/accruals
concepts were covered
earlier in Section 1.2.1.
Depreciation can also be linked to the matching/accruals concept. If the business
benefits from the use of a non-current asset over a number of years then it makes
sense that the cost of the asset is matched (the accruals concept) to when the
business benefits from the asset’s use. For example, if a machine is purchased for
$25 000 and it is expected to be used within the business for five years, it may seem
reasonable to spread the cost of this depreciation by charging $5 000 to the statement
of profit or loss for each of the five years of the asset’s life.
How to calculate depreciation using the reducing balance
and straight-line methods
There are two main methods we will use to calculate the amount of depreciation. Here
we will explore each method and how depreciation is calculated.
The straight-line method of depreciating non-current assets
The straight-line method requires that the same amount is charged annually to the
statement of profit or loss over the lifetime of a non-current asset.
To calculate depreciation using the straight-line method it is therefore necessary
to consider:
» the cost of the non-current asset
» the estimated life of the non-current asset
» the estimated residual value or scrap value.
Annual depreciation charge =
Cost of non-current asset – Any residual value
Estimate of number of years’ use
If we know the life of an asset we can calculate the annual rate of depreciation
(assuming no residual value).
» If an asset has an expected life of ten years, the annual rate of depreciation would
be ten per cent (100 per cent divided by ten years).
» If an asset has an expected life of 50 years, the annual rate of depreciation would
be two per cent (100 per cent divided by 50 years).
» If an asset has an expected life of two years, the annual rate of depreciation would
be 50 per cent (100 per cent divided by two years).
68
WORKED EXAMPLE 2
A computer is purchased for $2300. Its useful life is expected to be two years,
after which it will be replaced. It is expected that it will have a trade-in value of
$100.
1.3
Required
Calculate the annual depreciation charge using the straight-line method.
Annual depreciation charge = $1100.
Workings
Cost of computer – Residual value
=
Estimated years of use
$2 300 – $100
2
The provision for depreciation account is found in the general ledger.
I know that my car is depreciating (a known expense) but I cannot tell you exactly the
amount of annual depreciation. I will only be able to give you a realistic figure in the
future when I change my car.
1.3.2 Changing asset values
Answer
We have just seen how to calculate depreciation. How is the charge entered in the
double-entry system?
Entry on the statement
of profit or loss
Credit provision for depreciation account
WORKED EXAMPLE 3
Tanya purchases a delivery van for $18 000 on 1 January 2021 on credit from
MCL Motors Ltd. She will use the van for four years, after which she estimates
she will be able to sell the van for $6 000.
Tanya’s financial year end is 31 December.
Required
Prepare:
a
b
c
d
the delivery van account
the provision for depreciation account
the statement of profit or loss extracts to record the necessary entries
the statement of financial position extracts for the four years.
Answer
Delivery van
a
$
2021
Jan 1
Bank
18 000
69
1.3
b
Provision for depreciation on delivery van
$ 2021
2021
Dec 31
Balance c/d
3 000 Dec 31
$
Statement of
profit or loss
3 000
2022
1.3 aCCountIng for non-Current assets
Dec 31
3 000
2022
Balance c/d
6 000 Jan 1
Dec 31
Balance b/d
3 000
Statement of
profit or loss
3 000
6 000
2023
Dec 31
6 000
2023
Balance c/d
9 000 Jan 1
Dec 31
Balance b/d
6 000
Statement of
profit or loss
3 000
9 000
2024
Dec 31
3 000
9 000
2024
Balance c/d
12 000 Jan 1
Dec 31
Balance b/d
Statement of
profit or loss
12 000
9 000
3 000
12 000
2025
Jan 1
c
Balance b/d
12 000
Extract from statement of profit or loss for the year ended 31 December 2021
$
Less Expenses
Provision for depreciation of delivery van
3 000
Extract from statement of profit or loss for the year ended 31 December 2022
$
Less Expenses
Provision for depreciation of delivery van
3 000
Extract from statement of profit or loss for the year ended 31 December 2023
$
Less Expenses
Provision for depreciation of delivery van
3 000
Extract from statement of profit or loss for the year ended 31 December 2024
$
Less Expenses
Provision for depreciation of delivery van
70
3 000
d
Extract from statement of financial position at 31 December 2021
1.3
$
Non-current asset
Delivery van at cost
18 000
Less Accumulated depreciation
3 000
15 000
1.3.2 Changing asset values
Extract from statement of financial position at 31 December 2022
$
Non-current asset
Delivery van at cost
18 000
Less Accumulated depreciation
6 000
12 000
Extract from statement of financial position at 31 December 2023
$
Non-current asset
Delivery van at cost
18 000
Less Accumulated depreciation
9 000
9 000
Extract from statement of financial position at 31 December 2024
$
Non-current asset
Delivery van at cost
18 000
Less Accumulated depreciation
12 000
6 000
Remember
The books of prime
entry are the places
where accounting
transactions are initially
recorded – they are not
accounts.
Note the following:
» the double entries – debit entry in the statement of profit or loss; credit the
provision for depreciation account
» the equal instalments in each year’s statement of profit or loss
» the delivery van is entered in the statement of financial position at cost
» the accumulated depreciation is taken from the non-current asset in the statement
of financial position
» the total shown at the end of each year in the statement of financial position for
the delivery van is the net book value.
The entries for depreciation would also appear in the general journal. The entries for
the first year of the asset’s life (the purchase of the asset and its depreciation) would
appear as follows:
Journal entries for the year ended 31 December 2021
For the purchase of the asset:
Delivery van
MCL Motors Ltd
Dr
Cr
$
$
18 000
18 000
Delivery van purchased on credit
71
For the depreciation of the asset:
1.3
Statement of profit or loss
3 000
Provision for depreciation – delivery van
3 000
Depreciation charge for the year ended 31 December 2021
There would be further entries in the journal for each subsequent year’s depreciation.
1.3 aCCountIng for non-Current assets
The reducing balance method of depreciating non-current assets
A fixed percentage is applied to the cost of the non-current asset in the first year of
ownership. The same percentage is applied in subsequent years to the net book value
of the asset.
WORKED EXAMPLE 4
A vehicle was purchased for $18 000 on 1 January 2021. Depreciation is to be
provided at the rate of 40% per annum using the reducing balance method.
Required
a Calculate the annual charge for depreciation in the years ended 31 December
2021, 2022 and 2023.
b Prepare journal entries for the years 2022 and 2023 to show the entries in
the double-entry system.
Answer
a
Workings
Year 2021
$7 200
($18 000 × 40%)
Year 2022
$4 320
($18 000 – $7 200) × 40%
Year 2023
$2 592
($18 000 – $7 200 – $4 320) × 40%
b Journal entries for the year ended 31 December 2022:
Statement of profit or loss
Debit
Credit
$
$
4 320
Provision for depreciation of vehicles
4 320
Depreciation charge for vehicles for the year ended 31 December 2022
Journal entries for the year ended 31 December 2023:
Statement of profit or loss
Debit
Credit
$
$
2 592
Provision for depreciation of vehicles
2 592
Depreciation charge for vehicles for the year ended 31 December 2023
The provision for depreciation account will look very similar no matter which method
is used; only the annual charge entered in the statement of profit or loss will change.
72
WORKED EXAMPLE 5
1.3
Steig Wallander purchased a machine on 1 January 2021 for $64 000.
Depreciation is to be charged at 20% per annum using the reducing balance
method.
Steig’s financial year end is 31 December.
Required
Answer
a
Machinery
1.3.2 Changing asset values
Prepare:
a a machinery account
b a provision for depreciation of machinery account
c statement of profit or loss extracts to record the necessary entries
d extracts from the statements of financial position for the three years 2021,
2022 and 2023.
$
2021
Jan 1
Bank
b
64 000
Provision for depreciation of machinery
$ 2021
2021
Dec 31
Balance c/d
12 800 Dec 31
$
Statement of
profit or loss
12 800
2022
Dec 31
2022
Balance c/d
23 040 Jan 1
Dec 31
Balance b/d
12 800
Statement of
profit or loss
10 240
23 040
2023
Dec 31
12 800
12 800
23 040
2023
Balance c/d
31 232 Jan 1
Dec 31
Balance b/d
23 040
Statement of
profit or loss
8 192
31 232
31 232
2024
Jan 1
c
Balance b/d
31 232
Extract from statement of profit or loss for the year ended 31 December 2021
$
Gross profit
Less Expenses
Provision for depreciation of machinery
12 800
Extract from statement of profit or loss for the year ended 31 December 2022
Gross profit
$
Less Expenses
Provision for depreciation of machinery
10 240
73
Extract from statement of profit or loss for the year ended 31 December 2023
1.3
$
Gross profit
Less Expenses
Provision for depreciation of machinery
d
8 192
Extract from statement of financial position at 31 December 2021
1.3 aCCountIng for non-Current assets
Non-current asset
$
Machinery at cost
64 000
Less Accumulated depreciation
12 800
51 200
Extract from statement of financial position at 31 December 2022
$
Non-current asset
Machinery at cost
64 000
Less Accumulated depreciation
23 040
40 960
Extract from statement of financial position at 31 December 2023
$
Non-current asset
Machinery at cost
64 000
Less Accumulated depreciation
31 232
32 768
The most appropriate method of calculating depreciation
Given there are two methods available (and other methods not featured on this
course do exist), a business should ensure it chooses the most appropriate method for
calculating depreciation.
The method chosen should match how the business expects to use the asset. If the
main period of use for the asset is likely to be earlier in the asset’s lifespan, then it
would make sense to provide for more depreciation in the earlier years of its life. In
this case, the reducing balance method would be the most appropriate. This would
also closely follow the actual value of some types of non-current assets. Vehicles, for
example, lose most of their value in the first few years of the vehicle’s lifespan. In
later years, the vehicle will still lose value but not as much as in previous years.
For some assets, the business will use them at a fairly constant rate or at a rate that is
not significantly different year-on-year. In this case, the straight-line method may be the
most appropriate. This also happens to be the simplest method of depreciation available
and, perhaps by no coincidence, is the most popular method selected in most countries.
How to measure the value of non-current assets
by the cost model or the revaluation model
The accounting standard that refers to depreciation is IAS 16. This standard allows
two approaches to depreciation. We have so far covered one of the allowable
approaches known as the ‘cost model’ of depreciation. This is where the asset is valued
at its historical (initial) cost less accumulated depreciation.
However, there is another allowable method for depreciation known as the revaluation
model.
74
The revaluation method of depreciating non-current assets
The revaluation method is generally used where the asset is made up of many small
items.
1.3
An example could be the small tools that are used on a regular basis in a large auto
repair business or in an engineering works. Clearly, it would be inappropriate to use
either of the two methods of providing for depreciation previously described on
a hammer that cost $4.50 or on a pair of wire cutters costing $4.75, so these are
collectively known as ‘loose tools‘.
Individually, these items are small and might seem to be insignificant, but they are
non-current assets because they are to be used for more than one financial year.
Examples of assets depreciated using this method could include crockery and cutlery,
books and other small value groups of assets.
In order to calculate the depreciation provision in such cases, the following
calculation is necessary:
Value placed on the items at the start of the financial year
1.3.2 Changing asset values
You can imagine the amount of time that would be taken up if each small tool was
entered in the general ledger and depreciated separately at the end of each year.
plus any purchases of more items during the year
less the value placed on the items at the end of the year
equals depreciation for the year.
WORKED EXAMPLE 6
The managers of Redjor Engineering Works valued loose tools on 1 January
2021 at $2190. During the year more tools costing $930 were purchased.
On 31 December 2021 the managers valued loose tools at $2400.
Required
Calculate the depreciation of loose tools for the year ended 31 December 2021.
Answer
$
Value of loose tools at 1 January 2021
Remember
The revaluation method
of depreciation is not
the same as when
a limited company
decides to revalue
(increase in value) its
non-current assets
– this is covered in
Section 1.5.4.
Plus Additions during the year
2 190
930
3 120
Less Value of loose tools at 31 December 2021
Depreciation for the year
2 400
720
For this business, the depreciation would appear as a charge in the manufacturing
account (covered in Section 3.1.4).
The value at the end of the year of $2400 is shown as the net book value for the
non-current asset on the statement of financial position at 31 December 2021.
The revaluation method is likely to be the most appropriate method when the
assets consist of many small value items that individually are immaterial in terms
of providing an estimated value for each single one.
75
How to prepare ledger accounts and journal entries
1.3
The recording of non-current assets being purchased and their revaluation were
covered in earlier sections.
1.3 aCCountIng for non-Current assets
Depreciation and disposal including entries for part exchange are covered in the
following section.
How to calculate profit or loss on disposal
of a non-current asset
You will have noticed that the word ‘expected’ has been used quite freely in the
discussion so far. The owner of a business tries to guess how many years a non-current
asset will be used and how much cash will be received when the asset is sold when it
is no longer of any use.
When an asset is sold it is highly unlikely that the sum received will be the same
as the net book value. It is likely that a profit or loss based on the net book value
will arise.
WORKED EXAMPLE 7
A machine which cost $32 000 five years ago has been sold for $14 000. The
accumulated depreciation was $15 000.
Required
Calculate the profit or loss arising from the disposal of the machine.
Answer
$
Machine at cost
Accumulated depreciation
32 000 The cost of the machine
(15 000) less accumulated depreciation
Net book value
17 000 gives the net value recorded in the ledger.
Sale proceeds
14 000 The cash received from the sale
Loss on disposal
3 000 is less than the value shown in the ledger, hence
the loss on disposal.
WORKED EXAMPLE 8
A machine which cost $18 000 ten years ago has been sold for $1500. The
accumulated (total) depreciation was $17 000.
Required
Calculate the profit or loss on disposal.
Answer
$
Machine at cost
Accumulated depreciation
(17 000) less accumulated depreciation
Net book value
1 000 gives the net value recorded in the ledger.
Sale proceeds
1 500 The cash received from the sale
Profit on disposal
76
18 000 The cost of the machine
500 is more than the value shown in the ledger,
hence the profit on disposal
The ledger accounts used to record the disposal of non-current assets
The following procedure should be followed when ledger accounts are required to
record the disposal of a non-current asset. The disposal account should be named after
the asset being disposed of. For example, the sale of machinery would be recorded in
the disposal of machinery account or machinery disposal account.
Open an account in the general ledger headed ‘disposal
account’.
2
Debit the disposal account with the cost of the asset.
Credit the asset account.
3
Debit the provision for depreciation account.
Credit the disposal account.
4
Debit the cash account with the cash received for sale.
Credit the disposal account.
5
Debit the disposal account with loss on disposal. OR
Credit the disposal account
with profit.
WORKED EXAMPLE 9
Mmasekgoa provides the following information from her general ledger:
1.3.2 Changing asset values
1
1.3
Machinery
2020
Apr 1 Balance b/d
$
66 000
Provision for depreciation of machinery
$
2020
Apr 1 Balance b/d
43 000
In January 2021, Mmasekgoa sold a machine for $3 000 cash. She has entered
the cash received in the cash book but has made no other entries in the ledger.
The machine had cost $18 000 some years ago. The accumulated depreciation
relating to the machine amounted to $16 500.
Required
a Prepare the journal entries to record the sale of the machine.
b Prepare the disposal account.
Answer
a
General journal
Debit
$
18 000
Credit
$
Disposal of machinery account
Machinery account
18 000
Transfer of machinery to disposal account
Provision for depreciation of machinery account
16 500
Disposal of machinery account
16 500
Depreciation relating to the machine being sold transferred to disposal account
Cash account*
3 000
Disposal account
Cash received for sale of machine
Disposal of machinery account
1 500
Statement of profit or loss
Profit on disposal of machine transferred to statement of profit or loss
3 000
1 500
77
1.3
1.3 aCCountIng for non-Current assets
Remember
Disposal of a noncurrent asset does not
mean it is discarded but
that it will no longer
be used for business
activities.
STUDY TIP
Accounting for part
exchange of noncurrent assets is very
similar to standard
asset disposal covered
earlier.
* Cash entries should not really be shown in the general journal. The cash book is
the book of prime entry that is used for all transactions using cash.
b
Disposal of machinery
$
$
Machinery
18 000 Provision for depreciation of
16 500
Statement of profit or loss
1 500 machinery
Cash
3 000
19 500
19 500
Part exchange of non-current assets
A non-current asset may be replaced by a part exchange. This is where a new asset is
acquired and the ‘old’ asset being replaced is accepted as part payment for the new
asset, i.e. the old one is ‘traded-in’.
I recently purchased a new delivery van for $14 000. The garage took my old delivery
van in part exchange. They made an allowance on my old van of $6500. I paid $7500
cash for the new van. The garage actually bought my old van from me for $6500 –
this, together with my payment of $7500, made up the total purchase price.
WORKED EXAMPLE 10
Alessandro purchased a delivery van registration number DQ13 costing $19 000.
The new van replaced vehicle B19, which cost $11 500 a number of years ago.
The accumulated depreciation on B19 amounted to $9000.
The garage gave an allowance of $2750 on B19; the balance due was paid by
cheque.
Required
Prepare the ledger accounts to record the purchase of the new van.
Answer
Provision for depreciation
on van B19
Van B19
$
Balance b/d 11 500
$
Disposal
11 500
$
Disposal
Van B19 disposal
$
Van
Statement
of profit or
loss
11 500
250
11 750
78
9 000
$
Balance b/d
Van DQ13
$
Provision for
depreciation
9 000
Van DQ13
2 750
11 750
$
Disposal
Bank
2 750
16 250
9 000
The journal entries for this example would be as follows:
1.3
Part exchange of van (B19) in respect of new van (DQ13)
Journal entries
Van B19 Disposal
Debit
Credit
$
$
11 500
Van B19
11 500
Provision for depreciation on van B19
9 000
Van B19 Disposal
9 000
Closing off account for depreciation of ‘old’ van
Van DQ13
2 750
Van B19 Disposal
2 750
STUDY TIP
Part exchange on old van – amount put towards new van
The procedure is very
similar to that used
when a non-current
asset is purchased for
cash only. The only
difference is that the
new non-current asset
is debited with any
allowance being made
by the supplier and
the disposal account
is credited with the
allowance.
Van B19 Disposal
250
Statement of profit or loss
1.3.2 Changing asset values
Van disposal – closing off account of ‘old’ van
250
Profit on part exchange of old van
Van DQ13
16 250
Bank
16 250
Payment made for new van (*)
Note
* Technically, this entry would be in the cash book but is grouped here for
convenience.
How to record the effect of a charge for depreciation
in the statement of profit or loss and statement
of financial position
In the examples used earlier in this chapter, we saw that charging for depreciation
affects both the statement of profit or loss and also the statement of financial
position.
In general terms, charging for depreciation has the following effects:
STUDY TIP
When dealing
with provisions or
allowances, it is the
change in its size
that is entered in the
statement of profit or
loss, but the full value
is subtracted from the
asset on the statement
of financial position.
Financial statement
Effect of depreciation
Statement of profit
or loss
That year’s depreciation appears as an expense in the statement
of profit or loss and therefore will reduce the profit (or increase
the loss) for the business for that year.
Statement of
financial position
The accumulated depreciation (including the current year’s
depreciation) is subtracted from the relevant ‘asset at cost’
balance – this value is known as the net book value.
The balance on the provision for depreciation account will increase
each successive year. This means the net book value will get
smaller over time.
79
1.3 aCCountIng for non-Current assets
1.3
SUMMARY
After reading this chapter you should:
» know how to classify expenditure and income
between capital and revenue
» determine the effects of incorrect classification of
expenditure and income
» know the methods of depreciation used for noncurrent assets
» calculate depreciation values and enter these into
the ledger accounts and journal
» calculate the profit or loss on asset disposal (or
part exchange of an asset)
» understand the effects of depreciation on the
financial statements.
SELF-TEST QUESTIONS
1 Why is it important to classify expenses into capital expenditure and revenue
expenditure?
2 Give an example of capital expenditure that could be incurred by a food shop.
3 Explain what is meant by the term ‘revenue expenditure’.
4 Identify two factors that cause a non-current asset to depreciate.
5 In which type of account would you expect to find non-current assets?
6 A second-hand vehicle is purchased. Because the previous owner charged
depreciation on the vehicle, the new owner does not need to. True/False?
7 A reducing balance method of providing for depreciation of non-current assets is
more realistic than the straight-line method. True/False?
8 What are the double entries to record the provision for depreciation using a
reducing balance method?
9 Define depreciation.
10 Name two methods of calculating annual depreciation.
11 What are the book-keeping entries required to record the annual charge for
depreciation?
12 What is meant by the term ‘accumulated depreciation’?
13 What is meant by the term ‘net book value’?
14 An asset with a net book value of $4000 is sold for $3800. Calculate the profit or
loss on disposal.
Calculation questions (answers on page 494)
15 A van is bought for $25 000 and is expected to last for 6 years. It can be traded in
at the end of its life for $4 000. If straight-line depreciation is the chosen method,
calculate the yearly depreciation on this van.
16 A machine is bought for $12 000 and is depreciated using reducing balance at
a rate of 25%. If the van is sold exactly 2 years after its purchase for $5 000,
calculate the profit or loss on its disposal.
80
1.4
Reconciliation and verification
By the end of this chapter you should have an understanding of:
l reconciliation and verification of ledger accounts
l the need to reconcile and verify ledger accounts using documentation from
internal and external sources
l the benefits and limitations of reconciliation and verification procedures
l errors that do and do not affect the trial balance
l how to prepare ledger accounts and journal entries to correct errors using a
suspense account
l the effect on the financial statements of the correction of errors
l the benefits and limitations of a trial balance
l how to prepare bank reconciliation statements
l the benefits and limitations of preparing a bank reconciliation statement
l updating of cash books
l entries in control accounts
l sales ledger control accounts and purchases ledger control accounts
l reconciliation statements between control account balances and ledger
balances
l the benefits and limitations of control accounts.
1.4.1 Reconciliation and verification
Learning outcomes
Introduction
Once a business grows, the number of financial transactions recorded will grow
as well. This increases the chances of errors being made. Locating these errors
is vital and it is important that they are found and corrected as soon as possible.
In this chapter, we will explore the systems that are in place to both check for
errors and locate the errors. Once any error has been discovered processes and
new techniques are used to correct them.
1.4.1 Reconciliation and verification
The need to reconcile and verify ledger accounts using
documentation from internal and external sources
As we saw in Chapter 1.2, the trial balance provides an arithmetic check on the
double-entry system of ledger accounts. We know that if the trial balance fails to
agree (the debit and credit columns do not give the same totals as each other) then
mistakes are present in the accounts.
For a small business, locating an error may be a minor inconvenience. For a larger
business, locating an error (and there may be more than one) can be very timeconsuming indeed. To help speed up the process of finding errors, there are a number
of additional checks that can be used to identify where the error may be located.
81
The techniques covered in this chapter provide a verification of the figures and totals
appearing in the accounts, i.e. they help to confirm they are accurate. The techniques
can also be used to reconcile why figures may be different – differences may exist
that are not the result of errors being made. The sources of information used to check
for and locate errors will be from within the accounting systems used by the business
(internal sources), such as the books of prime entry, as well as from the double-entry
accounts. This may also involve use of source documentation (e.g. invoices, and so
on), some of which will be external to the business (i.e. from outside, such as bank
statements, invoices received and credit notes issued to the business).
1.4 reConCIlIatIon and verIfICatIon
1.4
The benefits and limitations of reconciliation and verification
procedures
The benefits of the reconciliation and verification techniques used are largely two-fold:
» They help to ensure that accounts and the financial statements that are produced
based on the accounts are error-free. This means those groups using the financial
statements can be confident that the financial statements are based on realistic
information.
» The techniques help speed up the location of any errors that are present in the
account system.
Learning link
The trial balance used
to provide an arithmetic
check on the ledger
accounts will later be
used to produce the
financial statements
of the business (see
Chapter 1.5).
These techniques and systems are potentially time-consuming. However, one may
argue that overall they provide a saving of time given that they are more likely to
locate an error sooner rather than later.
1.4.2 Trial balance
The trial balance was originally covered in Chapter 1.2. If the totals of the debit and
credit columns disagree (i.e. are not the same) then errors will exist in the ledger
accounts. However, you may recall that even if the totals of the debit and credit
columns agree (i.e. they are the same figure) then there may still be errors present.
Errors that affect the trial balance
As stated above, a trial balance that ‘agrees’ can indicate that there are no errors
present in the double-entry system of ledger accounts.
If the totals of a trial balance disagree, you must run through a few checks in order to
see that you have not made a simple error:
1 Check that you have added the debit column correctly and also that you have
added the credit column correctly.
2 Check that there are lots more entries in the debit column than there are in the
credit column. The debit column should only contain assets and expenses. The
credit column should only contain liabilities and incomes or benefits.
3 If you cannot find the error, look at the totals. If the total of the debit column is
smaller than the total of the credit column, check that you have not missed a debit
balance. If the credit column total is the smaller of the two, check that you have
not missed a credit balance.
4 If the error has not been found by going through the three previous points,
divide the difference in the totals by two. Then look to see if an asset has been
incorrectly placed in the credit column or if a liability has been placed in the debit
column; items in the incorrect column will double the mistake.
5 If you divide the difference in trial balance totals by nine and your answer is a
whole number, then the error could be what is known as a transposition error, for
82
example $123 entered as $132 would give a difference in the trial balance totals
of nine; $96 written as $69 would cause a difference in trial balance totals of 27,
which is divisible by nine.
1.4
In general, a trial balance that fails to agree is likely to have been caused by one or
more of the following:
Try using a mnemonic
to help you remember
facts. You could
remember the types of
errors as ‘CROPOC’ – a
letter for each type of
error:
Commission
Reversal
Omission
Principle
Original entry
Compensating
Action will need to be taken to deal with a trial balance that fails to agree. This will
be covered shortly. However, even if the trial balance totals agree, errors may still be
present.
Errors that do not affect the trial balance
As mentioned, even if the trial balance totals agree, errors may still be present.
There are six types of errors that are not revealed by extracting a trial balance:
1 errors of commission
2 reversal of entries
3 errors of omission
4 errors of principle
5 errors of original entry
6 compensating errors.
It is essential that you learn the names of these errors.
STUDY TIP
Commission
Errors of commission
commonly happen with
entries in personal
accounts – especially
if the names of
customers or suppliers
are very similar.
Errors of commission arise when the correct amount is entered on the correct side of
the wrong account. The two accounts are of the same class; for example, if $600 rent
was paid by cheque and the motor expenses account was debited with $600, the error
would not be revealed by the trial balance. It is common for the error of commission
to involve personal accounts, for example, entering in the wrong customer or supplier’s
accounts.
1.4.2 Trial balance
STUDY TIP
» a debit or credit entry (but not both) being missed out
» different amounts being entered for each half of the double entry
» two debits or two credits being entered for a transaction, rather than one of each.
Reversal
This occurs when the correct figures are used but both entries are entered on the
wrong side of the accounts used.
For example, if $70 of goods were purchased from P. Smith and P. Smith’s account in
the purchases ledger was debited with $70, and the purchases account in the general
ledger was credited with $70, a trial balance would still balance.
Omission
These errors occur when a transaction is completely missed from the ledgers. If a
purchase invoice was destroyed there would be no entry in the purchases journal and
therefore the purchases account in the general ledger would not contain the debit
entry recording the transaction; neither would the supplier’s account contain the
credit entry. The debit entry is zero; the credit entry is zero. The debit and credit
entries agree.
Principle
These errors are when a transaction is posted to the incorrect class of account. For
example, if a new vehicle was purchased and was inadvertently entered into the
motor expenses account in the general ledger, this would not be revealed by the
trial balance. Some readers may be confused by the difference between an error of
commission and an error of principle.
83
1.4
» An error of commission will not affect profits and/or the validity of the statement
of financial position.
» An error of principle will affect both the profit of the business and will either
understate or overstate an entry on the statement of financial position.
1.4 reConCIlIatIon and verIfICatIon
You may wish to use this rule when trying to decide whether an incorrect posting is an
error of commission or an error of principle.
For example, a vehicle costing $23 500 is posted incorrectly to the motor expenses
account. Profit will be understated by $23 500. (Profit will be reduced by the ‘extra’
expense in the statement of profit or loss.) The non-current assets shown on the
statement of financial position will be understated by $23 500 also.
Original entry
If a credit sale for $176 was entered in the sales journal as $167, then a debit entry
of $167 would be recorded in the customer’s account in the sales ledger and a credit
entry of $167 would be entered in the sales account in the general ledger.
The debit entry is $167; the credit entry is $167. The debit and credit entries agree.
Compensating
Compensating errors cancel each other out. If the debit side of an account is totalled
incorrectly and is $100 too much and another totally separate account with credit
entries is incorrectly totalled by $100 too much, then no error will be revealed by
extracting a trial balance.
This worked example shows you some typical errors and how they would be identified:
WORKED EXAMPLE 1
1 Vehicle repair paid by cheque $649
Debit entry
Credit entry
Bank account $649
Motor expenses account $649
2 Machine used by the business sold for $4 000
Debit entry
Credit entry
Bank account $4000
Sales account $4000
3 Goods purchased $29 from Trip & Co. on credit
Debit entry
Credit entry
Purchases account $29
Prit & Co. $29
4 Goods sold $76 on credit to Ricket
Debit entry
Credit entry
Ricket’s account $67
Sales account $67
Required
Identify the types of errors listed above.
Answer
1
2
3
4
84
Reversal of entries
Error of principle
Error of commission
Error of original entry
How to prepare ledger accounts and journal entries to
correct errors using a suspense account
Although the prime function of a trial balance is to test the accuracy of our doubleentry system, we often use a trial balance as a list from which we prepare financial
statements. This saves much time.
1.4
However, if the trial balance fails to balance, then any financial statements prepared
from the trial balance will not balance either.
If the debit column of the trial balance has a smaller total than the credit column, we
insert an item ‘suspense account’ in the debit column in order that the two columns
will have the same total.
1.4.2 Trial balance
When the trial balance fails to balance, the difference between the total of the
debit side and the total of the credit side is placed in a temporary account called a
suspense account.
If the total of the credit column of the trial balance is smaller than the total of the
debit column, then the amount for the suspense account would be inserted in the
credit column.
EXAMPLE
Lara has extracted a trial balance. The totals of the debit and credit columns do
not agree.
Debit
column total
Credit
column total
$
$
123 456
132 546
Lara inserts a suspense account to make the trial balance
balance
9 090
132 546
132 546
EXAMPLE
Lawrence has extracted a trial balance from his ledgers. The totals of the debit
and credit columns do not agree.
Debit
column
total
Credit
column
total
$
$
890 321
889 617
704
Lawrence inserts a suspense account to make the trial balance
balance
890 321
890 321
We can then prepare a set of draft financial statements safe in the knowledge that
they will balance.
In the draft financial statements, a suspense account shown as a debit balance in the
trial balance will be shown as a current asset in the statement of financial position.
If the suspense account has been included as a credit balance in the trial balance, it
should be shown as a current liability on the statement of financial position.
85
1.4
Lara’s suspense account balance would be shown as a current asset $9090 on her draft
statement of financial position.
Lawrence’s suspense account balance would be shown as a current liability $704 on his
draft statement of financial position.
1.4 reConCIlIatIon and verIfICatIon
When the errors that have prevented the trial balance from balancing are found and
corrected, the draft financial statements are amended and should be correct according
to the information given.
When errors affecting the balancing of the trial balance are found, they will be entered
in the suspense account (and in another account since we are using a double-entry
system).
The correction of errors
Errors are corrected in the ledger accounts using the double-entry system. However,
correction of errors requires an entry to be made first of all in the general journal
(another one of its uses).
Remember that:
» not all errors affect the balancing of the trial balance
» when the errors are entered in the suspense account, the suspense account balance
should be eliminated.
WORKED EXAMPLE 2
On 31 March 2021, Vijay’s trial balance failed to agree. The debit column total
was $20 500; the credit column totalled $21 000. The difference was entered in
a suspense account.
Since extracting the trial balance the following errors have been found:
1 The purchases account was under added by $1000.
2 Goods sold on credit to J. Latino for $500 were debited to J. Latino’s account.
These goods had not been included in the sales journal.
Required
Prepare:
a general journal entries to correct the errors
b a suspense account showing the corrections that have been made.
Workings
When general journal entries are required, we ask ourselves questions as
follows.
In the first example:
l Which account should be debited? Answer – purchases account
l Which account should be credited? Answer – suspense account
In the second example:
l Which account should be debited? Answer – suspense account
l Which account should be credited? Answer – sales account
86
Answer
a
1.4
General journal
1 Purchases account
Debit
Credit
$
$
1 000
Suspense account
1 000
2 Suspense account
500
Sales account
500
Correction of error: Sale of goods to Latino not included in sales journal
b
Suspense
$
Trial balance difference
500
Sales account
500
1.4.2 Trial balance
Correction of error: Purchases account under added by $1000
$
Purchases
1 000
1 000
1 000
WORKED EXAMPLE 3
The totals on Maura’s trial balance at 30 November 2021 failed to agree.
The debit column totalled $230 161; the credit column totalled $189 521. The
difference was entered in a suspense account. On further examination of the
books of account, the following errors were found:
1 Motoring expenses $1700 had been entered in the vehicles account.
2 The total of the sales journal for July $16 320 had been posted to the debit
side of the purchases account.
3 The total of rent received $4000 for the year had been entered as a debit
entry in the rent payable account.
4 Maura had withdrawn goods for her own use $4700 during the year. This had
not been recorded in the books of account.
Required
Prepare:
a journal entries to correct the errors (narratives are not required)
b a suspense account.
87
Answer
1.4
a
General journal
Motor expenses account
Debit
Credit
$
$
1 700
1.4 reConCIlIatIon and verIfICatIon
Vehicles account
1 700
Suspense account
32 640
Sales account
16 320
Purchases account
16 320
Suspense account
8 000
Rent receivable account
4 000
Rent payable account
4 000
Drawings account
4 700
Purchases account
4 700
b
Suspense
STUDY TIP
$
Just because there is
no remaining balance
on the suspense
account, errors (that
do not affect the trial
balance’s ability to
agree) may still be
present!
STUDY TIP
It will help you become
more skilled at
correcting errors if
you practice this topic
frequently.
Sales account
16 320
Purchases account
16 320
Rent receivable account
4 000
Rent payable account
4 000
$
Balance
40 640
40 640
40 640
The effect on the financial statements of the correction of
errors
Any errors occurring in the double-entry system will generally have an effect on:
»
»
»
»
profit
assets
liabilities or
a combination of any of the three.
Errors that affect the profit of a business will also affect the statement of financial
position in that profit affects the owner’s capital.
WORKED EXAMPLE 4
The following accounts contain errors:
l office equipment account
l sales account
l wages account
l sales returns account
l Horace’s account – a trade receivable account.
88
Required
Complete the table showing changes to profit for the year and a statement of
financial position when corrections are made.
Account
Profit
1.4
Statement of financial position
Office equipment account
Sales account
Sales returns account
Horace’s account
Answer
Account
Profit
Statement of financial position
1.4.2 Trial balance
Wages account
Office equipment account No change Change to assets
Sales account
Change
Change to capital (because of change to profit)
Wages account
Change
Change to capital (because of change to profit)
Sales returns account
Change
Change to capital (because of change to profit)
Horace’s account
No change Change to trade receivables
After any errors are discovered:
l the journal should be used to effect the changes that are necessary
l the ledger accounts should be corrected
l profit for the year should be adjusted
l changes to items on the statement of financial position should be made.
WORKED EXAMPLE 5
The trial balance of Divya Talwar failed to balance on 31 March 2021. The
difference was entered in a suspense account. A set of draft financial
statements was prepared before the errors were discovered. The draft profit
for the year was $27 864.
The following errors were discovered:
1 The purchases journal had been over added by $100.
2 A payment made to M. Dhillon $121 had been posted to the incorrect side of
her account.
3 Fixtures purchased for $2340 had been entered in the purchases journal.
4 Goods sold on credit to B. Irfan $97 had been completely omitted from the
books of account.
5 An insurance payment for $430 had been correctly entered in the cash book
but had not been entered in the insurance account.
Required
Prepare:
a general journal entries to correct the errors
b a suspense account showing the correction of appropriate errors
c a statement showing the corrected profit for the year.
89
Answer
1.4
a
General journal
Debit
Credit
$
$
Suspense account
100
Purchases account
100
1.4 reConCIlIatIon and verIfICatIon
Correction of error: Purchases journal over added by $100
M. Dhillon
242
Suspense account
242
Correction of error: Payment of $121 posted to the incorrect side of Dhillon’s account
Fixtures account
2 340
Purchases account
2 340
Correction of error: Fittings incorrectly entered in Purchases account
B. Irfan
97
Sales account
97
Correction of error: Sale of goods to Irfan omitted from ledgers
Insurance account
430
Suspense account
430
Correction of error: Insurance premium omitted from insurance account
b
Suspense
$
$
Purchases account
100
M. Dhillon
242
Trial balance difference*
572
Insurance account
430
672
672
* The amount of the difference on the trial balance was not given in the
question. The $572 must be assumed to be the amount necessary to make
the suspense account balance after all the errors have been corrected.
c
Statement of corrected profit
$
Profit as per draft accounts
27 864
1 Decrease in purchases
100
3 Decrease in purchases
2 340
4 Increase in sales
5 Increase in insurance
Corrected profit for the year
97
(430)
29 971
STUDY TIP
Always include your
workings even if the
transaction has no
overall effect on the
result.
90
l Error 2 does not affect the profit for the year. It would, however, affect
the total of trade payables which appears on the statement of financial
position. It would reduce current liabilities.
l Error 3 will also decrease profit by the amount of depreciation provided
for on the fixtures purchased.
When correcting a draft profit for the year, remember that:
» any expense account that is debited in the journal will reduce draft profit for
the year
» any expense account that is credited in the journal will increase draft profit for
the year.
1.4
The benefits and limitations of a trial balance
Benefits of a trial balance:
» Helps to spot errors in the double-entry ledger accounts.
» Makes construction of financial statements easier.
Limitations of a trial balance:
1.4.2 Trial balance
We have covered most of the benefits and limitations of a trial balance throughout
this textbook. A summary of these is as follows:
» Certain errors may still be present even if a trial balance agrees.
» It takes time to construct the trial balance – and may not be necessary for a
business that manages a limited number of accounts.
SELF-TEST QUESTIONS
1 A trial balance balances. This is proof that there are no mistakes in any ledger.
True/False?
2 What is the purpose of extracting a trial balance from the ledgers?
3 Can a trial balance be used for any other purpose than checking for the accuracy
of the double-entry system?
4 A trial balance is extracted from the general ledger. True/False?
5 On which side of a trial balance would you find rent receivable?
6 What is an error of original entry?
7 What is the difference between an error of principle and an error of commission?
8 The debit column of a trial balance totals $230 150 and the credit column totals
$230 000. What amount will be entered in a suspense account?
9 Why is it important to make the distinction between capital and revenue
expenditure?
10 Would an error in the purchases returns account affect profit for the year?
Calculation questions (answers on page 494)
11 Advertising of $89 is paid by bank transfer. The entry is debited to the bank column
of the cash book and credited to the advertising account. What is the double-entry
needed to correct this error?
12 Sales are over added by $78. Purchases are under added by $13. Sales returns are
over added by $9. Once these errors are correct, calculate the overall change to
the profit of the business.
91
1.4.3 Bank reconciliation statements
1.4
When attempting to locate an error, bank reconciliation can highlight whether or not
errors have been made in the maintenance of the business’s cash book.
Updating of cash books
1.4 reConCIlIatIon and verIfICatIon
We have seen that the whole double-entry system can be checked by extracting a trial
balance.
Remember that even if the trial balance does agree, it does not necessarily mean
that there are no errors in the double-entry system. All you can be sure of is that the
double-entry system is arithmetically correct.
The trial balance is usually prepared on a monthly basis. This will reveal whether errors
are present but we know that not all errors are revealed by the completion of a trial
balance. There are other methods used to verify the accuracy of the double-entry
system.
Let us first look at the two checks that are used to verify the entries in the cash book.
Checking the accuracy of a cash balance shown in a cash book
The cash columns of the cash book can be checked to see if the amounts of cash held
in the business matches the amounts shown on the cash book.
If you are the owner of a store, how often you will check the balances of cash in the
tills will depend on how much cash goes into the tills on a daily basis. It will also
depend on how many staff have access to the tills and how trustworthy those staff are.
When checking the cash, we count all the money that is in the till and check the
amount held against the total shown on the till roll. The two should be the same. It
is done at least once a day and may be done several times a day, because if there is a
discrepancy it is much easier to remember what might have caused any difference. For
example, money may have been taken from the till to pay a cleaner and no note has
been made of the payment. It is much easier to remember this immediately after the
event than, say, some four months later.
The cash in the till should not only agree with the till roll total but also should agree
with the total of the cash columns in the cash book kept by the business.
This is the most frequent check undertaken by businesses.
Checking the accuracy of transactions recorded in the bank columns of
a cash book
The bulk of banking transactions are undertaken by the bank on instructions given by
the managers of the business. The instructions to undertake transactions involving
the use of the banking system are given to the bank by:
» cheque – cheques are instructions given to the bank to take money from an
account and give the money to someone else
» paying-in slip – these slips record the amount of cash and cheques paid into the
business bank account
» electronic transactions – automated payments into and out of a bank account.
When any bank transaction is undertaken, two records are kept of the transaction. One
is recorded by the business in a cash book. The other record is kept by the bank. The
two records kept are taken from different parts of a source document.
92
1.4
Recording monies paid into a bank account
When money is paid into a bank the person paying in the money will fill in a slip
showing the numbers and amounts of each type of coin and bank note deposited
plus a list of all the cheques that are being paid in. The person fills in a counterfoil,
which duplicates this information. The money and cheques are handed to the bank
cashier, who checks the amounts for accuracy and then stamps the paying-in slip and
the duplicate (the counterfoil or the stub). From this counterfoil, the debit entries
are made in the cash book – so this is one of the source documents to write up the
cash book.
1/10/21
Date
Paid in by
Date
A. N. Other
Cashier s
Stamp
1/10/21
1.4.3 Bank reconciliation statements
▲ Records of every transaction are kept by the bank and the bank’s customer
bank giro credit
A. N. Other
ANYTOWN BANK PLC
Total
cash
1
$ 250 — 00
Total cash
Account A. N. OTHER
Cheques
$
Cash Book
250 — 00
ANYTOWN BANK
A. N. Other
Current account statement
Cash
1/10 S. David
250 — 00
Bank
250.00
Cash
Bank
A. N. Other
Account name
Account number 007457892
Karachi
Branch
Transactions
Details
Date
1 October
Lodgement
Debit
Credit
Balance
250.00
250.00
▲ Figure 1.4.1 Records of a transaction when money is paid into the bank
93
1.4
The bank uses the actual paying-in slip to show how much money and cheques have
been deposited in the business bank account. These entries will appear as credit
entries on a copy of the bank’s records.
The cheque counterfoil is used as the source document to write up the credit bank
column in the cash book.
The bank uses the cheque that has been sent to the payee to enter withdrawals from
the business account. These withdrawals will be shown on the debit side of a copy of
the bank’s records.
1/10/21
Date
Payee
ANYTOWN BANK PLC
Pay
D. Dhillon
Only
Deposits
$
One hundred and fifty dollars
Total
This
cheque
$ 150— 60
& sixty cents
150 — 60
MR A. N. Other
New Balance
Cash Book
1/10/21
Date
D. Dhillon
Old Balance
Account Payee
1.4 reConCIlIatIon and verIfICatIon
Recording monies withdrawn from a bank account
When payment is made by cheque, the cheque is filled out with the payee’s name, the
date, the amount (both in words and in figures) and then the drawer signs the cheque
and sends it to the person who is to receive the money.
A. N Other
ANYTOWN BANK
A. N. Other
Current account statement
1/10 D. Dhillon
150.60
A. N. Other
Account name
Account number 007457892
Karachi
Branch
Transactions
Details
Date
3 October
D. Dhillon
Debit
Credit
150.60
Balance
150.60 OD
▲ Figure 1.4.2 Records of a transaction when a payment is made by cheque
A statement will be sent to the business on a frequent basis, usually at the end of
every month but in the case of very large businesses the bank statement may be
sent to the business on a weekly basis. A copy of the bank’s records may be obtained
electronically if the account is managed online.
Note
The fifth column on the bank statement (or copy of the bank’s records) shows a
running balance figure.
Reasons why a cash book and bank statement might not show identical
entries
The records kept by the bank and the cash book should be identical since the cash
book is prepared from the counterfoils, which are duplicates of the original documents
94
from which the bank prepares its bank statement. The bank statement is a copy of the
account in the bank’s ledger.
We have seen how entries using the banking system are recorded in the cash book.
1.4
» Cheques received are shown in the bank column on the debit side of the cash book.
» Cheques paid to suppliers of goods and services are shown in the bank column on
the credit side of the cash book.
» The counterfoil might not have been filled in at all. The amount shown in the bank
statement should be entered in the cash book.
» The bank may have made payments from the account on a standing order and the
payment from the account has for the moment been overlooked by the drawer and
not yet included in the business cash book. The amount should be entered as a
payment in the bank column on the credit side of the cash book.
» The bank may have made payment from the account by direct debit and the
payment from the account has been overlooked by the drawer. The amount should
be entered as a payment in the bank column on the credit side of the cash book.
» The bank may have taken money from the account as bank charges and this
amount has not yet been included in the business cash book. The amount should
be included as a payment in the bank column on the credit side of the cash book.
» The bank may have made an interest charge for times when the bank statement shows
a debit balance (i.e. the account has been overdrawn). The amount of interest charged
should be entered as a payment in the bank column on the credit side of the cash book.
» The bank may have received deposits on behalf of the business directly through the
banking system. Any credit transfers should be entered as receipts by debiting the
bank column in the cash book.
» When a cheque is received, the cheque will be banked. It is entered in the bank
column on the debit side of the cash book. If, subsequently, the cheque is
dishonoured this fact will be shown on the bank statement. (This is referred to
colloquially as a cheque that has ‘bounced’.) The trader cannot adjust the bank
account in the cash book until the trader is informed by the bank. If it is not also
shown in the cash book, the dishonoured cheque should be entered as a payment
in the bank column on the credit side of the cash book.
» The trader can make the following errors:
– addition errors in either bank column of the cash book
– entering the incorrect amount from the cheque and paying-in counterfoils
– entering the correct amount on the incorrect side of the cash book.
» The bank could make the following errors:
– entering a withdrawal that should have been debited to the account of
someone else
– entering a deposit that should have been credited to the account of someone else.
Note
It is highly unlikely that addition errors will take place in bank statements since they
are, generally, computer generated.
1.4.3 Bank reconciliation statements
The amounts withdrawn from the bank account by cheque should appear as identical
amounts in the bank column on the credit side of the cash book and in the debit
column of the bank statement.
Amounts paid in should appear as identical amounts in the bank column on the debit
side of the cash book and in the credit column of the bank statement. Can you think
of any reasons why the cash book entries should not be identical to those shown in
the bank’s ledger?
The counterfoil might not agree with the cheque. The cheque might say $110 but the
cheque counterfoil could say $101. So the cash book will show $101 and the bank
statement will show $110. Which amount is correct? The bank will have taken $110
out of the account since this is what the instruction (the cheque) says, so this is the
correct amount and the counterfoil and cash book should be changed.
95
If we correct the differences all should be well.
Why is there a need to prepare a bank reconciliation statement?
1.4
We need to check that:
1 all transactions using banking facilities have been recorded
2 all transactions have been recorded accurately by both the business and the bank
3 all transactions have gone through the drawer’s account kept at the bank.
1.4 reConCIlIatIon and verIfICatIon
When a trader pays a supplier by cheque, this should be entered in the bank column on
the credit side of the cash book (using the counterfoil as the source document) on the
same date that the cheque was written. However, the bank may not show the cheque
on the bank statement until several days later – this could be as much as a week later
(days in the postal system plus days in the clearing system).
When the trader pays money into the business bank account, it will be immediately
recorded in the trader’s bank column in the cash book. However, the bank will not
credit any cheques that are deposited to the trader’s bank account until the cheques
are cleared.
Note
The drawer’s account shown on the bank statement is prepared from the actual
cheques and paying-in slips received by them. If an error is made on the counterfoil,
two different amounts will be recorded by the bank and by the trader.
21/10/21
Date
Payee
ANYTOWN BANK PLC
Date
J. Brown
Pay
J. Brown
Deposits
Three hundred and fifteen dollars
Total
This
cheque
Only
Account Payee
Old Balance
$ 351.00
only
New Balance
21/10/21
$315.00
MR A. N. Other
A. N. Other
▲ Figure 1.4.3 Cheque (right) and counterfoil
Which is correct?
The bank will react to the instructions (the cheque), which are to remove $315 from
the account and pay it to Brown.
After all the necessary adjustments have been made, the cash book should contain
exactly the same information as the bank statement. Or should it? Well, it could, but
in real life, the likelihood of this happening is fairly remote because of the reasons
outlined earlier.
Some deposits made by the trader on the day the bank statement is produced by the
bank may not yet be recorded on the statement. These items are called ‘lodgements
not yet credited by the bank’. Some cheques paid out by the trader and entered in the
cash book will still be in the postal system, in the payee’s office or in the bank clearing
system. These cheques have yet to be presented at the trader’s bank – they are called
‘unpresented cheques’.
STUDY TIP
Make sure that you
learn the correct
layout for a bank
reconciliation
statement.
96
So we have to reconcile (bring together) the two different amounts shown in the cash
book and on the bank statement. This is done in a bank reconciliation statement.
How to prepare bank reconciliation statements
A bank reconciliation statement can help to reconcile the differences in the balance
from the updated cash book and the balance as shown on the bank statement. The
layout of a bank reconciliation statement is as follows:
EXAMPLE
1.4
Bank reconciliation statement at … (the date when the reconciliation is prepared)
Balance at bank as per cash book
Add Unpresented cheques
Less Lodgements not yet credited by the bank
The procedures for producing this statement are as follows:
1 Balance the cash book. Remember, only the cash and bank columns are balanced;
the discount columns are totalled.
2 Compare the bank columns of the cash book with the bank statement. Tick all
the entries shown in the cash book and their corresponding entries in the bank
statement.
3 Bring the cash book up to date by:
a entering payments made by the bank but not yet entered in the cash book in
the bank column on the credit side of the cash book (standing orders, direct
debits, bank charges, fees, interest and dishonoured cheques)
b entering amounts received by the bank but not entered in the cash book in the
bank column on the debit side of the cash book.
4 Correct any errors discovered in the bank columns of the cash book.
5 If the bank statement contains errors, inform the bank, make a note of the error
and ask the bank for an adjusted bank statement balance.
6 Prepare the bank reconciliation statement.
1.4.3 Bank reconciliation statements
Balance at bank as per the bank statement … (date)
Note
The adjusted balance shown in the bank columns of the cash book is the balance to be
shown in both the trial balance and the statement of financial position.
Remember to post all the items entered in the cash book adjustments to the
appropriate accounts in the ledgers.
WORKED EXAMPLE 6
The bank columns of P. Chene’s cash book show the following details for April:
Cash book (bank columns only)
$
Cheque
$
Apr 1
Balance b/d
487 Apr 3
H. Pater
341
Apr 7
H. Rajah
346 Apr 4
T. Hannibal
342
73
Apr 10
F. Thon
56 Apr 17
C. Dob
343
310
Apr 23
M. Singh
179 Apr 22
D. Cols
344
130
Apr 30
J. Cust
13 Apr 24
N. Bedi
345
54
R. Edy
346
147
Apr 30
Balance c/d
1 081
May 1
Balance b/d
34
333
1 081
333
97
She received her bank statement on 3 May:
1.4 reConCIlIatIon and verIfICatIon
1.4
Date
Details
Debit
Credit
Balance
$
$
$
Apr 1
Balance
487
Apr 7
Lodgement
Apr 9
342
73
760
Apr 10
341
34
726
346
Lodgement
56
782
Apr 15
Direct debit (insurance)
Apr 17
Credit transfer (M. Chorte)
Apr 23
Lodgement
Apr 29
344
130
846
345
54
792
6
786
Apr 30
Bank charges
46
833
736
61
797
179
976
Required
a Make any necessary adjustments to P. Chene’s cash book.
b Prepare a bank reconciliation statement at 30 April.
Workings
‘Tick’ all the items that appear both in P. Chene’s cash book and on her bank
statement.
l The item that remains unticked in the bank column on the debit side of the
cash book is: Cust / $13
l The items that remain unticked in the bank column on the credit side of the
cash book are: Dob / $310; Edy / $147
l The item that remains unticked in the credit column of the bank statement
is: Chorte / $61
l The items that remain unticked in the debit column of the bank statement
are: direct debit for insurance / $46; Bank charges / $6
l It is important that Chene’s cash book is updated. The cash book is a vital
part of her double-entry records so it should be correct and contain all the
transactions relating to the business.
The three transactions remaining unticked on the bank statement have taken
place. They remain unticked because she has not yet recorded them in her cash
book.
The first task is to record the transactions in her cash book.
In real life, the cash book would be extended for a few lines to enable the
entries to be made.
Also, we should not forget to complete the double entry for these transactions
(although it is purely for illustrative purposes, as the question did not ask for
this):
98
Chorte
$
$
Apr 17
Bank
1.4
61
Insurance
$
Bank
46
Bank charges
$
Apr 30
Bank
$
6
Answer
Cash book
$
Apr 1
Balance b/d
Apr 17
M. Chorte
$
333 Apr 15
Insurance
61 Apr 30
394
Balance b/d
46
Bank charges
Balance c/d
May 1
1.4.3 Bank reconciliation statements
Apr 15
$
6
342
394
342
Note
The balance of $342 is the balance to be entered on Chene’s trial balance. It is
also the balance to be shown as a current asset on her statement of financial
position.
Bank reconciliation statement at 30 April
$
Balance at bank as per the cash book
$
342
Add Unpresented cheques –
Dob
310
Edy
147
457
799
Less Lodgements not yet credited –
Cust
13
Balance as per bank statement
786
We have reconciled the bank balance shown in the cash book with that shown in
the bank statement. We can say with certainty that the transactions recorded in
the bank columns of the cash book have been accurately recorded.
99
1.4
WORKED EXAMPLE 7
The bank columns of D. Dhillon’s cash book are shown:
Cash book
1.4 reConCIlIatIon and verIfICatIon
$
$
Oct 1
Balance b/d
127.63
Oct 2
M. Vaughan
673
272.61
Oct 7
D. Paster
367.42
Oct 4
C. Chan
674
81.13
Oct 15
T. Henkel
84.56
Oct 11
M. Vere
675
364.42
B. Tain
97.42
Oct 27
D. Perth
676
182.09
M. Sond
216.84
Oct 29
N. Lister
677
12.13
Oct 31
Balance c/d
18.51
912.38
912.38
Nov 1
Balance b/d
He received his bank statement on 4 November.
ANYTOWN BANK PLC
Current account statement
D. DHILLON
Account name
Account number 007457892
Karachi
Branch
Transactions
Details
Date
1 October
3 October
7 October
10 October
15 October
16 October
31 October
Balance
Lodgement
674
Lodgement
Lodgement
675
673
Credit transfer G. Jackson
Stdg order Loan repmt
Dishonoured cheque
Bank charges
Debit
Credit
367.42
81.31
84.56
97.42
364.42
272.61
41.99
150.00
12.48
27.56
Balance
127.63
495.05
413.74
498.30
595.72
231.30
41.31 OD
0.68
149.32 OD
161.80 OD
189.36 OD
▲ Figure 1.4.4 Dhillon’s bank statement
Required
a Make any adjustments to Dhillon’s cash book.
b Prepare a bank reconciliation statement at 31 October.
100
18.51
Answer
a
1.4
Cash book
$
Oct 31
$
Oct 31
Balance b/d
Balance c/d
Oct 4
C. Chan (correction)
Oct 31
Loan account
(repayment)
166.74
18.51
0.18
150.00
Trade receivable
(dishonoured cheque)
12.48
Bank charges
27.56
208.73
208.73
Balance b/d
166.74
Note
l The amount paid to Chan has been increased – the bank has paid him
$81.31, so the cash book has to record the payment.
l The dishonoured cheque has been credited in the cash book.
l The opening balance is a credit balance on the bank statement, indicating
1.4.3 Bank reconciliation statements
G. Jackson (credit transfer) 41.99
that Dhillon has money in the bank; at the end of October a debit balance is
shown on the bank statement indicating that Dhillon is overdrawn.
b
D. Dhillon
Bank reconciliation statement at 31 October
$
Balance at bank as per cash book
$
166.74 OD
Add Unpresented cheques:
D. Perth
182.09
N. Lister
12.13
194.22
27.48
This positive
amount added
to a negative
amount gives this
positive result.
Less Lodgements not yet credited:
M. Sond
Balance at bank as per bank statement
216.84
This amount
deducted gives a
negative result.
189.36 OD
Once more we can now say that all the transactions recorded in the bank
columns of the cash book have been recorded accurately.
The benefits and limitations of preparing a bank
reconciliation statement
The main benefit of preparing a bank reconciliation statement is that, along with
the other techniques covered in this chapter, it helps to locate errors made in the
financial records of a business. Specifically, it identifies errors made in the cash book
(bank column) of the business.
101
Other benefits of preparing a bank reconciliation statement include:
1.4 reConCIlIatIon and verIfICatIon
1.4
» it identifies where the bank may have made an error (unlikely, but possible)
» it can identify fraud – where an employee is taking money out of the business
without recording the withdrawal
» it makes sure the ‘true’ cash balance is known and helps prevent a business
spending money that is not there
» it reminds a business of any automated transactions that may otherwise not be
considered until later (and possibly move the bank balance into an unwanted
overdrawn balance if spending is allowed that is in excess of the true bank balance).
However, updating a cash book and producing a bank reconciliation statement takes
time. This should be conducted only when necessary. For a small business, especially
one operating as a sole trader, the process may not be necessary – at least not that
often.
1.4.4 Control accounts
Entries in control accounts
We have seen that the arithmetical accuracy of the whole double-entry book-keeping
system is checked by extracting a trial balance. Although in theory there is only one
book used to record all double-entry transactions, we have seen that the ledger is
actually divided into three parts. The bulk of all entries in the double-entry system
are in the personal ledgers: the sales ledger and the purchases ledger.
Because there are so many entries in these two ledgers, there is great potential for
errors to be made. Control accounts are used to check the accuracy of the entries
made in each of the sales ledgers and in each of the purchases ledgers.
Each month a control account is prepared for each ledger. In this way, errors can be
identified as being in one particular ledger in the month that they have occurred.
A control account summarises all the individual entries that have been made in the
sales ledgers and the purchases ledgers in any particular month. Any entry in any sales
ledger or purchases ledger will be duplicated in the control account.
Sales ledger control accounts and purchases ledger control
accounts
Preparation of a sales ledger control account
If a business has a large number of credit customers it may divide the sales ledger
according to geographical areas, customers of particular sales persons, alphabetically,
etc. The sales journal would reflect any divisions of the sales ledger.
Some businesses use control accounts as part of their double-entry system. They
maintain personal credit customers’ accounts in detail as memorandum accounts.
These memorandum accounts are used:
» to send out monthly statements
» for credit control purposes, i.e. identifying irrecoverable debts and potential
irrecoverable credit customers.
Other businesses use control accounts as memorandum accounts, using them only for
control purposes.
102
The sales ledger control account is a replica, in total, of all the entries made in the
individual sales ledger accounts. Any entries that appear in an individual credit
customer’s account will appear in the control account for that ledger.
1.4
Here is a simple illustration:
WORKED EXAMPLE 8
1.4.4 Control accounts
Sales ledger
Clogg
$
May 1 Sales
$
50 May 9 Cash
48
Discount allowed
50
2
50
Saddler
May 7 Sales
60 May 7 Sales returns
29
May 14 Bank
20
May 31 Balance c/d
11
60
Jun 1 Bal b/d
60
11
Required
Prepare the sales ledger control account for the month of May.
Answer
Sales ledger control account
$
$
May 9
May 31
Credit sales for month
110
STUDY TIP
The most common
error made when
working on control
accounts is to reverse
the entries.
110
Jun 1
Balance b/d
Cash
Discount allowed
48
2
May 12
Sales returns
29
May 14
Bank
20
May 31
Balance c/d
11
110
11
The control account is an exact replica of all the sales ledger entries, so you should not
get the items required in preparing a control account on the wrong side.
In reality, we cannot look at every individual account in a sales ledger and copy them
into a sales ledger control account. Nor can we add each of the different categories
of entries together – it would be too time-consuming. We can, however, get the
necessary figures in total by using the books of prime entry.
103
Sales journal
Individual entries
1.4
Sales
Sales ledger
Art
$
5 Cash
Discount
1.4 reConCIlIatIon and verIfICatIon
5
Sales
Bart
$
10 Cash
Balance c/d
10
Balance
b/d
Sales
Sales
Bart
10
Carter
15
Dart
12
42
Total entries
Sales ledger
control account
1
5
Sales
$
42 Cash
Cash book
$
8
2
10
Art
1
Bart
4
8
1
$
12
Discount
allowed
1
Returns
inwards
4
Irrecoverable
12
debts
12
2
Carter
$
$
15 Sales returns 4
Balance c/d 11
15
15
Balance
b/d
$
4
Art
$
5
Sales returns
journal
Carter
$
4
4
11
Dart
$
$
12 Irrecoverable 12
debt
General journal
Sales ledger
control account
Irrecoverable
12
debts
Dart
12
Sales
$
42
Schedule of trade receivables
$
2
Bart
Carter
11
Total
credit customers
13
Cash
$
12
Discount
allowed
1
Returns
inwards
4
Irrecoverable 12
debt
42
Bal
bd
13
Bal c/d
13
42
▲ Figure 1.4.5 The sales ledger control account
WORKED EXAMPLE 9
Example 1
Petra started business in May 2021. She provides the following totals from her
books of prime entry on 31 May 2021:
credit sales $7300; cash sales $2100; sales returns $420; monies received
from credit customers $5400.
A schedule of trade receivables extracted from Petra’s sales ledger on 31 May
2021 shows they owed $1480.
Required
Prepare a sales ledger control account for May 2021.
104
Answer
1.4
Sales ledger control account
$
May 31
Sales
7 300
$
May 31
Sales returns
Bank
5 400
Balance c/d
1 480*
Balance b/d
7 300
1 480
* Figure included to make control account balance.
The total amount owed by trade receivables at the end of May according to
the control account should be $1480. This figure should agree with the total of
balances listed on the schedule of trade receivables – it does, so we can say
that the sales ledger is arithmetically correct for the month of May 2021.
1.4.4 Control accounts
7 300
Jun 1
420
Note
l The $2100 (cash sales) should not be included – these do not appear in the
sales ledger as the sales ledger is reserved only for credit customers.
l The $1480 debit balance should also be brought down on the sales ledger
control account.
Example 2
At the end of her second month of trading, Petra provides you with the following
information, which she has extracted from her books of prime entry on June 30
2021:
credit sales $9400; cash sales $2750; monies received from credit customers
$6200; discount allowed $610; sales returns $240.
Required
Prepare a sales ledger control account for June 2021. (Bring forward the trade
receivables’ balance from the May sales ledger control account.)
Answer
Sales ledger control account
$
Jun 1
Balance b/d
1 480
Jun 30
Sales
9 400
$
Jun 30
Bank
Discount allowed
610
Sales returns
240
Balance c/d
10 880
Jul 1
Balance b/d
6 200
3 830
10 880
3 830
Preparation of a purchases ledger control account
The purchases ledger control account is a replica of all the entries made in the
individual purchases ledger accounts.
105
Here is a simple illustration:
1.4
EXAMPLE
1.4 reConCIlIatIon and verIfICatIon
Jul 13 Cash
Discount
received
Saleem
$
347 Jul 1 Purchases
3
$
350
350
350
Toshak
$
20 Jul 7 Purchases
18
87
Jul 19 Cash
Jul 24 Purchases returns
Jul 31 Bal c/d
$
125
125
125
87
Aug 1 Bal b/d
Jul 13
Jul 19
Jul 24
Jul 31
Purchases ledger control account
$
Cash
347 Jul 31
Purchases for month
Discount received
3
Cash
20
Purchases returns
18
Balance c/d
87
475
Aug 1
Balance b/d
$
475
475
87
The purchases ledger control account here can be seen as the total of the two separate
accounts of the trade payables’ of Saleem and Toshak. Note that it is normal to
summarise the total of credit purchases at the end of the month rather than to include
each separate credit purchases transaction.
This illustration relies on the fact that you must understand what an individual
account in a purchases ledger looks like.
We cannot look at every individual account in a purchases ledger and total them. We
use totals that can be found in the books of prime entry.
WORKED EXAMPLE 10
Example 1
Yip started in business in February 2021. He provides the following totals from
his books of prime entry on 28 February 2021:
credit purchases $9430; cash purchases $1790; purchases returns $105;
monies paid by Yip to credit suppliers $8100.
A schedule of trade payables extracted from the purchases ledger on
28 February 2021 totals $1225.
Required
Prepare a purchases ledger control account for February 2021.
Answer
Purchases ledger control account
$
Feb 28
Purchases returns
105
Cash
8 100
Balance c/d
1 225
$
Feb 28
Purchases
9 430
9 430
Mar 1
106
9 430
Balance b/d
1 225
The trade payables at the end of February according to the control account
should amount to $1225. This agrees with Yip’s schedule, so we can say that his
purchases ledger is arithmetically correct for the month of February.
1.4
Cash purchases were not included because they do not appear in the purchases
ledger – the ledger is only used to record Yip’s transactions with his credit suppliers.
Example 2
credit purchases $8600; cash purchases $2930; monies paid by Yip to credit
suppliers $6800; discount received from trade payables $460; purchases
returns $120.
Required
Prepare a purchases ledger control account for March 2021. (Bring forward the
trade payables’ balance from the February purchases ledger control account.)
1.4.4 Control accounts
Yip provides you with the following information, which has been extracted from
his books of prime entry for March 2021, his second month of trading:
Answer
Purchases ledger control account
$
Mar 31
Cash
6 800
Discount received
460
Purchases returns
120
Balance c/d
$
Mar 1
Balance b/d
1 225
Mar 31
Purchases
8 600
2 445
9 825
9 825
Apr 1
Balance b/d
2 445
Credit balances in a sales ledger
Usually, any closing balance in the account of an individual credit customer will be a
debit. However, it is possible that an individual credit customer account may end with
a credit balance. How can this possibly happen?
WORKED EXAMPLE 11
Example 1
Phara sells $720 goods to Claude on 3 October 2021.
On 23 October 2021 Claude sends Phara a cheque for $720.
On 29 October 2021 Claude returns $30 of goods which have proved to be faulty.
Required
Prepare Claude’s account as it would appear in Phara’s sales ledger at 31 October 2021.
Answer
The question asks for the account so it must be produced in detail, not as a ‘T’
account.
Oct 3
Sales
Claude
$
720 Oct 23
Oct 29
Bank
Sales returns
$
720
30
107
1.4
You can see that at 31 October there is a credit balance in Claude’s account,
although this account is contained in Phara’s sales ledger (her trade
receivables ledger).
1.4 reConCIlIatIon and verIfICatIon
In Phara’s list of outstanding balances in the sales ledger at 31 October 2021,
she will have to show this balance on Claude’s account as a payable. It will also
feature in the sales ledger control account for October as a payable.
Note
Do not deduct this amount from Phara’s total of trade receivables (credit
customers) at the end of the month. It must be included in a trial balance at 31
October 2021 and a statement of financial position prepared at 31 October 2021,
with trade payables.
Example 2
Toddy is a regular customer of Phara. He has paid $50 on the 24th of each
month to Phara by standing order since 24 May 2021. On 6 September Phara
sells $230 of goods to Toddy.
Required
Prepare the account of Toddy as it would appear in Phara’s sales ledger at
30 September 2021.
Answer
Sep 6
Sep 30
Sales
Balance c/d
Toddy
$
230 May 24
20 Jun 24
Jul 24
Aug 24
Sep 24
250
Oct 1
Bank
Bank
Bank
Bank
Bank
Balance b/d
$
50
50
50
50
50
250
20
In Phara’s list of outstanding balances in her sales ledger at 30 September
2021, the balance standing on Toddy’s account will be shown as a credit $20 –
Phara owes him money at that date – and this should be shown accordingly on
a trial balance extracted on 30 September 2021 or any statement of financial
position prepared at 30 September 2021.
A credit balance could also appear in a credit customer’s account if the
customer had made an overpayment or was allowed additional cash or trade
discount after the account had been settled.
Debit balances in a purchases ledger
We have seen how credit balances can occur in sales ledger accounts; similar
circumstances could result in debit balances appearing on the list of balances
extracted from a purchases ledger.
Debit balances would appear in the purchases ledger if a trader:
» settled his or her account with a supplier and then returned faulty goods
» pays a fixed amount each month, which in total exceeds the amount of
purchases made
» was allowed additional discount after settling the account
» had overpaid an outstanding balance.
Any credit balances in the sales ledger at a month end will be shown as credit
balances in the sales ledger control account for that month.
108
Any debit balances in the purchases ledger at a month end will be shown as debit
balances in the purchases ledger control account for that month.
1.4
WORKED EXAMPLE 12
Harvey provides the following information from his books of prime entry at
31 July 2021:
$
6 930
Monies received from credit customers during month
5 100
Discounts allowed
450
Sales returns
180
1.4.4 Control accounts
Credit sales for July
He provides the following additional information:
$
Debit balances appearing in the sales ledger at 1 July 2021
2 100
Credit balances appearing in the sales ledger at 1 July 2021
30
Balance of credit customer who had overpaid at 31 July 2021
90
Required
Prepare the sales ledger control account for July 2021.
Answer
Sales ledger control account
$
$
Jul 1
Balance b/d
2100
Jul 1
Balance b/d
Jul 31
Sales
6 930
Jul 31
Cash
Balance c/d (given)
90
30
5 100
Discount allowed
450
Sales returns
180
Balance c/d (missing figure)
3 360
9 120
Aug 1
Balance b/d
3 360
9 120
Aug 1
Balance b/d
90
Contra entries in control accounts
Contra entries are sometimes called set-offs. A business may well be both a customer
of and a supplier to another business.
EXAMPLE
Niki had supplied Hoole with goods valued at $4300 on credit. Niki had also
purchased $700 of goods for his business on credit from Hoole.
This would appear in Niki’s books of account thus:
Sales ledger
Hoole
Purchases ledger
Hoole
$
Sales account
4 300
$
Purchases account
700
109
It would not seem sensible for Niki to send $700 to Hoole while demanding that
Hoole pay $4300.
1.4
The usual procedure in cases like this is to transfer the smaller amount from
one ledger to the other. The entries are:
Sales ledger
Purchases ledger
Hoole
Hoole
1.4 reConCIlIatIon and verIfICatIon
$
Purchases ledger
(transfer)
Sales ledger
(transfer)
700
This will close one account (in the purchases ledger) and reduce the balance
owed by Hoole (in the sales ledger). The account now looks like this:
Sales ledger
Purchases ledger
Hoole
Hoole
$
Sales
account
$
4 300 Purchases ledger
(transfer)
700
$
Sales ledger
(transfer)
700 Purchases
account
$
700
All transactions should be recorded in a book of prime entry. Entries involving
transfers should be entered in the journal:
General journal
Learning link
Contra entries also
appeared in Chapter 1.2
when we looked at the
cash book.
Hoole (purchases ledger)
Hoole (sales ledger)
Remember
Memorandum or a
‘memo’ can refer to
a written method of
communication. This
should not be confused
with the use of the
term ‘memorandum
accounts’, which are
accounts not part of the
double-entry system.
110
700
$
Debit
Credit
$
$
700
700
Transfer of credit balance in Hoole’s account in purchases ledger
to Hoole’s account in sales ledger
The general journal is used for inter-ledger transfers. This is another use of
the general journal as a book of prime entry.
l All entries in the personal ledgers must also be shown in the control
accounts.
l There will be an entry on the credit side of Niki’s sales ledger control
account.
l There will also be an entry on the debit side of Niki’s purchases ledger
control account reflecting the entries in the two personal ledgers.
WORKED EXAMPLE 13
1.4
Example 1
Erin’s accounts have a debit balance of $100 in Ricardo’s sales ledger and a
credit balance of $30 in Ricardo’s purchases ledger.
Answer
Sales ledger control account
$
Purchases ledger control account
(transfer)
30
1.4.4 Control accounts
Required
Show the contra entries (set-offs) as they would appear in both Ricardo’s sales
ledger control account and his purchases ledger control account.
Purchases ledger control account
$
Sales ledger control account
(transfer)
30
Example 2
Erick’s accounts have a debit balance of $710 in Djarak’s sales ledger and a
credit balance of $1400 in Djarak’s purchases ledger.
STUDY TIP
It does not matter
whether the debit
balance or the credit
balance is greater
when showing the
contra in the control
accounts:
» The sales ledger
control account is
always credited.
» The purchases
ledger control
account is always
debited.
In the personal
ledgers it is the
smaller balance that is
transferred.
Required
Show how the contra (set-offs) would appear in both Djarak’s sales ledger
control account and his purchases ledger control account.
Answer
Sales ledger control account
$
Transfer to purchases ledger
control account
710
Purchases ledger control account
$
Transfer from sales ledger
control account
710
111
1.4
WORKED EXAMPLE 14
Damien provides the following information taken from his books at 30
November 2021:
1.4 reConCIlIatIon and verIfICatIon
$
Sales ledger balances at 1 November 2021
4 114
Purchases ledger balances at 1 November 2021
2 324
Credit sales for November
194 803
Credit purchases for November
101 918
Cash sales
89 808
Cash purchases
26 770
Cash and bank receipts in respect of credit sales
189 991
Dishonoured cheques
864
Credit balances in sales ledger at 1 November 2021
213
Transfers from sales ledger to purchase ledger balances
540
Sales returns
766
Irrecoverable debts
1 150
Payments made for credit purchases
98 080
Discounts allowed
2 210
Discounts received
1 310
Purchases returns
414
Sales ledger balances at 30 November 2021
5 151
Purchases ledger balances at 30 November 2021
3 898
Credit balances in sales ledger at 30 November 2021
240
Required
Prepare:
a a sales ledger control account showing clearly the closing balance of
outstanding trade receivables at 30 November 2021
b a purchases ledger control account showing clearly the closing balance of
outstanding trade payables at 30 November 2021.
Answer
a
Sales ledger control account
2021
$ 2021
Nov 1
Balance b/d
Nov 30
Credit sales
$
4 114 Nov 30 Balance b/d
194 803
Cash/Bank
864
Discounts allowed
2 210
Balance c/d
240
Irrecoverable debts
1 150
Sales returns
766
Purchases ledger transfer
540
200 021
112
189 991
Bank
Balance c/d
Dec 1
213
Balance b/d
5 151 Dec 1
5 151
200 021
Balance b/d
240
b
1.4
Purchases ledger control account
2021
Nov 30
$ 2021
Cash/Bank
$
98 080 Nov 1
Discount received
Balance b/d
2 324
1 310 Nov 30 Credit purchases
414
Sales ledger transfer
540
Balance c/d
3 898
104 242
104 242
Dec 1
STUDY TIP
Practise preparing
individual accounts
from the sales ledger
and the purchases
ledger – control
accounts are similar
but use larger
amounts of money.
STUDY TIP
If you have to complete
both a purchases
ledger and sales
ledger control account,
it is easier if you work
on each one separately
rather than at the
same time. Extract
relevant information to
prepare a purchases
ledger control account;
when you have
completed this task,
extract information
and prepare a sales
ledger control account.
3 898
Balance b/d
Note that cash sales and cash purchases are ignored – they are not part of the
sales and purchases ledgers.
1.4.4 Control accounts
Purchases returns
101 918
Irrecoverable debts and allowance for irrecoverable debts
A debt that cannot be paid should be written off. This entails crediting the individual
credit customer’s account with the amount written off; thus ‘balancing’ the account.
Any entry in an individual trade receivable account (credit customer’s account) must
be duplicated in the sales ledger control account since the control account is a
summary of all the entries that appear in the ledger.
WORKED EXAMPLE 15
Reeta owes Belinda $540. Reeta cannot pay the amount that she owes. Belinda
writes off the debt.
Required
Prepare:
a Reeta’s account in the sales ledger
b the entry in the sales ledger control account.
Answer
Sales ledger control account
Reeta
$
Balance b/d
540 Irrecoverable
debts account
$
$
540
Irrecoverable
debts
540
Allowance for irrecoverable debts is not included in a sales ledger control account.
Unlike a debt that is written off, the allowance is not entered in specific individual
credit customers’ (trade receivables) accounts. Only transactions that appear in ledger
accounts appear in control accounts. Therefore, if the allowance does not appear in a
personal ledger account, it will not appear in the control account.
113
Reconciliation statements between control account balances
and ledger balances
1.4
If a comparison of a trade receivables balance shown in a control account fails to
agree with a total of trade receivables balances extracted from the sales ledger there
must be an error or errors in either:
1.4 reConCIlIatIon and verIfICatIon
» the control account
» and/or the sales ledger concerned.
STUDY TIP
Remember that some
errors will affect both
totals and some will
affect neither total.
Similarly, if the trade payables balance in a control account does not agree with a
schedule of trade payables balances extracted from the purchases ledger there must
be an error or errors in either:
» the control account
» and/or the purchases ledger concerned.
Steps must be taken to identify the transactions that have caused the difference in
the two totals. Once identified a correction of the error(s) should reconcile the two
totals.
Items that will affect the total of trade receivables balances extracted from the
personal ledger include incorrect postings from the books of prime entry to the ledger.
Items that will affect the control accounts include errors in the books of prime entry
that affect the totals shown in the book.
WORKED EXAMPLE 16
Babita maintains a sales ledger control account. At the end of September
2021 she discovered that the schedule of trade receivables extracted from her
sales ledger amounted to $6640 while her control account showed outstanding
balances of $9102 on that date. An investigation revealed the following errors:
l The sales journal had been under added by $1000.
l The debit balance on a customer’s account $430 had been omitted from the
schedule of trade receivables.
l Discount received $18 from Nimola had been entered correctly in the cash
book but had been debited to Minola, a credit customer.
l Discount allowed $340 had not been entered in the control account.
l Sales returns $2800 had not been entered in the control account.
l A cheque received from Smythe for $650 had been entered in his account as
$560.
Required
Reconcile a corrected sales ledger control account balance with a corrected
schedule of trade receivable balances.
Answer
Adjusted sales ledger control account for September
$
9 102
Discount allowed
Sales
1 000
Sales returns
2 800
Balance c/d
6 962
10 102
Balance b/d
114
$
Balance b/d
6 962
340
10 102
Adjusted schedule of trade receivables balances at end of September
1.4
$
Incorrect balances
6 640
Discount received
(18)
Balance omitted
430
Correction of transposition
(90)
Balance as per control account
6 962
On 30 June 2021, the purchases ledger control account for the month showed
the following balances:
1.4.4 Control accounts
WORKED EXAMPLE 17
$
Balances from purchases ledger accounts as at 1 June 2021
3 140
Credit purchases for June 2021
59 870
Cash payments made in respect of trade payables
60 530
Based on this information, the balance on the purchases ledger control account
on 30 June 2021 did not agree with a schedule of trade payables extracted from
the purchases ledger on that date. During July 2021, the following errors were
revealed:
l An invoice received from a supplier $1230 had been correctly entered in the
purchases journal but had been posted to the supplier’s account as $2130.
l Goods valued at $190 returned to a supplier had been omitted from the
books of account.
l A payment of $1890 to a supplier had been entered twice in the cash book
and the supplier’s account.
l A contra item $340 had been entered only in the purchases ledger.
Required
a Prepare the corrected purchases ledger control account.
b Calculate the original total of trade payables before the correction of errors.
Answer
Adjusted purchases ledger control account for June
$
$
Purchases returns
190
Balance b/d
2 480
Sales ledger control account
(name of account of opposite
entry)
340
Cash (entered twice)
1 890
Balance c/d
3 840
4 370
4 370
Balance b/d
3 840
115
1.4
Adjusted schedule of trade payables balances at end of June original balances
$
Original balances
?
Less transposition error
(900)
1.4 reConCIlIatIon and verIfICatIon
Omission of purchases returns
(190)
Double payments
1 890
Balance as per control account
3 840
By working backwards we can see the original balance was $3040
(= $3840 – $1890 + $190 + $900).
The effects on financial statements of the correction of
errors
If the total of trade receivables or trade payables balances from the respective control
accounts agree with the total of trade receivables or trade payables from the sales or
purchases ledgers then it may seem that no errors are present. However, there still
may be errors in the sales and purchases ledgers.
These errors are not always easy to discover as they are not obviously visible, initially.
An error of commission could still occur – where the correct amount is entered in the
wrong personal account (of a customer or a supplier) but the totals for the personal
ledger balances, as well as the relevant control account, would agree.
Missing out an entry (error of omission) completely may also not be easy to uncover
given that the ledger accounts would still balance. If we miss out a credit sale or
credit purchase (or their respective returns) then this may not be discovered until
some time later.
Errors made in the recording of any of the items entered into either control account
have the potential to affect either (or both) the statement of profit or loss and the
statement of financial position. Likely errors and their impact would include:
Potential error
Statement affected
Error with sales or purchases
Statement of profit or loss
Error with sales returns or purchases returns
Statement of profit or loss
Error with trade receivables or trade
payables
Statement of financial position
Error with discounts
Statement of profit or loss
Errors with irrecoverable debts
Statement of profit or loss or Statement of
financial position
The benefits and limitations of control accounts
Benefits of using control accounts as part of a control system
1 Control accounts act as a check on the accuracy of all the postings made to the
personal ledgers and this checks the reliability of the ledger accounts.
2 They enable some errors in ledgers to be located quickly.
3 If a trial balance does not balance, the control accounts may indicate which
personal ledger(s) contain the error(s).
4 Total amounts owed by trade receivables and total amounts owing to trade
payables can be ascertained quickly, enabling a trial balance and/or a statement of
financial position to be prepared quickly.
116
5 They may be used to give responsibility to staff by making them responsible for
sections of the ledger.
6 They may be used as a check as to the honesty of staff. Control accounts should
be prepared by a member of staff who is not involved in the maintenance of the
ledger(s) being checked.
1.4
Limitations of using control accounts as part of a control system
Within the ledger there could be compensating errors, plus errors of reversal,
omission, original entry and commission. See Chapter 1.2 for the details of how these
errors can arise.
EVALUATION
1.4.4 Control accounts
The main limitation of using control accounts as a means of verifying the accuracy of
the personal ledgers rests on the fact that not all errors in the ledgers will be revealed
by the preparation of a control account.
A sole trader currently does not use a trial balance when producing her financial
statements. She believes that because the business is small, the time taken to
produce the trial balance is not worth it.
Advise her whether or not she should produce a trial balance.
A strong answer would include:
Reasons for producing a trial balance:
l It provides a check on the arithmetical accuracy of the double entry – i.e. it
may uncover errors in the ledgers.
l It can help in the production of financial statements.
l Even a small business will still need to balance off each ledger account and a
trial balance would not require much more time.
Reasons for not producing a trial balance:
l It is time-consuming – if there are a small number of transactions then it
may seem unnecessary.
l Not all errors are uncovered from a trial balance (e.g. errors of commission,
etc).
l Financial statements can be produced without a trial balance.
EVALUATION
There are regular differences between the cash book figure and the bank
statement figure for the bank account of the business. This worries the
managing director of a business who thinks this indicates potential fraud by
junior employees.
Advise the managing directors whether or not using more electronic systems
for payments and receipts make these differences between the two balances
less likely.
A strong answer would include:
l Electronic payments instead of cheques will reduce the incidence of
unpresented cheques.
l Electronic receipts instead of cheques will reduce the incidence of
lodgements not yet credited.
l Fraud may be easier to spot with less use of notes and coins.
117
1.4
However:
l The cash book balance will need bringing up to date more frequently if more
electronic transactions are made.
l Fraud is a separate issue and may need systems introducing in terms of
logging payments/receipts.
Decision:
1.4 reConCIlIatIon and verIfICatIon
l It may make it slightly easier to track the balance but it may also just
shift the discrepancies to making the cash book in need of more regular
updating.
l Fraud is unlikely to be uncovered by this unless the business dealt with lots
of transactions in notes and coins.
EVALUATION
A small business has decided to computerise all of its financial records. The
manager of the business believes that this will prevent errors occurring in the
personal ledgers of the business. At the moment, they deal with a large number
of customers and suppliers and frequently errors are made in the personal
ledgers. Advise the manager whether or not computerising the personal
accounts will prevent errors from being made.
A strong answer would include the following points:
l It will make it less likely that there are certain errors – such as errors of
principle.
l It will make it less likely that differing amounts are entered for each part of
the same transactions.
l It will ensure both parts of the double entry are recorded correctly.
However:
l If someone inputs the incorrect amount, then the computerised system will
not spot this.
l If someone inputs the incorrect name, then the computerised system will not
spot this.
Overall:
l It will reduce the number of errors but not eliminate all (human) errors.
SUMMARY
After reading this chapter you should be able to:
» explain the need for reconciliation and verification of ledger accounts, and their
benefits and limitations
» state the benefits and limitations of a trial balance
» identify errors that do and do not affect the trial balance, and know how the
correction of errors affects financial statements
» prepare and update a suspense account for errors and their correction
» update a cash book with entries from a bank statement
» prepare a bank reconciliation statement to verify the accuracy of the cash book
and bank statement
» explain the benefits and limitations of a bank reconciliation statement
» understand entries in control accounts
» prepare control accounts for the purchases and sales ledgers
» reconcile totals for sales and purchases ledgers where differences exist
» explain the benefits and limitations of using control accounts.
118
SELF-TEST QUESTIONS
1 List three items that could be classified as current liabilities.
1.4
2 Why would a trader prepare a bank reconciliation statement?
3 How often is a bank reconciliation statement prepared?
4 Explain the term ‘drawer’.
5 What is a standing order?
7 What is meant by the term ‘overdrawn’?
8 A bank statement shows a closing credit balance. Does this indicate that the
business is running an overdraft?
9 Why are credit transfers often missing from the bank columns of the cash book?
10 Fill in the gaps.
Bank reconciliation statement
1.4.4 Control accounts
6 What is the difference between a standing order and a direct debit?
March 31 2021
$
Balance at bank as per cash book
unpresented cheques
lodgements not yet credited
210
156
99
Balance at bank as per bank statement
11 Explain why debit entries in a cash book are shown as credit entries on a bank
statement.
12 Explain the term ‘trade receivables’.
13 Is trade discount entered on the debit or credit side of the sales ledger control
account?
14 Sales returns is entered on the credit side of a sales ledger control account.
True/False?
15 Explain the term ‘trade payables’.
16 Is trade discount entered on the debit or the credit side of a purchases ledger
control account?
17 Purchases returns is entered on the debit side of a purchases ledger control
account. True/False?
18 Explain two reasons why debit balances might appear in a purchases ledger
control account.
19 Is it possible for there to be both debit and credit balances on a sales ledger
control account at the end of a month?
20 State a reason why there could be a credit balance on a sales ledger control
account at the end of a month.
21 Why might a business maintain control accounts?
22 Give an example of a business that would not maintain a sales ledger control account.
23 How often would a business prepare control accounts?
24 In which control account would you expect to find purchases returns?
25 In which control account would you expect to find irrecoverable debts?
119
1.4
26 In which control account would you expect to find an allowance for irrecoverable
debts?
27 Explain one advantage of maintaining control accounts.
28 Explain how a debit balance might arise in a purchases ledger account.
29 Explain how a credit balance might arise in a sales ledger account.
1.4 reConCIlIatIon and verIfICatIon
Calculation questions (answers on page 494)
30 At the end of the month there is a credit balance on the cash book of $45.The
following items are later discovered on the bank statement that were not in the
cash book.
Bank charges
$23
Interest received
$12
Standing order received
$200
Direct debit expense
$88
Calculate the balance on the cash book after it has been brought up to date.
31 Based on the following data, calculate the value of credit sales for the month of
October.
Trade receivables balance at 1 October
$4 521
Trade receivables balance at 31 October
$3 272
Sales returns
$390
Irrecoverable debts
$120
Receipts from customers in respect of credit sales
120
$34 150
1.5
Preparation of financial statements
By the end of this chapter you should have an understanding of:
l how to calculate and record adjustments to financial statements with respect to:
– accruals and prepayments
– irrecoverable debts
– depreciation
– inventory valuation
– correction of errors
l how to prepare the financial statements of a sole trader
l how to prepare the financial statements of a partnership:
– why partners may maintain separate capital and current accounts, and how
to prepare them
– partnership agreements, their advantages and disadvantages
– the provisions of the Partnership Act 1890
l how to prepare the financial statements of a limited company:
– the features and accounting treatment of ordinary shares, bonus shares,
rights issues, debentures, dividends and reserves
– the advantages and disadvantages of bonus issues and rights issues of
shares
– the advantages and disadvantages of issuing shares and debentures
– the distinction between capital and revenue reserves
– how to prepare ledger accounts when issuing different types of shares
– sources of finance for different purposes.
1.5.1 Adjustments to draft financial statements
Learning outcomes
Introduction
Producing the financial statements of businesses is often seen as one of the key
functions of an accountant. Therefore, you will be expected to be able to produce
realistic statements of profit or loss and statements of financial position.
Knowing the layout of the financial statements for each of the three types of
business entity is important. However, knowing how to prepare and adjust the
various incomes, expenses and capital balances will also be necessary.
1.5.1 Adjustments to draft financial statements
Before we begin constructing the financial statements of a business, it is worthwhile
thinking about some of the work covered earlier in this book. There are a number of
accounting concepts that underpin the methodology used in constructing accounts.
Applying the accruals (or matching) concept means that when constructing financial
statements of an annual nature, we should account only for the costs and revenues
that belong to that period – irrespective of when they were paid or received.
121
Learning link
1.5 preparatIon of fInanCIal statements
1.5
The matching/accruals
concept was covered in
Chapter 1.2.
Before we can begin to calculate the profit or loss for a year, we must address the
adjustments that will be needed to ensure that the expenses and incomes incurred and
received by the business for that year are correct.
How to calculate and record the adjustments needed and the
effect on financial statements
Learning link
Accruals and prepayments of income and expenses
The statement of
financial position
was first introduced
when we studied the
accounting equation in
Chapter 1.2.
So far, we have assumed that money spent and money received exactly matched the
year under review. For example, we have assumed that:
» rent paid in February was for the use of premises in February
» wages paid in July was payment for work done in July
» the figures shown in the trial balance prepared at December 31 2021 showed all
the incomes and all the expenses for the year ended December 31 2021, nothing
more and nothing less.
When calculating profit, accountants are interested in accounting for the resources
that the business has used during the financial year to generate the revenue receipts
for that same year. This is an application of the matching/accruals concept which was
covered in Chapter 1.2.
When preparing financial statements, a trader must include all items of expenditure,
paid and payable.
This sounds a little strange at first but it will soon become clear.
When we prepare a set of financial statements we need to include all the items that
apply to the accounting period under consideration.
Some expenses listed in a trial balance are always paid in advance, for example:
» insurance has to be paid in advance
» business rates are generally paid in advance.
Other expenses listed in a trial balance might not be paid up to date:
» part of rent payable may not yet have been paid
» wages earned for work already done may not be due to be paid until the next
month.
An accountant will look at rent differently from the way a landlord or a tenant sees it.
Dealing with accrued expenses
EXAMPLE
Lori runs a small store. She has signed a tenancy agreement with her landlord,
stating that she can use the store premises for the next five years on payment of
a rental of $6000 per annum payable quarterly in advance on 1 January, 1 April,
1 July and 1 October.
At 31 December 2021, Lori’s financial year end, Lori has only paid her landlord
$4500; she still owes the rent that was due to be paid on 1 October.
The amount shown on Lori’s statement of profit or loss as an expense for rent is
$6000 since Lori has had the use of a resource (the store) worth $6000 to help
her generate her profits.
122
An extract from Lori’s trial balance at 31 December 2021 would show:
Rent payable
Debit
Credit
$
$
1.5
4 500
When we prepare the statement of profit or loss for the year ended 31 December 2021,
the entries shown above would show:
$
Expenses
Rent payable
6 000
But this cannot be totally correct. Lori has increased her debit entries by $1500 with
no corresponding increase in her credit entries. She needs to include an extra credit in
her financial statements – rent payable owed at the year end.
In the statement of financial position prepared at the year end, trade payables
represent amounts owed to suppliers who have supplied goods but who have not yet
been paid. Since the rent payable is owed at the date when the statement of financial
position is prepared, this too must be a payable.
Lori has used her premises and not yet fully paid for their use. Rent payable must be
shown as other payables: a current liability, along with the trade payables.
Note
1.5.1 Adjustments to draft financial statements
Extract from statement of profit or loss for the year ended 31 December 2021
» The statement of financial position has not been credited.
» The statement of financial position is not part of the double-entry system; it is
merely a statement showing balances outstanding at the end of a financial year.
» The outstanding rent is included in current liabilities with other credit balances
(for example, the trade payables).
Remember
Be careful when using
the word accruals – do
you mean the accruals
concept or accrued
expenses?
A statement of financial position at 31 December 2021 would show:
Extract from statement of financial position at 31 December 2021
$
Current liabilities
Other payables (rent)
1 500
Dealing with prepaid expenses
Sometimes a business will pay for services before it actually receives the services.
Insurance, for example, has to be paid for before cover is provided. Some other
expenses, such as utility bills and business rates, are also to be paid before the period
for which they are due.
Since we are accounting for resources used in the period covered by the financial
statements, any amounts paid in advance must not be included in the current period
we are accounting for.
123
1.5
WORKED EXAMPLE 1
An extract from Lori’s trial balance at 31 December 2021 shows:
1.5 preparatIon of fInanCIal statements
$
Insurances
2 300
Business rates
1 200
l Insurance paid for January 2022 amounts to $100.
l Business rates paid for the three months ending 31 March 2022 amount to
$300.
Required
Prepare an extract from the statement of profit or loss for the year ended
31 December 2021 showing the entries for insurance and business rates.
Answer
Lori
Extract from statement of profit or loss for the year ended 31 December 2021
$
Insurance
Business rates
2 200
900
Lori does not include the $100 paid for next year’s insurance cover or the $300 for next
year’s business rates. She only includes the payments made to acquire the resources
that have been used to run her business this year.
But it cannot be right to reduce the two expenses without corresponding entries. We
can reduce debit balances with credit entries.
In effect, Lori has credited insurance with $100; she has credited business rates with
$300. She needs to include two extra debits – two extra receivables.
Lori’s statement of financial position at 31 December 2021 will show:
$
Current assets
Other receivables
400
Recording accrued expenses and prepaid expenses in the general ledger
We have seen that payments made to acquire goods and services for a business are not
always perfectly matched to the receipt of the actual goods and services. Sometimes
goods and services are received during a financial year but are not paid for until after
the financial year end.
Accrued expenses and prepaid expenses must be recorded in the business books of
account.
124
WORKED EXAMPLE 2
During the year ended 31 December 2021, Jahangir has paid wages of $443 408
to his staff. The summarised entries in the wages account are shown:
1.5
Wages
$
127 938
Bank
89 267
Bank
131 442
Bank
94 761
$
At the financial year end, Jahangir owes his workers $2793 for work completed
during December 2021.
Required
a Complete the wages account for the year ended 31 December 2021.
b Show appropriate entries in the financial statements.
Workings
At the year end, Jahangir owes his workers $2793. This accrued expense is
owed at the financial year end – therefore, it is a credit (a payable). It has to be
shown as a credit in the books of account at the start of the next financial year.
Wages
$
1.5.1 Adjustments to draft financial statements
Bank
$
Balance b/d
2 793
The rules of double entry mean we cannot make a credit entry without a corresponding
debit entry. Enter a debit entry ‘above the line’ to complete the double entry.
Wages
$
Balance c/d
$
2 793
Balance b/d
2 793
Total the account and transfer the adjusted amount to the statement of profit or
loss.
The balance left on the account at the financial year end is shown on the statement
of financial position as a current liability – the amount that still has to be paid to
Jahangir’s staff.
125
1.5
Answer
a
Wages
1.5 preparatIon of fInanCIal statements
$
Bank
127 938
Bank
89 267
Bank
131 442
Bank
94 761
Balance c/d
$
Statement of profit or loss
2 793
446 201
446 201
Balance b/d
b
446 201
2 793
Extract from statement of profit or loss for the year ended 31 December 2021
$
Expenses
Wages
446 201
Extract from statement of financial position at 31 December 2021
$
Current liabilities
Other payables
2 793
WORKED EXAMPLE 3
Josie has paid $1798 for insurance at 31 December 2021. The summarised
entries are shown. $340 has been paid in advance for insurance in 2022.
Insurance
$
Bank
610
Bank
720
Bank
468
Required
a Prepare the insurance account for the year ended 31 December 2021.
b Show appropriate entries in the financial statements.
Workings
At the financial year end the insurance company owes Josie $340; therefore it is
a receivable. It has to be shown as a debit in the books of account at the start of
the next financial year.
Insurance
$
Balance b/d
126
340
Remember, every debit entry needs a corresponding credit entry.
1.5
Insurance
$
$
Balance c/d
Balance b/d
340
340
1.5.1 Adjustments to draft financial statements
Now complete the account.
Answer
a
Insurance
$
Bank
610
Bank
720
Bank
468
$
Statement of profit or loss
Balance c/d
1 798
Balance b/d
b
1 458
340
1 798
340
Extract from statement of profit or loss for the year ended
31 December 2021
$
Expenses
Insurance
1 458
Extract from statement of financial position at 31 December 2021
$
Current assets
Other receivables
340
Dealing with outstanding revenues and revenues paid in advance
Recording outstanding revenues
When revenue has been earned during a financial year but has not yet been received,
the revenue due must be included in the financial statements.
WORKED EXAMPLE 4
Lori sublets the rooms above her shop to Dan for a rental of $50 per week. At
31 December 2022, Dan owes two weeks’ rent.
Lori’s statement of profit or loss would show a full year’s rental income of
$2600 even though she has actually received only $2500 from Dan.
Workings
A partially completed ledger account for rent receivable would appear as follows:
Rent receivable
$ 2022
Dec 31 Bank
$
2500
127
Required
1.5
a Complete the ledger account for rent receivable for Lori for the full year.
b Show appropriate entries in the financial statements.
Answer
Rent receivable
$ 2022
1.5 preparatIon of fInanCIal statements
2022
Dec 31 Statement of
profit or loss
$
Dec 31 Bank
2600
Balance c/d
2600
2023
Jan 1
2500
100
2600
2023
Balance b/d
100
Extract from statement of profit or loss for the year ended 31 December
$
Income
Rent received
2600
Extract from statement of financial position as at 31 December
$
Current assets
Other receivable (rent)
100
When preparing a statement of profit or loss, a trader must include all items of
revenues received or receivable for the year under review (even if the money has not
actually been received).
Recording revenues that are paid in advance
Sometimes commission receivable and rent receivable may be paid in advance. The
amounts relating to next year will not be included in this year’s financial statements.
WORKED EXAMPLE 5
Hua works on commission for Henri. Hua has earned $5320 commission for the
year ended 31 January 2021. At 31 January 2021, Hua has received commission
payments of $6000.
Required
a State the amount to be entered in Hua’s statement of profit or loss for the
year ended 31 January 2021.
b Calculate the amount to be shown in the statement of financial position at
31 January 2021. Name the section of the statement of financial position in
which it will appear.
Answer
a The amount to be shown in the statement of profit or loss is $5320. This
should be shown as an addition to the gross profit.
b $680 is shown under current liabilities in the statement of financial position.
(Hua owes Henri $680 at the end of the financial year.)
128
WORKED EXAMPLE 6
Gerda sublets part of her premises to Colin for $6240 per annum. At Gerda’s
financial year end, 31 July 2021, Colin had paid $6600 rent.
Answer
a The amount shown in the statement of profit or loss is $6240. This should be
added to gross profit.
b $360 is shown as a current liability in the statement of financial position.
Amounts owed for expenses by a business at the financial year end are usually totalled
and entered in the statement of financial position as a current liability. The total is
shown as ‘other payables’.
Amounts paid in advance for expenses by the business at the financial year end are
usually totalled and entered in the statement of financial position as a current asset.
The total is shown as ‘other receivables’.
Amounts owed to a business for commission receivable and rent receivable are usually
added to receivables.
1.5.1 Adjustments to draft financial statements
Required
a State the amount to be entered in Gerda’s statement of profit or loss for the
year ended 31 July 2021.
b Calculate the amount to be shown in the statement of financial position at
31 July 2021. Name the section of the statement of financial position in which
it will appear.
1.5
Irrecoverable debts, irrecoverable debts recovered and allowance for
irrecoverable debts
In the business world of today, a large proportion of all business is conducted on
credit. A business that deals with credit customers always runs the risk that some of
those customers may not honour their debt.
Irrecoverable debts
If it is known that a credit customer will not or cannot pay his or her debt (an
irrecoverable debt), we cannot leave the debit balance in the trade receivables
account.
If we did:
»
»
»
»
the total amount of trade receivables would be overstated
the current assets would be overstated
the total assets would be overstated
capital would be overstated.
Once we are certain that a credit customer is unable to pay, the debt must be written
off. This is done by debiting an irrecoverable account in the general ledger and
crediting the trade receivables account in the sales ledger.
129
1.5 preparatIon of fInanCIal statements
1.5
WORKED EXAMPLE 7
The following accounts appear in Nobel’s sales ledger:
Balance b/d
Moussa
$
143
Balance b/d
Rett
$
51
Balance b/d
Deck
$
628
Balance b/d
Cindy
$
619
Balance b/d
Sandie
$
430
Balance b/d
Tina
$
92
It has been revealed that Moussa and Tina are unable to pay their debts and
Nobel has decided to write them off at the year ended 31 December 2021.
Required
Show the necessary entries to record the transactions.
Answer
Sales ledger
Moussa
Balance b/d
$
143 Irrecoverable
debts
$
143
Tina
$
92 Irrecoverable
debts
Balance b/d
$
92
General ledger
Irrecoverable
debts
$
Moussa
Tina
143
92
Any entries in the double-entry system must first be entered in a book of prime
entry.
We should use the general journal to record the transfer of each credit customer to
the Irrecoverable debts account before recording the entries in the general ledger.
The general journal entries would show:
Debit
Credit
$
$
Irrecoverable debts account
143
Moussa
143
Writing off Moussa’s debt to the irrecoverable debts account
Irrecoverable debts account
Tina
Writing off Tina’s debt to the irrecoverable debts account
130
92
92
At the end of the financial year, the irrecoverable debts account is totalled
and closed by transferring the amount to the statement of profit or loss as a
revenue expense.
Moussa
Tina
Irrecoverable debts
$
143 Statement of profit or loss
92
$
235
235
Nobel
Extract from statement of profit or loss for the year ended 31
December 2021
$
Expenses
Irrecoverable debts
235
Allowance for irrecoverable debts
As we have seen, individual debts that cannot be paid are transferred to an
irrecoverable debts account. As well as irrecoverable debts that have already occurred,
there is also the possibility that a portion of the current trade receivables may
eventually turn into irrecoverable debts at some point in the future. An estimate of
these likely future irrecoverable debts may be made by a business. This estimate is
referred to as the allowance for irrecoverable debts.
1.5.1 Adjustments to draft financial statements
235
1.5
We should be prudent where possible and this means we should not anticipate possible
profits but will make allowances for likely losses. It therefore seems to be sensible to
make an allowance for trade receivables where there is a strong possibility that they
will not be able to settle their debt. We can never know for sure which of our trade
receivables might become the ones that are irrecoverable so we cannot be sure how
big the allowance should be.
STUDY TIP
Learning link
Prudence was covered
in Chapter 1.2.
An allowance for irrecoverable debts is where the business subtracts an estimate of
the likely size of future irrecoverable debts from the trade receivables figure, so as to
be prudent.
How do we calculate the amount to be provided?
We can:
» examine the sales ledger and try to identify the individual trade receivables who
are most likely to default on payment
» take a percentage of total trade receivables based on experience of irrecoverable
debts written off in previous years
» prepare an age profile of trade receivables and base the provision on the age of
each outstanding amount.
131
Calculation of the allowance based on past experience
1.5
WORKED EXAMPLE 8
Digby has estimated that each year around 2% of his credit customers (trade
receivables) fail to pay.
1.5 preparatIon of fInanCIal statements
At 31 October 2021, his trade receivables amounted to $31 900.
He wishes to make allowance for irrecoverable debts at the rate of 2%.
Required
a Calculate the amount of allowance for irrecoverable debts at 31 October 2021.
b Prepare an extract from the statement of financial position at that date,
showing the details.
Answer
a The allowance for irrecoverable debts is $638 ($31 900 × 2%).
b
Extract from statement of financial position at 31 October 2021
$
$
Current assets
Trade receivables
31 900
(638)
31 262
Less Allowance for irrecoverable debts
Calculation of the allowance based on an age profile of individual trade receivables
WORKED EXAMPLE 9
Deirdre provided the following age profile of her trade receivables at 31 May
2021. The percentage of credit customers proving to be irrecoverable has been
gained from over 20 years’ experience in her business.
0–1
1–3
3–6
6 months– over
Time outstanding
month
months months 1 year
1 year
Amounts owed
$120 000
$3 000
$400
$300 $1 100
Allowance for irrecoverable debts
1%
3%
5%
20%
50%
Required
a Calculate the amount of allowance for irrecoverable debts at 31 May 2021.
b Prepare an extract from the statement of financial position at that date.
Workings
120 000 × 1%
3000 × 3%
400 × 5%
300 × 20%
1100 × 50%
$
= 1 200
= 90
= 20
= 60
= 550
1 920
Answer
a The allowance for irrecoverable debts is $1920.
b Extract from statement of financial position at 31 May 2021
$
$
Current assets
Trade receivables
124 800
Less Allowance for irrecoverable debts
(1 920)
122 880
132
Note
It was doubtful whether Digby would receive $31 900 from his trade receivables. From
past experience, he feels that $31 262 will be a more realistic figure. The creation of
the allowance has allowed him to be prudent.
1.5
It was also doubtful whether Deirdre would receive $124 800 from her trade receivables.
She feels that $122 880 is a more realistic figure. She has been prudent in creating an
allowance for irrecoverable debts.
Once an allowance for irrecoverable debts account has been opened in the general
ledger it stays open from one financial year to the next. Adjustments will be made
each year to the balance in the allowance for irrecoverable debts account and a
corresponding entry made in the statement of profit or loss with the adjustments either
increasing gross profit or decreasing it.
WORKED EXAMPLE 10
Lew has decided to create an allowance for irrecoverable debts account at 2%
of trade receivables outstanding at the financial year end on 31 December 2019
each year. Trade receivables outstanding at 31 December 2019 was $36 700.
Required
Prepare:
a an allowance for irrecoverable debts account at 31 December 2019
b an extract from the statement of profit or loss for the year ended
31 December 2019 showing relevant details
c an extract from the statement of financial position at 31 December 2019.
1.5.1 Adjustments to draft financial statements
The ledger accounts recording allowance for irrecoverable debts
In which ledger would the allowance for irrecoverable debts be found? It is not a person,
so the allowance for irrecoverable debts account would be found in the general ledger.
Answer
a
Allowance for irrecoverable debts
$
2019
Dec 31
b
Statement of profit or loss
734
Extract from statement of profit or loss for the year ended 31 December 2019
$
Expenses
Allowance for irrecoverable debts
c
734
Extract from statement of financial position at 31 December 2019
$
$
Current assets
Trade receivables
Less Allowance for irrecoverable debts
36 700
(734)
35 966
133
1.5 preparatIon of fInanCIal statements
1.5
WORKED EXAMPLE 11
At the financial year end 31 December 2020 Lew had outstanding trade
receivables amounting to $41 300. He continues to maintain his allowance
for irrecoverable debts account at 2% per annum based on trade receivables
outstanding at his year end.
Required
Prepare:
a an allowance for irrecoverable debts account at 31 December 2020
b an extract from the statement of profit or loss for the year ended
31 December 2020 showing relevant details
c an extract from the statement of financial position at 31 December 2020.
Answer
a
Allowance for irrecoverable debts
$ 2019
2019
Dec 31
Balance c/d
2020
Jun 30
$
734 Dec 31
Statement of profit or loss
734
Balance b/d
734
2020
Balance c/d
826 Jan 1
Dec 31
Statement of profit or loss
92
826
826
2021
Jan 1
b
Balance b/d
826
Extract from statement of profit or loss for the year ended 31 December 2020
$
Expenses
Allowance for irrecoverable debts
92
c
Extract from statement of financial position at 31 December 2020
$
Current assets
Trade receivables
41 300
Less Allowance for irrecoverable debts
(826)
$
40 474
Note
» The amount entered on the statement of profit or loss is only the increase in the
allowance.
» It is the amount needed to ‘top up’ the account to the required level.
In each example and question used so far, there has been an increase in the allowance
for irrecoverable debts. A decrease in the allowance now needs to be considered.
Decreasing an allowance for irrecoverable debts
WORKED EXAMPLE 12
Bernie maintains an allowances for irrecoverable debts account. His allowances
for the last three years are listed:
2019
Year ended 30 April
Allowance for irrecoverable debts
134
2020
2021
$
$
$
250
340
270
Required
1.5
Prepare for each of the three years
a an allowance for irrecoverable debts account
b an extract from statement of profit or loss showing the adjustment to the
allowance account.
Answer
a
$ 2019
2019
Apr 30
Balance c/d
250 Apr 30
May 1
2020
Apr 30
$
Statement of profit or
loss
Balance b/d
250
*250
2020
Balance c/d
340 Apr 30
Statement of profit or
loss
90
340
2021
Apr 30
340
May 1
Statement of profit
or loss
Balance c/d
Balance b/d
*340
2021
70
270
340
340
May 1
1.5.1 Adjustments to draft financial statements
Allowance for irrecoverable debts
*270
* The balance brought down is always equal to the amount of allowance
needed.
b
Bernie
Extract from statement of profit or loss for the year ended 30 April 2019
$
250
Less Expenses
Allowance for irrecoverable debts
Bernie
Extract from statement of profit or loss for the year ended 30 April 2020
$
Less Expenses
90
Allowance for irrecoverable debts
Bernie
Extract from statement of profit or loss for the year ended 30 April 2021
$
Gross profit
Plus reduction in allowance for irrecoverable debts
70 (added to gross profit)
135
1.5
EXAMPLE
Mussa Green makes an allowance for irrecoverable debts based on 1% of trade
receivables outstanding at the financial year end.
1.5 preparatIon of fInanCIal statements
The following table shows the entries in the books of account for each of the first
five years in business:
Trade receivables Allowance Statement of profit Statement of financial
End
outstanding
or loss entry
position detail
of
year
$
$
$
$
$
1
10 000
100
100 expense
10 000
(100)
2
12 000
120
20 expense
12 000
(120)
3
16 000
160
40 expense
9 900
11 880
16 000
(160) 15 840
4
14 000
140
20 ‘income’
14 000
(140) 13 860
5
18 000
180
40 expense
18 000
(180)
17 820
To summarise:
» The amount needed to increase the allowance for irrecoverable debts is entered as
an expense on the statement of profit or loss.
» The amount needed to decrease the allowance for irrecoverable debts is entered as
an ‘income’ on the statement of profit or loss.
Recovery of irrecoverable debts
Sometimes a credit customer, whose debt has been written off as an irrecoverable
debt in an earlier year, may subsequently be able to settle his or her previously
outstanding debt.
There are two ways to account for recovery of irrecoverable debts: a simple way and a
more complex way.
The simple treatment is as follows:
Debit cash book
Credit irrecoverable debt recovered account
Then at the financial year end:
Debit irrecoverable debt recovered account
Credit statement of profit or loss.
The more complex treatment involves reinstating the original debt in the credit
customer’s account, as follows:
Firstly, we reinstate the original debt:
Debit credit customer’s account
Credit irrecoverable debt recovered account
Secondly, we record the receipt of the recovered debt:
Debit cash book
Credit credit customer’s account
Then at the financial year end, the balance on the irrecoverable debt recovered
account is transferred to the statement of profit or loss.
136
Entry on statement of profit or loss.
If ledger accounts are not required, the result of the transactions above can be
recorded in the financial statements as:
1.5
» an increase in profit, and
» an increase in cash.
In the following worked example, the more complex method is used.
Hassan owed Bill $237 five years ago. At that time, Bill wrote Hassan’s debt off
as irrecoverable.
Hassan
$
Balance b/d
$
237 Irrecoverable debts
237
Irrecoverable debts
$
Hassan
$
237 Statement of profit or loss
237
Hassan has set up in business again and is now able to pay the $237 that was
previously written off.
Hassan should be reinstated as a credit customer as he is about to repay the
debt. This fact should be recorded in Bill’s books of account.
1.5.1 Adjustments to draft financial statements
EXAMPLE
This is important to Hassan since he may require credit facilities from Bill in the
future. The fact that he has repaid his debt may be taken into consideration by Bill.
Hassan
$
Irrecoverable debt recovered
237
Irrecoverable debt recovered
$
Hassan
237
Hassan has now been reinstated.
Hassan is then credited with the payment made to Bill.
Hassan
$
Irrecoverable debt recovered
237 Cash
237
Irrecoverable debt recovered
$
Statement of profit or loss
237 Hassan
237
137
1.5 preparatIon of fInanCIal statements
1.5
Learning link
Depreciation was
covered earlier in
this textbook, in
Section 1.3.2.
STUDY TIP
If a non-current asset
is acquired during the
financial year then
you should pay close
attention to how it is to
be depreciated, e.g. is
depreciation provided
for a fraction of a year,
none at all, or a full
year’s worth?
Depreciation
As a reminder, the appropriate adjustments in the financial statements include:
Financial statement:
Adjustment needed:
Statement of profit or loss
Subtract the annual charge only from that year’s profit – i.e.
treat annual depreciation as a revenue expense.
Statement of financial
position
Subtract the full balance on the provision for depreciation
account at the year end from the cost of the respective
asset, to give the net book value for each class of asset.
Inventory valuation
Up to now, the businesses that we have looked at have, in the main, been in the first
year of trading. As part of our statements of profit or loss and our statements of
financial position, we have had to consider inventories.
Inventories are valued physically at the end of each financial year. Even if a trader
keeps manual or computerised inventory records, the figures produced are not used in
the end-of-year financial statements.
Despite what you might think, inventory records kept manually or on a computerised
system will be inaccurate! Why? Because goods get stolen, they get damaged, some goods
deteriorate, and these occurrences are not shown in our manual or computer records.
The most accurate way to value inventories is to count them manually and then value
them – but more of that later.
After the trial balance is extracted from the ledgers, a value is placed on closing
inventories.
Closing inventory is deducted from the goods available for sale to obtain the cost of
goods that the business has sold, in other words the cost of sales figure for the year.
Closing inventory is a current asset and must be shown in the statement of financial
position at the end of the financial year.
We have seen that the statement of profit or loss is prepared using revenue incomes
and expenditures by closing the nominal accounts in the general ledger. An inventory
account appears in the general ledger and is prepared as follows:
EXAMPLE
Inventory
$
End of Year 0 Deducted from cost of
(now)
sales in statements of
profit or loss
$
1 234
At the end of the following year:
Inventory
$
138
End of Year 0 Deducted from cost of
(now)
sales in statements of
profit or loss
1 234
End of Year 1 Deducted from cost of
sales in statements of
profit or loss
2 345
$
Start of Added to cost of
Year 1
sales in statements
of profit or loss
1 234
The entries for the following year:
1.5
Inventory
$
$
1 234
Start of Added to cost of
Year 1
sales in statements
of profit or loss
1 234
End of Year 1 Deducted from cost of
sales in statements of
profit or loss
2 345
Start of Added to cost of
Year 2
sales in statements
of profit or loss
2 345
End of Year 2 Deducted from cost of
sales in statements of
profit or loss
3 456
At the financial year end, inventories are valued and recorded as a debit in the
account since they are assets (referred to as valuation of inventory).
The closing inventory is deducted from the current year’s cost of sales (since it has not
as yet been sold) and the balance in the inventory account is shown in the statement
of financial position as a current asset.
At the end of the financial year a trader will physically count the items that remain
as inventory (goods remaining unsold) in the business. A list is made of all the items.
Each category of goods held has then to be valued (referred to as valuation of
inventory).
»
»
»
»
1.5.1 Adjustments to draft financial statements
End of Year 0 Deducted from cost of
(now)
sales in statements of
profit or loss
If closing inventory is overvalued, gross profit is overvalued.
If gross profit is overvalued, then the profit for the year is overvalued.
If closing inventory is undervalued, then gross profit is undervalued.
If gross profit is undervalued, then the profit for the year is undervalued.
We can check this with a simple example.
EXAMPLE
The following is the statement of profit or loss of Figaro:
l Closing inventory should be valued at $15.
l Sales amount to $50.
Inventory overvalued
Realistic inventory value
$
Sales
50
Less Cost of sales:
$
Sales
We will revisit the
valuation of inventory in
Chapter 2.1.
50
Less Cost of sales:
$
Sales
50
Less Cost of sales:
Opening inventory
10
Opening inventory
10
Opening inventory
10
Purchases
25
Purchases
25
Purchases
25
35
Learning link
Inventory undervalued
35
35
Less Closing inventory
20
Less Closing inventory
15
Less Closing inventory
8
Cost of sales
15
Cost of sales
20
Cost of sales
27
Gross profit
35
Gross profit
30
Gross profit
23
l Highest inventory valuation gives highest gross profit.
l Lowest inventory valuation gives lowest gross profit.
139
Learning link
1.5 preparatIon of fInanCIal statements
1.5
How to correct for
errors and their
effects on the financial
statements of a
business were covered
in Chapter 1.4.
Correction of errors
Before all the adjustments are made to the various expenses and incomes of the
business, it is important that the data is error-free before the beginning. Obviously,
a trial balance not balancing will indicate errors are present. However, we also know
that a trial balance that balances does not rule out the possibility of errors still being
present in the accounts.
If there are errors present then it is likely to have an effect on either the statement of
profit or loss or the statement of financial position, or both. It is therefore important
that you check, as far as possible, to ensure the data is error-free before the financial
statements are constructed.
SELF-TEST QUESTIONS
1 Define an accrual.
2 Give two examples of accrued expenses at a financial year end.
3 How should an accrued expense be classified in a statement of financial position?
4 Define a prepayment.
5 Give an example of a prepayment at a financial year end.
6 How should a prepayment be classified in a statement of financial position?
7 Fill in the gaps with ‘debited’, ‘credited’, ‘income’ or ‘expense’.
a When an irrecoverable debt is written off, the trade receivables account is
and the irrecoverable debts account is
.
b When the allowance for irrecoverable debts is increased, the allowance
and the amount is entered in the statement of profit or
account is
loss as an
.
8 In which ledger would you find the irrecoverable debts account?
9 Name the three methods that a trader may use to calculate the amount needed for
the allowance for irrecoverable debts.
10 In which ledger would you find the allowance for irrecoverable debts account?
11 Goods held at the end of a financial year cost $450; they can currently be
purchased for $500; they have a resale value of $700. What is the value of closing
inventory?
12 A damaged article held at the end of a financial year cost $40; after repairs costing
$14 it can be sold for $55. What is the value of the article for inventory purposes?
13 Gross profit is $50 000. Closing inventory was valued at $3000. It has been
discovered that closing inventory should have been valued at $2000. What is the
correct gross profit?
1.5.2 Sole traders
How to prepare a statement of profit or loss and statement
of financial position for a sole trader from full or incomplete
accounting records
A full set of financial statements for most businesses would include the following:
» a statement of financial position
» a statement of profit or loss.
140
Learning link
We first saw the
statement of financial
position in Section 1.2.1
when looking at the
accounting equation.
There are other aspects to the financial statements but the above two are probably the
ones you will encounter more than any other financial statement during this course.
Statement of financial position
1.5
When we looked at the accounting equation earlier in this book we found out that the
value of assets in the business will always be equal to the combined value of liabilities
and capital.
The layout of a statement of financial position
A statement of financial position is made up of two sections: assets and liabilities.
Assets are classified in a statement of financial position according to how long they
are likely to be used in the business, and how liquid they are.
1.5.2 Sole traders
Here, we are going to look at the statement of financial position and its layout in
more detail and as one of the financial statements produced by business entities.
Inventory is more liquid than premises. Inventory can be turned into cash much more
quickly than premises. Think about how long it would take to sell a property.
Machinery is less liquid than trade receivables. It is generally easier to obtain money
from credit customers than it is to obtain money from selling surplus machinery.
Non-current assets may be tangible (that is, they have a physical presence) or they
may be intangible and cannot be seen or touched. Tangible and intangible
non-current assets should be shown separately. The name of your favourite cola or
sports wear would appear as an intangible non-current asset on the statement of
financial position of the owner.
» Examples of tangible non-current assets might include business premises; factory
machinery; delivery vehicles.
» Goodwill is an example of an intangible non-current asset.
Liabilities are classified according to the time allowed by the credit supplier to settle
the debt. In reality, many current liabilities need to be paid much more quickly than
within one year; for example, a supplier of goods is unlikely to allow a business
365 days before the debt is settled.
WORKED EXAMPLE 13
We can produce a statement of financial position based on information for Rollo’s
general store. The following are the assets, liabilities and capital of his store:
$
Assets
$
Capital
43 820
Premises
45 000
Van
16 000 Liabilities
Shop fittings
Inventory
Trade receivables
Bank
18 000 Mortgage
1 670 Bank loan
140 Trade payables
900
25 000
12 000
890
81 710
81 710
141
1.5
If we apply the asset classifications outlined above to Rollo’s statement of financial
position, it will look like this:
EXAMPLE
1.5 preparatIon of fInanCIal statements
$
ASSETS
Non-current assets
Premises
Shop fittings
Van
Current assets
Inventory
Trade receivables
Bank
Total assets
$ Comment
45 000 Normally used for many years
18 000 Normally used for, say, ten years
16 000 Normally in use for, say, four or five years
79 000
1 670
140
900
Should become cash in the next few months
Should settle their debts within 30 days
2 710 Almost as good as cash
81 710
If we classify Rollo’s liabilities, the next section of his statement of financial
position would look like this:
$
CAPITAL AND LIABILITIES
Capital
Non-current liabilities
Mortgage on premises
Bank loan to purchase van
Current liabilities
Trade payables
Total capital and liabilities
$ Comment
43 820 Capital is normally the first item to appear.
25 000
Mortgage is owed over several accounting
12 000 37 000 years, as is money borrowed to purchase a
vehicle. However, both of these would be
classified as current liabilities in the final
year of the debt.
890 Suppliers will normally expect payment
within 30 days of the debt being incurred.
81 710
The order in which assets appear under their headings is known as the reverse order
of liquidity. This means the most liquid of the assets appears last while the least
liquid appears first.
Assets are recorded on statements of financial position at their original cost.
This does initially cause a problem for some students of accounting. The reason for
valuing assets at cost is quite simple. Cost is the only objective valuation that can be
applied to the assets that are owned.
We can now put the two parts of Rollo’s completed statement of financial position
together:
142
EXAMPLE
CAPITAL AND LIABILITIES
Capital
Non-current liabilities
Mortgage
Loan for van
1.5
1.5.2 Sole traders
Rollo’s general store
Statement of financial position at 31 March 2021
$
$
ASSETS
Non-current assets
Premises at cost
45 000
Shop fittings at cost
18 000
Van at cost
16 000
79 000
Current assets
Inventory
1 670
Trade receivables
140
900
2 710
Bank
Total assets
81 710
43 820
25 000
12 000
Current liabilities
Trade payables
Total capital and liabilities
37 000
890
81 710
This layout is based on the accounting equation.
The total assets of the business are shown in the top section of the vertical statement
of financial position and the capital and total liabilities of the business are shown
under the total assets.
Using the statement of financial position to calculate profit
A statement of financial position tells us what the business has in the way of assets,
liabilities (and, by implication, capital) at one particular time. It may seem that we
cannot calculate profit unless we have the information used within the statement of
profit or loss. However, it is still possible to calculate the profit if we only have the
statement of financial position.
Many teachers and textbooks have said that a statement of financial position is rather
like a photograph – it only captures a moment. A statement of financial position only
shows the state of affairs of the business at the time when the statement was prepared.
However, over a financial year it is likely that the financial position of a business will
change. Assets may increase or decrease. Liabilities may increase or decrease. Many of
the changes will take place due to business activity.
If a business is profitable, one would expect that the assets owned by the business
would increase, unless the owner of the business takes more cash and/or goods from
the business than the profits warrant. If a business is unprofitable one would expect
that the business assets would decrease over time.
143
1.5 preparatIon of fInanCIal statements
1.5
Profits increase the capital of the business unless all the profits are taken out by the
owner as drawings. The capital of the business can be calculated as the difference
between the total assets of the business (non-current plus current assets) less the
total liabilities of the business (non-current plus current liabilities). The capital of the
business will always be the same value as the net assets of the business (total assets
less total liabilities) as this is a representation of the accounting equation.
The converse is also true. That is, if there is an increase in the capital then this must
be due to the business being profitable. The only exception to this rule would be if
extra assets were introduced into the business from outside or if liabilities were paid
off by using money obtained from outside the business. An example of this would be
if the owner of the business injected more money into the business or if more assets
were introduced into the business from another source.
How can we calculate the profits made by a business?
WORKED EXAMPLE 14
Barker Animal Foods had the following assets and liabilities at 1 January 2020:
non-current assets $270 000; current assets $21 000; trade payables $5000.
One year later on 1 January 2021 the business had the following assets and liabilities:
non-current assets $290 000; current assets $27 000; trade payables $8000.
During the year, there were no withdrawals or injections of money or assets by the
owner.
Required
Calculate the profit earned by Barker Animal Foods for the year ended
31 December 2020.
Answer
Barker Animal Foods capital at 1 January 2020
Non-current assets
Current assets
$
270 000
Less Current liabilities
21 000
291 000
5 000
Capital
286 000
Barker Animal Foods capital at 1 January 2021
Non-current assets
Current assets
Less Current liabilities
Capital
$
290 000
27 000
317 000
8 000
309 000
The capital of the business increased by $23 000 ($309 000 – $286 000) during the
year. This is the profit that Barker Animal Foods made during the year. It has
to be profit since we were told that no money or assets had been introduced or
withdrawn during the year.
144
Capital introduced and withdrawn from a business
It is unrealistic to think that money or assets would not be injected into a business if
this was necessary to safeguard the business or in order to expand the business.
1.5
It is also unrealistic to imagine that the owner of a business would not withdraw
some cash or resources from the business in order to pay for various items of private
household expenditure during the year. This cash and/or resources taken from the
business is termed drawings.
In order to calculate business profits, it is important that we only consider
transactions that involve the business:
» Money received from an inheritance and paid into the business bank account
should not be included in any calculations to determine profits.
» Cash taken from the business and used to buy food for the family should not be
used in our calculation of profits.
» A cheque for $85 drawn on the business bank account to pay for a repair to the
family television set is not part of the calculation.
1.5.2 Sole traders
It is also unrealistic to imagine that Pusmeena, who owns a garage, would send her
car to another garage for servicing or for repairs. The value of servicing or repairing
Pusmeena’s car in her own garage is drawings.
WORKED EXAMPLE 15
Anjni has been in business for a number of years. At 1 March 2020 her business
assets and liabilities were as follows:
non-current assets at cost $40 000; current assets $10 000; current liabilities
$5000.
One year later, on 28 February 2021, her business assets and liabilities were:
non-current assets $45 000; current assets $9000; and current liabilities $6000.
During the year, she withdrew cash from the business $14 500 for private use.
Required
Calculate Anjni’s business profits for the year ended 28 February 2021.
Answer
$
Anjni’s capital at 1 March 2020 ($40 000 + $10 000 – $5 000)
45 000
Anjni’s capital at 28 February 2021
48 000
Increase in capital over the year (profits ploughed back into the business)
3 000
$
Increase in capital over the year
3 000
Drawings (profits withdrawn during the year)
14 500
Business profit earned during the year
17 500
145
1.5
WORKED EXAMPLE 16
Chang had business capital on 1 August 2020 of $16 000. On 31 July 2021 his business capital stood at $45 000.
During the year his Uncle Hua died and left Chang a legacy of $20 000. The legacy was paid into Chang’s
business bank account.
1.5 preparatIon of fInanCIal statements
Required
Calculate the profit that Chang’s business made for the year ended 31 July 2021.
Answer
Chang’s capital at 1 August 2020
Chang’s capital at 31 July 2021
Increase in capital over the year
$
16 000
45 000
29 000
Some of the increase in capital is due to Uncle Hua’s legacy. This has to be disregarded if we wish to
determine the profits generated by the business, so:
Increase in capital over the year
Less Capital introduced
Business profit earned during the year
$
29 000
(20 000)
9 000
WORKED EXAMPLE 17
Rahila has been in business for a number of years. On 1 February 2020 her capital stood at $30 500. At 31
January 2021 her business statement of financial position showed the following:
non-current assets $45 000; current assets $18 000; non-current liabilities $20 000; current liabilities $7000.
During the year, she paid into the business bank account a cash gift of $10 000 from her grandmother. Her
drawings for the year amounted to $21 000.
Required
Calculate the profit or loss made by the business for the year ended 31 January 2021.
Answer
Rahila’s capital at 1 February 2020
Rahila’s capital at 31 January 2021
Increase in capital over the year
Add Drawings
Less Capital introduced
Business profit for the year ended 31 January 2021
$
30 500
36 000
5 500
21 000
26 500
(10 000)
16 500
WORKED EXAMPLE 18
Helen’s statement of financial position at 1 May 2020 showed:
non-current assets $16 000; current assets $4000; current liabilities $3500; capital $16 500.
On 30 April 2021 her statement of financial position showed:
146
non-current assets $30 000; current assets $5000; current liabilities $6000 and a non-current liability
$20 000.
During the year Helen paid into the business bank account a legacy of $18 000. Her drawings for the year
amounted to $14 000.
1.5
Required
Calculate the profit or loss made by Helen’s business for the year ended 30 April 2021.
Answer
1.5.2 Sole traders
$
Helen’s capital at 1 May 2020
16 500
Helen’s capital at 30 April 2021
9 000
Decrease in capital over the year
(7 500) Negative numbers are
Add Drawings for the year
14 000 often shown in brackets.
6 500
Less Capital introduced
18 000
Loss made by Helen’s business during the year
(11 500)
Incomplete records
In addition to calculating profit from changes in the capital of a business, there are
other techniques that can be used where incomplete financial records exist.
Using control accounts
Control accounts can be used to calculate the level of sales and purchases where
incomplete records exist. If we have information relating to cash book transactions
and the opening and closing balances of trade receivables and payables, then we may
be able to calculate the missing sales and purchases figures. It is worth pointing out
that this will only calculate sales and purchases made on credit – cash sales and cash
purchases would not be included in any total calculated.
WORKED EXAMPLE 19 (TYPE 1 – MISSING SALES
FIGURE)
The following information is available relating to credit sales.
$
Trade receivables at start of year
15 500
Trade receivables at end of year
21 200
Receipts from credit customers
77 000
Required
Construct a sales ledger control account to calculate the total for credit sales.
Answer
If we construct a sales ledger control account, then it will appear as follows:
Sales ledger control account
$
Balance b/d
Sales
15 500 Cash book
$
77 000
82 700 Balance c/d
21 200
98 200
98 200
147
WORKED EXAMPLE 20 (TYPE 2 – MISSING PURCHASES
FIGURE)
1.5
$
1.5 preparatIon of fInanCIal statements
Trade payables at start of year
5 700
Trade payables at end of year
2 200
Purchases returns
1 000
Money paid to suppliers
40 000
Required
Construct a purchases ledger control account to calculate the credit purchases
total.
Answer
Purchases ledger control account
$
Cash book
Purchases returns
Balance c/d
$
40 000 Balance b/d
5 700
1 000 Purchases
37 500
2 200
43 200
43 200
Using mark-up and margin
In Chapter 1.6 we will calculate the mark-up and the gross profit margin figures
from data. These accounting ratios can be also used when incomplete records exist.
You should look at the formulae for these two ratios now in order to understand this
section (page 149).
The gross profit of a business is calculated as the difference between the sales and
the cost of sales. The mark-up represents the percentage profit added on to the cost
of sales which gives us the sales value (some businesses – often smaller ones – use
mark-up as a method of setting their selling prices). The margin is calculated as the
same profit as a percentage of the selling price. In this case you can probably expect
that there will be a connection between the concepts of mark-up and margin.
If we convert the mark-up and margin ratios into fractions, rather than percentages,
then there is also a connection between the mark-up ratio and the gross profit margin
ratio. This can be expressed as follows:
FORMULA
Mark up
1
therefore
Gross profit margin
1
n +1
n
Or:
FORMULA
Gross profit margin
1
n
148
therefore
Mark-up
1
n −1
For example, where the cost of sales has been ‘marked-up’ by 33.3%, we can say that
the mark-up is ¹⁄³. In this case, based on the above formula, the gross profit margin
would be ¼, or 25%.
1.5
WORKED EXAMPLE 21
Consider the following data:
Opening inventory: $18 000
1.5.2 Sole traders
Closing inventory: $27 000
Sales: $45 000
Mark-up: 50%
Required
From this information, calculate the value of purchases.
Answer
For a mark-up of 50% (or ½), the gross profit margin would be ¹⁄³ (33.3%).
This means that 33.3% of the sales would be gross profit.
Gross profit = 33.3% × $45 000 = $15 000
Therefore, the cost of sales must be $30 000 (gross profit = sales less cost of sales).
If cost of sales is $30 000 equivalent to opening inventory ($18 000) plus purchases (?) less closing inventory
($27 000), the purchases figure must be $39 000.
WORKED EXAMPLE 22
Paul Jones is a sole trader who does not maintain full accounting records.
The following balances are available for the start and end of the most recent year.
At 1 January 2022
At 31 December 2022
$
$
413
532
12 900
11 250
Trade receivables
891
1 190
Trade payables
546
543
31
40
Inventory
Non-current assets (at book value)
Accrued general expenses
During the year ended 31 December 2022, the following transactions were recorded:
$
General expenses
850
Receipts from trade payables
7 041
Payments to trade payables
4 898
Rent received
500
Sales returns
77
Purchases returns
43
Required
Prepare the statement of profit or loss for Paul Jones for the year ended 31 December 2022.
149
1.5
Answer
We can assume all sales and purchases are on credit as there is no information provided on cash sales or
cash purchases. To calculate the credit sale and purchases, we can use control accounts as follows:
Sales ledger control account
$
1.5 preparatIon of fInanCIal statements
Balance b/d
$
891 Receipts from credit customers
Credit sales
7 041
7 340 Balance c/d
1 190
8 231
8 231
Purchases ledger control account
$
Payments to credit suppliers
Balance c/d
$
4 898 Balance b/d
546
543 Credit purchases
4 895
5 441
5441
The statement of profit or loss would appear as follows:
Paul Jones
Statement of profit or loss for year ended 31 December 2022
$
$
Sales
$
7 340
Less sales returns
77
7 263
Less cost of sales
Inventory at 1 January 2022
Add purchases
413
4 895
Less purchases returns
43
4 852
5 265
Less inventory at 31 December 2022
532
Gross profit
4 733
2 530
Add Rent received
500
3 030
General expenses
859
Depreciation (*)
1 650
Profit for the year
2 509
521
* Depreciation is calculated as the change in the net book value of the non-current assets – given no
purchases or sales were made of these during the year.
Statement of profit or loss
A statement of profit or loss details the incomes and expenditures incurred by the
business during a set period of time (usually a financial year). Although, as we have
seen, profits and losses can be calculated accurately and fairly quickly by using the
‘capital’ method, managers or owners of a business generally need to know more than
just the profit figure in isolation.
150
A statement of profit or loss is divided into two sections:
» The first section calculates gross profit and shows the results of trading.
» The second section shows the profit or loss remaining after all business expenses
have been subtracted from the gross profit.
Learning link
Deciding whether
an item is capital or
revenue expenditure (or
income) is important
here for deciding how
to treat that in the
statement of profit or
loss – this was covered
in Chapter 1.3.
Although the capital method of calculating the profit of a business does calculate the
profit easily and realistically, it does have a major drawback. It does not give us any
details of how the profit or loss was arrived at.
The details of how a profit has been earned or why a loss has been incurred are
important to both the owner and any external providers of finance:
1.5.2 Sole traders
Profits are generally calculated over a financial year but they could be calculated
for any time period. Many business owners calculate their profits halfway through
the year as well as at their financial year end in order to plot the progress of their
business. Financial statements will be produced at any time they might be required by
the owner or managers of a business.
1.5
» The owner will probably wish to make greater profits in the future.
» Lenders will wish to see that their investment is safe and that any interest due or
repayments due will be able to be met by the business.
The details of how profits are arrived at are shown in a statement of profit or loss.
Calculating gross profit within the statement of profit or loss
The first section of a statement of profit or loss calculates the gross profit that a
business has made by buying and selling its goods during a particular period of time.
This section shows how much it cost to buy the goods that are sold and how much
they were sold for. The goods in question are the goods that the business buys and
sells in its everyday activities.
Calculating gross profit means comparing the value of sales and the value of purchases
over time. It is normally prepared for a year but could be done for any period of time.
Note
» Statements of profit or loss are prepared for a period of time.
» The statements of financial position we prepared earlier were prepared at one
moment in time.
WORKED EXAMPLE 23
Bernadette owns a business selling magazines and books. She is able to give you the following information
relating to her business for the year ended
31 December 2021:
Purchases of magazines and books
Purchase of cash register
Sales of magazines and books
Sales of shop fittings
$
32 500
840
65 800
1 200
Required
Prepare a calculation to show gross profit for the year ended 31 December 2021.
151
1.5
Answer
Bernadette
Statement of profit or loss for the year ended 31 December 2021
1.5 preparatIon of fInanCIal statements
$
Revenue
65 800
Purchases
32 500
Gross profit
33 300
Note
l The figures included in the extract from a statement of profit or loss are figures for a year, the heading
l
l
l
l
l
tells us this.
The purchase of the cash register has not been included – it is capital expenditure.
The sales of shop fittings has not been included – it is a capital receipt.
Purchases are revenue expenditure. They are part of the everyday costs associated with running
Bernadette’s business.
Sales are revenue receipts. These receipts are from Bernadette’s normal trading activities.
The gross profit is found by deducting the value of purchases from the revenue generated by the sales.
Calculation of gross profit is found by using the total value of purchases (an example
of revenue expenditure) and sales (an example of a revenue receipt).
The treatment of inventories
Very few businesses sell all the goods that they purchase each day. At the end of every
day there will be goods left on the shelves, in display cabinets, and in the warehouse.
Generally, there will be goods left unsold at the end of any financial year. The last
millisecond of the last day of the financial year is (almost) the same time as the first
millisecond of the new financial year.
So, the inventory value at the end of one financial year is the inventory value at the
start of the following financial year.
» Inventory at 30 November 2021 is inventory at 1 December 2021.
» The inventory held by a business at 31 May 2022 is the inventory held on 1 June 2022.
Unsold goods need to be valued.
The inventory held at the start of a financial year is sometimes referred to as opening
inventory. The inventory held one year later at the end of the financial year is
sometimes referred to as closing inventory.
What effect will opening and closing inventory values have on the gross profit in the
statement of profit or loss?
We need to calculate the value of the goods that have actually been sold during the
year, since not all purchases will be sold during the year of purchase. The cost of sales
refers to the costs of the goods that were sold during the year. This is calculated
as opening inventory + purchases of inventory − closing inventory. There are other
amendments to this cost of sales calculation that will be dealt with later in this chapter.
WORKED EXAMPLE 24
Baldeep has a market stall selling spices. She provides the following information:
l inventory of spices at 1 September 2020: $345
l purchases of spices for the year ended 31 August 2021: $18 450
l sales of spices for the year ended 31 August 2021: $42 750
l inventory of spices at 31 August 2021: $400
152
Required
Calculate gross profit for the year ended 31 August 2021.
1.5
Workings
We first have to find the value of the spices that Baldeep sold during the year.
$
Baldeep started the year with
345 worth of spices
18 450 worth of spices
So she could have sold
18 795 worth
... but she didn’t … she had
400 worth left
… some left. She had
18 395 worth of spices.
So she must have sold
The $18 395 of spices represents the cost of Baldeep’s sales – the cost of sales. From this we can calculate
the gross profit.
1.5.2 Sole traders
She bought a further
How much did she sell these spices for? $42 750
Her gross profit for the year was $24 355.
Talk yourself through this example a few times. It is important that you understand the process that you
have gone through.
The actual gross profit should be presented like this:
Answer
Baldeep
Statement of profit or loss for the year ended 31 August 2021
$
Revenue
$
42 750
Less Cost of sales
Inventory 1 September 2020
Purchases
345
18 450
18 795
Less Inventory 31 August 2021
Gross profit
400
18 395
24 355
Note
l Opening inventories are added to purchases.
l Closing inventories are deducted from goods available for sale to calculate cost of sales.
The description for $18 395 is ‘cost of sales’.
$18 395 is the cost price of the spices Baldeep sold during the year for $42 750.
Notice the use of two columns. After a few times using this technique you will see
that it makes the calculation of gross profit much clearer.
The treatment of returned goods
Even in businesses that are extremely well run, some goods are returned by customers.
The way that these sales returns are treated in the statement of profit or loss seems fairly
obvious: the total value of sales returns is deducted from the total value of sales for the
year.
153
1.5
No matter how good and how careful suppliers are, there will inevitably be occasions
when a business has to return goods. Again, our treatment of any purchases returns
seems to be fairly obvious: the total value of purchases returns is deducted from the
total value of purchases for the year.
1.5 preparatIon of fInanCIal statements
WORKED EXAMPLE 25
The following information for the year ended 31 August 2021 relates to the
business of Beebee:
inventory at 1 September 2020 $1200; inventory at 31 August 2021 $1500;
purchases $48 000; sales $72 380; sales returns $180; purchases returns $360.
Required
Calculate the gross profit for the year ended 31 August 2021.
Answer
Beebee
Statement of profit or loss for the year ended 31 August 2021
$
$
$
Revenue
72 380
Less Sales returns
180
72 200
Less Cost of sales
Inventory 1 September 2020
1 200
Purchases
48 000
Less Purchases returns
360
47 640
48 840
Less Inventory 31 August 2021
1 500
47 340
Gross profit
24 860
Once again, notice the way that the calculation to find the ‘net’ purchases figure has
been set back from the second column. Accountants often use ‘extra’ columns so that
the main column does not get too confused.
The treatment of expenses incurred in the carriage of goods
Carriage inwards makes the goods that are purchased more expensive. It is added to
the goods that appear as purchases in the statement of profit or loss.
Carriage outwards is an expense that is dealt with later in this chapter.
WORKED EXAMPLE 26
Benji owns a store. The following figures relate to the year ended
30 September 2021:
inventory at 1 October 2020 $5300; inventory at 30 September 2021 $4900;
purchases $124 600; sales $314 000; sales returns $930; purchases returns
$2100; carriage inwards $1750.
Required
Prepare an extract from the statement of profit or loss for the year ended 30
September 2021 showing the calculation of gross profit.
154
Answer
1.5
1.5.2 Sole traders
Benji
Statement of profit or loss for the year ended 30 September 2021
$
$
$
Revenue
314 000
Less Sales returns
930
313 070
Less Cost of sales
Inventory 1 October 2020
5 300
Purchases
124 600
Less Purchases returns
2 100
122 500
Carriage inwards
1 750
124 250
129 550
Less Inventory 30 September 2021
4 900
124 650
Gross profit
188 420
This example shows the most complicated form that a statement of profit or loss can
take.
Notice once more the use of three columns. This has enabled us to get one figure for the
total cost of net purchases ($124 250) without lots of calculations in the main columns.
When you attempt the questions below you may find it helpful to refer to Benji’s
statement of profit or loss to get a good layout. Do not worry about this. You will
soon start to remember where to enter the various items.
The full statement of profit or loss
So far, we have calculated the first measure of profit to be included in the statement of
profit or loss (gross profit). Here we now consider the full statement of profit or loss.
If your weekly income does not cover your weekly expenditure, what do you do? You
draw some money from your savings (if you have any) or you may borrow sufficient
money to tide you over until your income is enough to cover your spending.
The same principle applies to someone in business. If the business is unprofitable, the
owner may have to inject some of his or her savings into the business or borrow money
to help the business to survive.
We have just seen how to calculate the gross profit. The gross profit is the difference
between the cost of goods sold by a business and the amount that the goods have
been sold for.
Clearly there are expenses that have to be paid out of this gross profit in order that
the business can continue in business. Profit for the year is calculated by deducting
all expenses incurred by the business from the gross profit that it has earned through
buying and selling its goods during a financial year.
EXAMPLE
During April, Didi buys 1000 DVDs for $4000 and she sells them all for $6990.
She has made a gross profit of $2990 on the sales. However, she will have
incurred some expenses in selling the DVDs, and they could have included:
l rent paid for the use of a market stall
l transport costs to get the DVDs to the stall
155
l wages of any sales assistants
l money paid to purchase wrapping materials, etc.
1.5
1.5 preparatIon of fInanCIal statements
When all other expenses incurred in making the sales have been taken into
account the result is profit for the month.
Therefore, if Didi paid the following expenses:
l rent of the stall $400
l wages to her assistant $880
l wrapping materials $34
l electricity to light the stall $61,
her profit for the month would be $1615:
Gross profit $2990 – Expenses $1375 ($400 + $880 + $34 + $61) = $1615
For a sole trader operating as a trader, the main form of revenue receipts will be from
the sale of goods, shown as revenue or sales. However, a sole trader may have other
forms of revenue receipt that do not arise from the sale of goods. These additional
forms of income are included in the statement of profit or loss. These can take the
form of income earned by the business for other kinds of business activity, such as
renting out part of the business premises.
In addition, these incomes could include ‘accounting’ adjustments to the profit that
are added on as revenue receipts. In particular, a profit on the disposal of any noncurrent asset, or a reduction in the allowance for irrecoverable debts would both
appear as additional income. The example below incorporates this additional income.
Remember
Some income or
expenses in the
statement of profit
or loss may actually
include adjustments to
profits and losses that
involve no spending
or receipt of money at
all, such as a reduction
in the allowance for
irrecoverable debts.
WORKED EXAMPLE 27
Vitaly owns and runs a general store. In the year ended 31 March 2021, he
made a gross profit of $21 500. During the same year, he incurred the following
incomes and expenditure:
Wages
Insurance
Purchase of new weighing scales
Motor expenses
Light and heating expenses
Rent received
Commission received
Stationery and advertising
Bank charges
Purchase of new delivery van
General expenses
Money spent on family holiday
$
8 000
400
2 340
1 100
500
540
95
250
135
15 600
185
2 300
Required
Prepare the statement of profit or loss for the year ended 31 March 2021.
156
Answer
1.5
Vitaly
Statement of profit or loss for the year ended 31 March 2021
$
Gross profit
$
21 500
Add Other income:
540
Commission received
95
635
22 135
Less Expenses:
Wages
8 000
Insurance
400
Motor expenses
1.5.2 Sole traders
Rent received
1 100
Light and heating expenses
500
Stationery and advertising
250
Bank charges
135
General expenses
185
Profit for the year
10 570
11 565
Note
l The weighing scales and the delivery van have not been included because
they are both examples of capital expenditure. They will appear on Vitaly’s
statement of financial position.
l The money spent on the holiday has not been included since this is not a
business expense. A statement of profit or loss only includes business expenses.
l The money spent on the family holiday is drawings since the transaction had
gone through the records of the business.
l Additional incomes of rent and commission received are added on to gross
profit first.
It is usual for businesses to include the calculation of gross profit within the statement
of profit or loss. This means two measures of profit will appear in the statement.
WORKED EXAMPLE 28
Danielle is a trader buying and reselling furniture. She supplies the following
information relating to the year ended 31 May 2021:
$
Inventory 1 June 2020
27 268
Inventory 31 May 2021
28 420
Purchases
481 690
Carriage inwards
523
Carriage outwards
568
Commission received
1 290
Sales
748 381
Wages
132 471
Rent
26 402
157
1.5
Advertising and insurance
8 327
Motor expenses
10 513
Office expenses
12 468
Lighting and heating expenses
11 235
1.5 preparatIon of fInanCIal statements
Required
Prepare a statement of profit or loss for the year ended 31 May 2021.
Answer
Danielle
Statement of profit or loss for the year ended 31 May 2021
$
Revenue
$
748 381
Less Cost of sales
Inventory 1 June 2020
Purchases
27 268
481 690
508 958
Add Carriage inwards
523
509 481
Less Inventory 31 May 2021
28 420
Gross profit
481 061
267 320
Add Other income:
Commission received
1 290
Less Expenses
Wages
Carriage outwards
Rent
Advertising and insurance
268 610
132 471
568
26 402
8 327
Motor expenses
10 513
Office expenses
12 468
Lighting and heating expenses
11 235
Profit for the year
201 984
66 626
The first section of the statement of profit or loss calculates the gross profit of the
business. This is the profit earned on trading, i.e., the buying and selling of goods.
The remainder of the statement of profit or loss shows what is left of the gross profit
when all other incomes and expenses have been taken into account. This leaves us
with the profit for the year.
The treatment of the expense of carriage outwards
Carriage outwards is an expense borne by the business. It is included in the
statement of profit or loss with all other expenses incurred by the business.
Statement of profit or loss for a service business
Many of the examples used in this book deal with businesses that are either
manufacturers or traders. Today, many businesses in the world provide a service.
This means they will not have a ‘cost of sales’ calculation as found in a trader’s or
manufacturer’s statement of profit or loss. The statement of profit or loss for a service
business will look very similar to that of other business organisations but will have no
calculation for gross profit.
158
WORKED EXAMPLE 29
The following data relates to Mark Ritchie’s graphic design business for the year
ended 31 December 2020:
1.5
$
Revenue
Insurance
2 313
24 530
Rent
8 970
Heating and lighting
1 765
Commission received
450
Sundry expenses
Advertising
1.5.2 Sole traders
Salaries
95 000
990
1 230
Required
Prepare a statement of profit or loss for Mark Ritchie for the year ended
31 December 2020.
Answer
Mark Ritchie
Statement of profit or loss for the year ended 31 December 2020
$
Revenue
$
95 000
Add commission received
450
95 450
Less expenses
Insurance
Salaries
2 313
24 530
Advertising
1 230
Rent
8 970
Heating and lighting
1 765
Sundry expenses
990
Profit for the year
39 798
55 652
SELF-TEST QUESTIONS
1 Explain what is meant by the terms ‘capital’ and ‘drawings’.
2 Non-current assets $7000; current assets $3000; current liabilities $2000.
Calculate capital.
3 Explain why the owner of a business might prefer to determine the profits made
by his business by using a statement of profit or loss rather than relying on a
‘capital’ calculation.
4 Why is it important to classify expenses into capital expenditure and revenue
expenditure?
5 Inventory held at close of business on 31 July cost $13 000. It will be sold for
$20 000. What is the value of inventory at start of business 1 August?
159
6 Explain the effect that the inclusion of sales returns has on the gross profit of a
business.
1.5
7 Sales $37 980; sales returns $356; purchases returns $299. What is the value of
net sales?
Calculation question (answer on page 494)
1.5 preparatIon of fInanCIal statements
8 The balance on the allowance for irrecoverable debts was $1 910 on 1 January.
The business wishes to maintain the balance on this allowance at 4% of trade
receivables based on the year-end trade receivables balance. If trade receivables
at 31 December are $62 500, calculate the amount to be included in the statement
of profit or loss in respect of the allowance for irrecoverable debts for the year.
1.5.3 Partnerships
Partnerships are another type of business entity. Just to remind you, these are
businesses that consist of two or more partners. Each partner is involved in the
running of the business. The partnership does not have limited liability and therefore
there is no difference between the partnership and those running the partnership in
terms of the law. There are differences in the financial statements of the partnership
compared with other types of business entity.
STUDY TIP
It does not matter particularly if the partnership is a trader or a service sector
business. The differences in the statement of profit or loss for partnership compared
with a sole trader appear only after the profit for the year has been calculated.
How to prepare a statement of profit or loss, appropriation
account and statement of financial position for a partnership
from full or incomplete accounting records
Learning link
Partnerships as a
type of a business
entity were covered
earlier in Chapter 1.1.
Partnerships will also
appear again in Section
3.1.2.
Partnership statements of profit or loss
The internal financial statements for all businesses are prepared in much the same way
in most respects. It is only after the calculation of profit for the year that a change
may take place.
When you prepared the financial statements of a sole trader, the profit or loss was
entered in the trader’s capital account.
The profit or loss earned by a partnership has to be shared between the partners in
accordance with any agreement (or according to the Act if there is no agreement).
How profits or losses are distributed is shown in detail in the final section of the
statement of profit or loss.
Partners usually agree to share profits in ways that will reflect:
» the workload of each partner
» the amount of capital invested in the business by each partner
» the risk-taking element of being in business.
Partners, like all entrepreneurs, receive a share of profits. The profit division is shown
in the appropriation account under the following headings:
» salaries
» interest on capital
» share of residual profits.
160
Partners’ salaries
1.5
WORKED EXAMPLE 30
Antoine and Burcu are in partnership, sharing residual profits in the ratio of 2:1
respectively.
The profit (before tax) for the year ended 31 July 2021 was $36 450.
Answer
Antoine and Burcu
Appropriation account for the year ended 31 July 2021
$
$
Profit for the year
1.5.3 Partnerships
Required
Prepare an appropriation account for the year ended 31 July 2021.
36 450
Share of profit – Antoine
Burcu
(24 300)
(12 150)
(36 450)
Note that negative numbers are sometimes shown in brackets.
If a partner is entitled to a partnership salary, this is taken from the profit for the
year before the residual profit shares are calculated.
WORKED EXAMPLE 31
Conserva and Divya are in partnership, sharing residual profits in the ratio 3:2
respectively after crediting Divya with a partnership salary of $4200.
The profit for the year ended 31 December 2021 was $29 460.
Required
Prepare an appropriation account for the year ended 31 December 2021.
Answer
Conserva and Divya
Appropriation account for the year ended 31 December 2021
$
$
Profit for the year
29 460
Less Salary – Divya
(4 200)
25 260
Share of profit – Conserva
Divya
(15 156)
(10 104)
(25 260)
Note
l Divya’s salary is deducted before the sharing of residual profits.
l Divya’s share of profits is $14 304. (She does not earn a salary in the same
way that employees earn a salary, she is a part owner of the business and as
such she earns profits no matter how they are described.)
161
Interest on partners’ capital account balances
1.5
WORKED EXAMPLE 32
1.5 preparatIon of fInanCIal statements
Enriques and Faraz are in partnership. They maintain fixed capital accounts,
the balances of which are $30 000 and $20 000 respectively. Their partnership
agreement provides that profits and losses are shared 2:1 after interest on
capital is provided at 8% per annum. The profit for the year ended 31 March 2021
was $32 269.
Required
Prepare an appropriation account for the year ended 31 March 2021.
Answer
Enriques and Faraz
Appropriation account for the year ended 31 March 2021
$
Profit for the year
$
32 269
Less Interest on capital – Enriques
Faraz
(2 400)
(1 600)
(4 000)
28 269
Share of profit – Enriques
Remember
A partnership salary is
not the same as a salary
that is paid to a worker
– it is an appropriation
of profit, rather than a
business expense.
Faraz
(18 846)
(9 423)
(28 269)
Note the use of the ‘inset’ to show clearly the individual appropriations and the
total appropriations.
l Enriques’ share of the profit is $21 246 (interest $2 400 plus $18 846 share of
residual profit).
l Faraz’s share of the profit is $11 023.
WORKED EXAMPLE 33
Gervais and Harpreet are in partnership. They maintain fixed capital accounts
at $50 000 and $32 000 respectively. The profit for the year ended 31 August
2021 was $47 632.
The partnership agreement provides that Harpreet be credited with a
partnership salary of $3750 per annum; that interest at the rate of 7% per
annum be credited on partners’ capital account balances; and that residual
profits be shared in the ratio 4:1 respectively.
Required
Prepare an appropriation account for the year ended 31 August 2021.
162
Answer
1.5
Gervais and Harpreet
Appropriation account for the year ended 31 August 2021
$
$
Profit for the year
47 632
Less Salary – Harpreet
(3 750)
Less Interest on capital – Gervais
Harpreet
Learning link
How profits are
appropriated to each
partner will depend
on any partnership
agreement – covered in
Section 1.1.1.
(3 500)
(2 240)
(5 740)
38 142
Share of profit – Gervais
(30 514)
(7 628)
Harpreet
(38 142)
1.5.3 Partnerships
43 882
Note that the residual profit shares have been rounded.
Interest on partners’ drawings
Some partnership agreements provide that partners will be charged interest on any
drawings made during the financial year. This is to deter partners from drawing cash
from the business in the early part of the financial year.
WORKED EXAMPLE 34
The partnership agreement of Arbuthnot and Beebee provides that interest
be charged on drawings at 6 per cent per annum. The business year end is
31 December.
During the year the partners made drawings as follows:
Arbuthnot
Beebee
$
$
Mar 31
3 000
2 000
Jun 30
5 000
6 400
Sep 30
4 200
5 600
Required
Calculate the amount of interest on drawings to be charged to each partner for
the year.
Answer
Arbuthnot will be charged $348 interest on drawings.
Beebee will be charged $366 interest on drawings.
Workings
Arbuthnot:
Beebee:
$3000 × 6% × ¾ year = $135
$2000 × 6% × ¾ year = $90
$5000 × 6% × ½ year = $150
$6400 × 6% × ½ year = $192
$4300 × 6% × ¼ year = $63
$5600 × 6% × ¼ year = $84
163
The entries in the partnership account:
» add the interest on drawings to the profit for the year in the appropriation section
of the statement of profit or loss
» debit the partners’ current accounts with the interest charged on their drawings.
1.5
The debit entry in the partners’ current accounts has the effect of increasing the
amount withdrawn during the year. It is in effect an additional amount of drawings.
1.5 preparatIon of fInanCIal statements
WORKED EXAMPLE 35
Goctay and Hanif are in partnership. They supply the following information for
the year ended 31 August 2021:
l The partnership agreement provides that Goctay be credited with a
partnership salary of $5 600; that partners be credited with interest on
capital of 8% per annum; that partners be charged interest on their drawings
at 5% per annum; and that residual profits be shared equally.
l Goctay’s fixed capital account stands at $42 000, while Hanif’s fixed capital
account stands at $50 000.
l The profit for the year before appropriations was $56 934.
l During the year Goctay made drawings of $32 900 and Hanif’s drawings were
$21 750.
l Interest on drawings was calculated at $348 for Goctay and $180 for Hanif.
Required
Prepare an appropriation account for the year ended 31 August 2021.
Answer
STUDY TIP
If an issue is
not covered by
the partnership
agreement, or if there
is no agreement at
all, then you must
apply the rules set
out in your territory’s
partnership legislation,
similar to the 1890
Partnership Act in the
UK.
Goctay and Hanif
Appropriation account for the year ended 31 August 2021
$
$
Profit for the year
56 934
Add Interest on drawings – Goctay
348
Hanif
180
528
57 462
(5 600)
Less Salary – Goctay
51 862
Less Interest on capital – Goctay
(3 360)
Hanif
(4 000)
(7 360)
44 502
Share of profit – Goctay
(22 251)
Hanif
(22 251)
(44 502)
How to prepare partners’ capital and current accounts
A statement of financial position for a partnership differs from that of a sole trader
in that, since there is more than one owner, there must be more than one capital
account, showing the financial commitment of each partner to the business.
Indeed, the capital employed in the business is usually divided into partners’ capital
accounts and partners’ current accounts.
The capital accounts normally remain fixed and are only adjusted if there is a
structural change to the partners’ capital account balances. The current accounts of
164
each partner are adjusted for changes in appropriations made to each partner and
drawings made by each partner during the year.
WORKED EXAMPLE 36
1.5
The appropriation account for the year ended 30 June 2021 of Tayyiba and Adnan
is shown:
$
$
34 745
Less Salary – Tayyiba
(6 000)
1.5.3 Partnerships
Profit for the year
28 745
Interest on capital – Tayyiba
(2 400)
Adnan
(3 000)
(5 400)
23 345
Share of profit – Tayyiba
Adnan
(9 338)
(14 007)
(23 345)
l The current account balances at 1 July 2020 were $40 000 and $50 000,
respectively.
l Drawings for the year were Tayyiba $22 350 and Adnan $26 850.
Required
Prepare the current accounts of Tayyiba and Adnan at 30 June 2021.
Answer
Current accounts
Tayyiba
Adnan
Tayyiba
Adnan
$
$
40 000
50 000
$
$
Drawings
22 350
26 850
Balance b/d
Balance c/d
35 388
40 157
Salary
6 000
Interest on capital
2 400
3 000
Share of profit
9 338
14 007
57 738
67 007
35 388
40 157
57 738
67 007
Balances b/d
Notice that a columnar layout has been used. This saves time and space. By using this
approach it does mean that you do not have to repeat the descriptions used in each
account.
The current accounts would generally be shown on the statement of financial position
of the partnership as follows:
$
$
Current account
Tayyiba
35 388
Adnan
40 157
75 545
Note: The current account balances would be added to the capital account balances to
give the total capital balance for the partnership.
It is more usual for a partnership to maintain fixed capital accounts and show all
appropriations in the partnership current accounts.
165
1.5
All entries relating to profits earned and profits withdrawn are entered in the current
accounts.
WORKED EXAMPLE 37
Tawanda and Jacob are in partnership. They provide the following information
for the year ended 31 August 2021:
1.5 preparatIon of fInanCIal statements
Tawanda
Capital account balances 1 September 2020
$
30 000
45 000
Current account balances 1 September 2020
1 542 Cr
Drawings for the year were
Jacob
$
238 Cr
20 653
16 234
541
452
Interest to be charged on drawings
An extract from the appropriation account shows:
$
Salary – Tawanda
4 800
Interest on capital – Tawanda
2 100
Jacob
3 150
Share of residual profits – Tawanda
18 000
Jacob
9 000
Required
Prepare detailed capital accounts and current accounts for the partnership at
31 August 2021.
Answer
Capital accounts
Tawanda
Jacob
Tawanda
Jacob
$
$
$
$
30 000
45 000
Balances b/d
Current accounts
Drawings
Interest on drawings
Tawanda
Jacob
Tawanda
Jacob
$
$
$
$
20 653
16 234
Balances b/d
1 542
238
541
452
Salary
4 800
Interest on capital
2 100
3 150
18 000
9 000
Share of profits
Balance c /d
5 248
26 442
Balance b/d
Balance c/d
16 686
4 298
4 298
26 442
Balance b/d
16 686
5 248
The capital accounts have remained ‘fixed’ and the profits earned and profits
withdrawn from the business (drawings) and interest on drawings are recorded in the
current accounts.
It is, of course, possible that a partner may withdraw more profits from the business than
they have earned. In such a case the partner’s current account will show a debit balance.
166
WORKED EXAMPLE 38
Vikram and Walter provide the following information for their partnership for
the year ended 30 April 2021:
Vikram
1.5
Walter
$
Current account balances as at 1 May 2021
164 Cr
298 Cr
Interest on capital for the year
500
700
Share of residual profits
25 300
12 650
Drawings for the year
20 000
15 000
Interest on drawings
270
460
1.5.3 Partnerships
$
Required
Prepare:
a an appropriation account for the year ended 30 April 2021
b current accounts at 30 April 2021.
Answer
a
Vikram and Walter
Appropriation account for the year ended 30 April 2021
$
Profit for the year
$
38 420*
Add Interest on drawings – Vikram
270
Walter
460
730
39 150
Less Interest on capital – Vikram
(500)
Walter
(700)
Remember
The current account
of a partner is not
the same thing as a
current account held
with a bank. It shows
the amount each
partner has built up
in terms of additions
and subtractions to
their overall capital
balances in the form
of appropriations each
partner receives, as well
as drawings and other
charges made to each
partner.
(1 200)
37 950
Share of profits – Vikram
(25 300)
Walter
(12 650)
(37 950)
*Missing figure
b
Current accounts
Drawings
Interest on drawings
Vikram
Walter
20 000
15 000
270
460
Vikram
Walter
Balances b/d
164
298
Interest on capital
500
700
25 300
12 650
Share of profits
Balance c/d
5 694
25 964
Balance b/d
Balance c/d
15 460
1 812
1 812
25 964
Balance b/d
15 460
5 694
Why partners may maintain separate capital accounts and current accounts
It would be possible to record all the appropriations of profit (and loss), as well as all
the adjustments to capital, in the same account for each partner, just as with a sole
trader. This is more likely when a major event is occurring, such as the dissolution of
the partnership (where it is being closed down).
167
However, you will find that partnerships frequently maintain both a current account
and a capital account separately for each partner. A reason for doing this is that it
separates the adjustments to each partner’s overall ‘capital’ into those arising out
of the partnership’s normal trading operations, i.e. from earning profits, and those
that are more likely to be one-off, long-term adjustments to the balance, such as the
introduction of new capital.
1.5 preparatIon of fInanCIal statements
1.5
Keeping the two accounts separate would also act as a psychological warning for
partners not to withdraw too much from the partnership. In effect, the current
account represents the amount that they could draw on from what they have ‘earned’.
Having said that, the total of capital and current account balances for each partner
is technically available for each partner to draw from – which is why partnerships
often charge interest on drawings, i.e. to actively discourage partners from taking out
drawings too frequently.
Learning link
If a partnership
undergoes a structural
change then the
accounting techniques
needed are covered in
Section 3.1.2.
STUDY TIP
Even if a new
agreement says profits
are still to be shared
equally between
partners, adding a new
partner will mean a
smaller ‘fraction’ each
of the profits as there
are more partners
to divide the profit
between.
The contents of a partnership agreement
The contents of a partnership agreement will deal with the rules on how the
partnership is to be run. As far as recording the accounting transactions of a
partnership, you should apply only what is presented within the partnership
agreement. This was covered earlier in Section 1.1.1.
If a partnership changes during the course of time, then the old partnership ceases
to be and a new one is formed. In this case, the old partnership agreement ceases
to apply, and the provisions of local legislation, or the 1890 Partnership Act should
act as a guide as to how to deal with items. However, it is just as likely that the new
partnership will have a new partnership agreement.
The provisions of the Partnership Act 1890
This was previously covered in Section 1.1.1. As mentioned before, if a particular
item is missing from the partnership agreement, then the partners must follow the
1890 Partnership Act on how things will progress. For example, if there is no mention
of a partnership salary being given to a partner for extra work, then this cannot be
retrospectively added in to the financial statements.
The key features of the Act are as follows:
»
»
»
»
»
Profits and losses to be shared equally.
Partners are entitled to five per cent interest if they loan the partnership money.
Partnership salaries are not permitted.
Interest on capital should not be awarded to partners.
Interest on drawings should not be charged to partners.
It is vital that any partnership agreement deals with these features if the partners
want to deviate from the content of the Act.
The advantages and disadvantages to partners of maintaining a
partnership agreement
Clearly, preparing a partnership agreement will help to prevent disputes occurring
where partners feel that they deserve a higher share of profits (or more appropriations
in the form of salaries or interest on capital). The partnership agreement cannot be
ignored while that partnership exists. Of course, if the partners strongly disagree with
the agreement then it is up to the partners to resolve this where possible. Sometimes
a new agreement may be prepared to reflect changes, such as a partner increasing or
decreasing their workload within the business.
168
However, if a disagreement cannot be resolved then it may lead to a change in the
partnership in terms of which partners stay and which partner leaves. As mentioned
above, a partnership ceases to exist when a partner leaves (or a new one joins),
though given there is no legal distinction between the partners as individuals and the
partnership, there is nothing to stop the partners continuing with the same business
name. This could cause a protracted battle if different partners want to ‘keep’ the
business name – especially if the operation of the partnership adds value to the
business (which is covered in Section 3.1.2).
SELF-TEST QUESTIONS
1 Explain why a partner may be entitled to a partnership salary.
2 Interest on capital is paid to a partnership by the business’s bankers. True/False?
3 Profit for the year is $40 000, partners’ salaries are $12 000 and interest on capital
is $16 000. Calculate the amount of residual profits.
1.5.4 Limited companies
There are no great disadvantages to preparing a partnership agreement other than the
extra legal work and cost required to do so.
1.5
4 A partner works as a sales assistant in the partnership store. Explain how his
partnership salary should be shown in a statement of profit or loss.
5 Partners have unlimited liability. True/False?
6 Explain two advantages of being in partnership.
7 Give the date of the Partnership Act.
8 Give an example of an entry in a partner’s capital account.
9 Give two examples of debit entries in a partner’s current account.
10 Give two examples of credit entries in a partner’s current account.
Calculation question (answer on page 494)
11 Rosa is a partner. Her current account balance at 1 January 2022 was $490
(credit). Based on the following appropriation to her, calculate her current account
balance at 31 December 2022.
Share of residual profits
Interest on drawings
Interest on capital
Drawings
$8 000
$320
$1 340
$10 000
Learning link
1.5.4 Limited companies
Limited companies and
how they are financed
was covered in
Chapter 1.1.
We first encountered limited companies at the beginning of the textbook. A limited
company exists separately from its owners in terms of its legal structure. There are
two types of limited company – the private limited company (Ltd) and the public
limited company (plc). The finance available for the limited company includes some
sources of finance that were not available for sole traders and partnerships.
The features and accounting treatment of ordinary shares,
debentures, dividends and reserves
One way a company differs from a sole trader or partnership is in its capital structure. A
company’s capital will consist of items different from simpler forms of business entity.
169
Capital structure
1.5
A limited company raises capital in order to provide finance for the purchase of non-current
assets (and initially to provide working capital). It raises capital in a variety of ways.
A company can:
1.5 preparatIon of fInanCIal statements
» issue shares
» issue debentures
» borrow from financial institutions.
The statement of financial position of a limited company is very similar to the
statements of financial position that you have already prepared many times before.
But there are some important differences in layout and in the accounting terms used.
The ‘top’ section of a statement of financial position for sole traders and partnerships
might look like this:
$
ASSETS
Non-current assets
Current assets
Total assets
100
30 Figures are included for
130 illustrative purposes only
It is only the ‘lower part’ of the statement that looks different.
Sole trader
Partnership
$
CAPITAL AND LIABILITIES
Capital
Non-current liabilities
Current liabilities
Total capital and liabilities
$
CAPITAL AND LIABILITIES
70 Capital accounts – Doe
50
Ray
10
130 Current accounts – Doe
Ray
Non-current liabilities
Current liabilities
$
40
25
65
3
2
5
50
10
Total capital and liabilities
130
The lower part of the statement of financial position of a limited company might look
like this:
$
EQUITY AND LIABILITIES
Equity
Ordinary shares of $1 each
Reserves
Non-current liabilities
Current liabilities
Total equity and liabilities
60
10
70
50
10
130
We will now look in detail at the lower section of a statement of financial position for
a limited company.
The first section should be headed ‘Equity’.
170
.
Share capital should be described fully, for example:
$m
Equity
Ordinary shares of $1 each
1.5
60
The extract from the statement of financial position shows that the nominal value of each
class of share is $1. It shows that 60 million ordinary shares have actually been issued.
Ordinary shares
Ordinary shares are the most common type of share. The holders of ordinary shares are
part owners of the company. At meetings in which voting is required, each shareholder
can cast one vote for each share they own, so the shareholders can appoint directors
and can influence policies that directors and managers wish to follow. They may
receive a variable dividend in years when the company is profitable (and has sufficient
cash resources). They may receive interim dividends during the year and a final
dividend shortly after the financial year end.
1.5.4 Limited companies
Any ordinary dividend to be paid will be expressed as a percentage of the nominal
value or as an amount per share. So a dividend may be declared as five per cent (i.e.
five per cent of $1 nominal value) or as an amount of, say, 6.3 cents (i.e. the holder of
100 shares would receive $6.30 as a dividend).
If shares are issued at nominal value (i.e. they are issued at their face value and not
at a premium) then the accounting entries are straightforward. Remember that issuing
shares is just another way of adding to the company’s capital – so it follows the
double-entry rules for increased capital.
The issue of shares (assuming they are fully paid on application) would involve the
following double entry:
Debit
Credit
Bank
Ordinary share capital
Dividends and reserves
STUDY TIP
If the nominal value
of a share is not $1
then be careful when
calculating the amount
of dividends given from
a quote ‘dividends per
share’.
Although ordinary shareholders have no automatic right to expect dividends each
year, it is likely that these will be paid out to the shareholders so as to ensure that
they keep hold of their shares and do not try to sell them. Dividends are paid out of
the profit for the year. The amount paid out will depend in part of how successful the
company has been in generating profits but also by how much the directors want to
retain profits for reinvestment into the company – the more they retain, the lower the
level of dividends.
The amount given as dividends will be quoted as either a total amount (measured in $)
or may be expressed as a certain amount (usually cents per share, e.g. $0.04 per
share). If expressed as an amount per share, the total amount paid will be the amount
per share multiplied by the number of issued shares.
171
WORKED EXAMPLE 39
1.5 preparatIon of fInanCIal statements
1.5
A company has ordinary share capital of $200 000. This consists of 400 000
shares at $0.50 per share. The directors decide to pay a dividend of $0.02 per
share.
Required
Calculate the total amount of dividend paid and show the accounting entries
needed.
Answer
If $0.02 is paid per share, then the total dividend will be:
$0.02 × 400 000 = $8000
The accounting entries would be as follows:
Ordinary dividends
$
Bank
$
8 000
Bank
$
Learning link
Debentures were first
introduced in Section
1.1.1 when we looked
at finance available for
limited companies.
STUDY TIP
Do not show debentures
as part of equity. They
should always be
shown on a statement
of financial position as
a non-current liability.
$
Ordinary dividends
8 000
Debentures
Debentures are not shares; they are bonds recording a long-term loan to a company.
As they are a loan to the company, the debenture holder is entitled to a fixed rate of
interest each year.
Debentures may be repayable at some future date or they may be irredeemable – that
is, the holder will only be repaid if the company goes into liquidation.
Some debentures have the loan secured against specific non-current assets or against
all the company’s assets. These are known as mortgage debentures.
If the company is wound up or fails to pay the interest due, the holders of mortgage
debentures can sell the assets of the company and recoup any outstanding amounts.
Characteristics of long-term finance available to limited companies
▼ Table 1.5.1 Ordinary shares and debentures
172
Ordinary shares
Debentures
Shares
Long-term loans
Part owner of company
Not owners
Voting rights
No voting rights
Paid out last in case of liquidation
Paid out before shareholders in case of
liquidation
Dividends
Interest
Variable dividend
Fixed rate of interest
Part of equity
Part of non-current liabilities
The advantages and disadvantages to the company and to
the shareholders of a company issuing shares and issuing
debentures
1.5
Whether a company decides to use a share issue (Table 1.5.2) or a debenture issue
(Table 1.5.3) to raise finance will depend on the company itself. Each of these sources
of long-term finance will have its own advantages and disadvantages. These will depend
on whether this is viewed from the perspective of the shareholder of the company itself.
Share issue
Company
Shareholders
Advantages
Disadvantages
Company does not have to pay back the amount raised
from the share issue – it is permanent capital
Control over the company may be lost if
shareholders become sufficiently concentrated in
the hands of certain individuals (or institutions)
The company can choose whether to pay dividends or
not
Organising a share issue can be very expensive
for a plc
The level of dividends can be decided based on the
company’s ability to pay
Dividends are not tax-deductible (they are paid
after tax has been calculated)
1.5.4 Limited companies
▼ Table 1.5.2 Advantages and disadvantages of a share issue
Shareholders have a chance to influence company
direction based on the voting power of ordinary shares
▼ Table 1.5.3 Advantages and disadvantages of a debenture issue
Debentures
Company
Shareholders
Advantages
Disadvantages
No control over the company is lost as debentures are
unable to vote on company matters
Interest must be repaid on the debentures
Interest on debentures is a tax-deductible expense
(i.e. it appears as deduction before tax on profits is
calculated)
Debentures themselves must be repaid at a
specified date in the future – regardless of the
level of profits
Shareholders are not being asked to provide further
capital
Shareholders may not receive dividends if the
level of interest is so large that the company
cannot afford a dividend payment
The choice between debt (debentures) and equity (shares) finance is not an easy one
for most businesses. It will also depend on the current level of debt that a business
has – the more indebted a company is, the harder it may be to acquire new borrowing.
The distinction between capital reserves (share premium
and revaluation reserve) and revenue reserves (retained
earnings and general reserve)
Reserves
The profits of any business belong to the owners. The profit earned by a sole trader or
by partners belongs to them (the owners). The profit earned by a limited company also
belongs to the owners – that is, the ordinary shareholders.
In the case of a sole trader or partnership, some profits may be taken out of a
business by the owners as drawings. In the case of a limited company, some of the
profits may be paid to the shareholders as dividends. The profit that remains in the
business increases the capital structure of the business.
173
EXAMPLE
1.5 preparatIon of fInanCIal statements
1.5
Sole trader
Partnership
Limited company
Profit $26 000
Drawings $12 000
Drawings, say $8000
and $4000
Dividends $12 000
Retained profits
$14 000
$14 000
$14 000
Part of capital
account
Part of capital or
current accounts
Part of equity as
revenue reserve
Retained earnings (profits)
Share capital and reserves show how much a company is worth. They show how the
assets have been financed.
STUDY TIP
Do not say that
reserves are cash.
Some of the profits
will already have
been used to replace
non-current and other
assets.
Non-current assets
+
current assets
Share capital
+
reserves
+
liabilities
▲ Figure 1.5.1 The accounting equation
Reserves are profits. Retained earnings are a major source of finance for all successful
businesses.
There are two types of reserves: revenue reserves and capital reserves.
Revenue reserves
Revenue reserves are the most flexible form of reserve. If in the future the revenue
reserves are found to be excessive or are unnecessary they can be added back to
current profits and used for dividend purposes.
The revenue reserves can either be set aside for a specific purpose like the expansion
of the company or replacement of non-current assets or, more generally, in order to
strengthen the financial position of the company.
The main revenue reserves are:
» retained earnings
» general reserve.
Capital reserves
Since capital reserves do not arise through ‘normal’ trading activities, they are not
available for the payment of cash dividends. Any distribution to shareholders of these
reserves will take the form of bonus shares.
The main capital reserves are:
» share premium account
» revaluation reserve.
174
STUDY TIP
A share premium account only arises when the company issues the shares.
If Margaretha sells her $1 shares in Placton plc to Ncube for more than the
nominal value or the price that she paid for them, there is no share premium.
This is a private financial transaction and will not be recorded in the company’s
books of account. Margaretha’s name will be taken out of the company share
register and Ncube’s name will be included.
A share premium account arises when a company issues shares at any price that is
greater than the nominal value of the shares.
The book keeping entries are shown below.
WORKED EXAMPLE 40
Premsha plc offers 100 000 ordinary shares of $0.50 each for sale at $1.50 each.
All monies were received on application.
1.5.4 Limited companies
The issue of shares and the share premium account
1.5
Required
Prepare the ledger accounts to record the share issue.
Answer
Ordinary share capital
Bank
Bank
$
$
50 000
Ordinary share capital 150 000
and share premium
Share premium
$
Bank
100 000
More often than not, the ledger accounts will not be required, although you may be
asked to show the effect on the company statement of financial position.
Changes to a statement of financial position:
$
Current assets
Bank
+150 000
Equity
Ordinary shares of $0.50 each
Share premium account
+50 000
+100 000
A share premium account may be used to:
»
»
»
»
pay up unissued shares to issue as bonus shares
write off preliminary expenses (expenses incurred in the formation of a company)
write off any expenses incurred in an issue of shares
provide any premium payable on the redemption of shares or debentures.
175
1.5
WORKED EXAMPLE 41
The summarised statement of financial position for Capdo Ltd at 31 October
2021 is shown:
Capdo Ltd
Statement of financial position at 31 October 2021
1.5 preparatIon of fInanCIal statements
$
$
ASSETS
Non-current assets
17 000
Other current assets
10 000
Bank
2 000
12 000
Total assets
29 000
EQUITY AND LIABILITIES
Equity
Ordinary shares of $0.10
10 000
Retained earnings
11 000
21 000
Current liabilities
8 000
Total equity and liabilities
29 000
On 1 November 2021 a further 200 000 ordinary shares were issued at a price of
$0.50 each.
Required
Prepare a summarised statement of financial position at 1 November 2021 after
the share issue.
Answer
Capdo Ltd
Summarised statement of financial position at 1 November 2021
$
$
ASSETS
Non-current assets
Other current assets
Bank ($2000 + $100 000)
Total assets
17 000
10 000
102 000
112 000
129 000
EQUITY AND LIABILITIES
Equity
Ordinary shares of $0.10 each
30 000
Share premium (200 000 X $0.40)
80 000
Retained earnings
11 000
121 000
Current liabilities
Total equity and liabilities
176
8 000
129 000
Revaluation reserves
The book keeping entries for revaluation reserves are as follows.
1.5
WORKED EXAMPLE 42
A summarised statement of financial position of Kato plc is shown:
Kato plc
Summarised statement of financial position at 31 December 2021
ASSETS
Non-current assets at cost
Current assets
Total assets
40 000
12 000
52 000
EQUITY AND LIABILITIES
Equity
Ordinary shares
Retained earnings
1.5.4 Limited companies
$ 000
25 000
23 000
48 000
4 000
52 000
Current liabilities
Total equity and liabilities
The directors of the company revalue the non-current assets on 31 December
2021 at $51 000 000.
Required
Prepare a summarised statement of financial position at 31 December 2021
after revaluation of the non-current assets.
Answer
Kato plc
Summarised statement of financial position at 31 December 2021
$ 000
ASSETS
Non-current assets at valuation
Current assets
Total assets
EQUITY AND LIABILITIES
Equity
Ordinary shares
Revaluation reserve
Retained earnings
Current liabilities
Total equity and liabilities
51 000 (increase of $11 000 000)
12 000
63 000
25 000
11 000
23 000
59 000
4 000
63 000
The book keeping entries would be:
Non-current assets
$000
Balance b/d
40 000
Revaluation reserve
11 000
Revaluation reserve
Non-current assets
$000
11 000
177
1.5
If the non-current asset to be revalued has been depreciated, then any depreciation
needs to be written off.
WORKED EXAMPLE 43
The ledger of Heret plc shows the following accounts:
Provision for depreciation of
premises
1.5 preparatIon of fInanCIal statements
Premises
$
$
200 000
120 000
The directors revalue the premises at $350 000.
Required
Prepare:
a book keeping entries to record the revaluation of premises
b journal entries to record the revaluation.
Answer
a
Premises
Provision for depreciation of premises
$
Bal b/d
200 000
Revaluation
reserve
150 000
$
$
Revaluation
reserve
120 000 Bal b/d 120 000
Revaluation reserve
$
Premises
150 000
Provision for
depreciation 120 000
b
General journal
$
$
Premises account
150 000
Provision for depreciation of premises account
120 000
Revaluation reserve
270 000
Revaluation of premises to a value of $350 000
The features and accounting treatment of bonus issues and
rights issues of shares
There are a number of different ways a company can increase the size of its share
capital. The simplest way is for the company to issue more shares. Companies
usually set out how much they can raise in share capital when they are formed – and
companies do not necessarily issue this all in one go.
However, there are other ways in which a business can increase its issued share
capital. Two ways include bonus issues of shares and rights issues of shares.
178
Rights issues and bonus issues of shares is an important topic, so make sure you are
clear about this distinction.
▼ Table 1.5.4 The characteristics of a rights issue and a bonus issue
Rights issue
Bonus issue
Issue is offered to existing shareholders
Issue is offered to existing shareholders
Issue based on present holding
Issue based on present holding
Specified price is usually cheaper than
present market price since the company
saves on widely advertising the issue and
preparing a full prospectus
No charge to shareholders
Generates cash for business
Does not generate cash for business
If shareholder does not wish to exercise his
or her right, it may be sold to a third party
1.5.4 Limited companies
The control of the company does not change; The control of the company does not change;
it remains with the existing shareholders
it remains with the existing shareholders
1.5
A rights issue of shares
A company can issue more shares if it needs to raise more capital. A rights issue of
shares is a much cheaper way of raising capital than an issue of shares to the general
public. A rights issue is an invitation to existing shareholders to subscribe for more
shares. A rights issue entitles existing shareholders to apply for a specified number of
shares based on their existing shareholding.
A rights issue can be issued at both a premium and a discount. The premium is
because a rights issue often occurs some time after the first batch of shares were
issued, often many years later, and the market price of the share will be significantly
above the shares’ original face value. Therefore, the rights issue is at a premium
compared to the original share price.
The new shares are often issued at slightly less than the current market price. This is
the discount offered on a rights issue. This is to encourage existing shareholders to
buy the rights issue shares – and make it a success.
So, the premium is compared to the original share value, and the discount is compared
to the current market value.
WORKED EXAMPLE 44
The summarised statement of financial position of Ardele plc is shown:
$
Total assets
2 925 000
EQUITY
Ordinary shares of $0.50 each
Retained earnings
Total equity
2 500 000
425 000
2 925 000
The company made a rights issue of one new share for every four shares
already held at a price of $1.25. All shareholders took up their rights and
monies due were paid.
179
1.5 preparatIon of fInanCIal statements
1.5
Required
a Redraft the statement of financial position after the rights issue has been
completed.
b Gahir owns 500 ordinary shares in Ardele plc. After the rights issue has
been completed, calculate:
i the total number of ordinary shares owned by Gahir
ii the price paid by Gahir for her new shares.
Answer
a
Ardele plc
Statement of financial position after the rights issue
$
Total assets
4487 500
EQUITY
Ordinary shares of $0.50 each
3 125 000
Share premium
937 500
Retained earnings
425 000
Total equity
4487 500
b Gahir now owns 625 ordinary shares. She paid $156.25 for the new shares.
Shareholders who do not wish to exercise their rights may sell their rights. The effect
of a rights issue on a statement of financial position is exactly the same as the
effects of a ‘normal’ issue to the general public.
A bonus issue of shares
Bonus shares are issued when the directors of a company feel that the ordinary share
capital account does not adequately reflect the capital base of the company.
Consider two scenarios for the same limited company:
Statement of financial position
many years ago
Statement of financial position today
$
Total assets
Total assets
800
EQUITY
EQUITY
Ordinary share capital
Ordinary share capital
800
25 000
800
Reserves
24 200
Total equity
25 000
You can see that over the years the ordinary share capital has remained unchanged,
whereas the asset base of the company has increased with retained revenue reserves
and capital reserves.
The directors may redress this imbalance, if the shareholders agree, by transferring
some of the balances on reserve accounts to the ordinary share capital account.
The process is as follows:
Debit the reserve(s) account
180
Credit the share capital account
WORKED EXAMPLE 45
The following summarised statement of financial position is given for Blazet plc:
$
13 000
4 000
2 000
7 000
13 000
A bonus issue is made on the basis of one new share for every share already
held.
It is the directors’ policy to maintain reserves in their most flexible form.
Required
Prepare the ledger accounts and a summarised statement of financial position
after the bonus issue has been completed.
1.5.4 Limited companies
Total assets
EQUITY
Ordinary share capital
Share premium account
Retained earnings
Total equity
1.5
The ledger accounts would appear as follows:
Share premium
$
STUDY TIP
The information
relating to ‘maintaining
the reserves in their
most flexible form’
means that capital
reserves should be
used before using
revenue reserves
for an issue of bonus
share, since capital
reserves have a much
more restricted use
than revenue reserves.
Ordinary share capital
$
2 000 Balance b/d
2 000
Retained earnings
$
Ordinary share capital
$
2 000 Balance b/d
7 000
Ordinary share capital
$
$
Balance b/d
4 000
Share premium
2 000
Retained earnings
2 000
STUDY TIP
Although capital
reserves are used
frequently for the issue
of bonus shares, the
revaluation reserve
should NOT be used
for this purpose (i.e.
the share premium
account should be
used if capital reserves
are to be used).
Blazet plc
Summarised statement of financial position after completion of the bonus issue
$
Total assets
13 000
EQUITY
Ordinary share capital
8 000
Retained earnings
5 000
Total equity
13 000
181
Advantages and disadvantages to the company and to the shareholders of
a company making a bonus issue of shares and a rights issue of shares
1.5
STUDY TIP
1.5 preparatIon of fInanCIal statements
Remember that the bonus issue of shares does not raise finance in the same way as
a normal share issue or a rights issue. A bonus issue of shares is a way of making the
equity more closely reflect the size of the company’s assets.
If a company uses a bonus issue to increase the size of its share capital, then there
will be advantages and disadvantages for either the company or the shareholder
(Table 1.5.5).
▼ Table 1.5.5 Advantages and disadvantages of a bonus issue
Bonus issue
Company
Advantages
Disadvantages
Control of company remains in the same hands as before
the bonus issue (as the bonus shares are allocated in
proportion to existing shareholdings)
No extra finance is raised through a bonus
issue as it is a ‘paper’ exercise
Reserves are no longer available to allow
dividend payments, if current profits are too
low to make dividend payments from
Shareholders
There is no charge for these shares made to shareholders
Reserves are reduced, which means they are no longer
available for distribution to shareholders as dividends
(some shareholders may actually want this as it may
increase the chances of capital growth in the share value)
Similarly, if a company uses a rights issue to increase the size of its share capital,
then there are clearly going to be advantages and disadvantages for the shareholders
and the company itself (Table 1.5.6).
▼ Table 1.5.6 Advantages and disadvantages of a rights issue
Rights issue
Advantages
Company
Compared with a normal share issue, a rights issue is a lot Rights issues may be unsuccessful in raising
cheaper to arrange and organise
finance if shareholders are not interested in
acquiring new shares
Significant sums of money can be raised by the issue –
especially if at a premium
The control of the company will not be diluted –
assuming every shareholder takes up their ‘rights’ to buy
shares fully
If the company is successful, the rights issue can take
place at a premium to the original price when the shares
were first issued
Shareholders
182
Disadvantages
Shareholders are often offered the rights issue shares
at a discount on the current market value of shares – to
encourage them to purchase the shares
Control of the company may be lost if the
rights issue shares are quickly sold on by the
original shareholders to other investors
How to prepare a statement of profit or loss, a statement of
financial position and statement of changes in equity for a
limited company
1.5
As mentioned earlier, the financial statements of a limited company will look similar
to those of a sole trader and partnership but with some differences. Here are examples
of each type of financial statement.
Here is an example of a statement of profit or loss of a limited company:
Nedert Ltd
Statement of profit or loss for the year ended 31 December 2021
$000
Revenue
$000
3 434
1.5.4 Limited companies
EXAMPLE
Less Cost of sales
Inventory 1 January 2021
632
Purchases
1 578
Inventory 31 December 2021
(711)
Looks similar to ‘other’
financial statements so far,
doesn’t it?
2 210
Gross profit
1 499
1 935
Less Expenses
Wages
(451)
Other general expenses
(349)
Depreciation
(56)
(856)
Profit from operations
1 079
Finance costs (debenture interest)
 Here is where there are
(223)  changes.
831 
Profit before tax
Tax
Profit for the year
(25)
1 054
Why is it important to identify the profit from operations?
STUDY TIP
Learn the layout for a set of financial statements for a limited company. You already
know most of it. So concentrate on the lower third – the parts after the profit from
operations has been calculated.
183
Consider this simple example:
1.5
EXAMPLE
1.5 preparatIon of fInanCIal statements
Kris is a sole trader. His wealthy father set him up in business a number of years
ago by providing all the necessary finance. His business earns a gross profit of
$100 000 per annum.
Kate is a sole trader. She is in the same business sector as Kris. Their
businesses are a similar size. Kate has no wealthy relatives and she borrowed
money from a bank to help finance her business. Her business also earns a
gross profit of $100 000 per annum.
Kris’s business expenses for the year are $60 000. Kate’s business expenses for
the year are $70 000, of which $20 000 is interest payments to the bank.
Which of the two business owners runs a more efficient business?
Kris’s profit from operations for the year is $40 000 while Kate’s is $50 000.
If Kate’s parents had given her the necessary finance for her business, her
profits would have been the greater of the two. She appears to be running a
more efficient business.
After the deduction of interest payable from the profit from operations, we have
profit before taxation.
One other point is that it is usual to group certain types of expenses together. The reason
for this is that it makes the production of published accounts easier.
WORKED EXAMPLE 46
The directors of Treadle plc provide the following information at
31 October 2021:
$
Sales
956 230
Purchases
438 920
Inventory 1 November 2020
43 310
Inventory 31 October 2021
41 760
Directors’ fees
106 900
Salaries – sales personnel
administrative
Depreciation – delivery vehicles
premises
Other expenses – selling and distribution
administrative
184
54 970
67 830
54 000
20 000
31 140
34 800
Audit fees
23 000
Debenture interest
40 000
Corporation taxation
21 000
Required
Prepare a statement of profit or loss for the year ended 31 October 2021.
Answer
Treadle plc
Statement of profit or loss for the year ended 31 October 2021
$
Revenue
Inventory 31 October 2021
Gross profit
Overheads:
Selling and distribution costs
Salaries
Directors’ fees
Other expenses
Audit fees
Depreciation – delivery vehicles
Administrative expenses
Salaries
Other expenses
Depreciation – premises
Profit from operations
Finance costs
Profit before tax
Corporation tax
Profit for the year
43 310
438 920
482 230
(41 760)
(54 970)
(106 900)
(31 140)
(23 000)
(54 000)
(67 830)
(34 800)
(20 000)
$
956 230
440 470
515 760
1.5.4 Limited companies
Less Cost of sales
Inventory 1 November 2020
Purchases
1.5
(270 010)
(122 630)
123 120
(40 000)
83 120
(21 000)
62 120
Statements of changes in equity
International Accounting Standards (see Chapter 3.1) require that limited companies
show how the shareholders’ (the owners’) stake in the company has changed over the
course of the financial year.
STUDY TIP
The example here
shows a trading
business. The
statement of profit
or loss for a service
business would look
very similar and would
require little change to
the format used here.
The statement of profit or loss concludes with the profit for the year. Standards
require that a statement of changes in equity is prepared. This provides the link
between the statement of profit or loss and the statement of financial position by
showing changes to permanent share capital and reserves (equity).
Dividends are the part of the profits of a company that are paid to the shareholders
(owners). Any part of the profit that is not paid out to the shareholders as dividends is
retained within the company as a revenue reserve.
The portion of profit retained in the company is sometimes said to be ‘ploughed back’,
and is described on the statement of financial position as retained earnings.
All profits after taxation and dividends belong to the ordinary shareholders so the
amount of profit retained within the company will, generally, have a positive effect on
the price of second-hand shares in the (stock) market.
185
1.5
WORKED EXAMPLE 47
An extract from the statement of financial position of Tantang plc at 31 December 2020 shows the following
details:
$000
EQUITY AND LIABILITIES
1.5 preparatIon of fInanCIal statements
Equity
Issued share capital
2 500
Share premium
500
Revaluation reserve
1 000
General reserve
750
Retained earnings
1 876
During the year ended 31 December 2021 the following changes to equity took place:
1 000 000 ordinary shares of $1 each were issued at a price of $2.50 each.
Non-current assets currently valued at $850 000 were revalued at $1 000 000.
A transfer of $50 000 was made from retained earnings to the general reserve.
The profit for the year ended 31 December 2021 was $638 000.
Ordinary dividends paid were $125 000.
Required
Prepare a statement of changes in equity for the year ended 31 December 2021.
Answer
Statement of changes in equity for the year ended 31 December 2021
Share
capital
Share Revaluation
premium
reserve
General
reserve
Retained
earnings
Total
$ 000
$ 000
$ 000
$ 000
$ 000
$ 000
Balance at start of the year
2 500
500
1 000
750
1 876
6 626
Share issue
1 000
1 500
Revaluation
2 500
150
Transfer to general reserve
150
50
Profit for the year
Dividends paid
Balance at end of the year
3 500
2 000
1 150
800
(50)
0
638
638
(125)
(125)
2 339
9 789
You can see that the statement has been adjusted to reflect the new value of each component making up
equity capital.
186
WORKED EXAMPLE 48
1.5
The following information is available at 31 March 2021 for Evahline plc:
1.5.4 Limited companies
Profit before tax
Tax
Ordinary dividends paid
Retained earnings at 1 April 2020
$000
746
218
146
814
Required
STUDY TIP
Be careful when using
millions and thousands
– many errors are
caused when decimal
points are put in the
wrong place. For
example:
Correct ✓
Wrong ✗
$ 000
$ 000
30
Prepare:
a an extract from the statement of profit or loss for the year ended
31 March 2021
b an extract from a statement of changes in equity for the year ended
31 March 2021.
Answer
Evahline plc
a
Extract from statement of profit or loss for the year ended 31 March 2021
$000
Profit before tax
746
Tax
218
Profit for the year
528
30 000
1.6
1 600
Errors like this can
be expensive!
If you are not confident,
then write the figures
in full, for example:
$
30 000
1 600
b
Evahline plc
Extract from statement of changes in equity for the year ended 31 March 2021
Retained earnings
$000
Balance at Apr 1 2020
814
Profit for the year
528
1 342
Dividends paid
(146)
Balance at Mar 31 2021
1 196
A statement of changes in equity shows details of changes that have taken place to
any of the components of a limited company’s equity. Changes to permanent share
capital and any changes to the reserves held by a company are shown.
187
1.5 preparatIon of fInanCIal statements
1.5
WORKED EXAMPLE 49
The following information is provided for the year ended 31 December 2021 for
Dohoma plc:
$ 000
Revenue
3 160
Purchases
211
Inventory at 1 January 2021
87
at 31 December 2021
91
Salaries and general expenses
531
Directors’ fees
312
Rent and business rates
80
Depreciation of delivery vehicles
75
Salaries of sales assistants
612
Advertising
147
Ordinary share dividend paid
200
Tax
312
Depreciation of office equipment
28
Debenture interest
230
Retained earnings at 1 January 2021
4 106
Required
Prepare:
a a statement of profit or loss for the year ended 31 December 2021
b an extract from a statement of changes in equity for the year ended
31 December 2021.
Answer
a
188
Dohoma plc
Statement of profit or loss for the year ended 31 December 2021
$000
$000
Revenue
3 160
Less Cost of sales
Inventory at 1 January 2021
87
Purchases
211
298
Inventory at 31 December 2021
(91)
207
Gross profit
2 953
Selling and distribution costs
Salaries
(612)
Advertising
(147)
Depreciation – delivery vehicle
(75)
(834)
Administrative expenses
Salaries and general expenses
(531)
Directors’ fees
(312)
Rent and business rates
(80)
Depreciation – office equipment
(28)
(951)
Profit from operations
1 168
Finance costs
(230)
Profit before tax
938
Tax
(312)
Profit for the year
626
b
Extract from statement of changes in equity for the year ended
31 December 2021
1.5
$000
Retained earnings
Balance at 1 January 2021
Profit for the year
4 106
626
4 732
(200)
Balance at 31 December 2021
4 532
Note the way that the expenses are categorised. You should be able to tell which
expense goes under which heading.
Make sure that you use the correct labels as they are crucial in the financial
statements:
»
»
»
»
»
1.5.4 Limited companies
Dividends paid
cost of sales
gross profit
profit from operations
profit before tax
profit for the year.
The appearance of the statement of financial position would look similar to those
that appeared when studying sole traders and partnerships earlier in this chapter. The
main differences would be in the ‘bottom’ half of the statement in terms of capital or
equity.
Learning link
Sources and methods of
finance were covered in
Chapter 1.1. Remember
that limited companies
can use share issues
and debentures as well
as all other sources.
Sources of finance for specified purposes
The sources of finance for a limited company are wider than those available for other
forms of business entity. The sources that are available for other business entities
were covered in Chapter 1.1.
Matching the type of finance for the time period is important. For a company looking
to expand (or set up in the first place) long-term finance is more appropriate than
short-term finance. This means that the company is likely to use share issues or
debenture issues to finance set-up or significant expansion. Long-term finance is
unlikely to need repayment until a number of years in the future (and share issues are
not repaid at all).
EVALUATION
Hall and Wang are in partnership, sharing profits equally. They wish to expand
and are deciding whether or not to admit Stoddard as a partner. She would be
able to contribute significantly greater capital into the partnership than the
existing partners. Hall is in favour of this. However, Wang believes they should
convert the partnership into a private limited company instead, with Hall, Wang
and Stoddard all receiving an equal allocation of shares in the new company.
Advise Hall and Wang as to whether or not they should admit Stoddard as a
partner or as an equal shareholder.
189
A good answer should include the following.
1.5 preparatIon of fInanCIal statements
1.5
Arguments for admitting Stoddard as a partner:
l Stoddard can be rewarded with interest on capital.
l Profit shares can be adjusted to reflect who performs most work (or brings
greatest expertise).
l Stoddard may be unwilling to accept an equal share of the business if
contributing more capital.
Arguments for converting the partnership to a private limited company:
l Partners would then be protected by limited liability.
l Future investment may still be found with new shareholders at a later date.
l Hall and Wang may not wish to give equal ‘power’ in decision-making to
Stoddard.
l If the duties performed by each partner are comparable in weight, then it
may seem more equitable.
Overall:
l This will depend on the motivations of each of the three involved. If the
partnership is long-established, Stoddard may feel she will not have much
of a say in the decision-making if Hall and Wang continue to ‘run’ the
business.
l Is limited liability important? This may not matter if the partnership is
unlikely to have many debts.
l Personalities may matter more than the finances of the decision.
l Finally, a decision should be made as to whether Stoddard should be a
partner or equal shareholder.
SUMMARY
After reading this chapter, you should:
l know how to adjust incomes, expenses, allowances and provisions so that they
represent the appropriate amount for entry into the financial statements
l know how to calculate the profit based on incomplete information
l be able to produce the financial statements for a sole trader
l be able to produce the financial statements for a partnership – including
adjusting current and capital account balances
l know how to make accounting entries for different types of share issue and
revaluation of assets
l be able to produce the financial statements for a limited company.
SELF-TEST QUESTIONS
1 Share capital is one of the terms applied to the shares issued by a limited
company. True/False?
2 Explain one difference between a rights issue and a bonus issue of shares.
3 Why is the price quoted for a rights issue of shares generally lower than the
current market price?
4 What does the term ‘maintaining reserves in their most flexible form’ mean?
5 Explain the difference between revenue reserves and capital reserves.
190
6 Shares issued through a rights issue are more valuable to a shareholder than
shares given in a bonus issue. True/False?
7 Identify one revenue reserve.
1.5
8 Bonus shares can be issued out of capital reserves. True/False?
9 Explain to a potential investor the difference between the return on debentures
and the return on ordinary shares.
11 What expenses might be found under the heading of financial costs?
12 Name two sets of people who should receive the annual financial statements of a
limited company.
13 What is shown in a statement of changes in equity?
14 Explain why dividends paid are shown in a statement of changes in equity.
Calculation questions (answers on page 494)
15 Ordinary share capital is $500 000. Each share has a nominal value of $0.25.
If a dividend is paid equivalent to $0.01 per share, calculate the total value of
dividends.
1.5.4 Limited companies
10 Ordinary shareholders must own a minimum of 100 shares in order to have a vote
at a company’s AGM. True/False?
16 Property originally bought for $750 000 is revalued at $2 000 000. One million $1
shares are also issued at a premium of $0.50 per share. Calculate the overall
change in the equity of this business.
17 The equity of section of a company’s statement of financial position is as follows:
$000
Ordinary share capital
1 000
Share premium account
500
Retained earnings
250
If the directors organise a bonus issue of shares on the basis of one bonus share
for every two existing shares held, produce an extract from the statement of
financial position showing the equity section after the bonus issue. You should
assume that reserves are utilised equally.
191
1.6 analysIs and CommunICatIon of aCCountIng InformatIon to stakeholders
1.6
Analysis and communication of
accounting information to stakeholders
Learning outcomes
By the end of this chapter, you should have an understanding of:
l the differing requirements of accounting information for stakeholders
l how to communicate and analyse information required by different
stakeholders
l how to calculate and evaluate ratios that measure profitability, liquidity and
efficiency
l how to evaluate the profitability, liquidity and efficiency of an organisation
l possible measures to improve the profitability, liquidity and efficiency of an
organisation
l the limitations of accounting information.
Introduction
Businesses have a number of different stakeholder groups. These groups will
be interested in business activities for a number of different reasons. Financial
information can have more meaning if it is combined with other data.
Accounting ratios combine different financial data to provide information on
business performance in terms of the profitability, liquidity and efficiency of
the business. However, these ratios should always be treated with caution as,
although useful, they do have their limitations.
1.6.1 Users of accounting information
The differing requirements for information of stakeholders
There are many different stakeholders in the performance of a business, as shown in
Figure 1.6.1.
Managers
Employees
Public and environmental
bodies
ent
Financial Statem
ounts
ences
y Links
Owners/existing investors
Financial press
Potential investors
Government agencies
Lenders
General public
Suppliers and customers
▲ Figure 1.6.1 The users of the financial statements of a limited company
192
What are these different groups of people interested in? With the odd exception, all
are probably interested in the survival of the business. The exceptions might include
competitors and environmental groups.
1.6
Survival of the business will depend on the business’s ability to generate:
» profits – profitability
» cash – liquidity.
The published financial statements of limited companies must satisfy the requirements
of the Companies Acts, international accounting standards and the Stock Exchange.
The statements are also used in various ways by other user groups (Table 1.6.1).
▼ Table 1.6.1 The requirements for information of different groups of users
User
Use
Managers
As an aid to general decision-making; also in order to make
decisions regarding planning and control of the business
Employees
For wage negotiations and to gauge their job security
Owners/existing
investors
To make decisions about the adequacy of return on their investment
and whether or not to sell or increase investment in the company
Potential investors
To make a decision on whether or not to invest in the business
(based on the information in the statements)
Lenders
To know whether or not the business is able to service loans and, at
term, to repay them
Suppliers and
customers
May wish long-term survival to ensure a sound and lasting trading
partnership
General public
To gain information regarding the business’s attitude towards
environmental issues, etc.
1.6.1 Users of accounting information
Profits are necessary for the long-term survival of the business and cash is needed for
its day-to-day running, in other words its short-term survival.
Government agencies For tax purposes and to ensure that the business conforms to Acts
of Parliament that may be relevant, e.g. long-term planning
Financial press
To comment and report on various business issues and activities
Public and
To monitor the business for its impact on the community and
environmental bodies environment
How to communicate and analyse the information required by
different stakeholders
Analysing business data
193
1.6
Users of financial information will look at the published financial statements of
limited companies. However, the results obtained from a set of financial statements
cannot be viewed in isolation; and the information may not be in a form that is
required by the users. The data must be put into a useful form.
1.6 analysIs and CommunICatIon of aCCountIng InformatIon to stakeholders
It is desirable to compare performance over a period of four or five years. If the time
period reviewed is too short then it would be difficult to identify any trends. If the
time period is too long then much of the earlier information will be out of date.
Methods of arranging data for analysis purposes
There are three main methods of arranging the data into a form that can be used by a
person or organisation that wishes to analyse the results of a business.
1 Horizontal analysis makes a line-by-line comparison of each year’s results,
revealing trends in the raw data.
EXAMPLE
Sales
2019
2020
2021
$ 000
$ 000
$ 000
2 176
2 581
2 667
This may be done using percentage changes:
%
%
8.8*
18.6
%
3.3
* Assuming sales in 2018 of $2 000 000.
2 Trend analysis uses a base level of 100 for the first year of analysis. Each
subsequent year is then related to the base level of 100.
EXAMPLE
Using same data as example 1:
2019
2020
2021
108.8
129.05
133.35
3 Ratio analysis: To be useful, ratio analysis must be put into context. Ratios must
not be used in isolation.
EXAMPLE
Anders scores 28 in an accounting test. Has he done well? We cannot tell; we
need to put the result in context.
l If the maximum mark available was 30, then he has done well.
l If the maximum mark was 100, he has not done too well.
l If the rest of the class scored more than 60 marks, then Anders has a poor
score. However, if the rest of the class scored below 20 marks, he has done
well.
194
STUDY TIP
How would the users of accounting information decide whether the profitability
and/or the liquidity of a business is acceptable?
1.6
The answer is: the same way that you decide whether the state of your earnings is
acceptable or not.
»
»
»
»
You compare your earnings this year with your earnings last year.
You compare your earnings with those of your friends.
You compare your earnings with the national average.
You might even compare your earnings with what you planned to earn.
The users of accounting information follow similar procedures to the ones that you
might use.
Managers will ask: ‘Is the business performing better (or worse) than the figures
produced in budgets or forecasts?’
They and other users ask:
» ‘Is the business performing better (or worse) than last year?’ They compare
previous results with the current year’s results.
» ‘Is the business performing better (or worse) than similar businesses?’ They
compare the results of businesses in the same industrial sector.
» ‘Is the business performing better (or worse) than the figures available for national
publicly quoted companies in the same business sector?’ They compare the results
with those available for quoted companies, published as national statistics.
1.6.1 Users of accounting information
Interpretation
and analysis can
require performance
evaluation using
ratio analysis. Learn
the following ratio
formulae and what
they reveal.
Performance evaluation
WORKED EXAMPLE 1
Businesses A and B compete in the same market. Based on the following
information, which of the two businesses is the better performing?
Sales revenue
Gross profit
Business A
$
Business B
$
125 000
200 000
50 000
65 000
l Business B has the higher gross profit by $15 000 – could be used to say it is
better performing.
l Business A is better at ‘turning sales into profit’, i.e. it has the higher gross
profit margin (gross profit as a percentage of sales revenue) (40.0% compared
with 32.5%).
l Using accounting ratios would help to answer this sort of question.
195
1.6.2 Calculation and evaluation of ratios
1.6
Why use ratios?
1.6 analysIs and CommunICatIon of aCCountIng InformatIon to stakeholders
Annual raw data is converted into ratios for the following reasons:
» Amounts expressed in isolation are meaningless; they need to be put into some
context.
» Conversion into ratios helps in the analysis of the current year’s performance.
» It allows identification of trends by comparing results over a number of years.
» It means that trends may be extrapolated to make decisions that will influence
future performance.
» It allows comparisons to be made with other similar businesses.
Learning link
Investment ratios
are not covered until
Chapter 3.5.
The most common ratios may be classified into:
»
»
»
»
profitability ratios
liquidity ratios
efficiency ratios
investment ratios.
In order to calculate and explain the ratios, we will use the following financial
statements of Oyan Magenta, a public limited company, for the years 2021 and 2020.
Even though the figures relate to a limited company, the principles would apply
equally as well to the financial results of a sole trader or a partnership.
EXAMPLE
Oyan Magenta plc
Statement of profit or loss for the year ended 31 March
2021
$ 000
Revenue
$ 000
$ 000
2 600
$ 000
2 000
Less Cost of sales
Inventories
Purchases
Inventories
110
90
1 460
1 240
1 570
1 330
(120)
Gross profit
1 450
(110)
1 150
Less Selling and distribution costs
(310)
Administrative expenses
(340)
1 220
780
(140)
(650)
(180)
(320)
Profit from operations
500
460
Finance costs (debenture interest)
(40)
(16)
Profit before tax
460
444
(145)
(151)
315
293
Tax
Profit for the year
196
2020
Oyan Magenta plc
1.6
Statements of financial position
at 31 March 2021 at 31 March 2020
$ 000
$ 000
$ 000
$ 000
ASSETS
Non-current assets (net book value)
3 063
1 800
Inventories
120
Trade receivables
240
Cash and cash equivalents
140
Total assets
110
220
500
570
900
3 563
2 700
1 600
1 600
849
595
2 449
2 195
800
200
Trade payables
169
154
Taxation
145
151
314
305
Total liabilities
1 114
505
Total equity and liabilities
3 563
2 700
EQUITY AND LIABILITIES
Equity
Ordinary shares of $1
Retained earnings
Non-current liabilities
8% debentures
1.6.2 Calculation and evaluation of ratios
Current assets
Current liabilities
Oyan Magenta plc
Extract from statement of changes in equity for the year ended 31 March 2021
$ 000
Retained earnings
Balance Apr 1 2020
595
Profit for the year
315
910
Dividends paid
(61)
Balance Mar 31 2021
849
How to calculate and evaluate key accounting ratios to
measure profitability, liquidity and efficiency
The ratios we will examine in this chapter can be split into areas that focus on
different aspects of business performance. In general, ratios are grouped according
to whether they focus on the profitability, liquidity or efficiency of the business
(Table 1.6.2).
197
▼ Table 1.6.2 Areas of focus of groups of ratios
1.6 analysIs and CommunICatIon of aCCountIng InformatIon to stakeholders
1.6
Group of ratios Areas of focus
Profitability
Profitability ratios look at different measures of profit of a business in
relation to other variables, such as sales or capital employed.
Liquidity
Liquidity ratios look at the solvency and liquidity of a business –
whether or not it has sufficient liquid assets in order to settle the shortterm debts of the current liabilities.
Efficiency
Efficiency ratios look at how efficiently the business manages its
inventory, trade payables and trade receivables.
In the following section, each ratio is explored in terms of what formula should be
used, how the ratios are calculated and what the results of the calculations actually
mean – i.e. how we interpret the meaning behind the calculations.
Profitability ratios and how to interpret and evaluate them
Return on capital employed (ROCE)
This ratio is often known as the primary ratio. It is the measure of how effectively
the managers of the business are using the capital employed in the business.
Capital employed can be calculated by using:
» total assets less current liabilities, or
» issued share capital and reserves plus non-current liabilities.
There are a variety of ways of calculating the capital employed. We could use:
» opening capital employed
» closing capital employed
» or an average of opening and closing capital employed.
It is important that you use the same method each time. Choose the method you feel
most comfortable with.
To enable your answer to be checked, always state the formula that you use. This
principle applies to all ratio calculations.
Generally, return on capital employed, inventory turnover, trade receivables turnover
and trade payables turnover use average figures. However, on occasion it is impossible
to calculate an average figure, so closing figures are used.
It is important that the same method of calculating is used each year (consistency)
in order that results may be compared either with previous years or with other similar
businesses.
Profit for the year to be used is profit from operations (i.e. profit before interest and
tax). This enables us to make comparisons between businesses with different levels of
borrowings.
FORMULA
ROCE =
Profit from operations (i.e. before interest and tax)
× 100
Capital employed
2021
500 × 100
= 15.39%
3249
198
2020
460 × 100
= 19.21%
2395
This tells us that for every $100 invested in the business for the year ended 31 March
2020, the business earned $19.21; a year later, the business earned $15.39 for every
$100 invested – a worse result.
1.6
Could the capital be used elsewhere to earn a greater return? Compare this ratio with
the return in similar businesses.
Certainly, there has been a deterioration since 2020.
Gross margin
Gross margin =
STUDY TIP
An increase in the
volume of sales will
not affect mark up or
margin. These ratios
will remain constant.
Changes in selling
price and/or changes
in purchasing price
will affect both these
ratios.
Gross profit
× 100
Revenue
2021
1150 × 100
= 44.23%
2600
2020
780 × 100
= 39%
2000
This shows that for every $100 of sales, the margin was $39.00 in 2020; that is, every
$100 of sales earned the business $39.00 of gross profit. It then improved to $44.23
in 2021.
1.6.2 Calculation and evaluation of ratios
FORMULA
The margin will vary from business to business. Businesses with a rapid turnover of
inventory will generally have a lower margin than a business with a slower inventory
turnover.
The change identified might be due to a decrease in the cost of goods sold while
maintaining selling price or it may be due to a slight increase in the selling price while
the cost of goods sold has reduced.
Mark up
Mark up is calculated as follows:
FORMULA
Mark up =
Gross profit
× 100
Cost of sales
2021
1150 × 100
= 79.31%
1450
2020
780 × 100
= 63.93%
1220
The mark-up percentage represents the gross profit as a percentage of the cost of
the product. This means that the gross profit for every $100 of goods purchased by
the business would be $63.93 in 2020 and the selling price is therefore $163.93
(i.e. cost + gross profit = selling price). In 2021, for every $100 of goods purchased,
the gross profit is then $79.31 meaning a final selling price of $179.31.
199
Profit margin
1.6
FORMULA
Profit margin =
Profit for the year (after interest)
× 100
Revenue
1.6 analysIs and CommunICatIon of aCCountIng InformatIon to stakeholders
2021
2020
460 × 100
= 17.69%
2600
STUDY TIP
The difference
between expenses and
operating expenses is
that finance charges
(i.e. interest) are
normally separated
out from operating
expenses. In some
cases, ‘expenses’ and
‘operating expenses’
may be the same if
there are no finance
charges.
444 × 100
= 22.20%
2000
This shows that, in 2020, out of every $100 sales, the business earned $22.20 after
all operating costs and cost of sales had been covered. This amount fell to $17.69 the
following year. We can look at this from another angle.
Expenses to revenue ratio
FORMULA
Expenses to revenue ratio =
Expenses
× 100
Revenue
2021
690 × 100
= 26.54%
2600
2020
336 × 100
= 16.80%
2000
Operating expenses to revenue ratio
STUDY TIP
Profit and profitability
are clearly similar
and are connected but
can move in different
directions, i.e. profits
may increase even
if profitability is
decreasing.
There is also the operating expenses to revenue ratio, which excludes finance
charges. This means the operating expenses will normally be smaller than the expenses
as they do not include finance charges. As a result, this ratio should give results that
are lower than those calculated in the expenses to revenue ratio.
Operating expenses to revenue =
2021
650 × 100
= 25%
2600
Operating expenses
× 100
Revenue
2020
320 × 100
= 16%
2000
This ratio tells us that in 2020, the business expenses were $16.80 out of every $100
of goods sold. In 2021, this amount spent on expenses rose to $26.54. This begs
the question: is the business losing control as far as expenses are concerned?
In absolute terms, expenses have more than doubled yet sales have only increased by
600/2000, i.e. 30 per cent. We can perhaps see why this has happened by examining
the details of the expenses shown in the statement of profit or loss.
In 2020, selling and distribution expenses accounted for $7 of each $100 of sales
revenue generated; in 2021, it rose to $11.92.
In 2020, administration costs amounted to $9 in every $100 of sales revenue
generated; in 2021, it rose to $13.08.
200
STUDY TIP
In the above analysis,
we have simply
considered the
available information.
You must try to develop
this technique.
Liquidity ratios and how to interpret and evaluate them
Liquidity ratios assess the ability of a business to pay its short-term liabilities as they
fall due. Liquidity is important since a business has not only to pay its trade payables
but its employees and other providers of resources too. Although trade payables are
grouped on a statement of financial position under headings that indicate payment
within 12 months and payments due after 12 months, in reality, many trade payables
require payment in a much shorter time.
Although solvency means an excess of assets over liabilities, many assets are difficult
to dispose of and so many users of accounts are more interested in the liquidity
position of the business. They wish to examine and analyse the components of
working capital in detail.
Current ratio
STUDY TIP
There is no ideal
current ratio that suits
all businesses.
This ratio shows how many times the current assets are covering the current
liabilities. It is usually expressed as a ‘times’ ratio, that is, the right-hand term should
be expressed as unity so the ratio should be expressed as ‘something’:1. Generally, the
ratio should be in excess of unity (i.e. greater than 1:1), although many businesses
prosper with a ratio which is less than this.
1.6.2 Calculation and evaluation of ratios
Long-term investors are mainly interested in the solvency of the business – they
require that the business will survive into the foreseeable future (or at least until
their debt can be settled).
1.6
Once again, we should be looking for trends when we consider the current ratio. If
a series of results shows that the current ratio has been declining over a number of
years, this may mean that the business might have some difficulties in meeting its
short-term obligations in the future.
If the series shows that the current ratio is increasing each year, this could be an
indication that the business is tying up an increasing proportion of its resources
in inventory, trade receivables and cash and cash equivalent balances, i.e. nonproductive assets instead of the resources being invested in non-current assets that
will earn profits.
Many analysts consider that a reasonable current ratio should fall between 1.5:1 and
2:1, although it is dangerous to be too dogmatic about this. The ratio will depend on
the type of business and the direction of any trend.
FORMULA
Current ratio =
Current assets
Current liabilities
2021
500
= 1.59:1
314
2020
900
= 2.95:1
305
The current ratio has fallen by around 46 per cent (1.36/2.95). It appears that in 2020,
too many resources were tied up in unproductive assets and it appears that in 2021,
this was more under control.
Obviously, the greater the number of years’ results that are available, the easier it is
to identify and confirm a trend.
201
Acid test ratio
1.6
We should be looking for trends when considering this ratio. Liquid assets are current
assets and a definition of current assets is that they are assets that are cash or will be
cash in the near future. The least liquid of the current assets is inventory. The acid
test ratio tests the ability of the business to cover its current liabilities with its
current assets other than inventories.
1.6 analysIs and CommunICatIon of aCCountIng InformatIon to stakeholders
FORMULA
Acid test ratio =
Current assets – Inventory
Current liabilities
2021
380
= 1.21:1
314
2020
790
= 2.59:1
305
The ratio for 2020 seems rather high, so too many resources are tied up in a liquid
form not earning profits.
The ratio improved in 2021. The business is still able to cover every $1 owed with
$1.21 of liquid assets.
Once again, it is impossible to say what is an acceptable level of ratio – some
businesses, for example some supermarkets, perform satisfactorily with a liquid ratio
of less than 0.5:1.
Efficiency ratios and how to interpret and evaluate them
Non-current asset turnover
Non-current assets are the wealth generators of a business, acquired to generate sales
revenue and hence profits. A high level of non-current assets should generate a high
level of sales. The ratio is a measure of the efficient use of non-current assets. It
indicates how much $1 investment in non-current assets is able to generate in terms
of sales. The higher the non-current asset turnover ratio, the greater is the recovery of
the investment in those non-current assets.
An increase in the ratio year on year indicates a more efficient use of non-current
assets.
A fall in the ratio might indicate:
» less efficient use of the assets
» purchase of more non-current assets
» revaluation of the assets.
FORMULA
Non-current asset turnover =
2021
2600
= 0.85 times
3063
202
Net revenue
Total net book value of non-current assets
2020
2000
= 1.11 times
1800
There has been less efficient use of non-current assets in 2021. In 2020, each $1
invested earned $1.11. Investment in non-current assets increased by more than
70 per cent. However, the sales revenue only increased by 30 per cent. There is no
indication when the extra assets were purchased. The increase may be greater in the
future when a full year’s revenue will be earned.
1.6
Trade receivables turnover
This ratio is also known as trade receivables turnover or average collection period.
It calculates how long, on average, it takes a business to collect its debts.
It may not be immediately obvious if sales are cash, credit or both, but it is essential
that the same basis is used when making comparisons.
FORMULA
Trade receivables turnover =
2021
240
× 365 = 34 days
2600
Trade receivables
× 365 days
Credit sales
2020
220
× 365 = 41 days
2000
1.6.2 Calculation and evaluation of ratios
Generally, the longer a debt is outstanding, the more likely it is that the debt will
prove to be irrecoverable. It is also advisable to have a shorter debt collection period
than the trade payables turnover.
Note the rounding of the answer. In 2020 the actual figure calculated was 40.15 days.
We always round upwards to the next full day.
Remember that the calculation will give us an average collection time. It uses all
trade receivables – this may mask the fact that one significant credit customer is a
very poor payer while the other trade receivables pay promptly.
Thirty days’ credit is a reasonable yardstick to use. So, using this measure, in
2020, debts were outstanding for 41 days – perhaps a little too long. There was an
improvement in 2021 when debts were collected in 34 days – a week faster.
Trade payables turnover
This is also known as average payment period.
It measures the average time a business takes to pay its trade payables.
FORMULA
Trade payables turnover =
2021
169
× 365 = 43 days
1460
Trade payables
× 365 days
Credit purchases
2020
154
× 365 = 46 days
1240
In 2020, the business was paying its trade payables on average in 46 days; a year later
it was paying in 43 days. Note again that we have rounded up to the next full day.
203
The 3-day reduction does need investigation.
1.6
A comparison of the trade receivable collection days and the trade payables payment
days shows that, in both years, the trade payables are on average being paid more slowly
than cash is being received from the trade receivables. This is a good policy. However,
care must be taken to ensure that suppliers are not antagonised by being paid too slowly.
1.6 analysIs and CommunICatIon of aCCountIng InformatIon to stakeholders
Inventory turnover
In every ‘bundle’ of inventory held by a business there is an element of profit and
there is cash tied up in the goods. It is essential that this cash is released and that
profits are earned as quickly as possible. So the more often inventory can be ‘turned
over’(sold), the better it is for the business.
FORMULA
Inventory turnover =
Average inventory held
× 365 days
Cost of sales
2021
115 × 365
= 29 days (28.95)
1450
2020
100 × 365
= 30 days (29.92)
1220
This shows that in 2021, Oyan Magenta sold the inventory held one day faster than
in 2020.
Rate of inventory turnover
FORMULA
Rate of inventory turnover =
2021
1450
= 12.61 times
115
Cost of sales
Average inventory held during the year
2020
1220
= 12.2 times
100
This shows that in 2020, the company sold the goods held as inventory approximately
12 times over during the year; its inventory turnover was slightly faster in 2021.
Possible measures to improve the profitability, liquidity and
efficiency of an organisation
If the ratios indicate a particular weakness in the financial performance of the
business, then there are measures that can be taken to deal with the problem. We
would need to know what area to focus on (i.e. profitability, liquidity or efficiency).
204
Possible measures that would improve performance are shown in Table 1.6.3.
▼ Table 1.6.3 Possible measures that would improve financial performance
Area for improvement
Possible action(s) to take
1.6
Profitability
• Low/falling ROCE
• Increase selling price (or reduce price if demand is
likely to rise)
• Reduce costs (e.g. switch suppliers)
• Increase selling price
• Reduce costs (e.g. switch suppliers)
• Improve productivity in production
Liquidity
• Low current/acid test ratio
• Arrange short-term finance (e.g. loan)
• Reduce trade payables by paying suppliers early
• Arrange (or extend) overdraft
• High current/acid test ratio
• Offer cash discounts to trade receivables for
prompt payment
• Invest surplus cash in business
• Reduce interest-paying liabilities
1.6.2 Calculation and evaluation of ratios
• Low/falling profit margins
Efficiency
• High trade receivables turnover • Offer discounts for prompt payment
• Allow credit only with regular/reliable customers
• Sell trade receivables to debt factoring company
• Low trade payables turnover
• Seek suppliers who offer trade credit
• Extend credit periods
• Low inventory turnover
• Move to system of ordering inventory only when
needed (just-in-time) – though this may be
industry specific
The limitations of accounting information
Accounting ratios help provide meaning to the complex financial data facing
any stakeholder. Combining numbers or calculating them in a certain way allows
judgements to be determined in how well a business may be performing. However, the
ratios are not without their limitations.
» The results are based on the use of historic cost because it is objective. However,
some results may be misleading if results are compared over a long period. For
example, the value of assets shown on a statement of financial position from a
number of years ago is unlikely to be the same as the market value today.
» Emphasis is placed on past results. Past results are not a totally reliable indicator
of future results. If your football team has won its past six matches, there is no
guarantee that it will win its seventh game.
» Published accounts only give an overview – perhaps disguising inefficient sections
of a business. The return on capital employed may be 27 per cent; however, on
closer scrutiny, we might find that one section of the business is earning a return
on capital of 50 per cent and the other section earns a return of just 4 per cent.
205
» Financial statements only show the monetary aspects of a business. They do not
show the strengths and weaknesses of individual managers or members of staff.
They do not show staff welfare. Some businesses are very successful and pay top
wages but have workers who hate going to work each day.
» It is extremely difficult to compare like with like between two businesses. They
have:
– different sites
– different management teams
– different staff
– different customers, etc.
» The external environment faced by the business may change. The changes may have
an immediate effect or the result of the changes may only be felt after a time lag.
A devaluation of a currency may cause imported materials to rise in price, but if
the business carries large inventories and issues those items using the FIFO method
of issue, increased costs may not be incorporated into product costs for some time.
» Different organisations have different structures; different methods of financing
their operation; different expense and revenue patterns. They may use different
accounting policies, techniques, methods of measuring; and they may apply
different conventions. No matter how similar businesses appear to be from the
outside, all businesses are different.
» The financial statements of a business are prepared on a particular date. A statement
of financial position on that date may well be unrepresentative of the usual position
of the business. A fancy goods business may well have low inventories after a public
holiday rush. The rest of the year it may carry large inventories.
» Ratios only show the results of business activity. They do not indicate the causes
of good or bad results.
1.6 analysIs and CommunICatIon of aCCountIng InformatIon to stakeholders
1.6
EVALUATION
Tom Clark is the owner of a small audio equipment
retailer ‘Seriously Hi-Fi’. He is concerned about
the liquidity position of the business. He has just
calculated the current ratio and acid test ratio as at
December 31 2021 and has compared them with the
calculations from last year. Here are his results:
2021
2020
Current ratio
1.3 : 1
2.4 : 1
Acid test ratio
0.7 : 1
1.1 : 1
Howard, a shop worker, studying Accounting in his
spare time, believes that Tom is wrong and that the
liquidity position is not a concern. This is because
Howard thinks retail businesses need to worry less
about liquidity than many other businesses.
Is Tom right to be concerned about the shop’s
liquidity position?
206
A strong answer might include the following.
Arguments that would support concern would include:
l The liquidity position has worsened since last
year based on the ratios.
l The acid test ratio is now below 1:1 meaning that
trade receivables and cash would not cover the
current liabilities in 2021.
l Inventory may not be very liquid after the
December holiday period (unless sales were
offered).
Arguments against concern would include:
l The business may be able to extend its overdraft
if it is seen as a reputable business.
l It is unlikely that all trade payables would need
paying immediately.
l The current ratio is still above 1:1 indicating more
current assets than current liabilities.
SUMMARY
l understand the meaning behind the results of the
1.6
ratio calculations
l evaluate business performance and understand
how to improve profitability, liquidity and efficiency
based on the results of financial ratios
l understand that there are limitations in using the
financial information to make judgements about
business performance.
SELF-TEST QUESTIONS
1 Why are results converted into ratios?
2 What do profitability ratios tell us?
3 Give an example of a profitability ratio.
4 What do liquidity ratios tell us?
5 Give an example of a liquidity ratio.
1.6.2 Calculation and evaluation of ratios
After reading this chapter, you should:
l know who the different stakeholder groups are,
their differing information requirements and the
reasons they have for interest in the financial
statements of a business
l know how to communicate and analyse information
required by these different stakeholders
l be able to calculate ratios for the profitability,
liquidity and efficiency of a business
6 Give the formula for calculating the profit margin.
7 Give the formula for calculating inventory turnover.
8 How is average inventory calculated?
9 Bima makes a gross profit margin ratio of 54 per cent. Is this good or bad?
10 Mary’s trade receivables turnover is 42 days; her trade payables turnover is
19 days. Explain whether or not this is a good or a bad policy.
11 Identify two limitations of using ratios as an evaluation of performance.
Calculation questions (answers on page 494)
12 Use the information below to calculate the acid test ratio and current ratio:
Inventory
$18 710
Trade receivables
$9 807
Bank
$4 533
Trade payables
$7 865
13 Use the information below to calculate the mark-up and gross profit margin:
$
Sales
$
87 400
Less cost of sales
Opening inventory
11 210
Purchases
60 900
72 110
Less closing inventory
Gross profit
9 995
62 115
25 285
207
2 Cost and management accounting (AS Level)
2.1 Costs and Cost behavIour
2.1
Costs and cost behaviour
Learning outcomes
By the end of this chapter, you will have an understanding of:
l how to account for the cost of labour and raw materials
l how to identify and calculate fixed costs, variable costs, semi-variable costs
and stepped costs
l how to identify and calculate the elements of direct and indirect costs
l how to calculate the value of closing inventory using the first-in first-out (FIFO)
and weighted average cost (AVCO) methods (perpetual and periodic)
l the principles of just-in-time (JIT) management of inventory.
Introduction
Remember
Cost refers to the
amount a business
spends in its operations.
Price refers to the value
the product is sold for
to customers. Do not
mix up cost and price.
Businesses aiming to improve performance often focus on the costs incurred
by their activities. Controlling these costs is often a key aspect of improving
business performance. In order to control them more efficiently the nature of
business costs, and how they are affected by changes in the level of output,
must be understood. Knowing how to value any inventory, and how to manage
inventory in general, are also ways of improving business efficiency – which can
also help contribute towards better business performance.
2.1.1 Materials and labour
Accounting for material and labour costs
When we examine the costs incurred by a business, it is normal to classify the costs
according to the type of cost and also to its relationship with output. For service
sector businesses, a major cost (as a proportion of overall costs) is likely to be wages
paid to the employees of the business. For trading business, there is also the cost of
purchasing goods to be sold.
For a business that manufactures its own output, there is likely to be a significant
cost incurred in the production of output. Raw materials will need to be purchased,
which are than transformed into finished goods. Understanding how these costs
are related to the level of output is important for managers when making business
decisions. This is explored in the following section.
Learning link
Accounting for the manufacture of output is covered in manufacturing accounts
(Section 3.1.4).
How to identify and calculate fixed costs, variable costs,
semi-variable costs and stepped costs
Here we define some of the terms commonly used when dealing with any system of
costing. It is important that you learn the terms used by cost accountants.
208
STUDY TIP
Fixed costs do not change with levels of business activity. Examples would include
supervisors’ wages, factory rent, etc. In the long run, fixed costs may change:
supervisory staff may get a pay rise; the landlord may increase the rent to be paid for
the use of the factory.
2.1
Total fixed costs
$
Fixed costs
0
Activity level
(units of output)
2.1.1 Materials and labour
Practise defining
terms on a regular
basis. When you have
a spare moment
between lessons, or
waiting for a friend,
go over definitions in
your head. Remember
that a definition is an
explanation of a term;
it is not an example.
However, an example
may help to clarify your
thoughts and persuade
the reader or listener
that you know exactly
what the term means.
Fixed costs
▲ Figure 2.1.1 Total fixed costs
Unit fixed costs
$
STUDY TIP
Do not state that fixed
costs never change.
In the long term they
may.
Fixed costs
0
Activity level
(units of output)
▲ Figure 2.1.2 Unit fixed costs
Variable costs
Variable costs vary in direct proportion to levels of activity. For example, if
production is 10 000 units and each unit of direct material costs $8.50, the total
variable material costs would be $85 000. If production rises to 11 000 units, the total
variable material costs would rise to $93 500. If production fell to 9000 units, the
total variable material costs would fall to $76 500.
Other examples of variable costs would include:
» direct labour costs, when workers are paid using piece work rates
» royalties.
209
Short-term decision-making is mainly concerned with accounting for variable costs.
2.1
Unit variable costs
$
2.1 Costs and Cost behavIour
Variable costs
0
Activity level
(units of output)
▲ Figure 2.1.3 Unit variable costs
Total variable costs
$
Variable costs
0
Activity level
(units of output)
▲ Figure 2.1.4 Total variable costs
Semi-variable costs
These are costs that cannot be classified as either fixed costs or variable costs
because they contain an element of both.
An example of a semi-variable cost is the charge for consumption of electricity. The
standing charge is a fixed cost – it is charged at a fixed rate that is not dependent on
the amount of electricity used. The variable cost part is based on the number of units
consumed during the period.
Semi-variable costs
$
Semi-variable costs
Fixed costs
0
▲ Figure 2.1.5 Semi-variable costs
210
Activity level
(units of output)
Stepped costs
Stepped costs remain fixed until a certain level of business activity is reached. When
production exceeds this level, additional fixed costs may be incurred. The cost then
rises to a higher fixed level. Costs remain at this level until the next level of activity
requiring a change is reached.
Stepped fixed costs
$
Stepped fixed costs
(semi-fixed)
0
2.1.1 Materials and labour
An example of a stepped cost is the salaries of quality controllers. One quality
controller can inspect 200 units of production per week. If output is 200 units,
one quality controller must be employed. If output rises to 210 units per week, two
controllers must be employed. If output rises to 410 units per week, three quality
controllers must be employed.
2.1
Activity level
(units of output)
▲ Figure 2.1.6 Stepped fixed costs
How to identify and calculate the elements of direct and
indirect costs
Another way to classify costs is into direct or indirect costs.
Direct costs are defined by the Chartered Institute of Management Accountants
(CIMA) as ‘expenditure which can be economically identified with a specific saleable
cost unit’. Direct costs can be directly attributed to a unit of production, so direct
costs are always variable costs. The cost of the paper that this book is printed on is an
example of a direct materials cost. The wages of a hairdresser styling your hair is an
example of a direct labour cost.
Direct expenses are any other costs that can be specifically identified with the
finished product (or service). Royalties payable to the inventor of a process or design
of a product is an example of a direct expense; another example might be the costs
of hiring equipment needed for a specific job. The total of the direct costs and direct
expenses is referred to as the prime cost. This is covered in Chapter 3.1.
Indirect costs are those that are related to the production of output within the
business but cannot be easily linked with a particular unit of output. They may vary in
relation to the level of output but they do not vary directly with the level of output.
For example, maintenance, servicing and repairs costs connected with machinery and
other productive equipment will usually increase when output levels significantly
increase, but the increase will not be proportional to the level of output.
Learning link
You will encounter the classification of costs into direct and indirect when you study
manufacturing accounts in Section 3.1.4.
211
Remember
2.1 Costs and Cost behavIour
2.1
Inventory refers to
quantities of goods
ready for sale, goods
in the process of being
completed or raw
materials.
How to calculate the value of closing inventory using the
first-in first-out (FIFO) and weighted average cost (AVCO)
methods (perpetual and periodic)
The use of cost and net realisable value
Inventory is valued at the lower of cost and net realisable value. According to the
IAS2 ‘Inventories’, that cost would include:
» costs of purchase
» conversion costs
» any other costs incurred in bringing the inventories to their present location and
condition.
A warehouse storing unsold goods – inventory
The standard defines net realisable value as the estimated selling price in the ordinary
course of business less estimated costs of completion and all estimated costs to be
incurred in marketing, selling and distributing the items.
WORKED EXAMPLE 1
Thea sells one type of vacuum cleaner. They cost $80 each to purchase. At
31 March 2021, Thea has 14 vacuum cleaners in her inventory, which sell for
$120 each. One of these is damaged. She intends to have the cleaner repaired at
a cost of $35. It can then be sold for $100.
Required
Calculate the value of Thea’s closing inventory at 31 March 2021.
Answer
Thea’s inventory should be valued at $1105.
Workings
$
13 cleaners at $80 each
$
1 040
1 damaged cleaner:
Selling price
Less Repair costs
100
35
65
1 105
212
Up to now, we have valued most inventory at cost and net realisable value, but now
consider the following example.
EXAMPLE
2.1
Jitesh sells only one product, a ‘sedrit’. He provides the following information:
Purchases of sedrits
Sales of sedrits
2 at $10 each
May
4 at $30 each
April
3 at $15 each
December
3 at $35 each
November
4 at $20 each
In total, Jitesh purchased nine sedrits. He has sold seven. Therefore, he has two
sedrits remaining as inventory at 31 December. How should he value the two
sedrits remaining?
He should value them at cost!
Should he choose to value them at $10 each; or $15 each; or $20 each; or one at
$10 the other at $15; or …?
2.1.1 Materials and labour
January
You can see that there are many combinations that we could choose when
valuing Jitesh’s closing inventory.
So valuing inventory at cost is not quite as simple as it first seems. The total
purchases figure for the year is $145 and the total sales revenue for the year is $225.
We could prepare the statement of profit or loss if we could decide on a method by
which we could value the closing inventory.
In the example used above, it might be fairly simple to identify the actual units of
sedrits that had been sold and hence identify the two remaining in the business.
However, if we had many hundreds of items available for sale this would be almost
impossible.
Most businesses will be unable to identify with any precision the actual items that
they have remaining as inventory at the end of their financial year and even if they
could it would be a huge task to go back through purchase invoices to determine the
price paid for each item.
The valuation of inventories is therefore a matter of expediency rather than strict
accuracy.
In the valuation of closing inventory, we do not trace through the actual units that
have been sold; rather we identify certain items that are deemed to be sold and
therefore certain items that are deemed to remain.
The methods listed in the following section are most frequently used to identify the
goods deemed to have been issued either to a final customer or to another department
within the same business.
Methods of valuing inventory
First-in first-out method of valuing inventory (FIFO)
As the name suggests, first-in first-out (FIFO) assumes that the first goods received
by the business will be the first ones to be delivered to the final customer or the
department requisitioning the goods. It assumes that goods have been used in the
order in which they were purchased. Therefore, any remaining inventory will be valued
as if it were the latest goods purchased.
Remember this is only an assumption.
213
2.1
FIFO, like the methods below, is a method of valuing inventory. It is not necessarily the
way that goods are actually issued. Goods may be issued in any way that best suits a
particular business, regardless of when goods were received.
2.1 Costs and Cost behavIour
EXAMPLE
A garage mechanic requires a battery to fit into the car he is working on. The
store keeper in the parts department will issue the first battery he can lay his
hands on; he will not waste time seeking out the first one bought in to give to the
mechanic.
Weighted average cost method of valuing inventory (AVCO)
The average cost of goods (AVCO) held is recalculated each time a new delivery of
goods is received. Issues are then priced out at this weighted average cost.
Perpetual and periodic ways of valuing closing inventory
Some businesses keep extremely detailed records of the goods that they hold. Every
transaction affecting the purchases and sales of goods is recorded in great detail.
The value of the inventory held is then recalculated after each transaction. (The
inventory records look rather like a bank statement.)
The method of recalculating the value of goods held after each transaction is known
as the perpetual method.
This method is used by businesses that need to cost their work out to customers very
carefully. It is also used in major supermarkets. Each time a transaction is ‘scanned’ at
the check-out the bar code is read and the inventory records are updated electronically to
record the sale (issue). Each time a delivery arrives in the warehouse the goods received
will be ‘scanned’ and the inventory records will be updated with the receipt of the goods.
Other less sophisticated businesses may simply value their inventory once at the
financial year end. The owner of your local store or restaurant will probably value
inventory at close of business on the last day of the financial year. They will list all
items remaining unsold on the last day of the financial year; they will then assign
a value to each category of goods held, and the total value of all goods gives the
closing inventory figure to be used in the year end financial statements.
This is known as a periodic method of inventory valuation.
Let us now examine the results given when we use a perpetual method of inventory
valuation.
WORKED EXAMPLE 2
During the month of February, the following receipts and issues of the
component SMH/19 took place:
Receipts of SMH/19
2 February
8 @ $10
7 February
9 February
6
9 @ $11
16 February
24 February
27 February
214
Issues of SMH/19
10
7 @ $12
6
Required
Calculate the value of closing inventory of component SMH/19 using the first-in
first-out method of valuation (FIFO).
2.1
Answer
The value of closing inventory using the FIFO method of issue is $24.00.
Receipts
2 February
8 @ $10
Issues
$80.00 (8 @ $10)
7 February
9 February
6
9 @ $11
$20.00 (2 @ $10)
$119.00 (2 @ $10; 9 @ $11)
16 February
24 February
Balance
10
7 @ $12
$11.00 (1 @ $11)
$95.00 (1 @ $11; 7 @$12)
27 February
6
$24.00 (2 @ $12)
2.1.1 Materials and labour
Date
Check each of the methods shown above. They are an important element of your
studies and you will need to know them well.
WORKED EXAMPLE 3
Use the same data for February shown above.
Required
Calculate the value of closing inventory of component SMH/19 using the
weighted average cost method (AVCO).
Answer
The value of closing inventory of component SMH/19 using the weighted average
cost (AVCO) method is $23.70.
Date
Receipts
2 February
8 @ $10
7 February
9 February
27 February
Balance
$80.00 (8 @ $10)
6
9 @ $11
16 February
24 February
Issues
$20.00 (2 @ $10)
$119.00 (Average cost $119.00/11 = $10.82)
10
7 @ $12
$10.82 ($10.82 x 1)
$94.82 (Average cost $94.82/8 = $11.85)
6
$23.70 ($11.85 x 2)
The effect of inventory valuation on reported profit
and capital
Since each method gives a different closing inventory figure, it follows that different
gross profits will be revealed by using different methods of valuation.
Imagine that component SMH/19 has been sold for $20 per unit.
215
2.1 Costs and Cost behavIour
2.1
STUDY TIP
If the value of closing
inventory is altered,
reported profits will
also change:
What would be the gross profit for each method of issue?
FIFO
$
Sales
l Increase the value
Less Cost of sales
of closing inventory
and you increase
reported profit.
l Decrease the value
of closing inventory
and you decrease
reported profit.
Opening inventory
Purchases
Less closing inventory
AVCO
$
$
440.00
440.00
0
0
263.00
263.00
263.00
263.00
24.00
Gross profit
239.00
201.00
$
23.70
239.30
200.70
The level of profits revealed in a set of financial statements always depends on the
way the inventory has been valued.
The value of closing inventory also has an effect on the capital of a business. A high
valuation gives a higher capital figure. A low valuation gives a lower capital figure.
Perpetual or periodic?
Twenty-four SMH/19 components were purchased during February and 22 were issued,
so at the end of the month there were two remaining. Using FIFO we assume that
the first components were the first ones to be issued. The two components that
are remaining as inventory are deemed to be from the last ones purchased. Closing
inventory is therefore deemed to consist of two from the last batch purchased. Closing
inventory is valued at $24.00 (2 x $12).
We have arrived at the same figure that we calculated using the perpetual method –
coincidence? No, FIFO will give the same result whether you use the perpetual or the
periodic method.
Unfortunately, there is no shorter version of calculating closing inventory when an
average price is taken for issuing goods.
Advantages and disadvantages of using FIFO and AVCO
Advantages of using FIFO
» Most people feel that it is intuitively the right method to use, since it seems to
follow the natural way that goods are generally issued, i.e. in the order in which
they are received.
» Inventory values are easily calculated.
» Issue prices are based on prices actually paid for purchases of goods.
» Closing inventory is based on prices most recently paid.
» It is a method that is acceptable for the purposes of the Companies Act 1985
and IAS 2.
Disadvantages of using FIFO
» Because it feels right intuitively many people feel that this is actually the way
goods are issued.
216
Learning link
There are several
accounting concepts
(covered in Chapter 1.2)
that relate to the
valuation of inventory.
» Issues from inventory are not at the most recent prices and this may have an
adverse effect on pricing policy.
» In times of rising prices FIFO values inventory at higher prices. This lowers the
value of cost of sales and thus increases reported profits (advantageous if the
business is to be sold). However, this can be regarded as being contrary to
the concept of prudence.
2.1
Advantages of using AVCO
2.1.1 Materials and labour
» Issues of goods are made at a weighted average price. This recognises that all
issues from stores have equal value and equal importance to the business.
» Variations in issue prices are minimised.
» AVCO allows the comparison of reported profits to be made on a more realistic
basis, since any marked changes in the price of inventory issues are ironed out.
» Because the average price used for issues is weighted towards the most recent
purchases, the value of closing inventory will be fairly close to the latest prices
paid for purchases.
» AVCO is acceptable to the Companies Act 1985 and international accounting
standards (IAS 2).
Disadvantages of using AVCO
» AVCO requires a new calculation each time a purchase of goods is made. This makes
it rather more difficult to calculate than the other two methods.
» The prices charged for issues of inventory will not generally agree with the prices
paid to purchase the goods.
STUDY TIP
FIFO and AVCO are
methods of valuing
inventory; they do not
necessarily reflect the
way that actual issues
are made.
Accounting concepts and inventory valuation
You will need to decide which concepts to use when valuing inventory.
» Clearly, the cost concept is adhered to.
» The principle of consistency is important since results obtained from the financial
statements must be able to be used for comparative purposes.
» The concept of prudence should be adhered to so that profits are not overstated –
this means that the lower of cost and net realisable value should be applied when
valuing inventories.
» The accruals concept is used when considering repair costs or delivery charges,
etc. to be deducted from selling price to determine net realisable value.
IAS 2 states that:
» inventory should be valued at the total of the lower of cost and net realisable value
of the separate items of inventory. (It allows the grouping of similar items.)
» FIFO and AVCO are acceptable bases for valuing inventory.
» inventories include finished goods and work in progress.
The principles of just-in-time (JIT) management of inventory
The holding of inventory is necessary to ensure that demand for the finished product
is always met on time. It also acts as a protection against any shortages of raw
materials or components and any price increases. Management of inventories can be
achieved by employing just-in-time (JIT) techniques. Much profit and cash is tied up
in excessive holdings of inventory. JIT means that raw materials inventory is delivered
just before it is needed. This again means that holding large amounts of inventory is
unnecessary and that inventory holding costs are kept to a minimum.
217
2.1 Costs and Cost behavIour
2.1
EVALUATION
Two partners are in business together. One of the
partners wants to switch from AVCO to FIFO for the
purpose of valuing inventory. He claims that it will
lead to increased profits. The other partner disagrees.
Advise the partners on which method of inventory
valuation they should use, FIFO or AVCO.
A strong answer would contain some of the following
points:
l Changing to FIFO would boost profits for the next
period via lower cost of sales.
l If purchase prices are rising, then more recent
inventory is likely to have a higher cost value.
l FIFO may also be more intuitive in terms of how
inventory is actually used up in business.
However:
l The effect on profits is ‘smoothed’ out over
multiple periods – with no increase in profit as a
result.
l Volatile inventory prices may actually lead to
falling profits if purchase prices have been
falling.
l It is not prudent (or consistent) to change
valuation methods to boost profits.
SUMMARY
After reading this chapter, you should:
l be able to classify costs into variable, fixed,
semi-variable or stepped
l understand the nature of costs in terms of their
relationship with production – i.e. in terms of
direct and indirect costs
l be able to calculate the value of any closing
inventory based on FIFO and AVCO methods
(period and perpetual)
l understand the principle of a just-in-time system
of inventory management.
SELF-TEST QUESTIONS
1 Identify a direct cost incurred in the manufacture of a pair of shoes.
2 Identify an indirect cost incurred in their manufacture.
3 Identify a direct cost incurred in the manufacture of the bread you may have eaten
yesterday.
4 Identify an indirect cost incurred in their manufacture.
5 Number of units produced 200. Total costs involved in their production $7500.
Calculate the cost per unit.
6 Which methods used to value inventory are acceptable under IAS 2?
7 Which methods are acceptable for the purposes of the Companies Act 1985?
8 A greengrocer must always use FIFO as a method of valuing his closing inventory.
True/False?
9 Which method of inventory valuation uses the most recent prices paid to purchase
the goods?
10 In times of rising prices, which method reveals profits sooner?
11 Borgia sends Mungo some goods on a sale or return basis. Who includes these
goods as part of their inventory?
12 If inventory has been overvalued, what effect has this had on reported profits?
13 If inventory has been undervalued, this will
reported profits.
Calculation question (answer on page 494)
14 The following information relates to stock purchases and sales during May 2022.
• At 1 May 2022, a business had one unit of inventory in stock which cost $400.
• Two further units were purchased on 10 May 2022, which each cost $425.
• On 17 May 2022, one unit was sold.
Assuming FIFO is used, calculate the value of closing inventory at 31 May 2022.
218
2.2
Traditional costing methods
By the end of this chapter you should have an understanding of:
l traditional costing methods to prepare costing statements
l absorption costing
– cost centres, cost units and allocating overheads
– calculating absorption rates, under absorption and over absorption
– preparing costing and profit statements using absorption costing
– uses and limitations of absorption costing
– usefulness for management decision-making and non-financial factors
l marginal costing
– calculating contribution and interpreting break-even charts
– calculating break-even point, contribution to sales ratio, target profit and
margin of safety
– use and limitations of break-even analysis
– preparing costing and profit statements
– reconciling reported profits using marginal and absorption costing
– usefulness for management decision-making and non-financial factors
l cost–volume–profit analysis
– advantages and disadvantages of CVP analysis
– usefulness for management decision-making and non-financial factors
– how to apply costing concepts to make business decisions and
recommendations.
2.2.1 Costing applications
Learning outcomes
Introduction
Accounting for costs is an important part of business activity. When deciding
how much a unit of output actually ‘costs’, decisions have to be made about those
costs not directly connected with the unit itself. The methods of costing are
based around decisions on which costs are included and which are not. Decisionmaking in general can be improved through the appropriate use of costing
methods. Setting the right selling price for output is often based on costing
information and therefore making a profit will be dependent on ensuring the
costing information is realistic and relevant for the particular activity.
Learning link
FIFO and AVCO were
covered in Chapter 2.1.
2.2.1 Costing applications
How to apply traditional costing methods to prepare costing
statements using unit, job and batch costing principles
Unit costs
Unit costs are those that can easily be identified and so allocated to a specific unit,
for example, material costs, labour costs and other direct costs. When it is not possible
219
to identify material costs to a specific unit, the costs will be allocated by using firstin first-out (FIFO) or weighted average cost (AVCO) methods of issue.
2.2
Labour costs are generally much simpler to allocate to specific units.
The cost of each individual unit of production can be calculated by dividing the total
costs attributed to it by the number of units actually produced. Any partly completed
units (work in progress) are converted into their equivalent number of completed units.
2.2 tradItIonal CostIng methods
STUDY TIP
At this point in your
studies, you need to
concentrate only on
job, unit and batch
costing.
A method of costing is designed to meet the needs of the business using it.
Managers will adopt a costing system to suit the individual requirements of their
business. The system they employ will depend on the type of production process in
their factory and the type of good or service being provided.
Absorption costing can be used in any business. Absorption refers to the process
whereby the unit cost of production contains not only the direct costs of production,
but also a portion of the indirect overheads incurred by a business in the production
of output. The principles of cost allocation and apportionment are still applied. The
type of costing system used will depend on the type of business being considered.
Business activity generally falls into one of two categories:
» businesses whose production process is a continuous operation
» those that deal with specific orders.
Unit costing
Continuous operation costing is used in organisations where goods or services are
produced using a sequence of continuous or repetitive operations or processes. This
type of costing is used to find the cost of a single unit of production or single unit of
providing a service. This is an example of unit costing.
Job costing
Job costing is used where each product or service is different from the provision
of other products. It is used by businesses that produce specialised or made to
order outputs, where jobs are tailored to the specific requirements of an individual
customer as a result of a special order. The system is employed where goods or
services are provided on a ‘one off’ basis, as opposed to being mass produced.
In organisations that produce a wide range of products or jobs and where each order
is unique, the cost of each order must be separately calculated. Each job will require
differing amounts of labour, materials and overheads spent on it. Because of this,
separate costing records are kept for each job, detailing all the costs incurred in
completing the job and identifying the profit or loss for the job.
The job is a cost centre to which all the costs are charged.
The costing details may also be used to cost similar future jobs and to form the basis
of preparing future quotations for jobs being considered.
It is therefore an appropriate costing system for businesses whose work consists of
separate jobs, for example, installers of air conditioning units, specialist building
contractors, specialist home decorators, architects and tailors.
220
Batch costing
Batch costing is used where a quantity of identical items is manufactured as a batch;
the identical items are manufactured and treated as one individual job for costing
purposes. This could be because a customer orders a quantity of identical items; for
example, a builder of houses requires a woodworking business to make identical roof
timbers or uniform kitchen cupboards. The woodworker would use a system of batch
costing.
Costs are recorded against each batch and the final total production cost for the
whole batch is divided by the number of good individual units produced to get the
production cost per article.
It is ideally suited to the costing requirements of mass-production industries where
identical items are manufactured. Such items keep their individual identity as separate
units, even though there may be several common, distinct stages in arriving at the
end result.
2.2.1 Costing applications
Costing a batch is very similar to costing a job, and the same procedures are followed.
But the whole batch is treated as one separate identifiable job.
2.2
Examples of industries employing batch costing techniques would include a business
producing components for a car manufacturer or a business making micro-chips for an
electrical goods manufacturer.
When the batch is completed, the total cost of the batch is divided by the number of
goods completed to determine the cost per unit.
Consider a business making women’s dresses. Each unit may have the same basic
design and require the same operation but the remaining operations may differ. Some
dresses may require pockets, others no pockets; other dresses may require higher
quality materials. The cost of a dress will therefore consist of the basic pattern plus
additional costs. The product cost will consist of the average cost of the common
operation to achieve the ‘basic’ dress plus the specific costs of the additional changes.
The final product cost consists of a combination of batch costing techniques and job
costing techniques.
In both examples used to illustrate job and batch costing principles, we have used
a business that manufactures output. It is perfectly possible that a service sector
business could apply the principle of job costing. For example, a design business may
produce a unique service for each client it deals with, such as designing a logo for the
business, and provide a unique cost for each job completed.
Calculation of the value of inventory
When using unit, job or batch costing principles, closing inventory is valued according
to the principle of taking the lower of cost and net realisable value. This is usually
fairly straightforward when raw materials or finished goods are considered. However,
it would be rather unusual if there were no partly completed goods remaining as
inventory at the end of a period. The costs incurred during the period are for all the
goods passing through the factory: those that are complete and those that have yet
to be completed. The units that are partly completed have to be converted into the
equivalent number of completed units.
221
2.2
WORKED EXAMPLE 1
The following information is given for January:
Total production costs amount to $29 440. By the end of January, 12 000 units
had been completed and 1000 were partly finished. It is decided that these partly
finished goods are 80% complete.
2.2 tradItIonal CostIng methods
At 31 January, 1500 completed units were held as inventory.
Required
Calculate the value of closing inventory.
Answer
Cost per unit =
$29 440
= $2.30
12 000 + 800
Closing inventory = $3450.00 (1500 complete units at $2.30 each)
$1 840.00 (80% of 1000 units at $2.30 each)
Total value of closing inventory $5290.00
2.2.2 Absorption costing
The difference between a cost centre and a cost unit
Cost centres are usually determined by the type of business being considered. A cost
centre may be a department, a machine or a person to whom costs can be associated.
In your school or a large retailer, the primary cost centre might be each department.
In a car repair garage, the cost centres might be the repair department, the sales
department or the parts department.
Cost unit is a unit of a product (or service) to which costs can be attributed – a
unit which absorbs the cost centre’s overhead costs. Cost units in a school might be
students, while in the garage repairs department the cost unit might be each car being
worked on. It could be a vehicle in a factory producing motor vehicles. In a passenger
transport business, a cost unit might be a passenger mile.
How to allocate and apportion overhead expenditure between
production and service departments
When costing a product it may seem that we would just add the overhead costs to the
total of the direct or variable costs incurred in the production of output. This would
seem to give us the total cost of production.
Overheads
Some costs are not easily allocated to a cost centre, yet the cost centre may have
benefited from the service provided. For example, the cost of rent or business rates
applies to the business as a whole; each cost centre should bear some part of the total
cost of providing the services.
Cost centres that are actively involved in the production process will be allocated,
mainly, with direct costs – there is no need for apportionment in such cases but they
should also be charged with other appropriate indirect costs. This is referred to as
‘allocation of costs’.
These are usually costs which apply to the business as a whole. They need to be
apportioned on some equitable basis. Apportionment of overheads will be based on
222
managers’ perception of the benefits that each individual cost centre receives from
the provision of the service.
Consider the following scenario.
2.2
EXAMPLE
Ivor can very easily prepare an absorption costing statement since all the costs
go towards manufacturing the toothbrushes. He can use the statement to
calculate his profits and he can even use it to work out his pricing strategy.
After a couple of successful years, Harry, by now a skilled brush maker,
suggests that they should diversify into also producing hairbrushes. Ivor agrees
that this would be an excellent idea. In the smaller of the two rented units, Ivor
continues to produce toothbrushes, while in the larger unit, Harry produces
hairbrushes.
2.2.2 Absorption costing
Ivor Fillin sets up in business manufacturing toothbrushes. He employs Harry
Sheen to help in the manufacturing process. Ivor rents two units on a local
industrial estate.
How would Ivor determine the costs involved in producing the two different
types of brushes?
He can easily allocate, the direct costs to each product, since labour costs, and
material costs, are unique to each product.
The problem arises when rent, business rates utility charges and other
overheads have to be charged to the two products. These are costs that apply to
the business as a whole. They need to be apportioned in some equitable manner.
▼ Table 2.2.1 Bases of apportioning indirect costs
Overhead
Basis of apportionment to cost centres
Rent
Floor area of cost centre
Business rates
Floor area of cost centre
Insurance
Value of items being insured
Heating and lighting Volume of cost centre (if this is not available then floor area may be
used)
Depreciation
Cost or book value of the asset in cost centre
Canteen
Numbers of personnel in each cost centre
Personnel
Numbers of personnel in each cost centre
WORKED EXAMPLE 2
The directors of the Beckmond Engineering Company provide the following
information for the month of February.
The following budgeted overheads cannot be allocated to the two departments
run by the company:
Rent
Business rates
Power
Supervisory wages
Depreciation of factory machinery
$
375 000
90 000
300 000
96 000
150 000
223
Additional information
2.2
Total factory area is 240 000 square
metres
Power used in each department
2.2 tradItIonal CostIng methods
Cost of machinery in each department
Staff employed in each department
Department A occupies 60 000 square metres
Department B occupies 180 000 square metres
Department A 60 000 kWh
Department B 40 000 kWh
Department A $300 000
Department B $600 000
Department A 30 workers
Department B 10 workers
Required
Prepare an overhead analysis sheet for February.
Answer
Overhead
Rent
Business rates
Power
Supervisory wages
Depreciation of
machinery
Total cost
$
375 000
90 000
300 000
96 000
150 000
Basis of
apportionment
Floor area
Floor area
kWh
Number of workers
Cost of machinery
1 011 000
Dept A
Dept B
$
93 750
22 500
180 000
72 000
50 000
$
281 250
67 500
120 000
24 000
100 000
418 250
592 750
Transfer of service department costs
Departments that provide services for the production department, and, hence, other
cost centres, clearly are not involved directly in the production of finished products.
They cannot recoup their costs by incorporating them into the selling price of their
product or service. Yet their costs must be recovered by the business.
A canteen provides a service to all other departments
The estimated costs of service departments must be apportioned to each production
department. This means that each production department will recover its own
overheads and some of the overheads incurred by the service department.
224
Service departments in effect charge the other cost centres in the business for the
services that they provide for them.
Sometimes service departments keep detailed records of work completed in each
department. In such cases these costs can be allocated to the appropriate department.
2.2
This is often the case in a reprographics department of a college or school. Each
department will be charged for the photocopying they are responsible for.
Examples of service departments include:
canteen
stores
maintenance
personnel.
WORKED EXAMPLE 3
Thierity Ltd has three production departments. The company operates a staff
canteen for all staff. The following budgeted cost information is given after all
costs have been allocated or apportioned to the appropriate department.
2.2.2 Absorption costing
»
»
»
»
$
Department D
412 000
Department E
346 000
Department F
110 000
Canteen
63 000
Required
Prepare a table showing the apportionment of canteen overheads to the
production departments.
Answer
Total
Overhead
Total
Basis of
$ apportionment
931 000
Canteen
?
931 000
Dept D
Dept E
Dept F
Canteen
$
$
$
$
412 000
346 000
110 000
63 000
30 000
24 000
9 000
(63 000)
442 000
370 000
119 000
Note
Can you guess how the canteen costs have been apportioned? What information
was missing in the question?
The information that was missing was the numbers of people working in each
department. There were ten workers in Department D; eight in Department E;
three in Department F.
Reciprocal services
The picture becomes a little more complicated when reciprocal services are provided.
Reciprocal services is the term used when a department provides a service for another
department and receives a service from the same department.
For example, the canteen provides a service for all staff including the maintenance
engineers; the maintenance engineers keep the canteen equipment in good working
order as well as servicing equipment and machinery in all other departments.
225
2.2
We will use the elimination method to apportion costs incurred by service
departments.
WORKED EXAMPLE 4
The cost accountant of Oxian Ltd provides the following information on budgeted
total departmental costs after all costs have been allocated or apportioned:
2.2 tradItIonal CostIng methods
Production departments
M
Total costs
N
Service departments
P
Q
R
$
$
$
$
$
45 000
60 000
20 000
10 000
12 000
The service departments’ costs are to be apportioned as follows:
Department Q
40%
30%
20%
–
10%
Department R
20%
10%
30%
40%
–
Required
Prepare a statement to show how the costs of the service departments are
reapportioned between the production departments.
Answer
Production departments
M
Total costs
Apportionment of Dept R costs
N
P
Service departments
Q
R
$
$
$
$
$
45 000
60 000
20 000
10 000
12 000
2 400
1 200
3 600
4 800
(12 000)
47 400
61 200
23 600
14 800
Note
l Department R has now been eliminated.
l Always start with the service department with the greater costs.
l The remaining overheads with Department R could then be reapportioned to
the other departments until the amount remaining is immaterial.
l An alternative method would be to ignore the work done by the service
departments and not apportion overheads to these departments.
From above:
Apportionment of Dept Q costs
47 400
61 200
23 600
14 800
5 920
4 440
2 960
(14 800)
53 320
65 640
26 560
1 480
1 480
This method ignores the amount left over for Department R.
The method of apportioning overheads is only a matter of convention and none of the
methods that could have been used can claim to be perfectly realistic. In most cases,
the figure remaining when the process is completed will be insignificant.
226
Remember
How we calculate the
OAR is based on what is
the appropriate basis –
it is based on opinion
rather than scientific
fact.
How to calculate overhead absorption rates using an
appropriate basis
The absorption of overheads
2.2
After the overheads have been apportioned to the appropriate cost centres, we need
to calculate the amount of the overhead to be included into the cost of each unit
passing through the cost centre.
There are a number of different methods of calculating the overhead absorption rate.
Direct labour hour rate
When a particular department is labour intensive and there is little machinery used or
machine costs are low, the overhead absorption rate may be calculated using the labour
hours required to complete each unit of production (direct labour hours per unit).
WORKED EXAMPLE 5
2.2.2 Absorption costing
The amount of each cost centre’s overheads that needs to be absorbed (added) to each
unit of production is termed the overhead absorption rate (OAR).
Stemods Ltd manufactures two products: ‘culas’ and ‘ginars’.
The budgeted production for each product for October is shown:
Cula
Ginar
Units
10 000
8 000
Direct labour hours per unit
2
1.5
Budgeted overheads for October are expected to be $75 840.
Required
Calculate:
a the overhead absorption rate for each product using the direct labour hour
method
b the total amount of overheads absorbed by each product if budgets are met.
Answer
Total direct labour hours = 20 000 + 12 000 = 32 000
$75 840
Labour hour overhead absorption rate =
= $2.37 per hour
32 000
a Overhead absorption rate for each unit: cula = $4.74 (2 hours × $2.37)
ginar = $3.56 (1½ hours × $2.37)
b If the budgets are met, then the total overheads will be absorbed as follows:
$
10 000 units of cula will absorb
47 400
(10 000 × $4.74)
8 000 units of ginar will absorb
28 440
(8 000 × $3.555)
Total overheads absorbed
75 840
Machine hour rate
This method is appropriate when production methods are capital intensive or machine
costs are relatively high. The overhead absorption rate will take into account the
number of machine hours required to produce each unit of output.
227
2.2 tradItIonal CostIng methods
2.2
WORKED EXAMPLE 6
The following information relates to a business using a system of absorption
costing:
Department
Budgeted overheads
Absorption base
Machine shop
$18 000
4 000 machine hours
Assembly shop
$10 500
3 000 labour hours
$5 000
2 500 labour hours
Paint shop
An order is placed for job A/341 with a selling price of $9 000.
The following information relates to job A/341:
Direct materials costs
$3 450
Direct labour costs – machine shop
60 hours at $5.00 per hour
assembly shop
240 hours at $4.00 per hour
paint shop
40 hours at $4.50 per hour
Time booked in the machine shop for the job is 120 machine hours.
Administration and selling overheads are calculated at 20% of factory cost.
Required
Calculate the cost of job A/341 and the profit made on the job.
Answer
Overhead absorption rates (OAR):
Machine shop:
$18 000
= $4.50 per machine hour
4 000
Assembly shop: $10 500 = $3.50 per labour hour
3 000
Paint shop:
$5000
= $2.00 per labour hour
2 500
Costings for Job A/341
$
Direct materials
Direct wages – machine shop
assembly shop
paint shop
Prime cost
Factory overheads – machine shop (120 × $4.50)
assembly shop (240 × $3.50)
paint shop (40 × $2.00)
Factory cost
Administration and selling overheads
Total cost
Selling price
Profit
228
300
960
180
540
840
80
$
3 450
1 440
4 890
1 460
6 350
1 270
7 620
9 000
1 380
WORKED EXAMPLE 7
Tryndra Ltd manufactures ‘dertins’ and ‘ghilos’. The budgeted production for
each product for February is shown:
Units
2.2
Machine hours per unit
4 000
0.5
Ghilo
20 000
0.25
Budgeted overheads for February are expected to be $66 780.
Required
Calculate:
a the overhead absorption rate using the direct machine hour method
b the total amount of overheads absorbed by each product if budgets are met.
Answer
2.2.2 Absorption costing
Dertin
Total machine hours: 2 000 + 5 000 = 7 000
$66 780
= $9.54 per hour
7 000
a Overhead absorption rate: dertin = 0.5 × $9.54 = $4.77
ghilo = 0.25 × $9.54 = $2.39
b If the budgets are met, the total overheads will be absorbed as follows:
Machine hour overhead absorption rate =
$
4 000 units of dertin will absorb
19 080
(4 000 × $4.77)
20 000 units of ghilo will absorb
47 700
(20 000 × $2.385)
66 780
The total overheads in February will be recovered partly by sales of dertin
($19 080) and partly by sales of ghilos ($47 700).
There are four other possible ways of calculating the overhead absorption rate.
Direct labour cost rate
The estimated overheads are expressed as a proportion of the estimated cost of direct
wages. The weakness of this method is that overheads will, in the main, accrue on
a time basis whereas wages often accrue in a more complex way depending on the
method of rewarding labour. For example, payment of wages may be based on some
kind of piecework or a premium bonus method.
WORKED EXAMPLE 8
Total overheads for April are estimated to be $283 992. Total direct labour costs
are estimated to be $151 060.
Required
Calculate the overhead absorption rate for April using the direct labour cost
method.
Answer
Overhead absorption rate =
$283 992
= $1.88 per $1 of direct labour cost.
$151 060
229
2.2
Direct material cost rate
This is a similar method to the direct labour cost method. The total cost of materials
is used as the denominator in the calculation. The method’s main weakness is that
it assumes that time taken to process materials bears some kind of relationship to
its cost. So high value materials will attract more overheads than cheaper materials,
regardless of the time taken to process them.
2.2 tradItIonal CostIng methods
WORKED EXAMPLE 9
Total overheads for December are estimated to be $1 954 170. Total material
costs are estimated to be $502 350.
Required
Calculate the overhead absorption rate for December using the direct material
cost method.
Answer
Overhead absorption rate =
$1 954 170
= $3.89 per $1 of direct materials used
$502 350
Prime cost rate
This method uses prime cost as the denominator. The method has the same
weaknesses as the direct labour cost method and the direct material cost method.
WORKED EXAMPLE 10
Total overheads for July are estimated to be $1 355 500. Prime cost is estimated
to be $412 200.
Required
Calculate the overhead absorption rate for July using the prime cost method.
Answer
Overhead absorption rate =
$1 355 500
= $3.29 per $1 of prime cost
$412 200
Unit produced rate (cost unit rate)
The total overheads allocated and apportioned to production are divided by the
estimated number of units produced; so the overheads are spread over the goods
produced. The method can only realistically be used if the business manufactures only
one type of product.
WORKED EXAMPLE 11
Total overheads for May are estimated to be $15 500. The total number of units
produced is estimated to be 14 500.
Required
Calculate the overhead absorption rate for May using the cost unit method.
Answer
Overhead absorption rate =
$15 500
= $1.07 per unit
$14 500
Products passing through several departments
So far, we have considered products that are produced in one department only. Some
jobs pass through several departments before completion. As a job passes through a
230
department, it attracts a proportion of the overheads of that department. When it
passes to the next department, it will attract a proportion of the overheads of the
second department and so on until it is complete.
Job
Prime costs
Proportion of overheads
Proportion of overheads
from Department 1
2.2
etc.
from Department 2
Total cost of product + Mark up = Selling price
Yves Pichot manufactures ‘desirs’. Each desir passes through two departments
on its path to completion.
Information for each department is given:
Department 1
Budgeted total overheads
Budgeted total labour hours worked
Budgeted total machine hours worked
Department 2
$40 320
$18 864
4 800
900
300
3 600
2.2.2 Absorption costing
WORKED EXAMPLE 12
A desir spends four hours passing through Department 1 and three hours
passing through Department 2 before completion.
Required
a Calculate the overhead absorption rate for a desir for each department
using:
i labour hours
ii machine hours.
b State which method of overhead absorption should be used in the two
departments. Give reasons for your answer.
c Calculate the total overheads to be absorbed by one unit of desir if budgets
are met.
Answer
a
Department 1:
OAR using labour hours = $8.40 ($40 320 ÷ 4800)
OAR using machine hours = $134.40 ($40 320 ÷ 300)
Department 2:
OAR using labour hours = $20.96 ($18 864 ÷ 900)
OAR using machine hours = $5.24 ($18 864 ÷ 3600)
b Since Department 1 is labour intensive, labour hours should be chosen as
the method of overhead absorption. Machine hours should be chosen for
Department 2 since it is capital intensive.
c A desir takes four hours in Department 1, so $33.60 needs to be absorbed.
A desir takes three hours in Department 2, so $15.72 needs to be absorbed.
Total overheads to be absorbed by a desir: $49.32 ($33.60 + $15.72) if budgets
are met.
The causes and the calculation of under absorption and over
absorption of overheads
Overhead absorption rates are based on predictions of future levels of activity and
predicted (budgeted) levels of overhead expenditure.
If the actual level of activity is equal to that budgeted, and actual expenditure on
overheads is equal to budgeted expenditure, then the expenditure on overheads will
be absorbed exactly.
231
2.2
If the actual level of activity is less than the budgeted level, and spending on
overheads is equal to the predicted level, then the actual overheads will not be
recovered. There will be an under absorption of overheads.
2.2 tradItIonal CostIng methods
If the actual level of activity is equal to the level that was budgeted, but the actual
spending on overheads is greater than the budgeted amount, then this too will mean
an under absorption of overheads.
If the actual level of activity is higher than the budgeted level, and actual spending
on overheads is equal to that budgeted, then the overheads will be more than
recovered. There will be an over absorption of overheads.
If activity levels are the same as those budgeted, but actual spending is less than that
budgeted, then this too will mean less spending on overheads. There will be an over
absorption of overheads.
Any under absorption of overheads is debited to the costing statement of profit or loss.
Any over absorption of overheads is credited to the costing statement of profit or loss.
WORKED EXAMPLE 13
Bartasil Ltd manufactures ‘kityos’. The directors budget for overhead
expenditure of $25 000 each month. This figure is based on an output of 5000
kityos. The overhead absorption rate is $5.00 per unit.
The following information is given:
Actual output Actual expenditure on overheads
Units
$
January
5 000
24 000
February
4 900
25 000
March
5 100
25 000
April
5 000
25 100
May
5 100
28 050
June
5 100
26 000
Required
Calculate the over or under absorption of overheads for each of the six months.
Answer
Actual expenditure Overheads
on overheads
absorbed
232
Over/under absorption
of overheads
$
$
$
January
24 000
25 000
1 000
February
25 000
24 500
500
under absorption
March
25 000
25 500
500
over absorption
April
25 100
25 000
100
under absorption
May
28 050
25 500
2 550
under absorption
June
26 000
25 500
500
under absorption
over absorption
Other overheads
The other costs incurred by a business must also be recovered if the business is to
survive in the long term.
2.2
» Selling and distribution costs must be recovered.
» Administration costs must be recovered.
» Finance charges must be recovered.
These costs are treated as fixed costs and as such are entered in the statement of
profit or loss as we have done on previous occasions in this book.
How to prepare costing and profit statements using
absorption costing
It is of vital importance that a business is able to calculate what each product
or service (or group of products or services) has cost to make or provide. This is
necessary so that the business can fix a selling price in order to recover the costs
incurred in operating the business and provide profits to ensure the survival of the
business.
2.2.2 Absorption costing
These costs are usually recovered through the mark-up added to the goods before they
are sold to the final customer.
Absorption costing determines the total cost of production. This means that all costs
incurred in the production of the product are absorbed into the cost of production.
WORKED EXAMPLE 14
The following information is available for the month of January 2021 for
Chaudhry and Son, a manufacturing business. The business produces one
product, a ‘higle’. Production for January 2021 was 1000 higles and the costs
involved were:
Direct labour costs
Direct material costs
Indirect labour costs
Indirect material costs
Other indirect costs
Selling and distribution costs
Administration expenses
Manufacturing royalties
Depreciation of factory machinery
$
78 000
56 000
34 000
17 000
26 000
46 000
62 000
2 000
14 000
Required
a Prepare an absorption costing statement for the month of January 2021.
b Calculate the cost of producing one higle, using an absorption costing basis.
233
2.2
Answer
a
Absorption costing statement for January 2021
Direct materials
56 000
Direct labour
78 000
Royalties
2 000
Prime cost
2.2 tradItIonal CostIng methods
$
136 000
Indirect materials
17 000
Indirect labour
34 000
Other indirect costs
26 000
Depreciation
14 000
Total production cost
227 000
Selling and distribution costs
46 000
Administration costs
62 000
335 000
Total cost
b On an absorption costing basis, each higle has cost $335.00 (= $335 000 ÷
1 000).
Once the absorption costing statement has been produced, this information, as well
as information relating to selling price and profits, can be used to produce a profit
statement.
Based on the same example, a profit statement could appear as follows:
Profit statement for January 2021
$
Revenue
446 667
Total cost of produce higles
335 000
Profit
111 667
(selling price = $446 667 /1 000 = $446.67 per unit)
The usefulness and limitations of absorption cost data as a
support for management decision-making
As we saw in the previous section, one use of absorption costing is that it can be used
to determine the selling price of output, whether for a one-off job, or for a batch of
products. It should ensure that all costs are covered and the price is set high enough
for losses to be avoided (and, hopefully, profits to be made).
Management decision-making relies heavily on the provision of realistic information;
the information provided by absorption costing may be unrealistic, since it relies on
budgeted information. Of course, if the output level is lower than the level budgeted
for, then under-recovery of overheads will occur. To ensure that overheads are fully
recovered, overhead absorption rates must be updated on a regular basis. They are
derived from budgeted information and are therefore subject to change. If done
appropriately, then absorption costing will at least go some way to help avoid setting
a selling price that does not cover all costs.
Absorption costing and IAS 2
IAS 2 Inventories requires that the value of inventories, reported in the published
financial statements of limited companies, includes the costs of converting the raw
materials used into finished goods.
234
All ‘normal’ production costs will be included in the total cost of the product.
Occasionally, there may be ‘unusual’ items of expenditure incurred during production.
These might include idle time losses or exceptional wastage due to unforeseen
circumstances. These should be excluded in the valuation.
2.2
Other overheads may be included if management deems it prudent to do so. Examples
might include overheads incurred by the accounts department or the personnel
department if either has a direct input into the running of the production department.
Limitations of absorption costing
However, there are also limitations in using absorption costing:
» The methods chosen to apportion and absorb overheads (which are fixed and direct
costs of production) into cost centres and cost units are arbitrary in nature and
there is never a completely satisfactory method of linking these costs to cost units
and cost centres. Even without this limitation, there are still times when a manager
may find that the absorption costing approach provides misleading information.
» Absorption costing in general is not so useful when making decisions about one-off
changes – such as the decision to accept an order from a customer at an unusually
low selling price, or the decision on whether to keep a product line running when
there is a shortage of raw materials. These decisions are better answered by using
a marginal costing approach.
2.2.2 Absorption costing
Managers can use whatever basis they like when producing financial statements for
internal management use, since IAS 2 does not apply.
Marginal costing, as an approach to costing, is more useful for making some
management decisions and this is explored in Section 2.2.3.
The non-financial factors and their significance
When using costing to make business decisions, a manager should always ensure the
wider issues are considered – often of a non-financial nature. Decisions on what are
financial and non-financial factors are not always straightforward, as something that
would appear to be non-financial may well impact on the financial aspects of any
decisions. Common areas for relevant non-financial factors may include:
» How worker motivation may affect the level of production costs – this could be
connected to internal factors, such as management techniques used within the
business, or external factors, such as increased unemployment leading to job
insecurity among the workforce.
» Ethical considerations may need to be considered by a business. A business that is
suspected of behaving in an unethical way may find that its image and, ultimately,
its sales are adversely affected. A switch to a more ethical form of production may
be considered. This may involve a change in supplier and could lead to increased
costs of raw materials. The business may also have to change the employment
practices used within the business with regard to its workers. For example, longer
breaks, more generous holiday allowances and other ‘perks’ to workers may be
given, all of which may lead to increased costs of production through higher labour
costs.
» Changes in the law may also affect a business and its production costs. For
example, a tightening up of environmental legislation may mean that a business
has to spend more money on disposing of production materials, or the method of
production – i.e. what machinery and power methods can be used in manufacturing
output.
235
SELF-TEST QUESTIONS
2.2
1 What is meant by the term ‘job’?
2 Identify a business that is likely to employ a system of job costing.
3 Ali runs a mobile catering business. He will cost out each booking using job
costing techniques. True/False?
2.2 tradItIonal CostIng methods
4 Explain the term ‘batch’.
5 Identify an industry that would employ a system of batch costing.
6 A custom car company adapts production cars into racing cars. It would use a
system of batch costing. True/False?
7 A manufacturer of television remote controls would use a system of batch costing.
True/False?
8 Which of the following industries is likely to use a system of batch costing – a
producer of breakfast cereals; a house builder; a potato chip manufacturer?
9 Linas installs swimming pools using the customer’s specification. What type of
costing system is Linas likely to use?
10 Identify one use of absorption costing.
11 Identify one example of a cost centre.
12 Identify one example of a cost unit.
13 Tick the appropriate box to indicate whether the expense should be allocated or
apportioned to the appropriate cost centre:
Overhead
Direct wages
Heating and lighting
Direct materials
Insurances
Cost of running the canteen
Allocate

Apportion
14 Explain what is meant by the term ‘reciprocal service departments’.
15 Identify two methods of calculating an overhead absorption rate other than by
using a direct labour hour method.
16 Budgeted overheads are $23 600; actual overheads are $24 000; and actual activity
is equal to budgeted activity. Does this result in an over or under absorption of
overheads?
17 Budgeted overheads are equal to actual overheads and actual activity is 23 000
units of production compared to budgeted activity of 25 000 units. Does this result
in an over or under absorption of overheads?
18 What is meant by the term ‘marginal’?
19 Total cost = $3 500. After producing one more unit of production, total cost rises to
$3 510. What is the marginal cost?
Calculation question (answer on page 494)
20 Total overheads for July are estimated to be $236 800. Prime cost is estimated to
be $175 600.
Calculate the overhead absorption rate for July using the prime cost method.
236
2.2.3 Marginal costing
2.2
How to calculate the contribution of a product
Marginal costing
Marginal costing is a decision-making technique used by management accountants. It
is based on the costs incurred and the revenue generated by the production and sale
of an additional unit of output.
FORMULA
Total variable Variable production Variable selling and Variable administrative
+ distribution cost +
cost of sales =
cost
cost
2.2.3 Marginal costing
Marginal costing makes a clear distinction between fixed and variable costs. When
using marginal costing, no attempt is made to allocate or apportion any fixed costs
incurred by cost centres or cost units.
When used in a marginal cost statement or marginal cost calculation, variable cost is
total variable cost of sales.
We saw that the total cost of a product was made up of variable costs plus fixed costs.
We also know that fixed costs are not affected by changes in the number of units
produced. Therefore, if the number of units produced is increased, then only the
variable cost part of total cost would increase.
Marginal costs usually comprise material costs, direct wage costs, direct expenditure,
other variable costs in selling and distributing the product and any administration
costs that arise when there is an increase in the level of production.
By definition, an increase in production (that is an increase in business activity) will
not increase fixed costs – they will remain unchanged.
EXAMPLE
Output in units Fixed costs Variable costs Total costs Marginal costs per unit
$
$
$
$
100
5 000
1 000
6 000
101
5 000
1 010
6 010
10
102
5 000
1 020
6 020
10
103
5 000
1 030
6 030
10
l Note the variable costs change in line with the level of production.
l The fixed costs have not changed with the increase in the level of production.
l The variable costs are the marginal costs (in this simple example).
How to calculate the break-even point, contribution to sales
ratio, level of output or sales to achieve a target profit, and
margin of safety
Marginal costing is very much concerned with the concept of contribution. Although
total contribution can be calculated as the difference between the sales revenue and
the total variable cost, it is the unit contribution which is useful. This is calculated
237
2.2 tradItIonal CostIng methods
2.2
as the difference between the selling price and the variable cost per unit. Decision
making, when using marginal costing, is often based around the contribution of each
unit of output towards the fixed costs and profits of the business.
One of the uses of marginal costing, is to help a business determine how many units
of output it needs to sell to ensure that it no longer makes a loss. This is referred
to as break-even analysis. Being able to calculate the break-even point is a very
important skill to possess. The margin of safety is the difference betwen the actual
sales achieved or forecast as achievable and the break-even level of sales. The margin
indicates to managers how far the sales can fall before the business will move out of
profit and into a loss-making situation.
The unit contribution method
This is the most commonly used method.
If the contribution per unit can be calculated, then it is possible to determine how
many of those units must be sold to cover the total fixed costs incurred.
FORMULA
Break-even point =
Total fixed costs
= Number of units required to be sold
Contribution per unit
Note that it is total fixed costs that are used.
Sometimes information is not given in the precise way that we would like. We may
need to get it into a form that we would prefer.
WORKED EXAMPLE 15
The following information is given for the production and sales of 2450 ‘hupers’:
$
Total direct material costs
56 350
Total direct labour costs
41 650
Total fixed costs
54 000
Total sales revenue
183 750
Required
Calculate:
a the break-even point for hupers
b the margin of safety.
238
Workings
The information given uses total costs and total revenue. The break-even
calculation using this formula uses total fixed cost and contribution per unit. So it
is necessary that we work out the contribution per unit to use in our calculation.
2.2
$
23
($56 350 ÷ 2 450)
Direct labour costs per unit
17
($41 650 ÷ 2 450)
Total variable costs
40
Sales revenue per unit
75
($183 750 ÷ 2 450)
Contribution per unit
35
($75 – $40)
Answer
Total fixed costs
$54 000
=
= 1543 hupers
Contribution per unit
$35
b Margin of safety = Achievable sales – Break-even sales level
= 2450 – 1543
= 907 hupers
Note
The exact answer for break even is 1542.857 hupers, but we always round up
since it is usually impossible to sell part of the unit that we are concerned with.
a Break-even point =
2.2.3 Marginal costing
Direct material costs per unit
WORKED EXAMPLE 16
The following information is given for the production and sales of 1500 ‘dorcs’:
$
Direct material costs per unit
Direct labour costs per unit
Fixed costs per unit
8.00
13.00
7.50
Selling price per unit
40.00
Required
Calculate:
a the break-even point for dorcs
b the margin of safety.
Workings
Total fixed costs must be used but contribution per unit is required when using
this formula.
Total fixed costs = $11 250 ($7.50 × 1500)
Contribution per unit = Selling price per unit – Variable costs per unit
= $40 – $13 and $8
= $19
Answer
Total fixed costs
$11 250
=
= 593 dorcs (actually 592.105)
Contribution per unit
$19
b Margin of safety = Achievable sales – Break-even level of sales
= 1500 – 593
= 907 dorcs
a Break-even =
239
If the break-even level of sales revenue is required, then the break-even volume is
multiplied by the selling price per unit.
2.2
Total sales revenue required in order for hupers to break even was
$115 725 (1543 × $75).
2.2 tradItIonal CostIng methods
Total sales revenue required in order for dorcs to break even was
$23 720 (593 × $40).
STUDY TIP
Always start your
calculations with the
formula.
Target profit
Break-even analysis can be used to determine the level of production and sales
revenue that would be required in order to achieve a particular level of profit.
This information is useful to managers when planning the future activities of a business.
FORMULA
Units to be sold to reach target profit =
Total fixed costs + Profit required
Contribution per unit
WORKED EXAMPLE 17
Tanzeel requires a profit of $80 000. He supplies the following information:
$
Selling price per unit
56.00
Variable costs per unit
32.00
Total fixed costs
60 000
Required
Calculate the number of units that need to be sold in order to achieve a profit
of $80 000.
Answer
Total fixed costs + target profit
Contribution per unit
$60 000 + $80 000
=
$56 – $32
$140 000
=
$24
= 5834 units (rounded from 5833.33)
Units to be sold =
240
You can always calculate the target profit in terms of sales revenue as well. This would
be found by multiplying the number of units that need to be sold to reach the target
level of profit by the selling price. In this example, this would be as follows:
2.2
5834 units × $56.00 = $326 704.00
The major drawback with using this method of determining break even is that it will
only work for a single product. Obviously, different products will have different cost
patterns and therefore different contributions to different fixed costs. In order to
overcome this problem, the following method can be used.
This method is used when:
» there are a number of products being manufactured and sold
» a marginal costing statement is given
» the variable cost per unit and the selling price per unit are not available or would
be extremely difficult to calculate.
2.2.3 Marginal costing
The contribution to sales method
FORMULA
Contribution to sales (c/s) ratio =
Break even =
Total contribution
Total sales revenue
Total fixed costs
Contribution/sales (c/s) ratio
Provided that the selling price per unit and the marginal costs per unit do not change,
the contribution/sales ratio will remain fixed.
A simple illustration demonstrates this:
EXAMPLE
1 unit
2 units 3 units
10 units 1000 units
Sales at $4 per unit
4
8
12
40
4 000
Marginal costs
$3 per unit
3
6
9
30
3 000
Contribution
1
2
3
10
1 000
… which
Contribution
1
2
3
10
1000
× 100
× 100
× 100
× 100
× 100
× 100 are all 25%
Sales
4
8
12
40
4000
241
2.2
We can use this information to calculate break even and the total sales revenue
needed to achieve a particular level of profits.
EXAMPLE
Ben Chan plc
Marginal cost statement for the year ended 31 August 2021
2.2 tradItIonal CostIng methods
$
Sales
358 700
Variable costs
(126 300)
Total contribution
232 400
Fixed costs
(150 000)
82 400
Profit
C/S ratio =
Contribution $232 400
=
= 64.8% or 0.648
Sales
$358 700
Break-even point =
Total fixed costs
$150 000
=
= $231 482 sales revenue
Contribution/sales ratio
0.648
This method gives the break-even level of sales revenue.
WORKED EXAMPLE 18
The following information relates to Gorki Ltd:
Marginal cost statement for the year ended 30 November 2021
$
Sales
400 000
Less Variable costs
(190 000)
Contribution
210 000
Fixed costs
140 000
70 000
Profit
Required
Calculate the sales revenue necessary to give Gorki Ltd a profit of $90 000.
Answer
$210 000
× 100 = 52.5% (0.525)
$400 000
Fixed costs + $90 000
Sales volume required to give $90 000 profit =
Contribution/sales ratio
Contribution to sales ratio =
Sales volume required =
$140 000 + $90 000 $230 000
=
= $438 096
52.5%
0.525
So sales have to increase by $38 096 from the current level of $400 000.
242
How to interpret a break-even chart
Break-even analysis can also be shown using a break-even chart. This is a graph that
uses cost and revenue information to represent break-even data. In this course, you
are not expected to prepare a break-even chart, but you will be expected to interpret
a chart. This means you must know what the chart shows and be able to use the chart
to ascertain various pieces of information, such as the break-even point, the profit at
different levels of output and the margin of safety.
WORKED EXAMPLE 19
The following information is given for the production of 100 000 tables:
$
Selling price per table
25
Costs per unit – Wood
4
Direct wages
7
Variable manufacturing overhead
3
Variable sales overhead
2.2.3 Marginal costing
Although you will not have to prepare a chart, it is worthwhile seeing how the process
of constructing a chart works, to make it easier for you to interpret the chart itself. To
do so, we will use a simple worked example.
2.2
1
Fixed costs
600 000
This data can be used to construct a break-even chart. This appears as follows:
Workings
Stage 1
The horizontal axis of the chart is used to show the sales output in units.
The vertical axis of the chart is used to show costs and revenues.
Where the two axes meet is called the origin and denotes zero for both axes. It
should be marked 0.
2500 (a)
2000
Costs
1500
and
revenues 1000
($000)
500
0
25 000
50 000
75 000
100 000
Units per
year
It is important to remember that the data must be scaled evenly; otherwise the
chart will be distorted and will give unrealistic results.
243
2.2
Stage 2
Always give your chart a heading.
Break-even chart for tables
2.2 tradItIonal CostIng methods
2500 (b)
2000
Costs
1500
and
revenues 1000
($000)
500
0
25 000
50 000
75 000
100 000
Units per
year
Stage 3
Draw in the fixed costs.
Break-even chart for tables
2500 (c)
2000
Costs
1500
and
revenues 1000
($000)
500
Fixed costs
0
25 000
50 000
75 000
100 000
Units per
year
Stage 4
In order to plot the variable costs, you need to do a few calculations.
The variable costs are $15 per table (Wood costs + direct wages + variable
manufacturing overheads + variable sales overhead).
0
10 000
Production and sales (units)
$
Variable costs ($15 per unit)
60 000
$
$
0
150 000
900 000
Fixed costs
600 000
600 000
600 000
Totals costs
600 000
750 000
1 500 000
The point x indicates 0 on the horizontal axis and 600 000 on the vertical axis.
We then put an x on the point that indicates 10 000 on the horizontal axis and
750 000 on the vertical axis.
We then put an x on the point that indicates 60 000 on the horizontal axis and
1 500 000 on the vertical axis.
Break-even chart for tables
Total costs
2 500 (d)
2 000
Costs
1 500
and
revenues 1 000
($000)
500
Variable
costs
Fixed costs
0
25 000
50 000
75 000
We now have in place the total cost curve.
Each curve must be labelled.
244
100 000
Units per
year
Stage 5
2.2
The complete break-even chart appears as follows:
Break-even chart for tables
Total revenue
Total costs
2 500 (e)
2 000
Costs
1 500
and
revenues 1 000
($000)
500
Variable
costs
0
25 000
50 000
75 000
100 000
Units per
year
Stage 6
We can show on the chart the break-even point and indicate the margin of safety.
Answer
2 500
(f) Break-even graph
for tables
2 000
Costs
1 500
and
revenues 1 000
($000)
500
2.2.3 Marginal costing
Fixed costs
Total revenue
Total costs
Break-even
point
Variable
costs
Fixed costs
Margin of safety
0
25 000
50 000
75 000
100 000
Units per
year
The use and limitations of break-even analysis
The main uses of break-even analysis are as follows:
» It allows a business to know how many units must be sold before a profit can be
made.
» It shows how much output can fall by from its current level before the business
experiences a loss, known as the margin of safety.
» It is relatively simple to calculate and interpret.
» The output level needed for a target level of profit can be calculated.
» Changes in the data can be analysed, such as changes in selling price, variable cost
per unit and fixed costs.
However, break-even analysis is limited in several ways:
» Costs that are variable in nature may not be constant per unit of output produced.
» The assumption that the selling price will be constant is also unrealistic as a
business may have to alter this to capture more sales or changing economic
conditions.
» It assumes all output produced is also sold, which is highly unrealistic.
» The distinction between fixed and variable costs is not as may be implied. Many
costs will have both fixed and variable elements, such as semi-variable costs.
» For multi-product businesses, it becomes very difficult to separate out the fixed
costs individually.
245
2.2
How to prepare costing and profit statements using marginal
costing
Marginal cost statements
Marginal cost statements offer an alternative layout to the traditional statements of
profit and loss already encountered.
2.2 tradItIonal CostIng methods
Marginal cost statements emphasise fixed and variable costs separately and so
emphasise the total fixed costs incurred by the business.
WORKED EXAMPLE 20
Rault Ltd is a manufacturing business. The following information relates to the
year ended 31 May 2021:
$
Direct materials
120 000
Direct wages
360 000
Variable factory overhead expenses
60 000
Fixed factory overhead expenses
110 000
Variable selling and distribution expenses
56 000
Fixed selling and distribution expenses
45 000
Variable administrative expenses
16 000
Fixed administrative expenses
38 000
Total sales revenue
950 000
Required
Prepare a marginal cost statement for the year ended 31 May 2021.
Answer
Rault Ltd
Marginal cost statement for the year ended 31 May 2021
$
Revenue
Less
Variable costs
Direct materials
(120 000)
Direct wages
(360 000)
Factory expenses
(60 000)
Selling and distribution expenses
(56 000)
Administrative expenses
(16 000)
Total contribution
Less
(612 000)
338 000
Fixed costs
Factory overheads
(110 000)
Selling and distribution overhead
(45 000)
Administrative overhead
(38 000)
Profit for the year
246
$
950 000
(193 000)
145 000
WORKED EXAMPLE 21
Emam produces a single product. The following information relates to the
production and sales of the product in October:
$
70
15
12
5
20
Production and sales = 1000 units.
Required
Prepare a marginal cost statement for October, showing the total contribution
and profit.
2.2.3 Marginal costing
Costs and revenues per unit
Sales revenue
Costs – direct materials
direct labour
royalties
fixed costs
2.2
Answer
Emam
Marginal cost statement for the month of October
$
$
Revenue
Less
70 000
Direct materials
(15 000)
Direct labour
(12 000)
Royalties
(5 000)
(32 000)
Contribution
38 000
Less Fixed costs
(20 000)
Profit for the month
18 000
WORKED EXAMPLE 22
The data are the same as in the above worked example but 1001 units are
produced and sold.
Required
Prepare a statement of profit or loss for October, showing the total contribution
and profit.
Answer
Emam
Statement of profit or loss for the month of October
$
Revenue
Less
70 070
Direct materials
(15 015)
Direct labour
(12 012)
Royalties
Contribution
Less Fixed costs
Profit for the month
$
(5 005)
(32 032)
38 038
(20 000)
18 038
247
2.2 tradItIonal CostIng methods
2.2
Note
l The total contribution has risen by the contribution of the extra unit
produced and sold.
l The fixed costs have not risen even though the activity rate has risen.
l The profit has risen by the amount of the contribution gained from the sale
of the one extra unit.
Marginal costing splits total costs into its two main elements – fixed costs and
variable costs.
The identification of contribution is essential in this type of problem.
How to prepare a statement reconciling the reported profits
using marginal costing and absorption costing
The absorption cost of production will be greater than the marginal cost of production
due to the overheads absorbed into each unit of output produced. Any inventory
remaining at the end of the period will have a higher cost value if the absorption
costing method has been used. In the cost of sales calculation, subtracting this
increased value for closing inventory (based on absorption costing) will mean that
the cost of sales is lower than if we had used a marginal costing approach to valuing
inventory. Consequently, absorption costing will give a higher profit figure for the
business compared with a marginal cost approach when there is inventory remaining in
the business at the end of the period.
We can prepare a statement that reconciles the difference in reported profits using
marginal cost and absorption costing.
WORKED EXAMPLE 23
Meadows Ltd produces one product. Data relating to the production of one unit
is as follows:
$
Direct materials
40
Direct labour
30
Variable overhead
10
Each unit is sold for $120.
The fixed overhead is an indirect manufacturing overhead and does not vary
with output. The business usually includes a $5 amount to cover these fixed
overheads when costing each unit of output. There were an additional $5000 in
selling and administration costs each month.
Fixed overheads totalled $2500.
In March, budgeted output was the same as actual output and actual production
was 500. Sales were 450 units. There was no inventory in the business as at
1 March.
Prepare statements showing profits earned by the business for March using
both absorption costing and marginal cost.
248
Profit statement for March using absorption costing
$
Revenue
2.2
$
54 000
Less cost of sales:
Direct materials
20 000
Direct labour
15 000
Fixed overhead
5 000
2.2.3 Marginal costing
Variable overhead
2 500
42 500
Less Closing inventory
4 250
Gross profit
38 250
15 750
Less Expenses
5 000
Selling and administrative costs
10 750
Profit for month
Profit statement for March using marginal costing
$
Revenue
$
54 000
Less cost of sales:
Direct materials
20 000
Direct labour
15 000
Variable overhead
5 000
40 000
Less Closing inventory
4 000
Gross profit
36 000
18 000
Less Expenses
Fixed overheads
2 500
Selling and administrative costs
5 000
Profit for month
7 500
10 500
There is a $250 difference in the profit earned by the business for March.
Profit is higher when absorption costing is used. This difference is explained
by the closing inventory for March containing some of the fixed overheads
when absorption costing is used. A higher value of closing inventory means a
lower cost of sales and therefore a higher profit figure. The difference can be
reconciled as follows:
Meadows Ltd
Reconciliation of profits under absorption and marginal costing for March
$
Profit under Absorption costing for March
Less Fixed overheads in closing inventory for March (50 units × $5 per unit)
Profit under Marginal costing for March
10 750
(250)
10 500
This difference in profit would eventually be compensated for in the following
month as the value of opening inventory for April would be higher when
absorption costing is used – giving an increased cost of sales figure.
249
2.2
The usefulness of marginal costing data as a support for
management decision-making
Break-even analysis is based on a marginal costing approach and we have already seen
that this can be a useful technique for managers in certain cases. Marginal costing is
also a useful technique for managers in other scenarios. Specifically, marginal costing
is likely to prove useful when faced with the following situations.
2.2 tradItIonal CostIng methods
Make or buy
A business may have the opportunity to purchase the product that it currently
manufactures itself.
In order to arrive at a decision whether or not to purchase the product, rather than
make it, the managers should consider the marginal costs and revenues.
WORKED EXAMPLE 24
Achim Droblin manufactures sweatshirts in Mauritius for sale to sports
retailers. The estimated costs and revenues for the next financial year are
given:
Costs and revenues per unit, based on production and sales of 140 000 sweatshirts
$
Selling price
Direct materials
12
2
Direct labour
3
Fixed costs
4
Total production cost
9
Profit per sweat shirt
3 Total profit $420 000
A manufacturer in India has indicated that the sweatshirts could be supplied
to Achim at a total cost of only $7 each. Achim has calculated that if existing
selling price is maintained then profits will rise to $5 per sweatshirt and total
profits will rise to $700 000 next year – an increase in profits of $280 000.
Required
Advise Achim whether, on financial grounds, he should accept the offer from
the Indian manufacturer.
Answer
Achim should not accept the offer. If he did, he would be worse off next year
than if he continued to manufacture the sweatshirts himself. Profits would fall
to only $140 000.
Workings
Contribution per unit if he continues to manufacture himself = $7.00
(Selling price $12.00 – Marginal (variable costs) $5.00 ($2.00 + $3.00))
Contribution per unit if he purchases from India = $5.00
(Selling price $12.00 – Marginal (variable cost) $7.00).
Marginal costing statements show the positions clearly:
250
Make
$
Revenue
$
Direct materials
(280 000)
Direct labour
(420 000)
Contribution
(700 000)
980 000
Less Fixed costs
(560 000)
Buy
$
Revenue
1680 000
Purchase price
(980 000)
Less Fixed costs
Profit
2.2.3 Marginal costing
420 000
Profit
Contribution
2.2
1680 000
700 000
(560 000)
140 000
Note
It has been assumed that any resources released by accepting the offer from
India could not be used elsewhere by Achim.
If the manufacturing space could be sublet to another manufacturer, the
income received would be a source of marginal revenue and should be added
to the sales revenue as extra income.
If extra costs had to be incurred in transporting the goods to Mauritius, this
would have represented a further marginal cost.
If extra costs were incurred keeping the manufacturing area safe and/or
secure, these costs would also represent marginal costs and would have to be
included in Achim’s calculations.
WORKED EXAMPLE 25
Achim is faced with the same details given above. However, he can sublet his
manufacturing area at a rental of $200 000.
Required
Advise Achim whether, on financial grounds, he should accept the offer from
India.
Answer
He should not accept the offer.
With the rental income, the total contribution would rise to $900 000 (original
contribution $700 000 + rental income $200 000), which is still less than
the $980 000 contribution he would earn by continuing to manufacture the
sweatshirts himself. Profit would fall to $340 000 compared to $420 000.
251
WORKED EXAMPLE 26
2.2
Achim is faced with the same details as given in the original example. But Achim
has to employ a security business to keep the factory premises secure from
vandals. This will cost $120 000 per year and additional maintenance costs of
$100 000.
2.2 tradItIonal CostIng methods
Required
Advise Achim whether, on financial grounds, he should accept the offer from
India.
Answer
Achim should not accept the Indian offer.
The contribution would only be $480 000 compared to the original contribution
of $980 000.
Although in each case the contribution is positive, the new contribution would be less
than the contribution earned if Achim continued to manufacture the sweatshirts.
Special orders
Another use of marginal costing is that it helps with the decision over whether to
accept a special order or not. A special order is usually a request from a potential
customer who wishes to buy output from the business but will not necessarily pay the
normal selling price. Although the accepting of a special order may seem initially like
a bad idea, on financial grounds it may be worthwhile.
WORKED EXAMPLE 27
The Troncell Manufacturing Company is based in Malaysia. It manufactures one product, ‘troncells’. The
following information is available for a production level of 5000 troncells:
Costs and revenues per unit
$
Selling price
45
Direct materials
12
Direct labour
19
Royalties
1
Fixed costs
8
There is spare capacity in the factory. A retailer in the USA has indicated that she would be willing to
purchase 200 troncells but only if the price to her was $35 each.
Required
Advise the management of Troncell whether they should accept the order.
Answer
The order should be accepted. The order will make a positive contribution of $600 ($3 per unit).
Workings
Contribution = Selling price per unit – Marginal costs per unit
= $35 – $32
= $3 per troncell
252
Note
l The special order has no need to cover the fixed costs since they have already been absorbed into the
‘normal’ selling price.
l The US contract has no need to cover the fixed costs again.
l The contract is providing the manufacturer with an extra (marginal) contribution.
2.2
We can check to see if the acceptance of the US contract does make the business more profitable by
preparing marginal cost statements:
$
Revenue
Direct materials
(60 000)
Direct labour
(95 000)
Royalties
$
225 000
(5 000)
Contribution
(160 000)
65 000
Fixed costs
2.2.3 Marginal costing
Non-acceptance of the order
(40 000)
Profit
25 000
Acceptance of the order
$
Revenue
232 000
Direct materials
(62 400)
Direct labour
(98 800)
Royalties
$
(5 200)
(166 400)
65 600
Fixed costs
Profit
(40 000)
25 600
Note
l The fixed costs have not changed with the increased level of production.
l The profit has increased by the amount of the total contribution earned by accepting the order from the
USA.
However, if the special order is to be accepted based on marginal costing techniques,
then there are special conditions that should be satisfied.
Care must be taken when accepting an order based on marginal costing principles.
» There must be spare production capacity in the business.
» The order must not displace other business. (If it does, then the revenue lost also
becomes a marginal cost.)
» There must be clear separation of existing customers from customers receiving the
order priced at marginal cost. (Existing customers are likely to be unaware of the
cheaper price charged to the customer receiving the goods at the lower price.)
» The customer receiving the goods should not be in a position to sell the goods to
other customers at a price lower than the regular price.
253
» The customer receiving the order priced using marginal costing must be aware that
the price quoted is for that one order only – the price charged should not set a
precedent so that the ‘cheaper price’ is demanded for future orders.
» Care must be taken to ensure that competitors do not match the price for their
regular customers, thus starting a price war in which all producers will suffer from
lower prices.
2.2
2.2 tradItIonal CostIng methods
A manufacturing business must cover all costs incurred in running the business. A
business cannot survive by costing all its production at marginal cost. If it did, then
none of the fixed costs would be covered (absorbed).
So, generally, any ‘special’ order which results in a positive contribution should be
accepted.
Although it would seem that we would wish to reject a special order if it generates
negative contribution, there are some conditions that might make a special order
worth accepting even if on financial grounds it does not seem worthwhile.
A special order that yields a negative contribution may be accepted under the
following conditions:
» in order to retain a highly skilled workforce
» in order to maintain machinery in good condition, i.e. if failure to use the
machinery would result in its deterioration
» in order to stimulate further orders (at the ‘normal price’ in the future)
» for altruistic reasons, i.e. because it is a worthwhile thing to do, for example,
providing a product at less than full cost for children with disabilities.
Closure of business unit
Marginal costing can also help with deciding whether to close part of the business (a
business unit), such as a product line, or branch, or even operations in one particular
country for a large multinational business.
WORKED EXAMPLE 28
Eleanor Ryan runs a chain of three coffee shops. The chain as a whole is profitable but the Fallwood branch
appears to be losing money for the business and she is considering whether or not to close down that
branch to boost overall profits for the business.
Data relating to the three branches is as follows:
Brimehill
Ranmore
Total
$
$
$
$
Revenue
285 000
185 000
170 000
640 000
Materials
92 000
72 000
43 500
207 500
Labour
100 000
62 000
38 000
200 000
Rent
18 500
16 400
11 100
46 000
Selling and marketing expenses
35 625
23 125
21 250
80 000
Administration expenses
30 000
18 600
11 400
60 000
276 125
192 125
125 250
593 500
8 875
(7 125)
44 750
46 500
Total expenses
Profit
254
Fallwood
Direct labour and materials, as well as rent, are all direct costs connected with each branch. Selling and
marketing costs, and administration costs, are indirect in nature and have been apportioned to each branch
as follows:
l selling and marketing – on the basis of sales revenue
l administration – on the basis of direct labour.
2.2
Overall profits are $46 500. If the Fallwood branch is closed then it might seem that profits would rise to
$53 125 (i.e. by an extra $7125). Should Ryan close the Fallwood branch to boost profits?
Although it appears that closing the Fallwood branch would boost profits by
$7125, marginal costing may give us a more useful approach.
Based on the decision to close the Fallwood branch, a statement of contribution made by each remaining
branch would show the following:
Brimehill
Ranmore
Total
$
$
$
Revenue
285 000
170 000
455 000
Materials
92 000
43 500
135 500
100 000
38 000
138 000
Rent
18 500
11 100
29 600
Contribution
74 500
77 400
151 900
Labour
2.2.3 Marginal costing
Answer
From this, we can still calculate the overall profit for the business if we subtract the indirect costs from the
total contribution:
$
Total contribution
151 900
Indirect expenses ($80 000 + $60 000)
140 000
11 900
Profit
We can see that closing the Fallwood branch has actually reduced profits, which would suggest closing the
branch is not a good idea.
The confusion may have been caused by focusing on the profits of each branch rather than the contribution
made by each branch. A marginal costing statement that focused on contribution rather than profits would
have shown the following:
Brimehill
Revenue
Direct materials
Direct labour
Fallwood
Ranmore
Total
$
$
$
$
285 000
185 000
170 000
640 000
92 000
72 000
43 500
207 500
100 000
62 000
38 000
200 000
Rent
18 500
16 400
11 100
46 000
Contribution
74 500
34 600
77 400
186 500
We can see that the Fallwood branch makes a positive contribution of $34 600 towards the overall profits of
the business. If the branch is closed then this contribution disappears and overall profits are lower.
255
2.2
This can be a difficult decision to make if we consider whether or not the indirect expenses would be reduced
if we had closed one of the branches. It is likely that the costs associated with selling and marketing, as well
as administration, would be lowered if one branch were closed. However, we would need to be told this in
advance – we can only base our decision on what information we have. If indirect costs were reduced, then
the savings made would have to at least compensate for the lost contribution made by the branch.
2.2 tradItIonal CostIng methods
In general, if a business unit, such as a branch of the business, is making a positive contribution, then it is
worth keeping this open and not closing it down.
There are non-financial factors to consider, which will be explored shortly.
Limiting factors
A business may be faced by a short-term shortage of one or more factors of
production necessary to continue the manufacturing process. There could be a
temporary shortage of skilled labour; there could be a temporary shortage of direct
materials or a temporary shortage of storage space. Any shortage of a particular
resource will limit the business’s ability to maximise profits.
A scarce resource is sometimes referred to as a limiting factor.
It is essential that the managers of a business utilise the scarce resources available in
a way that will yield the maximum return to the business.
WORKED EXAMPLE 29
The Laville Company manufactures four products. The products use the same
type of materials and skilled labour. The following information is given:
Product
P
Q
Selling price per unit ($)
R
S
200
300
100
400
1 000
800
1 200
900
Material usage per unit (kg)
7
12
4
15
Labour hours per unit
3
4
2
6
Maximum demand for product (units)
Materials cost $10.00 per kilogram; labour costs $15.00 per hour.
Required
Prepare a statement showing the level of production for each product that
would maximise the profits for the Laville Company if:
a only 25 000 kilograms of materials are available
b only 10 000 labour hours are available.
Answer
a
P
Q
R
S
Contribution per kilogram of material used
Ranking
$12.14
$10.00
1
3
$7.50
$10.67
4
2
You can see that the Laville Company should produce as many of product P
as possible. If there are still materials available, it should produce as many
of product S as possible, then product Q and finally product R.
If Laville could produce all products:
P
256
they would produce
1 000
this would use
7 000 kg
Q
R
800
9 600 kg
1 200
S
900
4 800 kg 13 500 kg
Since this is not possible:
Total materials available (in kg)
25 000
Less Production of P (1 000 units)
2.2
(7 000)
18 000
Less Production of S (900 units)
(13 500)
4 500
(4 500)
0
Leaving no materials for production of R
b
P
Contribution per kilogram of material used
Q
$28.33
Ranking
R
$30.00
2
1
S
$15.00
$26.67
4
3
2.2.3 Marginal costing
Less Production of Q (375 units)
You can see that the Laville Company should produce as many units of
product Q as possible; then produce as many units of product P as possible;
then product S and finally product R.
If Laville could produce all products:
P
they would produce
this would use
Q
1 000
R
800
1 200
S
900
3 000 hrs 3 200 hrs 2 400 hrs 5 400 hrs
Since this is not possible:
Total materials available (in kg)
10 000
Less Production of Q (800 units)
(3 200)
6 800
Less Production of P (1 000 units)
(3 000)
3 800
Less Production of S (633 units)
(3 798)
2
Leaving no labour for production of R
This production pattern would maximise profits while only using 9998 hours
of scarce labour. (The company has to produce only 633 of product S since
the next unit would be only two-thirds complete!)
Target profit
Target profit was covered on pages 240–41.
The uses and limitations of marginal costing
Marginal costing is used whenever a business is:
»
»
»
»
costing ‘special’ or ‘one off’ opportunities
deciding whether to make or buy a product
choosing between competing alternative actions
calculating the break-even level of output.
257
Limitations of marginal costing:
2.2 tradItIonal CostIng methods
2.2
» It assumes that all costs can be divided into fixed or variable – this is not always
possible as some costs contain both fixed and variable elements (e.g. semi-variable
or stepped-fixed costs).
» Inventories are generally undervalued if marginal costing is used as they do not
contain any of the fixed overheads associated with their production and, based on
IAS2, a proportion of fixed costs must be included within the valuation of inventories.
» Marginal cost is not suitable for tax purposes for the valuation of inventories.
» Although it is useful for making short-term decisions, if too many decisions are
based on marginal costing techniques then there is the risk that fixed costs and
indirect costs will not be covered and losses will be incurred too often.
Non-financial factors and their significance
As with absorption costing, non-financial factors will influence decision-making. This
could include any of the following scenarios:
» The impact on regular customers of accepting a special order at lower than normal
selling price – who would be unhappy to hear that the business is offering discounts
to ‘new’ customers rather than rewarding regular customers for their loyalty.
» When faced with a shortage of a production resource (i.e. a limiting factor), a
business would need to consider the impact of scaling back (or cancelling) the
production of one of its product ranges on sales of other products. For example,
if a shortage of a raw material means that a business can no longer produce a full
product range, would consumers cancel all their purchases if they often buy products
at the same time (e.g. a range of kitchenware products might be bought as part of
a matching set – and not bought at all if one part of the set is no longer produced).
» When aiming for a target level of profit, changes to the selling price should not be
ruled out based on action taken by competitors. It is often assumed that all that
is produced can be sold, whereas this may be unrealistic and only true for small
businesses in very large markets. The impact of competition on actual sales is
usually expected to make some difference, however small.
2.2.4 Cost–volume–profit analysis
The uses, advantages and limitations of cost–volume–profit
data as a support for management decision-making
The main use of cost–volume–profit (CVP) analysis is similar to that of break-even
analysis. It can tell us how many units of output need to be sold for a business to
break even. This can be measured both in terms of the number of units and the sales
revenue associated with that level of output. We saw that you can also calculate the
number of units of output that need to be sold in order to achieve a certain level of
profit (target profit).
Earlier, we saw how break-even analysis can be illustrated using a chart. This provides
a visual guide to how many units of output need to be sold to avoid losses and,
subsequently, to make profits. However, there are some limitations of these charts.
» There is an assumption that all data behave in a linear manner:
– Fixed costs are assumed to remain fixed regardless of circumstances.
– Selling price is assumed to remain constant in all circumstances.
» The break-even chart assumes that the only factor affecting costs and sales
revenues is sales volume. Costs and revenues may be affected by:
– increases in output
– changes in economic climate
– changes in technology, etc.
258
» It is assumed that the cost mix remains constant but businesses change their
capital mix over time or as circumstances may dictate.
» There is an assumption that all production is sold.
» The charts generally apply to only one product.
2.2
Cost–volume–profit charts
The chart shows how profits change as the volume of sales changes.
Profit-volume graph
Profits
$
Profits/losses
Break-even
point
0
Loss
area
Profit
area
2.2.4 Cost–volume–profit analysis
Another problem associated with break-even charts is that they do not show clearly
the actual amount of profit or loss at each level of sales. To see the profit or loss, the
gap between the total sales revenue line and the total cost line must be measured.
Units of production
and sales
Losses
$
▲ Figure 2.2.2 Cost–volume–profit chart
The CVP chart as shown here (Figure 2.2.2) is helpful in visualising the effect on
profits (or losses) of changes in the level of output.
CVP analysis also has further uses:
» it is a useful tool in short-term decision-making
» it examines the relationship that exists between sales volume, sales revenue, costs
and profits
» it shows how costs behave at varying levels of output
» it can be used in ‘what if’ analysis
» it can help management when deciding which course of action to follow.
Charts:
» depict CVP in a form that helps most people understand the information shown
quickly and more effectively (but do remember that for decision-making purposes
the use of calculations is much more realistic)
» show clearly the break-even point
» identify the margin of safety
» show visually and clearly the impact that changes in sales volume have on profits.
The limitations of CVP data were largely summarised earlier when we looked at the
limitations of break-even analysis. Fundamentally, there is a risk that decisions will
be made in such a way that costs not directly connected to a unit of output will be
259
neglected. For many businesses, the fixed and indirect costs of output are substantial
and cannot be left to one side while decisions are made. Marginal costing is useful in
certain scenarios but a profitable business must ensure that all costs are accounted for.
2.2
How to apply costing concepts to make business decisions
and recommendations using supporting data
2.2 tradItIonal CostIng methods
So far, we have considered both marginal and absorption costing and the application
of these methods. There is important information concerning the valuation of
inventories and the costing method chosen to consider.
Inventories should not be valued using marginal costing techniques.
IAS 2 Inventories states that inventories should be valued at the lower of cost and
net realisable value (see Chapter 2.1). It states that costs should include costs of
purchase, costs of conversion and other costs incurred in bringing the inventories to
their present location and condition.
Costs of conversion include fixed and variable manufacturing overheads. Since
marginal costing principles ignore fixed costs, it is evident that marginal costs cannot
be used as a basis for inventory valuation.
At various stages in this chapter we have discussed the uses, advantages and
disadvantages of the costing methods used. In general, it is absorption costing that is
more likely to be used to support long-term decisions. Marginal costing, on the other
hand, is more likely to be associated with short-term decision-making.
Non-financial factors and their significance
In terms of the cost–volume–profit analysis, the non-financial factors have been
covered when we looked at those affecting marginal costing decisions (and to a lesser
extent, those affecting absorption costing decisions).
EVALUATION
A component used in the production of output is
costed as follows:
Labour cost per unit
Materials cost per unit
Fixed cost per unit
Total cost per unit
$
8.60
7.40
5.10
21.10
The marketing manager has been approached by a
manufacturer from Spain who has offered to supply
the component for a cost of $20.00 per unit.
Advise the marketing manager whether the company
should continue to produce this component, or close
down manufacturing of the component and buy it
from Spain.
Arguments for buying-in the component from Spain:
l Although both financial and non-financial information
should be used, it is normal for the initial decision
to be based largely on the financial data.
l It initially looks cheaper to buy-in rather than to
produce if we compare the $21.10 current cost
with the $20 buy-in cost.
l Although the total cost of each component
manufactured is $21.10, the important cost
260
to consider in this decision is the marginal
cost – which is $16.00, which would support
manufacturing the component.
l Some fixed costs may be reduced if production is
ceased.
Arguments for continuing to produce the component:
l Are there any ‘hidden’ fixed costs of buying in the
product that have not been taken into account?
l Is the supplier reliable – will they deliver on time?
l Is the bought-in product of at least comparable
quality to the one currently manufactured?
l Is the price offered by the Spanish supplier likely
to rise in the near future?
l Would there be any social impactions of closing
down production (as well as any hidden costs,
such as redundancies)?
l Are there potential exchange rate issues, tariffs,
language barriers or legal issues?
Overall:
l Would buying in the component help reduce fixed
costs? If so, it might justify this decision.
l Non-financial factors may be crucial in terms
of the effect on production, quality, customer
feedback, etc.
SUMMARY
» calculate break-even points and interpret
2.2
break-even charts
» understand and calculate data relating to
cost–volume–profit scenarios and use them to
make decisions
» prepare costing statements and make decisions
based on these statements, for each method of
costing
» understand the relevance and potential impact of
non-financial factors.
SELF-TEST QUESTIONS
1 Contribution is the amount that a single unit of a product can be sold for.
True/False?
2 Fixed costs + Profit = ?
2.2.4 Cost–volume–profit analysis
After reading this chapter, you should be able to:
» categorise costs in terms of their relationship with
output
» apply costing methods to a variety of businesses
» use absorption costing to allocate and apportion
costs to relevant cost centres
» apply marginal costing to a variety of short-term
scenarios (e.g. break-even, make or buy, etc.)
3 What is the difference between a marginal cost statement and statement of profit
or loss?
4 How would total contribution be calculated?
5 Give two examples of direct costs that might be used in a marginal cost statement.
6 Give two examples of fixed costs that might appear in a marginal cost statement.
7 Marginal costing can only be used when a business is considering whether or not
to undertake a ‘one off’ contract. True/False?
8 Outline two conditions that must apply when a special price based on marginal
costing techniques is accepted by a business.
9 Outline two reasons why the manager of a business might accept an order even
when the order yields a negative contribution.
10 Explain the term ‘limiting factor’.
11 Give an example of a limiting factor.
12 Would the shortage of a component used in the production of computers be
classified as a limiting factor?
13 A limiting factor should be used to produce the product that gives the highest
profit. True/False?.
14 State the formula used to calculate the break-even point using the unit
contribution method.
15 Break-even output = 7 500 units; total production = 10 000 units. What is the margin
of safety in units?
16 A graph should be used where possible to find the break-even point since it is the
most realistic of the methods. True/False?
Calculation question (answer on page 494)
17 Use the information below to calculate the break-even level of output:
Fixed costs
$88 000
Selling price
$25
Variable cost per unit
$17
261
3 Financial accounting (A Level)
3.1 preparatIon of fInanCIal statements
3.1
Preparation of financial statements
Learning link
Learning outcomes
It may be worthwhile
revisiting your work
on the construction of
statements of profit or
loss and statements
of financial position
from Chapter 1.5 before
starting this chapter.
By the end of this chapter you should have an understanding of:
l the need for and purpose of financial statements for specific types of business
l partnerships
– the difference between purchased goodwill and inherent goodwill
– how to prepare partners’ capital and current accounts to record changes
required in respect of purchased and inherent goodwill and revaluation of
assets
– how to prepare the partnership appropriation account, statement of
profit or loss and statement of financial position including changes in a
partnership occurring part way through an accounting year
– how to prepare a realisation account and a revaluation account
l clubs and societies
– the distinction between a receipts and payments account and an income
and expenditure account
– how to define and calculate the accumulated fund
– how to prepare accounts from full or incomplete accounting records
– how to account for other receipts, including life memberships and
donations
– how to make adjustments to financial statements
– how to evaluate possible sources of finance and methods of fundraising
l manufacturing
– how to prepare a manufacturing account
– how to prepare a statement of profit or loss and a statement of financial
position
– how to account for manufacturing profit and the elimination of unrealised
profit from unsold inventory
– the reasons why a business may account for manufacturing profit
l limited company
– how to prepare accounts for a limited company in line with the relevant
international accounting standards and legal requirements.
Introduction
We know that there are different types of business entity. As well as businesses,
there are other types of organisations, such as clubs and societies. Here, we will
introduce clubs and societies as well as businesses set up as manufacturing
organisations.
The financial statements of all the different entities still follow the basic
principles and accounting concepts covered so far – the need to compare
incomes with expenses, and the need to ensure that we account only for relevant
expenses for the correct period. However, these different entities will have
different features that have not been seen so far in this book.
262
Limited company accounts have been covered earlier but here we will look
into the formal requirements of their financial statements, and how they must
appear, based on international accounting standards. We will also look in more
detail at partnerships and focus on the impact of structural changes to the
partnership.
3.1
3.1.1 Financial statements
So far, we have covered the financial statements of a number of types of business
entity. We have looked at the financial statements of sole traders, of partnerships
and of limited companies.
Learning link
Partnerships were
covered in Chapter 1.1
as well as in Chapter 1.5.
Remember
A structural change in a
partnership means that
there is a major change
in how the partnership
is run. It is likely to
lead to changes in the
capital balances for
each partner.
3.1.2 Partnerships
3.1.1 Financial statements
The need for and purpose of financial statements for specific
types of business
Partnerships are a type of business entity consisting of two or more partners. The
owners of the partnership are the partners themselves and the partnership is not
treated as a separate legal entity, which means each partner still has unlimited
liability.
Earlier in this book we saw how partnership accounts consist of many of the same
elements that we would expect for a sole trader. However, the profit of the partnerships
will be shared out on the basis of any partnership agreement (or the provisions of the
1890 Partnership Act if no agreement exists). The capital balance of a partner was
split into both a fixed capital account, representing the original contribution to the
partnership, as well as a flexible capital account, known as the current account, which
represented how much each partner has built up in terms of the appropriations from the
profits made by the partnership.
In this section we will explore, where there is a major change, how the partnership is
run. This could include the admission or retirement of a partner, as well as changes to
the value of the assets held by the partnership, changes to the partnership agreement
or even the dissolution (final closure) of the partnership. These events are often
referred to as structural changes in the partnership and these are likely to lead to
changes in each partner’s capital accounts balance.
Goodwill and the difference between purchased goodwill
and inherent goodwill
Goodwill is explained in more detail later in this chapter, starting on page 272.
How to prepare partners’ capital and current accounts
to record changes in the partnership agreement
A change in the partners’ profit sharing ratio and the introduction
of new partners
During the lifetime of any business there could well be changes in the ownership of
that business.
263
The ownership of a partnership could change for any of these reasons:
» Partners may decide to terminate the partnership.
» Partners may decide to admit another partner.
» Partners may decide to alter their profit sharing ratios.
3.1
When there is any kind of change to the structure of a partnership the treatment is
the same; one business ceases to exist at the date of the change and immediately
after the date of the change a new business comes into being.
3.1 preparatIon of fInanCIal statements
EXAMPLE
1 When Arturo and Batista admitted Carlos as a partner on 1 April 2021 there
were two businesses involved:
Up to 31 March 2021
Owners are Arturo and Batista.
From 1 April 2021
Owners are Arturo, Batista and Carlos.
2 When Iain retired from the partnership of Iain, Jing and Kris on 30 September
2021 there were two businesses involved:
Up to 30 September 2021
Owners are Iain, Jing and Kris.
From 1 October 2021
Owners are Jing and Kris.
3 Deirdre and Englebert were in partnership sharing profits and losses
equally. When they changed their profit sharing ratio to 3:2 on 30 June 2021
there were two businesses involved:
Up to 30 June 2021
Owners are Deirdre and Englebert.
(profit share equal)
From 1 July 2021
Owners are Deirdre and Englebert.
(profit share 3:2)
different profit share = different business
STUDY TIP
When there is a
structural change to a
partnership, treat the
information relating
to the business
before the change
separately from the
information relating to
the business after the
change.
The admission of a new partner
WORKED EXAMPLE 1
Adele and Gaynor are in partnership, sharing profits and losses equally. Their
financial year end is 31 December. They admit Chin as a partner on 1 July 2021.
They all agree that Adele, Gaynor and Chin will share profits 3:2:1 respectively.
The profit for the year ended 31 December 2021 was $40 000. The profit accrued
evenly throughout the year.
Required
Prepare the appropriation accounts for the year ended 31 December 2021.
Answer
Remember that we are dealing with two businesses.
Up to 30 June 2021
Owners were Adele and Gaynor.
264
From 1 July 2021
Owners are Adele, Gaynor and Chin.
STUDY TIP
Note that the profit
share has been
rounded.
So:
3.1
Adele and Gaynor
Appropriation account for the six months ended 30 June 2021
$
$
Profit for the six months
20 000
Profit share – Adele
(10 000)
(10 000)
(20 000)
Adele, Gaynor and Chin
Appropriation account for the six months ended 31 December 2021
$
Profit for the six months
$
3.1.2 Partnerships
Gaynor
20 000
Profit share – Adele
(10 000)
Gaynor
(6 667)
Chin
(3 333)
(20 000)
The worked example shown was fairly straightforward.
However, common sense would tell us that Adele and Gaynor would not have allowed
Chin to become a partner without her contributing some capital to the business.
Common sense would also suggest that Adele and Gaynor would have considered the
value of their business assets before allowing Chin to become a part owner of those
business assets.
Imagine that your grandparents have been in business for 40 years. Their business
assets are recorded on the business statement of financial position as follows:
$
Premises at cost
18 500
Equipment at cost
5 500
Other assets at cost
2 000
Remember that we value
assets at cost, not at what
they could be sold for – the
‘going concern’ concept.
26 000
Capital – Grandfather
Grandmother
11 000
15 000
26 000
Now imagine that your grandparents admit William Fox as a partner into their
business. They ask him to provide $20 000 capital. He agrees and enters the business.
What would the statement of financial position look like now?
265
$
3.1
Premises at cost
Equipment at cost
Other assets at cost
18 500
5 500
22 000
46 000
3.1 preparatIon of fInanCIal statements
Capital – Grandfather
11 000
Grandmother
15 000
William Fox
20 000
Simple!
Your grandparents would not agree to
what has taken place! Remember that
they have been in business for 40 years.
How much must the premises be worth
now? Surely they are worth more than
the carrying amount (net book value)
shown?
46 000
Can you see your likely future inheritance disappearing into William Fox’s pocket?
In fact, what needs to happen when any kind of structural change takes place is that
the business assets have to be revalued. The increase in value (or decrease in value)
belongs to the original partners.
Even if there is no new partner admitted to the partnership, the existing partners may
still wish to change the profit sharing ratio of the business. This could be the result
of changes in the level of work performed by each partner, or to correct for what was
later perceived to be an ‘unfair’ ratio of profit sharing.
A change in the profit sharing ratio
It is normal that when admitting a new partner to the partnership the ‘old’ partners
may place a value on goodwill that the business has built up over time. This is where
the value of the business is increased through reputation, status and often many
years of successful trading. We will explore goodwill in more detail shortly but for
now, consider it to be the value of the business over and above the value of its
capital.
Any change to the profit sharing ratios must be treated in much the same way as
other structural changes.
View the change as that involving two separate distinct businesses. The ‘first’ business
must be valued in order that the ‘old’ owners can be credited with any increase in the
value of their business.
If a goodwill account is not to be maintained in the books of account of the ‘new’
business then it must be deleted and the ‘new’ partners debited in their profit sharing
ratios.
266
WORKED EXAMPLE 2
Juan and José are in partnership, sharing profits and losses in the ratio 3:1
respectively. From 1 January 2021 they agree to share profits and losses equally.
3.1
Their summarised statement of financial position at 31 December 2020 showed:
CAPITAL AND LIABILITIES
Capital accounts – Juan
José
Current liabilities
Total capital and liabilities
3.1.2 Partnerships
Juan and José
Statement of financial position at 31 December 2020
$
ASSETS
Non-current assets
48 000
Current assets
12 000
Total assets
60 000
30 000
22 000
52 000
8 000
60 000
The partners agreed that non-current assets be valued at $70 000 and that
goodwill be valued at $28 000. They further agreed that a goodwill account
would not be maintained in the business books of account.
Goodwill will be shared between the partners in their old profit sharing ratio
of 3:1. This means that Juan will be allocated 3/4 of the total goodwill ($21 000)
and Jose will be allocated 1/4 of the total goodwill ($7 000). However, if the
goodwill is not maintained then this is deducted from their capital account
balances in the new profit sharing ratio. Given the new ratio is for partners
to share profits equally, the total goodwill is ‘written off’ in equal shares of
$14 000 from each partner’s capital account balance.
Required
Prepare a statement of financial position at 31 December 2020 after the change
to the new profit sharing ratios has been implemented.
Answer
Juan and José
Statement of financial position at 31 December 2020
$
ASSETS
Non-current assets
Current assets
Total assets
70 000
12 000
82 000
CAPITAL AND LIABILITIES
Capital accounts – Juan
José
53 500
20 500
74 000
Current liabilities
Total capital and liabilities
8 000
82 000
($30 000 + $37 500 – $14 000)
($22 000 + $12 500 – $14 000)
267
Non-current assets are increased in value by $22 000. Goodwill is being valued
at $28 000. The total increase in the assets of the partnership of $50 000 is
shared between each partner in the old ratio of 3:1. This means Juan receives
$37 500 and Jose receives $12 500. The subtraction of $14 000 from each
partner’s capital balance is the goodwill being written off.
3.1 preparatIon of fInanCIal statements
3.1
STUDY TIP
Profits and losses
on revaluation of
assets are shared
out between partners
based on the ‘old’
partnership agreement
– i.e. the one before the
change.
Revaluation of assets
As we can see, when a new partner is admitted into the partnership, there is likely
to be a need to revalue at least some of the assets of the partnership. In this case,
we would need to calculate the profit or loss made on any revaluation. This will be
shared out based on the partnership agreement before the new partner was admitted
to the partnership (i.e. a new partner would not benefit from any profits made on
the revaluation of the assets – but would also not have to ‘pay’ for any losses on
revaluation either).
WORKED EXAMPLE 3
Mikael and Jeanette have been in partnership for many years, sharing profits
and losses equally. They decide to admit Kiri into the partnership with effect
from 1 May 2021. Kiri will pay $25 000 capital into the business bank account.
The partnership statement of financial position at 30 April 2021 was as follows:
Mikael and Jeanette
Statement of financial position at 30 April 2021
$
$
ASSETS
Non-current assets
Premises at cost
28 000
Vehicles at cost
16 000
44 000
Current assets
Inventory
3 500
Trade receivables
4 300
Bank
1 560
Total assets
9 360
53 360
CAPITAL AND LIABILITIES
Capital accounts – Mikael
Jeanette
25 000
25 000
50 000
Current liabilities
Trade payables
Total capital and liabilities
3 360
53 360
Over the years, property prices have risen. The premises were valued at
$70 000 at the end of April 2021.
268
Required
Prepare a statement of financial position at 1 May 2021 after the admission of
Kiri as a partner.
3.1
Answer
ASSETS
Non-current assets
Premises at valuation
Equipment at cost
Current assets
Inventory
Trade receivables
Bank
Total assets
CAPITAL AND LIABILITIES
Capital accounts – Mikael
Jeanette
Kiri
$
70 000
16 000
86 000
3 500
4 300
26 560
3.1.2 Partnerships
Mikael, Jeanette and Kiri
Statement of financial position at 1 May 2021
$
34 360
120 360
46 000
46 000
25 000
117 000
Current liabilities
Trade payables
Total capital and liabilities
3 360
120 360
The rise in the value of the premises has taken place while Mikael and Jeanette
have been the only proprietors, so any profits (because of property inflation)
belong to them.
The increase in the value of the premises did not occur when Kiri was a partner,
so she should not benefit. As they are equal partners, the increase has been
divided equally between Mikael and Jeanette.
It is more usual to find a statement of financial position showing details of all
assets and liabilities. When a structural change takes place in such instances we use
an account to record any changes to the values of assets and liabilities shown on the
statement of financial position and hence to calculate the profit or loss resulting from
the changes in value.
A temporary account is opened and it is only used to record adjustments to the
account balances from the ledgers shown on the statement of financial position.
This is how the temporary account works:
269
3.1
WORKED EXAMPLE 4
Xandra and Aziz are in partnership, sharing profits and losses in the ratio 4:3
respectively. They admit Liana as a partner on 1 August 2021. She pays $35 000
to the partnership as her capital.
3.1 preparatIon of fInanCIal statements
The partnership statement of financial position at 31 July 2021 was:
Xandra and Aziz
Statement of financial position at 31 July 2021
$
ASSETS
Non-current assets
Premises at cost
Equipment at cost
Vehicle at cost
$
48 000
12 000
15 000
75 000
Current assets
Inventory
Trade receivables
Bank
Total assets
2 400
1 750
2 200
6 350
81 350
CAPITAL AND LIABILITIES
Capital accounts –
Xandra
Aziz
40 000
30 000
Current accounts – Xandra
Aziz
3 410
5 150
70 000
8 560
78 560
Current liabilities
Trade payables
Total capital and liabilities
2 790
81 350
It was agreed that the assets on 31 July 2021 be valued as follows:
$
Premises
100 000
Equipment
4 500
Vehicle
6 000
Inventory
2 000
Trade receivables
1 650
Required
Prepare a statement of financial position at 1 August 2021 after the admission
of Liana as a partner.
270
Workings
3.1
An account is opened for each asset that is to be revalued:
Premises
Equipment
$
Balance b/d
48 000
Revaluation
52 000
Balance
c/d
100 000
100 000
100 000
Balance b/d 100 000
$
Balance 12 000
b/d
$
7 500
Balance c/d
4 500
12 000
Inventory
$
$
15 000 Revaluation
9 000
Balance b/d 2 400
Balance c/d
6 000
15 000
Balance
b/d
Revaluation
12 000
Balance
b/d
4 500
Vehicle
Balance
b/d
$
Revaluation
400
Balance c/d 2 000
15 000
6 000
$
3.1.2 Partnerships
$
2 400
2 400
Balance b/d 2 000
Trade receivables
$
Balance
b/d
Balance
b/d
$
1 750 Revaluation
100
Balance c/d
1 650
1 750
1 750
1 650
A revaluation account is used to adjust the asset accounts and to calculate any
profit or loss on revaluation. The profit or loss is transferred to the existing
partners’ capital accounts before the new partner is admitted.
Equipment
Vehicle
Inventory
Trade
receivables
Capital –
Xandra
Aziz
Revaluation
$
7 500 Premises
9 000
400
100
20 000
15 000
52 000
$
52 000
Balance
c/d
Capital – Xandra
$
Balance b/d
60 000 Revaluation
60 000
Balance b/d
$
40 000
20 000
60 000
60 000
52 000
Capital – Aziz
$
Balance
c/d
$
Balance b/d 30 000
45 000 Revaluation 15 000
45 000
45 000
Balance b/d 45 000
271
Answer
3.1
3.1 preparatIon of fInanCIal statements
Xandra, Aziz and Liana
Statement of financial position at 1 August 2021
$
$
ASSETS
Non-current assets
Premises at valuation
100 000
Equipment at valuation
4 500
6 000
Vehicle at valuation
110 500
Current assets
Inventory
2 000
Trade receivables
1 650
Bank
37 200
40 850
Total assets
1 51 350
CAPITAL AND LIABILITIES
Capital accounts – Xandra
Aziz
Liana
Current accounts – Xandra
Aziz
Current liabilities
Trade payables
Total capital and liabilities
60 000
45 000
35 000
3 410
5 150
140 000
8 560
148 560
2 790
151 350
Note that the changes to the capital structure of the business are entered in
the partners’ capital accounts. The current accounts have not been used. The
current accounts will only change when trading profits or losses are shared
between partners or as partners make drawings.
Notice also that the non-current assets are now labelled ‘at valuation’ since
they do not now appear ‘at cost’.
STUDY TIP
Profits and losses
on revaluation are
entered in the capital
accounts as these
profits/losses are not
the same are profits/
losses on trading – and
cannot be easily drawn
from by a partner.
272
When you get used to making adjustments to the partnership statement of financial
position because of a structural change you may find that you do not have to open an
account for each asset and liability. However, it will be safer for you to always open a
revaluation account to ‘collect’ the changes that have been implemented.
Goodwill
Goodwill is an intangible asset. It cannot be seen; it has no physical presence, unlike
tangible assets like premises or machinery or vehicles.
When a successful business is sold the vendor will generally price the business at a
price greater than the total of the capital being sold.
EXAMPLE
The statement of financial position of a local restaurant owned by Terri is shown:
$
3.1
$
ASSETS
Non-current assets
Equipment
34 000
3.1.2 Partnerships
8 400
Fixtures and fittings
42 400
Current assets
Inventory
Bank
840
2 345
Cash in hand
Total assets
455
3 640
46 040
CAPITAL AND LIABILITIES
Capital – Terri
44 620
Current liabilities
Trade payables
Total capital and liabilities
1 420
46 040
Terri decided to sell her business. She advertised it at $90 000. Hua bought the
business for $90 000.
Two points emerge:
l Terri sold her business at a profit of $48 180.
$
Non-current assets
Current assets (excluding cash and bank)
42 400
840
43 240
STUDY TIP
Goodwill is not sold; it
is only purchased. The
seller makes a profit;
the purchaser buys all
the capital including
goodwill.
Less Current liabilities
1 420
Net assets of business
41 820
Selling price of business
90 000
Profit on sale of business
48 180
l Hua purchased the business capital for $90 000. He has purchased net
tangible assets for $41 820 and an intangible asset (goodwill) for $48 180.
We have already said that when there is a structural change to a partnership the
change involves two businesses:
» the business that existed before the change
» the business that comes into existence because of the change.
When a new partner is admitted to a partnership we have already seen that the assets
need to be revalued. We also need to place a value on the intangible asset goodwill.
The valuation of goodwill
We cannot give a definitive method that can be used in every type of business when goodwill
has to be valued. If a business were being purchased, then goodwill would represent how
much would be paid in excess of the value of the capital being purchased. We have already
seen this when Terri sold her restaurant to Hua in the example used above.
273
3.1
How can we value goodwill when there is a structural change to a partnership, when no
one is actually purchasing the business?
The value placed on goodwill has to be acceptable to the partners in the ‘old’ partnership
as well as being acceptable to the ‘new’ partner(s).
The following are the most commonly used methods of determining the value of goodwill.
3.1 preparatIon of fInanCIal statements
Goodwill is valued at a multiple of the:
»
»
»
»
average profits generated over the past few years
average weekly sales generated over the past financial year
average of gross fees earned over a number of years
super profits earned by the business.
1 A multiple of average profits generated over the past few years
WORKED EXAMPLE 5
It has been agreed that goodwill be valued at two years’ purchase of the average
profits taken over the past five years. Profits for the past five years were:
Year
$
1
12 450
2
12 560
3
14 890
4
8 450
5
11 650
Required
Calculate the value to be placed on goodwill.
Answer
Goodwill is valued at $24 000.
Workings
Total profits for five years = $12 450 + $12 560 + $14 890 + $8450 + $11 650
= $60 000
Goodwill valued =
Total profits for five years
×2
5
= $60 000 × 2
5
= $24 000
2 A multiple of average weekly sales generated over the past financial year
WORKED EXAMPLE 6
It has been agreed that goodwill be valued at four weeks’ purchase of average
weekly sales over the past financial year. Last year’s annual sales were
$322 400.
Required
Calculate the value to be placed on goodwill.
274
Answer
Goodwill is valued at $24 800.
3.1
Workings
$322 400
52
× 4 = $6200 × 4 = $24 800
WORKED EXAMPLE 7
3.1.2 Partnerships
3 A multiple of an average of the gross fees earned over a number of years
This method is used by many professional businesses, such as accountants, doctors,
lawyers, veterinary surgeons, etc., when a partner retires or a new partner enters the
business.
It has been agreed that goodwill be valued at two years’ purchase of average
gross fees over the past four years. Fees for the past four years were:
Year
$
1
98 000
2
77 000
3
72 000
4
69 000
Required
Calculate the value to be placed on goodwill.
Answer
Goodwill is valued at $158 000.
Workings
$98 000 + $77 000 + $72 000 + $69 000 = $316 000
$316 000
× 2 = $79 000 × 2 = $158 000
4
4 A multiple of super profits earned by the business
WORKED EXAMPLE 8
Dirgen, a property developer, has $50 000 capital invested in his business. If he
were working for another property developer he could earn $23 000 salary per
annum. His business is currently earning profits of $38 000.
Required
Calculate the amount of super profits earned by Dirgen’s business.
Answer
Super profits earned were $12 500.
275
Workings
3.1
$
If Dirgen worked for another property developer he could earn:
If Dirgen invested his capital outside his business he could earn (say) 5%
23 000
2 500
25 500
3.1 preparatIon of fInanCIal statements
By carrying on as a self-employed property developer, he earns $12 500 more
than he would earn using his capital and talents in the next best alternative.
WORKED EXAMPLE 9
Homer owns and runs a small car repair business. Profits for the past few years
have averaged $18 000. Homer has $14 000 capital invested in his business.
He could earn $12 000 as a car mechanic working locally. He currently earns
5% per annum on a savings account at a local bank. Goodwill is to be valued at
three years’ super profits.
Required
Calculate the value to be placed on goodwill.
Answer
Goodwill is valued at $15 900.
Workings
Earnings as mechanic
$12 000
Interest on capital ($14 000) invested in bank
$700
$12 700
($18 000 – $12 700) × 3 = $5 300 × 3 = $15 900
Factors that contribute to the establishment of goodwill
The factors that determine the value of goodwill placed on a business vary. They include:
»
»
»
»
»
»
a good reputation because of the quality of a product
a good reputation because of good service
a good reputation for the helpfulness of staff
good after sales service
a prominent physical position of premises
popularity among customers.
No doubt you can think of one or two other factors that might contribute to the
establishment of goodwill.
So, why might you pay $30 000 more than the capital value placed on a business in
order to purchase it?
» You cannot purchase a good reputation – you could destroy that overnight.
» You cannot buy popularity.
» You certainly cannot purchase customers.
The reason why you might pay the ‘extra’ $30 000 is because you can see the prospect
of earning high profits in the future – you can envisage yourself earning lots of profits.
Adjustments to partners’ capital accounts to record goodwill
A payment for goodwill is paid by the purchaser of a business in order to gain access
to future profits that may be generated by that business. Let us see the two methods
of dealing with goodwill when a partner is admitted into a business.
276
Adjustments made with a goodwill account
3.1
WORKED EXAMPLE 10
Issmail and Gudrun are in partnership, selling cleaning materials. They travel
from house to house selling their products to people in their homes. They share
profits and losses in the ratio 3:1 respectively. Their statement of financial
position at 31 August 2021 showed:
3.1.2 Partnerships
Issmail and Gudrun
Statement of financial position at 31 August 2021
$
ASSETS
Current assets
Bank
370
Total assets
370
CAPITAL
Capital accounts – Issmail
200
Gudrun
170
Total capital
370
Issmail and Gudrun admit Lucrezia to the partnership with effect from
1 September 2021. Lucrezia contributes $2 000 as her capital. They agree
that goodwill be valued at $8 000.
Required
Prepare a statement of financial position at 1 September 2021 immediately
after Lucrezia was admitted to the partnership.
Answer
Issmail, Gudrun and Lucrezia
Extract from statement of financial position at 1 September 2021
$
ASSETS
Goodwill
8 000
Non-current assets
Current assets
2 370
Bank
Total assets
10 370
CAPITAL
Capital accounts – Issmail
6 200
Gudrun
2 170
Lucrezia
Total capital
2 000
10 370
277
3.1 preparatIon of fInanCIal statements
3.1
Workings
Notice that a new asset has appeared on the statement of financial position, a
non-current asset (intangible) that has built up over the years while Issmail and
Gudrun have been in business as partners. The two original partners have been
responsible for creating the goodwill through their personality, products, after
sales service, etc., so it is only their capital accounts that have been credited in
the profit sharing ratios.
The book-keeping entries to record the introduction of goodwill into the
partnership books would look like this:
Capital – Issmail
$
$
Balance b/d
Bal c/d
Capital – Gudrun
200
6 200 Goodwill
6 000
6 200
6 200
Balance b/d
$
$
Balance b/d
Bal c/d
170
2 170 Goodwill
2 000
2 170
2 170
6 200
Balance b/d
2 170
Goodwill
$
Capital – Issmail 6 000
Gudrun
2 000
Goodwill only appears in a statement of financial position when it is purchased. If
you see the asset on any statement of financial position, you can say with some
certainty that
» either the ownership has changed recently
» or the business has recently purchased another business.
This applies no matter what type of business statement of financial position you are
examining.
Inherent goodwill is not entered in the books of account so it is never shown on a
statement of financial position.
Well established businesses like Royal Dutch Shell Petroleum plc or McDonald’s enjoy
much inherent goodwill but this will not be shown on their statements of financial
position. Both these businesses are going concerns.
The going concern concept tells us that assets should be shown at cost price, not at
what they would fetch if sold. Neither Shell nor McDonald’s is due to be sold in the
next few days, so as a going concern neither would show inherent goodwill on their
statement of financial position.
Goodwill can appear in the books of any business when it is purchased.
Adjustments made when no goodwill account is introduced
We have considered scenarios where a goodwill account remains in the business books
of account after a new partner is admitted. On other occasions, goodwill is written off
immediately after purchase.
278
WORKED EXAMPLE 11
Adhaf and Shavay are in partnership, sharing profits and losses equally. They provide the following
information:
3.1
Adhaf and Shavay
Extract from statement of financial position at 31 July 2021
$
Current assets
Bank
6 500
Total assets
6 500
CAPITAL
Capital accounts – Adhaf
Shavay
Total capital
3.1.2 Partnerships
ASSETS
3 500
3 000
6 500
They admit Paris as a partner with effect from 1 August 2021. Paris pays $5000 into the partnership bank
account as her capital. They agree that goodwill be valued at $18 000 and that the account will not appear in
the statement of financial position. They further agree to share future profits and losses 3:2:1 respectively.
Required
Prepare a statement of financial position at 1 August 2021 after the admission of Paris as a partner.
Answer
Adhaf, Shavay and Paris
Extract from statement of financial position at 1 August 2021
$
ASSETS
Current assets
Bank
11 500
Total assets
11 500
CAPITAL
Capital accounts – Adhaf
Total capital
3 500
Shavay
6 000
Paris
2 000
11 500
279
3.1
Workings
The book-keeping entries showing the above transactions are:
Bank
Capital – Adhaf
3.1 preparatIon of fInanCIal statements
$
$
$
Balance b/d
6 500
Goodwill (4)
9 000 Balance b/d
3 500
Capital – Paris (3)
5 000
Balance c/d
3 500 Goodwill (1)
9 000
12 500
12 500
Balance b/d
Capital – Shavay
Capital – Paris
$
Goodwill (5)
Balance c/d
3 500
$
6 000 Balance b/d
6 000 Goodwill (2)
12 000
$
3 000
Goodwill (6)
3 000 Bank (3)
9 000
Balance c/d
2 000
12 000
Balance b/d
$
5 000
6 000
5 000
5 000
Balance b/d
2 000
Goodwill
$
Capital – Adhaf (1)
Shavay (2)
$
9 000 Capital – Adhaf (4)
9 000
9 000
Shavay (5)
6 000
Paris (6)
3 000
18 000
18 000
Numbers in brackets have been placed next to each entry so that you can trace each entry individually to
each account.
Notice that the goodwill account has disappeared and is not shown in the final statement of financial
position.
Clearly it is very unusual for a business to have a bank balance as its only asset. The
above examples were used to highlight the way goodwill is treated when it does not
remain in the books of account.
Let us put together a more detailed scenario – a situation where the assets are
revalued and a value is placed on goodwill.
280
WORKED EXAMPLE 12
Lopata, Djilali and Beauregard are in partnership, sharing profits and losses in the ratio 3:2:1 respectively.
They provide the following information:
3.1
Lopata, Djilali and Beauregard
Statement of financial position at 31 May 2021
$
3.1.2 Partnerships
ASSETS
Non-current assets at cost
26 000
Current assets
9000
Total assets
35 000
CAPITAL AND LIABILITIES
Capital accounts – Lopata
10 000
Djilali
15 000
Beauregard
8 000
33 000
Current liabilities
2 000
Total capital and liabilities
35 000
They agree that Chantile be admitted as a partner with effect from 1 June 2021. Profits and losses in future
will be shared equally. They further agree that non-current assets be valued at $28 000 and that goodwill be
valued at $10 000. Goodwill should not remain in the business books of account.
Chantile is to pay $5000 into the business bank account as capital.
Required
Prepare:
a a revaluation account
b a goodwill account
c capital accounts for each partner
d a statement of financial position at 1 June 2021 after the admission of Chantile as a partner.
Answer
a
b
Revaluation
$
Capital – Lopata
6 000 Non-current assets
Djilali
4 000 Goodwill
Beauregard
2 000
12 000
Goodwill
$
2 000
$
Revaluation a/c
$
10 000 Capital – Lopata
2 500
Djilali
2 500
Beauregard
2 500
Chantile
2 500
10 000
12 000
10 000
10 000
281
3.1
c
Capital accounts
Lopata
$000
Goodwill
Balances c/d
Djilali Beauregard Chantile
Lopata
$000
$000
$000
2.5
2.5
2.5
2.5
Balances b/d
13.5
16.5
7.5
2.5
Revaluation a/c
Djilali Beauregard Chantile
$000
$000
$000
10.0
15.0
8.0
6.0
4.0
2.0
3.1 preparatIon of fInanCIal statements
Bank
16.0
19.0
10.0
5.0
Balances b/d
d
$000
5.0
16.0
19.0
10.0
5.0
13.5
16.5
7.5
2.5
Lopata, Djilali, Beauregard and Chantile
Statement of financial position at 1 June 2021 (after the admission of Chantile)
$
ASSETS
Non-current assets at valuation
28 000
Current assets
14 000
Total assets
42 000
CAPITAL AND LIABILITIES
Capital accounts – Lopata
Djilali
Beauregard
Chantile
Current liabilities
Total capital and liabilities
STUDY TIP
13 500
16 500
7 500
2 500
40 000
2 000
42 000
Write figures out in
full. Many students
make errors when they
forget that they are
using thousands and
put a figure as, say,
$13.5 when it should
say $13 500. Check
your work carefully.
Note the use of columnar capital accounts; this technique saves a little time. Four partners have been
involved in the partnership to show that the techniques do not change when there are more than three
partners.
Note the heading too. All accounting statements need a heading, including the name of the business.
If we consider a more detailed statement of financial position, we will
see that the principles for dealing with the introduction of another
partner are just the same as those already used.
Remember that we collect all the detailed changes to assets and
liabilities in the revaluation account.
282
WORKED EXAMPLE 13
Gwok and Dimitri are in partnership, sharing
profits and losses in the ratio 3:2 respectively. The
following information is provided:
Gwok and Dimitri
Statement of financial position at 30 June 2021
ASSETS
Non-current assets
Premises at cost
Equipment at cost
Vehicles at cost
Current assets
Inventory
Trade receivables
Bank
Total assets
CAPITAL AND LIABILITIES
Capital accounts – Gwok
Dimitri
11 000
4 500
1 500
17 000
102 000
60 000
40 000
100 000
Current liabilities
Trade payables
Total capital and liabilities
It was agreed that the assets of the business be
valued at:
$
45 000
23 000
17 000
85 000
3.1
Premises
Equipment
Vehicles
Inventory
Trade receivables
Goodwill
$
80 000
15 000
8 000
10 800
4 400
40 000
3.1.2 Partnerships
$
Antoinette was admitted to the partnership on 1 July
2021. It was agreed that she paid $30 000 into the
business bank account as her capital and share of
the goodwill.
It was further agreed that in future profits and
losses be shared equally and that goodwill should
not remain in the books of account.
Required
Prepare:
a a revaluation account
b a goodwill account
c partners’ capital accounts
d a statement of financial position at 1 July 2021
after the admission of Antoinette as a partner.
2 000
102 000
Answer
a
Equipment
Vehicles
Inventory
Trade receivables
Capital – Gwok
Dimitri
Revaluation
$
8 000 Premises
9 000 Goodwill
200
100
34 620
23 080
75 000
$
35 000
40 000
75 000
283
b
3.1
Goodwill
$
40 000 Capital – Gwok
Dimitri
Antoinette
40 000
Revaluation account
3.1 preparatIon of fInanCIal statements
c
$
13 334
13 333
13 333
40 000
Capital
Gwok Dimitri Antoinette
$
$
$
Goodwill
13 334
13 333
Gwok Dimitri Antoinette
$
$
$
13 333 Balances b/d
Revaluation a/c
Balances c/d 81 286
49 747
16 667 Bank
94 620
63 080
30 000
40 000
34 620
23 080
94 620
63 080
30 000
81 286
49 747
16 667
30 000
Balances b/d
d
60 000
Gwok, Dimitri and Antoinette
Statement of financial position at 1 July 2021
$
$
ASSETS
Non-current assets
Premises at valuation
80 000
Equipment at valuation
15 000
Vehicles at valuation
8 000
103 000
Current assets
Inventory
10 800
Trade receivables
4 400
Bank
31 500
Total assets
46 700
149 700
CAPITAL AND LIABILITIES
Capital accounts – Gwok
81 286
Dimitri
49 747
Antoinette
16 667
147 700
Current liabilities
Trade payables
2 000
Total capital and liabilities
149 700
STUDY TIP
Remember that both goodwill and revaluation profits are given to the ‘old’ partners in
their original profit sharing ratio.
284
The retirement of an existing partner
We have dealt with the admission of a new partner in some detail. The same principles
regarding a valuation of the business apply when a partner leaves a partnership. The
business assets and liabilities need to be examined in order to determine whether they
reflect the true worth of the business.
3.1
EXAMPLE
$
ASSETS
Non-current assets at cost
Current assets
12 000
8 000
Total assets
20 000
These non-current assets include your premises that were purchased many
years ago. Property prices in general have risen over your years of ownership
and these premises could now be sold for, say, $80 000!
Would you settle for a payout of $10 000 – your worth (capital) shown on
the statement of financial position? I think not!
3.1.2 Partnerships
Imagine that you have been a partner in a business for many, many years and the following is the
summarised statement of financial position:
Capital
Capital – You
10 000
Your partner
Total capital
10 000
20 000
You would have the business assets valued so that you could retire (or perhaps start a new business) and
receive the true value of your worth represented by the capital of the business.
WORKED EXAMPLE 14
Gerard, Sylvestre and Jean are in partnership, sharing profits and losses in the ratio 3:2:1 respectively. They
supply the following information:
Gerard, Sylvestre and Jean
Statement of financial position at 30 September 2021
$
$
ASSETS
Non-current assets at cost
45 000
Current assets
Inventory
4 300
Trade receivables
3 700
Bank
4 000
Total assets
12 000
57 000
CAPITAL AND LIABILITIES
Capital accounts – Gerard
20 000
Sylvestre
15 000
Jean
14 000
49 000
Current liabilities
Total capital and liabilities
8 000
57 000
285
Jean has decided to retire with effect from close of business on 30 September 2021.
3.1 preparatIon of fInanCIal statements
3.1
The partners have agreed that:
l non-current assets be valued at $100 000
l inventory be valued at $4000
l trade receivables be valued at $3000
l goodwill be valued at $12 000 and that goodwill should not appear in the business books of account.
l Any amount due to Jean would be paid from the business bank account (assume that overdraft facilities
have been agreed with the business bank).
l In the future, Gerard and Sylvestre will share profits and losses equally.
Required
Prepare:
a a revaluation account
b a goodwill account
c partners’ capital accounts
d a statement of financial position at 30 September 2021 after the retirement of Jean.
Answer
a
Inventory
Trade receivables
Capital – Gerard
Capital – Sylvestre
Capital – Jean
b
Revaluation
$
300 Non-current assets
700 Goodwill
33 000
22 000
11 000
67 000
$
55 000
12 000
67 000
Goodwill
Revaluation account
$
12 000 Capital – Gerard
Capital – Sylvestre
12 000
c
Gerard Sylvestre
$
$
Bank
Goodwill
6 000
Balances c/d 47 000
53 000
6 000
31 000
37 000
$
6 000
6 000
12 000
Capital
Jean
Gerard Sylvestre
$
$
$
25 000 Balances b/d 20 000
15 000
Revaluation 33 000
22 000
Jean
$
14 000
11 000
25 000
25 000
53 000
37 000
Balances b/d 47 000
31 000
Gerard and Sylvestre
Statement of financial position at 30 September 2021
$
d
ASSETS
Non-current assets at valuation
Current assets
286
100 000
Inventory
4 000
Trade receivables
3 000
Total assets
$
7 000
107 000
CAPITAL AND LIABILITIES
Capital accounts – Gerard
47 000
Sylvestre
3.1
31 000
78 000
Current liabilities
8 000
Bank overdraft
21 000
Total capital and liabilities
29 000
107 000
Workings
Note this is dealt with in two parts because it involves two businesses:
Up to midnight 30 September 2021
Immediately after midnight 1 October 2021
Owners were Gerard, Sylvestre, Jean.
Owners are Gerard and Sylvestre.
3.1.2 Partnerships
Trade payables
We credited the capital accounts with the increase in the value of the capital in order that Jean can receive
his just dues before his retirement. After all, he has presided over the increase in the value of the assets as
well as contributing to the value of the goodwill of the business.
We debited the two capital accounts (there are only two partners, Gerard and Sylvestre, in this ‘new’
business) with the writing off of the asset of goodwill. Notice that when we wrote off the goodwill there were
only two partners in the ‘new’ business – Jean is now no longer involved in the running of the business.
Methods of paying a partner when they leave a partnership
A retiring partner could have a considerable amount standing to the credit of their
capital and current account. If a large sum were to be paid out, the withdrawal could
deprive the business of a great deal of liquid resources. How can the problem be
resolved?
» The retiring partner’s capital account balance could be transferred to a loan
account and an amount could be paid each year to the partner who had retired.
» A new partner could join the business and the payment made by the new partner
could be used to pay off the ‘old’ partner.
» The cash to pay off the ‘old’ partner could be borrowed from a bank or other
financial institution.
» Remaining partners could inject sufficient further capital into the business,
allowing the payment to be made.
The dissolution of a partnership and the realisation account
Partnership dissolution
A partnership may be dissolved, that is, it may cease to be a partnership, under the
following circumstances:
»
»
»
»
on the death of a partner
on the retirement of a partner
when a partner is declared bankrupt
by mutual agreement of the partners.
287
Realisation accounts
When a partnership is dissolved, the assets of the business are disposed of and any
liabilities are then settled. The order of settling any debts (liabilities) is as follows:
1 trade and other payables
2 partners’ loan accounts
3 partners’ capital accounts
The assets can be disposed of in a variety of ways:
3.1 preparatIon of fInanCIal statements
3.1
» Some assets may be sold for cash.
» Some assets may be taken over by one or more of the partners.
» Some assets may be sold to a limited company.
As we saw previously, all entries in books of account must first be entered in a book of prime
entry. We use the general journal as the book of prime entry when a business closes down.
The way we tackle the closing down of a partnership is by preparing a realisation
account.
STUDY TIP
The most common
error made by
students is to enter
the amount raised by
the sale of the assets
in the debit side of the
realisation account.
Make sure that it is the
net book value of the
assets that you enter
on the debit side.
On the debit side of the account, we find the assets that are disposed of and any
expenses incurred in the dissolution. On the credit side, we find what the assets
realised (what they have been sold for).
Realisation account
The carrying amount of the assets
The proceeds from the sales of the assets
shown opposite
Costs of the dissolution
Other incomes or benefits
Discounts allowed
Discounts received
Profit on dissolution
Loss on dissolution
Unless you are told differently, assume that the partnership will collect any outstanding
monies from trade receivables (credit customers) and pay off outstanding trade
payables (credit suppliers). Try to think what you would be doing in the circumstances
when a partnership is dissolved.
» All the assets to be disposed of are entered on the debit side of the realisation
account.
» All the proceeds are entered on the credit side.
Any profit resulting from the disposal of the assets will appear on the debit side of the
realisation account. It is posted from here to the credit side of the partners’ capital
accounts in their profit sharing ratios.
Any loss will be shown on the credit side of the realisation account and it will be
posted to the debit side of the partners’ capital accounts in their profit sharing ratios.
If any partner takes over any of the partnership assets, treat this as a ‘sale’ to that
partner. Credit the realisation account with the agreed value of the asset(s) to be
taken over by the partner and debit the respective capital account.
EXAMPLE
A partner, Josie, takes over the inventory of the partnership.
Debit Josie’s capital account with
the agreed value of the inventory
Credit Realisation account
A partner, Hernan, takes a business-owned vehicle at an agreed valuation of $3 500.
Debit Hernan’s capital account $3 500 Credit Realisation account $3 500
288
WORKED EXAMPLE 15
Wu and Xian are in partnership, sharing profits and losses in the ratio 2:1 respectively. They agree to
dissolve the partnership on 30 November 2021. They provide the following information:
CAPITAL AND LIABILITIES
Capital accounts – Wu
Xian
3.1.2 Partnerships
Wu and Xian
Statement of financial position at 30 November 2021
$
$
ASSETS
Non-current assets
80 000
Other current assets
17 000
Bank
3 000
20 000
100 000
Total assets
3.1
50 000
36 000
86 000
Current liabilities
Total capital and liabilities
14 000
1 00 000
l The current liabilities were paid their due amounts.
l The non-current assets were sold for $100 000 cash.
l The current assets realised $15 000.
Required
Prepare:
a a bank account
b a realisation account
c partners’ capital accounts.
Answer
Bank
a
$
Balance
Realisation – Non-current assets
Current assets
$
3 000 Current liabilities
14 000
100 000 Capital account – Wu
62 000
15 000
Xian
118 000
b
42 000
118 000
Realisation
$
Non-current assets
80 000 Bank (non-current assets)
Current assets
17 000 Bank (current assets)
Capital accounts – Wu
12 000
Xian
$
100 000
15 000
6 000
115 000
115 000
289
3.1
c
Capital
Wu
Xian
$
Bank
62 000
Wu
$
42 000 Balance b/d
Realisation account
3.1 preparatIon of fInanCIal statements
62 000
42 000
Xian
$
$
50 000
36 000
12 000
6 000
62 000
42 000
Workings
In order to show the sequence of the entries shown above, the entries have been journalised:
Current liabilities
Debit
Credit
$
$
14 000
Bank account
14 000
Paying current liabilities
Realisation account
80 000
Non-current assets
80 000
Clearing the non-current assets from the partnership books of account
Realisation account
17 000
Current assets
17 000
Clearing current assets from the partnership books of account
Bank account
100 000
Realisation account
100 000
Sale of non-current assets for cash
Bank account
15 000
Realisation account
15 000
Sale of current assets for cash
Realisation account
12 000
Capital account – Wu
12 000
Wu’s share of profit on realisation
Realisation account
6 000
Capital account – Xian
6 000
Xian’s share of profit on realisation
Capital account – Wu
62 000
Bank account
62 000
Payment from partnership bank account to clear the balance on Wu’s capital account
Capital account – Xian
Bank account
42 000
42 000
Payment from partnership bank account to clear the balance on Xian’s capital account
290
STUDY TIP
You may find the
preparation of journal
entries to be a very
useful revision aid.
If you journalise any
complex answer or
an exercise that your
teacher has gone
through in class, you
should find it easier
to revise the order in
which the processes
involved took place
when you return to the
example some weeks
or months later.
Note
l Do not attempt to share any balance left in the bank account in any pre-determined ratio. The bank
account is used to clear any outstanding balances left on the partners’ capital accounts.
l At the end of this type of exercise there should be no outstanding balances anywhere in your answer.
3.1
WORKED EXAMPLE 16
Rollo and Johann
Statement of financial position 28 February 2021
$
3.1.2 Partnerships
Rollo and Johann are in partnership, sharing profits and losses 3:2 respectively.
They agree to dissolve their partnership on 28 February 2021. They provide the
following information:
$
ASSETS
Non-current assets
40 000
Other current assets
8 000
Bank
2 000
Total assets
10 000
50 000
CAPITAL AND LIABILITIES
Capital accounts – Rollo
Johann
25 000
19 000
44 000
Current liabilities
Total capital and liabilities
6 000
50 000
l The non-current assets were taken over by Rollo at an agreed value of
$36 000.
l The current assets realised $7000 cash.
l The current liabilities were settled at the value shown in the business books of
account.
Required
Prepare:
a a realisation account
b a bank account
c partners’ capital accounts.
Answer
a
Non-current assets
Current assets
Realisation
$
40 000 Capital – Rollo
8 000 Bank
Capital – Rollo
Johann
48 000
$
36 000
7 000
3 000
2 000
48 000
291
3.1
b
Bank
$
2 000 Current liabilities
7 000 Capital account – Johann
14 000
23 000
3.1 preparatIon of fInanCIal statements
Balance b/d
Realisation account
Capital account – Rollo
c
Realisation account
Realisation account
Bank
Rollo
$
36 000
3 000
39 000
Capital
Johann
Rollo
$
$
Balances b/d 25 000
2 000 Bank
14 000
17 000
19 000
39 000
$
6 000
17 000
23 000
Johann
$
19 000
19 000
Workings
Again, to show the sequence of events, here are the journal entries:
Current liabilities
Debit
Credit
$
$
6 000
Bank account
6 000
Paying off current liabilities
Realisation account
40 000
Non-current assets
40 000
Closing down non-current asset accounts
Realisation account
8 000
Current assets
8 000
Closing down current asset accounts
Capital account – Rollo
36 000
Realisation account
36 000
Rollo ‘buys’ non-current assets from the partnership.
Bank account
7 000
Realisation account
7 000
Sale of current assets
Bank account
14 000
Capital account – Rollo
14 000
Rollo pays off the deficit on his capital account.
Capital account – Johann
Bank account
17 000
17 000
Johann withdraws sufficient cash to clear the amount the partnership owes him.
292
Clearly, there are times when trade receivables do not all pay the amounts that they
owe to the business when a partnership is wound up. This may be because there may
be some irrecoverable debts or because the partnership offers cash discounts in order
to get the cash in quickly.
3.1
Similarly, there may be times when a partnership is able to benefit from cash
discounts available from trade payables.
WORKED EXAMPLE 17
3.1.2 Partnerships
Any discounts allowed to trade receivables is debited to the realisation account (as
would any credit customers who proved to be irrecoverable). Any discounts received
from trade payables is credited to the realisation account. The actual cash received
from trade receivables is debited to the partnership bank account and the cash paid to
trade payables is credited to the bank account.
Aslam, Brannen and Chesney decide to dissolve their partnership on 30 April 2021. At that date, trade
receivables amounted to $7450 and trade payables totalled $3950.
Trade receivables paid $7250 in settlement and trade payables accepted $3800 in settlement.
Required
Prepare the following accounts to record the transactions:
a a realisation account
b a bank account
c total trade receivables account
d total trade payables account.
Answer
Trade receivables account
Realisation
$
200 Total Trade payables account
$
150
Trade receivables account
Bank
$
7 250 Total Trade payables account
$
3 800
Trade receivables
$
7 450 Bank account
Realisation account
7 450
$
7 250
200
7 450
a
b
c
Balance b/d
d
Bank account
Realisation account
Trade payables
$
3 800 Balance b/d
150
3 950
$
3 950
3 950
293
Winding up a partnership will inevitably incur costs. These costs may be to advertise
various assets to be sold; there may be costs paid to a lawyer who will tie up and
formalise the legal side of the dissolution. The process is:
3.1
Debit realisation account
Credit bank account
Finally, remember to settle any partnership loans after you have dealt with trade
receivables and trade payables:
3.1 preparatIon of fInanCIal statements
Debit loan account
WORKED EXAMPLE 18
Yoko and Cesc were in partnership, sharing profits and losses equally. They agreed to dissolve their
partnership on 31 July 2021. They provide the following information:
Yoko and Cesc
Statement of financial position at 31 July 2021
$
$
ASSETS
Non-current assets
40 000
Current assets
Inventory
9 000
Trade receivables
4 000
Bank
2 000
15 000
Total assets
55 000
CAPITAL AND LIABILITIES
Capital accounts – Yoko
Cesc
Non-current liabilities
Loan from Cesc
Current liabilities
Trade payables
Total capital and liabilities
l
l
l
l
l
25 000
20 000
45 000
2 000
8 000
55 000
Non-current assets were sold for $58 000 cash.
Inventory was taken over by Yoko at an agreed valuation of $7700.
Trade receivables paid $3800 in settlement.
Trade payables were paid $7500 in settlement.
The costs incurred during the dissolution amounted to $3400.
Required
Prepare:
a a realisation account
b a bank account
c partners’ capital accounts.
294
Credit bank account
Answer
3.1
Realisation
a
$
Discounts allowed
200
Non-current assets
40 000
9 000
Bank (costs)
3 400
Capital account – Yoko
6 800
Cesc
6 800
Discounts received
500
Bank (non-current assets)
58 000
Capital account – Yoko (inventory)
66 200
7 700
66 200
Bank
b
$
$
Balance b/d
2 000
Loan – Cesc
2 000
Trade receivables
3 800
Trade payables
7 500
Realisation account (non-current assets)
58 000
3.1.2 Partnerships
Inventory
$
Realisation account (costs)
Capital accounts – Yoko
Cesc
3 400
24 100
26 800
63 800
63 800
Capital
c
Realisation account
Bank
Yoko
Cesc
Yoko
Cesc
$
$
$
$
25 000
20 000
6 800
6 800
31 800
26 800
7 700
Balances b/d
24 100
26 800
31 800
26 800
Realisation account
How to prepare the partnership appropriation account,
statement of profit or loss and statement of financial
position when a partnership changes part way through
an accounting year
If a change in a partnership occurs during the accounting year then the partnership
before the change ceases to exist and a new partnership is created. In this case, a
partnership would need to produce financial statements that reflect the changes. In
many cases, the statement of profit or loss and appropriation account will need to be
split into two periods.
Care must be taken to ensure that the provisions of any partnership agreement are
closely followed for the period prior to and following the change. It is normal to
allocate income and expenses evenly across an accounting year. For example, if a
partnership is changed one-third of the way into a period, then one-third of the
incomes and expenses would be allocated to that first period. In the case of interest
on capital, salaries and other appropriations of profit, this must be factored in to any
calculations, i.e. in this case one-third of the salary would be allocated, as well as
one-third of the annual interest on capital and so on.
295
3.1
WORKED EXAMPLE 19
Clark and Parker are in partnership. They currently share their profits in a 2:1 ratio – with Clark receiving
two-thirds of the profit. Their partnership agreement allows for the following:
Interest on capital: 5%
3.1 preparatIon of fInanCIal statements
Capital account balances – Clark
Salaries:
$50 000
Parker
$36 000
Clark
$16 000
Parker
$8 000
On 1 April 2020, they admit Pickford to the partnership. She contributes $40 000 in capital. The new
partnership agreement allows for the following:
l Interest on capital is reduced to 4%.
l Clark will no longer take a salary but Parker will continue to receive the same salary. Pickford will also
be allowed a salary of $10 000 per year. The partners will now share profits equally.
l Profit for the year ended 31 December 2020 was $220 000, which was earned evenly throughout 2020.
Prepare the partnership appropriation account for the year ended 31 December 2020.
Answer
Clark, Parker and Pickford
Appropriation account for the year ended 31 December 2020
1 January to 31 March 2020 1 April to 31 December 2020 Year to 31 December 2020
$
Profit for the year
$
$
55 000
$
$
165 000
$
220 000
Less Salaries
Clark
4 000
0
4 000
Parker
2 000
6 000
8 000
Pickford
0
6 000
7 500
49 000
13 500
7 500
151 500
19 500
200 500
Less Interest on capital
Clark
625
1 500
2 125
Parker
450
1 080
1 530
Pickford
0
1 075
1 200
47 925
3 780
1 200
147 720
4 855
195 645
Share of profit
Clark
(31 950)
(49 240)
(81 190)
Parker
(15 975)
(49 240)
(65 215)
Pickford
296
0
(47 925)
(49 240)
(147 720)
(49 240)
(195 645)
STUDY TIP
If there are alterations
to the capital account
balances when a
change occurs in
the partnership, the
interest on capital will
need to be based on
the new balances for
the second period of
the year (i.e. after the
changes have been
made).
How to prepare a realisation account and a revaluation
account
This was covered earlier in this chapter, starting on page 288.
3.1.3 Clubs and societies
3.1
3.1.3 Clubs and societies
Points to note
l Unless informed otherwise, the profits are allocated according to the year allocated.
l The period of the year before Pickford joins is three months (which is one quarter of a full year) so all
appropriations for this period are one quarter of the full year’s total. Similarly, after Pickford joins all
appropriations represent three quarters of the full year’s total.
l The final columns, which represent the totals for the year, can then be added to the current accounts to
update the balance on these accounts.
l Clark and Parker could have chosen to revalue their assets when Pickford joined – this would have
altered their capital account balances for the interest on capital calculations in the second period.
The distinction between a receipts and payments account and
an income and expenditure account
Changes in terminology
There are a number of superficial changes made to some of the headings used when
preparing financial statements.
» The revenue statement of a club is not called a statement of profit or loss. It is
called an income and expenditure account.
» Any profit made by a club is called surplus (or an excess of income over
expenditure). Similarly, any loss made by a club is called a deficit (or an excess of
expenditure over income).
» The capital account of a club is known as the accumulated fund.
» The summarised cash book is called a receipts and payments account.
Receipts and payment account
Clubs and societies require a form of financial statement different from that of a
commercial organisation.
The main function of a club or society is not to trade. Its existence is to provide
facilities for members or to provide an opportunity for people to meet and further
their common interest.
Often, the members of a club have little or no knowledge of accounting or bookkeeping and because of this many club treasurers present a ‘receipts and payments
account’ to the club’s annual general meeting as a set of financial statements.
A receipts and payments account does not show the members:
» the true financial position of the club
» any accrued expenses or any prepayments made
» the asset base of the club or by how much the assets have depreciated during
the year
» any liabilities that are outstanding at the year end.
To present a more complete picture of the club’s financial activities and position,
an income and expenditure account and a statement of financial position should be
prepared.
297
Learning link
3.1 preparatIon of fInanCIal statements
3.1
The matching/accruals
concept (covered in
Chapter 1.2) still applies
when constructing the
financial statements of
the business.
Remember
A receipts and payments
account is just the cash
book (or bank or cash
account) for clubs and
societies. It is NOT a
new kind of account.
Income and expenditure account
An income and expenditure account is prepared using the matching/accruals concept
(see Chapter 1.5), and so:
»
»
»
»
»
all incomes and expenditures for the period under review are recorded
it includes all expenditures accrued and as yet unpaid for the period
it includes all incomes due that have not yet been received
it includes non-cash expenses such as depreciation
the completed income and expenditure account will reveal a surplus or deficit for
the period
» it shows whether the club is generating sufficient income to pay for members’
activities.
Any profit made by a club is called an excess of income over expenditure. It is often
shortened to ‘surplus’. Any loss made by a club is called an excess of expenditure over
income, sometimes shortened to ‘deficit’.
Statement of financial position
The statement of financial position of a club is very similar to that of a sole
trader; non-current assets and liabilities are identified, as are the current assets
and liabilities. The major difference is in the heading of what would be the capital
account for a business.
The capital account of a club is known as the accumulated fund.
How to define and calculate the accumulated fund
The accumulated fund represents the capital of clubs and societies. As covered in
Chapter 1.5, the profit of a business can be calculated by comparing the changes in
the capital balances between the start and end of the accounting period. An increase
in the capital balance (adjusted for extra capital contributions and drawings) would
indicate a profit has been earned.
The same reasoning can also be applied here. If we examine the changes in the
accumulated fund over time, we can calculate a profit figure (though this would be
referred to as a surplus). In fact, in the case of clubs and societies, this method may
be more likely to be used as full accounting records may not be available.
To calculate the surplus or deficit for a club requires a comparison of the capital at
the start of the period with the capital at the end of the period. Can you remember
how you calculated the profit or loss for a business using the capital method?
There are four stages to this procedure.
» Stage 1: calculate the opening accumulated fund (capital) of the club either by:
– listing the assets and then deducting the liabilities, or
– preparing a statement of affairs.
» Stage 2: calculate the closing accumulated fund (capital).
» Stage 3: deduct the opening accumulated fund from the closing accumulated fund.
This will indicate the surplus or deficit earned by the club during the year.
» Stage 4: deduct any ‘extra’ funds introduced. Sometimes the club may receive
a donation or a legacy that has to be treated as a capital receipt. This extra
injection of funds will increase the assets owned by the club at the end of the
year. In turn this will increase the figure we have calculated as a surplus (it could
reduce the figure calculated as a deficit). Obviously the amount of the donation
or legacy is not an increase in capital ‘earned’ by the activities of the club so it
must be disregarded in our calculation – hence, Stage 4: deduct any ‘extra’ funds
‘introduced’.
298
We can summarise these stages as follows:
Closing accumulated fund
3.1
Opening accumulated fund
Deduct
xxxxxxxxxxxx
Deduct
Funds ‘introduced’
Surplus (deficit) for the year
xxxxxxxxxxxxxxx
Hightown Tennis Club had the following assets and liabilities at 1 January 2021:
nets $112; inventory of tennis balls $26; amount owed to supplier of tennis balls $72; inventory of fertiliser
$54; line paint $8; balance at bank $136
At 31 December 2021 the club assets and liabilities were:
nets $80; inventory of tennis balls $20; inventory of fertiliser $48; balance at bank $207
3.1.3 Clubs and societies
WORKED EXAMPLE 20
Required
Calculate the surplus or deficit for the year ended 31 December 2021.
Answer
Net assets at 1 January 2021
Nets
$
112
Net assets at 31 December 2021
$
Nets
80
Inventory of balls
26
Inventory of balls
20
Inventory of fertiliser
54
Inventory of fertiliser
48
Line paint
8
Bank
136
Bank
207
Accumulated fund at 31 December 2021
355
336
Less Amounts owing to supplier
Accumulated fund at 1 January 2021
72
264
Accumulated fund at 31 December 2021
355
Accumulated fund at 1 January 2021
264
Surplus for the year ended 31 December 2021
91
How to prepare financial statements of clubs and societies,
from full or incomplete accounting records
To prepare the financial statements for clubs and societies you will normally be
expected to produce:
» an income and expenditure account
» a statement of financial position.
However, there are likely to be other statements and accounts that we will need to
produce often as a means of working out the amounts to include within the financial
statements.
299
Accounts for trading and revenue-generating activities
3.1
Many clubs organise activities that are not the core activity of the club. These
activities are useful in
3.1 preparatIon of fInanCIal statements
» raising additional funds, which means that subscriptions may be lower than if
additional activities were not undertaken
» keeping members interested at times when major club activities are quiet – a
cricket club may organise ‘out of season’ activities, for example, social events
during the ‘out of season’ months.
For each ancillary activity, the club treasurer should calculate whether the activity is
profitable or not and include the profit or loss in the income and expenditure account.
Café statement of profit or loss
If a club has a café in order to raise additional funds for the club, a statement of
profit or loss should be prepared. The profit or loss generated should be transferred to
the income and expenditure account.
The statement of profit or loss prepared is no different to any other statement of
profit or loss that you have produced on a regular basis during your studies.
Full information may not be available. You may have to use other techniques for
calculating some of the information. For example, sales and purchases figures may be
calculated using control accounts. (This was covered in Chapter 1.5.)
WORKED EXAMPLE 21
The treasurer of the Apes Rugby Club provides the following information for the
year ended 31 May 2021 for a café operated by the club:
l 1 June 2020: amount owed to supplier of fruit juices and snacks $213
l 31 May 2021: amount owed to supplier of fruit juices and snacks $186
l café sales for the year $27 759
l amounts paid to the supplier of fruit juices and snacks during the year $14 621
l inventory of fruit juices and snacks 1 June 2020: $165
l inventory of fruit juices and snacks 31 May 2021: $191.
Required
Prepare a café statement of profit or loss for the year ended 31 May 2021.
Answer
Apes Rugby Club
Café statement of profit or loss for the year ended 31 May 2021
$
Revenue
$
27 759
Less Cost of sales
Inventory 1 June 2020
Purchases
165
14 594
14 759
Inventory 31 May 2021
Café profit (to income and expenditure account)
300
(191)
14 568
13 191
Workings
3.1
Trade payables
2020
Jun 1
2021
May 31
$
Balance b/d
213
$ 2021
Cash
Café statement
of profit or loss
(missing figure)
14 594
186
14 807
14 807
Jun 1
Balance b/d
186
If we examine the receipts and payments account of a club or society, we will often
see incomes and expenses that are connected to one another. These are usually
connected to a specific event, such as a one-off event that took place to raise funds
(e.g. a charity ball, a dinner and dance, a raffle, a party, and so on).
3.1.3 Clubs and societies
Balance c/d
14 621 May 31
Where there are income and expenses relating to one activity, we would normally
prepare a separate account for the activity and, based on the financial data, calculate
the profit or loss that arises out of this activity. It is important to know the profit or
loss made on these separate activities as it will allow members of the club or society
to make a decision on whether that activity should continue in the future. Clearly, an
unprofitable activity may be worth discontinuing (unless it perhaps fulfils another
function, such as recruiting new members).
A subscriptions account
Subscriptions are the amounts paid to the club or society by its members. Usually,
these subscriptions relate to annual membership fees charged. These represent an
important source of income for the organisation and it is important that these are
accounted for correctly. In terms of the outstanding balances:
» subscriptions owing to the organisation are debit balances (similar to revenues
outstanding)
» subscriptions paid in advance to the organisation are credit balances (similar to
revenues paid in advance).
These subscriptions may relate to the start of the accounting year or the end of
the accounting year. It is important that you are methodical in placing these in the
correct position in the subscriptions account.
301
3.1
Monies received during the year from members are debited in the receipts and
payments account. We need to complete the double entry in the subscriptions
account. We complete the double entry by crediting the subscriptions account. You
will make fewer errors if you use the technique outlined earlier in Section 1.5.1. Put
your closing balances below the account and then bring them back into the account.
3.1 preparatIon of fInanCIal statements
WORKED EXAMPLE 22
During the year ended 30 June 2021, cash received for subscriptions to the
Dropkick Rugby Club amounted to $1860.
At 1 July 2020, subscriptions paid in advance amounted to $140; at 30 June 2021
subscriptions paid in advance were $80.
At 30 June 2021, subscriptions totalling $60 remained unpaid.
It is club policy to write off any subscriptions that remain unpaid at the financial
year end.
Required
Prepare a subscriptions account for the year ended 30 June 2021.
Answer
Subscriptions
$ 2020
Jul 1
2021
Jun 30 Income and
expenditure
(missing figure)
$
Balance b/d
Receipts and payment
140
1 860
1 980
2021
Balance c/d
80 Jun 30 Subscriptions written off *
2 060
60
2 060
Jul 1
Balance b/d
80
* Subscriptions written off appears as an expense in the income and expenditure
account – in the same way as irrecoverable debts.
An income and expenditure account
In order to show these various accounts, techniques and tools used in this topic,
we will work through one long example. This is based on the following information:
302
WORKED EXAMPLE 23
The following receipts and payments account for the year ended 31 October 2021 has been prepared by the
treasurer of the Dantong Gardening Club:
$
$
Bank 1 November 2020
146 Payments to seed supplier
Seed sales
612 Purchase of gardening equipment
Show entry fees
Annual dinner dance ticket sales
Equipment hire
5 040 Meeting room rent
326 Secretary’s honorarium
2 250 Speakers’ expenses
420 Bank charges
407
2 842
750
100
240
28
Advertising
126
Insurances
348
Postages and telephone
142
Dinner dance expenses
1 874
Printing for dinner dance
128
Show prizes
247
Show expenses
148
Balance at bank 31 October 2021
8 794
3.1.3 Clubs and societies
Subscriptions received
3.1
1414
8 794
The following additional information is available:
at 31 October 2021 at 1 November 2020
Assets and liabilities
$
$
Equipment at valuation
3 000
840
Amounts owed for seed purchases
84
128
Amount owed for printing for dinner dance
75
62
Prepayment for insurance
206
112
Subscriptions paid in advance
135
360
Subscriptions owing at financial year end
225
180
Required
Prepare an income and expenditure account for the year ended 31 October 2021 and a statement of financial
position at that date.
Answer
There are a number of steps that will need to be taken in order to produce a correct answer. We will need to
do the following before we can produce the financial statements:
l Calculate the opening balance for the accumulated fund (for the statement of financial position).
l Calculate the correct values for all income and expenses relating to this year.
l Calculate the profits or losses made on any ancillary activities undertaken during the period.
303
3.1
Calculating the balance on the ‘opening’ accumulated fund
Although this can be completed quickly, producing a statement of affairs will make it more likely no errors
are made:
3.1 preparatIon of fInanCIal statements
$
Assets
Equipment
Prepayment – insurance
Subscriptions owing
Bank
Liabilities
Trade payables – seed merchants
Printing
Subscriptions paid in advance
Accumulated fund
$
840
112
180
146
(128)
(62)
(360)
Subscriptions owing – members
who owe the club money are trade
receivables (credit customers).
1 278
Subscriptions in advance – trade
(550) payables (credit suppliers).
728
Calculating the correct values for incomes and expenses
Equipment
$
2020
Nov 1
2021
Oct 31
Nov 1
Balance b/d
Bank
Balance b/d
840 2021
Oct 31
2 842
$
Income and expenditure
account (missing figure)
Balance c/d
3 682
3 000
Nov 1
2021
Oct 31
Balance b/d
Bank
Balance b/d
Bank
Balance c/d
112 2021
Oct 31
348
$
Income and expenditure
account (missing figure)
Balance c/d
460
206
Seed supplier
$
2020
Nov 1
407 2021
84 Oct 31
Nov 1
254
206
460
$
Balance b/d
128
Income and expenditure
account (missing figure)
363
491
304
3 000
3 682
Insurance
$
2020
Nov 1
2021
Oct 31
682
Balance b/d
491
84
2021
Oct 31
Printing
2020
$ Nov 1
128 2021
75 Oct 31
Bank
Balance c/d
141
Income and expenditure
account (missing figure)
203
203
75
Balance b/d
Again, we could complete this through basic calculations but it is more likely to be correct if we use ledger
accounts to calculate the missing figures – the ones needed for the income and expenditure account.
For the Dantong Gardening Club example we are working through, the subscriptions
account would appear as follows (ensure you read through the notes to accompany the
account to understand what each figure relates to).
Subscriptions
2020
Nov 1
$ 2020
Balance b/d (1)
180 Nov 1
2021
Oct 31
Income and expenditure
(missing figure) (6)
2021
5 310 Oct 31
3.1.3 Clubs and societies
Nov 1
3.1
$
62
Balance
$
Balance b/d (2)
360
Receipts and payments (5)
5 040
2021
Balance c/d (3)
135 Oct 31
Balance c/d (4)
225
5 625
Nov 1
Balance b/d (4)
5 625
225 Nov 1
Balance b/d (3)
135
Notes
1 Outstanding subscriptions at start of year is an asset – a debit balance.
2 Subscriptions in advance at start of year is a liability – a credit balance.
3 Subscriptions in advance at the end of year is a liability – a credit balance.
4 Outstanding subscriptions at end year is an asset – a debit balance
5 Money received is a credit entry (debited to bank account).
6 Figure needed to balance up whole account is subscriptions income for the year –
credited to the income and expenditure account.
We can now produce the full income and expenditure account.
Dantong Gardening Club
Income and expenditure account for the year ended 31 October 2021
$
$
Income
Subscriptions
Profit on seed sales (612 – 363)
5 310
249
Profit on dinner dance (2 250 – 1 874 – 141)
235
Equipment hire
420
6 214
Expenditure
Loss on show (326 – 247 – 148)
69
Rent
750
Secretary’s honorarium
100
305
Speakers’ expenses
3.1
240
Bank charges
28
Advertising
126
Insurance
254
Postages and telephone
142
Depreciation of equipment
682
3.1 preparatIon of fInanCIal statements
Surplus
2 391
3 823
Note
Each of the additional activities, i.e. sales of seeds, the dinner dance and the show,
has been ‘netted’ to reveal whether the activity has been beneficial to the club or
whether it has drained resources from the club.
The workings have been shown to help you. Do show your workings, but show them
separately, outside the main body of your answer.
Notice also the change in the terms used: income and expenditure account, surplus
and accumulated fund.
In practice, many clubs write off any subscriptions not paid by the end of the club’s
financial year, since if a member has not paid their subscription by the end of the year
there is a strong likelihood that the membership has lapsed.
A statement of financial position
The statement of financial position will appear in the same form as those in
Chapter 1.5 and Section 3.1.2. The capital section of the statement will contain the
accumulated fund as at the start of the period and this would be adjusted by the
surplus or deficit accordingly.
Dantong Gardening club
Statement of financial position at 31 October 2021
$
ASSETS
Non-current assets
Equipment at valuation
Current assets
Bank
Trade receivables – Insurance
Subscriptions
Total assets
3 000
1 414
206
225
CAPITAL AND LIABILITIES
Accumulated fund
Opening balance
Add Surplus
Current liabilities
Trade payables – Seeds
Printing
Subscriptions in advance
Total capital and liabilities
306
$
1 845
4 845
728
3 823
4 551
84
75
135
294
4 845
STUDY TIP
Some clubs gain income from other sources.
3.1
Life membership
This is a lump sum paid by a member. It entitles the member to use the club’s facilities
for the rest of his or her life without any further payment. Money received from the
member is debited to the bank account and credited to a life membership fund.
The balance on the life membership fund is credited to the income and expenditure
account in equal annual instalments over a period that has been agreed by the club
committee.
The balance on the life membership fund is shown on the statement of financial
position as a non-current liability.
WORKED EXAMPLE 24
3.1.3 Clubs and societies
A life membership
payment is a ‘one off’
payment and is received
by the club when the
payment is made. The
annual transfers to
the club income and
expenditure account are
merely transfers in the
club’s books of account.
The amount transferred
does not increase the
cash inflow that year.
How to account for other receipts, including life memberships
and donations
The Old Jacks Bowling Club operates a life membership scheme. The life membership subscription is $350.
The balance standing on the life membership fund at 30 September 2020 was $2940.
During the year ended 30 September 2021, five members took out life membership, paying $1750. The club
transfers 10% of the balance standing in the life membership fund at the end of each financial year to the
income and expenditure account.
Required
Prepare a life membership fund for the year ended 30 September 2021.
Answer
Life membership fund
2020
Oct 1
2021
Sep 30
$
Balance b/d
2 940
Bank
1 750
$ 2021
Income and expenditure account
Balance c/d
469 Sep 30
4 221
4 690
Oct 1
Balance b/d
Note
l $469 is shown as an income on the income and expenditure account.
l $4221 is shown as a non-current liability in the statement of financial position.
4 690
4 221
Entrance fees paid by new members
In their first year of membership, members may be charged an entrance fee in addition
to the normal annual subscription. Generally these entry fees are regarded as revenue
income and are credited to the income and expenditure account. However, some clubs
treat this form of income as a capital income and in these cases they would be added
to the accumulated fund.
307
3.1
Donations
Another source of income is in the form of donations. Small donations should be
treated as revenue income. However, if a large donation is received it should be
treated as a capital receipt.
3.1 preparatIon of fInanCIal statements
If a club receives a large donation (or legacy) that has been given for a particular
purpose it should be credited to a special trust fund and a special bank account should
be opened. This avoids the money being used for general club expenditure.
The trust fund should be debited each year with the amount of the annual expenditure
on the special purpose; the credit entry is in the income and expenditure account. The
entries are similar to those used in a life membership fund account.
WORKED EXAMPLE 25
On 1 January 2021 the Stumps Cricket Club received a donation of $50 000 to build
a new pavilion. In August 2021, Chang, a builder, was paid $3874 after laying the
foundations. In September 2021, another builder, Chou, was paid $4751 for work
done.
Required
Prepare the necessary accounts to record the transactions.
Answer
[1] Trust fund – pavilion
Balance b/d
Bank – building
$
50 000 [4] Chang
[5] Chou
Balance c/d
50 000
41 375
Trust fund – pavilion
$
[6] Income and expenditure account
8 625 [1] Bank
Balance c/d
41 375
50 000
Balance b/d
$
50 000
50 000
41 375
Pavilion
$
3874
4751
[2] Chang
[3] Chou
[4] Bank
$
3 874
4 751
41 375
50 000
Chang
$
3 874 [2] Pavilion
$
3 874
[5] Bank
Chou
$
4 751 [3] Pavilion
$
4 751
The numbers refer to the sequence of events. There will be an ‘extra’ income in
the income and expenditure account for the year.
308
How to evaluate possible sources of finance and methods
of fundraising
Clubs and societies are often in need of finance to meet any shortfalls over the
accounting year. As an organisation not focused on profits, it is likely that the
organisation will not always be as efficient as other types of entity in ensuring it has
sufficient finances. In this case, it would be useful for the organisation to ensure it
has access to potential sources of finance where possible.
As we have already seen, income-generating activities will often provide vital income
for the organisation to ensure that, even when the club or society is not running its
main activities, it still has money coming in. Senior members or treasurers of the
club would be advised to plan ahead. This would involve looking for periods in the
typical year when incomes are lower than normal, or expenses are likely to be higher.
Fundraising activities may be necessary for these periods.
3.1.3 Clubs and societies
Encouraging members to pay their subscriptions on time is also useful in ensuring
there is no shortfall. Encouraging members to take out life memberships, or to
consider making a voluntary donation (either a one-off or as a regular amount) would
be valuable for the organisation.
3.1
If needed, the organisation may seek out more conventional sources of finance,
such as bank overdrafts or bank loans – or even hope a club member could lend the
organisation some money. A club would have to be careful that it could meet the
interest payments due on any borrowed money. If it fails to keep up interest payments
and loan repayments then the existence of the club may be threatened. A club is not
like a business, which may be able to explain why it is currently underperforming
and how it will take steps to improve its financial position. A club that is struggling
financially in the present is unlikely to improve significantly in the future.
SELF-TEST QUESTIONS
1 Identify two types of structural change to a partnership.
2 Explain why it is necessary to revalue the assets of a partnership when a
structural change takes place.
3 Explain one method of placing a value on goodwill.
4 Non-current assets $30 000; current liabilities $8000; purchase price $50 000.
What is the value placed on goodwill?
5 A partnership is dissolved.
a Which account should be debited if a partner takes over the inventory of the
business?
b Which account should be credited if a partner takes over one of the business
vehicles?
6 From the following list, identify the items that could be found on the debit side of a
realisation account:
– bank balance
– non-current assets
– discounts allowed
– partners’ capital account balances
– discounts received
– partners’ current account
– dissolution costs
balances.
– inventory
309
3.1
7 Identify from the list the items that could be found on the credit side of a
realisation account.
8 What is the name given to the summarised cash book of a club?
9 Give one advantage that a club will obtain by running a life membership scheme.
10 Give one disadvantage of running a life membership scheme.
11 How would entrance fees be treated in the financial statements accounts of a club?
3.1 preparatIon of fInanCIal statements
12 What is the name of the capital account of a club?
13 Subscriptions in arrears is a current asset. True/False?
14 Equipment at valuation at the beginning of a year $3 400; equipment at valuation at
the end of a year $2 700. There have been no additions or disposals during the year.
What has caused the $700 difference?
Calculation questions (answers on page 494)
15 Pressman, Woods and Stringer have been in partnership sharing profits equally.
On 31 December 2022, the partners decide that Pressman will reduce his work
commitments and will only take one-fifth profits from 1 January 2023, with Woods
and Stringer still sharing profits equally. At that date, the partners decide to value
goodwill at $12 000. Goodwill will not be kept within the partnership accounts.
At 31 December 2022, the balances on the capital accounts for the partners were:
Pressman
$10 000
Woods
$9 000
Stringer
$5 600
Calculate the balance of the three partners’ capital accounts immediately after the
goodwill has been written off.
16 Use the information below to calculate the value of the accumulated fund at 1
January 2023.
Equipment
Subscriptions owing
$7 600
$85
Subscriptions paid in advance
$112
Café inventory
$290
Café payables
$180
Cash in hand
$92
17 Using the information below, calculate the subscription income for the year ended
31 December 2022.
• At 1 January 2022: Subscriptions paid in advance $40; subscriptions still owing
$23.
• At 31 December 2022: Subscriptions paid in advance $71; subscriptions still
owing $88.
• Subscriptions received in 2022: $840.
3.1.4 Manufacturing businesses
So far, we have prepared the financial statements of traders – business people who have
bought finished goods and sold them on to the final customer. Most of the businesses that
you come into contact with in everyday life fall into the category of trading organisations.
The common factor is that retail outlets buy their products from a manufacturer and
sell them on.
310
We have already produced many statements of profit or loss. Now, we need to prepare
the financial statements of businesses that make goods that are sold to retailers,
who then sell them to members of the general public – in other words, manufacturing
businesses.
3.1
These business organisations prepare manufacturing accounts as part of their
internal financial statements. A manufacturing account shows the costs of running
and maintaining the factory in which a final product is made.
A manufacturing business will also trade by selling its finished product to wholesalers
or retailers, so it will prepare a statement of profit or loss as well as a manufacturing
account.
How to prepare a manufacturing account
Prime cost
Prime costs are direct costs. Examples of direct costs include purchases of direct
materials and direct labour charges. The purchase of wood and paint to make a table
and the wages of the person who assembled the parts of the table are direct costs.
Examples of indirect costs include factory rent, any business rates paid for the factory
and depreciation of factory machinery.
3.1.4 Manufacturing businesses
▲ A manufacturer that
produces clothes
A manufacturing account is split into two main sections showing separately prime
costs and overheads.
The prime cost section shows all the direct expenses incurred in production. The
expenses can be directly and clearly traced to the particular product being produced.
For example, in every pair of trousers that you buy you can see the cloth used, the
thread, buttons and zip. You also know that someone has stitched the pieces together;
they have worked directly on the trousers – their wages are a direct cost. The other
main direct cost is the payment of royalties.
The overheads section includes all other revenue expenditure for a factory that is not
part of prime cost.
EXAMPLE
Hinge & Co. is a manufacturer of cotton clothes and it has the following
expenses:
l sales staff wages
l purchases of cotton
l office heating and lighting expenses
l cotton dyes
l managers’ salaries
l rent of canteen
l weaving machine operatives’ wages.
Among the above expenses, purchases of cotton, cotton dyes and weaving
machine operatives’ wages can be used to prepare the prime cost section of
its manufacturing account. All of these expenses can be easily traced to the
final product.
311
3.1 preparatIon of fInanCIal statements
3.1
The prime cost section of a manufacturing account would contain all the resources
used in the manufacturing process:
»
»
»
»
purchases of raw materials
direct wages
royalties
any other direct costs.
The raw materials used in the manufacturing process are not necessarily the raw
materials purchased, so we have to make an adjustment to the raw material purchase
figure in order to find how many of the raw material purchases were actually used
during the year. The cost of raw materials consumed will cover the purchases of raw
materials, adjusted for any changes in the levels of raw materials inventory, as well as
for returns and carriage inwards on raw materials.
WORKED EXAMPLE 26
Ralph Shoemaker makes footwear. The following information relates to the year
ended 31 March 2021:
l inventory of leather at 1 April 2020 $4790
l purchases of leather during the year $50 790
l inventory of leather at 31 March 2021 $3640.
Required
Calculate the cost of raw materials consumed to make shoes during the year
ended 31 March 2021.
Answer
$
Cost of raw materials consumed:
Inventory 1 April 2020
Purchases of raw materials
4 790
50 790
55 580
Less Inventory 31 March 2021
(3 640)
51 940
A prime cost section can now be prepared.
WORKED EXAMPLE 27
Shavay makes cakes for sale to hotels and restaurants. She provides the
following information for the year ended 30 April 2021:
l inventory of materials at 1 May 2020 $376
l inventory of materials at 30 April 2021 $297
l purchases of materials during the year $58 748
l direct wages $27 380; other wages $16 492.
Required
Prepare a statement showing the prime cost for the year ended 30 April 2021.
312
Answer
Shavay
Statement showing prime costs for the year ended 30 April 2021
$
3.1
$
Cost of raw materials consumed:
Inventory of raw materials 1 May 2020
376
58 748
59 124
Less Inventory of raw materials 30 April 2021
(297)
58 827
Direct wages
27 380
Prime cost
86 207
Note
Only the direct wages have been included. Prime cost lists only the resources
directly used in the production of the cakes, i.e. the flour, butter, sugar, and so
on, plus the wages of the people who work directly on producing the cakes –
the people who mix the ingredients, bake the cakes and decorate them. Office
workers’ wages or sales assistants’ wages are not included – these people do
not work in the factory.
3.1.4 Manufacturing businesses
Purchases of raw materials
Factory overheads
Factory overheads are the expenses incurred in running the factory that cannot be
easily traced to the product.
WORKED EXAMPLE 28
STUDY TIP
Factory overheads
are still connected to
production but not in
a direct manner – they
are known as indirect
costs.
The following list has been prepared by Bhooni Beech, a manufacturer of garden
furniture:
l
l
l
l
l
Purchases of timber
Rent of workshop
Office manager’s wages
Delivery van expenses
Wood glue
l Depreciation of power saws,
l
l
l
l
planes, etc.
Wages of assembly workers
Screws and nails
Bhooni’s drawings
Factory power
Required
Identify which are prime costs and which are factory overheads.
Answer
Purchases of timber, screws and nails, wood glue and wages of assembly
workers can all be identified as prime costs. Rent of workshop, depreciation of
power saws, planes, etc and factory power are all overheads.
Note
Office manager’s wages would appear in the profit and loss account of the
statement of profit or loss, as would delivery van expenses. Bhooni’s drawings
would be deducted from her capital on the statement of financial position.
313
3.1
STUDY TIP
Initially, you might find
it helpful to label the
items PC (prime cost)
or OH (overhead).
The manufacturing account
The manufacturing account will consist of the prime cost and the factory overheads of
the business.
Let us put the prime cost section and the factory overheads together.
3.1 preparatIon of fInanCIal statements
WORKED EXAMPLE 29
The factory manager of Fawcett Products has supplied the following information
for the year ended 30 November 2021.
$
Inventory of raw materials 1 December 2020
90 000
Inventory of raw materials 30 November 2021
80 000
Purchases of raw materials
390 000
Manufacturing wages
212 000
Manufacturing royalties
15 000
Supervisor’s wages
27 000
Factory rent
120 000
Factory insurance
30 000
Depreciation of machinery
17 500
Required
Prepare a manufacturing account for the year ended 30 November 2021.
Answer
Fawcett Products
Manufacturing account for the year ended 30 November 2021
$
$
Cost of material consumed
Inventory of raw materials 1 December 2020
90 000
Purchases of raw materials
390 000
480 000
Less Inventory of raw materials 30 November 2021
(80 000)
400 000
Manufacturing wages
212 000
Royalties
15 000
Prime cost
627 000
Add Factory overheads
Supervisor’s wages
Factory rent
27 000
120 000
Factory insurance
30 000
Depreciation of machinery
17 500
Production cost of goods completed
194 500
821 500
Note
l The most common mistake you can make when preparing a manufacturing
account is to deduct the total overheads from the prime cost. Remember, we
are calculating the total cost of manufacturing a product.
l Always label the prime cost and the production cost – these labels help to
show the high standard of your work.
314
In Chapter 1.5, we saw that carriage inwards was included on the statement of profit
or loss. Carriage inwards always makes purchases more expensive. A manufacturing
business is no exception. Carriage inwards is added to the purchases (of raw materials)
in the manufacturing account.
3.1
WORKED EXAMPLE 30
Purchases of raw materials
Manufacturing wages
Manufacturing royalties
Supervisory wages
Carriage inwards
Rent
Factory power
Other factory overheads
Depreciation of machinery
Depreciation of office equipment
Inventory of raw materials 1 January 2021
Inventory of raw materials 31 December 2021
$000
2 470
1 380
37
87
3
90
30
27
42
13
89
111
3.1.4 Manufacturing businesses
The following balances have been extracted at 31 December 2021 from the
books of Atul Patel, a manufacturer of kitchen furniture:
Additional information
Rent is allocated between the manufacturing and office functions of the business
in a 2:1 ratio.
Required
Prepare a manufacturing account for the year ended 31 December 2021,
showing prime cost and cost of manufacture.
Answer
Atul Patel
Manufacturing account for the year ended 31 December 2021
$000
$000
Cost of material consumed
Inventory of raw materials 1 January 2021
89
Purchases of raw materials
2 470
Carriage inwards
3
2 473
2 562
(111)
Less Inventory of raw materials 31 December 2021
2 451
Manufacturing wages
1 380
Royalties
37
Prime cost
3 868
Add Factory overheads
Supervisory wages
Factory rent
Factory power
Other factory overheads
Depreciation of machinery
Production cost of goods completed
87
60
30
27
42
246
4 114
315
3.1 preparatIon of fInanCIal statements
3.1
Note
Office equipment is not used in the factory – it is an office expense and so should
be entered in the statement of profit or loss. Machinery is always used in the
factory, hence its inclusion in the manufacturing account.
Office rent of $30 000 would be included in the statement of profit or loss as an
expense.
How to account for inventory in manufacturing organisations
In any manufacturing business there are always three kinds of inventory:
» raw materials: As yet these resources are in the factory in the condition in which
they were bought – they have not entered the manufacturing process. Examples of
inventories of raw materials from previous examples would include flour, butter,
leather, wood, etc.
» work in progress: These are partly finished goods; goods that are still undergoing
part of the manufacturing process – cakes waiting to be decorated; partly finished
shoes; partly assembled garden furniture, etc.
» finished goods: These are goods that have completed the journey through the
manufacturing process and are waiting to be sold or despatched to a customer.
Each type of inventory appears in a different part of the financial statements. They
appear in chronological order in the financial statements, i.e. the manufacturing
account and the statement of profit or loss.
Inventories are current assets and are shown in the statement of financial position.
In the case of a manufacturing business, the three types of inventory held have to be
identified.
We have just seen how to treat inventories of raw materials.
You have already worked with inventory of finished goods – in the statement of profit
or loss (a business usually trades with finished goods).
Work in progress still has to go through the remainder of the manufacturing process
before it becomes a finished product, so it should appear in the manufacturing
account. Work in progress appears after the cost of manufacture has been calculated.
The treatment is the same as for all types of inventories. We add the value of work in
progress at the start of the period and deduct the value of work in progress at the end
of the period.
WORKED EXAMPLE 31
Berti Logg is a manufacturer. He provides the following information for the year
ended 31 July 2021:
$
Cost of manufacture
Work in progress 1 August 2020
Work in progress 31 July 2021
217 432
4 698
3 481
Required
Calculate total production costs for the year ended 31 July 2021 for Berti.
316
Answer
$
Cost of manufacture
Add Work in progress 1 August 2020
3.1
217 432
4 698
222 130
Less Work in progress 31 July 2021
(3 481)
218 649
How to prepare a statement of profit or loss and a statement
of financial position
For a manufacturing business, the statement of profit or loss and the statement of
financial position will look very similar to a trading business or a service business. For
a manufacturing business, the main difference in the statement of profit or loss will
be that there is no ‘purchases’ figure. The purchases figure in the statement of profit
or loss will be replaced with the production cost of goods completed, taken as the
final figure in the manufacturing account.
3.1.4 Manufacturing businesses
Production cost of goods completed
On the statement of financial position, the only difference for a manufacturing
organisation is that there will usually be three kinds of inventory appearing within
current assets:
» Raw materials
» Work in progress
» Finished goods.
WORKED EXAMPLE 32
Laurel Choo is a manufacturer. She provides the following information for the year ended 28 February 2021:
$
Inventories at 1 March 2020:
Raw materials
16 500
Work in progress
18 200
Finished goods
20 600
Purchases of raw materials
237 300
Manufacturing wages
458 900
Office salaries
186 200
Factory supervisor’s wages
Carriage inwards
17 800
1 500
Rent:
Factory
14 900
Office
7 200
Depreciation:
Machinery
90 000
Office equipment
21 000
317
3.1
Royalties
7 500
Other indirect expenses:
Factory
32 600
Office
28 400
Sales
1000 000
3.1 preparatIon of fInanCIal statements
Inventories 28 February 2021:
Raw materials
16 000
Work in progress
19 400
Finished goods
21 350
Required
Prepare:
a a manufacturing account for the year ended 28 February 2021
b a calculation of gross profit for the year ended 28 February 2021
c an extract from a statement of financial position at 28 February 2021 showing how inventories would
appear.
Answer
a
Laurel Choo
Manufacturing account for the year ended 28 February 2021
$
$
Cost of material consumed
Inventory of raw materials 1 March 2020
Purchases of raw materials
Carriage inward
16 500
237 300
1 500
255 300
Less Inventory of raw materials 28 February 2021
(16 000)
Manufacturing wages
239 300
458 900
Royalties
7 500
Prime cost
705 700
Add Factory overheads
Supervisor’s wages
17 800
Rent
14 900
Other indirect expenses
32 600
Depreciation – machinery
90 000
Manufacturing cost
Add Work in progress 1 March 2020
155 300
861 000
18 200
879 200
318
Less Work in progress 28 February 2021
(19 400)
Total production cost
859 800
b
Laurel Choo
Extract from statement of profit or loss for the year ended 28 February 2021
$
Revenue
3.1
$
1 000 000
Less cost of sales
20 600
Production cost of goods completed
859 800
880 400
(21 350)
Less closing inventory of finished goods
Gross profit
859 050
140 950
Laurel Choo
c
Extract from statement of financial position at 28 February 2021
$
Current assets
Inventories – Raw materials
3.1.4 Manufacturing businesses
Opening inventory of finished goods
16 000
Work in progress
19 400
Finished goods
21 350
WORKED EXAMPLE 33
Mike Tong is a manufacturer. He provides the following information for the year ended 31 May 2021:
$
Sales
2 913 502
Inventories at 1 June 2020:
Raw materials
49 780
Work in progress
23 640
Finished goods
40 210
Purchases of raw materials
846 289
Direct wages
750 199
Supervisors’ wages
Indirect wages
Royalties
68 720
187 442
19 000
Carriage inwards
4 612
Carriage outwards
5 218
Rent – Factory
48 700
Office
21 300
Insurance – Factory
19 170
Office
10 830
319
3.1
Heating expenses – Factory
4 260
Office
1 830
Factory power
17 282
General expenses
11 342
Depreciation – Factory equipment
48 000
3.1 preparatIon of fInanCIal statements
Office equipment
12 000
Inventories at 31 May 2021:
Raw materials
48 340
Work in progress
20 119
Finished goods
38 461
Note
General expenses are divided between the factory and the office in a 50:50 ratio.
Required
Prepare:
a a manufacturing account for the year ended 31 May 2021
b a calculation of gross profit for the year ended 31 May 2021.
Answer
a
Mike Tong
Manufacturing account for the year ended 31 May 2021
$
$
Cost of material consumed
Inventory of raw materials 1 June 2020
Purchases of raw materials
Carriage inwards
49 780
846 289
4 612
900 681
Less Inventory of raw materials 31 May 2021
(48 340)
Direct wages
852 341
750 199
Royalties
19 000
Prime cost
1 621 540
Add Factory overheads:
Indirect wages
187 442
Supervisors’ wages
68 720
Rent
48 700
Insurance
19 170
Heating expenses
Power
General expenses (50% × $11 342)
Depreciation
4 260
17 282
5 671
48 000
399 245
2 020 785
Add Work in progress 1 June 2020
23 640
2 044 425
Less Work in progress 31 May 2021
Production cost of goods completed
320
(20 119)
2 024 306
b
Mike Tong
3.1
Extract from statement of profit or loss for the year ended 31 May 2021
$
Revenue
$
2 913 502
Less cost of sales
Inventory of finished goods 1 June 2020
Production cost of goods completed
40 210
2 024 306
Less Inventory of finished goods 31 May 2021
Gross profit
(38 461)
2 026 055
887 447
Often an expense will be split between the manufacturing section of the business and
the non-manufacturing section. The non-manufacturing costs are often referred to as
‘office’ expenses. If an expense is divided between sections, you should ensure that
it appears in both the manufacturing account and also in the expenses section of the
statement of profit or loss.
3.1.4 Manufacturing businesses
2 064 516
If an expense (or income) has to be adjusted for accruals or prepayments, then you
should always make the adjustment first before dividing up the item.
The purpose of factory profit on manufacturing and how to
account for it
Sometimes the managers of a business will wish to gauge how efficiently their factory
is operating. They compare the price that the goods cost to produce in their factory
with the cost of purchasing the same goods from an ‘outside’ supplier. If it would be
cheaper to purchase the goods externally then it may be in the best interest of the
business to cease manufacturing and purchase the goods.
When the managers of a business transfer the total production cost to the statement
of profit or loss, gross profit is found by deducting the cost of sales from sales
revenue. The problem with this method is that there is no indication from the gross
profit of how profitable the factory is when producing output. Gross profit in a
manufacturing business is derived in two ways:
» by manufacturing efficiently
» by selling the goods at a price that is higher than the production cost.
We can determine the factory manufacturing profit by finding the difference between
the cost of production and the cost of purchasing the goods externally (i.e. the
savings that have been made by producing rather than purchasing inventory). Hence,
factory profit is a method of showing where the overall profit of a manufacturing
business is actually generated – in production or in the trading part of the business.
Let us look at the manufacturing accounts of Laurel Choo and Mike Tong that we
produced earlier.
321
3.1 preparatIon of fInanCIal statements
3.1
WORKED EXAMPLE 34
The same number of goods made in Laurel’s factory could be purchased by
Laurel’s buying department for $900 000.
Required
Prepare:
a a summarised manufacturing account for the year ended 28 February 2021
showing the manufacturing profit
b a calculation of gross and factory profit for the year ended 28 February 2021.
Answer
a
Laurel Choo
Summarised manufacturing account for the year ended 28 February 2021
$
Prime cost
705 700
Add Overheads
155 300
Add Work in progress 1 March 2020
18 200
879 200
Less Work in progress 28 February 2021
(19 400)
Production cost of goods completed
859 800
Factory profit
40 200
Transfer price to statement of profit or loss
b
900 000
Laurel Choo
Extract from statement of profit or loss for the year ended 28 February 2021
$
Revenue
$
1 000 000
Less cost of sales
Inventory of finished goods 1 March 2020
Transfer price of manufactured goods
20 600
900 000
920 600
Less Inventory of finished goods on 28 February 2021
Gross profit
Factory profit
(21 350)
899 250
100 750
40 200
140 950
322
WORKED EXAMPLE 35
Mike Tong’s buying department could purchase the same number of goods made
in his factory for $2.5 million.
3.1.4 Manufacturing businesses
Required
Prepare:
a a summarised manufacturing account for the year ended 31 May 2021
b a calculation of gross and factory profit for the year ended 31 May 2021.
Answer
a
Mike Tong
Summarised manufacturing account for the year ended 31 May 2021
$
Prime cost
1 621 540
399 245
Add Overheads
2 020 785
Add Work in progress 1 June 2020
3.1
23 640
2 044 425
(20 119)
Less Work in progress 31 May 2021
Production cost of goods completed
2 024 306
Factory profit
475 694
Transfer price to statement of profit or loss
b
2 500 000
Mike Tong
Extract from statement of profit or loss for the year ended 31 May 2021
$
Revenue
$
2 913 502
Less Cost of sales
Inventory of finished goods 1 June 2020
Transfer price of manufactured goods
40 210
2 500 000
2 540 210
Less Inventory of finished goods on 31 May 2021
(38 461)
2 501 749
Gross profit
411 753
Factory profit
475 694
887 447
Rather than showing the factory profit as the difference between the manufacturing
cost and the external price, it is normal to show the factory profit as a percentage
mark-up on the cost of manufacturing goods, as calculated in the manufacturing
account.
323
3.1
WORKED EXAMPLE 36
Olga Stravinska is a manufacturer. The following information relates to her
business at 31 October 2021:
3.1 preparatIon of fInanCIal statements
Production cost of goods completed $348 700; inventory of finished goods at
1 November 2020 $37 498; inventory of finished goods at 31 October 2021
$39 613; sales for the year $598 136
Olga transfers goods from her factory to the statement of profit or loss at cost plus
20%
Required
Prepare:
a an extract from the manufacturing account
b the statement of profit or loss for the year ended 31 October 2021, showing
both the gross profit and the factory profit of the business.
Answer
a
Olga Stravinska
Extract from manufacturing account for the year ended 31 October 2021
$
Production cost of goods
completed
348 700
Factory profit
69 740
Transfer price
418 440
b
($348 700 × 20%)
Olga Stravinska
Extract from statement of profit or loss for the year ended 31 October 2021
$
Revenue
$
598 136
Cost of sales
Inventory of finished goods 1 November 2020
Transfer price of manufactured goods
37 498
418 440
455 938
Less Inventory of finished goods on 31 October 2021
Gross profit
Factory profit
(39 613)
416 325
181 811
69 740
251 551
Once the factory profit has been added on to the gross profit (it is not part of gross
profit) then the remainder of the statement of profit or loss would appear as normal
(i.e. as it would for a trading business).
324
Elimination of unrealised profit from unsold inventory
The overriding principle that governs all inventory valuations is that all goods should
be valued at the lower of cost and net realisable value because it is prudent.
3.1
This does not pose a problem with raw materials or work in progress. It can cause a
problem with finished goods, however.
There is no problem if the finished goods are passed to the warehouse at their cost
price. Like raw materials and work in progress, the finished goods would be valued at
cost or their realisable value if this was lower than cost.
A problem does arise when finished goods are passed from the factory at cost price
plus a profit margin.
We stated above that inventories should be valued at cost if cost is less than net
realisable value – not at cost and some factory profit.
If goods are valued at cost plus some factory profit we need to get rid of the
factory profit because it has not yet been earned – we need to find the cost price of
the goods.
3.1.4 Manufacturing businesses
Finished goods are stored in a warehouse ready for sale or ready to be despatched to
a customer. In all probability, some of these finished goods will be left unsold at the
end of the financial year, so we need to know how these goods should be valued.
WORKED EXAMPLE 37
Mougli Godin manufactures printed circuits. He passes the goods from his
factory at cost plus 25%. At his financial year end, his inventory of finished goods
is valued at $250 000.
Required
Calculate the cost price of Mougli’s closing inventory to be entered in the
business statement of financial position.
Answer
The cost price of the closing inventory of finished goods is $200 000.
25%
25%
25%
25%
25%
25%
25%
25%
=
125% of cost
=
$250 000
+
25%
=
$250 000
25%
So
100
of $250 000
125
+
25
of $250 000
125
=
$250 000
$200 000
+
$50 000
=
$250 000
325
WORKED EXAMPLE 38
3.1
Siobhan O’Riley manufactures generators. The finished generators are
transferred to a statement of profit or loss at cost price plus 10%. At her
financial year end Siobhan’s inventory of finished goods is valued at $385 000.
3.1 preparatIon of fInanCIal statements
Required
Calculate the cost price of Siobhan’s closing inventory of finished goods as it
would be shown in a statement of financial position prepared at the end of the
financial year.
Answer
The closing inventory of finished generators should be valued at $350 000.
10% 10% 10% 10% 10%
10%
=
110% of cost
=
$385 000
10% 10% 10% 10% 10%
10% 10% 10% 10% 10%
+
10%
=
$385 000
100
of $385 000
110
+
10
of $385 000
110
=
$385 000
$350 000
+
$35 000
=
$385 000
10% 10% 10% 10% 10%
So
If the value of inventory is increased by the profit element, then the gross profit and
hence the profit for the year will be increased by the same amount.
The closing inventory of finished goods has yet to be sold, so we are anticipating the
earning of profit that has not yet been realised.
Remember
If we are marking up
inventory with factory
profit, then subtracting
the same percentage
from the value of the
inventory will not get
you back to the original
value before you added
on the mark-up.
326
The concept of prudence tells us that we should not do this. We need to remove the
profit element from our financial statements. We do this by creating a provision for
unrealised profit.
The provision for unrealised profit account appears similar to the provision for
depreciation account used to record depreciation of non-current assets. You may
recall that there is a credit balance on provision accounts and this is increased (or
decreased) with further credit (or debit) entries to the account. Any increase in the
provision will appear as an expense in that period’s statement of profit or loss. The
full provision would appear on the statement of financial position (and would be
subtracted from the value of the relevant asset.
Learning link
Provision accounts
were first covered in
Chapter 1.3.
The balance on a provision for unrealised profit account is shown in the statement of
financial position as a deduction from the closing inventory of finished goods, thus
ensuring that the inventory appears in the statement of financial position at cost
price. The amount shown in the provision account described as ‘statement of profit or
loss’ ($150) is deducted from the gross profit on manufacturing in the statement of
profit or loss.
3.1
WORKED EXAMPLE 39
Required
Prepare a provision for unrealised profit account showing clearly the amount to be transferred to the
statement of profit or loss.
Answer
Provision for unrealised profit
$
2020
Apr 1
2021
Mar 31
3.1.4 Manufacturing businesses
Paquito plc transfers manufactured goods to its statement of profit or loss at cost plus 30%. The balance
brought down in the provision for unrealised profit account at 1 April 2020 is $1 300. Inventory of finished
goods is valued at $6 500 on 31 March 2021.
$
Balance b/d
1 300
2021
Balance c/d
1 500
Mar 31
Statement of profit
or loss
1 500
200 Missing figure to be deducted from
gross profit on manufacture in
statement of profit or loss
1 500
Apr 1
Balance b/d
1 500 ($6500 × 30 ÷ 130)
The opening and closing values for inventory of finished goods will be used to
calculate the opening and closing balances on this provision account. In this case, it
is the change between these opening and closing balances that is adjusted for by the
entry in the statement of profit or loss.
WORKED EXAMPLE 40
Celine marks up the goods manufactured in her factory by 35% to transfer them to a statement of profit or
loss. Her inventory of finished goods on 1 March 2020 was $9450. Her inventory of finished goods one year
later on 28 February 2021 was $9720.
Required
Prepare a provision for unrealised profit account for the year ended 28 February 2021.
327
3.1
Answer
Provision for unrealised profit
$
$
2020
Balance b/d
2 450 ($9450 × 35% ÷ 135%)
Mar 1
3.1 preparatIon of fInanCIal statements
2021
Feb 28
2021
Balance c/d
2 520
Feb 28
Statement of
profit or loss
2 520
70 Missing Statement of profit or
loss figure
2 520
Mar 1
Balance b/d
2 520 ($9720 × 35% ÷ 135%)
WORKED EXAMPLE 41
Bertoli manufactures washing machines. They are transferred to a statement of profit or loss at cost plus
60%. The inventory of finished washing machines at 1 June 2020 was $57 600; at 31 May 2021 it was $60 160.
Required
Prepare a provision for unrealised profit account showing the amount to be transferred to a statement of
profit or loss for the year ended 31 May 2021.
Answer
Provision for unrealised profit
$
$
2020
Jun 1
2021
May 31
Balance b/d
21 600 ($57 600 × 60% ÷ 160%)
2021
Balance c/d
22 560
May 31
Statement of profit or
loss
22 560
960 Missing figure
22 560
Jun 1
Balance b/d
22 560 ($60 160 × 60% ÷ 160%)
Like all provision accounts, it is possible that the provision at the end of the financial
year could be less than the provision brought down at the start of the financial year.
In such cases, the amount transferred to a statement of profit or loss would be added
to the gross profit on manufacture shown in the statement of profit or loss.
WORKED EXAMPLE 42
Chin manufactures woks. The finished woks are transferred to her statement of profit or loss at cost price
plus 50%. The inventory of finished woks at 1 November 2020 was $4500. The inventory of finished woks at
31 October 2021 was $3900.
Required
Prepare a provision for unrealised profit account showing clearly the amount to be transferred to a
statement of profit or loss for the year ended 31 October 2021.
328
Answer
3.1
Provision for unrealised profit
$
Missing figure 2021
added to GP
Oct 31
$
2020
Statement of
profit or loss
Nov 1
1 300
2021
Balance b/d
1 500 ($4500 × 50% ÷ 150%)
1 500
1 500
Nov 1
Balance b/d
1 300 ($3900 × 50% ÷ 150%)
Finally, let us see how the relevant figures are dealt with in a statement of profit or
loss.
WORKED EXAMPLE 43
Matisse manufactures lawnmowers. He transfers finished goods from the factory to his statement of profit
or loss at cost plus 30%. He provides the following information for the financial year ended 30 September
2021:
3.1.4 Manufacturing businesses
Balance c/d
200
$
Total production at cost price
76 500
Inventory of finished goods 1 October 2020
6 045
Inventory of finished goods 30 September 2021
6 864
Sales for the year ended 30 September 2021
210 000
Required
a Calculate the transfer price of goods manufactured for inclusion in a statement of profit or loss for the
year ended 30 September 2021.
b Prepare a statement of profit or loss for the year ended 30 September 2021 showing the transfer.
c Prepare a provision for unrealised profit account for the year.
d Prepare an extract from a statement of profit or loss for the year ended 30 September 2021 showing total
gross profit and the treatment of the provision for unrealised profit.
e Prepare an extract from a statement of financial position at 30 September 2021 showing how the
inventory of finished goods is treated.
Answer
a Transfer price is $99 450: production cost $76 500 plus $22 950 ($76 500 × 30%).
b
Matisse
Extract from statement of profit or loss for the year ended 30 September 2021
$
Revenue
$
210 000
Less cost of sales
Inventory at 1 October 2020
Production cost of goods completed
6 045
99 450 ($76 500 × 130%)
105 495
Less inventory at 30 September 2021
Gross profit
(6 864)
98 631
111 369
329
c
Provision for unrealised profit
3.1
$
$
2020
Oct 1
2021
Sep 30
Balance b/d
1 395 ($6045 × 30% ÷ 130%)
2021
Balance c/d
1 584
Sep 30
Statement of profit or loss
Oct 1
Balance b/d
3.1 preparatIon of fInanCIal statements
1 584
d
189 Missing figure
1 584
1 584 ($6864 × 30% ÷ 130%)
Matisse
Extract from statement of profit or loss for the year ended 30 September 2021
$
$
Gross profit
111 369
Factory profit (from part a)
22 950
Less Provision for unrealised profit
(189)
22 761
134 130
e
Matisse
Extract from statement of financial position at 30 September 2021
Current assets
Inventory of finished goods
Less Provision for unrealised profit
$
$
6 864
(1 584)
5 280
WORKED EXAMPLE 44
Rawstric manufactures bedroom furniture. He transfers finished goods from his factory to his statement of
profit or loss at cost plus 70%. He provides the following information for the year ended 31 December 2021:
$
Sales for the year ended 31 December 2021
974 000
Total production at cost price
476 400
Inventory of finished goods 1 January 2021
10 540
Inventory of finished goods 31 December 2020
15 980
Required
a
b
c
d
Calculate the transfer price of goods manufactured for inclusion in a statement of profit or loss.
Prepare an extract from the statement of profit or loss for the year ended 31 December 2021.
Prepare a provision for unrealised profit account for the year.
Prepare an extract from the statement of profit or loss for the year ended 31 December
2021 showing total gross profit and the treatment of the provision for unrealised profit.
e Prepare an extract from a statement of financial position at 31 December 2021 to show how the inventory
of finished goods is treated.
Answer
a Transfer price $809 880: production cost $476 400 plus $333 480 ($476 400 × 70%).
330
b
Rawstric
Extract from statement of profit or loss for the year ended 31 December 2021
$
Revenue
3.1
$
974 000
Cost of sales
Inventory at 1 January 2021
10 540
809 880
Inventory at 31 December 2021
(15 980)
820 420
Gross profit
c
804 440
169 560
Provision for unrealised profit
$
2021
Dec 31
$
2021
Balance c/d 6 580
Jan 1
Balance b/d
4 340 ($10 540 × 70% ÷ 170%)
Dec 31
Statement of profit
or loss
2 240
6 580
3.1.4 Manufacturing businesses
Production cost of goods completed
6 580
2022
Jan 1
d
Balance b/d
6 580 ($15 980 × 70% ÷ 170%)
Rawstric
Extract from statement of profit or loss for the year ended 31 December 2021
$
$
Gross profit
169 560
Factory profit
333 480
Less Provision for unrealised profit
(2 240)
331 240
500 800
e
Rawstric
Extract from statement of financial position at 31 December 2021
Current assets
$
$
Inventory of finished goods
15 980
Less Provision for unrealised profit
(6 580)
9 400
SELF-TEST QUESTIONS
1 Identify two costs that would be included in the calculation of prime cost.
2 Identify two expenses incurred by a manufacturing business that would be
included as factory overheads.
3 A factory produces rice noodles. Which section of a manufacturing account would
you expect to find the wages of the owner’s personal assistant?
331
4 Identify two costs that would be included in the calculation of prime cost.
3.1
5 Name the three types of inventory generally held by a manufacturing business.
6 Define the terms ‘direct costs’ and 'indirect costs'.
7 Why might a manufacturing business transfer goods to a statement of profit or
loss at a price exceeding total production cost?
3.1 preparatIon of fInanCIal statements
8 Why is there a need to make provision for unrealised profit?
9 From which type of inventory is the provision for unrealised profit deducted in a
statement of financial position of a manufacturing business?
Calculation question (answer on page 494)
10 The following data is available:
• Inventory of finished goods at 1 January 2022: $49 280
• Inventory of finished goods at 31 December 2022: $45 780
It is company policy to transfer goods from the manufacturing account to the
statement of profit or loss at cost plus 40%. The provision for unrealised profit on
unsold inventory at 1 January 2022 was $14 080.
Calculate the amount to be included in the statement of profit or loss to deal with
the adjustment on the provision for unrealised profit.
3.1.5 Limited companies
We saw in Chapter 1.5 that the owners of a limited company are the shareholders. We
have also said that directors conduct the everyday management of a limited company.
Control of a limited company is therefore separate from the ownership. The UK
Companies Act 2006 requires the directors to report regularly to the shareholders on
the way that they have managed the company on the shareholders’ behalf. This is an
example of the stewardship function of accounting.
The financial statements must be approved by the board of directors and signed by
one of the directors on behalf of the board before they are filed.
The Act requires that five documents must be published annually – these are known
as the statutory accounts. The statutory accounts are produced in accordance with
company law and must be filed with the Registrar of Companies. The documents that
make up the statutory accounts are:
»
»
»
»
»
a statement of profit or loss
a statement of financial position
a statement of cash flows
a directors’ report
an auditor’s report.
The annual return is filed with the Registrar of Companies and may be examined by
any member of the general public.
Legislation requires every company to send a copy of the corporate report to:
» every shareholder
» every debenture holder
» all other persons entitled to receive copies.
The financial statements must be sent not less than 21 days before the Annual General
Meeting (AGM).
332
In addition to the statutory accounts, the corporate report will contain notes to the
accounts and a statement of the accounting policies that have been applied in the
preparation of the accounts.
3.1
The Companies Act 1985 requires that the financial statements give a true and fair
view of the financial state of the company during the year covered by the statements.
Directors are responsible for ensuring that the provisions of the Companies Act 1985 are
adhered to. The directors must also ensure that the financial statements are prepared in
accordance with International Accounting Standards (IAS).
» details of all transactions involving money
» a record of all the company’s assets and liabilities, including details of inventories
held at the financial year end.
The directors must also ensure that the records:
» show and explain the company’s financial transactions
» disclose the financial position of the company with reasonable accuracy
» enable the directors to be confident that the statement of profit or loss and the
statement of financial position show a true and fair view of the company’s financial
position.
3.1.5 Limited companies
The directors must ensure that the company’s accounting records contain:
IAS 1 details how a company’s financial statements should be presented. This is
intended to ensure comparability with previous accounting periods and with other
businesses. Details of the standards used in the preparation of the statutory accounts
and the corporate report are given later in this chapter.
The compliance to the Companies Acts and the international standards should ensure that
the information contained in the published accounts is presented fairly and without bias.
IAS 1 requires that all companies must make a statement in the notes to the accounts
stating that the accounts do comply with the standards. Any departure from applying
standards must be noted and reasons for such deviation explained. (A departure from the
application of standards may be necessary in order to achieve a fair presentation.)
Standards have been introduced to provide a framework for the production of
accounting information in order to reduce the subjective elements that could be evident
if company directors had free licence to produce accounting information in a format
of their own choosing. The standards help to increase the uniformity in presentation.
So, the standards are the ‘ground rules’ that apply to the preparation of the published
accounts of limited companies and to the audit of those accounts. This ensures that the
standards that apply in Canberra are the same as those applied in Canton.
The financial statements that a limited company produces are used by the directors
and managers for decision-making purposes. They contain much useful detail. If
those same accounts were published in this form, competitors might gain access to
information that could be used to undermine the company.
So, although legally the shareholders, lenders and others must be sent a copy of
the financial statements, the law protects the company by allowing it to publish an
‘abridged’ version that contains much less detail.
The financial statements that are published are incorporated into an annual report.
IAS 1 states that a complete set of financial statements must include:
»
»
»
»
»
a statement of profit or loss
a statement of financial position
a statement of cash flows
a statement of changes in equity
notes on accounting policies and explanatory notes on items in the statements.
333
3.1
In addition, financial statements will include:
» a statement from the chairperson
» a directors’ report
» an auditors’ report.
You may obtain copies of company reports by writing to the registered office of the
company or you may visit the company website.
3.1 preparatIon of fInanCIal statements
Notes on accounting policies
The notes on accounting policies will explain the accounting policies used to prepare the
accounting statements and will show details of the figures published in the statement of
profit or loss, the statement of financial position and statement of cash flows. They will
cover items such as: turnover, depreciation policy, treatment of goodwill, etc.
The chairperson’s statement
The statement from the chairperson will give a brief review of the company’s progress
over the past year. It may indicate future developments in the company while
evaluating current developments.
The directors’ report
The directors’ report will consist of a review of the period covered by the financial
statements, commenting on results and dividend policies. It will outline company
employment policy, paying particular attention to equal opportunities and policies
on the employment of people with disabilities. It provides a list of directors and their
interest in the company, together with any share options. The report itemises political
and charitable donations, health and safety policy, and provides an insight into future
developments for the company.
The auditors’ report
The auditors’ report is a legal requirement. The report sets out the respective
responsibilities of directors and auditors. The report makes a statement on the basis
of the audit opinion (how the audit was planned and conducted) and then gives the
auditors’ opinion stating whether the financial statements present a ‘true and fair view’
of the company’s activities over the financial period covered by the financial statements.
How to prepare for a limited company in line with the relevant
international accounting standards and legal requirements
Statement of profit or loss
The layout of the statement of profit or loss for external publication is set out in
IAS 1. The contents of this accounting standard will be covered later.
Although much of the detail of all expenses does not need to be shown in the
statement of profit or loss of a company, certain items must be disclosed:
»
»
»
»
revenue
finance costs
tax expense
profit or loss for the period attributable to equity holders.
In reality, you would be required to show more detail. Indeed, more information is
needed to make the statement of profit or loss understandable.
334
WORKED EXAMPLE 45
The following information is available for Sonuk plc for the year ended
31 August 2021:
3.1
$000
Administrative expenses
173
Debenture interest paid
28
158
Ordinary dividends paid
48
Inventories – 1 September 2020
32
31 August 2021
28
Purchases
243
Retained earnings at 1 September 2020
623
Revaluation reserve at 1 September 2020
470
Sales
900
Sales returns
3.1.5 Limited companies
Distribution costs
12
The directors wish to make a provision for corporation tax of $69 000.
Required
Prepare a statement of profit or loss for the year ended 31 August 2021.
Answer
Sonuk plc
Statement of profit or loss for the year ended 31 August 2021
$000
Revenue
Cost of sales
888 Sales less sales returns
(247) Opening inventory plus purchases less closing
inventory
Gross profit
641
Distribution costs
(158) Warehouse costs plus cost of getting goods to
customers
Administrative expenses
(173) Costs of maintaining and running the offices
Profit from operations
310
Finance costs
(28) Interest paid
Profit before tax
282
Tax
(69)
Profit for the year
213
Statement of financial position
IAS 1 states the items that must be shown as a minimum in the statement of financial
position. These include:
»
»
»
»
»
»
intangible assets
property, plant and equipment
investment property
financial assets
investments
inventories
335
3.1 preparatIon of fInanCIal statements
3.1
»
»
»
»
»
»
»
»
trade receivables and other receivables
cash and cash equivalents
trade payables and other payables
provisions
financial liabilities
tax liabilities
issued capital
reserves.
Current assets and non-current assets
Current assets comprise:
» cash and cash equivalents
» assets that will be disposed of within the next financial year; examples are
inventories, trade receivables and cash and cash equivalents.
All other assets are classified as non-current assets.
Current liabilities and non-current liabilities
Current liabilities comprise liabilities that are expected to be settled within the next
financial year; examples are trade payables, tax liabilities and bank overdrafts (shown
as short-term borrowing and cash equivalents).
All other liabilities are non-current liabilities.
Equity
The following details must be shown either as part of the statement of financial
position or in the notes to the financial statements:
» the number of shares issued and fully paid
» the number of shares issued and not fully paid
» the nominal value of the shares.
All shares of a permanent nature are classified as equity, so equity comprises ordinary
shares and reserves.
Reserves
A list of all the reserves created is shown either on the face of the statement of
financial position or as a note to the financial statements. If the detailed list of
reserves is shown as a note, then the total of all reserves is shown on the face of the
statement of financial position.
WORKED EXAMPLE 46
The directors of Nivlan plc provide the following information at 31 July 2021:
Cash and cash equivalents
Goodwill
Inventories at 31 July 2021
Issued share capital
Property, plant and equipment
Retained earnings
Revaluation reserve
Share premium account
Trade payables and other payables
Trade receivables and other receivables
9% debentures (repayable 2035)
336
$000
142
150
896
3 000
8 760
2 298
1 500
1 000
587
779
2 000
The directors have made a provision for corporation tax of $342 000.
3.1
Required
Prepare a statement of financial position at 31 July 2021.
Answer
ASSETS
Goodwill
Non-current assets
Property, plant and equipment
Current assets
Inventories
Trade receivables and other receivables
Cash and cash equivalents
Total assets
150
8 760
896
779
142
EQUITY AND LIABILITIES
Equity
Issued share capital
Share premium account
Revaluation reserve
Retained earnings
Non-current liabilities
9% debentures (2034)
Current liabilities
Trade payables and other payables
Tax liability
Total equity and liabilities
$000
8 910
3.1.5 Limited companies
Nivlan plc
Statement of financial position at 31 July 2021
$000
1 817
10 727
3 000
1 000
1 500
2 298
7 798
2 000
587
342
929
10 727
Statement of cash flows
Limited companies must prepare financial statements that adhere to international
accounting standards. Although countries will have their own laws and rules governing
how financial statements are to be constructed, the differences in these laws are not
as big as you might think. Apart from the USA, which has its own set of accounting
standards, many other countries follow the same accounting standards as set by the
International Accounting Standards Board.
STUDY TIP
Make sure you
understand the
format for cash flow
statements as set out
in IAS 7.
All but the smallest limited companies are required to prepare a statement of cash
flows using the format dictated in IAS 7. This ensures that businesses report their
cash generation and cash absorption in a way that makes the statements comparable
with other businesses.
Uses of statements of cash flows
What are the uses of a statement of cash flows?
» The statement highlights and concentrates on cash inflows and cash outflows.
» Liquidity is important for the short-term survival of all businesses; this is of great
interest to trade payables, investors (potential investors and current shareholders),
workers, etc.
337
3.1 preparatIon of fInanCIal statements
3.1
» The statement provides information that enables users to assess the efficiency
or inefficiency of how cash and cash equivalents have been used during the
financial period.
» The statement explains why profits and losses are different from changes in cash
and cash equivalents.
» The statement shows sources of internal financing and the extent to which the
business has relied on external financing. It reveals information that is not
disclosed in the statement of profit or loss. This helps in financial planning.
» It provides information that helps to assess the liquidity, viability and financial
adaptability of the business.
» It allows comparisons to be made year on year or between businesses. This is
facilitated by the prescribed format. But do remember, when making comparisons,
that the statement is a historical document. The statement is prepared using
figures from the previous financial year.
» It helps provide information that will assist in the projection of future cash flows.
Transactions that result in cash inflows and cash outflows
IAS 7 requires that companies prepare a statement of cash flows in the format
described in the standard. A statement of cash flows should be included with the
other published financial statements.
The standard requires an adjustment to profit from operations in order to calculate the
cash flow generated from operating activities.
So, the statement of cash flows should include all inflows and outflows from the
business involving cash. Any transactions that do not involve cash should not appear
in the statement.
▼ Table 3.1.1 Examples of transactions that result in cash inflows and cash outflows
Cash inflows
Cash outflows
Profits
Losses
Interest received
Interest paid
Investment income received
Dividends received
Dividends paid
Tax refund
Taxation paid
Sale of non-current assets
Purchase of non-current assets
Decrease in inventory
Increase in inventory
Decrease in trade receivables
Increase in trade receivables
Increase in trade payables
Decrease in trade payables
Increase in share capital
Redemption of share capital
Increase in debentures
Redemption of debentures
Increase in long term loans
Repayment of long-term loans
The IAS 7 headings
IAS 7 ‘Statement of cash flows’ requires that cash flows should be analysed under
three headings:
» operating activities
» investing activities
» financing activities.
The standard provides a template using the three headings.
338
Operating activities
Cash flows from operating activities are the cash inflows and outflows resulting from
operating or trading activities. They are the main revenue producing activities of the
company.
3.1
Using the indirect method of preparing a statement of cash flows means that we have
to adjust the profit or loss for the year since this figure has been calculated using the
accruals basis of preparation.
»
»
»
»
»
»
add depreciation for the year (and any amortisation of goodwill)
add losses on sales of non-current assets
deduct profits on sales of non-current assets
add decrease in inventory (or deduct decrease in inventory)
add decrease in trade receivables (or deduct increase in trade receivables)
add increase in trade payables (or deduct decrease in trade payables).
3.1.5 Limited companies
The calculation is done using the profit from operations (that is, profit for the year
before deduction of tax and interest). So, the operating cash flows section of the
statement contains the following adjustments:
These adjustments to the profit from operations gives the cash (used in)/from operations.
Two further adjustments are necessary:
» deduct interest paid during the year
» deduct taxation paid during the year.
The result is the net cash (used in)/from operating activities.
Investing activities
Investing activities are inflows and outflows of cash resulting from the acquisition and
disposal of non-current assets (but not cash equivalents) and investments.
» Cash inflows include receipts from the sale or disposal of all types of non-current
assets.
» Cash outflows include payments to acquire all types of non-current assets.
Financing activities
Financing activities are activities that change the equity capital or long-term
borrowing structure of the company. They are the result of receipts from and payments
to external providers of finance.
» Cash inflows include receipts from share issues or issues of debentures; also
receipts from other long-term borrowings (but not overdrafts).
» Cash outflows include dividends paid and payments to redeem shares and the
repayment of long-term loans.
Calculation of profit from operations
Profit from operations is the profit for the year calculated before tax and interest.
WORKED EXAMPLE 47
The following information is given for the year ended 31 July 2021 for Schmidt plc:
$000
Profit before tax (interest paid $60)
Tax liability
212
70
339
3.1
Required
Prepare an extract from the statement of profit or loss showing clearly the
profit from operations, profit before tax and the profit for the year.
3.1 preparatIon of fInanCIal statements
Answer
Schmidt plc
Extract from statement of profit or loss for the year ended 31 July 2021
$000
Profit from operations
272
Less Interest paid
(60)
Profit before tax
212
(70)
Tax
Profit for the year
142
WORKED EXAMPLE 48
The following extracts are taken from the statements of financial position of
Ocset plc at 31 December:
Current liabilities
Tax liability
Equity
Ordinary shares
General reserve
Retained earnings
2021
$000
2020
$000
(120)
(168)
2 500
400
1 662
2 500
350
1 346
During the year ended 31 December 2021, debenture interest paid amounted to
$78 000. Dividends amounting to $150 000 were paid.
Required
Calculate the profit from operations for the year ended 31 December 2021.
Answer
$000
Increase in retained earnings over the year
Add Provision for taxation
Debenture interest paid
Transfer to general reserve
Dividends paid
Profit from operations
340
120
78
50
150
$000
316
398
714
Extracts from the financial statements would have shown:
Extract from statement of changes in equity
$000
Retained earnings
Balance at 1 January 2021
1 346
Profit for the year
516
1 862
Dividends paid
(150)
Transfer to general reserve
(50)
1 662
Balance at 31 December 2021
General reserve
Balance at 1 January 2021
350
Transfer for the year
50
Balance at 31 December 2021
400
3.1
3.1.5 Limited companies
Extract from statement of profit or loss for the year ended 31 December 2021
$000
Profit from operations
714
Less Debenture interest
(78)
636
Tax
(120)
Profit for the year
516
Calculation of cash flows created by depreciation of non-current assets
In some cases, the calculation of cash flows created by the provision of depreciation
of non-current assets is straightforward. It involves comparing the accumulated
depreciation at the start of the financial year with the accumulated depreciation
at the end of the year.
The resulting amount should then be added to the profit from operations.
WORKED EXAMPLE 49
The following extracts have been taken from the statements of financial position
of Beta and Bigga plc:
31 July 2021
$000
$000
31 July 2020
$000
$000
ASSETS
Non-current assets
Premises
Less Accumulated depreciation
Machinery
Less Accumulated depreciation
Office equipment
2 500
(1 850)
2 500
650
1 830
(1 281)
(369)
Vehicles
1 100
Less Accumulated depreciation
(855)
700
1830
549
611
Less Accumulated depreciation
(1 800)
(1 098)
732
611
242
(308)
303
1100
245
(630)
470
341
3.1
Required
Calculate:
a the charge to be added for depreciation for the year ended 31 July 2021 for
each non-current asset
b the amount to be included in the statement of cash flows for the year ended
31 July 2021.
3.1 preparatIon of fInanCIal statements
Answer
a
$
Charge for depreciation for the year – Premises
Machinery
Office equipment
Vehicles
50 000
183 000
61 000
225 000
b The amount to be added to the profit from operations under the heading of
‘operating activities’ is $519 000.
Calculation of cash flows resulting from the disposal of non-current assets
(derecognition)
WORKED EXAMPLE 50
The following is an extract from the statements of financial position of Nepps
plc at 30 April:
Non-current assets at cost
Less Depreciation
2021
2020
$000
$000
2 573
2 332
(1 238)
(1 021)
1 335
1 311
During the year ended 30 April 2021, non-current assets which had cost $720 000
were sold for $274 000. The assets sold had been depreciated by $433 000.
Required
Identify any cash flows resulting from the sale of non-current assets.
Workings
The ledger accounts are constructed here as part of the working. Note though
that dates have not been included as they are not necessary to understand what
is happening.
Journal entries are given to help you with the timing of each entry:
Non-current assets account
$000
Balance b/d
2 322
Disposal
Missing figure
1 171
Balance c/d
3 293
Balance b/d
342
$000
2 573
720
2 573
3 293
Provision for depreciation of non-current assets account
$000
Disposal account
433
Balance c/d
1 238
$000
Balance b/d
1 021
Missing figure
650
1 671
1 671
Balance b/d
1 238
$000
720
$000
Provision for depreciation
of non-current assets
433
Bank
274
Statement of profit or
loss
13
720
3.1.5 Limited companies
Non-current assets disposal account
Non-current assets
3.1
720
Journal entries showing the ‘timing’ of each entry:
Disposal of non-current assets account
Debit
Credit
$
$
720 000
Non-current assets account
720 000
Non-current assets are removed from the non-current assets account and are entered
in a disposal account.
Provision for depreciation of non-current assets
account
433 000
Disposal of non-current assets account
433 000
Depreciation ‘belonging’ to the asset is taken from the provision for depreciation
account and entered in the disposal account.
Bank account (not shown)
274 000
Disposal of non-current assets account
274 000
The cash inflow is entered in the disposal account.
At this point we need to insert a ‘missing’ figure of $13 000:
$
Statement of profit or loss
Disposal of non-current assets account
$
13 000
13 000
The ‘loss’ incurred on disposal is entered in the statement of profit or loss.
It is not cash but it has been entered in the statement of profit or loss as an
extra expense – it reduces profit but $13 000 is not cash – there has been no
movement of cash.
343
Enter the closing balances given in the question. Enter them underneath the
account and take them back diagonally into the account.
3.1 preparatIon of fInanCIal statements
3.1
344
Add the non-current asset account and the depreciation account. They will
not add unless you put in the two missing figures. The missing figure in the
non-current account must either be a revaluation or the purchase of further
non-current assets. A revaluation has not been mentioned, so the missing
figure must be non-current assets purchased during the year: a cash outflow
of $961 000.
To make the provision for depreciation account balance, this year’s charge to
the statement of profit or loss must be inserted: $650 000 is the amount to be
entered in the account and in the statement of profit or loss.
The profit is reduced by $650 000 but no cash has moved in or out of the
business.
Both the loss on disposal $13 000 and the depreciation for the year of $650 000
have reduced profit but there has been no movement of cash.
Both have to be added back to the profit from operations to arrive at the actual
cash flow generated by the company.
Answer
Cash ‘inflows’: loss $13 000 and depreciation $650 000; cash outflow: $961 000.
STUDY TIP
Treatment of a revaluation of non-current assets
Remember that
statements of cash
flows are historic
documents, that is,
they relate to a past
year. Do not confuse
a statement of cash
flows with a cash flow
forecast, which
should more properly
be known as a cash
budget. Statements of
cash flows do not try
to determine future
cash flows. However,
detailed knowledge
of specific sources
of cash receipts and
the uses of cash
outflows made may
have some use in the
assessment of future
inflows and outflows
of cash.
A revaluation of non-current assets will clearly have an impact on the statement of
financial position of a company. The non-current assets will increase in value, as
will the equity of the company. However, since such a revaluation merely involves
book entries there will be no movement in cash, so there will be no entry in a
statement of cash flows.
Treatment of a bonus issue of shares
Such transactions will impact on the statement of financial position of a
limited company but will not cause any movements in cash resources. The book
entries to record the issue of bonus shares will not be shown in a statement of
cash flows.
Reasons why a business might prepare a statement of cash flows
» It may be a statutory requirement.
» Together with the statement of profit or loss and the statement of financial
position it helps to give a fuller picture of the financial activities of the business.
» It is one of the statements that ‘bridges the gap’ between the dates of statements
of financial position.
» Cash flows are an objective measure.
You have now seen how the constituent parts of cash flows are calculated.
Statements of cash flows should be prepared in accordance with IAS 7. Here is a
worked example to show you where your calculated figures fit into such a statement.
WORKED EXAMPLE 51
The directors of Yukita plc provide the following statements of financial position
at 31 May:
31 May 2021
31 May 2020
$000
$000
23 970
18 215
1 990
3 370
950
1 050
6 000
5 050
32 910
27 685
2 000
1 730
Trade receivables
850
550
Cash and cash equivalents
283
278
3 133
2 558
36 043
30 243
Ordinary shares
12 600
12 100
Share premium
6 150
4 650
Revaluation reserve
3 200
-
11 298
10 906
33 248
27 656
1 200
1 200
Trade payables
1 175
1 007
Tax liabilities
420
380
3.1
ASSETS
Land and buildings
Machinery
Vehicles
Investments
Current assets
Inventories
Total assets
3.1.5 Limited companies
Non-current assets (Note 1)
EQUITY AND LIABILITIES
Equity
Retained earnings (note 2)
Non-current liabilities
8% debentures (repayable 2050)
Current liabilities
Total liabilities
Total equity and liabilities
1 595
1 387
2 795
2 587
36 043
30 243
345
Notes to the statements of financial position:
3.1
Note 1 Non-current assets
31 May 2021
31 May 2020
$000
$000
31 020
27 815
Land and buildings
3.1 preparatIon of fInanCIal statements
Cost
Revaluation
3 200
Accumulated depreciation
(10 250)
(9 600)
23 970
18 215
Cost
?
6 500
Accumulated depreciation
?
(3 130)
Carrying amount
?
3 370
Cost
1 750
1 650
Accumulated depreciation
(800)
(600)
950
1 050
Carrying amount
Machinery
Vehicles
Carrying amount
During the year ended 31 May 2021, machinery which had originally cost
$1200 000 was sold for $750 000. The depreciation charge on this machinery up
to 31 May 2020 was $480 000. No additions to machinery were made during the
year ended 31 May 2021.
There were no disposals of land, buildings or vehicles during the year ended
31 May 2021.
Note 2
The summarised statement of profit or loss for the year ended 31 May 2021 was
as follows (a changes in equity statement has not been used):
$000
Profit for the year before tax
1 112
Provision for corporation tax
(420)
692
Dividends paid
(300)
Increase in retained earnings for the year
392
Required
Prepare a statement of cash flows for the year ended 31 May 2021 using the IAS 7
format.
Workings
(mf = missing figure)
Land and buildings
$000
$000
27 815
3 200
mf 3 205
34 220
34 220
34 220
34 220
346
Depreciation
$000
$000
9 600
10 250
mf 650
10 250
10 250
10 250
Cash flows
$000
$000
650
(3 205)
Revaluation reserve
$000
3 200
Depreciation
$000
$000
480
3130
3 310
mf 660
3 790
3 790
3 310
Cash flows
$000
750
660
Disposal of machinery
$000
$000
1 200
480
30
750
1 230
1 230
Cash flows
$000
(30)
3.1.5 Limited companies
Machinery
$000
$000
6 500
1 200
5 300
6 500
6 500
5 300
3.1
Carrying amount at year end = $5300 000 – Depreciation = $1 990 000
So, balance on depreciation account at year end = $3 310 000.
Vehicles
$000
$000
1 650
mf 100
1 750
1 750
1 750
1 750
Investments
$000
$000
5 050
mf 950
6 000
6 000
6 000
6 000
Increase in inventories
Increase in trade receivables
Increase in trade payables
Taxation
Dividends paid
Debenture interest
8% of $1 200 000 = $96 000
Increase in share capital
Increase in share premium
Revaluation reserve
Depreciation
$000
$000
600
800 mf 200
800
800
800
Cash flows
$000
$000
200
(100)
Cash flows
$000
(950)
Cash flows
$000
$000
(270)
(300)
168
(380)
(300)
(96)
500
1 500
No movement of cash
347
3.1 preparatIon of fInanCIal statements
3.1
Profit from operations
(Profit before tax + Interest $1 112 000 + $96 000)
The difference in the total of these cash flows should
equal the change in cash and cash equivalents over
the year.
Totals
Change in cash and cash equivalents over the year
$5 000
Change in cash flows $5636 000 – $5631 000 = ($5 000)
Increase in cash and cash equivalents during the year
1 208
5 631
5 631
5
We now have all the necessary information required to prepare a statement
of cash flows. Take the figures from your workings and insert them under the
correct headings.
Answer
Yukita plc
Statement of cash flows for the year ended 31 May 2021
$000
$000
Cash flows from operating activities
Profit from operations
1 208
Adjustments for
Depreciation charges – Land and buildings
650
Machinery
660
Vehicles
200
Profit on disposal of machinery
1 510
(30)
Increase in inventories
(270)
Increase in trade receivables
(300)
168
Increase in trade payables
Cash from operations
2 286
Interest paid
(96)
Income tax paid
(380)
Net cash from operating activities
1 810
Cash flows from investing activities
Purchases of non-current assets
Proceeds from sale of non-current assets
Purchases of investments
(3 305)
750
(950)
Net cash from investing activities
(3 505)
Cash flows from financing activities
Proceeds from issue of share capital
2 000
Dividends paid
(300)
Cash from financing activities
348
1 700
Net increase in cash and cash equivalents
5
Cash and cash equivalents at 1 June 2020
278
Cash and cash equivalents at 31 May 2021
283
Reconciliation of net cash to movement in net debt
This part of a statement of cash flows shows how increases or decreases in the
components of a company’s debt have influenced the increase/decrease in cash
generated during the year.
3.1
WORKED EXAMPLE 52
The following information relates to Fagus plc:
31 May 2020
$000
$000
144
81
(150)
(300)
Cash and cash equivalents
6% debentures
Required
Prepare a reconciliation of net cash flow to movement in net debt.
3.1.5 Limited companies
31 May 2021
Answer
Reconciliation of net cash flow to movement in net debt for the year
ended 31 May 2021
$000
Increase in cash in the period
63
Cash used to repurchase debentures
150
Change in net debt
213
Net debt at 1 June 2020
(219)
Net debt at 31 May 2021
(6)
Note
Net increase in cash and cash equivalents during the year ended 31 May 2021:
$63 000.
Net debt is borrowings less cash and cash equivalents.
Debentures – Cash 1 June 2020 ($300 000 – $81 000 = $219 000)
31 May 2021 ($150 000 – $144 000 = $6 000)
An increase in cash resources of $63 000, coupled with a reduction of $150 000
in debenture debt, accounts for the improvement of $213 000 in the net debt.
Statement of changes in equity
Statements of changes in equity show the changes in the equity over the most recent
accounting period of the limited company. This will show the adjustments made to the
share capital, the revenue and the capital reserves of the company. It will be adjusted
for any new share issues (including rights issues, bonus issues at par or premium), any
revaluation of assets as well as the adjustment to retained earning through profits
earned and dividends paid.
IAS 1 requires that a statement of changes in equity is included as part of the
financial statements. This statement shows the changes that have affected the
shareholders’ stake in the company.
This was covered in Section 1.5.4, but here is another example.
349
3.1
WORKED EXAMPLE 53
As at 1 January 2020, the equity of Stoddard plc comprised the following:
$000
3.1 preparatIon of fInanCIal statements
Issued share capital
1 000
Share premium account
200
Revaluation reserve
850
Retained earnings
178
Total equity
2 228
During 2020, the following occurred:
A further 200 000 $1 shares were issued at a premium of $0.75.
Non-current assets were increased in value from $600 000 to $1 000 000.
Profit for the year was $74 000.
Dividends paid totalled $24 000.
l
l
l
l
Required
Prepare a statement showing the changes in equity for the year ended 31 December 2020.
Answer
Stoddard plc
Statement of changes in equity for the year ended 31 December 2020
Balance as at 1 January 2020
Issue of shares
Share capital
Share premium
account
Revaluation
reserve
Retained
earnings
Total
$000
$000
$000
$000
$000
1 000
200
850
178
2 228
200
150
Revaluation of non-current
assets
350
400
Profit for the year
74
Dividends
Balance as at 20 December
2020
400
1 200
350
1 250
74
24
24
228
3 028
Schedule of non-current assets
IAS 1 requires that notes to the financial statements be included. These notes give
additional detail to items that may be summarised in the main body of the financial
statements. They provide additional information to help the users understand the
financial statements and are also used to explain the particular treatment of items
contained in the main body, that is, the bases used in their preparation.
One common inclusion in these notes to the accounts is a schedule of non-current
assets. This shows the non-current assets held by the company, which are shown on
the statement of financial position. This will contain more detail than is shown on the
statement of financial position as it will include the calculations for depreciation, any
disposals or additions to the totals, along with any revaluations.
350
WORKED EXAMPLE 54
3.1
Hamman plc had the following non-current assets as at 31 December 2020:
Cost
$
Provision for depreciation
$
900 000
n/a
Plant and equipment
750 000
150 000
Motor vehicles
360 000
120 000
It is company policy to provide depreciation as follows:
l Plant and equipment: 10% per year using straight-line method (on the value of assets held at the year-end).
l Motor vehicles: 20% per year using straight-line method (on the value of assets held at the year end).
l No depreciation is provided on land.
During 2021, the following events occurred:
l Land was revalued to $1 500 000.
l Plant and equipment was purchased for $600 000 at cost.
l Motor vehicles that originally cost $90 000 were sold for $100 000, which generated a profit on disposal
totalling $30 000.
l Motor vehicles purchased during 2021 totalled $180 000.
3.1.5 Limited companies
Land
Required
Prepare a schedule of non-current assets for inclusion in the notes to the accounts as at 31 December 2021.
Answer
Hamman plc
Schedule of non-current assets for the year ended 31 December 2021
Property, plant and equipment
Land
$
Plant and equipment
$
Motor vehicles
$
At 1 January 2021
900 000
750 000
360 000
Revaluation
600 000
600 000
180 000
Cost
Additions
Disposals
At 31 December 2021
(90 000)
1 500 000
1 350 000
450 000
n/a
150 000
120 000
Depreciation:
At 1 January 2020
Disposals
Provided in year
(20 000)
n/a
At 31 December 2020
135 000
90 000
285 000
190 000
Net book value
At 31 Dec 2021
1 500 000
1 065 000
260 000
At 31 Dec 2020
900 000
600 000
240 000
Note
If motor vehicles were sold for a profit of $30 000, the net book value must have been $70 000. Given they had
originally cost $90 000, the depreciation on this amount must have totalled $20 000.
351
3.1 preparatIon of fInanCIal statements
3.1
EVALUATION
The Lidbury Film Club is a small club that shows
movies in a local venue on a weekly basis. It is
struggling financially and the bank balance has
gradually moved into an overdrawn amount. The
club’s committee is looking for ways to improve
the financial position of the club. Morton – one of
the longest serving members – believes that a
life membership scheme would be a good way of
improving the finances of the club. Roach – another
long-serving member – disagrees as he thinks the
discount offered in this scheme would mean the
long-term financial position would be worsened.
Advise the committee whether the life membership
scheme is a good way of improving the club’s
finances.
A good answer would include the following.
Arguments in favour of scheme:
l It will generate substantial income in the
short-term if current members take up ‘life
membership’.
l It may encourage new members.
l It is reasonably cheap to administer.
Arguments against the scheme:
l Although it will boost short-term income, in the
longer term, there will be no more membership
income from those with life membership.
l It may not be successful unless the discount
offered is big enough.
l Other methods could be used – fundraising
events, etc.
Overall:
l It depends on how serious the financial
difficulties are – if seasonal, then it may be worth
continuing with the existing membership scheme
and perhaps using some fundraising activities.
l Do they have problems collecting membership
subscriptions in the existing scheme – if so, the
life membership scheme may solve some of
these issues.
SUMMARY
After reading this chapter you should:
» understand the need for different financial statements for particular types of
business
» know the difference between purchased goodwill and inherent goodwill
» know how to prepare partners’ capital and current accounts after structural
changes in a partnership – both at the end of an accounting year and during the
financial year
» know how to prepare partnership appropriation accounts, statements of
profit or loss and statements of financial position after structural changes in a
partnership
» know the differences between the accounts used for profit-focused businesses
and those used by clubs and societies
» be able to produce the financial statements for clubs and societies
» be able to account for other receipts for clubs and societies, such as life
membership and donations
» know the extra features in the accounts of business entities that manufacture
goods rather than purchase goods
» be able to prepare manufacturing accounts and the financial statements for
manufacturing business entities
» understand the reasons for manufacturing profit and be able to account for it
» be able to adjust inventory values for any unrealised profit
» be able to prepare, in accordance with IAS 1, a statement of profit or loss, a
statement of financial position, a cash flow statement, a statement of changes
in equity and a schedule of non-current assets for a limited company.
352
SELF-TEST QUESTIONS
1 Private limited companies do not have to file their statutory accounts with the
Registrar of Companies. True/False?
3.1
2 Directors own a company. True/False?
3 Directors run a company for the shareholders. True/False?
4 Auditors run a company for the tax authorities. True/False?
6 Name two public limited companies.
7 Name the components of a complete set of financial statements.
8 Identify three items that must be disclosed in a statement of profit or loss for a
limited company.
9 All businesses must prepare a statement of cash flows. True/False?
10 Statements of cash flows calculate the profits earned by a business. True/False?
3.1.5 Limited companies
5 A shareholder could be a director of a limited company. True/False?
11 State two reasons why a business might prepare a statement of cash flows.
12 Explain why depreciation is added to profit from operations when calculating cash
flows.
13 Explain how a profit on the disposal of a non-current asset is treated in a
statement of cash flows.
14 Explain how a loss on the disposal of a non-current asset is treated in a statement
of cash flows.
15 Land and buildings have been revalued from $120 000 to $250 000. Under which
heading would this transaction be shown in a statement of cash flows?
16 A company that makes losses does not have to produce a statement of cash flows
until it becomes profitable. True/False?
Calculation questions (answers on page 494)
17 The operating profit for the year ended 31 December 2022 is $100 000.
Depreciation for the year is $7 200. Using this information and the changes below,
calculate the cash flows from operating activities.
At 31 December 2022
At 31 December 2021
$
$
11 312
9 901
Trade receivables
7 879
8 522
Trade payables
4 342
6 413
Inventories
18 The statement of profit or loss shows an entry for dividends totalling $8 700. At
the start of the year, dividends owing totalled $500. At the end of the current
year, dividends owing totalled $750. Calculate the amount to be included in the
statement of cash flows for equity dividends paid.
353
3.2 regulatory and ethICal ConsIderatIons
3.2
Regulatory and ethical considerations
Learning outcomes
By the end of this chapter you should have an understanding of:
l the main provisions of each of the following International Accounting
Standards (IAS):
– IAS 1 Presentation of financial statements
– IAS 2 Inventories (not long-term contracts)
– IAS 7 Statement of cash flows
– IAS 8 Accounting policies, changes in accounting estimates and errors
– IAS 10 Events after the reporting period
– IAS 16 Property, plant and equipment
– IAS 36 Impairment of assets
– IAS 37 Provisions, contingent liabilities and contingent assets
– IAS 38 Intangible assets
l the need for an ethical framework in accounting
l the fundamental accounting principles
l how the ethical behaviour of accountants and auditors impacts the business
and other stakeholders
l the social implications of decision-making
l the role and responsibilities of the auditor
l the differences between an external audit and an internal audit
l the difference between a qualified and unqualified audit report
l stewardship and the role of directors and their responsibilities to shareholders
l the importance of a true and fair view in respect of financial statements.
Introduction
In this chapter you will examine the regulatory framework by exploring a
number of international accounting standards and how they are applied in the
preparation of financial statements. You will further consider the wider ethical
issues that underpin the practice of accounting, and the subsequent need for
accountants and businesses to behave in an appropriate manner. Related to this,
you will assess the nature of stewardship in the context of a limited company,
developing a more detailed appreciation of the issues of ownership and control
and the requirement for an independent examination of financial statements by
an auditor. In addition, you will consider the impact of increasing focus on ethical
behaviour by businesses, accountants and auditors.
Learning link
More detail on the
presentation of the
financial statements of
limited companies was
covered in Chapter 3.1.
354
3.2.1 International Accounting Standards
The main provisions of International Accounting Standards (IAS)
IAS 1 Presentation of financial statements
The standard sets out the ground rules of how financial statements should be
presented. Adherence to the standard means that comparisons can be made with
previous accounting periods and with other companies.
The standard identifies five components that make up a complete set of financial
statements. These are:
»
»
»
»
»
a statement of profit or loss
a statement of changes in equity
a statement of financial position
a statement of cash flows
a statement of accounting policies and explanatory notes to the accounts.
The standard requires that the statements comply with accounting concepts.
In order to facilitate comparison, there is a requirement that the figures from previous
periods must be published.
The name of the company should be given, along with the year covered by the
financial statements.
Dividends
Dividends are distributions to shareholders of profits earned by a limited company.
Dividends are paid annually but most limited companies will pay an interim dividend
approximately halfway through their financial year.
Interim dividends are based on the profits earned during the financial year. The final
dividend is based on the reported profits for the full year.
3.2.1 International Accounting Standards
The standard requires that the financial statements should contain an explicit and
unreserved statement that they comply with international standards. This should mean
that the statements achieve a fair presentation.
3.2
Since directors do not have the authority to pay dividends without the approval of the
owners of the company (i.e. the shareholders), the final dividend can only be proposed
after the financial year end. Shareholder approval should occur two or three months
later at the company annual general meeting.
Only dividends actually paid during a financial year can be recorded in the financial
statements.
WORKED EXAMPLE 1
The following information is available for Engary plc for the financial year
ended 31 December 2021:
January 2021 Directors propose a final dividend of $34 000 on ordinary shares
based on reported profits for the year ended 31 December 2020
March 2021
Shareholders approve the final dividend for the year ended
31 December 2020
May 2021
Final dividend of $34 000 for the year ended 31 December 2020 paid
to shareholders
August 2021
Interim dividend of $19 000 paid to shareholders based on reported
profits for the half year ended 30 June 2021
January 2022
Directors propose a final dividend of $41 000 based on reported
profits for the year ended 31 December 2021
Required
Prepare a statement detailing the total entry in the financial statements for the
year ended 31 December 2021 for dividends.
355
Answer
3.2
Dividend entry in financial statements for the year ended 31 December 2021
3.2 regulatory and ethICal ConsIderatIons
$
Final dividend for the year ended 31 December 2020
34 000
Interim dividend for half year ended 30 June 2021
19 000
Total entry for dividends
53 000
The details of dividends paid during the financial year are shown in a note to the
published accounts. The above information for Engary plc would be shown as follows:
EXAMPLE
Dividends
$
Equity dividends on ordinary shares
Amounts recognised during the year:
Final dividend for the year ended 31 December 2020 of 3.4 cents
34 000
Interim dividend for the year ended 31 December 2021 of 1.9 cents
19 000
53 000
Proposed final dividend for the year ended 31 December 2021 of 4.1 cents
41 000
The proposed final dividend is subject to approval by shareholders at the annual
general meeting and accordingly has not been included as a liability in the financial
statements.
The financial statements must contain a directors’ report and an auditors’ report.
The directors’ report
The report contains:
»
»
»
»
»
»
»
»
»
»
a statement of the principal activities of the company
a review of performance over the preceding year
a review of likely future developments
the names of directors and their shareholdings
details of dividends
differences between book value (carrying amount) and market value of land and
buildings
political and charitable donations
a statement on employees and employment policies (i.e. equal opportunities
policy; policy with regard to people with disabilities; and health and safety of
employees)
policy of opportunities and participation of employees
suppliers’ payment policy.
The auditors’ report
This report contains three sections:
» Respective responsibilities of directors and auditors. The directors’ responsibilities
are to prepare the annual report and financial statements in accordance with the
law and international reporting standards.
» Basis of audit opinion. The audit should be conducted in accordance with
international accounting standards. The auditors should obtain all the information
356
Learning link
The role of an auditor is
explored in more detail
later in this chapter.
and explanations that are necessary to provide sufficient evidence to allow them
to assure the shareholders that the financial statements are free from material
misstatement.
» Opinion. This is the auditors’ view of the financial statements and their opinion
as to whether they give a true and fair view, in accordance with international
financial reporting standards and international accounting standards, of the state
of the company’s affairs and of its profit/loss for the period covered by the audit.
Notes to the financial statements
IAS 1 requires that notes to the financial statements be included. These notes:
Learning link
How to value inventory
was covered in Chapter
1.5 and Chapter 2.1.
» give additional detail to items that may be summarised in the main body of the
financial statements
» provide additional information to help the users understand the financial
statements
» are also used to explain the particular treatment of items contained in the main
body, that is, the bases used in the preparation (see IAS 8 below).
IAS 2 Inventories (not long-term contracts)
Inventories are defined as:
»
»
»
»
»
goods or other assets purchased for resale
consumable stores
raw materials and components purchased for incorporation into products for sale
products and services in intermediate stages of completion
finished goods.
3.2.1 International Accounting Standards
The auditors’ report should also give an opinion as to whether or not the financial
statements have been properly prepared in accordance with the Companies Act 1985.
3.2
Cost of purchase comprises the purchase price including import taxes, transport and
handling costs and any other costs that are directly attributable to the goods.
Costs of conversion comprise:
» costs that can be specifically attributed to units of production, for example, direct
labour, other direct expenses and subcontracted work
» production overheads
» any other overheads.
The standard states that inventory should be valued at ‘the lower of cost and net
realisable value’ of separate items of inventory or of groups of similar items.
Inventories should be categorised in a statement of financial position as:
» raw materials
» work in progress or
» finished goods.
The standard accepts valuations using:
» the first-in first-out method (FIFO)
» the weighted average cost method (AVCO)
» the standard cost if it bears a reasonable relationship to actual costs obtained
during the period.
The standard does not accept:
» the last-in first-out method (LIFO)
» the base cost
» the replacement cost (unless it provides the best measure of net realisable value
and that this is lower than cost).
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IAS 7 Statement of cash flows
3.2
IAS 1 states that a statement of cash flows forms part of the financial statements for
many limited companies. This was covered fully in Chapter 3.1.
IAS 8 Accounting policies, changes in accounting estimates and errors
3.2 regulatory and ethICal ConsIderatIons
IAS 1 requires companies to include details of specific accounting policies used in the
preparation of financial statements. IAS 8 gives more detail. It defines accounting
policies as:
‘… the specific principles, bases, conventions, rules and practices applied … in
preparing and presenting financial statements’.
The principles are the concepts that you have already learned. They apply to all the
financial statements that you have prepared in your studies so far. They are the
going concern concept, the matching/accruals concept, prudence, consistency and
materiality.
The bases are the individual methods of treatment used when applying accounting
principles to particular situations, for example, the application of cost value or net
realisable value to certain items of inventory.
Accounting bases are selected by directors, for example, method of selecting and
applying the methods of depreciation to be used in preparing the financial statements.
Where an accounting policy is given in a standard, that policy must be applied. If
there is no standard to provide guidance, the directors must use their judgement in
selecting a policy to follow, bearing in mind that any information provided in the
financial statements should be relevant and reliable.
Accounting policies should be applied consistently in similar situations.
IAS 8 also deals with the effect of errors on financial statements.
Once a material error is discovered, it should be corrected in the next set of financial
statements by adjusting the comparative figures.
IAS 10 Events after the reporting period
These are events that occur after the reporting period but before the financial
statements are authorised for issue. The events may be:
» adjusting events – this is evidence that certain conditions arose at or before the
end of the reporting period that have not been taken into account in the financial
statements. If the financial implications are material, then changes should be
made in the financial accounts before they are authorised. An example is where a
customer that owed a material debt at the financial year end becomes insolvent
after the end of the financial year. It would be necessary to make a change to the
amount recorded as trade receivables
» non-adjusting events – these arise after the end of the reporting period and
no adjustments to the financial statements are necessary. However, if they are
material, they should be disclosed by way of a note to the accounts. An example
would be a large purchase of non-current assets.
Proposed dividends at the financial year end are non-adjusting events and so are
not recorded as a current liability on the statement of financial position. They are
recorded as a note to the accounts. See the example of Engary plc in Section 36.2.5.
IAS 16 Property, plant and equipment
The objective of the standard is to ensure that accounting principles regarding noncurrent assets are applied consistently and that the company’s treatment of the assets
is understood by the users of the financial statements.
358
Property, plant and equipment should initially be valued at cost in the statement
of financial position. Cost includes expenditure directly attributable to bringing the
asset into a usable condition. Costs could include import duties, delivery charges, the
costs of preparing the site and other installation costs.
3.2
After acquisition of property, plant and equipment, the company must show the
carrying amount of the assets at either:
Fair values based on the revaluation model for land and buildings would generally
be based on market value calculated by professional valuers. In the case of plant and
equipment, the fair value would usually be based on market value.
Depreciation
The object of providing depreciation is to reflect the cost of using an asset.
The depreciation for a financial period is shown in the statement of profit or loss and
should reflect the cost of using the asset over the financial period under review. It
should reflect the pattern in which the economic benefits derived from the asset are
consumed.
When determining the useful life of an asset, several factors should be taken into
account:
»
»
»
»
3.2.1 International Accounting Standards
» cost less accumulated depreciation and impairment losses or
» revaluation based on fair value less subsequent depreciation and impairment losses
(IAS 36 below).
the expected use of the asset
the expected wear and tear on the asset
economic and technical obsolescence
legal or similar restraints.
Depreciation policy is not affected by repairs and/or maintenance. However, the
residual value and the useful life of the asset need to be reviewed on an annual basis
to determine if any change should be made in the depreciation policy.
Generally, land and buildings should be treated separately since land is not
depreciated; it has an infinite economic life, unlike other non-current assets, which
have a finite economic life. Note that leasehold land does have a finite life (the
duration of the lease), and therefore should be depreciated.
A variety of methods can be used to calculate the annual depreciation charge. The
three that you will find most useful are:
» the straight-line method, which charges a constant annual amount over the life of
the asset
» the reducing balance method, which charges a decreasing annual amount over the
life of the asset
» the revaluation method, which charges the difference between the value of an
asset at the end of a year and the value at the start of the year plus any additions
to the asset during the year.
When the pattern of use of an asset is uncertain, the straight-line method is usually
adopted.
Changing the basis of calculating the annual charge is permissible only when the new
method gives a fairer representation of the use of the asset. The change must be
documented in a note to the financial statements. Any change to methods must be a
permanent change. The method chosen should reflect, as closely as possible, the way
that the assets’ benefits are consumed.
359
Derecognition means that the asset will no longer be recognised on the statement of
financial position. If the asset is sold then the profit or loss on disposal is shown in
the statement of profit or loss.
3.2
3.2 regulatory and ethICal ConsIderatIons
For each asset, the financial statements must show (generally in the notes to the
financial statements):
»
»
»
»
»
the basis for determining the carrying amount
the depreciation method used
the duration of the useful economic life or the rates of charging depreciation
the carrying amount
accumulated depreciation and impairment losses at the start and end of the
accounting period
» a reconciliation of the carrying amount at the start and end of the accounting
period that shows:
– additions
– disposals
– revaluations
– impairment losses
– depreciation.
IAS 36 Impairment of assets
Impairment applies to nearly all non-current assets.
Learning link
We first encountered
provision accounts
in Chapter 1.3 (for
depreciation of noncurrent assets) and
Chapter 3.1 (for
unrealised profit on
unsold inventory).
Impairment occurs when the recoverable amount is less than the asset’s carrying
amount (the value shown in the statement of financial position after deduction of
accumulated depreciation).
The value of assets shown on the statement of financial position needs to be reviewed
at each statement of financial position date to determine if there is any indication of
impairment.
Evidence of impairment could be:
»
»
»
»
a significant fall in the market value of the asset
a significant fall in the value of an asset due to a change in technology
a significant fall in the value of an asset due to an economic downturn
a significant fall in the value of an asset due to it being damaged, resulting in the
asset’s fair value falling or its future cash-generating ability falling
» a significant fall in the value of an asset due to a restructuring of the business.
An impairment loss is recognised when the recoverable amount is less than the carrying
amount. The amount of the loss is to be shown in the statement of profit or loss.
IAS 37 Provisions, contingent liabilities and contingent assets
The standard seeks to ensure that there is sufficient information given to enable the
users of the financial statements to understand the effects of provisions, contingent
liabilities and contingent assets.
Provisions are to be recognised as a liability in the financial statements if the
company has an obligation because of a past event and it is probable that the
obligation requires settlement (i.e. a more than 50 per cent chance of occurrence). It
is also necessary that a reliable estimate of the amount of the liability can be made.
A note to the financial statements should detail the provisions.
Contingent liabilities are possible obligations (i.e. a less than 50 per cent chance of
occurrence). If the liability is possible, the contingent liability should be disclosed as
a note to the financial statements, but no disclosure is necessary in the main body of
the statements. If there is only a remote chance of the occurrence then no reference
needs to be made in either the financial statement or the notes.
360
Contingent assets are possible assets arising from past events and it is possible that
economic benefit could accrue in the future.
If there is a probable economic benefit in the future deriving from the past event,
then a note to the financial statements should be made. If the future economic
benefits are only possible or remote, no reference needs to be made.
Learning link
IAS 38 Intangible assets
Intangible assets do not have physical substance. They are identifiable and are
controlled by the company. They include licences, quotas, patents, copyrights,
franchises, trademarks, etc. Goodwill is not covered in this standard.
Intangible assets are either purchased or internally generated. Internally generated
assets cannot be recognised in the financial statements.
Like property, plant and equipment, intangible assets are initially shown at cost in the
statement of financial position. After acquisition they can be shown at:
» cost less accumulated depreciation and impairment losses
» revaluation based on fair value less subsequent amortisation and impairment losses.
3.2.2 Ethical considerations
We first covered
goodwill in partnership
accounts in Chapter 3.1.
3.2
Revaluations are to be made regularly to ensure that the carrying value does not differ
materially from the fair value at the date of the statement of financial position.
Any increase in value should be recognised in the statement of changes in equity and
shown as part of any revaluation reserve.
Any reduction in value will be recognised as an expense in the statement of profit or loss.
An intangible asset with a finite life is amortised over its useful economic life,
whereas an intangible asset with an infinite life is not amortised.
Research and development is the exploration of new scientific methods of
manufacturing, and using the results to produce an end product. The research can be:
» pure research, where no end result was foreseen when the research was first
undertaken; the main aim was to further knowledge in the field
» applied research, directed towards a practical application, for example, a cure for
cancer.
Development is the application of knowledge gained from research to produce or
improve a product or process before it is marketed commercially.
IAS 38 requires that a distinction is made between revenue expenditure and capital
expenditure on research.
Revenue expenditure is entered in the statement of profit or loss, while capital
expenditure on non-current assets is recorded as non-current assets and they are
depreciated over their useful life.
Development costs are treated as an expense in the statement of profit or loss when
they are incurred, or they may be capitalised as an intangible asset if the directors can
demonstrate that they can establish the result as an asset that can be used or sold.
3.2.2 Ethical considerations
The need for an ethical framework in accounting
As mentioned in IAS 1, the auditor’s report will provide independent verification that
the financial statements produced by another organisation are a ‘true and fair’ view
of the organisation’s financial position. This allows investors and the general public to
have confidence when making potential investment decisions (e.g. to buy or sell shares
in a particular company). It is crucial that the trust of the public is not undermined by
accountants deviating from this role as the independent verifier of financial statements.
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3.2 regulatory and ethICal ConsIderatIons
3.2
Ethical behaviour is fundamental to this trust. Ethics is concerned with people,
businesses and, by implication, accountants, acting in a morally correct when it comes
to their specific role. If an accountant does not behave in an ethical manner when
performing their duties, their public may not be able to trust the financial statements
that they read, and this means they are less likely to have confidence when making
investment decisions.
There have been cases where accountants, as auditors, did not behave in an ethical
manner, which resulted in thousands of individuals losing money by buying shares
in companies whose financial statements did not provide a true and fair view of
the companies’ position. If this sort of unethical behaviour becomes widespread,
companies will find it difficult to attract investment, due to a lack of confidence in
the available financial information.
Therefore, it is vital that accountants, and accountants as auditors, behave in an
ethical manner.
Fundamental principles
In 2018, the International Ethics Standards Board for Accountants (IESBA) published
the Code of Ethics for Professional Accountants. It is expected that this code will be
followed by the accounting profession globally. A number of accountant authorities
across the world have published their own code of ethics, which broadly complies with
the IESBA’s code of ethics. For example, the ICAEW expects all accountants to conform
with their code of ethics. This sets out the acceptable rules for how an accountant
should behave. There are five fundamental principles of ethics for professional
accountants:
Integrity
This principle means that accountants need to be straightforward and honest in all
professional and business relationships.
Objectivity
This means not to allow bias, conflict of interest or influence of others to compromise
professional judgements made in the role of accountant.
Professional competence and due care
This principle means that accountants should ensure they attain and maintain the
correct level of skill and knowledge necessary for them to perform their duties for the
client. It also means that they should be diligent when applying relevant accounting,
technical and professional standards.
Confidentiality
Accountants should respect the confidentiality of information acquired as a result of
their duties and their professional and business relationships.
Professional behaviour
Accountants should always comply with the relevant laws and regulations that apply
to the situation they are dealing with. They should avoid any conduct that might
discredit the profession.
How the ethical behaviour of accountants and auditors
impacts the business and other stakeholders
As mentioned earlier, if people do not have confidence in the behaviour of
accountants and auditors then this will impact on businesses and the stakeholders
interested in businesses.
362
Businesses may struggle to raise finance if lenders and investors (and other businesses)
have low confidence in the reliability of financial statements. Businesses will struggle
to expand or survive if the finance necessary is no longer available. A business that
relies on retained earnings to fund growth and survival will be less affected but there
are very few businesses that do not rely on external finance at some point.
If a business is struggling to survive then it will find it hard to attract finance. If it
can convince an auditor to accept financial statements that exaggerate the positive
aspects of performance, then it may survive longer.
However, this is merely postponing the inevitable – that the business will eventually
be ‘found out’ as not performing as well as its financial statements suggest. This will
have a significant effect not only on investors but also on governments (who may
not receive the tax revenue from these businesses as expected), the workers of the
business who may lose employment, and also suppliers who are owed money (and
customers if they have not received products paid for in advance). As we can see,
many stakeholders groups can be affected by the failure of auditors to do their job
to the correct standard. Cases where auditors have not performed their duties to the
appropriate level – i.e. where they have not provided independent verification – have
often been linked to business failure and public scandal.
3.2.2 Ethical considerations
The risk to the lender or investor is increased if they cannot be sure whether the financial
statements are accurate. However, it is always in the short-term interest of the business to
ensure financial statements look as favourable as possible, so as to attract finance in the
form of borrowing or investment. This means that the auditor’s role as the independent
verifier is vital. Although a business can attract finance more easily if it exaggerates its
own performance, the knock-on effect on other businesses will be increased when it is
discovered that the exaggerated financial statements are not accurate.
3.2
The social implications of decision-making
In recent years, managers of businesses of all sizes have had to consider the impact of
their business decisions on stakeholders. This impact affects:
» staff working in the business
» people outside the business, for example, customers, suppliers and others that use
or rely on the business
» the local, national and international environment.
Non-financial aspects of accounting
Traditionally, financial statements were prepared for management and stewardship
purposes and concentrated on purely monetary aspects of the business. However,
consideration of the non-financial aspects of running and controlling a business have
become increasingly more important, since business activity affects all our lives in
one way or another.
Social awareness
Consumers and society at large are becoming increasingly aware of the environmental
damage that is often a by-product of business activity and the danger of depleting
non-renewable resources.
Social networking sites on the internet mean that we are constantly updated on
business issues that affect our everyday lives.
As a result of this, business managers are under pressure to show that they are:
» aware of and accepting of their social responsibilities
» manufacturing products with an appreciation of more than just financial considerations.
Profitability is now just one factor considered by managers. Today, consideration must
also be given to the impact that a business has on others. We are all consumers, some
363
3.2
of us are employees and we all live in a global environment that is influenced to a
greater or lesser degree by the business world.
A business may be profitable but what of its ‘hidden costs’? In pursuing profitability
what are the costs to people outside the organisation as well as those employed
within the business?
Social costs
3.2 regulatory and ethICal ConsIderatIons
The social costs of carrying out business activity include:
» stress in the workplace, such as fears about job security, introduction of new
technologies, etc.
» pollution in the workplace, such as dust, fumes, noise, etc.
» pollution of the local surroundings of the workplace, for example, noise, traffic
congestion, etc.
The business activity may also have an impact nationally in the form of pollution and
damage to rivers and air quality and even globally, for example, through pollution
which contributes to global warming.
Social costs versus profitability
Cynics among us would say that managers do not care about the impact that their
business has on others so long as sufficient profits are earned. However, social issues
can affect profitability adversely.
If the workforce are stressed or unhappy because of environmental issues inside
or outside the workplace, they are less likely to work at full capacity and so their
productivity will suffer. There may be high staff turnover and/or absenteeism.
Replacement staff may need to be trained thus increasing recruitment and training costs.
If the environment close to the business is poor, new staff might be difficult to
recruit; product sales in the locality could be affected. Both these factors could
attract adverse publicity.
Bad publicity via global social network sites might affect not only a business’s national
sales, but in the case of larger organisations, could affect worldwide sales too.
If consumers unite in opposition against a producer or supplier and cease to use a
product, inevitably sales and therefore profits will suffer. Managers who ignore such
reactions from pressure groups do so at their peril.
The major problem that managers face when trying to evaluate the consequences
of following a particular line of action is that it is difficult to put a monetary value
on the issues discussed above. As accountants, we have already stated that when
preparing the accounting statements we do not include items that cannot be measured
in monetary terms (the money measurement concept).
Some areas of concern
If a factory closes we can calculate the savings in variable costs and in the longer
term the savings in fixed costs. In such a case, we can measure any redundancy and
pension payments due. But how do we put a value on the distress caused to an office
worker or factory floor worker?
When a business purchases a new IT system the cost of purchase is very obvious. The
time and effort saved by staff can be quantified and costed. But what of the cost to
workers who have been made redundant? What price can be put on frustration or the
feeling of threat felt by employees who find the operation of the system difficult?
A supermarket relocates to an out-of-town shopping mall. How do we value the
convenience that many consumers will experience by being able to get all their
shopping at one outlet? And how do we balance this against the cost and convenience
364
to your grandparents who can no longer shop locally because shops have had to close
because they were less competitively priced than the supermarket?
There are no easy answers to any of these questions but it is vital that business
managers take such issues into consideration when making long-term decisions so that
the profitability of the business is not adversely affected.
3.2
3.2.3 Auditing and stewardship of limited companies
Auditing
Auditing is normally associated with the accounts of limited companies. It is
compulsory that larger limited companies have their financial statements audited by
external auditors.
However, tax authorities or a business’s bank may request sight of audited financial
statements of non-incorporated businesses.
An external auditor investigates whether or not the business has kept adequate records,
that financial statements are consistent with the records from which they are prepared
and that financial statements prepared by management give a true and fair view of the
business’s state of affairs. The auditor verifies that transactions have actually taken
place and that they have been recorded in the books of account accurately.
The audit provides the users of financial statements with an assurance that the
statements provided to them can be relied upon.
3.2.3 Auditing and stewardship of limited companies
The role and responsibilities of the auditors (both internal
and external)
The auditor’s opinion
If, in the auditor’s opinion, adequate records have not been kept of the company’s
financial statements or the auditable part of its directors’ report is not in agreement
with the company’s records and returns, the auditor will issue a qualified opinion to
the report.
A qualified report will raise points that the auditor considers have not been dealt with
correctly by the directors in their preparation of the financial statements.
Where such points are not of a serious nature, the report might state ‘… with the
exception of … the financial statements do show a true and fair view …’ If, however,
the auditor is of the opinion that there has been a serious breach the statement will
state that ‘the financial statements do not show a true and fair view’.
The auditor’s report has three main sections:
1 Responsibilities of directors and auditors
a Directors are responsible for preparing the financial statements.
b Auditors are responsible for forming an opinion on the financial statements.
2 Basis of opinion – the framework of auditing standards within which the audit was
conducted, other assessments and the way in which the audit was planned and
performed. If the auditor fails to obtain information and explanations necessary
to support his audit then this must be reported. Any deviation from the necessary
disclosure requirements must be identified.
3 Opinion – the auditor’s view of the company’s financial statements.
Audit requirements
The main statements that have to be audited are:
» the statement of profit or loss
» the statement of financial position
365
»
»
»
»
»
3.2
statement of cash flows
statement of total recognised gains and losses
reconciliation of movements in shareholders’ funds
accounting policies
notes to the accounts.
Regulatory framework
The regulatory framework is made up of shareholders, directors and auditors:
3.2 regulatory and ethICal ConsIderatIons
» Shareholders are responsible for the appointment of directors and auditors.
» Directors recommend the appointment of auditors to the shareholders.
Shareholders
appoint
Auditors
recommend
Directors
▲ Figure 3.2.1 The regulatory framework
Because of the interdependence of the three stakeholders there is a need for rules and
regulations that accountants follow in the preparation and presentation of financial
statements. The sources of the regulations are the Companies Acts and the application
of accounting standards.
Accounting standards are not laws. However, in the UK, the Companies Act 1985 requires
that directors must state in the notes to the financial statements that international
accounting standards have been applied in the preparation of the statements.
The difference between a qualified and unqualified audit report
If the auditors are satisfied that the financial statements have been produced in the
appropriate manner, the auditor’s report is likely to contain a comment suggesting
that the statements are a ‘true and fair view’ of the business’s overall financial
performance (i.e. the financial statements are not misleading to potential or current
investors). This is an unqualified audit report – meaning there is nothing to suggest
that the accounting statements have not been prepared with correct application
of the relevant accounting standards. If they are satisfied with the financial
statements, they will ‘sign off’ the statements.
STUDY TIP
An audit prepared
by a qualified person
is different from a
‘qualified audit’.
If the auditors are not satisfied that the financial statements have been presented
appropriately, they may present a qualified audit report. A qualified audit report is
likely to appear where the auditors and the managers of the company disagree over
some aspect of the financial records – this could include a change to an accounting
policy, or an interpretation of an accounting standard. The disagreement may be
relatively minor. However small the disagreement is, the auditors may feel they have
a duty to bring the disagreement to the shareholders’ (and potential shareholders’)
attention by making this qualified report.
An unqualified audit report does not mean that the company is performing well, but
that the accounts have been prepared in a manner that gives a true and fair view of
the business in terms of its financial position. It would be up to an investor then
to make a decision on whether the company was worth investing in as a potential
shareholder.
Stewardship and the role of directors and their
responsibilities to shareholders
Financial statements are produced for two purposes:
» to show the providers of finance that their funds are safe and are being used wisely
by the manager or owner of the business in question
366
» to enable the managers or owner of a business to gauge how well the business
has performed and to provide information that might highlight areas in which
improvements can be made in the way that the business is run.
3.2
The first is called the stewardship function of accounting, and the second is the
management function.
The managers or owner of a business often use other people’s money (from banks,
relatives, etc.) to help provide some of the finance necessary to enable the business
to operate.
The managers of a business will wish to improve the performance of the business. A
profit figure alone will not highlight areas of good practice or identify any problem
areas that need to be improved. Details of all expenditure might show that a business
is paying a high rent or has a large amount of vehicle expenses. If these could be
reduced, then profits would rise.
How could the business reduce rent paid and spend less on vehicle expenses?
Answers could include:
» moving to smaller premises (if present premises are too large)
» moving to ‘out-of-town’ premises (provided customers would not be lost)
» charging delivery to some customers.
3.2.3 Auditing and stewardship of limited companies
Bank managers would not be able to say whether a profit of $12 765 would give them
confidence that the money provided by their bank is secure and being used wisely. The
profit figure in isolation does not show how the gross profit of the business is being
used. It does not answer the question of how much is the business spending on wages,
rent, insurance, etc.
Under the stewardship umbrella, we also find the need to provide accounts that
comply with:
»
»
»
»
governmental requirements
accounting standards
stock exchange regulations
tax legislation.
We have seen that the financial statements prepared for all business organisations are
broadly similar. Apart from the heading, a set of financial statements prepared for a limited
company would look similar to a set of financial statements prepared for a sole trader.
Figure 3.2.2 shows the potential users of the financial statements prepared for a limited
company.
Investors
Employees
Public and environmental
bodies
ent
Financial Statem
ounts
ences
y Links
Owners/existing investors
Financial press
Potential investors
Government agencies
Lenders
General public
Suppliers and customers
▲ Figure 3.2.2 The users of the financial statements of a limited company
367
3.2
Directors
As just mentioned, keeping financial records and producing financial statements has
two primary functions:
3.2 regulatory and ethICal ConsIderatIons
1 the stewardship function
2 the management function.
Shareholders provide the capital of limited companies by the purchase of shares. In
the case of public limited companies, there are often many thousands of shareholders.
Clearly, all these shareholders cannot run the business on a day-to-day basis, so it is
the responsibility of shareholders to appoint directors to run and manage the business
on their behalf. The directors of a limited company are responsible for the preparation
of annual financial statements that are then used by shareholders to assess the
performance of the company and the directors whom they have appointed. The
directors must ensure that the provisions of the Companies Act 1985 are implemented.
Directors are paid emoluments as their reward for running the business.
‘Divorce of ownership and control’ is the term often used to describe the relationship
between shareholders and directors because although shareholders are the owners of a
company, it is the directors who control the day-to-day affairs of the business.
Directors’ responsibilities
Directors have a responsibility to:
» keep proper accounting records that allow financial statements to be prepared in
accordance with relevant companies legislation
» safeguard business assets
» select the accounting policies to be applied to the business books of account
» state whether international standards have been applied
» report on the state of the company’s affairs
» ensure that the financial statements are signed by two members of the board of
directors.
If the directors are responsible for keeping financial records and the preparation of
the annual financial statements, how can shareholders be guaranteed that the records
are prepared in an objective way? Shareholders appoint a team of professionally
qualified accountants (auditors) to check and verify the financial statements and the
transactions that led to their preparation.
The importance of a true and fair view in respect of financial
statements
A true and fair view requires that the auditor must give an opinion as to whether the
financial statements presented to the shareholders are truthful and unbiased.
In the UK, Section 226[2] of the Companies Act 1985 requires that ‘the [statement
of financial position] should give a true and fair view of the state of affairs of the
company at the end of the financial year; and the [statement of profit or loss] shall
give a true and fair view of the profit or loss of the company for the financial year.’
The auditor must give an opinion as to whether or not the financial statements
presented to the shareholders are a fair representation of the company’s results. So
the auditor must be satisfied that the records audited have formed a suitable basis for
the preparation of the statements.
The auditor must verify that financial statements agree with company records. They
must confirm that:
»
»
»
»
368
results shown in statement of profit or loss are truly and fairly stated
fundamental accounting concepts have been applied
the accounting convention followed in the preparation of financial statements is stated
the preparation of financial statements is consistent with previous periods.
The auditor must verify that:
» assets exist and are owned by the company and are stated at amounts that are in
accordance with accepted accounting policies
» all liabilities are included and stated at amounts that are in accordance with
accepted accounting policies.
3.2
SUMMARY
» understand the importance of a ‘true and fair view’
» recognise the need for ethical behaviour in
accounting
» understand the fundamental accounting principles
» understand how the ethical behaviour of
accountants and auditors impacts businesses and
stakeholders
» understand the social implications of decisionmaking.
SELF-TEST QUESTIONS
1 Why is there a need for international accounting standards?
2 What does IAS 7 deal with?
3 Which standard deals with depreciation of non-current assets?
4 What does IAS 2 deal with?
3.2.3 Auditing and stewardship of limited companies
After reading this chapter you should:
» be familiar with the accounting standards covered
(IAS1, IAS2, IAS7, IAS8, IAS10, IAS 16, IAS36, IAS37
and IAS38)
» understand the role of auditors
» know the difference between qualified and
unqualified audit reports, and internal and
external audits
» understand the role of directors and stewardship
5 Which standard deals with the treatment of research and development costs?
6 Which standard deals with intangible non-current assets?
7 Which standard says that financial statements should be understandable?
8 What concept(s) are used in the valuation of inventories?
9 What are the five components of a complete set of financial statements?
10 Identify two social issues affecting staff that a manager might consider.
11 Social responsibility issues do not apply to sole traders who do not employ any
workers. True/False?
12 Multinational organisations do not need to take social costs into consideration
since they are extremely powerful. Do you agree?
13 ‘Profits are more important than members of staff.’ Outline a case to refute such
a statement.
14 Auditor is another term used to describe a director. True/False?
15 Auditors appoint directors. True/False?
16 ‘The main role of a director is the application of the management function of
accounting; while the main role of auditors is stewardship’. How true is this statement?
17 What is meant by the term ‘emoluments’?
18 Identify two items that the auditor must verify.
19 In what circumstances might auditors qualify their opinions?
369
3.3 busIness aCQuIsItIon and merger
3.3
Business acquisition and merger
Learning outcomes
By the end of this chapter you should have an understanding of:
l the nature and purpose of mergers of different types of businesses to form a
new business
l how to prepare the journal entry and make entries in the relevant ledger
accounts for the:
– merger of two or more sole trader businesses to form a partnership or a
limited company
– merger of a sole trader’s business with an existing partnership to form a
new partnership
– acquisition of a sole trader’s business or partnership by a limited company
l how to value goodwill on the acquisition of a business by another entity
l how to prepare statements of profit or loss and statements of financial position
for the newly formed business
l the advantages and disadvantages of acquisitions and mergers.
3.3.1 Business acquisition and merger
The nature and purpose of the merger of different types of
business to form a new business entity
The owners of a business may decide at some point that they wish to combine their
business with another business. This could take the form of a merger – where two
businesses are amalgamated together, or an acquisition (also known as a takeover).
In general, the accounting entries needed for a merger and for an acquisition are
the same. In the case of an acquisition, it may be the case that the business being
‘taken over’ is not in agreement with the terms of the amalgamation. However, in this
chapter we will assume that mergers and acquisitions are the same thing.
There will be potential benefits for the businesses after the merger or acquisition
(return on investment). There may also be unexpected drawbacks for the business
and these are explored at the end of the chapter.
How to prepare the journal entry and making entries in the
relevant ledger accounts
Merger of two or more sole trader businesses to form a partnership or a
limited company
Sole traders forming a partnership
The process here involves the fusing together of the two statements of financial
position. This takes place after the owners of the two businesses have agreed
on values for all the assets and liabilities that are to form the basis of the new
partnership business.
370
After the assets have been valued it may be necessary for the partners to make
payments or withdrawals of capital in order to achieve the required capital accounts
balances that the two partners have agreed upon.
3.3
WORKED EXAMPLE 1
Aiisha and Borak are sole traders. They agree to merge their two businesses
into a partnership as from 1 January 2021.
Statements of financial position at 31 December 2020
Aiisha
Borak
$
$
$
$
ASSETS
Non-current assets
25 000
75 000
Current assets
Inventory
3 500
Trade receivables
6 000
Cash and cash equivalents
16 000
7 000
700
10 200
Total assets
1 200
35 200
Aiisha
24 200
99 200
3.3.1 Business acquisition and merger
The following information relating to the two businesses is given:
Borak
$
$
$
$
CAPITAL AND LIABILITIES
Capital
32 700
94 200
Current liabilities
2 500
5 000
35 200
99 200
Trade payables
Total capital and liabilities
The partners agree the following values for the assets to be taken over by the
partnership:
Aiisha
Borak
$
$
30 000
70 000
Inventories
3 000
15 000
Trade receivables
5 000
6 700
Non-current assets
The partnership would assume responsibility for the current liabilities at
31 December 2020 of both sole traders.
They further agree that each partner will start in the partnership business with
capital of $50 000.
The partnership bankers have agreed to provide any necessary overdraft
facilities.
Required
Prepare a statement of financial position for the partnership as it would appear
at the start of trading on 1 January 2021.
371
3.3 busIness aCQuIsItIon and merger
3.3
Answer
Aiisha and Borak
Statement of financial position at 1 January 2021
$
$
ASSETS
Non-current assets
100 000 (30 000 + 70 000)
Current assets
Inventories
18 000
(3 000 + 15 000)
11 700
29 700 (5 000 + 6 700)
Trade receivables
Total assets
129 700
CAPITAL AND LIABILITIES
Capital accounts – Aiisha
Borak
Current liabilities
Trade payables
Cash and cash equivalents (overdraft)
Total capital and liabilities
50 000
50 000
7 500
22 200
100 000
(2 500 + 5 000)
29 700 (14 500 − 36 700)
129 700
Workings
Capital – Aiisha
$
Cash
700 Balance b/d
Balance c/d 35 500 Revaluation
36 200
Balance b/d
Cash
$
32 700
3 500
36 200
35 500
14 500
Capital – Borak
$
$
Cash
1 200 Balance b/d 94 200
Revaluation 6 300
Balance c/d 86 700
94 200
94 200
Cash
36 700 Balance b/d 86 700
Journal entries will be necessary before the transactions are posted to the ledger
accounts. These entries would then be transferred to the ledger accounts for each
type of asset and liability. The capital accounts for each partner are shown above. The
cash balances from the previous businesses (as sole traders) are used to increase or
decrease the capital balances for each partner to the level of $50 000. Note that Borak
receives money from the new partnership and Aiisha pays money in – which leads to
an overdrawn balance on the partnership bank account.
Sole traders forming a limited company
The process involved when more than one business is taken over by a limited company
follows the same procedures as if only one business is involved.
372
WORKED EXAMPLE 2
Sole traders, Axel and Brian, decide to form a limited company, Briaxel Ltd,
that will incorporate both businesses. The company will commence trading on
1 February 2021 and will have an issued share capital of 400 000 ordinary
shares of $1 each to be issued at par; the shares will be divided equally
between the two men. Statements of financial position for the two businesses
at 31 January 2021 are shown:
CAPITAL AND LIABILITIES
Capital – Axel
Brian
Current liabilities
Trade payables
Total capital and liabilities
3.3.1 Business acquisition and merger
Statements of financial position at 31 January 2021
Axel
Brian
$
$
ASSETS
Non-current assets
Premises
60 000
80 000
Machinery
40 000
50 000
Vehicles
12 000
10 000
112 000
140 000
Current assets
Inventory
8 000
9 000
Trade receivables
6 000
7 500
2 000
1 500
Cash
16 000
18 000
128 000
158 000
Total assets
3.3
124 000
153 000
4 000
128 000
5 000
158 000
All assets held by the two sole traders will be taken over by Briaxel Ltd at the
following values. The new company will assume responsibility for the payment
of current liabilities.
Axel
Premises
Machinery
Vehicles
Inventory
Trade receivables
$
100 000
20 000
10 000
7 000
5 000
Brian
$
90 000
20 000
10 000
8 000
7 000
Required
Prepare a statement showing the financial position of Briaxel Ltd at the start of
trading on 1 February 2021.
373
3.3
Answer
Briaxel Ltd
Statement of financial position at 1 February 2021
$
ASSETS
3.3 busIness aCQuIsItIon and merger
Goodwill
128 500
Non-current assets
Premises
190 000
Machinery
40 000
Vehicles
20 000
378 500
Current assets
Inventory
15 000
Trade receivables
12 000
Cash and cash equivalents
3 500
30 500
Total assets
409 000
EQUITY AND LIABILITIES
Equity
Ordinary shares of $1 each
400 000
Current liabilities
Trade payables
Total equity and liabilities
9 000
409 000
Workings
Goodwill calculations
‘Purchase’ consideration less value of Axel’s capital taken over by the
company:
200 000 ordinary shares of $1 each
= $200 000
($100 000 + $20 000 + $10 000 + $7000 + $5000 + $2000 – $4000)
= $140 000
Value of goodwill (Axel)
= $60 000
‘Purchase’ consideration less value of Brian’s capital taken over by the
company:
374
200 000 ordinary shares of $1 each
= $200 000
($90 000 + $20 000 + $10 000 + $8000 + $7000 + $1500 – $5000)
= $131 500
Value of goodwill (Brian)
= $68 500
WORKED EXAMPLE 3
Using the information given in the previous worked example, prepare relevant
accounts in the books of account of Brian to show the entries necessary to close
his business.
3.3
Answer
$
$
Premises
80 000 Trade payables
Machinery
50 000 Briaxel Ltd
Vehicles
10 000
Inventory
9 000
Trade receivables
7 500
Cash
1 500
Profit on realisation
5 000
200 000
47 000
205 000
205 000
Capital – Brian
$
Briaxel Ltd
200 000
3.3.1 Business acquisition and merger
Realisation
$
Balance b/d
Realisation
200 000
153 000
47 000
200 000
Briaxel Ltd
$
Briaxel Ltd
Learning link
The accounting entries
needed to admit a new
partner to an existing
partnership are covered
in Section 3.1.2.
200 000
$
Capital – Brian
200 000
Merger of a sole trader’s business with an existing partnership to form a
new partnership
We have previously covered the necessary accounting entries for the situation where a
sole trader merges with an existing partnership. When there is a structural change to
a partnership, then the old partnership legally ceases to exist and a new partnership is
formed. The structural change can be any change to the partnership agreement, such
as the retirement of a partner or the admission of a new partner.
In the case of a sole trader’s business merging with an existing partnership, the
accounting entries needed will be similar to those required for admitting a new
partner. It is likely that the sole trader’s contribution to the partnership’s capital
would include some of the assets of the sole trader, such as machinery, vehicles or
other tangible or intangible assets. It is also possible that the sole trader will have to,
on admission to the partnership, ‘pay’ for the goodwill of the existing partnership. The
assets transferred by the sole trader to the new partnership may also be transferred
at their existing ‘net book value’ or at either a profit or loss – in which case, a
calculation may be necessary on the transfer, which may adjust the sole trader (and
now partner’s) capital balance.
375
Acquisition of a partnership or a sole trader’s business by a limited company
3.3
Acquisition of a sole trader’s business by a limited company
When a sole trader’s business is taken over by a limited company the purchase
consideration may be discharged in a number of ways. The purchasing company may
pay the sole trader:
3.3 busIness aCQuIsItIon and merger
» by a cash payment
» by the issue of shares
» by a combination of a share issue and a cash payment.
The purchase consideration may be:
» the same as the value of assets taken over
» less than the value of assets taken over or
» more than the value of assets taken over.
EXAMPLE
Hovig owns a successful, busy general store. The latest summarised statement
of financial position shows:
$
ASSETS
Non-current assets
Current assets (including $1 000 cash)
Total assets
120 000
61 000
181 000
CAPITAL AND LIABILITIES
Capital – Hovig
Current liabilities
Total capital and liabilities
147 000
34 000
181 000
Fawzig purchases the business, paying $200 000.
Hovig has sold his business for a capital gain (profit) of $54 000 (he would not
sell his cash balances).
Fawzig purchased the capital for $200 000. She has purchased the business net
tangible assets for $146 000 and the intangible asset of goodwill for $54 000.
The opening statement of financial position for Fawzig would appear as follows:
$
ASSETS
Goodwill
Non-current tangible assets
Current assets
Total assets
54 000
120 000
60 000
234 000
CAPITAL AND LIABILITIES
Capital
Current liabilities
Total capital and liabilities
376
200 000
34 000
234 000
For more on goodwill, its treatment and valuation, see Section 3.1.2 on the structural
changes in partnerships.
Although the examples used refer to unincorporated businesses, the principles apply
to any business purchasing capital at a price greater than a value of those assets to
the vendor.
3.3
WORKED EXAMPLE 4
$000
ASSETS
Non-current assets
48
Current assets
12
Total assets
60
CAPITAL
60
A summarised statement of financial position of Seabee Hay plc on the same
date shows:
3.3.1 Business acquisition and merger
A summarised statement of financial position of Akrim shows the following
position at 31 December 2020:
$000
ASSETS
Non-current assets
Current assets
Total assets
1 750
290
2 040
EQUITY AND LIABILITIES
Equity
Ordinary shares of $1 each
Reserves
Current liabilities
Total equity and liabilities
1 500
520
20
2 040
Akrim’s business was purchased by Seabee Hay plc at the start of business on
1 January 2021. The purchase consideration was $100 000, made up of $35 000
cash and 30 000 ordinary shares in Seabee Hay plc.
Seabee Hay plc valued the non-current assets taken over at $75 000 and the net
current assets at $10 000.
Required
Prepare a summarised statement of financial position for Seabee Hay plc at
1 January 2021, immediately after the acquisition of the business of Akrim.
377
3.3 busIness aCQuIsItIon and merger
3.3
Answer
Seabee Hay Ltd
Summarised statement of financial position at 1 January 2021
$000
ASSETS
Goodwill
Non-current assets
Current assets
Total assets
EQUITY AND LIABILITIES
Equity
Ordinary shares of $1 each
Share premium
Other reserves
Current liabilities
Total equity and liabilities
15 ($85 000 tangible assets purchased for $100 000)
1 825 (1750 + 75)
265 (290 – 35 + 10)
2 105
1 530 ($1 500 000 + $30 000)
35 (30 000 Shares with a value of $ 65 000)
520
2 085
20
2 105
Note
Akrim has made a capital gain (profit) on the sale of his business of $40 000.
Akrim’s 30 000 ordinary shares have a value to Akrim of $65 000 ($100 000
purchase consideration less cash $35 000) or $2.17 per share ($65 000/30 000).
The journal entries, relating to this acquisition would appear as follows:
Seabee Hay plc
(Journal entries in respect of acquisition of Akrim)
Debit
Credit
$
$
Goodwill
15 000
Non-current assets
75 000
Current assets
10 000
Ordinary share capital
30 000
Share premium account
35 000
Cash
35 000
Transfer of capital from Akrim to Seabee Hay plc in exchange for
shares and cash in the plc for Akrim.
These journal entries would then be posted to the ledger accounts contained in the
books of Seabee Hay Ltd.
378
Acquisition of a partnership by a limited company
The process involved when a limited company purchases a partnership business is
similar to that employed when a sole trader’s business is purchased.
3.3
WORKED EXAMPLE 5
Yukio and Mussa are in partnership, sharing profits and losses in the ratio of 2:1
respectively. A statement of financial position at 31 January 2021 showed:
$
ASSETS
Non-current assets
Premises
Office equipment
Vehicles
Current assets
Inventory
Trade receivables
Bank
Total assets
CAPITAL AND LIABILITIES
Capital accounts – Yukio
Mussa
Non-current liabilities
Loan – Mussa
Current liabilities
Trade payables
Total capital and liabilities
150 000
40 000
60 000
250 000
18 000
6 000
4 000
28 000
278 000
3.3.1 Business acquisition and merger
Yukio and Mussa
Statement of financial position at 31 January 2021
120 000
100 000
220 000
50 000
8 000
278 000
The partnership was taken over by Sparta plc before the start of business on
1 February 2021. The purchase consideration was $400 000, consisting of:
l $30 000 cash
l $60 000 seven per cent debentures to be shared between the partners in
their profit sharing ratios
l 800 000 ordinary shares of $0.25 each shared equally between the partners.
379
3.3
For the purposes of the takeover, the partnership assets have been valued as
follows:
$
3.3 busIness aCQuIsItIon and merger
Premises
200 000
Office equipment
20 000
Vehicles
50 000
Inventory
16 000
Trade receivables
5 000
A statement of financial position for Sparta plc at 31 January 2021 showed:
Sparta plc
Statement of financial position at 31 January 2021
$000
ASSETS
Non-current assets
Land and buildings
6 700
Machinery
560
300
Vehicles
7 560
Current assets
Inventory
56
Trade receivables
34
Cash and cash equivalents
17
107
Total assets
7 667
EQUITY AND LIABILITIES
Equity
Ordinary shares of $0.25 each
Share premium
Revaluation reserve
Non-current liabilities
7% debentures
Current liabilities
Trade payables
Total equity and liabilities
4 000
1 000
2 269
7 269
350
48
7 667
Required
a Prepare a statement of financial position for Sparta plc at 1 February 2021
immediately after the takeover of the partnership.
b Based on the purchase consideration price, calculate the value of one share
held by a partner on 1 February 2021.
380
Answer
a
EQUITY AND LIABILITIES
3.3
3.3.1 Business acquisition and merger
Sparta plc
Statement of financial position at 1 February 2021
$000
ASSETS
Goodwill
117
Non-current assets
Land and buildings
6 900
Machinery
560
Office equipment
20
Vehicles
350
7 947
Current assets
Inventory
72
Trade receivables
39
111
Total assets
8 058
Equity
Ordinary shares of $0.25 each
4 200
Share premium
1 110
Revaluation reserve
2 269
7 579
Non-current liabilities
7% debentures
410
Current liabilities
Trade payables
56
Cash and cash equivalents
13
69
Total equity and liabilities
8 058
b $0.3875 each
Value of shares
$310 000
=
Number of shares 800 000
WORKED EXAMPLE 6
Using the information given in the above example, show the entries required
in the partnership books of account to dissolve the partnership of Yukio and
Mussa.
Remember do not try to close the books of account at the same time as you
prepare the company’s statement of financial position. Treat each part of such a
question as if it were a totally separate question.
If you need help in remembering how to do this, turn back to Chapter 3.1 on
structural changes to partnerships, where the dissolution of a partnership is
covered in detail.
381
3.3
Answer
Realisation
$
3.3 busIness aCQuIsItIon and merger
Premises
$
150 000 Sparta plc
400 000
Office equipment
40 000 Trade payables
Vehicles
60 000
Inventory
18 000
Trade receivables
8 000
6 000
Capital – Yukio
89 333
Capital – Mussa
44 667
408 000
408 000
Sparta plc
$
Realisation
$
400 000
Cash
30 000
Capital – Y
40 000
(deb)
Capital – M
20 000
(deb)
Capital – Y
155 000
(shares)
Capital – M
155 000
(shares)
400 000
400 000
Loan – Mussa
$
Bank
$
50 000
Balance b/d
50 000
Capital
Yukio
Mussa
$
Sparta (debs)
Sparta (shares)
Bank
Yukio
$
40 000
20 000 Balances b/d
155 000
155 000 Profit on realisation
14 333
$
120 000
100 000
89 333
44 667
30 333
175 000
209 333
Bank
$
$
4 000 Loan – Mussa
50 000
Sparta plc
30 000 Capital – Yukio
14 333
Capital – Mussa
30 333
64 333
382
$
Bank
209 333
Balance b/d
Mussa
64 333
175 000
Learning link
We first saw goodwill
mentioned in
partnership accounting
in Section 3.1.2.
STUDY TIP
When one business entity acquires another, the purchased consideration (amount
paid for the other business) is unlikely to be exactly same value as the capital of the
business. In many cases, the purchase consideration is higher than the value of the
capital of the business. There are often sound business reasons why the purchase
consideration exceeds the value of the capital.
The purchaser is paying for the advantage of acquiring an already established
business. This advantage usually takes the form of profits greater than those that
could reasonably be expected based purely on the tangible assets taken over. For
example, buying a business that has a strong brand image will mean that the sales of
the business are likely to be immediately higher than starting an unknown business
selling similar products. Customer loyalty to particular bands (such as Apple, Nike,
Samsung, Coca-Cola, etc) means that sales and profits are based on the value of
the intangible part of the business – though of course, this loyalty, and therefore
goodwill, can also change over time.
When a successful business is sold, the vendor will generally set the selling price at a
level greater than the value of the capital being sold. The cash paid by the purchaser
of a business to acquire the goodwill is paid in order to gain access to future profits
generated by the business taken over.
3.3
3.3.1 Business acquisition and merger
In this chapter,
goodwill appears in
many of the examples
used – look carefully
at how the goodwill is
calculated and where
it appears on the
financial statements.
How to value goodwill on the acquisition of a business by
another entity
Sometimes the amount paid for a business is less than the fair value of its separable
(individual) capital; this results in the purchase of negative goodwill. Negative
goodwill is shown as a negative amount under the heading of intangible non-current
assets.
How to prepare statements of profit or loss and statements
of financial position for the newly formed business entity
following acquisition or merger
Learning link
How goodwill is written
off from a partnership’s
accounts is shown in
Section 3.1.2.
As we can see in the examples in this chapter, the statement of financial position
will be based on the assets and liabilities taken on by the new business that exists
once the merger or acquisition has taken place. Assets and liabilities will be based on
agreed values prior to combining the businesses.
When partnerships merge to form a new partnership, or when a partnership has taken
over a sole trader, the goodwill that exists may be immediately written off and no
longer shown on the statement of financial position.
The statement of profit or loss would appear as it normally would for that type of
business entity. Even if the owners withdraw money or other resources from the
business, these do not appear in the statement of profit or loss so this statement
would be unaffected.
If the changes to a partnership take place during the normal accounting year then the
changes that have taken place – such as the admission of a new partner – will need to
be accounted for when producing the annual financial statements.
The advantages and disadvantages of the acquisition
or merger
When the owners (or directors in the case of a limited company) decide that they wish
to purchase another business they will appraise the financial benefits to be gained
through the acquisition.
383
3.3 busIness aCQuIsItIon and merger
3.3
Financial benefits may take the form of increased profitability of the ‘new’ enlarged
business due to:
» synergy – greater effectiveness obtained by two or more businesses joining forces
than could be obtained by them acting individually as single businesses
» vertical integration – control of different stages of production or sale of a product
» horizontal integration – controlling businesses at the same stage of production
will give a business greater market share and potentially more market power
» the acquisition of larger, more profitable contracts
» greater geographical coverage
» greater skills coverage – a larger business may be able to attract a more skilful
workforce
» perception of the ‘new larger’ business being more prestigious.
Other benefits may also be gained:
» An increase in market share may lead to disadvantaging a rival(s).
» The new company will be able to take advantage of internal economies of scale;
these could include:
– technical economies – larger businesses can often be more efficient since
costs are generally not proportionate to the increase in size
– managerial economies – larger businesses can generally afford specialist
managers who concentrate on one or two major areas of expertise
– financial economies – larger businesses are generally able to raise finance
more easily and they tend to have a greater variety of potential sources from
which to choose
– purchasing economies – larger businesses are more likely to purchase materials
in larger quantities and therefore take advantage of bulk discounting.
» Research and development can be undertaken more effectively by a larger business.
» Diversification is easier in a larger business; a more diverse portfolio of products
will open up further markets and reduce the risks associated with a limited range
of products.
Although there are clear advantages for businesses merging or combining with other
businesses, there are also disadvantages. Some common disadvantages include:
» Diseconomies of scale – normally, we associate a growing business with one that
has become more efficient and more able to control its costs. However, these is
the possibility that the bigger business will become less efficient and average
costs rise. This could be due to workers being less highly motivated in a bigger
business, communication problems arising and costs of administration rising
disproportionately.
» Clashing corporate cultures – each business has its own ‘style’ of operating.
This can include the leadership style adopted by managers, methods used to
communicate with workers and so on. Although these are not normally formally
encoded into a business’s operations, if the two businesses combining have
markedly different corporate cultures then business operations may be disrupted.
This is likely to be more of a problem when the two businesses combining are of
‘equal status’.
» Job insecurity – workers may feel less secure in their jobs – especially if there is
obvious duplication of roles. In this case, redundancies may occur. This is likely to
lead to rising feelings of job insecurity, which could cause demotivation and falling
productivity from the existing workforce.
» Loss of focus – a bigger business may lose the focus it previously had on satisfying
consumer demand. Often bigger businesses are seen as losing the ‘personal touch’
that a smaller business can provide. Following the combination of two or more
businesses, those running the business may be further removed from interaction
with customers, and even their own workers, meaning some of the reputation for
good customer service may be lost.
384
SUMMARY
SELF-TEST QUESTIONS
1 Explain the term ‘synergy’.
2 Explain the difference between vertical and horizontal integration.
3 Explain why a business might wish to acquire another business.
4 Identify and explain two types of economies of scale.
3.3
3.3.1 Business acquisition and merger
After reading this chapter you should be able to:
» understand why businesses undergo mergers and acquisitions
» prepare financial statements for sole traders, partnership and limited
companies that undergo mergers and acquisition
» prepare journal entries referring to the transfer of assets and liabilities
following a merger or acquisition
» understand how goodwill arises and prepare entries relating to the goodwill
following a merger or acquisition
» understand the benefits and drawbacks for businesses following mergers or
acquisitions.
5 A manufacturer of television sets starts production of microwave cookers. This is
an example of diversification. True/False?
6 Explain why two sole traders might combine their businesses and form a limited
company.
7 When two sole traders form a limited company they would retain the principle of
unlimited liability. True/False?
385
3.4 ComputerIsed aCCountIng systems
3.4
Computerised accounting systems
Learning outcomes
By the end of this chapter you should have an understanding of:
l the process of transferring business accounts to a computerised system
l ways in which the integrity of accounting data can be ensured during a transfer
to a computerised system.
Introduction
It is likely that many businesses will eventually adopt computers to aid with
the accounting functions of the business. As a result, a transfer of systems
will be needed – from paper-based manual systems, to computerised
accounting systems. This will require careful organisation and a business will
need to ensure that business accounts are transferred in a way that does not
compromise the integrity of the accounting data.
3.4.1 Computerised accounting systems
Computerised accounting packages are increasingly being used by businesses, both
large and small, for increased efficiency and effectiveness.
Small or medium-sized businesses may purchase an ‘off-the-shelf’ accounting package
to aid the recording of transactions particular to their own business needs. The
complexity of such packages varies according to the individual needs of the business,
with some being used to carry out functions such as invoicing or complete payroll
activities. Others are used to provide management with instant reports of the state of
the business.
Larger, more complex businesses will require bespoke packages ‘tailored’ to their own
individual business needs.
Whatever accounting package is chosen, all are designed to be easy to use. They
are also integrated, which means that the input of one transaction is recorded
simultaneously in all the appropriate accounting records. For example, when the
receipt of an invoice from a supplier is keyed into the system, all ledger entries are
made instantly:
» the supplier’s account in the purchases ledger is credited
» the purchases account in the general ledger is debited
» inventory records show an increase in goods held.
When the supplier is paid:
» the bank account is credited
» the supplier’s account is debited.
The advantages of using a computerised system include speed, accuracy and the
ability to produce detailed information about the state of the business at the touch of
a button. The disadvantages include cost, both in terms of investment in hardware and
software and also in terms of staff training, and the impact on staff morale.
386
The process of transferring the business accounts to a
computerised accounting system
The change from a manual system to a computerised system should be methodical, to
reduce the possibility of errors being introduced into the system.
A period of parallel operation may also help with the transfer. This would be where
the business runs a paper-based manual system of accounting at the same time as
running the newly installed computerised accounting system. This means that if there
are any discrepancies in the computerised data, the paper system can still be used for
the accounts.
Ways in which the integrity of the accounting data can be
ensured during the transfer to a computerised accounting
system
3.4.1 Computerised accounting systems
When a computerised accounting system is first installed great care must be taken
to ensure that the transition from manual records to computer records is smooth and
accurate. The opening entries in the computerised system should be double checked
by different members of staff. The check can take the form of, say, a manually
prepared control account that is then compared with a printout; clearly the two should
match. Similarly, a manually prepared trial balance can be compared to a trial balance
extracted from the computer. A bank reconciliation could also help at this stage to
ensure that any differences between the manual records and any computerised update
can be accounted for.
3.4
When the transfer to a computerised system takes place, there are a number of steps
that can be taken to ensure the integrity of the accounting data:
SUMMARY
After reading this
chapter, you should:
» understand
the process of
transferring
business accounts
to a computerised
system
» be able to explain
ways in which
the integrity of
accounting data
can be ensured
during transfer to
a computerised
system.
» A period of parallel operation could be implemented (as discussed above) until the
system has been fully transferred and appears to be working.
» Regular reconciliation of the cash book and maintenance of control accounts can
ensure any errors are discovered earlier (as the transfer may generate more errors
than during a normal period).
» A trial balance can be produced more regularly to check that the transfer of
information used within the double-entry accounts is correct.
» A system of protective devices (firewalls, virus protection, and so on) must also be
introduced into the system to prevent unauthorised access.
» Each member of staff should have a unique password allowing access to their
area(s) of responsibility within the system.
» A robust data backup system must be in place so that a complete failure of a
computer or server does not lead to lost data.
SELF-TEST QUESTIONS
1 Explain two disadvantages of using a computerised accounting system to record
financial transactions.
2 Explain two advantages of using a computerised accounting package to prepare a
production budget.
3 Outline advantages to members of staff who will be required to use a
computerised accounting system.
4 A spreadsheet can only be used in very large businesses. True/False?
5 Explain how a middle manager might use a spreadsheet.
387
3.5 analysIs and CommunICatIon of aCCountIng InformatIon
3.5
Analysis and communication of
accounting information
Learning outcomes
By the end of this chapter you should have an understanding of:
l the analysis and communication of accounting information
l how to calculate the following ratios:
– working capital cycle (in days)
– net working assets to revenue (sales)
– interest cover
– gearing ratio
– earnings per share
– price/earnings ratio
– dividend per share
– dividend yield
– dividend cover
l how to analyse and evaluate the results of the ratios and draw conclusions
l how to make appropriate recommendations to stakeholders on the basis of the
analysis undertaken
l the interrelationships between ratios.
3.5.1 Analysis and communication of accounting
information
Information from accounts and financial reports is used to provide shareholder,
debenture holders and other stakeholders with further data on their investments.
Remember, shareholders are the owners of the company but, in most cases, the
decision to become a shareholder was based on the prospect of making financial
gains. Therefore, they will be interested in the financial information available to
measure how well their investment is performing.
Shareholders, generally, have invested in a limited company to gain a return on their
investment. They are also interested in the market value of their shares.
Before ordinary shareholders are able to receive any return on their investment, the
providers of long-term loans (debenture holders) need to be rewarded. Debenture
holders must receive their interest, however profitable or unprofitable the company
has been.
Information from the financial statements of Oyan Magenta is given. Data in the
following sections will be based on this information:
388
Oyan Magenta & Co.
Statements of financial position
at 31 March 2021
$000
$000
3 063
120
240
140
EQUITY AND LIABILITIES
Equity
Ordinary shares of $1
Retained earnings
Non-current liabilities
8% debentures
Current liabilities
Trade payables
Taxation
Total equity and liabilities
3.5
1 800
110
220
570
500
3 563
900
2 700
1 600
849
2 449
1 600
595
2 195
800
200
169
145
314
3 563
154
151
305
2 700
Extract from statement of changes in equity for the year ended 31 March 2021
$000
Retained earnings
Balance Apr 1 2020
595
Profit for the year
315
910
Dividends paid
(61)
Balance Mar 31 2021
849
3.5.1 Analysis and communication of accounting information
ASSETS
Non-current assets at carrying amount
Current assets:
Inventories
Trade receivables
Cash and cash equivalents
Total assets
at 31 March 2020
$000
$000
Additional information
Profit for the year after tax
Debenture interest paid during the year
Market price per share
Dividends paid during the year
Ordinary shares
2021
$
315 000
40 000
1.70
2020
$
293 000
16 000
1.50
61 000
54 000
Results from Chapter 1.6
Sales
Profit from operations
Trade receivables turnover
Trade payables turnover
Inventory turnover
2021
$2 600 000
$500 000
34 days
43 days
29 days
2020
$2 000 000
$460 000
41 days
46 days
30 days
389
3.5
How to calculate, analyse and evaluate the results of ratios
and draw conclusions
3.5 analysIs and CommunICatIon of aCCountIng InformatIon
Working capital cycle (in days)
This ratio calculates the time taken between a business making payment for goods
received and the receipt of cash from customers for the sale of the goods. The shorter
the time between the business laying out cash for the purchase of goods and the
collection of cash for the sales of the goods, the better for the business, since less
finance from other sources is needed.
Working capital cycle = Trade receivables turnover + Inventory turnover – Trade payables turnover
2021
2020
34 + 29 − 43 = 20 days
41 + 30 − 46 = 25 days
In both years the ratios seem acceptable. There has been a slight improvement of
the situation. Although trade receivables and inventory turnovers are moving in the
right direction, for some reason the company is paying its trade payables some 3 days
faster! The shorter the cycle, the lower the value of working capital needed to be
financed from other sources.
The cycle can be shortened by:
» reducing levels of inventories held
» speeding up collection of monies from trade receivables
» delaying payment to trade payables.
Net working assets to revenue (sales)
This calculation shows the proportion of sales revenue that is tied up in the less liquid
net current assets; in other words, the value of the net working assets that is not
immediately available for use in the business.
Net working assets = Inventories + Trade receivables – Trade payables
Net working assets Inventories + Trade receivables – Trade payables
× 100
=
to revenue (sales)
Sales
2021
2020
120 + 240 − 169
× 100 = 7.35%
2600
110 + 220 − 154
× 100 = 8.8%
2000
This shows that the proportion of net current assets held in a non-cash form is low.
There has been a slight improvement over the two years under consideration.
Interest cover
Interest cover looks at how capable a business is at paying off the entire interest
charges for a year out of that year’s operating profit. The higher the ratio, the ‘safer’
the business is. Interest charges cannot normally be avoided; therefore it is vital
that this ratio is sufficiently high that the business has no trouble meeting interest
payments. It can also be used by shareholders as an indicator of the potential for
dividend payments – if the interest cover is high, this could indicate the business has
plenty of available profits remaining to make dividend payments to shareholders.
Interest cover =
390
Profit from operations
Interest charges
2021
2020
500 000
= 12.5 times
40 000
460 000
= 28.75 times
16 000
3.5
This means the interest charge for 2021 could have been paid 12.5 times over from the
2021 profit, down from almost 29 times in 2020. Both years’ interest covers are high
indicating the business should have no trouble paying interest out of the profit from
operations. However, it has fallen significantly between 2020 and 2021. This should be
monitored in case it falls much further.
The ordinary shareholders’ return may be at risk if the company’s capital is provided
mainly by debenture holders.
The degree of risk is measured by the gearing ratio.
So:
Gearing ratio =
Fixed cost capital
Non-current liabilities
=
Total capital
Non-current liabilities + Issued ordinary shares + All reserves
This is very occasionally expressed as:
Gearing ratio =
Fixed cost capital
Total capital
2021
800
800 × 100
=
= 24.6%
800 + 1600 + 849
3249
2020
200
200 × 100
=
= 8.4%
200 + 1600 + 595
2395
The gearing of a company is said to be:
3.5.1 Analysis and communication of accounting information
Gearing ratio
» high when the ratio is more than 50 per cent
» neutral when the ratio is 50 per cent
» low when the ratio is less than 50 per cent.
High geared means:
» high borrowing
» high debt
» high risk.
Low geared means:
» low borrowing
» low debt
» low risk.
In the first year, 2020, 8.4 per cent of total capital employed was provided by people
other than ordinary shareholders. In the second year, 2021, the company became
more highly geared: 24.6 per cent of capital employed was provided by people other
than the ordinary shareholders. The company became more highly geared but by our
measure, it remained a low-geared company: 75.4 per cent of capital employed was
provided by the ordinary shareholders.
Investment in a highly geared company is more of a risk than an investment in a lowgeared company because if the company is unable to service its long-term liabilities
then it may be forced into liquidation by those long-term investors. It follows that
a highly geared company may find it difficult to borrow further funds because of the
inherent risk. Banks may also be reluctant to lend to highly geared companies since
they may feel that the ordinary shareholders should be prepared to finance their own
company rather than rely on ‘outsiders’.
391
Earnings per share
3.5
This ratio indicates the portion of a company’s profit that is ascribed to each share.
Earnings per share =
Profit for the year (after taxation)
Number of ordinary shares
3.5 analysIs and CommunICatIon of aCCountIng InformatIon
2021
STUDY TIP
The calculation
uses the numbers
of ordinary shares
issued, not the value.
So $2 000 000 ordinary
shares of 25 cents each
would use 8 000 000 as
the denominator in the
calculation.
2020
315 000
= 19.7 cents
1 600 000
293 000
= 18.3 cents
1 600 000
The earnings per share (EPS) increased in the second year. It improved by 1.4 cents
per share.
Price/earnings ratio
The price earnings (P/E) ratio relates the market price of the share to the earnings per
share. It represents the number of years’ earnings that investors are prepared to pay to
purchase one of the company’s shares.
The higher the P/E ratio, the greater the confidence investors have in the future of the
company.
Price earnings ratio =
Market price per share
Earnings per share
2021
$1.70
= 8.63
$0.197
2020
$1.50
= 8.20
$0.183
Investors are more confident at 31 March 2021 than they were a year earlier. They are
paying 8.63 times the earnings to acquire shares in Oyan Magenta plc. Since the ratio
compares current market price with earnings per share, an increase in market price
will increase the ratio. Demand for shares is dependent on investors’ perception of
the company’s future performance. An increase in demand for the shares will generally
cause an increase in the share price. A high P/E ratio will indicate expected future
growth (or an overvalued share). A low P/E ratio indicates expected poor performance
in the future (or an undervalued share).
Dividend per share
This indicates how much dividend was paid for each ordinary share held.
Dividend per share =
STUDY TIP
Always indicate
whether the answer
to your calculations
is a percentage (%)
or numbers of days,
cents, times, etc.
Annual ordinary dividend paid
Number of issued ordinary shares
The annual dividend may be paid in a number of instalments. If it is, then do include
the total dividends paid to ordinary shareholders for the year.
2021
$61 000
= 3.8 cents
1 600 000
2020
$54 000
= 3.4 cents
1 600 000
The amount of dividends received per share held has risen slightly from 3.4 cents per
share to 3.8 cents per share.
392
Dividend yield
Shareholders invest in a company in order to gain a return (dividends) on their
investment (they also hope that the market price of the share will rise so that if they
sell their holding they will make a capital profit – a capital gain).
3.5
The dividend yield expresses the actual dividend received by the shareholder as a
percentage of the market price of the share. It shows the actual percentage return an
investor can expect based on the current market price of the shares.
Dividend per share
Market price of share
2021
2020
$0.038 × 100
= 2.2%
$1.70
$0.034 × 100
= 2.3%
$1.50
The dividend yield is reasonably low at just over 2% and has fallen slightly between
2020 and 2021.
Dividend cover
Dividend cover =
Profit for the year after tax
Dividends paid
2021
315 000
= 5.16 times
61 000
2020
293 000
= 5.43 times
54 000
Both are quite high but the second year shows a slight deterioration. Although profits
have increased the dividend paid has increased by a greater percentage. Is this a sign
of a change in dividend policy?
3.5.1 Analysis and communication of accounting information
Dividend yield =
How to make appropriate recommendations to stakeholders
on the basis of the analysis undertaken
Investors (current and potential) will normally be looking to maximise their own
financial returns. Investment decisions will be based on a combination of the following:
» capital gains – achieved by rising market prices for share values
» dividends received – paid out of profits earned by the business.
Clearly, rising profits will be crucial for an investor looking to increase their own
financial returns. Rising profits means more can be paid out as dividends, and more
can be retained within the business for future investment in growth and other profitmaking aspects of business performance.
Rising profits will usually send a clear signal to potential investors that the business
is an attractive investment option. This will usually mean the market price per share
rises as more investors decide to invest in the shares of this business.
Rising profits will normally send a signal to the workers of a business that jobs
are more likely to be secure and that wage increases may be affordable and worth
pursuing. Similarly, rising profits normally tell a lender or supplier offering credit
terms that the risk of default is lower than might otherwise be the case.
Different stakeholders might be interested in different ratios, for example:
» Suppliers – interested in the profitability and liquidity ratios when allowing for
trade credit.
» Lenders – interested in gearing, profitability and liquidity when deciding whether
to loan money and whether the business can maintain repayments.
393
3.5
» Workers – interested in profitability for job security and wage levels.
» Investors – interested in profitability and investor ratios to judge potential returns
on their investments as dividends and capital gains.
» Managers – interested in profitability, liquidity and efficiency in order to judge
business performance.
3.5 analysIs and CommunICatIon of aCCountIng InformatIon
The interrelationships between ratios
Clearly, a number of these ratios are interrelated. If one ratio changes, other ratios
will change. Many of these ratios will ‘move’ in the same direction. Examples of the
interrelationship between ratios would include:
» If dividends per share (and dividend yield) are rising due to the business allocating
more of its post-tax profits for ordinary shareholders as dividends, then we would
expect to see dividend cover fall.
» A rise in the earnings per share would mean a falling price/earnings ratio –
normally sending a signal that the current share price is undervalued (unless other
information is depressing the share price, such as wider, external factors).
» An increase in gearing may mean a fall in the interest cover ratio – unless the
new borrowing is taken a lower interest rates – or if interest rates are falling and
remaining at low levels (as in most countries since 2009 onwards).
» Earnings per share and dividends per share are clearly interrelated. The earnings
per share shows the amount potentially available to the ordinary shareholders as
dividends, whereas the dividends per share shows the amount actually paid out
to ordinary shareholders as dividends. You might suppose that the dividends per
share can be as high as the earnings per share but not higher (if all of the available
profits were paid as dividends). However, it is technically possible for a company
to draw from its revenue reserves and make a dividend payment in excess of the
earnings available – though this would be unusual.
EVALUATION
Nest Builders Ltd – a small building company – has seen its customer base
increase consistently over the last few years. The company is looking to expand
the business to cope with the increase in demand. The business is run by equal
shareholders: Steve and John. Steve wishes to borrow the money. John is
worried about the increased borrowing and points out to Steve that the gearing
ratio would be much higher than those of other, similar businesses.
Advise Steve and John on whether the increase in gearing is something to be
concerned with.
A good answer should include the following.
Arguments supporting the high gearing include:
l No loss of control – unlike with share issues.
l Loan capital has tax advantages over equity.
l Share capital can take time to administer (if they wish to expand).
l Investment opportunities may be missed if money is not quickly obtained.
Arguments against a high gearing ratio would include:
l Highly geared businesses will use a greater proportion of profits to pay
interest charges.
l Businesses will be more vulnerable to increases in interest rates.
l Borrowed money must be repaid – other forms of finance may not have this issue.
Overall:
l If interest rates are low and are likely to remain low for a few years then
interest charges may be low if they are borrowing for a limited period of time.
l What alternatives are available?
l Is the expansion and growth realistic and sustainable?
394
SUMMARY
3.5
After reading this chapter you should:
» be able to calculate investor and gearing ratios
» be able to analyse, evaluate and draw conclusions from ratio calculations
» be able to make recommendations to stakeholders on the basis of ratio
calculations
» understand the interrelationships between gearing and investor ratios.
1 How is the working capital cycle calculated?
2 Gearing shows how much long-term finance a limited company needs. True/False?
3 Sales ÷ Number of shares = Earnings per share. True/False?
4 A limited company has an issued ordinary capital of $200 000. Each share was
issued a number of years ago for $0.25. The total dividend paid for the year is
$56 000. The current market price is $0.70 per share. Calculate the dividend yield.
5 What is meant by an investment ratio?
Calculation questions (answers on page 494)
6 The following extracts are taken from the financial statement of a company. Use
this information to calculate the interest cover and dividend cover ratios for both
years.
2023
2022
$
$
350 000
285 000
Taxation
65 000
48 000
Debenture interest paid during the year
52 000
38 000
Dividends paid during the year
66 000
59 000
Operating profit
3.5.1 Analysis and communication of accounting information
SELF-TEST QUESTIONS
7 From the following data, calculate the gearing ratio for 2022 and 2023.
Ordinary share capital
2023
2022
$000
$000
1 000
800
Revaluation
190
190
Share premium
200
100
Retained earnings
654
432
1 800
1 200
5% Debentures
395
4 Cost and management accounting (A Level)
4.1 aCtIvIty based CostIng
4.1
Activity based costing
Learning outcomes
By the end of this chapter you should have an understanding of:
l the application of activity based costing, its uses and limitations
l what is meant by a cost driver
l how to use activity based costing to:
– identify the appropriate cost driver
– apportion and allocate overheads
– calculate the total cost and selling price of a unit
l the effect of different methods of overhead absorption on cost and profit
l how to apply activity based costing techniques to make business decisions and
recommendations.
Introduction
Activity based costing is an approach to costing that attempts to provide greater
accuracy on how overheads are apportioned to products. Absorption costing
apportions overheads on the basis of labour hours or machine hours once they
have been apportioned to cost centres. In reality, overheads are not generated by
labour hours or machine hours but out of specific activities. These activities are
used to apportion overheads to give a more realistic cost of a product. Overheads
will be absorbed on the basis of the number of times these activities occur.
4.1.1 Activity based costing
The application of activity based costing
The use of the absorption methods already considered in Chapter 2.2 assumes that all
factory overheads are linked to that particular method of absorption. However, closer
examination of the causes of activities that cause costs will allow a more realistic
method of absorption.
Activity based costing is an attempt to absorb factory overhead costs in a more
realistic way than the alternative methods of absorption that use labour hours or
machine hours as a basis.
Each activity that drives (generates) the cost is analysed in detail. The cost incurred is
then absorbed according to the number of times the activity is performed in the year
under review.
If a number of overheads are incurred it follows that a number of absorption rates will
need to be calculated.
The costs of running each department are analysed and each separate activity (or cost
driver) is totalled into cost pools. Cost pools can attract the cost of an activity that
‘bridges’ a number of different departments. The number of times that each activity is
performed is totalled.
396
The cost of each activity can then be calculated:
Cost of activity
4.1
Number of times that activity is performed
The result can then be determined if a product requires multiple performances.
What is meant by a cost driver?
»
»
»
»
»
»
»
set up machinery for a new batch of products
appropriate machinery may need to be hired to produce different products
maintenance of machinery
internal transportation within the business of goods from one area to another
inspection and checking
ordering of supplies and materials
packing of products.
4.1.1 Activity based costing
Most indirect costs or overheads incurred in modern manufacturing do not necessarily
arise from labour or from time. A cost driver is an activity within the business that
will cause an overhead to be generated. For example, a cost driver could be any of the
following:
These cost drivers are driven by the activity of the business and not directly related
to the cost of labour or cost of materials used within the business. These costs will
need to be included within the cost of each unit of output. For example, a specialist
product that requires the use of specialist machinery may be more expensive and
the cost of the product should reflect this increased cost. These overhead costs are
not connected with the time taken to produce a unit of output, or the labour costs
incurred in the production of output. As a result, it is believed that following this
approach will give more realistic costs.
Differences between cost pools and cost drivers
In theory, every single overhead cost could also be a cost driver. However, this is not
practical and many overheads arise out of similar activities. For example, the setting
up of machinery may generate overheads connected with the costs paid to the workers
physically moving the machinery around and the cost of checking the machinery has
been installed safely and so on. Logically, these costs can be grouped together as a
cost pool.
It is the setting up of the machinery that is the cost driver – i.e. this is the activity
that generates additional overhead costs.
How to use activity based costing
The stages of an activity based costing system are:
1 Record and classify all costs.
2 Identify the activities producing the overhead cost.
3 Identify cost drivers.
4 Apportion appropriate overheads to the cost drivers.
5 Calculate the cost driver rate.
6 Absorb both indirect and direct costs into the product or service.
397
4.1
WORKED EXAMPLE 1
Biolop incurred the following costs:
4.1 aCtIvIty based CostIng
$
Machinery set-up
7 452
Ordering costs
6 000
Quality control
1 972
Selling expenses
7 225
Product selling price is based on cost plus 30%.
Additional information
Product A
Product B
Product C
Direct materials
$10 000
$3 000
$9 000
Direct labour
$12 000
$15 000
$4 000
Number of machine set-ups
30
16
8
Number of purchase orders
3 000
1 000
2 000
20
18
30
Number of sales
4 000
3 500
1 000
Number of products produced
5 000
3 000
9 00
Number of quality inspections
Required
Calculate:
a The activity-cost driver rate
b Overheads per product
c Total cost per product
d Selling price for each product.
Answer
a
Activity
Machine set-ups
Cost ($)
Cost driver
Cost driver rate
b
Ordering
7 452
6 000
1 972
7 225
54
6 000
68
8 500
$138.00
$1.00
$29.00
$0.85
Machine set-ups
Ordering
Quality control
A
30 × $138 = $4 140
3 000 × $1 = $3 000
20 × $29 = $580
4 000 × $0.85 = $3 400
B
16 × $138 = $2 208
1000 × $1 = $1 000
18 × $29 = $522
3500 × $0.85 = $2 975
C
8 × $138 = $1 104
2000 × $1 = $2 000
30 × $29 = $870
1000 × $0.85 = $850
Total overheads:
A $11 120 ($4 140 + $3 000 + $580 + $3 400)
B $6 705 ($2 208 + $1 000 + $522 + $2 975)
C $4 824 ($1 104 + $2 000 + $870 + $850)
398
Quality control Selling expenses
Selling expenses
c
Product A
Product B
Product C
$
$
$
materials
10 000
3 000
9 000
labour
12 000
15 000
4 000
Apportioned overheads
11 120
6 705
4 824
Total cost
33 120
24 705
17 824
4.1
Allocated direct costs –
Product A
Product B
4.1.1 Activity based costing
d The selling price can be determined by using the total costs from (c) or by using the unit costs.
Using total costs $33 120 × 1.3 (mark-up) = $43 056 for 5000 units of A
Selling price per unit of product A = $8.61 ($43 056 ÷ 5000)
Total costs $24 705 × 1.3 = $32 117 for 3000 units of B
Selling price per unit of product B = $10.71 ($32 117 ÷ 3000)
Total costs $17 824 × 1.3 = $23 171 for 900 units of product C
Selling price per unit of product C = $25.75 ($23 171 ÷ 900)
Using unit costs for each product:
Product C
$
$
$
Direct materials
2.00
1.00
10.00
Direct labour
2.40
5.00
4.44
Prime cost
4.40
6.00
14.44
Overheads
2.22
2.24
5.36
Total cost per unit
6.62
8.24
19.80
Mark-up
1.99
2.47
5.94
Selling price per unit
8.61
10.71
25.74
Note that the slight difference in the totals is due to rounding ($25.75 versus $25.74).
Calculate the total cost and selling price of a unit
Activity based costing can be used to help a business set the selling price of its
output, either as a unit selling price or as a price for a batch of products. This would
normally be calculated as a percentage mark-up based on the activity based cost for
each unit of output or job completed.
WORKED EXAMPLE 2
Yellops Limited manufactures two products Stodd5 and PJ4. The following budgeted figures are available.
Sales (units)
Stodd5
PJ4
8 000
2 000
Direct labour hours per unit
3
2
Direct labour costs per hour
$10
$8
Direct materials used per unit
4 kg
6 kg
Direct materials cost per kg
$15
$12
The company’s directors use activity based costing to apportion the production overheads. They have
identified the four major activities involved in the production cycle as maintenance of machinery, set up
of machinery, ordering costs and inspection. The costs of each activity have been established and the
overheads apportioned between the activities as follows:
399
4.1
Production overheads ($)
Stodd5
PJ4
Machine maintenance costs
24 000
60 hours
40 hours
Machine set up
32 000
25 times
15 times
Ordering costs
30 000
8 orders
16 orders
Inspection costs
54 000
20 hours
10 hours
4.1 aCtIvIty based CostIng
140 000
Required
l Calculate the production overheads apportioned to each product using activity based costing.
l Calculate the cost per unit and selling price of each product based on a 20% mark-up on the unit cost of
production.
Answer
Activity
Machine maintenance
Machine set up
$24 000
$32 000
$30 000
$54 000
100 hours
40 times
24 orders
30 hours
$240
$800
$1 250
$1 800
Cost
Cost driver
Cost driver rate
Ordering
Inspection costs
Total overheads would be allocated as follows:
Stodd5
PJ4
Machine maintenance
Machine set up
Ordering costs
Inspection costs Total
$240 × 60
= $14 400
$800 × 25
= $20 000
$1 250 × 8
= $10 000
$1 800 × 20
= $36 000
$80 400
$240 × 40
= $9 600
$800 × 15
= $12 000
$1 250 × 16
= $20 000
$1 800 × 10
= $18 000
$59 600
Stodd5
PJ4
$
$
Direct labour cost
240 000
32 000
Direct materials cost
480 000
144 000
80 400
59 600
800 400
235 600
Apportioned overheads
Total cost
Cost per unit (total cost / number of units)
100.05
117.80
Selling price (20% mark-up)
120.06
141.36
The uses and limitations of activity based costing
Uses of activity based costing
A system of activity based costing allows managers to:
»
»
»
»
provide more realistic costing information
identify where and understand how overheads arise
set bench marks for planning and control purposes
improve performance by replicating good practice identified in one department
across other departments
» help in the preparation of estimates and quotes for other work
» identify individual products or services that are unprofitable or overpriced.
400
Limitations of activity based costing
Some of the limitations of an activity based cost system are:
» some overhead costs cannot be assigned to a cost pool, for example, the CEO’s
salary or factory depreciation
» implementing a system of activity based costing is also a costly process because of
its complexity.
Activity based costing apportions overheads differently from the more traditional
method of absorption costing. This means that the unit cost of production will differ
when using activity based costing compared to using absorption costing methods.
If the selling price is based on the unit cost then there will be a different selling price
depending on which method of costing is used.
If we continue with the Yellops Limited example used earlier we can illustrate how the
cost and selling price differ under each costing method.
4.1.1 Activity based costing
The effect of different methods of overhead absorption on
cost and profit
4.1
WORKED EXAMPLE 3
Using absorption costing, calculate:
a the total production cost
b the cost per unit
c the selling price based on a 20% mark-up.
The four fixed overheads totalled $140 000 and are to be allocated on the basis
of labour hours.
Answer
Based on the sales data, and the direct labour hours needed to produce each
unit, the total labour hours used:
Stodd5: 8000 units × 3 hours per unit
24 000
PJ4: 2 000 × 2 hours per unit
4 000
Total labour hours
28 000
Overhead absorption rate = $140 000 ÷ 28 000 = $5 per labour hour.
The total cost of production for each product, and the unit cost is calculated as
follows:
$
$
Direct labour cost
240 000
32 000
Direct materials cost
480 000
144 000
Overheads
120 000
20 000
Total production cost
840 000
196 000
105.00
98.00
Cost per unit (Total production cost ÷ output)
Using a 20% mark-up, the selling price for each product is:
Cost per unit (total cost ÷ number of units)
$105.00
$98.00
Selling price (20% mark-up)
$126.00
$117.60
401
4.1
We can see that in this example, when comparing absorption and activity based
costing techniques, activity based costing gives a lower unit cost for Stodd5
($100.05 compared with $105.00) but an increased unit cost for PJ4 ($117.80
compared with $98).
4.1 aCtIvIty based CostIng
When using a mark-up to set the selling price, the choice of costing method
will matter. In this case, the selling price will be higher when the activity based
costing unit cost is higher (and vice versa).
A company may switch from absorption costing to activity based costing as it usually
gives a more realistic picture of how costs arise. The cost drivers focus on what is
generating the costs, such as set-ups and checking. Knowing how the cost arises may
make it easier to control the cost if the business is looking to improve efficiency.
Some companies continue to use absorption costing. This may be through inertia or
lack of experience. The cost of switching systems, and the training of staff that goes
along with the switch, may also be substantial – even if it is largely a one-off cost.
There is also the possibility that some businesses continue to use absorption costing
as they recognise that the overheads they incur are not specifically driven by
particular activities. For example, rent of a factory is not particularly linked to any
one individual activity, i.e. it does not have a particular driver. In this case, time or
floor space may provide a better method of charging for this overhead. As a result
absorption costing will prevail as the chosen method.
How to apply activity based costing techniques to
make business decisions and recommendations using
supporting data
With absorption costing, although overheads can be apportioned between cost
centres using different criteria, the total overheads included in each unit of output
is based on an arbitrary choice of some basis (usually labour or machine hours). It
can be argued that this is an outdated approach. Activity based costing gives a more
meaningful allocation of overhead costs to each unit. This is because a multiple
number of cost drivers are used in recognition of the different sources of overhead
costs in manufacturing. As a result, activity based costing, however, provides a more
complex method of allocating overheads, which does not focus on labour hours,
machine hours, or any other simple method of deriving the overhead absorption rate.
The overall profits of the business will be the same regardless of which costing
method is used, as the same costs are still incurred for the overall business
operations. However, some suggest that adopting activity based costing may lead to
increased profits eventually. This is because it provides greater clarity on how costs
are arising, which may make them easier to control. By focusing on what drives costs,
it may be easier to identify where these need to be controlled more carefully.
Although it may appear to give a more realistic indicator on the overhead costs to
include within each unit of output, activity based costing is still not always used.
Implementing a system of activity based costing requires training, time and money.
Although initially popular in the 1990s, the adoption of this system costing by
manufacturing business has not been as widespread as was once anticipated.
402
SUMMARY
SELF-TEST QUESTIONS
1 Explain the difference between allocating costs and apportioning costs.
2 A business produces 850 units of a product. Allocated direct costs – materials
$10 000; labour $2000; apportioned overheads $1175. Calculate the cost of
producing one unit of the product.
4.1
4.1.1 Activity based costing
After reading this chapter you should:
» understand activity based costing, its uses and limitations
» understand the differences between cost pools and cost drivers
» be able to identify cost drivers, apportion and allocate overheads and calculate
the cost and selling price of a product using activity based costing
» make comparisons of differences in cost using activity based costing and
absorption costing, and the effect on selling price
» know how to apply activity based costing to make business decisions and
recommendations.
3 The allocation of overheads using labour hours is a much more realistic method of
apportioning overheads than using machine hours. Do you agree?
4 Cost drivers and cost pools are different descriptions for the same activity.
True/False?
5 Cost of ordering materials $400; number of purchase orders 200. Calculate the
cost driver rate per order.
403
4.2 standard CostIng
4.2
Standard costing
Learning outcomes
By the end of this chapter you should have an understanding of:
l the meaning of a system of standard costing and the advantages and
disadvantages of this system
l how to calculate the following variances:
– direct material price and usage
– direct labour rate and efficiency
– fixed overhead expenditure and volume
– fixed overhead capacity and efficiency sub-variances
– sales price and volume
l the possible causes of favourable or adverse variances and their relationship
to each other
l how standard costing can be used as an aid to improve the performance of a
business
l making business decisions and recommendations using supporting data
l the significance of non-financial factors.
Introduction
Businesses will often produce budgets (also covered in the next chapter)
that set out expected costs, revenues and profits for a forthcoming period. To
estimate likely cost and revenue, managers must have some idea of the likely
unit cost of production, the likely output level and the probable selling price.
A comparison of the budgeted data with the actual data can provide useful
information. A business may wish to analyse the reasons why budgeted and
actual data are not the same. Standard costing is the process of analysing why
differences exist between budgeted and actual data. Once analysed, causes of
the divergence can be investigated and recommendations of how to improve
matters can be formulated.
4.2.1 Standard costing
The meaning of a system of standard costing in an
organisation
We all set standards in our everyday lives. Standards are goals – things that we hope
to achieve.
» You may wish to save a certain sum of money in order that you can purchase a
more up-to-date games console.
» You may wish to run 400 metres in a time of 1 minute 10 seconds or less.
All the examples may be realistic targets that we believe are achievable.
404
The same idea is widespread in manufacturing businesses. In order to achieve an
efficient production process, a budget will be prepared. The details will set the
targets that the business hopes to achieve – standards are set for future performance.
4.2
If you failed to accumulate sufficient funds to allow the purchase of the games
console, you may need to investigate the reasons why. The failure could have been
because:
If the desired time for completion of the 400 metres was not achieved, this could be
due to:
» an unrealistic target
» poor training regime
» poor athletic diet, etc.
If a business does not achieve the standards set, the managers will also wish to find
out why the standards were not achieved.
4.2.1 Standard costing
» the target (standard) was unrealistic
» income was less than expected or
» other financial priorities took precedence.
Estimated costs for direct labour, direct materials and overheads will be calculated
and added together to give the standard cost for the product (the standard unit
price). The estimated or target costs are based on the costs that should be incurred
under efficient production conditions.
The standard costs can be based on:
» past data used to forecast likely usage of direct materials and direct labour
» detailed study of the production processes involved in manufacturing.
Material standards are based on the quantity of direct materials that will be necessary
to complete each unit of output.
Direct labour standards are based on production methods and the hours required by an
average worker to complete each unit of output.
Types of cost standard
» Basic cost standards are unchanged over long periods of time. This enables
managers to gauge efficiency of a process over time. Basic cost is rarely used
because of the historical nature of the data.
» Ideal standards are based on achieving minimum costs that are possible using the
most efficient production conditions. Once again, this type of standard is rarely
used since these standards are almost impossible to achieve and can therefore act
as a demotivating force.
» Attainable standard hours are costs that should be achievable using efficient
operating conditions. Allowance is made for the ‘usual’ production problems such
as lost time, machinery breakdowns and natural wastage.
STUDY TIP
You must ensure that
you memorise the
correct formula to use.
How to calculate variances
Variance is the difference between budgeted (standard) revenue and costs and
actual revenue and costs. Variances arise when actual results do not correspond with
predicted results.
Variances are judged in terms of their impact on the profits of the business. An
adverse variance occurs when the actual profits will be lower as a result of the
variance. A favourable variance occurs when the actual profits will be higher as a
result of the variance.
405
Direct materials variances
Direct materials variances arise when there is a difference between the amount the
managers thought they would spend on materials, which is the standard cost, and the
amount actually spent on direct materials.
4.2 standard CostIng
4.2
Direct materials variance =
Standard cost of direct materials – Actual cost of direct materials
Or
(Standard quantity × Standard unit price) − (Actual quantity × Actual unit price).
WORKED EXAMPLE 1
Harry Butterworth has a standard cost for direct materials of $72 000 in October. When confirmation is
available in November, Harry discovers that actual expenditure was $75 000.
Required
Calculate the total direct materials variance for October.
Answer
Total direct materials variance
$
Standard cost
72 000
Actual cost
75 000
Variance
(3 000) adverse
Note
The variance is adverse because the direct materials cost the business more than anticipated, as shown by
the standard costs, and will therefore reduce profits (i.e., it affects profits adversely).
WORKED EXAMPLE 2
Lucy Wang had a standard cost for her direct materials of $36 000 for January. In February she was able to
determine that actual direct materials cost $34 800.
Required
Calculate the total direct materials variance.
Answer
Total direct materials variance
$
Standard cost
36 000
Actual cost
34 800
Variance
1 200 favourable
Note
The direct materials variance is favourable as the actual cost to the business for direct materials was less
than the anticipated costs, as set out as standard cost. Therefore, this variance would increase profits (and
have a favourable effect on profits).
406
Direct material price and usage variances
It is useful to know whether the cost of direct materials is more or less than was
anticipated in the standard cost of direct materials. However, from a management
point of view it would be much more useful if we could discover why the variance from
standard figures had arisen.
4.2
The difference in the cost of direct materials used could be due to:
We can identify differences in budgeted and actual expenditure resulting from the
above factors by calculating sub-variances. If the reasons for the variances can be
identified, it should be possible to replicate any good efficient practices in other cost
centres of the business.
4.2.1 Standard costing
» more direct materials being used than was expected (giving an adverse variance)
» fewer direct materials being used than was expected (giving a favourable variance)
» an increase in the prices of direct materials since the budget was prepared
(giving an adverse variance)
» a decrease in the prices of direct materials since the budget was prepared
(giving a favourable variance)
» a combination of a change in the use of direct materials and a change in prices.
Direct materials usage sub-variance
The direct materials usage sub-variance calculates changes in total direct materials
expenditure caused by changes in the quantity of direct materials used compared to
the standard quantity of direct materials that were expected to be used.
» An adverse sub-variance will indicate that the production process used more direct
materials than was anticipated. Once identified, remedial action can be taken.
» A favourable sub-variance will indicate that the production process used fewer
direct materials than was anticipated.
» The direct materials usage sub-variance is calculated as follows:
Direct materials price sub-variance = (Standard quantity of direct materials −
Actual quantity of direct materials) × Standard unit price
WORKED EXAMPLE 3
R. Patel provides the following information for raw direct materials:
Direct materials used
Standard quantity
Actual quantity
2000 kg
2100 kg
The standard price and actual unit price for direct materials were both $8 per kg.
Required
Calculate the direct materials usage sub-variance.
Answer
Direct materials usage sub-variance: = (Standard quantity − Actual quantity) ×
Standard price
= (2 000 − 2 100) × $8
= $800 adverse
We know the variance is adverse because it is caused by using more than direct
materials than the standard quantity of direct materials.
407
4.2 standard CostIng
4.2
WORKED EXAMPLE 4
A. Pawel provides the following information for raw direct materials to be used in production during September:
Standard quantity
Actual quantity
Direct materials used
830 metres
810 metres
Material cost per metre
$4
$4
Required
Calculate the direct materials usage sub-variances for September.
Answer
Direct materials usage sub-variance = (Standard quantity − Actual quantity) × Standard price
= (830 − 810) × $4
= $80 favourable
This variance is favourable as it is caused by fewer direct materials being used than the standard quantity.
STUDY TIP
Always indicate
which variance you
have calculated and
state whether it is a
favourable variance or
an adverse variance.
Direct materials price sub-variance
A direct materials price sub-variance calculates any differences between the standard
cost and actual cost for direct materials caused by differences in the prices of the raw
direct materials being purchased.
» A direct materials price sub-variance will arise when the price of the direct
materials changes.
» An adverse price sub-variance will arise when the cost of acquiring the direct
materials has risen.
» A favourable price sub-variance arises when the cost of acquiring the direct
materials has fallen.
The direct materials price sub-variance is calculated as follows:
Direct materials price sub-variance = (Standard price per unit − Actual price
per unit) × Actual quantity of direct materials
WORKED EXAMPLE 5
Rosa provides the following information for raw direct materials to be used in her production process for
December:
Standard
Direct materials to be used
1 200
Cost per litre
$9.60
In January, the following information relating to December became available:
Actual
Direct materials used
1 200
Cost per litre
$9.80
Required
Calculate the direct materials price sub-variance for December.
Answer
408
Direct materials price sub-variance = (Standard price − Actual price) × Actual quantity
= ($9.60 − $9.80) × 1 200
= $240 adverse
The variance is adverse due to an increase in the unit price for the actual price paid for direct materials.
Direct materials usage and price sub-variances
It is quite possible that there will be both a direct materials price sub-variance and a
usage sub-variance occurring at the same time. The total of the two sub-variances will
always give the same value as the total direct materials variance.
4.2
WORKED EXAMPLE 6
The following information is given for the use of direct materials used to produce ‘befures’:
Direct material costs per metre
Actual
720 metres
730 metres
$3.00
$3.50
Required
Calculate:
a the direct materials usage sub-variance
b the direct materials price sub-variance
c the total direct materials variance.
4.2.1 Standard costing
Direct materials
Standard
Answer
a Direct materials usage sub-variance = (Standard quantity − Actual quantity) × Standard price
= (720 − 730) × $3 = $30 adverse
b Direct materials price sub-variance = (Standard price − Actual price) × Actual quantity
= ($3 − $3.50) × 730 = $365 adverse
c Total direct materials variance = (Standard quantity × standard price) − (Actual quantity × actual price)
= (720 × $3) − (730 × $3.50)
= $2 160 − $2 555 = $395 adverse
WORKED EXAMPLE 7
The following information is given for the use of direct materials used in the manufacturing of ‘trusmedas’:
Direct materials
Standard
Actual
2400 litres
2250 litres
$8
$10
Direct material costs per litre
Required
Calculate:
a the direct materials usage sub-variance
c the total direct materials variance.
b the direct materials price sub-variance
Answer
a Direct materials usage sub-variance = (Standard quantity − Actual quantity) × Standard price
= (2 400 − 2 250) × $8 = $1 200 (favourable)
b Direct materials price sub-variance = (Standard price − Actual price) × Actual quantity
= ($8 − $10) × 2 250 = $4 500 adverse
c Total direct materials variance = (Standard quantity × standard price) − (Actual quantity × actual price)
= (2 400 × $8) − (2 250 × $10)
= $19 200 − $22 500
= $3 300 adverse
Here, although the business used fewer materials, the increased price per unit of direct materials meant
that the total spent on direct materials was greater than was expected, given the standard quantities.
409
Direct labour variances
Total direct labour variances identify the difference between the amount that
managers thought that they would spend on direct labour costs (the standard set) and
the amount that they actually spent.
4.2
WORKED EXAMPLE 8
4.2 standard CostIng
Didi has standard direct labour costs for March of $172 000. The actual amount spent was $178 000.
Required
Calculate the total direct labour variance for March.
Answer
Total direct labour variance
$
Standard cost
172 000
Actual cost
178 000
Variance
(6 000) adverse
The variance is adverse as the business has spent more than it had expected.
WORKED EXAMPLE 9
Standard costs for direct labour were $83 000 in May. In early June, it was discovered the actual total spent
was $82 500.
Required
Calculate the total direct labour variance.
Answer
Total direct labour variance
$
Standard cost
83 000
Actual cost
82 500
Variance
(6 000) adverse
The variance is favourable as less has been spent on direct labour than expected.
Direct labour sub-variances
It would be useful for managers of a business to determine whether the total variance
was caused by:
»
»
»
»
»
workers being more efficient (favourable variance)
workers being less efficient (adverse variance)
workers being paid more (adverse variance)
workers being paid less (favourable variance) or
some combination of a change in efficiency and a change in wage rates.
As with the direct materials sub-variances, there are also two sub-variances for direct
labour costs. These are:
» direct labour efficiency – this looks at the quantity of direct labour hours used
» wage rate – this looks at the amount paid per hour worked.
410
Direct labour efficiency variance
This sub-variance arises from differences in direct labour costs which are the result
of work taking a longer period of time than the standard amount of direct labour that
was expected.
The direct labour efficiency variance is calculated as follows:
Direct labour efficiency sub-variance = (Standard quantity of direct labour −
Actual quantity of direct labour) × Standard wage rate
4.2
Wage rate variance
This sub-variance arises from differences in the wage rate paid to workers. Even if the
time taken to complete a job is the same, differences in the wage rate will lead to a
wage rate variance.
Wage rate sub-variance = (Standard wage rate − Actual wage rate)
× Actual direct labour hours
WORKED EXAMPLE 10
4.2.1 Standard costing
The wage rate variance is calculated as follows:
This example includes both sub-variances. As with the material sub-variances, the individual sub-variances
for direct labour totalled will equal the same value as the total labour variance.
Whitford Ltd provides the following information for the direct labour for November.
Direct labour
Standard
Actual
37 000 hours
39 000 hours
$7.00
$7.20
Direct labour wage rate per hour
Required
Calculate:
a the direct labour efficiency sub-variance
b the direct labour wage rate sub-variance
c the total direct labour variance.
Answer
a Direct labour efficiency sub-variance = (Standard quantity − Actual quantity) × Standard wage rate
= (37 000 − 39 000) × $7 = $14 000 adverse
b Direct wage rate sub-variance = (Standard wage rate − Actual wage rate) × Actual quantity
= ($7 − $7.20) × 39 000 = $7 800 adverse
c Total direct labour variance = (Standard quantity × Standard wage rate) − (Actual quantity × Actual wage rate)
= (37 000 × $7) − (39 000 × $7.20)
= $259 000 − $280 800 = $21 800 adverse
We can see that the individual sub-variances, when totalled, are equal to the total direct labour variance.
The three variances requested have been identified.
WORKED EXAMPLE 11
Bash Ltd provides the following information for direct labour for April:
Direct labour
Direct labour rate per hour
Standard
Actual
6200 hours
6250 hours
$9.50
$9.30
411
4.2
Required
Calculate the:
a direct labour efficiency sub-variance
b direct labour wage rate sub-variance
c total direct labour variance.
4.2 standard CostIng
Answer
a Direct labour efficiency sub-variance = (6200 − 6250) × $9.50 = $475
(adverse)
b Direct labour wage rate sub-variance = ($9.50 − $9.30) × 6250 = $1250
(favourable)
c Total direct labour variance
= (6200 × $9.50) × (6250 × $9.30)
= $58 900 − $58 125 = $775
(favourable)
Once again, we can see that the individual sub-variances, when totalled, are
equal to the total direct labour variance.
WORKED EXAMPLE 12
The managers of Hasbec Ltd provide the following information for December:
Standard costs
Actual costs incurred in manufacturing process
Direct materials: 430 kg
costing $18 per kg
Direct materials: 425 kg costing $18.10 per kg
Direct labour: 170 hours at
$7.50 per hour
Direct labour: 172 hours at $7.40 per hour
Required
Calculate the:
a direct materials usage sub-variance
b direct materials price sub-variance
c total direct materials variance
d direct labour efficiency sub-variance
e direct labour rate sub-variance
f total direct labour variance
g total direct expenses variance.
Answer
a Direct materials price sub-variance = ($18 − $18.10) × 425 = $42.50 (adverse)
b Direct materials usage sub-variance = (430 − 425) × $18 = $90 (favourable)
c Total direct materials variance
= (430 × $18) − (425 × $18.10) = $47.50
(favourable)
d Wage rate variance
= ($7.50 − $7.40) × 172 = $17.20
(favourable)
e Direct labour efficiency variance
= (170 − 172) × $7.50 = $15 (adverse)
f Total direct labour variance
= (170 × $7.50) − (172 × $7.40) = $2.20
(favourable)
g The total expenses variance is the total of the direct labour and direct
materials variances. In this example, this would be $47.50 (favourable) +
$2.20 (favourable)
= $49.70 (favourable)
412
Flexible budgets
So far, we have assumed that the actual output is the same as was originally budgeted
for when the standard costs were set. In reality, this will not always be realistic as
there will be many reasons why output levels change. As a result, many businesses
will use flexible budgets when conducting variance analysis. This is covered in the
following chapter on budgeting.
4.2
Fixed overhead expenditure and volume
Total fixed overhead variance
The total fixed overhead variance calculates the difference between standard
fixed overhead per unit absorbed by actual production and the actual fixed
overhead incurred.
Total fixed overhead variance = Standard fixed overhead absorbed by actual
production − Actual fixed overheads incurred
4.2.1 Standard costing
These variances seek to explain why there may be a difference between the actual
amount of fixed overhead incurred and the amount that is charged to production
through overhead absorption rates.
WORKED EXAMPLE 13
Budgeted fixed overhead for September $9080
l Budgeted output 908 units
l Actual production 900 units
l Fixed overhead incurred $10 000.
This data will be used to calculate other variances that follow.
Required
Calculate the total fixed overhead variance for September.
Answer
Standard fixed overhead per unit = (Total budgeted overhead/Budgeted output)
× Actual output
= ($9080/908) = $10 × 900 units = $9000
Total fixed overhead variance
= $9000 − $10 000 = $1000 (adverse)
This adverse variance could be due to:
l more expenditure on fixed overheads than was anticipated in the budget, or
l budgeted production not being achieved.
The total fixed overhead variance does not give managers enough relevant
information to enable improvements to the production process to be made. This
problem can be rectified by examining each individual item that makes up the
total fixed overhead. In this way reasons for variances may be identified and,
where possible, controlled.
The total fixed overhead can be separated into two parts to show these two
possible explanations.
Fixed overhead expenditure (or spending) variance
This variance seeks to identify the amount by which the actual spending on fixed
overhead differs from the budgeted amount.
413
Fixed overhead expenditure variance = Budgeted fixed overhead − Actual fixed
overhead
4.2
WORKED EXAMPLE 14
4.2 standard CostIng
Required
Based on the data used in Worked example 13, calculate the fixed overhead
expenditure variance.
Answer
Fixed overhead expenditure variance = $9080 − $10 000 = $920 (adverse)
This adverse variance may be caused by increases in the overheads incurred in
the production of the product.
Fixed overhead volume variance
This variance identifies the amount by which actual production differs from budgeted
production.
The fixed overhead volume variance is calculated as follows:
Fixed overhead volume variance = (Standard output − Actual output) × Standard
overheads per unit
WORKED EXAMPLE 15
Required
Based on the data used in Worked example 13, calculate the fixed overhead volume variance.
Answer
Fixed overhead volume variance = Budgeted fixed overhead $9080 – Standard cost absorbed by actual
production $9000 = $80 adverse.
If actual output had been greater than planned output, the volume variance would have been favourable.
Variances may be due to changes in the volume of goods produced caused by shortages in the factors of
production, machine breakdowns, industrial disputes, poor production scheduling, etc.
A favourable variance occurs when actual production exceeds budgeted production.
An adverse variance occurs when actual production is less than budgeted production.
Note that if the volume variance is combined with the expenditure variance the result is the total fixed
overhead variance.
Volume variance $(80) + expenditure variance $(920) = total variance $(1000)
Fixed overhead capacity and efficiency sub-variances
Fixed overhead capacity variance
The capacity variance calculates the variance caused by the difference in the hours
worked and the budgeted hours. An adverse capacity variance indicates that not
enough overhead has been absorbed into production.
The capacity variance will be favourable when actual hours are greater than budgeted
hours. For example, the standard hours of input based on direct labour hours might
be 4 hours per unit of production charged at $6.00 per hour. The budgeted output
414
is 4000 units, so the budget is based on the assumption that direct labour hours of
input will be 16 000 hours. If, in fact, the actual hours of input were 15 000 hours the
business has failed to use the planned capacity. If production had worked at the level
of efficiency that had been planned a further 1000 hours would have been worked and
$6000 more fixed overhead would have been absorbed.
4.2
The fixed overhead capacity variance is calculated as follows:
Fixed overhead capacity variance = (Standard hours − Actual hours) × Standard
overhead rate per hour
The fixed overhead efficiency variance is calculated as:
Fixed overhead efficiency variance = (Standard hours based on actual output −
Actual hours) × Overhead rate per hour
4.2.1 Standard costing
Fixed overhead efficiency variance
The second reason why there may be a variance is that the labour force has failed to
work at the level of efficiency anticipated by the budget.
WORKED EXAMPLE 16
The following information regarding fixed overheads is available for February:
Budgeted fixed overhead per unit (10 hours at $4.50 per direct labour hour) $45.00.
The budgeted production level was 1000 units.
Total budgeted fixed overhead was $45 000.
Actual fixed overhead cost $38 250.
900 units were produced in 8500 actual hours.
Fixed overheads are absorbed on the basis of direct labour hours.
Required
Calculate the following fixed overhead variances:
a Expenditure variance
b Capacity variance
c Efficiency variance
d Volume variance
e Total fixed overhead variance.
Answer
a Expenditure variance = Actual expenditure − Budgeted expenditure
= $38 250 − $45 000
= $6750 (favourable)
b Capacity variance
= (Standard hours − Actual hours) × Standard overhead
rate per hour
= (10 000 − 8500) × $4.50
= $6750 (adverse)
c Efficiency variance = (9000 − 8500) × $4.50
= $2250 (favourable)
d Volume variance
= (1000 − 900) × $45
= $4500 (adverse)
e Total variance
= $40 500 − $38 250
= $2250 (favourable)
415
Sales price and volume
4.2
Revenue is affected by both the price of the product being sold and the number of
units that are sold. Sales variances analyse the effect that changes in the volume of
sales and the selling price of the product has on overall profit.
4.2 standard CostIng
The following variances are calculated in respect of sales revenue:
» Total sales variance
» Sales price sub-variance
» Sales volume sub-variance
The volume of sales is not adjusted when calculating sales variances. After calculating
the two sub-variances, ask yourself whether the variance would make the business
better off (a favourable variance) or worse off (an adverse variance).
WORKED EXAMPLE 17
Budgeted sales of Redro were 11 000 units at $6.30 per unit. The actual sales
were 10 800 at $6.40 per unit.
Required
Calculate:
a the sales volume variance sub-variance
b the sales price sub-variance
c the total sales variance.
Answer
a Sales volume sub-variance = (Budgeted sales − Actual sales) × Budgeted
selling price
= (11 000 − 10 800) × $6.30 = $1 260 adverse
b Sales price sub-variance = (Budgeted selling price − Actual selling price)
× Actual sales
= ($6.30 − $6.40) × 10 800 = $1 080 favourable
c Total sales variance = (Budgeted sales × Budgeted selling price) −
(Actual sales × actual selling price)
= (11 000 × $6.30) − (10 800 × $6.40) = $180 adverse
Possible causes of favourable or adverse variances and their
relationship to each other
The actual results may differ from the standards because there have been errors in the
standards set. These errors could be caused by:
» setting unrealistic targets
» managers deliberately setting low standards.
▼ Table 4.2.1 Direct materials usage sub-variances
Favourable sub-variance
Adverse sub-variance
Use of better-quality direct materials
Use of poorer direct materials
Use of highly skilled workers
Use of less-skilled workers
Use of up-to-date capital equipment
Use of poor or outdated capital equipment
Deterioration of direct materials
Theft of direct materials
Note that the first three factors in both columns refer to wastage of direct materials.
416
▼ Table 4.2.2 Direct materials price sub-variance
Adverse sub-variance
Deflation – either general or specific to the
direct materials being purchased
Inflation – either general or specific to the
direct materials being purchased
Supplier reducing price
Supplier increasing price
Use of a cheaper alternative materials or
poorer quality of the same materials
Use of more expensive alternative materials
or better quality of the same direct materials
Increase in quantity purchased so better
trade discount obtained
Decrease in quantity purchased so loss of
trade discount
Increase in value of the country's currency,
making imported direct materials less
expensive
Decrease in value of the country's currency
making imported direct materials more
expensive
▼ Table 4.2.3 Direct labour efficiency sub-variance
Favourable sub-variance
Adverse sub-variance
Use of workers with higher skills
Use of workers with lower skills
Workers using better machinery
Workers using poor machinery
Good working conditions
Poor working conditions
High staff morale – highly motivated
Poor staff morale – poor motivation
Good levels of quality control
Poor levels of quality control
4.2
4.2.1 Standard costing
Favourable sub-variance
▼ Table 4.2.4 Direct labour rate sub-variance
Favourable sub-variance
Adverse sub-variance
Use of lower-grade workers earning lower
rates of pay
Use of higher-grade workers earning higher
rates of pay
Wage deflation
Wage inflation – general or specific to
workers being employed
Reduction in overtime or premium rates
being paid
Increase in overtime or premium rates being
paid
▼ Table 4.2.5 Sales volume sub-variance
Favourable sub-variance
Adverse sub-variance
More aggressive marketing strategy
Less aggressive marketing strategy
Increased seasonal sales
Decrease in seasonal sales
Less competition in sector:
• fewer sales by competitors
• higher market share
More competition in sector:
• more sales going to competitors
• lower market share
Change in consumer tastes
Change in consumer tastes
Defective product
▼ Table 4.2.6 Sales price sub-variance
Favourable sub-variance
Adverse sub-variance
Increase in price to compensate for
increased costs
Reduction in selling price for bulk sales
Increase in price after use of ‘penetration’
(marginal cost) pricing
Reduction in price – to attract new
customers; by using marginal cost pricing;
to penetrate a new market; to quickly sell
off goods, etc.
417
4.2
Interconnections between sub-variances
There are interconnections between sub-variances and you should try to identify these
interrelationships where possible.
4.2 standard CostIng
Here are a few interrelating sub-variances:
» Favourable direct materials usage sub-variance and Adverse direct labour rate
sub-variance: fewer direct materials being used because a higher skilled workforce
is being used and has to be paid more.
» Adverse direct labour efficiency sub-variance and Adverse direct materials usage
sub-variance: workers taking longer to make goods because of faulty machinery
which results in the machinery spoiling much of the direct materials being used.
As mentioned earlier, an adverse fixed overhead volume variance can arise out of a
shortfall in overhead absorption. A fixed overhead expenditure variance can arise out
of anything that affects the level of fixed overheads. There are too many possible
explanations to mention here.
How standard costing can be used as an aid to improve the
performance of a business
You must also be able to tell quickly whether a variance that you have calculated
is favourable or adverse.
Calculating variances is only part of the process; with practice, the calculations can
be mastered and you should be able to gain accurate results. However, more important
than merely calculating the variances is gaining information from your calculations.
Business managers introduce a system of standard costing because it can highlight
variances between the predicted costs and the actual costs. Variances lead to
investigation into the causes of the differences. Standard costing is the natural extension
of budgetary control. Budgetary control seeks to make sections and departments more
efficient and, hence, improve the performance of the business as a whole.
Standard costing goes into much greater detail than budgeting. It examines in detail
the costs of all the constituent parts of the production process for each product. When
variances are identified, action can be implemented to correct adverse variances. Managers
must know the cause of any deviation from standard in order to take remedial action.
Variance analysis highlights areas of concern and areas of good practice and you may
be asked to explain possible reasons for the variances.
You should consider any potential interrelationship between different sub-variances.
The variances that we have calculated up to this point have been calculated in
isolation from data prepared for setting standards and budgets. They have detailed
individual costs, output and incomes.
A business that operates a standard costing system and a system of budgetary control
should be able to use the systems and the data to calculate its future profitability.
Changes in operations due to variances are going to affect profit earned; favourable
variances in sales and costs explain how profits have improved from those budgeted;
adverse variances explain the factors that have reduced budgeted profit.
Future performance can be compared with the standards set by management.
The advantages and disadvantages of a standard costing
system
The advantages of using a system of standard costing:
» It can identify areas of the business where expenditure is higher than was planned.
» It allows a business to monitor the efficiency of its workers.
418
» It allows a business to monitor how efficiently direct materials are being used.
» It allows a business to judge whether the reason for any overspend is within the
control of the business.
» Reasons for sales revenue varying from budgeted levels can be analysed.
» Corrective action can made to improve business performance.
4.2
However, there are some disadvantages of implementing and using a standard costing
system:
4.2.1 Standard costing
» It takes time (and money) to set up in the first place.
» Time will be spent calculating and interpreting the results.
» The target result used to calculate the standards may not be realistic (e.g. might
be based on unrealistically high assumptions about worker productivity).
» Attempts to improve a ‘variance’ might lead to another variance worsening (see the
section on the interrelated nature of some variances).
» Some variances arise out of factors outside the control of the business (e.g. prices
charged for direct materials).
» If output levels differ from those budgeted for then the variances may be
misleading (though preparation of flexible budgets can help solve this issue).
How to make business decisions and recommendations using
supporting data
Information from variance calculations should help a business to make better
decisions. This is because remedial action can be taken where the variances are not
desirable and can be actioned.
An important distinction needs to be made between those variances that arise out
of differences in the output level and those that arise even if the actual output level
is the same as the budget. This is one reason why we will generally choose to use
flexible budgets. For example, an adverse expenditure variance may be the result of
increases in output – beyond the level budgeted for – which would ordinarily lead to
increased sales and profits.
Adverse variances in direct materials and direct labour costs are often seen as
variances that should be corrected. This will depend on the cause of these variances.
Sub-variance calculations will help inform the decision. For example, an adverse direct
labour cost variance could be the result of increased wage rates or poor direct labour
efficiency. It is important that this is identified in order to ensure the correct method
of dealing with the variance is used. Cutting wage rates when the cause of labour
variance was poor motivation leading to poor efficiency may make the situation worse.
Given that many of the variances are interrelated, a business looking to deal with its
variances should proceed with caution. Cutting wage rates to reduce an adverse wage
rate variance may demotivate workers, resulting in a direct labour efficiency adverse
variance. Similarly, switching to a cheaper supplier of raw direct materials to reduce
an adverse direct materials price variance may just mean wastage rates rise and the
direct materials usage variance worsens.
The significance of non-financial factors
Businesses are often affected by factors outside their control. Even if factors are
partly within the control of a business manager, there are plenty of non-financial
factors that will affect the results from variance calculations. Some of these include:
» The level of motivation among the workforce can affect direct labour efficiency
variance. A demotivated workforce is more likely to be associated with adverse
direct labour efficiency variance, whereas if the workforce is motivated,
a favourable direct labour efficiency variance may be more likely.
419
4.2 standard CostIng
4.2
» Management techniques can affect the material usage variance (e.g. many
managers focus on eliminating waste – techniques known as ‘Kaizen’ or ‘continuous
improvement’ strategies).
» The selling price of a product may be closely aligned with other aspects of its
‘marketing mix’ – a high price may form part of the product (and business’s) image,
so reducing the price may damage the reputation of the product.
» Trends and fashions will affect the sales volume. If the business is selling products
that are subject to volatile changes in demand, due to consumer trends and rapid
changes in tastes, there are more likely to be swings from adverse to favourable
variances in the sales volume variances.
SUMMARY
By the end of this chapter you should be able to:
» understand the system used for standard costing
» calculate variances (and sub-variances) for sales, direct labour, direct
materials and fixed overheads
» interpret any variances and suggest corrective action
» identify causes of the variances and understand how these can be interrelated
» understand the advantages and disadvantages of a standard costing system
and how it can help improve the performance of a business
» understand the impact of non-financial factors on a standard costing system.
SELF-TEST QUESTIONS
1 Total variance = Standard cost −
2 Explain a possible factor that would result in an adverse direct materials usage
sub-variance.
3 Explain a possible factor that would result in a favourable direct labour rate
sub-variance.
4 Explain how the use of poor machinery might affect a direct materials usage
sub-variance and a direct labour efficiency sub-variance.
Calculation questions (answers on page 494)
5 Standard quantity direct materials information: standard price per kg $12.50;
standard quantity to be used 232 kg; actual price per kg $12.65; actual quantity
used 228 kg.
Calculate the total direct materials variance, the direct materials price variance
and the direct materials usage variance.
6 Standard quantity direct labour information: standard wage rate per hour $10.35;
standard quantity of labour hours to be used 55 hours; actual wage rate $9.95;
actual quantity of labour hours used 66 hours.
Calculate the total direct labour variance, the direct labour wage rate variance and
the direct labour efficiency variance.
7 From the following data, calculate the total sales variance, the sales price
variance and the sales volume variance.
Standard quantity of sales: 525 units at a standard price of $24.50
Actual quantity of sales: 480 units at a standard price of $26.50
420
4.3
Budgeting and budgetary control
By the end of this chapter you should have an understanding of:
l the advantages and disadvantages of a budgetary control system and
preparing budgets using spreadsheets
l what is meant by a master budget
l how to prepare the following budgets:
– sales
– production
– purchases
– labour
– trade receivables
– trade payables
– cash
– budgeted statement of profit or loss and statement of financial position
l the effect of limiting factors on the preparation of budgets
l the benefits of flexible budgeting over fixed budgeting
l how to prepare a flexible budget statement
l possible causes of differences between actual and flexible budgeted data
l how to prepare a statement reconciling the flexible budgeted cost of
production with the actual cost of production
l how to prepare a statement reconciling the flexible budgeted profit with the
actual profit
l how to make business decisions and recommendations using supporting data
l the behavioural aspects of budgeting, including targets, incentives and
motivation and the significance of non-financial factors.
4.3.1 Budgeting and budgetary control
Learning outcomes
Introduction
This chapter follows on from the previous chapter on standard costing. Here we
look more closely at the construction of budgets. In particular, we look at how
there are different types of budget that are interconnected. For example, from the
sales budget we can produce a budget for production, purchases, trade receivables
and trade payables as well as a cash budget. Where budgeted values differ from
the actual values, we can reconcile the differences to see why these figures are not
the same. We will see how information from the budgets can be used, as well as
how to make decisions and recommendations based on analysis of the budgets.
4.3.1 Budgeting and budgetary control
We have already said that accounting fulfils two purposes: the stewardship function
and the management function.
The management function can be broken down into:
» planning
» coordinating
421
4.3
» communicating
» decision-making
» controlling.
4.3 budgetIng and budgetary Control
Planning can be divided according to the time horizon under review:
» long-term planning (sometimes referred to as strategic or corporate planning)
– Management identifies the current position of the business by using all the
accounting data at their disposal. This is the starting point for their future
strategies.
– After taking into account this position, they try to analyse the circumstances that
the business is likely to encounter in the period of the plan. For example, likely
demand for the product; influence on the product from competitors; availability of
resources.
– Finally, managers must decide on strategies to implement the strategic plan.
» short-term planning (sometimes referred to as operational planning).
– Operational plans, using monetary terms, are known as budgets. Such budgets
aid the functions of management outlined above. In addition, budgets can have
a motivating influence on managers and once implemented may be used as an
evaluative tool by comparing actual results with those outlined in the budget.
– The budgets produced by a business are ‘plans expressed in money’. The budgets
show what management hope to achieve in a future year in terms of overall
plans and individual departmental plans.
– The individual budgets are intertwined with each other – they depend on each
other and influence each other. There is a need to ensure that the individual
budgets are not contradictory or in conflict.
Because of the interdependency and the coordination of the budgets, managers must
communicate with each other when preparing budgets – they must also communicate
the plans to staff below and management above.
The nature of forecasting means that decisions have to be made. If profits are to
increase then decisions must be made regarding sales and production levels, etc.
Budgets will be compared with actual results. Remedial action can then be taken when
actual results are worse than budgeted results. In cases where actual results are better
than those budgeted, examples of good practice may be identified and repeated
elsewhere in the organisation.
The advantages and disadvantages of budgeting and
budgetary control systems to an organisation
Advantages of budgeting
» The preparation of individual budgets means that planning must take place.
Plans need to be prepared in a coordinated way and this requires communication
throughout all levels of the business.
» The budgeting process defines areas of responsibility and targets to be achieved by
different personnel.
» Budgets can act as a motivating influence at all levels, although this is usually
only true when all staff are involved in the preparation of budgets. If budgets are
imposed on staff who have had little or no involvement in their development they
can have a negative effect on morale and lead to staff feeling demotivated.
» Budgets are a major part of the overall strategic plan of the business and so
individual departmental and personal goals are more likely to be an integral part of
the ‘bigger picture’.
» Budgets generally lead to a more efficient use of resources at the disposal of the
business – leading to a better control of costs.
422
Disadvantages of budgeting
Budgetary control
Budgetary control delegates financial planning to managers. It evaluates their
performance by continuously comparing actual results achieved by their departments
against those set in the budget.
The characteristics of a system of budgetary control include the following:
4.3
4.3.1 Budgeting and budgetary control
» Budgets are only as good as the data being used. If data are inaccurate, the budget
will be of little use. Should one departmental budget be too optimistic or too
pessimistic this will have a knock-on effect on other associated budgets.
» Budgets might become an overriding goal. This could lead to a misuse of resources
or incorrect decisions being made.
» Budgets might act as a demotivator if they are imposed rather than negotiated.
» Budgets might be based on plans that can be easily achieved – so making
departments/managers appear to be more efficient than they really are. There is
also a possibility that this could lead to complacency and/or underperformance.
» Budgets might lead to departmental rivalry.
» Smaller businesses may find that they experience only limited benefits from what
can be a lengthy, complicated procedure to implement.
» While budgets are being prepared, any limiting factors need to be identified and
taken into account.
» A clear definition of each manager’s role.
» Once budgets have been approved, individual managers are responsible for the
implementation of their departmental budget outcomes.
» Departmental budgets are action plans for each area of responsibility. Any
deviations from set budgets must be approved by the senior management team.
» Performance is constantly monitored and compared to the agreed budget and in
cases where budget targets are not met, corrective action is taken. Unexplained
variations from budgets must be investigated and, where possible, departmental
performance modified to reflect the agreed budget outcomes.
Advantages and disadvantages of using a system of budgetary control
The advantages and disadvantages of implementing a system of budgetary control are
generally those outlined above. Budgeting and budgetary control systems involve a
set of complex procedures which can prove to be expensive to set up. So it seems to
be a matter of common sense that the benefits that accrue must outweigh the cost of
installing such procedures.
Learning link
Spreadsheets were first
covered in Chapter 1.2.
The advantages and disadvantages of preparing budgets
using spreadsheets
Spreadsheets are useful for a variety of accounting applications. One of their uses is
when preparing budgets in an organisation.
Advantages of preparing budgets using spreadsheets:
» Figures can be totalled automatically.
» A change to one of the figures can lead to the rest of the data being automatically
updated.
» Different scenarios and the effects on budgets can be analysed quickly.
» The effect of a change in one variable on all other budgets can be analysed easily.
Disadvantages of preparing budgets using spreadsheets:
» Someone will be needed to input the data – although modern software packages
can make this easy.
423
» Human error is still possible when inputting data.
» Those using the data may forget that there are often non-financial reasons behind
particular aspects, such as the motivation of workers, the ability to negotiate
effectively for input prices, etc.
4.3
4.3 budgetIng and budgetary Control
The master budget
The master budget provides a summary of all the planned operations of the business
for the period covered by the budgets. It is a sum of all the individual budgets
prepared by the different parts of the business.
It is made up of:
» a budgeted statement of profit or loss
» a budgeted statement of financial position.
Sales budget
Trade receivables budget
Production budget
Master budget
STUDY TIP
You may have to
produce a summarised
statement of profit
or loss or statement
of financial position
from a cash budget.
Be careful here, as
the matching/accruals
concept is used for
the production of the
statements but not
the cash budget.
Cash budget
Trade payables budget
Purchases budget
▲ Figure 4.3.1 Individual budgets used to prepare the master budget
Completing summarised statements will test your ability to:
» apply the concepts of matching/accruals and realisation
» differentiate between capital and revenue expenditures and capital and revenue
incomes
» distinguish between cash and non-cash expenses.
How to prepare budgets
Sales budget
The sales budget is generally the first budget to be prepared, because most businesses
are sales led. It shows predicted sales and the revenues that are expected to be
generated from the sales for the budget period.
Once the sales budget has been prepared, the other budgets can be prepared using
the information from the sales budget. If the sales budget is inaccurate, these
inaccuracies will filter through and make the other budgets inaccurate too.
The sales budget will be based on sales forecasts for the budget period.
Sales budgets are difficult to prepare because there are so many variables that are out
of the control of the managers who will prepare the budget.
These variables could include:
» actions of potential customers – e.g. customers changing to or from other suppliers
» actions of competitors – e.g. competitors increasing or decreasing their price and/
or output
424
» the state of the economy – e.g. cycles of ‘boom’ and ‘bust’
» government action – e.g. changes in levels of taxation; changes in government
spending; imposition of trade sanctions.
4.3
WORKED EXAMPLE 1
Zaid produces one type of machine, the ZT/103. The expected sales for the
machine for the three months ending 31 March are:
Expected selling price per machine
February
March
10
12
13
$2100
$2100
$2150
Required
Prepare a sales budget for the three months ending 31 March.
Answer
Sales budget for the three months ending 31 March
Budgeted sales (units)
Budgeted sales revenue
Jan
Feb
Mar
10
12
13
$21 000
$25 200
$27 950
4.3.1 Budgeting and budgetary control
Budgeted sales
January
Production budget
A production budget is prepared to determine whether the levels of production
necessary to satisfy the anticipated level of sales are attainable. The budget shows
the quantities of finished goods that must be produced to meet expected sales plus
any increase in inventory levels that might be required.
WORKED EXAMPLE 2
Zaid is expected to have an opening inventory of five ZT/103 machines on 1
January. He requires a closing inventory of six machines at 31 March.
Required
Prepare a production budget based on the budgeted sales used in the previous
worked example. Zaid requires an even production flow throughout the three
months.
Answer
The total production for the three months is found by using the following
calculation:
Budgeted sales (10 + 12 + 13)
Plus Budgeted closing inventory
Total production needed to meet budgeted sales and closing inventory
Less Budgeted opening inventory
Budgeted production over the three months
35
6
41
5
36
Note
The calculation has been used to determine the budgeted production for a
period of three months. The same calculation could be used to determine the
budgeted production for a month, six months, a year, etc.
425
4.3
An even production flow means that Zaid will have to produce 12 machines per
month. The production budget will look like this:
Production budget for the three months ending 31 March (units)
Budgeted sales
Plus Budgeted closing inventory
4.3 budgetIng and budgetary Control
Total production needed
Less Budgeted opening inventory
Budgeted production
Jan
Feb
Mar
10
12
13
7
7
6
17
19
19
5
7
7
12
12
12
Purchases budget
A purchases budget is required to determine the quantities of purchases required,
either for resale or, in the case of a manufacturing business, for use in the production
process. The method to be used is similar to that used to compile a production budget.
WORKED EXAMPLE 3
Danst Ltd has the following budget for sales of ‘limts’:
February
March
April
120
140
160
Budgeted sales (units)
The opening inventory on 1 February is expected to be 26 units of limts and the
closing inventory at 30 April is expected to be 41 units of limts.
Required
Calculate the number of limts to be purchased over the three months ending
30 April.
Answer
Units
Budgeted sales (120 + 140 + 160)
420
Plus Budgeted closing inventory
41
Total purchases needed to meet budgeted sales and closing inventory
Less Budgeted opening inventory
461
26
Budgeted purchases of goods for resale
435
Danst will need to purchase 435 units in total during February, March and April.
If an even amount of purchases were required each month throughout the year,
then 145 units (435 divided by 3) would be purchased each month. Therefore,
using the figures that we now know, the budget would look like this:
Purchases budget for the three months ending 30 April (units)
Budgeted sales
Feb
Mar
Apr
120
140
160
Plus Budgeted closing inventory
41
Total purchases needed
201
Less Budgeted opening inventory
Budgeted purchases of limts required for resale
426
145
145
145
We can now fill in the gaps (we hope!) by working back through the months:
Budgeted sales
Plus Budgeted closing inventory
Total purchases needed
Less Budgeted opening inventory
Mar
Apr
120
140
160
51
56
41
171
196
201
26
51
56
145
145
145
4.3
It is not usually necessary to have an equal flow of purchases each month. However, it
might be necessary to have a specified number of units held as inventory at the start
of each month.
The method of calculation for this type of budget is the same as that used in the
previous example.
WORKED EXAMPLE 4
Borga & Co. supply the following budgeted sales figures:
Budgeted sales (units)
July
August
September
October
40
72
92
96
4.3.1 Budgeting and budgetary control
Budgeted purchases of limts required for resale
Feb
It is the manager’s policy to maintain inventory levels at 25% of the following
month’s budgeted sales.
Required
Prepare a purchases budget for the three months ending September 30.
Answer
We can calculate the opening inventory each month from what we know:
July
August
September
10 units (25% of 40)
18 units (25% of 72)
23 (25% of 92)
We also know that the budgeted closing inventory at the end of September (i.e.
the opening inventory on October 1) should be 24 (25% of 96).
We can now put into our budget the figures that we know:
Purchases budget for the three months ending 30 September
Jul
Aug
Sep
Budgeted sales (units)
40
72
92
Plus Budgeted closing inventory
18
23
24
10
18
23
Total purchases needed
Less Budgeted opening inventory
Budgeted purchases of goods needed for resale
And now we just need to fill in the gaps:
427
4.3 budgetIng and budgetary Control
4.3
Jul
Aug
Sep
Budgeted sales (units)
40
72
92
Plus Budgeted closing inventory
18
23
24
Total purchases needed
58
95
116
Less Budgeted opening inventory
10
18
23
Budgeted purchases of goods needed for resale
48
77
93
If each unit of purchases costs $2.00, the budget in terms of $s spent would show.
Jul
Aug
Sep
$
$
$
Budgeted sales
80
144
184
Plus Budgeted closing inventory
36
46
48
116
190
242
Less Budgeted opening inventory
20
36
46
Budgeted purchases of goods needed for resale
96
154
186
Total purchases needed
Labour budget
A labour budget is prepared to determine the business’s need for planned labour in the
budget period. It can be prepared to show:
» the number of labour hours required
» the number of workers required
» the cost of hiring the required number of workers.
WORKED EXAMPLE 5
Cerise has produced the following production budget for the three months
ending 31 August:
Planned production in units
Jun
Jul
Aug
4000
5000
3500
Each unit of production requires four hours of labour. Each worker works 40
hours per week. Cerise has 100 workers.
Required
Prepare a labour budget for the three months ending 31 August (assume four
weeks in each month).
Answer
Labour budget for the three months ending 31 August
428
Jun
Jul
Aug
Hours presently available
16 000
16 000
16 000
Labour requirement (hours)
16 000
20 000
14 000
Surplus hours
–
–
2 000
Shortfall in hours
–
4 000
–
Workers presently available
100
100
100
Workers required
100
125
87.5
Surplus labour
–
–
12.5
Labour shortfall
–
25
–
The budget shows that in July Cerise has a shortage of workers required to meet
production targets. She will have to hire 25 full time workers.
In August, she has labour surplus to requirements so 12 full time workers will need
to be laid off and one member of staff will have to have his/her hours cut and work
part time. Alternatively staff may be moved to another part of the business if this
is possible.
4.3
Trade receivables budget
This budget is closely linked to the production budget, the sales budget and the
cash budget. It will take into account the length of credit period that is allowed on
customers’ balances that are outstanding.
WORKED EXAMPLE 6
The managers of Chin Ltd provide the following budgeted information for the
three months ending 31 March:
$
30 000
40 000
50 000
60 000
12 000
10 000
14 000
Jan 1 amounts owed by credit customers
Budgeted credit sales for
Jan
Feb
Mar
Cash sales for
Jan
Feb
Mar
4.3.1 Budgeting and budgetary control
The trade receivables budget forecasts the amounts that will be owed to a business by
credit customers at the end of each month.
All credit customers are expected to settle their debts in the month following
the sale of goods. They are allowed, and will take, 5% cash discount.
Required
Prepare a trade receivables budget for the three months ending 31 March.
Answer
Trade receivables budget for the three months ending 31 March
Jan
Feb
Mar
$
$
$
Balance brought forward
30 000
40 000
50 000
Credit sales
40 000
50 000
60 000
70 000
90 000
110 000
(28 500)
(38 000)
(47 500)
Discount allowed
(1 500)
(2 000)
(2 500)
Balance carried forward
40 000
50 000
60 000
Cash received from credit customers
Note
Cash sales have not been included. Cash customers do not have an account in the
sales ledger. Cash customers are never trade receivables. The cash received from
cash sales will be recorded in a cash budget.
429
4.3
WORKED EXAMPLE 7
The managers of Novotny Ltd provide the following information for the three
months ending 30 November:
$
4.3 budgetIng and budgetary Control
Budgeted credit sales
Jul
33 000
Aug
27 000
Aug 31 amount owed by credit
customers
38 000 (trade receivables from July $11 000;
trade receivables from August $27 000)
Budgeted credit sales
Sep
30 000
Oct
39 000
Nov
36 000
Two-thirds of credit customers are expected to settle their debts in the month
following receipt of the goods; the remainder will settle two months after receipt.
Required
Prepare a trade receivables budget for the three months ending 30 November.
Answer
Trade receivables budget for the three months ending 30 November
Sep
Oct
Nov
$
$
$
Balance brought forward
38 000
39 000
49 000
Credit sales
30 000
39 000
36 000
68 000
78 000
85 000
Cash received
(18 000) (Aug)
(20 000) (Sep)
(26 000) (Oct)
Cash received
(11 000) (Jul)
(9 000) (Aug)
(10 000) (Sep)
Balance carried forward
39 000
49 000
49 000
Trade payables budget
The trade payables budget forecasts the amounts that will be owed to trade payables
at the end of each month (whether suppliers of components or raw materials in the
case of a manufacturing business, or suppliers of goods for resale in the case of a
retailing business). It is linked to the purchases budget and the cash budget.
WORKED EXAMPLE 8
The managers of Pavla Ltd provide the following information for the three
months ending 30 June:
Apr 1 predicted amount owed to trade payables
Budgeted purchases on credit terms for
Apr
May
Jun
Budgeted cash purchases
Apr
May
Jun
430
$
14 000
15 000
16 000
17 000
2 000
5 000
3 000
All trade payables will be paid in the month following purchase. Pavla Ltd will
receive a cash discount of 5% on all credit purchases.
Required
Prepare a trade payables budget for the three months ending 30 June.
4.3
Answer
Trade payables budget for the three months ending 30 June
Credit purchases
Cash paid to suppliers
May
Jun
$
$
$
14 000
15 000
16 000
15 000
16 000
17 000
29 000
31 000
33 000
(13 300)
(14 250)
(15 200)
(700)
(750)
(800)
15 000
16 000
17 000
Discount received
Balance carried forward
4.3.1 Budgeting and budgetary control
Balances brought forward
Apr
WORKED EXAMPLE 9
The managers of Berghaus Ltd provide the following budgeted information for
the period ending 30 September:
$
Budgeted credit purchases
May
30 000
Jun
24 000
Jul
27 000
Aug
32 000
Sep
29 000
Jul 1 predicted amount owed to
suppliers
39 000 (trade payables from May $15 000;
trade payables from June $24 000)
Berghaus Ltd will settle 50% of outstanding trade payables in the month
following purchase of the goods; the remainder will be settled two months after
purchase.
Required
Prepare a trade payables budget for the three months ending 30 September.
Answer
Trade payables budget for the three months ending 30 September
Balance brought forward
Purchases on credit terms
Jul
Aug
Sep
$
$
$
39 000
39 000
45 500
27 000
32 000
29 000
66 000
71 000
74 500
Cash paid to suppliers
(15 000) (May)
(12 000) (Jun)
(13 500) (Jul)
Cash paid to suppliers
(12 000) (Jun)
(13 500) (Jul)
(16 000) (Aug)
Balance carried forward
39 000
45 500
45 000
431
Cash budget
The managers of most businesses will prepare a cash budget. A cash budget shows
estimates of future cash incomes and cash expenditures. It is usually prepared monthly
and includes both capital and revenue transactions. It is prepared to help management
be aware of any potential shortages or surpluses of cash resources that could occur, thus
allowing management to make any necessary financial arrangements.
4.3
4.3 budgetIng and budgetary Control
The availability of cash is essential for the short-term survival of all businesses.
Without it, resources required for the business to function cannot be acquired.
Holding excessive cash will result in a less profitable business since cash held does
not in itself yield profits.
The preparation of a cash budget:
» helps to ensure that there is always sufficient cash available to allow the normal
activities of the business to take place
» will highlight times when the business will have cash surpluses, thus allowing
management time to arrange short-term investment of those surpluses in order to
gain maximum return
» will highlight times when the business might have cash deficits, thus allowing
management to arrange short-term alternative sources of finance through the
arrangement of overdraft facilities or the arrangement of extended periods of
credit or the restructuring of existing longer-term debts.
A cash budget may be prepared weekly or monthly. The budget forecasts the cash
and bank receipts coming into a business and the cash and bank payments that the
managers think will be made.
The net cash flow refers to the difference between the forecasted cash inflows and the
forecasted cash outflows. The net cash flow can be positive if the cash inflows exceed
the cash outflows, or negative if the cash outflows exceed the inflows.
STUDY TIP
It is possible to have a
forecast negative cash
balance at the end of a
year since receipts and
payments will be made
up of both cash and
bank transactions.
STUDY TIP
There are a number
of different layouts
for cash budgets.
Choose the version
that you feel most
comfortable using and
stick with it.
Preparation of a cash budget
A cash budget is prepared in three parts:
» Part 1 shows the forecast receipts.
» Part 2 shows forecast expenditure.
» Part 3 shows a summary of the net cash flow for each period resulting from the
forecast positive cash flow from Part 1 and the negative cash flow from Part 2.
It will also show a forecast of cash balances to be carried forward at the end of
each year.
WORKED EXAMPLE 10
Arvane opens a small store using $8000 savings. She estimates that her
purchases and sales for her first three months of trading will be:
Purchases
Sales
$
$
March
8 000
12 000
April
7 000
14 000
May
11 000
28 000
Arvane will purchase fixtures and fittings for her store costing $11 000. She will
pay for these in April.
Her suppliers require payment for purchases in the month of purchase.
432
Her sales are 50% cash sales.
Her credit customers are expected to pay in the month following sale.
4.3
Wages will amount to $1000 per month payable when due.
Rent for the store is $2000 for a three-month period. The first payment for rent
is due on 1 March.
Other expenses are expected to be $1700 per month payable in the month
following that in which they occur.
Answer
a
Cash budget for each of the three months ending 31 May
Mar
Apr
May
$
$
$
6 000
7 000
14 000
6 000
7 000
6 000
13 000
21 000
Purchases
8 000
7 000
11 000
Wages
1 000
1 000
1 000
Rent
2 000
1 700
1 700
Receipts
Sales – cash
credit
4.3.1 Budgeting and budgetary control
Required
a Prepare a cash budget for each of the three months ending 31 May.
b Comment on the results shown by the budget.
Expenditure
Other expenses
Fixtures and fittings
11 000
11 000
20 700
13 700
Net receipts/(payments)
(5 000)
(7 700)
7 300
Balance brought forward
8 000
3 000
(4 700)
Balance carried forward
3 000
(4 700)
2 600
b Arvane will have to arrange an overdraft with her bank to cover her
expenditure during April and probably part of May. Hopefully, she will in
future have positive cash flows each month – understandably, the capital
expenditure was the largest expense in her first three months of trading.
Provided that the expenditure patterns are similar in future months it would
appear that Arvane’s cash flows should be positive.
Note
The heading should contain the word ‘budget’ or ‘forecast’ and the year
covered. Notice also that it is a forecast and so the heading tells us that the
three months will end at 31 May.
433
4.3 budgetIng and budgetary Control
4.3
WORKED EXAMPLE 11
The following budgeted figures relate to Cropp Ltd for the three months ending
30 September:
Cash sales
Cash received from credit customers
Payments made to suppliers
Cash purchases
Payment for rent
Payment for business rates
Payment of wages
Payments for other expenses
Jul
$
10 000
26 000
9 000
6 000
Aug
$
10 000
28 000
11 000
6 000
21 000
8 000
2 750
8 000
3 750
Sep
$
12 000
27 000
12 000
7 000
1 200
8 000
2 800
It is expected that cash in hand at 30 June will be $820.
Required
Prepare a cash budget for each of the three months ending 30 September.
Answer
Cash budget for each of the three months ending 30 September
Jul
Aug
$
$
Receipts
Cash sales
10 000
10 000
Cash received from customers
26 000
28 000
36 000
38 000
Payments
To suppliers
9 000
11 000
Cash purchases
6 000
6 000
Rent
21 000
Business rates
Wages
8 000
8 000
Other expenses
2 750
3 750
25 750
49 750
Balance brought forward
820
11 070
Receipts
36 000
38 000
36 820
49 070
Payments
25 750
49 750
Balance carried forward
11 070
(680)
Sep
$
12 000
27 000
39 000
12 000
7 000
1 200
8 000
2 800
31 000
(680)
39 000
38 320
31 000
7 320
The cash budget shows that overdraft facilities must be arranged to cover the
cash deficit in August.
There are alternative layouts. The one shown above is the version most frequently used.
Note
» Cash budgets include bank transactions. It is therefore possible to have negative
balances in a cash budget.
» Only cash and bank items are included.
» Cash budgets deal only with transactions involving the movement of cash.
They therefore will not include any non-cash expenses, such as a provision
for depreciation or an allowance for irrecoverable debts.
434
» Some business studies textbooks refer to cash budgets as ‘cash flow forecasts’. Do
not confuse cash flow forecasts with statements of cash flows.
4.3
WORKED EXAMPLE 12
Bradford Ltd sells one type of machine at a selling price of $6600 each. Fifty per
cent is received in the month of sale and 50 per cent the following month.
All operating costs are paid in the month in which they occur.
The following forecast information is available:
December January February
Budgeted sales (in units)
Budgeted purchases (units)
Budgeted operating costs
Rent
Wages
Other expenses
Depreciation
4
6
$
1 500
16 000
4 700
2 500
6
3
$
1 500
19 000
5 200
2 500
March
3
5
$
1 500
19 000
5 100
2 500
April
5
7
$
1 500
19 000
4 800
2 500
7
8
$
1 650
19 000
5 000
2 500
4.3.1 Budgeting and budgetary control
The machines are purchased from a supplier at a cost of $1500, paid in the
month following purchase.
The balance of cash in hand at 1 January is expected to be $1800.
Required
Prepare a cash budget for each of the three months ending 31 March.
Answer
Cash budget for each of the three months ending 31 March
Jan
Feb
Mar
$
$
$
Receipts
Cash received from trade
receivables
13 200 (Dec)
19 800 (Jan)
9 900 (Feb)
Cash received from trade
receivables
19 800 (Jan)
9 900 (Feb)
16 500 (Mar)
33 000
29 700
26 400
Payments
Payments to trade payables
9 000 (Dec)
4 500 (Jan)
7 500 (Feb)
Rent
1 500
1 500
1 500
19 000
19 000
19 000
5 200
5 100
4 800
34 700
30 100
32 800
1 800
100
(300)
33 000
29 700
26 400
34 800
29 800
26 100
34 700
30 100
32 800
100
(300)
(6 700)
Wages
Other expenses
Balance brought forward
Receipts
Payments
Balance carried forward
Note
Depreciation has not been included – it is a non-cash expense.
435
Budgeted statement of profit or loss
A master budget would include all the budgets mentioned above as well as a set of
budgeted financial statements. This includes a budgeted statement of profit or loss
for the period for which the budgets are prepared. The statement of financial position
will be prepared for the close of the budgeted period – i.e. the last date to which the
budgeted data applies to.
4.3
4.3 budgetIng and budgetary Control
In this first example, we only construct a cash budget and a budgeted statement of
profit or loss.
WORKED EXAMPLE 13
The following budgeted information is given for Plum Ltd:
Credit sales
Credit purchases
Wages paid
Other expenses
Purchase of machine
Depreciation of machine
Aug
$
30 000
15 000
7 500
8 200
Sep
$
40 000
20 000
7 500
8 400
10 000
100
Oct
$
35 000
15 000
7 500
8 100
Nov
$
45 000
25 000
7 500
9 000
100
100
Trade receivables will pay one month after goods are sold.
Trade payables will be paid one month after receipt of the goods.
All expenses are paid in the month in which they occur.
It is expected that cash in hand at 1 September will be $1200.
Inventory at 1 September is expected to be $2000.
Inventory at 30 November is expected to be $2500.
Required
Prepare:
a a cash budget for each of the three months ending 30 November
b a budgeted statement of profit or loss for the three months ending 30 November.
Answer
a
STUDY TIP
Always show the
months separately
when preparing a cash
budget.
436
Cash budget for each of the three months ending 30 November
Sep
Oct
$
$
Receipts
Cash received from credit customers
30 000
40 000
Payments:
Cash paid to credit suppliers
15 000
20 000
Wages
7 500
7 500
Other expenses
8 400
8 100
Purchase of machine
10 000
40 900
35 600
Balance brought forward
1 200
(9 700)
Receipts
30 000
40 000
31 200
30 300
Payments
40 900
35 600
Balance carried forward
(9 700)
(5 300)
Nov
$
35 000
15 000
7 500
9 000
31 500
(5 300)
35 000
29 700
31 500
(1 800)
STUDY TIP
The heading should
be precise and include
the word ‘budgeted’,
as well as the year
covered.
Remember, depreciation does not involve cash leaving the business.
b Budgeted statement of profit or loss for the three months ending 30 November
$
Sales
120 000
Less Cost of sales
Inventory Sep 1
Purchases
2 000
60 000
Inventory Nov 30
2 500
Gross profit
59 500
60 500
Less Expenses
Wages
(22 500)
Other expenses
(25 500)
Depreciation of machinery
Profit for the three months
Do not show separate
monthly figures in the
budgeted statement of
profit or loss.
(300)
(48 300)
12 200
The sales figure is the total of the budgeted figures for the three months under review
– September $40 000, October $35 000 and November $45 000 – not the amounts
shown in the cash budget.
4.3.1 Budgeting and budgetary control
62 000
STUDY TIP
4.3
$
The purchases figure is the total of the budgeted figures for the three months under
review – September $20 000, October $15 000 and November $25 000 – not the amounts
used in the cash budget. Once again, the realisation concept is being applied.
Depreciation is included in the budgeted statement of profit or loss because of the
matching/accruals concept – the machine is a resource that will be used to generate
profits, so a charge has to be made.
Budgeted statement of financial position
It is possible to construct a budgeted statement of financial position by itself.
However, it is fairly common practice to produce a budgeted statement of profit or
loss only after completing a cash budget and a budgeted statement of profit or loss.
It is usual to be presented with a current statement of financial position for a
particular date, and then be provided with some budgeted data relating to business
transactions for the immediate future period (e.g. the following few months or year).
From this provided data, a cash budget can be constructed, along with a statement
of profit or loss. From this, a budgeted statement of financial position can then be
produced, which updates the current statement of financial position but takes into
account the forecasted transactions that are expected to take place.
The budgeted statement of financial position will follow the same principles as any
other statement of financial position. If we had continued with the example of Plum Ltd,
and constructed a statement of financial position, then the following should be noted.
» Any credit sales or credit purchases made that have yet to be settled will appear on
the statement as either trade receivables (for credit sales) and trade payables (for
credit purchases).
» The closing balance on the cash budget at the end of the budget period will be the
cash balance under current assets (or current liabilities if the budget expected an
overdrawn balance).
» Non-current assets should appear at their varying amount, that is the cost value
less any accumulated depreciation (including any depreciation shown in the
budgeted statement of profit or loss).
437
4.3
» Capital will need to be adjusted for any profit or loss budgeted for over the period.
» Any drawings taken from the business by the owner(s) will need to be included as
an adjustment to the capital figure.
» Any expenses (or incomes) that are settled in arrears will need to be included under
current liabilities (for expenses) or current assets (for incomes).
4.3 budgetIng and budgetary Control
WORKED EXAMPLE 14
Cathy Butterworth is a sole trader. Her most recent statement of financial
position was prepared for 31 December 2020.
Cathy Butterworth
Statement of financial position at 31 December 2020
$
$
$
Cost Accumulated depreciation
Net book value
ASSETS
Non-current assets
Premises
Equipment
100 000
–
100 000
30 000
9 000
21 000
1 30 000
9 000
121 000
Current assets
Inventory
7 650
Trade receivables
10 800
Cash at bank
5 610
24 060
TOTAL ASSETS
145 060
CAPITAL AND LIABILITIES
Capital
118 660
Add Profit for the year
25 000
143 660
Less Drawings
(6 750)
136 910
Current liabilities
Trade payables
8 150
Total capital and liabilities
145 060
Additional information
1 Sales and purchases are all on credit – with one month’s credit being
allowed by the business and by the suppliers.
2 Expected sales and purchases are as follows:
Jan
Feb
Mar
Apr
May
Jun
Sales ($)
18 500
25 000
29 000
33 500
36 000
38 200
Purchases ($)
11 400
16 700
21 000
24 500
27 800
29 975
3 The owner takes personal cash drawings each month of $1000.
4 Wages and salaries are expected to amount to $3200 for January to March
and then $3600 each month afterwards.
5 Insurance of $150 is paid each month.
6 General expenses are $450 per month and are paid when they are due.
438
7 New equipment will be purchased on 1 March 2021 for $12 000. Equipment
is to be depreciated at 10% on cost – one month’s ownership equals one
month’s depreciation.
8 The owner expects to receive a quarter’s rent of $900 on both 1 January and
1 April.
9 The value of inventory on 30 June 2021 is expected to be $6 120.
4.3
Required
Answer
Cathy Butterworth
Cash budget for each of the six months ending 30 June 2021
Jan
Feb
Mar
Apr
May
Jun
$
$
$
$
$
$
10 800
18 500
25 000
29 000
33 500
36 000
Receipts
Cash received from credit
customers
Rent received
900
4.3.1 Budgeting and budgetary control
a A cash budget for each of the six months ending 30 June 2021.
b A budgeted statement of profit and loss for each of the six months ending
June 2021.
c A budgeted statement of financial position at 30 June 2021.
900
11 700
18 500
25 000
29 900
33 500
36 000
Payments to trade payables
8 150
11 400
16 700
21 000
24 500
27 800
Wages and salaries
3 200
3 200
3 200
3 600
3 600
3 600
Insurance
150
150
150
150
150
150
General expenses
450
450
450
450
450
450
1000
1000
1000
1000
1000
1000
26 200
29 700
33 000
6 660 (1 840)
1 860
5 660
Payments
Drawings
Equipment
Balance brought forward
Receipts
Payments
Balance carried forward
12 000
12 950
16 200
33 500
5 610
4 360
11 700
18 500
25 000
29 900
33 500
36 000
17 310
22 860
31 660
28 060
35 360
41 660
12 950
16 200
33 500
26 200
29 700
33 000
4 360
6 660
-1 840
1 860
5 660
8 660
Points to note:
l The cash balance at the start of January is taken from the statement of
financial position for 31 December 2020. The cash budget’s closing balance
will appear on the budgeted statement of financial position at 30 June 2021.
l The receipts from trade receivables for January will be December’s sales
as seen on the statement of financial position at 31 December 2020 and the
payment for trade payables in January will be found on December statement
of financial position.
l The sales and purchases figures for June do not appear in the cash budget
but appear as trade receivables and trade payables on the statement of
financial position at 30 June 2021.
l Drawings appear in the cash budget but not in the budgeted statement of
profit or loss.
439
4.3
Cathy Butterworth
Budgeted statement of profit or loss for the six months ending 30 June 2021
$
$
Sales
180 200
Less Cost of goods sold
4.3 budgetIng and budgetary Control
Opening inventory
Add Purchases
7 650
131 375
139 025
(6120)
Less Closing inventory
132 905
Gross profit
47 295
Add Rent receivable
1 800
49 095
Less Expenses
Wages and salaries
Insurance
General expenses
Depreciation (*)
20 400
900
2 700
1 900
25 900
23 195
Profit for the year
* The depreciation is calculated as follows:
$30 000 × 10%
= $3 000 × 6 months
= $1 500
$12 000 × 10%
= $1 200 × 4 months
= $400
Total depreciation
= $1 900
Cathy Butterworth
Budgeted statement of financial position at 30 June 2021
$
$
$
ASSETS
Non-current assets
Premises
Equipment
Cost Accumulated depreciation Net book value
100 000
100 000
–
42 000
142 000
10 900
10 900
31 100
131 100
Current assets
Inventory
Trade receivables
Cash at bank
TOTAL ASSETS
6 120
38 200
8 660
52 980
184 080
CAPITAL AND LIABILITIES
Capital
Add Profit for the period
136 910
23 195
160 105
Less Drawings
6 000
154 105
Current liabilities
Trade payables
Total capital and liabilities
440
29 975
184 080
The effect of limiting factors on the preparation of budgets
When budgets are being prepared it is essential that any limiting factors are identified
and budgets amended to take into account any change. Each individual budget is
incorporated into a master budget (see above). Change to one of the departmental
budgets will inevitably have a knock-on effect into other budgets. A change may be the
result of a limiting factor. For example: a factory may be able to produce 40 000 units
per month. It would be pointless for the sales budget to be prepared estimating sales
volume at 50 000 units. Production of 40 000 units is a limiting factor.
Limiting factors were
first covered in the
section on marginal
costing in Chapter 2.2.
This limiting factor would affect not only the sales budget but also the cash budget,
the purchases budget, the trade receivables budget, the trade payables budget and, of
course, the master budget.
The benefits of flexible budgeting over fixed budgeting
During the preparation of budgets it is important that any obstacle to achieving
the desired outcomes is identified. There could be a shortage of materials or of a
component used in the manufacturing process. Factory space might be limited. There
could be a shortage of labour possessing a particular skill.
When the productive capacity of a business is restricted so that demand for the
product cannot be met, the limiting factor must be identified. While individual budgets
are being prepared it is essential that coordination takes place and changes are made
to the budgets affected. For example, a production budget requiring 60 000 hours of
labour input would not be met if only 50 000 hours was available locally.
Remember
Variances are not
negative or positive but
adverse or favourable.
4.3.1 Budgeting and budgetary control
Learning link
4.3
Budgets are plans and may be used as control mechanisms when actual performance is
compared to the budgeted performance. Variations from the budgeted data need to be
investigated and action taken.
Adverse variances need investigation and may need corrective action to be taken.
The causes of favourable variances need to be identified and, where possible, applied
to other areas of the business.
Actual results can be compared to a fixed budget based on a set level of sales or
output. However, this type of comparison can give misleading results, which can lead
to managers making inappropriate business decisions.
To overcome this problem, flexible budgets can be produced to reflect changes in
output and turnover.
Flexible budgets
A system of standard costing identifies variances by making comparisons between
standard (budgeted) costs and the costs that have actually been incurred. One of the
overriding principles involved in making any comparisons is that we should try, as far
as is possible, to compare like with like. If the level of actual activity is greater than
the planned level of activity, then it is likely that actual expenditure will be greater
than planned expenditure. This will generate, in most cases, adverse variances. For
example, if actual output was double the level of planned output then it is likely, even
if the business generates costs savings on each individual unit produced, that more
will be spent on direct materials and direct labour. This adverse variance may result in
investigation and action being taken that is not really necessary.
To resolve this issue, a system of budgeting can be developed that adjusts the
standard quantities so that they match the actual level of activity.
This principle should be applied when comparing standard costs with actual costs. So,
if actual activity differs from budgeted activity, we should produce a budget which
reflects actual levels of activity rather than sticking to the planned level of activity.
This takes into account the basic idea that costs will rise when output rises and
441
4.3 budgetIng and budgetary Control
4.3
STUDY TIP
A flexible budget will
be used when the
actual output differs
from the output
level budgeted for –
remember to adjust the
budgeted quantities.
adjusts the budgeted or standard costs to account for differences in the actual level
of output. As a result, the behaviour of costs is taken into consideration when actual
output differs from budgeted output.
Variable costs will rise in proportion to any increases in output. However, the
relationship between other types of costs and output is not always the same. Fixed
costs will remain constant when output levels change. Semi-variable and stepped
costs will rise when output increases but not in proportion to the change in output.
As a result, it is important that we identify where a change in a particular cost is
not in keeping with expectations of how those costs would vary with changes in the
level of output. Using flexible budgets allows us to see more clearly the relationship
between costs and output, and how much of changes in costs is the result of the
established relationships.
EXAMPLE
The manager of Cottou plc has budgeted to produce 100 000 pairs of cotton trousers in August. She budgets
for the use of 140 000 square metres of cotton in the production process. The actual figures available in
September show that only 120 000 square metres of cotton was used and total production was 90 000 trousers.
Clearly, the production has used less cotton than had been anticipated but fewer trousers were manufactured,
so one would expect that less material had been used (140 000 square metres compared with 120 000 square
metres).
However, we are not comparing like with like.
l 140 000 square metres should have made 100 000 pairs of trousers.
l 120 000 square metres actually made 90 000 pairs of trousers.
In order to make a valid comparison to see if the materials have been used efficiently or not, we need to
adjust our budget quantities. This is part of producing a flexible budget.
If we had known earlier, when the standard was set, that only 90 000 pairs of trousers would be made, the
budgeted figures for materials to be used would have been:
l 126 000 square metres (i.e. 90 000/100 000 or nine-tenths of 140 000 square metres) and the adjusted
standard quantities to be used would be:
l Standard costs:
90 000 pairs of trousers requiring 126 000 square metres of cotton
So a comparison can now be made quite easily:
Standard materials usage
Actual materials usage
90 000 pairs of trousers requiring
126 000 square metres of cotton
90 000 pairs of trousers requiring
120 000 square metres of cotton
We can now see quite clearly that less material has been used than anticipated. This will result in a
favourable direct materials usage sub-variance.
WORKED EXAMPLE 15
The managers of Getang Ltd provide the following information for the
production of ‘selvings’ during March:
442
Budgeted output
Actual output
80 000 selvings
70 000 selvings
Budgeted use of direct materials
Actual use of direct materials
240 000 litres
220 000 litres
Required
Calculate the amount of direct materials saved or wasted during March.
4.3
Answer
Actual output
70 000 selvings
70 000 selvings
Flexible budgeted use of direct materials
Actual use of direct materials
210 000 litres (70 000/80 000) × 240 000
220 000 litres
So 10 000 litres of direct materials were used that had not been budgeted for.
The reasons for this ‘wastage’ should be investigated and if possible a remedy
sought.
It will also be necessary to adjust the standard quantities of direct labour hours
by producing a flexible budgeted quantity for the total.
WORKED EXAMPLE 16
The following information is given for direct labour hours for July for the
production of ‘lingts’:
STUDY TIP
Only use calculations
for a flexible budget for
the standard quantity
of direct materials
and/or the standard
hours of direct labour
to be used.
Standard
Actual
Production
250 000 units
225 000 units
Direct labour hours
70 000 hours
65 000 hours
4.3.1 Budgeting and budgetary control
Flexible budgeted output
Required
Calculate the direct labour hours to be used in a flexed budget for July.
Answer
Using a flexible budget, production of 225 000 lingts should use 63 000 hours of
direct labour (225 000/250 000 × 70 000 hours).
In fact, 2000 further hours have been used.
An investigation should be undertaken to determine why this has happened and
remedial action taken if possible.
WORKED EXAMPLE 17
The following information is given for the production of ‘trapeds’:
Standard costs for 1000 trapeds
Direct materials
220 kg at $5 per kg
Direct labour
60 hours at $9.50 per hour
Actual costs for the production of 950 trapeds
Direct materials
204 kg at $5.75 per kg
Direct labour
58 hours at $9.30 per hour
443
4.3
Required
Calculate the:
a direct materials usage sub-variance
b direct materials price sub-variance
c total direct materials variance
d direct labour efficiency sub-variance
e direct labour rate sub-variance
f total direct materials variance.
4.3 budgetIng and budgetary Control
Answer
Actual output is 95% of the level the standard quantities were based on. The first calculation would be to
provide flexible budgeted quantities for direct materials and direct labour hours based on the actual level
of output.
Standard quantity of direct materials = 220 kg.
Flexible budgeted quantity of direct materials = 950/1000 × 220 kg = 209 kg
Standard quantity of direct labour hours = 60 hours
Flexible budgeted quantity of direct labour hours = 950/1000 × 60 hours = 57 hours
Based on the flexible budgeted, the standard costs for 950 trapeds are:
l Direct materials: 209 kg at $5.00 per kg
l Direct labour: 57 hours at $9.50 per hour
The variances are as follows:
a Direct materials usage variance = (Flexible budgeted quantity − Actual quantity) × Budgeted quantity
= (209 − 204) × $5 = $25 favourable
b Materials price variance = (Budgeted price − Actual price) × Actual quantity
= ($5 − $5.75) × 204 kg = $153 adverse
c Total direct materials variance = (Flexible budgeted quantity × Budgeted price) − (Actual quantity × Actual
price)
= (209 × $5) − (204 × $5.75) = $128 adverse
d Direct labour efficiency variance = (Flexible budgeted hours − Actual hours) × Budgeted wage rate
= (57 − 58) × $9.50 = $9.50 adverse
e Wage rate variance = (Budgeted wage rate − Actual wage rate) × Actual hours
= ($9.50 − $9.30) × 58 hours = $11.60 favourable
f Total direct labour variance = (Flexible budgeted hours × Budgeted wage rate) − (Actual hours × Actual
wage rate)
= (57 × $9.50) − (58 × $9.30) = $2.10 favourable
How to prepare a flexible budget statement
We have now seen budgets can be adjusted to take into account variations in output
from the level that was originally budgeted for.
According to CIMA, a flexible budget recognises ‘… different cost behaviour patterns
… as volume of output changes’.
In order to prepare accurate budgets capable of being used for budgetary control
purposes, managers need to adjust budgeted levels of activity. If the actual level
of activity is different to the budgeted level then managers will have to allow for
differing levels of expenditure on the factors of production they use. Variable costs
and revenues must be changed to reflect the actual level of activity achieved.
The budgets that are prepared should be based on the adjusted levels of activity. The
flexible budget will reflect the different behaviour patterns of fixed and variable costs.
The process requires that variances are analysed and in the case of adverse variances
any necessary remedial action is taken. Responsibility for variances rests with
departmental heads.
444
WORKED EXAMPLE 18
The following data are available for Grizzel, a public limited company, for the
year ending 30 September:
Level of production (units)
Actual
$
$
8000
8500
direct materials
15 200
16 000
direct labour
19 200
21 000
4 800
5 000
Total variable costs
39 200
42 000
Fixed costs
15 000
16 000
Total cost
54 200
58 000
variable overheads
Required
Prepare a flexible budgeted operating statement for Grizell for the year ending
30 September.
Answer
4.3.1 Budgeting and budgetary control
Variable costs –
Budget
4.3
The actual level of output was 500 units higher than the original budgeted total
of 8000 units. This is a 6.25% increase. A flexible budget will adjust costs to
account for this change in output. Consequently the costs connected to output in
the flexible budget are all increased by 6.25% as well.
Flexible budget
Actual
Direct materials
16 150
16 000
Direct labour
20 400
21 000
5 100
5 000
41 650
42 000
(350) (adverse)
15 000
16 000
(1 000) (adverse)
56 650
58 000
(1 350) (adverse)
Variable overheads
Fixed costs
Learning link
See Chapter 4.2 for
more on the possible
causes of variances.
Variances
150 (favourable)
(600) (adverse)
100 (favourable)
Possible causes of differences between actual and flexible budgeted data
In the previous chapter, we looked at how variances in output levels may arise. To
summarise, the reason for difference between actual output and budgeted output
could include:
» poor forecasting of sales levels
» changes in market conditions affecting sales levels
» problems with production within the business (e.g. machinery break-down, worker
issues, etc)
» a shortage of a resource required (e.g. a limiting factor).
How to prepare a statement reconciling the flexible budgeted
cost of production with the actual cost of production
The reasons why there may be a difference between the profit forecast in a budget
and the actual profit earned are shown in detail by comparing the budgeted cost and
sales variances with the actual costs and sales when these figures become available.
These differences form the basis of remedial action where necessary.
445
4.3
The variances are summarised (after the budgets have been flexed) and the total is
then used to adjust budgeted costs for materials, labour and overheads. The adjusted
amount should total to the actual costs.
4.3 budgetIng and budgetary Control
If the total of the variances calculated amounts to a total favourable variance, this
is deducted from budgeted costs since favourable variances reduced the amount of
expenditure incurred. Conversely, a total adverse variance is added to the budgeted
costs because the total represents more expenditure on the factors of production.
WORKED EXAMPLE 19
Hussain industries manufactures one product. Management uses a standard
absorption costing system. Management prepared the following budget for
February based on sales of 10 000 units
Budget for February
$
$
Sales (10 000 units at $9.50 per unit)
95 000
Direct materials (14 000 kgs at $3.00 per kilo)
42 000
Direct labour (3750 hours at $7.20 per hour)
27 000
Fixed overheads ($0.70 per unit)
7 000
Cost of sales (10 000 units)
76 000
Budgeted profit
19 000
Hussain's actual sales for February were only 9500 units
Actual results for February
$
$
Sales (9500 units at $9.60)
91 200
Direct materials (15 250 kgs at $2.90 per kilo)
44 225
Direct labour (3500 hours at $8.00 per hour)
28 000
Fixed overheads
6 500
Cost of sales
78 725
Actual profit
12 475
Required
Prepare a statement reconciling budgeted cost with actual cost.
Answer
$
$
Budgeted costs (10 000 units)
76 000
Only 9500 units produced so standard cost
is actually
72 200
Favourable
Direct material variances – usage
price
Direct labour variances – efficiency
Fixed overhead variances – expenditure
5 850
450
2 800
500
volume
350
2 475
Actual costs
Adverse
1 525
rate
446
$
9 000
6 525
78 725
Note
l The fixed overhead expenditure variance is the difference between the
budgeted figure and the actual figure. The volume variance arise because 500
fewer sales were made thus giving a shortfall in the absorption of overheads
of 500 x $0.70 = $350.
l The total of the variances calculated is $6525 adverse which means that
further costs from the budgeted amount have been incurred and this total
needs to be added to the total budgeted costs.
Budgeted profit is often different to actual profit; this is due to changes in the cost
structure of the factors of production as well as differences in the volume of finished
goods being produced and sold. The business may also have to change the selling price
per unit to take into account changes in the price that customers are willing to pay.
Managers may prepare a budgeted cost statement of profit or loss in order to
reconcile the budgeted profit with the actual profit earned. They can then easily
identify the reasons why actual profit might have deviated from the profit forecast
in the budgeted statement of profit or loss. The cost and sales variances replace the
expenses and incomes found in a traditional statement of profit or loss. Negative
(adverse) variances allow management to identify areas of the business that need
some form investigation to determine if remedial action is necessary; while the
departments that produce positive (favourable) variances can be used as examples of
good practice to be replicated elsewhere in tbe business.
4.3.1 Budgeting and budgetary control
How to prepare a statement reconciling the flexible budgeted
profit with the actual profit
4.3
An example of budgeted cost statement of profit or loss is shown using the data for
Hussain industries in the section above.
EXAMPLE
Hussain industries
Statement for February reconciling budgeted profit and actual profit
$
$
Favourable
variances
Adverse
variances
Budgeted profit for February
Variances – Sales price variance
18 050
950
Direct materials – usage
price
Direct labour – efficiency
5 850
1 525
450
rate
Fixed overheads – expenditure
2 800
500
volume
350
3 425
Actual profit
$
9 000
5 575
12 475
447
$
4.3
Budgeted sales revenue (9500 × $9.5)
39 900
Direct labour (3750 × 0.95 = 3562.5 × $7.20)
25 650
Budgeted profit
4.3 budgetIng and budgetary Control
90 250
Direct materials (14 000 × 0.95 = 13 300 × $3.00)
Fixed overheads (9500 × $0.70)
$
6 650
72 200
18 050
How to make business decisions and recommendations using
supporting data
The data from budgets can be used to make decisions and recommendations for
business managers. In general, budgeted data will help with two types of decisions:
» decisions about the budgeted data itself
» decisions about the variances arising by comparison of budgeted data with actual data.
The second of these types of decision is largely covered in the previous chapter, when
we looked at the causes of variances and how a business might react. Sometimes the
variance may be outside the control of the business. Using flexible budgets will make
it easier to deicide if the variance is something that can be acted on.
The first type of decision involves using the information provided by the budget to
make decisions. These could involve some of the following:
» deciding whether to expand the business based on sales forecasts
» deciding whether to change selling prices based on sales forecasts and production
capacity level
» deciding on the level of production based on sales forecasts
» deciding on purchases and cash flow requirements based on production forecasts
» deciding whether to change the policy on credit sales based on the trade
receivables budget
» seeking out alternative sources of finance based on the cash budget.
Budgets are subject to change. It is highly unlikely that the budgeted data will ever be
completely accurate. The external environment changes quickly and this will mean that
the budgeted data will quickly become outdated as things change.
The behavioural aspects of budgeting, including targets,
incentives and motivation
We have covered some of the behavioural aspects of budgeting earlier in this chapter
when discussing the advantages and disadvantages of budgeting. One additional
aspect to consider is the use of incentives to ensure the business meets or exceeds
the targets that are outlined in the budget. This is often in the form of performance
bonus for staff and/or managers, which might mean extra cash at the end of a
financial period, or some other perk.
The significance of non-financial factors
As with other topics, non-financial factors will affect the budgets of businesses. It
is important that a business considers these when setting budgets, as well as when
analysing the results of any comparison between budgeted and actual data.
448
SUMMARY
After reading this chapter you should:
» understand what is meant by budgets and budgetary control
» understand the advantages and disadvantages of systems of budgetary control
– including using spreadsheets to help
» be able to construct budgets for sale, production, purchases, trade
receivables, trade payables and cash
» be able to produce a set of budgeted financial statements (and a master
budget)
» be able to reconcile differences in budget costs and profits to actual costs and
profits
» understand how budgets can be used to provide data to support decisionmaking
» understand the significance of non-financial factors that affect budgets and
decision-making.
4.3
4.3.1 Budgeting and budgetary control
» The motivation of the workforce of a business can be significantly affected by the
process of budgeting. Giving workers some control over the setting of budgets can
be a way to motivate the workers (see the theories put forward to explain worker
motivation by Herzberg or Maslow). However, setting restrictive budgets can also
demotivate workers.
» When conducting variance analysis it is important that the business can divide
factors between those within the control of the business and those outside of the
control of a business. For example, adverse variances on expenditure may arise out
of the increased sales level of the business – making a flexible budget a very useful
technique to use. Even if flexible budgets are used, the variances may not always be
something that can be controlled – and this was explored in Chapter 4.2.
» For some businesses, control of costs is essential. For other businesses, costs are
less important when compared with the quality of the output and the reputation of
the business. It is important that a business knows itself so that it does not focus
unnecessarily on reducing costs when it is the quality of the product that is the
main ‘selling point’ for the business.
SELF-TEST QUESTIONS
1 A budget is an accounting term used to describe a forecast. True/False?
2 Explain the term ‘budget’.
3 Who would generally prepare the budgets for a business?
4 Outline two advantages that managers of a business would hope to achieve by
preparing budgets.
5 Outline two drawbacks of budgeting that might be encountered by managers.
6 Explain the difference between a forecast and a budget.
7 Only large public companies use a system of budgetary control. True/False?
8 Explain how a system of budgetary control might demotivate a departmental
manager.
9 Identify how poor outcomes in a sales department budget might affect other
departmental budgets.
10 Explain two reasons why a manager might prepare a cash budget.
449
4.3
11 Explain how there can be a negative cash balance shown in a cash budget at the
end of a month.
12 A cash budget is another name for an a statement of profit or loss. True/False?
13 ‘There is no need to prepare a cash budget if my business is profitable,’ a
businessman was heard to say. Do you agree? Explain your reply to his statement.
14 Depreciation is only included in a cash budget in the final month. True/False?
4.3 budgetIng and budgetary Control
15 Identify one reason why a cash budget might be prepared.
16 Explain why depreciation is not included in a cash budget.
17 What is meant by the term ‘master budget’?
18 Name one component of a master budget.
19 Explain the term ‘variance’.
20 Why would a manager flex a budget?
Calculation question (answer on page 494)
21 Calculate the values for A, B and C from the following cash budget.
Jan
Feb
$
$
1 800
2 800
600
760
1 000
1 000
480
560
Total cash outflows
A
2 320
Net cash flow
B
480
Balance b/f
920
640
Balance c/f
640
C
Receipts
Cash sales
Payments
Payments to suppliers
Wages
Overheads
450
4.4
Investment appraisal
By the end of this chapter you should have an understanding of:
l future net cash inflows and outflows arising from the project
l how to apply the following capital investment appraisal techniques:
– payback
– accounting rate of return (ARR)
– net present value (NPV)
– internal rate of return (IRR)
l the advantages and disadvantages of these capital investment appraisal
techniques
l how to make investment decisions and recommendations using supporting
data, including the significance of non-financial factors.
4.4.1 Investment appraisal
Learning outcomes
Introduction
When business managers make investment decisions they will be considering
the long-term impact of the investment. This investment is likely to involve
significant amounts of money invested into a project. Although capital
expenditure does not directly affect the profits each year, the future profitability
of the business can be improved with the right choice of investment. As a result,
it is important that the correct choices are made. Investment appraisal uses
quantitative techniques to assess the likely impact of an investment project, and
being able to calculate these methods, as well as interpret the results, is vital for
a business manager.
4.4.1 Investment appraisal
We have seen that non-current assets are the wealth generators of a business. They
are purchased with the intention that they will generate profits for the business for
some years into the future.
The non-current assets used in a business usually comprise:
»
»
»
»
»
»
land
buildings
machinery
plant
vehicles
office equipment, etc.
They are used in the business for more than one financial year.
The managers of a business are always looking for good value when they purchase noncurrent assets, just as you do when buying clothes, a mobile phone, etc. The managers
of a business do not have unlimited resources and available cash is a scarce resource.
Consequently, the managers must plan their capital expenditure very carefully so that
they get the best value for their money. They want to ensure that they earn maximum
benefits from their purchase, just like you.
451
4.4
Since the money available to a business for a capital project is likely to be limited or
in short supply, some form of rationing the available money is often required. Capital
investment appraisal techniques are used by managers to assist them in their choice of
appropriate investment opportunities.
Capital projects are appraised according to potential earning power.
4.4 Investment appraIsal
Care must be taken when making a capital investment decision:
»
»
»
»
Large sums of money are generally involved.
The money may well be ‘tied up’ for a considerable length of time.
The decisions cannot generally be easily reversed.
The money committed is usually non-returnable.
Consider a family commitment to the purchase of their largest item of capital
expenditure – property, i.e. a house or apartment:
»
»
»
»
A large sum of money is involved.
The money will probably be tied up for many years.
It might be difficult to resell the property.
Once purchased, the property cannot be returned to the previous owners.
There are four main methods of appraising a capital project. They are:
»
»
»
»
the payback method
the accounting rate of return method (ARR)
the net present value method (NPV)
the internal rate of return method (IRR).
All the methods require predictions about future flows of either cash or profits.
If the predictions are inaccurate, there could be serious problems for the business
because of:
» the large sums of cash being involved
» the long-term commitment of cash and other resources
» the effect on profits.
Note: From this point, reference will be made only to ‘projects’ but be aware that the
text does also apply to the purchase of non-current assets.
So, managers will often use more than one method of appraising a project that could
affect the business for many years.
Future net cash inflows and outflows arising from the project
Investment appraisal techniques make use of estimates and forecasts of future
earnings or savings that result from a particular investment. Some investment
appraisal methods use cash flow forecasts while other methods use forecasts of profit.
If the method selected requires you to use cash flow forecast data, and you are only
given profit forecasts, then you will need to ensure that you can correctly adjust the
profit figures so that they represent the cash flow. It is also likely that profit and cash
flow will not always be the same figure. You will need to make adjustments for any
‘non-cash’ adjustments that are used in the profit calculations that do not feature in
the cash flow calculations.
For example, depreciation on non-current assets will usually appear as an expense in
the profit calculation. To arrive at the cash flow figure for the same period, we would
need to add back the depreciation charged. If there were any ‘non cash’ adjustments
that were added on as revenue income for the profit figure, we would then need to
subtract these to arrive at the cash flow forecast for that period. Usually, this would
include any reductions in the allowance for irrecoverable debts, or any profits made on
the disposal of non-current assets.
452
Another thing to look out for is where we are not provided with a single cash flow
forecast for a future period, but a combination of forecasted inflows of cash alongside
forecasted outflows of cash for future periods. In this case, it is the net cash flow
figure that is used for the investment appraisal calculation.
4.4
WORKED EXAMPLE 1
Cash inflows
Cash outflows
$000
$000
Year 1
65 000
49 000
Year 2
43 000
34 000
Year 3
38 000
27 000
Year 4
24 000
25 000
Answer
4.4.1 Investment appraisal
From the following data, calculate the net cash flow to be used in the investment
appraisal techniques.
The net cash flow is the cash inflows for a period less the cash outflows for the
same period:
Net cash flows
$000
Year 1
16 000 (e.g. 65 000 – 49 000)
Year 2
9 000
Year 3
11 000
Year 4
(1 000)
One more important piece of information is that investment appraisal calculations
should always be based on relevant cash flows and profit calculations. This means that
anything that is unaffected by the investment decision should not be included. For
example, if a business is deciding on different locations to open up a new branch of
its operations it may well conduct preliminary research on the locations that might be
chosen. This expenditure on research is an outflow that cannot be recovered once it is
spent. It should play no part in the investment decision, as whether the business goes
ahead with any particular location or decides against the overall idea of opening up
new operations, the money spent cannot be unspent.
How to apply the following capital investment appraisal
techniques
Payback
The payback period is the length of time required for the total cash flows to equal
the initial capital investment, i.e. how long will it take the project to pay for itself?
The payback period is measured in years.
Risk is an important factor to be taken into account when considering a project
lasting a few years. The sooner the capital expenditure is recouped, the better – this
is the essence of the payback method.
The method is used widely in practice since most businesses are concerned with short
time horizons.
453
4.4 Investment appraIsal
4.4
STUDY TIP
Payback uses cash
flows – so noncash items, e.g.
depreciation, accruals,
prepayments, are
ignored.
Also, the longer the time horizon involved, the less reliable are the predicted inflows
of cash. The earlier receipts are received, the sooner further investments can be made.
A long payback period increases the possibility that the initial outlay will not be
recouped at all.
WORKED EXAMPLE 2
Olive Branch is considering the purchase of a new machine. Two different
machines will suit her purpose.
The cash flows are given:
Machine Argo
Machine Binko
Cost $210 000
Cost $180 000
Estimated cash flows
Estimated cash flows
$
$
Year 1
70 000
70 000
Year 2
80 000
70 000
Year 3
90 000
80 000
Year 4
90 000
80 000
Required
Calculate the payback period for each of the two machines.
Answer
l Machine Argo
If we consider the cumulative cash flows over the four-year period, we can
see when payback is reached.
Cash flow
Cumulative cash flow
$
$
Year 1
70 000
(140 000)
Year 2
80 000
(60 000)
Year 3
90 000
30 000
Year 4
90 000
120 000
We can see that the payback is reached sometime in the third year. The exact
point is found by comparing the amount needed to reach payback with the
amount received in the following year, i.e., $60 000/$90 000 = 2/3rds of the year.
Payback period for Machine Argo is 2.67 years
l Machine Binko
Repeating this process with the other machine, we have the following
cumulative cash flows:
Cash flow
454
Cumulative cash flow
$
$
Year 1
70 000
(110 000)
Year 2
70 000
(40 000)
Year 3
80 000
40 000
Year 4
80 000
120 000
Here, the payback period is reached in the third year. This time the proportion
of the year needed is calculated as $40 000/$80 000, i.e. ½ of the year.
Payback period for Machine Binko is 2.5 years
4.4
Olive will choose Machine Binko when using the payback method of investment
appraisal as it has a quicker payback period.
Note
» the date of initial purchase is labelled Year 0.
» all cash outflows and inflows are deemed to accrue evenly throughout each year.
Type 1 When profits are given
The accounting rate of return method uses profits as the basis of the investment
appraisal calculation. If profits are given when using all other methods of investment
appraisal, the profits must be adjusted to generate the appropriate cash flows for
each year.
4.4.1 Investment appraisal
In the following questions and examples:
WORKED EXAMPLE 3
The following information is available for two proposed projects:
Project 2178
Initial costs
Expected profits generated:
Year 1
Year 2
Year 3
Year 4
Project 2179
$000
(14 000)
$000
(12 000)
3 500
5 000
8 000
10 000
3 500
4 000
5 500
6 500
Additional information
The profit for each project has been calculated after providing for annual
depreciation as follows:
Project 2178
Project 2179
$000
$000
1 500
1 200
Required
a Calculate the payback period for both projects.
b State which project should be undertaken.
455
4.4
Answer
a
Project 2178
4.4 Investment appraIsal
Cash flows
Project 2179
$000
$000
Year 0
(14 000)
(12 000)
Year 1
5 000
4 700
Year 2
6 500
5 200
Year 3
9 500
6 700
Payback
2.26 years
2.31 years
(2 years 2500/9500) (2 years 2100/6700)
b Project 2178 should be undertaken – it has the shorter payback period.
Type 2 When annual cash inflows and annual cash
outflows are given separately
In this type of example, deduct the annual cash outflows (expenses) from the annual
cash inflows (receipts) to obtain the net cash flows.
EXAMPLE
l Year 1 Cash receipts $100 000; cash expenditure $20 000; net cash flow
$80 000
l Year 2 Cash receipts $120 000; cash expenditure $25 000; net cash flow
$95 000
l Year 3 Cash receipts $130 000; cash expenditure $25 000; net cash flow
$105 000
The advantages and disadvantages of payback
Advantages of using the payback method
» It is relatively simple to calculate.
» It is fairly easy for non-accountants to understand.
» The use of cash is more objective than using profits that are dependent on the
accounting policies decided by managers.
» Since all future predictions carry an element of risk, it shows the project that
involves the least risk because it recognises that cash received earlier in the
project life cycle is preferable to cash received later.
» It shows the project that benefits a business’s liquidity.
Disadvantages of using the payback method
» It ignores the time-value of money (but see below).
» It ignores the life expectancy of the project; it does not consider cash flows that
take place after the payback period.
» Projects may have different patterns of cash inflows.
456
For example, consider:
Project 1
$
(10 000)
10 000
1
1
1
$
(10 000)
1
1
50 000
50 000
» Project 1 has a payback period of one year.
» Project 2 has a payback period of 2.2 years.
Payback in this case does not give a realistic appraisal.
If a machine has a scrap or trade-in value, this will be treated as an income in the
year of disposal.
Accounting rate of return (ARR)
4.4.1 Investment appraisal
Year 0
Year 1
Year 2
Year 3
Year 4
4.4
Project 2
The accounting rate of return (ARR) method of investment appraisal relates the
profit made to the financial size of the investment. Therefore, profits are used rather
than cash flows.
This method of appraisal has some similarities to the calculation of return on capital
employed (ROCE). It shows the return on the investment expressed as a percentage of
the average investment over the period.
Have a look at the way average investment is calculated and then learn the formula.
WORKED EXAMPLE 4
A machine is purchased for $100 000 and will be used for two years.
Required
Calculate the average investment on the machine over the two years.
Answer
The machine will incur depreciation, using the straight-line method, of $50 000
per annum.
($100 000 ÷ 2 years = $50 000 per annum)
Start of year
End of year
Average investment over year
Investment Year 1
$100 000
$50 000
($150 000 ÷ 2) = $75 000
Investment Year 2
$50 000
$0
($50 000 ÷ 2) = $25 000
So:
in Year 1, average investment =
$75 000
in Year 2, average investment =
$25 000
$100 000
Average investment over two years = $100 000 ÷ 2 = $50 000
457
WORKED EXAMPLE 5
4.4
A machine is purchased for $350 000. It will be used for five years, with no scrap
value.
Required
Calculate the average investment on the machine over the five years.
4.4 Investment appraIsal
Answer
Average investment = $175 000
Annual depreciation = $350 000 ÷ 5 = $70 000
Start of year
End of year
Average investment over year
$
$
$
Year 1
350 000
280 000
315 000
Year 2
280 000
210 000
245 000
Year 3
210 000
140 000
175 000
Year 4
140 000
70 000
105 000
Year 5
70 000
0
35 000
Total
875 000
Average investment over five years = $875 000 ÷ 5 years = $175 000 per year
There is an arithmetic shortcut that gives the correct answer without the long,
complicated calculation shown in the two worked examples given above:
Average investment = Initial investment ÷ 2
EXAMPLE
Example 1
Purchase price $100 000 ÷ 2 = Average investment $50 000
Example 2
Purchase price $350 000 ÷ 2 = Average investment $175 000
This shorter method works! It always works!
STUDY TIP
The calculation of ARR
uses profits, not cash
flows.
458
FORMULA
Accounting rate of return =
Average profits
Average investment
× 100
WORKED EXAMPLE 6
Aoife is considering the purchase of a machine. There are two models that will
suit her needs. All profits are assumed to accrue on the last day of the year.
Machine Ara
Cost $170 000
Estimated profits
Machine Bibi
Cost $250 000
Estimated profits
$
70 000
90 000
110 500
88 000
84 000
Required
a Calculate the accounting rate of return for both machines.
b Advise Aoife which machine she should purchase.
4.4.1 Investment appraisal
$
50 000
60 000
70 000
80 000
60 000
Year 1
Year 2
Year 3
Year 4
Year 5
4.4
Answer
Average profit:
Average investment:
Machine Ara
$320 000
= $64 000
5 years
Machine Bibi
$442 500
= $88 500
5 years
$170 000
2
= $85 000
$250 000
2
= $125 000
a Machine Ara: Accounting rate of return =
Machine Bibi: Accounting rate of return =
$64 000
$85 000
$88 500
× 100 = 75.3%
× 100 = 70.8%
$125 000
b Aoife should choose Machine Ara because this gives her a higher rate of
return than Machine Bibi
If there is a requirement for extra working capital during the lifetime of an investment
project, then this will increase the average investment in a project. It is safe to
assume that the extra working capital needed would be constant over the project’s
life. In this case, just add on the value of the extra working capital needed to the
average investment for the project.
The advantages and disadvantages of accounting rate of return (ARR)
Advantages of using the accounting rate of return method
» ARR is simple to calculate.
» Results can be compared to present profitability.
» It takes into account the aggregate earnings of the project(s).
Disadvantages of using the accounting rate of return method
» ARR does not take into account the time value of money.
» It does not recognise the timing of cash flows (see same disadvantage for
payback).
459
Net present value (NPV)
4.4
Which of the following would give you the better value for money?
» spending $100 today
» spending $100 in ten years’ time.
4.4 Investment appraIsal
I think that most people would say that $100 spent today would give them the
better value. The future is uncertain – there is an element of risk involved. Also, as
time goes on, money becomes less valuable.
When your grandparents bought their apartment many years ago, they may have spent
$2000. It is unlikely that sum would buy the same apartment today.
If $1 were received and invested at five per cent per annum, it would be worth $1.05 in
one year’s time; if it were left to accumulate interest it would be worth just over $1.10
in two years’ time and just under $1.16 in three years’ time.
Looked at from another perspective:
» If 86.4 cents were invested today at five per cent for three years, this would
yield $1.
» If 90.7 cents were invested today at five per cent for two years, this would
yield $1.
» If 95.2 cents were invested at five per cent for one year, this would yield $1.
The net present value method of investment appraisal of a project is calculated by
taking the present day (discounted) value of all future net cash flows based on the
business’s cost of capital and subtracting the initial cost of the investment.
Managers of a business invest in capital projects to provide security for the future
through profits and cash flows.
As individuals, we invest to provide for the future, and we hope that the monetary
rewards in the future will be worth waiting for.
In giving up the money today, we expect a reward. The reward is the interest that we
will earn on our investment.
In the same way that we may invest in, say, a bank savings account to get a return on
our investment, managers of a business will invest in projects that will pay a return on
their investment.
Managers evaluate a project by comparing the capital investment with the return that
the investment will bring in the future.
In order to make a meaningful comparison between the amount originally invested
and the income generated in the future by that investment, there is a need to
discount the cash flows so that they are the equivalent of cash flows now. Thus we
can compare like with like.
We can compare the initial investment at today’s price with future cash inflows,
discounted to give their values in today’s world.
The discount factor used in net present value calculations is generally based on a
weighted average cost of capital available to the business.
460
EXAMPLE
4.4
Schiffe Ltd has the following capital structure:
$
Ordinary shares (currently paying a dividend of 9% per annum)
1000 000
7% debenture stock
200 000
Bank loan (current interest rate payable 8%)
300 000
Ordinary shares
Debenture stock
Bank loan
Nominal value
$
1000 000
200 000
300 000
1 500 000
Average cost of capital =
Rate paid
9%
7%
8%
Cost of capital per annum
$
90 000
14 000
24 000
128 000
4.4.1 Investment appraisal
The weighted average cost of capital for Schiffe Ltd is:
Cost of capital per annum
Nominal value of capital
128 000
× 100 = 8.5%
=
1500 000
This shows that the average cost of Schiffe Ltd raising further capital would be
8.5%.
Note
The example is correct in principle. However, the interest on debenture stock and
the bank loan are revenue expenditure (they reduce profits) – they would reduce the
amount of tax payable by Schiffe Ltd. So, in reality, the two figures should be shown
in the calculation net of taxation.
There is a misconception by students that a discount factor is used to take into
account the effects of inflation on future cash flows – this is not so. The effects that
inflation have on results are self-correcting.
The discount factor is based on the business’s cost of capital (see above).
Generally, what we consider is what would happen if we were fortunate enough to be
able to invest, say, $1000 in a bank account or a business project for, say, four years.
We calculate how much our investment would be worth each year if the investment
were earning, say, five per cent per annum.
At the end of:
Year 1
$1050
Year 2
$1102
Year 3
$1158
Year 4
$1216
Discounting uses the same principle but in reverse.
If I require $1000 in four years’ time and the interest rate, or rate of return, was five
per cent, how much do I have to invest today? I would have to invest $823.
461
The present value gives the value of a future sum of money at today’s values.
4.4
If you wish to have $100 in four years’ time and the interest rates were seven per cent,
you should invest $76.30 today.
Working this in reverse, we can say that $100 received in four years’ time is equivalent
to receiving $76.30 today.
4.4 Investment appraIsal
($76.30 placed on deposit today and receiving interest of seven per cent per annum
would produce a deposit of $100 in four years’ time.)
How did I work these figures out? I used a set of present value tables!
WORKED EXAMPLE 7
Calculate the value of:
a $120
b $196
c $42
if the amount were invested for three years at 3% per annum.
The following figures give the value of $1 at a compound interest rate of 3%:
Year 1
1.030
Year 2
1.061
Year 3
1.093
Year 4
1.126
Answer
a $1 invested today would yield $1.09 ($1.093) in three years’ time, so $120
invested would yield $131.16 ($120 × 1.093).
b $214.23
c $45.91
WORKED EXAMPLE 8
Calculate the present value of:
a $926
b $62
c $1380
received in five years’ time if the current cost of capital is 9% per annum.
The following figures give the present value of $1 at 9%:
Year 1
0.917
Year 2
0.842
Year 3
0.772
Year 4
0.708
Year 5
0.650
Answer
a $1 received in five years’ time would have a value of 65 cents if received
today, so $926 received in five years’ time has a value of $601.90 today.
b $40.30
c $897.00
462
The net present value method of capital investment appraisal compares the investment
(at today’s prices) with future net cash flows (discounted to give the values at today’s
prices).
4.4
Here is a table showing the present value of $1 at a number of different discount rates:
5%
6%
7%
8%
9%
10%
Period 1
0.961
0.952
0.943
0.935
0.926
0.917
0.909
2
0.925
0.907
0.890
0.873
0.857
0.842
0.826
3
0.889
0.864
0.840
0.816
0.794
0.772
0.751
4
0.855
0.823
0.792
0.763
0.735
0.708
0.683
5
0.822
0.784
0.747
0.713
0.681
0.650
0.621
WORKED EXAMPLE 9
James Squirrel is considering whether to purchase a new machine for his
workshop. The machine will cost $5 000 and be used for five years, after which
time it will be scrapped. The following cash flows relate to the machine:
Revenue receipts
4.4.1 Investment appraisal
4%
Revenue expenditure
$
$
Year 1
8 000
4 000
Year 2
8 500
5 000
Year 3
7 000
4 000
Year 4
5 000
3 000
Year 5
3 000
1 000
The current cost of capital for James is 10%. All costs are paid and incomes
received on the last day of each financial year.
The following extract is taken from the present value tables for $1:
10%
Year 1
0.909
Year 2
0.826
Year 3
0.751
Year 4
0.683
Year 5
0.621
Required
a Calculate the net present value of purchasing the new machine.
b Advise James whether he should invest in the new machine.
463
4.4
Answer
Year
Cash flows
Discount factor
Net present value
$
4.4 Investment appraIsal
0 (now)
$
(5 000)
1.000
(5 000)
1
4 000
0.909
3 636
2
3 500
0.826
2 891
3
3 000
0.751
2 253
4
2 000
0.683
1 366
5
2 000
0.621
1 242
Net present value
6 388
James should invest in the new machine as it will yield a positive net present
value.
Note
The cash inflows are calculated from the revenue receipts less revenue expenditure.
Any project that yields a positive net present value should be considered.
Projects that yield negative net present values should be rejected on financial grounds
but may be considered on other grounds, for example, to keep a good customer
happy; to keep a good, skilled workforce within the business; perhaps to get further
profitable orders in the near future.
WORKED EXAMPLE 10
The managers of Dvorak Ltd wish to purchase a new machine. They will use the
machine for four years. There are three machines that are capable of producing
the quality of goods that are desired. The current cost of capital for Dvorak Ltd
is 9%. The following is an extract from the present value tables for $1.
9%
Year 1
0.917
Year 2
0.842
Year 3
0.772
Year 4
0.708
All cash flows arise at the end of the relevant year.
The following information is available for the three machines:
Machine
78/BA
92/DC
36/FE
$
$
$
88 000
99 000
115 000
Year 1
44 000
47 000
50 000
Year 2
44 000
47 000
49 000
Year 3
40 000
47 000
48 000
Year 4
40 000
45 000
44 000
Purchase price
Forecast net cash flows:
464
Required
a Calculate the NPV of each machine.
b Advise the managers of Dvorak Ltd which of the three machines they should
purchase.
4.4
Answer
a
Machine
92/DC
36/FE
$
$
$
Year 0
(88 000)
(99 000)
(115 000)
Year 1
40 348
43 099
45 850
Year 2
37 048
39 574
41 258
Year 3
30 880
36 284
37 056
Year 4
28 320
31 860
31 152
Net present values
48 596
51 817
40 316
b The managers should purchase machine 92/DC because it yields the highest
positive net present value.
4.4.1 Investment appraisal
Present values
78/BA
Note
When a selection has to be made, the machine that yields the highest net
present value should be chosen.
If all the machines yielded a negative net present value, then none of the machines
should be purchased. In this example, all machines will yield a positive NPV and,
under different circumstances, they would all be worth purchasing.
The advantages and disadvantages of net present value (NPV)
Advantages of using the net present value method
» Net present value is regarded as the most sound method of appraisal.
» The time value of money is taken into account as adjustments are made to take
account of the present value of future cash flows.
» It is relatively easy to understand.
» Greater importance is given to earlier cash flows.
Disadvantages of using the net present value method
»
»
»
»
Because the figures are projections, all the figures are of a speculative nature.
Inflows are difficult to predict; outflows are equally difficult to predict.
The current cost of capital may change over the life of the project.
The life of the project is difficult to predict.
When the net cash flows to be discounted are the same amounts, time can be saved by
totalling the discount factors for the appropriate years and multiplying the amount by
this total.
465
4.4
WORKED EXAMPLE 11
The following cash inflows are given for a machine:
4.4 Investment appraIsal
$
Year 1
40 000
Year 2
40 000
Year 3
40 000
Year 4
40 000
The present cost of capital is 4%.
All cash flows arise at the end of the relevant year.
Required
Calculate the present value of the cash flows.
Answer
Cash flows
Discount factor
Present values
$
Year 1
40 000
$
0.961
38 440
Year 2
40 000
0.925
37 000
Year 3
40 000
0.889
35 560
Year 4
40 000
0.855
34 200
Total present value
145 200
The same results would be given if 3.63 (0.961 + 0.925 + 0.889 + 0.855) is
multiplied by the (constant) $40 000.
You may notice that we have not used the word ‘net’ in this example of net
present value. This is because ‘net’ is only used when the present values are
subtracted from the cost of the asset. These are just the present values of the
cash inflows.
Internal rate of return (IRR)
A business must be profitable in order to survive. A business must ensure that projects
undertaken are profitable.
Net present value compares present day values of future estimated cash inflows with
present day cash outflows. However, such a comparison does not give managers the
rate of return expected on the investment.
The return on a project must cover the cost of capital, so if a business has a cost of
capital of 12 per cent, any projects undertaken must yield a return that is greater
than 12 per cent.
Managers need to be able to calculate the rate of return that any project being
considered is likely to yield; this expected yield can then be compared with the cost
of the capital needed to fund the project. The process involved is to calculate the
present value of future cash flows which, when discounted, will equal zero.
466
The process used is to select two discounting rates: one that will give a positive net
present value and a second that will give a negative net present value. The results are
then used in the following formula:
4.4
FORMULA


Internal rate of return = P + (P − N ) ×

p + n
P = % rate giving positive NPV
N = % rate giving negative NPV
p = value of positive NPV
n = value of negative NPV
Note
‘n’ is a negative value, so it is added to the value of ‘p’ in the denominator since
mathematically the subtraction of a negative number will result in an increase
in value.
4.4.1 Investment appraisal
where
p
WORKED EXAMPLE 12
The managers of Kai Ltd are considering whether or not to invest in a new
machine costing $9000. Their current cost of capital is 12%. They have estimated
that the future cash flows using a net present value of 10% will be $871.80 and
at 15% the value will be $(378.90).
Required
Advise the managers of Kai Ltd whether or not, on financial grounds, they should
invest in the new machine.
Answer
The machine should be purchased. It will yield an internal rate of return of
13.485%, which is greater than the cost of capital.
Workings
p


p + n

871.80


= 10 + (15 − 10) ×
871.80 + 378.90

IRR = P + (P − N) ×
= 10 + (5 × 0.697)
= 10 + 3.485
= 13.485%
The managers of Kai Ltd should invest in the new machine since the IRR is
greater than the company’s current cost of capital.
467
4.4
WORKED EXAMPLE 13
Hugo is considering the purchase of a machine which would require an initial
outlay of $160 000. His current cost of capital is 12.5%. The net present value of
future cash flows for the machine are as follows:
NPV at 10% = $5408; NPV at 40% = $(52 242)
4.4 Investment appraIsal
Required
Advise Hugo whether or not, on financial grounds, he should invest in the new
machine.
Answer
Hugo should invest in the new machine since it will yield 12.81%, which is
greater than his current cost of capital.
Workings


Internal rate of return = 10 + (40 − 10) ×
5408

5408 + 52242 
=.10 + (30 × 0.0938)
=.10 + 2.814
=.12.814%
Note
The internal rate of return can be calculated using two positive net present
values. However, in such cases the ‘n’ part of the denominator should be
deducted from the value of ‘p’.
The advantages and disadvantages of the internal rate of return (IRR)
Advantages of using the IRR method
» The IRR gives a rate of return for any project, which can then be compared with
the cost of the capital of any financing needed for the project.
» The IRR can also act as a useful benchmark to rank alternative projects.
Disadvantages of using the IRR method
» As with all methods of investment appraisal, it relies on the estimates being
reasonably reliable – the less accurate these are, the less useful will be the results
of the investment appraisal.
» It is based on an approximation, so the calculated IRR is not the true IRR (but it
should be reasonably close, so this is not a major disadvantage).
How to make investment decisions and recommendations
using supporting data
Once you have conducted an investment appraisal, you may need to make a
recommendation. This is likely to consist of one of the following decisions:
» Should an investment project be undertaken?
» Where multiple options exist for an investment, which is the best option to take?
468
In cases where you are using one method of investment appraisal, it is usually
straightforward. You will choose an investment on the basis of:
Is the payback period short enough for the business?
Which project (from multiple options) has the shortest payback period?
Is the ARR high enough to justify the investment?
Which ARR generates the highest return (from multiple options)?
Is the NPV positive, or at a specified target level?
Which project generates the highest NPV?
Is the IRR greater than the cost of capital (e.g. does it exceed the interest on any
money needed to finance the project)?
» Which project generates the highest IRR?
If you are asked to use multiple methods of investment appraisal and then make a
recommendation, it may be more difficult to make a choice. The choice will be easier
if the results of each method support the same project (where multiple projects exist).
However, if the results from the methods suggest different projects then a judgement
will need to be made. This will often focus on factors such as the objectives of the
business or the nature of the business ownership (i.e. what type of entity is the
business?). For instance, for limited companies, the objectives are more likely to
be profit-focused (due to shareholder pressure) which may mean that investment
appraisal methods that focus on the highest return (i.e. not payback) are more likely
to influence the decision.
4.4
4.4.1 Investment appraisal
»
»
»
»
»
»
»
It is also likely that you will wish to consider wider issues – non-financial factors, and
other external influences on the business.
The significance of non-financial factors
When managers of a business are making a capital investment appraisal, as much
detailed information as possible should be obtained from all sources that may be
affected by the decision, or that may affect the decision. This will clearly involve the
earning potential of a project but can also include additional information.
Personnel (staff issues)
Production
Project
Sales
Purchasing
Finance
▲ Figure 4.4.1 Some sources of information that may affect or be affected by an
investment decision
Capital projects are appraised in terms of their potential earning power. If the
managers of a business need to replace an obsolete piece of machinery or purchase
further pieces of machinery to complete a new project, they must decide which new
machine to purchase. There would be no choice to be made if there was only one type
of machine on the market that would do the job; they would not have to make a choice
(other than to buy or not to buy!). In the real world, there are usually alternative
options from which to choose.
469
Machines might:
4.4 Investment appraIsal
4.4
»
»
»
»
»
»
have different prices
have different qualities
produce different quantities of goods
produce different quality of goods
have different life spans
have different rates of obsolescence.
These differences apply to most capital purchases in both the business world and in
the world outside of business, for example, TV sets, home cinema system, computers.
In the examples used in this chapter, we have merely considered the financial aspects
of deciding on a project. Clearly, the managers of a business would consider all the
ways that a decision might impinge on the business. They would also consider, for
example, how a decision might affect:
»
»
»
»
»
the workforce – does the decision require more workers?
local employment – does the decision mean that some workers will lose their jobs?
the environment – pollution
the locality – is more space needed for expansion?
local infrastructure – is the local infrastructure capable of supporting the ‘new’
project?
SUMMARY
After reading this chapter you should:
» understand the concept of future net cash inflows and outflows
» be able to calculate net cash flows and profits from given data
» know how to calculate the payback, ARR, NPV and IRR from a set of data
» understand the advantages and disadvantages of each method of investment
appraisal
» be able to make investment decisions and recommendations based on
supporting data
» understand the impact of non-financial factors in investment decisions.
SELF-TEST QUESTIONS
1 Only large businesses need to evaluate capital projects. True/False?
2 Explain why the managers of a business would think it necessary to undertake a
capital investment appraisal.
3 Identify two reasons why it is important to appraise capital investment decisions.
4 When undertaking a capital investment appraisal it is only necessary to consider
the additional costs and additional revenues caused by the purchase of the new
asset. True/False?
5 Payback uses cash flows to appraise a possible capital investment decision.
True/False?
6 A machine is purchased for $600. The net cash inflows are: Year 1 $250; Year 2
$250; Year 3 $250. In which year will the machine pay for itself?
7 Identify one advantage of using payback as a method of investment appraisal.
8 Outline two limitations of using payback as a method of appraisal.
9 The accounting rate of return uses profits in the formula. True/False?
470
10 If a business has a return on capital employed of 23 per cent, what will be the
minimum return necessary in order to undertake a new project?
11 Outline two advantages of using ARR as a method of capital appraisal.
4.4
12 Outline two disadvantages of using ARR as a method of capital investment
appraisal.
13 Initial investment $100 000; additional working capital required $20 000. Calculate
the average investment.
15 $1000 received in two years’ time is worth more/less than $1000 received today?
(Delete the incorrect response.)
16 Identify two disadvantages of using NPV as a method of capital investment
appraisal.
17 The discount factor used in NPV calculations is based on the predicted average
inflation rate over the period of investment. True/False?
18 NPV of machine A is $4760; NPV of machine B is $1920. Identify the machine that
should be purchased.
4.4.1 Investment appraisal
14 NPV is an abbreviation of net positive value. True/False?
19 NPV of machine X is $(2350); NPV of machine Y is $(1990). Identify the machine that
should be purchased.
Calculation question (answer on page 494)
20 A machine costs $100 000. It is forecasted to generate the following profits for the
next five years:
Year 1
$18 000
Year 2
$15 000
Year 3
$12 000
Year 4
$10 000
Year 5
$9 000
Based on these estimates, calculate the ARR for the machine.
471
Examination-style questions
Multiple-choice questions
eXamInatIon-style QuestIons
1
What is an advantage of operating as a partnership rather than as a sole trader?
A Limited liability for all partners
B Greater power than a sole trader for decision-making
C Access to a larger amount of initial capital
D Raising capital through share issues
2
Which of these is a long-term source of finance?
A Overdraft
B Debenture issue
C Trade credit
D Payment by instalments
3
O’Brien sold goods to O Kitchen for $1200. O Kitchen paid promptly and received cash
discount of 2.5%. How did O’Brien record the discount?
Debit
4
Credit
A O Kitchen
$30 Discounts received
$30
B O Kitchen
$60 Discounts received
$60
C Discounts received
$60 O Kitchen
$60
D Discounts allowed
$30 O Kitchen
$30
A business buys on credit a non-current asset to be used within the business. In which
book of prime entry would this transaction be recorded?
A General journal
B Purchases returns journal
C Purchases journal
D Cash book
5
Maddie sells goods on credit to Luke for a price of $1200. Maddie offers Luke a 10 per
cent trade discount and a cash discount of 2.5% if Luke pays within 28 days.
What is the amount that Maddie will credit to her sales account?
A $800
B $1 200
C $1 052
D $1 080
6
Leila sells 5 units of inventory to Hollie at a price of $60 per unit. Leila allows Hollie a
trade discount of 20 per cent and a 5 per cent cash discount if Hollie pays within 28 days.
How much will Leila receive if Hollie pays in full within 28 days?
A $228
B $240
C $300
D $225
472
7
What would be recorded with a credit entry in a ledger account?
A A decrease in revenue
B An increase in cash
C An increase in capital
D A decrease in a liability
8
Which of the following statements is correct?
A The cash account can have either a credit or debit balance
C Drawings increase the balance on the capital account
D Capital must always involve the owner withdrawing money from the business
9
The following balances are extracted from a company’s books of account.
$
Sales
236 000
Purchases
185 102
Carriage inwards
1 804
Carriage outwards
2 462
Sales returns
198
Purchases returns
206
Examination-style questions
B The drawings account has a debit balance
How much do these balances add to the debit column of the trial balance?
A $189 578
B $187 116
C $189 566
D $236 206
10 A business owner recorded the repair costs of her private vehicle as a business expense.
Which accounting concept did the owner disregard?
A Realisation
B Going concern
C Materiality
D Business entity
11 Which of the following is an example of capital expenditure?
A Installation cost associated with purchase of machinery
B Bonus payment to staff
C Annual road tax paid on motor car
D Maintenance charge on company vehicles
12 The following costs are associated with the purchase of equipment used by a business
for production:
$
Purchase cost
14 450
Installation cost
445
Delivery cost
210
Maintenance cost
615
Annual servicing charge
420
473
What is the value of revenue expenditure?
A $16 140
B $1035
C $1245
D $1675
13 What is not a cause of depreciation of non-current assets?
eXamInatIon-style QuestIons
A Wear and tear of assets
B Technical obsolescence
C Property normally increases in value
D Market obsolescence
14 Equipment was purchased on 1 April 2020 for $2750 and is depreciated using the
reducing balance method at 20 per cent per annum. What was the net book value of this
asset at 31 March 2021?
A $1650
B $1760
C $2816
D $2200
15 Which errors would be revealed by a trial balance?
1
Making a debit entry without the corresponding credit entry
2
Making two credit entries to record a transaction
3
Making a debit entry with the credit entry being of a different amount
A 2 only
B 1 and 2 only
C 2 and 3 only
D 1, 2 and 3
16 A receipt of $1200 from Roper, a credit customer, was debited to Roper’s account and
credited to the bank account in error.
Which entries correct this error?
Debit
Credit
A
Bank $1 200
Roper $1 200
B
Bank $2 400
Roper $2 400
C
Roper $1 200
Bank $1 200
D
Roper $2 400
Bank $2 400
17 A business cash book was as follows:
Cash book
2020
$ 2020
Dec 1
Balance b/d
Dec 18
B Burley
Dec 27
A Hussein
90 Dec 2
$
C Plunkett
600
196 Dec 13
J Cashin
270
234 Dec 14
Z Naqvi
175
The following two items were found on the bank statement and need entering into the
cash book:
474
l
Interest charges
$112
l
Credit transfer received
$460
What was the balance on the updated cash book?
A $272 (Credit)
B $177 (Credit)
C $146 (Debit)
D $216 (Debit)
18 A business received a bank statement, updated its cash book and prepared a bank
reconciliation statement. With which item was the cash book updated?
B Lodgement not yet credited by bank
C Standing order
D Error made by bank
19 A company provided the following information:
$
Trade payables at 1 January 2021
Cash paid to credit suppliers
664
5 251
Discounts received
191
Contra entries from sales ledger accounts
320
Trade payables at 31 December 2021
412
Examination-style questions
A Unpresented cheque
What was the total of credit purchases in 2021?
A $4870
B $5128
C $5510
D $6014
20 A company paid rent of $7000 during the financial year. Rent of $650 was due to be paid
at the beginning of the year and $590 at the end of the year.
Which entry appeared in the rent account to make the transfer to the statement of profit
or loss?
A $6940 credit
B $6940 debit
C $7060 credit
D $7060 debit
21 On 1 January 2020, the balance on the allowance for irrecoverable debts account was
$370. On 31 December 2020, trade receivables totalled $6300. The business maintains
the allowance at 4% of the year-end balance of trade receivables.
How did the movement in the allowance for irrecoverable debts affect the profit for 2020?
A Decrease by $252
B Decrease by $370
C Increase by $118
D Increase by $252
475
22 Dicken is a sole trader. At the start of the year, the balance on his capital account was
$104 842. During the year he took drawings of $22 402 and profit for the year was $19 802.
What is the balance on Dicken’s capital account at the end of the year?
A $107 442
B $102 242
C $124 644
eXamInatIon-style QuestIons
D $82 440
23 A partnership was formed without a partnership agreement. What were the partners
allowed to receive under the terms of the Partnership Act 1890?
1
Equal shares of profits and losses
2
Interest on any partners’ loans at 5% per annum
3
Interest on capital at 5% per annum
A 1 only
B 1 and 2
C 2 only
D 2 and 3
24 A company issued 100 000 $1 ordinary shares at a premium of $0.50 per share. Profit for
the year after tax was $89 000 and dividends paid totalled $11 000.
By how much did total reserves increase by as a result of these transactions?
A $50 000
B $78 000
C $111 000
D $128 000
25 The following information is given in the financial statements of a limited company.
$
Ordinary shares
2 500 000
Share premium
500 000
Retained earnings
325 000
5% debentures
600 000
What is the value of total equity?
A $2 825 000
B $3 000 000
C $3 325 000
D $3 925 000
476
26 A company provides the following information: Inventory, $12 000; trade receivables,
$4500; trade payables, $2800; bank $3100 (overdrawn).
What is the company’s acid test ratio?
A 0.8:1
B 2.7:1
C 2.8:1
D 7:1
A Lower storage costs
B Reduced risk of spoilage to inventory
C Increased discounts from bulk buying
D Reduced risk of inventory becoming obsolete
28 A company provided the following information:
Overheads
Direct labour hours
Budgeted
Actual
$50 000
$45 000
20 000
19 000
Examination-style questions
27 What is not an advantage of introducing just-in-time inventory management?
What was the under- or over-absorption of overheads?
A $2500 over
B $2500 under
C $5000 over
D $5000 under
29 Contribution per unit is calculated as:
A Sales revenue less fixed costs
B Fixed costs less variable costs
C Selling price less variable costs per unit
D Variable costs less selling price
30 A business provided the following information.
Fixed overheads
$100 000
Selling price
$6
Variable cost per unit
$4
The selling price was later increased by 50 per cent.
What was the break-even point after the selling price was increased?
A 50 000 units
B 10 000 units
C 20 000 units
D 5 000 units
477
AS Level
1
The following information relates to the business of Moussa:
Bank
eXamInatIon-style QuestIons
Bank loan repayable in 2029
at 31 July
2021
at 31 July
2020
at 31 July
2019
$
$
$
800
1 100
1 000
30 000
Inventories
7 000
6 500
6 000
Machinery
65 000
65 000
48 000
Premises
70 000
50 000
50 000
Trade payables
2 700
2 600
2 500
Trade receivables
3 800
4 200
4 000
12 000
10 000
10 000
Vehicles
a
Calculate the profit or loss for the years ended 31 July 2020 and 31 July 2021.
b
Prepare a statement of financial position at 31 July 2021.
c
State four reasons why it might be in Moussa’s best interests to prepare a detailed
statement of profit or loss showing his profit or loss for the year.
[4]
d
Identify three pieces of additional information that Moussa would need in order
to prepare detailed financial statements.
e
[7]
[10]
[3]
Based on the data at 31 July 2021, calculate to two decimal places:
i The current ratio
[3]
ii The acid test ratio
[3]
[Total: 30]
2
The Ikhet manufacturing company has loose tools valued at $12 980 on 1 February 2020.
During the year tools costing $1780 were purchased. At 31 January 2021 loose tools were
valued at $10 740.
a
Calculate the depreciation of loose tools for the year ended 31 January 2021.
[3]
Additional information
The company sold some out-of-date equipment that had cost $30 000. It had been
depreciated at 50% per annum using the reducing balance method.
It was sold after three years of use for $3700.
b
Prepare a disposal account for the equipment.
[4]
c
Explain how a provision for depreciation affects a statement of financial position.
[2]
d
Explain why providing for depreciation does not affect the cash balance of a business. [6]
[Total: 15]
3
The following information is given for Bajpan plc:
Sales (credit)
Purchases (credit)
Opening inventory
Closing inventory
Trade receivables
Cash and cash equivalents
Trade payables
478
at 28 February 2021
$
1 100 000
524 000
50 000
52 000
102 000
1 000
44 500
at 28 February 2020
$
900 000
537 000
42 000
50 000
85 000
4 000
60 000
a
b
Calculate, to two decimal places, the following ratios (show the formulae used).
i
current ratio
[2]
ii
acid test ratio
[2]
iii trade receivables turnover
[2]
iv trade payables turnover
[2]
v
[2]
rate of inventory turnover.
[5]
[Total: 15]
4
The following is the draft statement of financial position of Kerris Emery, a sole trader, at
30 June 2021.
K Emery
Statement of financial position at 30 June 2021
$
$
ASSETS
Examination-style questions
Using your answers from part a, advise the directors of the business whether
or not you think business performance has improved.
Non-current assets
Property at valuation
600 000
Machinery at book value
1 080 000
Delivery vans at book value
660 000
2 340 000
Current assets
Inventories
140 000
Trade receivables
38 000
Other receivables
4 000
Cash and cash equivalents
8 000
190 000
2 530 000
Total assets
CAPITAL AND LIABILITIES
Capital
Opening balance
2 000 000
Add Draft profit for the year
160 000
2 160 000
Less Drawings
150 000
2 010 000
Non-current liabilities
Loan
400 000
Current liabilities
Trade payables
114 000
Other payables
6 000
Total capital and liabilities
120 000
2 530 000
Additional information
After preparation of the draft statement of financial position the following errors
were found:
479
eXamInatIon-style QuestIons
l
Goods in inventory at 30 June 2021, valued at cost $30 000, were found to be damaged.
The estimated net realisable value is $16 000.
l
Loan interest of 4% per annum had been omitted from the accounts.
l
No provision for depreciation on machinery had been made for the year. Depreciation
should have been provided at 5% per annum using the reducing balance method.
l
Delivery vans are depreciated by 10% per annum. During the year vehicle repairs of
$20 000 had been incorrectly debited to the delivery vans account.
l
On 21 June 2021 a credit customer, who owed $7200, was declared bankrupt. It was
decided to write off this amount in full as irrecoverable. No record of this has been
made in the accounts.
a
Prepare a statement to show the corrected profit for the year ended 30 June 2021. [9]
b
Prepare the corrected statement of financial position at 30 June 2021.
[7]
c
i
Explain what is meant by net realisable value.
[2]
ii
Discuss the accounting treatment of the damaged inventory in item 1.
[2]
d
Using your answers to a and b, calculate the following ratios to two decimal places:
i
current ratio
[2]
ii
acid test ratio.
[2]
e
State four ways in which Emery could improve her working capital.
[4]
f
Explain why the acid test ratio is a more reliable indicator of liquidity than the
current ratio.
[2]
[Total: 30]
5
An extract from the statement of financial position of Aitch Ltd at 1 January 2020 is
shown below:
Cost
Accumulated
depreciation
Net book
value
$
$
$
415 800
156 600
259 200
Non-current assets
Equipment
During 2020 the following transactions took place for equipment:
Date
Equipment ref.
Year of
purchase
Initial
cost
Disposal
proceeds
$
$
Disposals
12 March
E12
2016
56 000
28 400
8 August
E18
2017
32 000
5 280
12 December
E20
2018
38 400
3 400
Additions
480
11 April
E27
46 000
19 October
E31
64 800
l
All receipts and payments for these transactions are processed through the business
bank account. All of the remaining equipment at 31 December 2020 was purchased
after 2016.
l
Depreciation on equipment is charged on a straight-line basis, based on a five-year
life and an estimated residual value of 10% of the original cost.
l
It is the company policy to charge a full year’s depreciation in the year of purchase but
none in the year of disposal.
a
Prepare the following ledger accounts for the year ended 31 December 2020.
b
i
Equipment account
[4]
ii
Provision for depreciation of equipment account
[4]
iii Equipment disposals account.
[4]
State three causes of depreciation.
[3]
6
Asif operates a delivery service and does not keep proper accounting records.
He provided the following information for the year ended 30 June 2021.
$
Cash in hand at 1 July 2020
3 270
Cash in hand at 30 June 2021
2 349
Cash receipts and payments:
Vehicle repairs
Fuel payments for vehicles
2 400
14 301
Driver’s wages
4 748
Rent of a garage
1 600
Sundry expenses
Drawings
Receipts from sale of old vehicle
Cash stolen by Asif’s driver
Cash received from customers
a
Examination-style questions
Total: [15]
2 972
11 450
1 300
430
?
Prepare Asif’s cash account for the year ended 30 June 2021.
[7]
Additional information
$
Trade receivables at 1 July 2020
3 766
Trade receivables at 30 June 2021
2 863
Irrecoverable debts written off during the year
ended 30 June 2021
1 648
Required
b
Calculate Asif’s revenue figure for the year ended 30 June 2021.
[5]
Additional information
l
The vehicle that had been sold was purchased in May 2019 for $6200. Asif’s policy is to
depreciate the vehicles at 50% per annum using the reducing balance method. A full
year’s depreciation is charged in the year of acquisition. No depreciation is charged in
the year of disposal. Depreciation on remaining vehicles for the year was $1000.
l
At June 30 2021 driver’s wages of $200 were owing and garage rent of $400 was prepaid.
l
Asif wishes to create an allowance for irrecoverable debts. This will be calculated as
4% of the trade receivables at the year-end (to the nearest whole $).
Required
c
Prepare Asif’s statement of profit or loss for the year ended June 30 2021.
[16]
d
State two ratios that Asif could use to measure the profitability of his business.
[2]
[Total: 30]
481
7
Lucas, a trader, has provided the following balances at 31 March 2021 after the
preparation of the statement of profit or loss for the year.
$
Profit for the year
15 000
Non-current assets
– at cost
250 000
– accumulated depreciation
100 000
eXamInatIon-style QuestIons
Accrued expenses
10 000
Cash in hand
5 000
Bank overdraft
12 500
Inventory
40 000
Trade payables
17 500
Trade receivables
25 000
Opening capital
175 000
Drawings
10 000
a
Prepare the statement of financial position at 31 March 2021.
[6]
b
Calculate, stating the formula used, the current ratio and acid test ratio at
31 March 2021 correct to two decimal places.
[4]
Additional information
Ratio
2020
2019
Current
2.30:1
2.0:1
Acid test
1.0:1
1.40:1
Required
c
Advise Lucas whether he should be concerned with the liquidity position of the
business.
[5]
[Total: 15]
8
Kim owns and runs a small retail business. She supplies the following information for
the year ended September 30 2021:
All purchases and sales are on credit.
at 30 September 2021
at 1 October 2020
$
$
Trade receivables
27 000
16 000
Trade payables
12 000
14 000
During the year ended 30 September 2021, customers paid Kim $590 000 and were
allowed discounts of $10 000. Suppliers were paid $374 000 and allowed discounts
of $12 000.
During the year irrecoverable debts written off amounted to $2000 and transfers from
the purchases ledger to the sales ledger amounted to $9000.
482
At 1 October 2020 inventories were valued at $12 000 they increased by $3000 during the
year to 30 September 2021.
Operating expenses other than those derived from the control accounts for the year
ended 30 September 2021 amounted to $99 000.
Required
Prepare a sales ledger control account.
[6]
b
Prepare a purchases ledger control account.
[4]
c
Prepare a statement of profit or loss for the year ended 30 September 2021.
[6]
d
State one advantage of maintaining control accounts.
[1]
e
Calculate, to one decimal place, the following ratios for Kim’s business:
i
gross profit margin
[2]
ii
profit margin
[2]
iii rate of inventory turnover
[2]
iv expenses to revenue.
[2]
For the year ended 30 September 2020 Kim calculated the following ratios:
Gross profit margin
29.6%
Profit margin
14.7%
Rate of inventory turnover
24 times
Expenses to revenue ratio
16.4%
Examination-style questions
a
Required
f
Based on the 2020 ratios, Kim is pleased with the change in business performance
since the end of the previous year.
Advise her whether or not she is right to be pleased.
[5]
[Total: 30]
9
The following figures have been extracted from Alsop’s financial records for the month of
July 2021:
$
Sales
920 000
Total variable costs
598 000
Total fixed costs
180 000
Profit
a
$
778 000
142 000
Define the following terms:
i
Break-even point.
[2]
ii
Margin of safety.
[2]
b
Calculate Alsop’s contribution as a percentage of sales (c/s ratio).
[4]
c
Calculate Alsop’s break-even point measured in revenue.
[3]
d
Calculate the sales in dollars necessary to make a profit of $200 000.
[4]
e
Calculate the profit or loss if sales for the month are $750 000.
[4]
f
If the original sales prices are reduced by 5% but costs do not change, calculate
the value of sales needed to achieve a profit of $160 000.
[11]
[Total: 30]
483
10 Pierce Limited manufactures one product. The following information is available for the
production of one unit of product for the year ending 31 December 2021.
eXamInatIon-style QuestIons
$
Selling price
64
Direct materials
13
Direct labour
17
Fixed factory overhead
10
Variable factory overheads
6
Fixed selling and administrative overheads
7
Variable selling and administrative overheads
5
Budgeted output is 36 000 units per year, which represents 75% of total
production capacity.
a
Calculate the break-even point in units.
[5]
b
Calculate the break-even point as a percentage of capacity.
[3]
c
Prepare a marginal cost statement to show Pierce Limited’s budgeted total profit
for the year ending 31 December 2021 based on the budgeted output of 36 000 units.
[3]
Additional information
l
The directors are considering purchasing additional machinery at a cost of $90 000.
l
This will increase capacity by 20%.
l
The machinery will be written off over five years, with an estimated residual value of
$10 000.
l
The directors plan to reduce the selling price by 12.5% and this will increase demand
by 50%.
l
Fixed selling and administrative overheads will increase by 10%.
d
Calculate the revised break-even point in units.
[5]
e
Calculate the revised break-even point as a percentage of capacity.
[3]
f
Prepare a marginal cost statement to show Pierce Limited’s revised total profit for
the year ending 31 December 2021 if the machinery is purchased.
[4]
g
Advise the directors whether they should go ahead with their plans. Give reasons
for your answer.
[7]
[Total: 30]
484
A Level
1
The treasurer of the Boundary Cricket Club provides the following information for the
year ended 30 September 2021:
at 30 September 2020
$
$
120 000
120 000
27 000
26 000
?
12 800
2 146
1 790
Amounts owed to café suppliers
302
248
Subscriptions in arrears
140
350
Subscriptions paid in advance
490
630
General expenses paid in advance
387
842
Assets and liabilities
Land and buildings at valuation
Equipment at valuation
Life membership fund
Café inventory
The following receipts and payments account is available:
$
$
Balance 1 Oct 2020
10 830 Purchase of land
Subscriptions – annual
22 470 Purchases of equipment
life membership
5 850 Payments to café suppliers
25 000
6 540
39 672
Dinner dance receipts
2 480 Dinner dance expenses
2 360
Competition receipts
3 726 Competition expenses
1 988
Café takings
Balance 30 Sep 2021
Examination-style questions
at 30 September 2021
83 444 Café staff wages
5 491 Ground staff wages
General expenses
134 291
12 791
18 477
27 463
134 291
It is club policy to transfer 10% of the balance standing in the life membership fund at the
financial year end to the income and expenditure account.
Prepare:
a
a café statement of profit or loss for the year ended 30 September 2021
[3]
b
an income and expenditure account for the year ended 30 September 2021
[9]
c
a statement of financial position at 30 September 2021.
[6]
d
Evaluate methods of clearing the club’s bank overdraft.
[7]
[Total: 25]
2
The following statement of profit or loss for the year ended 31 August 2021 is given,
together with statements of financial position at 31 August 2020 and 31 August 2021.
Dratas plc
Statement of profit or loss for the year ended 31 August 2021
$000
Profit from operations
Finance costs
1 123
(29)
Profit before tax
1 094
Tax
(447)
Profit for the year
647
485
Extract from statement of changes in equity
$000
Retained earnings
Balance at 1 Sep 2020
544
Profit for the year
647
1 191
eXamInatIon-style QuestIons
Dividends paid
(298)
Balance at 31 Aug 2021
893
Statement of financial position at 31 August
2021
2020
$000
$000
$000
$000
ASSETS
Non-current assets
Patents
Premises
Accumulated depreciation
Machinery
Accumulated depreciation
Current assets
Inventories
Trade receivables
Cash and cash equivalents
Total assets
174
895
(186)
995
(447)
932
805
462
EQUITY AND LIABILITIES
Equity
Ordinary shares of $1 each
Retained earnings
Non-current liabilities
Current liabilities
Trade payables
Tax
Total equity and liabilities
820
447
709
548
1 431
2 199
3 630
198
1 045
(199)
770
(348)
634
656
77
846
422
1 466
1 367
2 833
1 170
893
2 063
1 020
544
1 564
300
300
1 267
3 630
606
363
969
2 833
Additional information
l
There were no disposals of machinery during the year.
l
Part of the premises were sold during the year, for $175 000. The profit on the sale
was $50 000. There were no additions to premises during the year.
l
Patents originally cost $240 000 and are being amortised (depreciated) over
ten years.
a
Prepare a statement of cash flows for the year ended 31 August 2021.
b
One of the directors believes the cash flow statement is of no importance as
shareholders are only interested in the profits earned by the business.
Advise the director whether or not his views have any merit.
486
[16]
[9]
[Total: 25]
3
Ferec Limited is considering a project to automate its production facilities. This will
require an investment of $150 000. The project will have a life of four years and the
equipment will have no residual value.
The automation will enable output to be increased, which will increase sales revenue and
production costs. In addition, the automation will require staff training over the next four
years.
There is concern that the automation will generate negative publicity as it may eventually
lead to staff redundancies. The automation is also considered to be environmentally
damaging.
Examination-style questions
The incremental cash flows associated with the automation are expected to be as
follows:
Increase in sales
revenue
Year
Increase in
production costs
Staff training costs
$
$
$
1
99 000
29 000
20 000
2
112 000
46 000
20 000
3
136 000
91 000
10 000
4
173 000
105 000
10 000
The company’s cost of capital is 8%. The discount factors are as follows:
Year
Discount factor
1
0.926
2
0.857
3
0.794
4
0.735
a
Calculate, for the automation project, the following:
i
the net incremental cash flow for each year 1 to 4
[2]
ii
the payback period in years and months
[2]
iii the accounting rate of return (ARR)
[3]
iv the net present value (NPV).
[3]
Additional information
The directors have established that if the cost of capital was 10%, the net present value
of the project would be $(655).
b
Calculate the internal rate of return (IRR) of the automation project, to one decimal
place.
[3]
c
Advise the directors whether or not the company should invest in the automation
project. Consider both financial and non-financial factors.
[5]
Additional information
It was then announced that the national government was introducing measures to
promote good environmental processes. This meant that a tax of $5000 would be paid by
the company in each of the years 1 to 4 if it went ahead with the automation project.
d
e
f
Calculate a revised net present value (NPV) for the automation project, taking
the new tax into consideration.
[2]
State the effect that the new tax would have on the decision whether or not to
invest in the project.
[1]
State two advantages and two disadvantages of using the payback method when
making investment decisions.
[4]
[Total: 25]
487
4
Hang, Ivan and Atiya are in partnership, sharing profits 2:1:1 respectively. Their
partnership agreement provides that:
l
interest at 4% per annum be allowed on capital account balances at the start of each
financial year
l
Hang be allowed an annual salary of $21 000.
The partners maintain only capital accounts (i.e. current account transactions appear in
the capital accounts). The balances on 1 August 2020 were:
eXamInatIon-style QuestIons
$
Hang
80 000
Ivan
50 000
Atiya
40 000
Drawings for the year to 31 July 2021:
$
Hang
28 000
Ivan
45 000
Atiya
35 000
The profit for the year ended 31 July 2021 was calculated at $96 000, and it accrued
evenly throughout the year. Hang retired from the business on 31 January 2021. The
partners agreed that:
l
goodwill be valued at $48 000 but would not be shown in the books of account
l
Hang was to take from the business $35 000 in cash and a vehicle (carrying amount
$10 200) at an agreed value of $7400
l
any balance on Hang’s capital account was to be regarded as a loan with interest at
7 per cent per annum.
After Hang’s retirement it was agreed that:
l
Ivan and Atiya share profits and losses 2:1 respectively
l
interest on capital accounts be credited at 4 per cent on balances at the start of the year
l
Ivan be credited with a salary of $12 000 per annum.
Ivan paid off the partnership debt to Hang on 31 July 2021 from private funds.
Prepare:
a
the appropriation account for the year ended 31 July 2021
[12]
b
capital accounts for the year ended 31 July 2021
[13]
[Total: 25]
5
Len Zurker provides the following budgeted information:
2021
Feb
Apr
May
$
$
$
$
Sales
56 000
52 000
48 000
60 000
Purchases
32 000
30 000
28 000
40 000
6 200
6 200
6 500
6 500
Wages
Rent
Other expenses
Depreciation
488
Mar
1 200
1 500
11 400
10 200
12 500
19 700
1 200
1 200
1 200
1 200
It is expected that:
the cash balance at May 1 will be $780
l
10% of all sales will be on credit
l
10% of all purchases will be for cash
l
trade receivables will settle their debts in the month following sale
l
trade payables will be paid two months after purchase
l
wages, rent and other expenses will be paid for as incurred
l
inventory at April 1 is expected to be $3460; at May 31 it is expected to be $4180.
a
Prepare a cash budget for the month of May 2021.
[7]
b
Prepare a budgeted statement of profit or loss for the two months ending
31 May 2021.
[9]
Discuss the advantages and disadvantages of budgeting.
[9]
c
[Total: 25]
6
Orooj Choudhry is a manufacturer. The following information is available for the year
ended 30 April 2021:
Revenue
$525 342
Production cost of goods completed
$258 600
Inventories
Apr 30 2021
Examination-style questions
l
May 1 2020
$
$
Raw materials
3980
3 720
Work in progress
7020
6 140
Finished goods (at transfer price)
9412
10 530
Orooj transfers goods to her statement of profit or loss at cost plus 30%.
a
Prepare an extract from the statement of profit or loss to show gross profit
for the year ended 30 April 2021.
[5]
b
Explain reasons why Orooj might transfer goods to her statement of profit or loss
at a price greater than the cost of production.
[6]
c
Prepare a provision for unrealised profit account for the year ended 30 April 2021. [4]
d
Prepare a statement showing the gross profit and adjustments for factory profit
and unrealised profit earned by Orooj’s business for the year ended 30 April 2021.
[5]
Some of the managers think that they should buy-in the goods rather than
manufacture them as it would save money. Other managers oppose this as they
believe non-financial reasons matter more. Advise the directors on the factors
they need to consider as to whether or not the business should continue to be a
manufacturer.
[5]
e
[Total: 25]
7
Mpofu Manufacturing Limited produces one product.
The budgeted costs and revenues for July are shown below:
l
Units produced and sold 1000
l
Standard selling price $125
l
Standard direct materials 6 kilos at $8 per kilo
l
Standard direct labour 5 hours at $10 per hour.
l
All overheads are fixed.
l
In July, 1200 units were produced and sold. Selling price remained at $125 per unit.
489
l
eXamInatIon-style QuestIons
a
Actual costs were:
l
Direct materials 7100 kilos at a total cost of $57 510
l
Direct labour 6150 hours at a total cost of $60 270.
Prepare the original budget and the flexed budget for July to show budgeted
contribution.
[8]
b
Calculate the actual contribution for July.
[1]
c
Explain the term ‘contribution’.
[2]
d
Prepare a statement reconciling the contribution from the flexed budget with the
actual contribution.
[10]
e
Suggest two reasons for the inter dependency of the material usage variance
and the labour efficiency variance.
[Total: 25]
8
Rowell wants to prepare budgets for 2024. The following information is available.
l
Sales and purchases are expected to be:
Total sales
2024
Total purchases
$
$
January
112 500
47 500
February
153 000
49 900
March
177 000
71 200
l
One third of all sales are expected to be cash sales.
l
All credit customers are expected to settle their debts in the month following the sale
of goods. Half of the credit customers will receive a discount of 4%.
l
Total trade receivables at 31 December 2023 are expected to be $55 000.
l
All purchases will be on credit terms. Half of trade payables will be paid in the month
following purchase. The remainder will be paid two months after purchase.
l
Credit purchases for November and December 2023 are expected to amount to
$39 900 and $45 650 respectively.
l
Rowell has a bank loan of $36 000 which he received in 2020. Interest payable of 7%
per annum is paid monthly. This loan will be repaid on 1 March 2024.
l
Wages and salaries are expected to be $30 000 in January 2024. A pay rise of 2% will
be implemented on 1 February 2024. Wages and salaries are paid in the month in
which they are incurred.
l
Sundry expenses are expected to be $6200 each month. These will be paid in the
month in which they are incurred.
l
Planned expenditure on additional non-current assets, $42 000, should take place in
February 2024.
l
Depreciation on non-current assets in 2024 is expected to be $1500 in January and
$1850 each month from February.
l
Cash at bank is expected to be $4560 on 31 December 2023.
a
Prepare, for each of the three months January to March 2024, the following:
i
a trade receivables budget
[5]
ii
a trade payables budget
[6]
iii a cash budget.
490
[4]
[9]
Additional information
Rowell has been preparing his budgets manually on paper. His brother has suggested
that he should use spreadsheets instead.
d
Advise Rowell whether or not he should start to prepare his budgets using a
spreadsheet. Justify your answer.
[5]
[Total: 25]
9
The summarised statement of financial position of Chaunte plc at 31 December 2019 was
as follows:
Examination-style questions
$000
ASSETS
Non-current assets (carrying amount)
Current assets
Total assets
2 840
288
3 128
EQUITY AND LIABILITIES
Equity
Ordinary shares ($0.25 each)
800
Share premium account
200
Retained earnings
1 328
2 328
Non-current liabilities
8% debentures (2025-2027)
600
Current liabilities
Trade payables
93
Other payables
107
200
Total equity and liabilities
3 128
The following additional information was available for the year ended 31 December 2019:
l
profit from operations was $682 000
l
the tax charged for the year was $80 000
l
a dividend of $0.03 was paid on each ordinary share
l
the ordinary shares had a market price of $1.20 each at 31 December.
a
Calculate the following ratios to two decimal places:
i
Gearing
[2]
ii
Interest cover
[2]
iii Earnings per share
[2]
iv Price earnings
[2]
491
Additional information
eXamInatIon-style QuestIons
l
A major expansion of the business was undertaken in 2020. As part of this the
following took place on 1 January 2020:
l
The company issued 400 000 new ordinary shares of $0.25 each at a premium of
$0.90 per share.
l
The company took out a long-term bank loan for $200 000. Interest was payable at
the rate of 10% per annum.
l
The expansion of the business enabled profit from operations in 2020 to be 20%
higher than in 2019.
l
The dividend per share was maintained at the same level as in 2019.
l
The tax charge for 2020 rose to $85 000.
l
The market price of one ordinary share was $1.60 at 31 December 2020.
b
Calculate:
i
the funds received from the share issue on 1 January 2020
[1]
ii
the retained earnings of the company at 31 December 2020.
[4]
c
Advise the directors of the company whether or not they should be concerned about
the level of financial risk the business is facing after the expansion. Support your
answer with revised calculations of two relevant ratios.
[5]
d
Discuss the effect that the expansion had on investor confidence. Support your
answer with relevant calculations.
e
[5]
Explain one reason, other than the receipt of dividends, why an investor might gain
financially from investing in the ordinary shares of a public limited company.
[2]
[Total: 25]
10 The following information is available for Wakoso plc at 1 July 2020:
Non-current
assets at cost
Accumulated
depreciation
$
Premises
$
1 200 000
272 000
180 000
126 000
Motor vehicles
85 000
68 000
Office equipment
35 000
14 000
Plant and machinery
During the year ended 30 June 2021, the following took place:
l
492
Purchases of non-current assets:
l
plant and machinery, cost $55 000
l
motor vehicles, cost $112 000
l
office equipment, cost $25 000
l
During the year machinery which cost $35 000 was sold. Accumulated depreciation on
the machinery was $28 000. The profit on disposal was $1000.
l
During the year vehicles which cost $47 000 were sold. Accumulated depreciation on
the vehicles was $22 000. The loss on disposal was $5000.
l
Depreciation is provided at the following per annum rates using the straight-line
method:
l
Premises 2%
l
Plant and machinery 10%
l
Motor vehicles 20%
l
Office equipment 10%
l
A full year’s depreciation is provided in the year of purchase but none in the year of
disposal.
l
The premises were revalued on 30 June 2021 at $3 000 000. The revaluation took
place after depreciation for the year had been provided.
a
i
Prepare a schedule of non-current assets at 30 June 2021.
[9]
ii
State the double entry to record the revaluation of the premises.
[2]
b
State, in accordance with IAS 16:
i
[3]
two costs, other than the initial purchase price, which could be included in the
cost of a non-current asset.
[2]
Additional information
The directors of Wakoso plc are planning to expand their business into gold mining
operations. If they decide to implement measures to limit the resulting water pollution
the costs could be considerable.
c
Advise the directors whether or not they should implement the measures to limit the
pollution.
[5]
d
i
Explain the stewardship role of the directors of a public limited company.
[2]
ii
State two responsibilities of directors.
[2]
Examination-style questions
ii
three factors that should be taken into consideration when determining the
useful life of an asset.
[Total: 25]
493
Answers to calculation self-test questions
ansWers to CalCulatIon self-test QuestIons
Page 18
15 Interest rate × Amount borrowed × Proportion of
year = Interest to be paid
5% × $50 000 × 6/12 = $1 250
Page 64
19 $400 − trade discount ($400 ×10% = $40) = $360 −
cash discount ($360 × 5% = $18) = $342 to be repaid
20 Debit balances = Drawings + Machinery + Purchases
$18 000 + $9 000 + $15 700 = $42 700
Page 80
15 Depreciation = (Cost − Residual value)/Expected life
(in years) = $25 000 − $4 000 = $21 000/6 = $3 500
16 After 2 years, the machine’s net book value would be
$12 000 × 75% = $9 000 × 75% = $6 750.
Loss on disposal = $6 750 − $5 000 = $1 750
Page 91
11 Debit: Advertising $178; Credit: Bank column of cash
book $178
12 Sales over added: reduce profit by $78
Purchases under added: reduce profit by $13
Sales returns over added: increase profit by $9
Overall change to profit: reduction of $82
−$78 − $13 + $9 = $82 reduction.
Page 120
30 New balance = $56 debit
Cashbook
Interest
12 Current balance
Standing order
200 Bank charges
45
23
Direct debit
88
Updated balance
56
212
212
31 Credit sales for month = $33 411
Sales ledger control account
Balance at 1 Oct
Credit sales for
October
4 521 Receipts from
credit customers
33 411 Sales returns
390
Irrecoverable
debts
120
Balance at 31 Oct
37 932
494
34 150
3 272
3 7932
Page 160
8 Balance for allowance at end of year = 4% × $62 500
= $2 500
Existing balance = $1 920
Change in balance = $2 500 − $1 920 = $580
Increase in balance means $580 charged as expense
Page 169
11 $490 + $8 000 + $1 340 − $320 − $10 000 = $490
(debit)
Page 191
15 Number of shares = $500 000/$0.25 = 2 000 000
Dividends = $0.01 × 2 000 000 = $20 000
16 Revaluation: Increase equity by: $1 250 000
Share issue: Increase equity by: $1 500 000
Overall increase by: $2 750 000
17 Ordinary share capital: $1 500 000
Share premium capital: $250 000
Page 207
12 Acid test ratio = (Current assets − inventory)/Current
liabilities = ($9 807 + $4 533)/$7 865 = 1.8:1
Current ratio = Current assets/Current liabilities =
($18 710 + $9 807 + $4 533)/$7 865 = 4.2:1
13 Mark-up = Cost of sales/Sales × 100 =
$62 115/$87 400 × 100 = 71.1%
Gross profit margin = Gross profit/Sales × 100 =
$25 285/$87 400 × 100 = 28.9%
Page 218
14 Opening inventory + Purchases − Sales = Closing
inventory
$400 + $850 − $400= $850
Page 236
20 Overhead absorption rate = $236 800/$175 600 =
$1.35 per $1 of prime cost
Page 261
17 Break-even output = Fixed costs/Unit contribution =
$88 000/($25 − $17) = 11 000 units
Page 310
15 Pressman: $10 000 + $4 000 − $4 800 = $9 200
Woods: $9 000 + $4 000 − $4 800 = $8 200
Stringer: $5 600 + $4 000 − $2 400 = $7 200
16 Assets = $7 600 + $85 + $290 + $92 = $8 067
Liabilities = $112 + $180 = $292
Accumulated fund = Assets − Liabilities = $7 775
Page 395
7
Page 310
17
Subscriptions
Subscriptions owing
at 1 January 2022
23 Subscriptions in
advance at 1 January
2022
Income and
expenditure
874 Receipts and
payments
840
71 Subscriptions owing
at 31 December 2022
968
88
968
Subscription income for 2022 = $874
Page 332
10 New provision = 40/(100 + 40) × $45 780 = $13 080
Therefore, adjustment will be $13 080 − $14 080 =
$1 000 – credited to statement of profit or loss
Page 353
17 Operating profit [$100 000] − Increase in
inventories [$1 411] + Decrease in receivables
[$643] − Decrease in payables [$2 071] + Depreciation
[$7 200] = $104 361
18 Dividends paid = Charge to statement of profit or
loss + Amount owing at start of year − Amount
owing at end of year
$8 700 + $500 − $750 = $8 450
Page 395
6
2023
2022
Interest cover
= 350 000/52 000
= 6.73 times
= 285 000/38 000
= 7.50 times
Dividend cover
= 285 000/66 000
= 4.32 times
= 237 000/59 000
= 4.02 times
Gearing
= 1 800/(1 800 +
1 000 + 190 + 200 +
654) × 100
= 46.8%
2022
$000
= 1 200/(1 200 + 800
+ 190 + 100 + 432)
× 100
= 44.1%
Page 420
5 Total direct materials variance: ($12.50 × 232 kg) −
($12.65 × 228 kg) = $15.80 (F)
Total direct materials price variance: ($12.50 −
$12.65) × 228 kg = $34.20 (A)
Total direct materials usage variance: (232 kg − 228
kg) × $12.50 = $50.00 (F)
6 Total direct labour variance: ($10.35 × 55) − ($9.95 ×
66) = $87.45 (A)
Total direct labour wage rate variance: ($10.35 −
$9.95) × 66 = $26.40 (F)
Total direct labour efficiency variance: (55 − 66) ×
$10.35 = $113.85 (A)
7 Total sales variance: ($24.50 × 525) − ($26.50 × 480)
= $142.50 (A)
Sales price variance: ($24.50 − $26.50) × 480 =
$960 (F)
Sales volume variance: (525 − 480) × $24.50 =
$1 102.50 (A)
Answers to calculation self-test questions
Subscriptions in
advance at 31
December 2022
40
2023
$000
Page 450
21 A = Total cash outflows = $2 080; B = Net cash flow =
Total inflows − total outflows = ($280); C = Balance
c/f = Balance b/f + Net cash flow = $1 120
Page 471
20 ARR = average annual profit/average investment =
$12 800/$50 000 × 100 = 25.6%
Glossary
Absorption The total to be charged to specific units of
production once all overhead costs have been apportioned
to a cost centre.
Accumulated fund Represents the capital for clubs and
societies.
Acquisition When one company purchases another.
Activity based costing Defined by CIMA as ‘cost
attribution to cost units on the basis of benefit received
from indirect activities, (i.e. overheads that cannot be
allocated to a particular product or process).’
Adverse variances An adverse variance occurs when the
actual profits will be lower as a result of the variance.
This is caused by actual revenue being lower than standard
revenue or actual costs being higher than standard costs
Allocation of costs Term used to describe the process of
charging whole items of expenditure to a cost centre or a
cost unit. The costs are easily identified as deriving from
the cost centre.
Amortisation The writing off of part (or all) of the cost
of an intangible asset such as goodwill. It is similar to the
depreciation charged on a tangible non-current asset.
Apportionment of overheads The process by which
some overhead costs are charged to cost centres on some
rational basis because they cannot be directly attributed
to a particular cost centre. When all overhead costs have
been apportioned to a cost centre, the total has to be
charged to specific units of production. This process is
known as absorption.
495
Appropriation account Shows how profits or losses are
shared between partners.
glossary
Assets Resources that are owned by or owed to an
organisation.
Auditors Professionals who examine the financial records
and financial statements of a business. An audit is carried
out by staff headed by a qualified accountant. External
auditors are independent of the business. In the case of
limited companies, external auditors are appointed by the
shareholders. Internal auditors are staff members who
scrutinise the internal controls of the business.
Average cost of goods (AVCO) A method of inventory
valuation that calculates an average cost for any inventory
held by the business.
Balancing figure An amount that needs to be included in
the debit side or credit side of an account to make the debit
side equal to the credit side. The amount used to balance a
cash book column is then used to ‘start’ the next year.
Bank charges Charges made by banks to cover the costs of
maintaining the drawer’s account.
Bank loan Money borrowed from a bank, which is repaid
over an agreed time period with interest charges added on
to the amounts to be repaid – the loan can be secured or
unsecured.
Bank reconciliation statement Prepared to make sure
that the entries in the bank columns of a trader’s cash
book are the same as those recorded by the bank in its
ledger.
Base cost The calculation of the cost of inventories on the
basis that a fixed unit value is ascribed to a predetermined
number of units of inventory.
Break-even analysis This involves calculating the number
of units that need to be sold for a business to cover all its
costs with revenue.
Capital The term used to describe how much a business is
worth. It represents how much is invested in the business
by the owner(s).
Capital receipts Derived from transactions that are not
the usual activities of the business.
Capital reserves Arise from capital transactions and
adjustments to the capital structure of the company.
Carriage inwards An expense incurred when a supplier
charges for delivery on the goods purchased.
Carriage outwards An expense which a business incurs
when it pays for delivery of goods to a customer.
Cash discounts Given to encourage customers to pay the
amounts they owe more quickly.
Cash in hand The term used to describe the amount of
cash held by a business at any one time. The cash in hand
in a shop would be found in the tills. In a larger business
it might be found in a safe.
Clearing a cheque Refers to the passage of a cheque
through the banking system. It involves the transfer of
money from one account to another. This can take a few
days if the accounts are held at different banks.
Contingent asset A potential asset which exists when the
statement of financial position is prepared. The inflow of
economic benefit is uncertain.
Contingent liability A potential liability which exists
when the statement of financial position is prepared, the
full extent of which is uncertain.
Contra entry A transaction that appears on both the debit
and credit sides of the double-entry system.
Break-even chart A graphical representation of the
break-even model, showing total cost, total revenue and
fixed costs curves – enabling a visual representation of
the break-even level of output, break-even level of revenue
and margin of safety.
Contribution The difference between selling price and
total variable costs. Contribution should more properly be
termed ‘contribution towards fixed costs and profit’, since
once fixed costs are all covered, contribution becomes
profit.
Break-even point The level of sales revenue and units
sold at which a business makes neither a profit nor a loss.
Alternatively, it is the point where contribution equals
fixed costs.
Control accounts Used to check the accuracy of the sales
and purchases ledger. These are not part of the doubleentry system and function as memorandum accounts.
Budget A short-term financial plan prepared in advance of
a defined time period. It is based on the objectives of the
business.
Called-up share capital The amount of issued share
capital that the shareholders have been asked to pay to
date. It may be less than the value of the issued share
capital.
Capital All assets of a business less all external liabilities.
496
Capital expenditure Spending on non-current assets or
the improvement of non-current assets; spending on the
everyday running costs of a business is known as revenue
expenditure.
Cost centre An identifiable area of a business (such
as a branch, department or person) where costs can be
associated.
Cost Defined as ‘expenditure which has been incurred in
the normal course of business in bringing the product or
service to its present location and condition’.
Cost drivers Activities undertaken in each department;
they are activities that are part of the process of making a
product.
Cost of an asset The purchase price including any taxes
plus any other costs directly attributable to bring the
asset to the location and condition ready for use. Costs
that are included as part of cost, for example delivery and
handling charges, professional fees charged by solicitors,
architects, site engineers, etc., making ready the site
where the asset is to be used and any costs involved in
assembling and testing the asset.
Cost of sales This is deducted from net sales to calculate
a gross profit earned by a business.
Cost pools Accounts that collect the costs incurred by
each activity.
Cost unit A unit of product to which costs can be
attributed.
Credit customers People (or businesses) that a business
sells goods to; they will pay for their goods at some time
in the future. The goods are sold on credit.
Credit suppliers People (or businesses) that a business
purchases goods from; the debt owed will be settled at
some future date. The goods are purchased on credit.
Credit transfer Amounts paid into an account directly
through the banking system instead of by issuing a
cheque.
Current assets Cash or assets that will be changed into
cash in the near future. Examples of current assets might
include inventory; trade receivables; bank balances; cash
in the till.
Current liabilities Debts owed by a business that are
due to be repaid within one year. Examples of current
liabilities include suppliers who are owed money for goods
supplied (trade payables); or money owed to a landlord for
overdue rent.
Debenture A form of long-term borrowing by a company;
it issues certificates of indebtedness to potential investors
who, in return for lending the company money, will receive
fixed interest payments each year.
Debenture interest Paid to debenture holders (investors)
who have loaned money to a company. The interest is
usually paid in two equal instalments during the year.
Deficit (or an excess of expenditure over income) The
loss for clubs and societies.
Depreciation The apportioning of the cost or valuation of
an asset over its useful economic life.
Derecognition Occurs when an asset is disposed of or is
incapable of yielding any further economic benefits.
Direct costs Defined by the Chartered Institute of
Management Accountants (CIMA) as ‘expenditure which
can be economically identified with a specific saleable
cost unit’.
Direct labour costs Costs that can be specifically
identified with the finished product (or service).
Direct labour hours per unit The number of hours (or part
of an hour) that a worker would take to produce one unit
of output.
Direct materials costs Costs that can be specifically
identified with the finished product (or service).
Glossary
Cost of capital This is based on the weighted average cost
of capital available to a business.
Direct debits Payments made by the bank on behalf of
customers. The authority to withdraw money from the
account is given to the payee. The amounts withdrawn
from the account are generally variable.
Directors The people elected by shareholders to run the
company on behalf of the shareholders.
Discount factor Allows the value of future cash flows to be
calculated in terms of their value if they were received today.
Dishonoured cheque Cheques that have not gone through
the drawer’s bank account. often this may be because the
drawer has insufficient funds in their account to honour
(pay) the cheque.
Dividends The rewards paid to shareholders out of profits
earned by a limited company. The dividends are paid to
individual shareholders in proportion to the number of
shares they own. Dividends are paid annually, but most
limited companies will pay interim dividends part way
through their financial year.
Drawer The person (or business) using a cheque for payment.
Drawings The term used to describe the withdrawal of
resources (cash or goods) from the business by the owner
for private use outside the business.
Earnings The profit for the year after taxation; that is,
earnings that belong totally to the ordinary shareholders.
Efficiency ratios These examine aspects of the working
capital of the business and measure how efficiently these
are being managed.
Emoluments The rewards that directors receive for running
a company on a daily basis. The payment takes the form of
a salary, possibly profit bonuses and share options based
on their performance and other benefits such as private
health insurance, a company car, etc.
Equity Made up of the ordinary share capital and reserves
of a limited company.
External auditors See auditors.
Factors of production Resources that are needed in the
process of manufacturing a product or in providing a
service; for example, land, labour, finance and capital
equipment.
Factory overheads The costs indirectly related to the
manufacturing of output.
Fair Implies that all transactions conform to generally
accepted accounting rules. (see page 368)
497
Fair value The amount for which an asset could be
exchanged between knowledgeable, willing parties in an
‘arm’s length’ transaction.
Favourable variances A favourable variance occurs when
the actual profits will be higher as a result of the variance,
caused by actual revenue being higher than standard
revenue or actual costs being lower than standard costs.
glossary
Finance costs Comprise interest paid on all debt.
Financial statement A term used to describe the
statement of profit or loss and statement of financial
position produced by the owner of a business at the
financial year end.
Financial year The recording of a business’s transactions
over a 12-month period. The process is then repeated for
each subsequent year.
Finite life A limited life span.
First-in first-out (FIFO) A method of inventory valuation
that assumes the oldest inventory is used up or sold first.
Inventory Goods held by the business throughout the
year, either as raw materials, work in progress or finished
goods ready for sale.
Irrecoverable debt Occurs when a trade receivable (credit
customer) cannot pay the amount that is owed.
Irrecoverable debts recovered Those debts that had been
written off as irrecoverable which are now received from
the trade receivable (credit customer).
Issued share capital The amount of share capital that has
actually been issued by a company.
Job Work carried out by a business for a customer who has
placed an order for specific work to be done.
Ledger account Contains the detailed record of financial
transactions undertaken by a business. Since all accounts
appear in a ledger (or book), the term is often shortened
to the single word ‘account’.
Fixed costs Costs that remain at the same level when the
level of production changes.
Ledger The book where all accounts are kept.
Flexible budgets Where budgeted totals are adjusted for
differences between actual and budgeted output levels.
Limited company An organisation that has a legal identity
that is separate from that of its owners. The owners of
a limited company are called shareholders (or members);
their liability is limited to the amount that they have
agreed to pay the company for their shares.
Forecast A prediction of what is likely to occur in the
future.
Gearing The relationship that exists between fixed cost
capital and total capital.
Goodwill The cost of acquiring a business less the
total value of the assets and liabilities that have been
purchased. It is an intangible asset, that is, it is without
physical substance. Goodwill must be tested annually for
impairment
Gross profit Revenue generated by selling goods, less the
cost of the same goods.
Honorarium A payment made to a club official to cover
expenses and time spent on club activities.
Income and expenditure account The statement of profit
or loss for clubs and societies.
Indirect costs Items of expenditure that cannot easily be
identified with a specific saleable cost unit.
Infinite life An unlimited life span.
Inherent goodwill The goodwill that has been generated
internally. It has not been purchased. It is the goodwill
that is enjoyed by a business while it is still ongoing.
Interest charge The interest charged by a bank when an
account is overdrawn.
Interest on overdrafts The interest charged by banks
when an account is overdrawn.
Interim dividends Dividends paid to shareholders out of
profits earned by a limited company that are paid part way
through their financial year.
498
Internal auditors See auditors.
Liabilities The debts owed by an organisation.
Limited liability Each shareholder is limited in how
much of the debts of the business they are personally
responsible for, up to their original investment.
Limiting factor This is defined by CIMA as ‘anything which
limits the activity of an entity’.
Liquid The term used to describe how easily an asset can
be turned into cash.
Liquidity ratios Examine the solvency position of the
business in terms of whether it has sufficient cash and
liquid assets to cover the short-term liabilities of the
business.
Lodgements Payments made into the bank account.
Loose tools The term used to describe small items of
noncurrent assets that have a life expectancy greater than
one year, but individually are owned for a much shorter
period due to breakages, being misplaced or being stolen.
They are also individually of much lower value than noncurrent assets.
Loss Occurs when expenditure exceeds income.
Machine hours Relates to the number of hours a machine
will be used in the production of one unit of output.
Manufacturers Businesses that produce output from raw
materials.
Manufacturing account Calculates the cost incurred by a
business in producing output for a financial year.
Margin of safety The difference between actual sales
achieved or forecast as achievable and the break-even
level of sales. Managers can use this figure to determine
how far sales can fall before the business will move out of
profit and into a lossmaking situation.
Marginal costing Defined by CIMA as ‘the cost of one unit
of a product or service which would be avoided if that unit
were not produced or provided’.
Marginal revenues The revenues earned by the sale of one
extra unit.
Matching/accruals concept Revenues and expenditure
should be matched to the period of time in which the
revenue or expense was incurred and not the period of time
in which the money was received or paid.
Memorandum accounts Record financial information in
account form, but they are not part of the double-entry
system.
Memorandum columns Record information that is not part
of the double-entry system.
Merger This takes place when two or more businesses join
together to form a new business. The term is generally
applied to the agreed takeover of one limited company by
another.
Money Can be in the form of cash, cheques, credit and
debit card transactions.
Net book value (NBV) The cost of a non-current asset
shown in the statement of financial position less the
total depreciation charged to date. NBV is also termed the
carrying amount.
Net cash flow The difference between cash inflows and
cash outflows for a period of time.
Net debt The borrowings of a company less cash and liquid
resources.
Net realisable value The actual or estimated selling price
(net of trade discount but before any cash discount that
may be allowed) less all further costs to completion and
all marketing, selling and distribution costs.
Nominal accounts Record expenses, profits, losses and
gains. They are found in the general ledger.
Nominal value The face value of shares. Once the shares
have been issued their market price can rise or fall.
Any change in the market price is not reflected in the
company’s books of account.
Non-current assets Assets that will be used by the
business for more than one accounting year.
Non-current liabilities Debts owed by a business which
fall due for repayment after more than one year. Examples
Operating activities The cash effects of transactions
that do not fall under either of the headings ‘investing
activities’ or ‘financing activities’.
Ordinary dividends These are variable in nature. The
dividend will vary according to the level of profits earned
by a company.
Other payables Amounts owed to the suppliers of goods
and services, other than those goods purchased for resale.
Glossary
Marginal costs Costs that are incurred when one extra
unit is produced above the planned level.
of non-current liabilities include a bank loan that needs
to be repaid in four years’ time. A 25-year loan would fall
under this heading (except in its final year)
Other receivables Amounts owed by people (or businesses)
who are not credit customers.
Over absorption of overheads Occurs when the actual
level of activity is greater than was budgeted for and
therefore the amount of overheads built into units of
output is greater than the amount of overheads actually
incurred.
Overdraft An agreement where a business can withdraw
more from its bank account than the funds available, i.e. it
can run a negative balance on the business bank account.
Interest is paid on the overdraft and this is higher than for
a bank loan.
Overhead absorption rate (OAR) The rate at which
overheads are to be added on to the direct costs of a unit
passing through a cost centre – usually calculated on an
agreed basis (e.g. labour or machine hours).
Overheads The expenses incurred by a company during the
financial year.
Paid-up capital The amount of share capital that appears
on the statement of financial position and is the amount
of cash that the company has actually received from the
shareholders. page 163
Partners’ capital accounts These show deliberate
injections of capital into the business, plus any goodwill
adjustments, plus any profits or losses arising on a
revaluation of assets (generally on the admission or the
retirement of a partner).
Partners’ current accounts Record entries relating to each
partner’s share of profits and drawings in the current year.
The current account is also used to adjust for any errors
made in the profit share in previous years.
Partnership A business entity that consists of two or more
people owning and running the business with unlimited
liability.
Payee The person to whom a cheque is made payable.
Personal accounts Accounts that record transactions with
credit customers and credit suppliers.
Prime cost The total of the direct costs incurred in the
manufacturing of goods for a financial year.
499
Production overheads Expenditures on materials, labour
or services for production purposes based on the normal
level of activity, taking one year with another.
Return on investment The term used to describe the
financial benefits that will result from investing in another
business.
Profit from operations The profit earned by a company
before deducting finance costs and taxation.
Revaluation reserve This is created when non-current
assets such as premises are revalued in order to reflect
an increase in the value. It ensures that the statement of
financial position shows the permanent increase in value.
glossary
Profit The excess of income over expenditure.
Profitability ratios Examine different measures of profits
earned by the business in relation to other financial
variables.
Property, plant and equipment All noncurrent tangible
assets from which economic benefits flow. They are held
for more than one year for use in the production process
or the supply of goods and services. Examples include land
and buildings, plant and machinery, office equipment,
vehicles, etc.
Provision An amount set aside out of profits for a known
expense, the amount of which is uncertain.
Purchase consideration The agreed amount that will be
paid to acquire a business.
Purchases Any items that are purchased with the intention
of selling them to customers.
Purchases returns Goods that the business sends back to
the supplier.
Qualified audit report A report where the auditors do not
believe the financial statements give a true and fair view
of the company’s financial position.
Ratio The term applied to the results of calculations
used to compare the performance of businesses. It is a
generic term applied to results expressed in true ratios,
e.g. a current ratio might be 4:1, percentages, e.g. a gross
margin might be 58% or time, e.g. a trade receivables
turnover might be 32 days.
Real accounts Record the acquisition and disposal of noncurrent assets like land, buildings, equipment and vehicles.
They are found in the general ledger.
Revenue expenditure Spending on the everyday running
costs of a business; spending on non-current assets is
known as capital expenditure.
Revenue receipts Incomes derived from the trading
activities of the business.
Revenue reserves Profits that are retained in a company
to strengthen its financial position. They are normal
trading profits that have been retained (‘ploughed back’)
in the company. They are added to the retained earnings
from previous years in a statement of changes in equity.
Reverse order of liquidity The order in which assets
appear under their headings; reverse order of liquidity
means that the most liquid of the assets appears last while
the least liquid appears first.
Royalties Payments made to the inventor of a product or a
process or an idea. The royalty is often a percentage of the
revenue earned by the user.
Sales Items that are sold in the normal course of business
to customers; the income from goods that are sold.
Sales returns Goods that have been returned by the
customer.
Schedule of non-current assets Shows the non-current
assets held by a company along with changes in their value
and composition over the most recent financial year.
Schedule of trade payables A list of credit suppliers’
balances extracted from each of the purchases ledgers.
Receipts and payments account The cash book used by
clubs and societies.
Schedule of trade receivables A list of credit customers’
balances extracted from each sales ledger.
Recoverable amount The higher of an asset’s fair value
(the amount for which the asset could be sold less selling
costs) and its value in use (calculated by discounting all
the future cash flows generated by using the asset).
Security Where a business offers one of its own assets in
order to obtain a bank loan, and the bank can keep the
asset if the business fails to maintain repayments of the
loan.
Residual (scrap) value The amount that a non-current
asset can be sold for at the end of its useful life.
Semi-variable costs Costs that contain elements of both
fixed and variable costs.
Residual value The amount that the company expects to
obtain for an asset less any disposal costs at the end of its
useful life.
Service provider Businesses that do not sell (or produce)
physical products but earn revenue from selling services
Retained profits Profits that are kept in a business
for expansion purposes. They increase the capital of a
business. They are sometimes said to be ‘ploughed back’.
500
Revenue Comprises the receipts from the sales of goods
and/or services by a company.
Shareholders The owners of a limited company; their
power and influence within the company relate to how
many shares they hold in that company.
Sole trader A business entity consisting of one person who
takes personal liability for the business.
Solvency The ability of a business to settle its debts when
they require payment.
worth more than $1 received in one year’s time or in five
years’ time.
Special orders Those orders for output received from other
businesses, which are normally for a lower than normal
selling price or have unusual conditions attached to the
order. The order is usually seen as a ‘one-off’.
Title The legal term for ownership. For example, title
deeds to premises shows that the holder of the deeds is
the owner of the premises.
Standard costing Sets levels of costs and revenues
that ought to be achievable when reasonable levels of
performance are attained, together with efficient working
practices to manufacture a product.
Standard hour The amount of work that ought to be
achieved in an hour.
Standard unit price The total of standard costs of all
the factors of production that make up a finished unit of
production.
Standing orders Payments made automatically by a bank
on behalf of customers. They are set amounts and may be
paid weekly, monthly or annually.
Statement of affairs A list of assets and liabilities, often
used to calculate the missing capital figure, or in the
case of clubs and societies, the missing accumulated fund
figure. It will often look like a statement of financial
position.
Statement of cash flows A financial statement showing
the inflows and outflows of cash over the most recent
financial year.
Statement of changes in equity Details changes that
have taken place in share capital and reserves during the
financial year.
Statement of financial position A list of the assets of an
organisation along with the financing for those assets –
usually a combination of liabilities and capital.
Statement of profit or loss A statement that calculates
the profit a business has made for a period of time (usually
the financial year).
Stepped costs Costs that remain fixed in value over a
limited range of output and rise in a fixed amount once
output rises above that range.
Sub-variance A constituent part of a total variance.
Sub-variances added together give the total variance.
Surplus (or an excess of income over expenditure) The
profit for clubs and societies.
Suspense account An account temporarily used when the
trial balance columns fail to agree and errors are present
within the ledger accounts. Correction of all errors will
eliminate the balance on the suspense account.
Time value of money Money received or paid in the future
does not have the same value as money received or paid
today. This concept recognises that $1 received today is
Total direct materials variance Identifies the difference
between the amount that managers thought would be
spent on direct materials (the standard set minus the
budgeted amount) and the amount that was actually spent
on the direct materials.
Trade discounts Often given between businesses to
increase sales, encourage bulk buying or maintain loyalty.
Glossary
Stakeholders Groups who have a shared interest in the
activities of a business, usually focusing on particular
areas of the business activities.
Trade payables People (or organisations) that the business
owes money to; they have supplied goods for resale that
the business has received but as yet has not paid for.
Trade receivables People (or organisations) that owe
money to a business; they are customers that have not
yet paid for the goods or services provided in the normal
course of trade.
Traders Businesses that operate by buying and selling
finished goods to make profits.
Transposition Occurs when numbers are fully or partially
swapped by mistake (e.g. $913 becomes $931); this may
or may not be an error of original entry – depending on
whether the transposition happens in one or both entries.
Trial balance A list of the totals of all ledger accounts as
they appear in all the ledgers.
True All the transactions reported in the statement of
profit or loss have taken place and assets recorded in
the statement of financial position actually exist and are
valued appropriately. (see p 368)
Under absorption of overheads Occurs when the actual
level of activity is less than was budgeted for and
therefore the amount of overheads built into units of
output is insufficient to cover the full actual amount of
overheads incurred.
Unincorporated businesses The term used to describe all
businesses that are not limited companies.
Unlimited liability Where the owner of a business is
personally liable for any unpaid debts of the business.
Unpresented cheques Cheques that have not yet been
cleared and debited to the account at the bank.
Unqualified audit report A report where the auditors
believe the accounts have been prepared correctly and
present a true and fair view of the company’s financial
position.
Valuation of inventory Inventory is always valued at the
lower of cost price and net realisable value.
Variable costs Costs that change in direct proportion to
the output of a product.
Working capital This is calculated as current assets less
current liabilities.
501
Index
A
absorption costing 220, 222–35
apportionment of overheads 222–6
comparison with activity based
costing 401–2
cost centres 222, 235
cost units 222, 235
costing statement 233–4
decision-making 234–5, 260
elimination method 226
other overheads and mark-up 233
overhead absorption rates (OAR)
227–31
products passing through several
departments 230–1
profit statement 234
reciprocal services 225–6
reconciliation of profits under
marginal and 248–9
service department costs, transfer of
224–5
under and over absorption of
overheads 231–2
usefulness and limitations 234–5
account see ledger accounts
accounting concepts or principles
56–60, 358
business entity 57
consistency 58, 217
duality 58
going concern 57, 278
historic cost 57, 205
matching/accruals 58, 59–60, 68,
121, 122, 217, 298, 424, 437
materiality 58–9
money measurement 57, 364
objectivity 59
prudence 58, 68, 217
realisation 58, 424, 437
substance over form 16, 60
accounting equation 25–7, 174
duality 58
accounting policies 332, 333, 334, 355,
358, 368
accounting rate of return (ARR) 452,
455, 457–9, 469
accrued expenses
calculating 121–2
general ledger 124–6
accumulated fund (clubs and societies)
297, 298–9, 307
acid test ratio 202, 205
acquisition or merger 370–84
advantages and disadvantages 383–4
limited company: acquisition of
partnership 379–82
sole trader business 376–8
merger of sole trader business with
existing partnership 375
502
merger of sole trader businesses
limited company 372–5
partnership 370–2
statement of financial position 383
statement of profit or loss 383
valuing goodwill 383
activity based costing 396–402
comparison with absorption costing
401–2
cost drivers 396, 397, 402
cost pools 396, 397, 401
decision-making 402
selling price 399–400
stages 397
uses and limitations 400–1
administrative staff 61
amortisation 339, 361
appropriation account (partners) 160–4,
295–7
assets 141, 143
accounting equation 25–7, 58
contingent 360, 361
current see separate entry
impairment 359, 360, 361
intangible see separate entry
mortgage debentures 172
non-current see separate entry
original cost 142
reverse order of liquidity 142
tangible 141
auditing
auditor’s report 332, 334, 356–7,
361–3, 365–6, 368–9
ethics 361–3
qualified and unqualified report 366
B
bank loans 16, 309
bank overdrafts 16, 309, 336, 339
bank reconciliations 92–102
benefits and limitations of 101–2
electronic payments and receipts
117
lodgements not yet credited by bank
96
preparing 96–101
reasons for non-identical entries
94–6
unpresented cheques 96
updating cash books 92–4
batch costing 221
bonus issues of shares 178–9, 180–2,
344
books of prime entry see prime entry,
books of
break-even analysis see marginal costing
budgeting and budgetary control 421–49
advantages and disadvantages 422–3
behavioural aspects 422, 423, 448,
449
cash budget 344, 432–5, 441
decision-making 448–9
flexible budgets
benefits of 441
budgeted and actual cost of production 445–7
budgeted and actual profit 447–8
preparing 444–5
standard costing 413, 419,
441–8, 449
labour budget 428–9
limiting factors 441
master budget 424, 441
production budget 425–6
purchases budget 426–8, 441
sales budget 424–5, 441
spreadsheets 423–4
standard costing 413, 418, 419,
441–8, 449
statement of financial position
437–40
statement of profit or loss 436–7
trade payables budget 430–1, 441
trade receivables budget 429–30,
441
business entity concept 57
buy or make
factory profit 321–4
marginal costing 250–2, 260
C
capital
clubs and societies
accumulated fund 297, 298–9
expenditure: revenue or 58–9, 65–6,
361, 424
income: revenue or 66, 424
inventory valuation 216
materiality 58–9
partnerships
capital and current accounts
164–8, 266–72, 276–87, 288,
372
interest on capital 160, 162–3,
295, 297
projects see investment appraisal
receipts 66, 307, 308, 424
reserves 174–8
sole trader 144–7
structure of limited companies
169–71
carriage inwards 154–5, 312, 315
carriage outwards 154, 158
cash 193, 336
cash book 31–8, 387
balancing 36–7
cash and bank payments 31–5
checking accuracy of
cash balance 92
transactions in bank columns of
92
contra entries 37–8
electronic payments and receipts
117
monies paid into bank account 93–4
monies withdrawn from bank account
94
non-identical entries in bank
statements and 94–6
source documents 36, 93, 94, 96
three-column 41
cash budgets 344, 432–5, 441
cash discounts 17, 39–42, 293
allowed 39–40
general ledger 41–2
received 40–1
cash flows
investment appraisal 452–3
statement of see separate entry
cash receipts and lodgement book 38
chairperson’s statement 334
cheque payments book 38
closure of business unit 254–6
clubs and societies 297–309
accumulated fund 297, 298–9, 307
donations 308, 309
entrance fees paid by new members
307
fundraising 300, 309, 352
income and expenditure account
297–8, 299, 302–6
life membership 307, 309, 352
receipts and payments account 297,
301
special trust fund 308
statement of financial position 297,
298, 299, 306
subscriptions account 301–2, 306
surplus or deficit 297
terminology 297
trading and revenue-generating
activities 300–1
codes of ethics 362
collateral for bank loan 16
commission, errors of 83–4, 116
Companies Act 1985 67, 216, 217, 333,
357, 366, 368
true and fair view 333, 368
Companies Act 2006 332
compensating errors 55, 84, 116
computerised accounting systems 60–3,
118, 386–7
advantages and disadvantages 61–2,
386
security of data 63, 387
consistency 58, 217
contingent
assets 360, 361
liabilities 360
continuous improvement 420
contra entries
cash book 37–8
control accounts 109–12
control accounts 102–16, 387
benefits of 116
contra entries 109–12
incomplete records 147–8, 300–1
limitations of 116
purchase ledger 105–7, 108–12, 113,
115, 116, 147, 148
reconciliation to ledger balances
113–15
sales ledger 102–5, 107–14, 116,
147–8
control systems
bank reconciliations 92–102
control accounts 102–16
trial balance 56, 82–4
correction of errors
financial statements 88–91, 116,
140
suspense account 85–8
cost of sales 138–9, 148, 158
carriage inwards 154–5
returned goods 153–4
cost-volume-profit (CVP) analysis
258–60
costing
absorption see separate entry
activity based 396–402
batch 221
continuous operation 220
job 220, 221
marginal see separate entry
standard see separate entry
unit 220, 221
unit costs 219–20
costs
allocation of 222, 225
direct 211, 311
direct labour 209, 311
direct material 211, 311
fixed 209, 233, 237, 238, 245, 248,
258, 260
indirect 211, 258, 260, 311, 313, 397
marginal 254
prime cost 230, 311–13, 314
reduction 449
semi-variable 210, 245, 258
social 364
stepped 211, 258
variable 209–10, 237, 245, 248, 258
credit balances in sales ledger 107–8
credit sales 28
cultures, corporate 384
current assets 15, 336
prepayments 124, 129
see also inventories; trade receivables
current liabilities 141, 336
accrued expenses 123, 129
see also trade payables
current ratio 201, 205
D
data security 63, 387
debentures 17, 172, 173, 388
advantages and disadvantages 173
statement of cash flows 339
debit balances in purchases ledger
108–9
debt factoring 17
decision-making see management
decision-making
depreciation 66–7, 138, 359
change of basis 359
cost model 74
factors causing 67
land 359
net book value 71, 79
purpose of accounting for 68
reducing balance method 72–4, 359
residual value 68, 359
revaluation method 75, 359
revalued asset 57, 178
statement of cash flows 339, 341–2
statement of financial position 79, 138
statement of profit or loss 79, 138
straight-line method 68–72, 74, 359
useful life of asset 359, 360
development costs 361
directors 14, 171, 180, 332
accounting policies 358, 368
accounting records 333, 368
dividends 355
divorce of ownership and control
332, 368
emoluments 368
financial statements 332, 333
directors’ report 332, 334, 356, 368
regulatory framework 366
responsibilities 333, 368
discounts
cash 17, 39–42, 293
trade 39
disposal of non-current assets 76–9, 360
ledger accounts 77–8
part exchange 78–9
statement of cash flows 339, 342–4
diversification 384
dividend cover 393, 394
dividend per share 392, 394
dividend yield 393, 394
dividends 185, 339, 355–6
interim 171, 355
ordinary 171–2
proposed final 355, 356, 358
revenue reserves 174
double-entry system 19–25
advantages of 56
cash book 31
duality 58
drawings 36, 143–4, 145, 173
interest on partners’ drawings 12,
163–4, 168
duality 58
503
IndeX
E
earnings per share 392, 394
economies of scale 384
efficiency ratios 196, 197, 198, 202–5,
394
electronic payments and receipts 117
environmental law 235
equity 171, 336, 339
statement of changes in 185–9, 333,
349–50, 355
see also reserves; share capital
errors 81–2
bank reconciliations 95, 96, 101, 102
of commission 83–4, 116
compensating 55, 84, 116
computerisation 62, 118, 387
control accounts 102, 103, 116
reconciliation to ledger balances
113–15
correction of see separate entry
double-entry system 56
financial statements 358
omission 83, 116
original entry 84, 116
of principle 66, 83–4
purchase ledger 116
reversal 83, 116
sales ledger 116
transposition 82–3
trial balance 55, 56, 82–4, 91
ethics 235, 361–3
events after reporting period 358
expenses to revenue ratio 200
F
finance
economies of scale 384
ethics 363
long-term and short-term 15, 189
sources and methods of 15–17,
169–70, 172–3, 189
clubs and societies 309
rights issues 178–80, 182
financial statements
adjustments to draft 121–40, 156
clubs and societies 297–308
correction of errors 88–91, 116, 140
interpretation/analysis of financial
data see separate entry
limited companies see financial
statements of limited companies
manufacturing businesses 310–31
partnerships see financial statements
of partnerships
sole trader see financial statements of
sole traders
users of 192–5
financial statements of limited companies
169–89, 332–51
accounting policies 332, 333, 334,
355, 358, 368
auditor’s report 332, 334, 356–7,
361–3, 365–6, 368–9
504
chairperson’s statement 334
directors’ report 332, 334, 356, 368
ethics 361–3
events after reporting period 358
IAS 1: presentation 57, 333–4,
335–6, 349, 350, 354–7
notes to accounts 332, 333, 355,
357, 358, 360, 361
depreciation 359, 360
international accounting standards
366
schedule of non-current assets
350–1
published form 333
purposes of 366–7
statement of cash flows 332, 333,
337–49, 355, 358, 435
statement of changes in equity
185–9, 333, 349–50, 355
statement of financial position
170–1, 172, 175–7, 180, 185, 189,
332, 333, 335–7, 355
statement of profit or loss 183–5,
332, 333, 334–5, 355
true and fair view 333, 334, 357,
361–2, 365, 366, 368–9
users of 192–5, 367
see also International Accounting
Standards (IAS)
financial statements of partnerships
160–9, 263–97, 383
appropriation account 160–4
change during accounting year
295–7
capital accounts of partners 164,
165–6, 167–8, 288
change in profit sharing ratios
266–8
merger of sole traders 372
new partner and goodwill 276–84
new partner and revaluation
268–72, 280–4
retirement of partner 285–7
current accounts of partners 164–8,
272
debit balance on partner’s current
account 166–7
dissolution of 287
realisation account 288–95
goodwill 272–3, 383
adjustments to partners’ capital
accounts 276–87
adjustments when no goodwill
account introduced 278–87
change in profit sharing ratios
266–8
factors contributing to 276
valuation 273–6
interest on capital 160, 162–3, 168,
295, 297
interest on partners’ drawings
163–4, 168
new partner, admission of 264–6,
295–7
goodwill 266, 273, 276–84
revaluation of assets 266,
268–72, 280–4
profit sharing ratios, change in
266–8
salaries 160, 161, 162, 168, 295
share of residual profits 161
statement of financial position
164–8, 170, 266–72, 276–87, 383
statement of profit or loss 160–4,
168, 295
financial statements of sole traders
140–59
calculating profit
changes in capital 143–7, 151
incomplete records 56, 147–9
capital introduced and withdrawn
145–7
statement of financial position
141–3, 151, 170
statement of profit or loss 149–58
first-in first-out (FIFO) method 206,
213–14, 216–17, 218, 220, 357
flexible budgets 413, 419, 441–8, 449
G
gearing ratio 391, 393, 394
general journal 42–5
correction of errors 86
inter-ledger transfers 110
narrative 43
source documents 43
uses of 43, 86, 110
general ledger 24–5
accruals and prepayments 124–7
cash discounts 41–2
nominal accounts 66
real accounts 66
going concern 57, 278
goodwill 278, 361
amortisation 339
inherent 278
merger and acquisition 375, 376–8
sole traders forming limited company 372–4
valuation 383
written off 383
negative 383
partnerships see goodwill under
financial statements of
partnerships
gross margin 199
gross profit
calculating 151–5
closing inventory 139, 215–16, 217
service business 158
gross profit margin
incomplete records 148–9
H
hire purchase agreements 16, 60
historic cost 57, 205
horizontal and vertical integration 384
I
impairment of assets 359, 360
income and expenditure account 297–8,
299, 302–6
incomplete records 56
clubs and societies 299–306
control accounts 147–8
mark-up and margin 148–9
intangible assets 141, 335, 361
goodwill see separate entry
interest
debenture 172, 173, 388
on partners’ capital account balances
160, 162–3, 168, 295, 297
on partners’ drawings 163–4, 168
statement of cash flows 339
interest cover 390–1, 394
internal rate of return (IRR) 452, 466–8,
469
International Accounting Standards (IAS)
56, 185, 193, 333, 366
individual standards
IAS 1 (Presentation of Financial
Statements) 57, 333–4,
335–6, 349, 350, 354–7
IAS 2 (Inventories) 212, 216, 217,
234–5, 258, 260, 357
IAS 7 (Statements of Cash Flows)
337, 338, 344, 358
IAS 8 (Accounting Policies, Changes
in Accounting Estimates and
Errors) 357, 358
IAS 10 (Events after the Reporting
Period) 358
IAS 16 (Property, Plant and Equipment) 57, 74, 358–60
IAS 36 (Impairment of Assets)
359, 360
IAS 37 (Provisions, Contingent Liabilities and Contingent Assets)
360–1
IAS 38 (Intangible Assets) 361
International Financial Reporting
Standards (IFRS) 56
interpretation/analysis of financial data
192–206, 388–94
horizontal analysis 194
limitations of accounting information
205–6
performance evaluation 195
ratios see separate entry
trend analysis 194
users of accounting information
192–5
inventories 141, 336
gross profit 152–3
IAS 2 212, 216, 217, 234–5, 258,
260, 357
just-in-time (JIT) management of
217
manufacturing organisations 312,
316–17, 325–31
opening and closing 152–3
sale or return, goods sent on 58
statement of cash flows 339
valuation of see separate entry
inventory turnover 204, 205
investment appraisal 451–70
accounting rate of return (ARR) 452,
455, 457–9, 469
decision-making 468–70
future net cash inflows and outflows
452–3
internal rate of return (IRR) 452,
466–8, 469
net present value (NPV) 452, 460–6,
469
payback 452, 453–7, 469
investment ratios 196, 392–3, 394
irrecoverable debts 102, 112–13, 129–31,
203
age profile 132
allowance for 113, 131–6, 156
dissolution of partnership 293
past experience 132
recovery of 136–7
J
job costing 220, 221
joint and several liability 13
K
Kaizen 420
L
labour budgets 428–9
leasing 16
ledger accounts 20–5
advantages of full accounting records
56
balancing 49–51
detailed entries in 45–6
disposal of non-current assets 77–8
from books of prime entry to 46–9
liabilities 141, 142, 143
accounting equation 25–7, 58
contingent 360
current see separate entry
non-current see separate entry
provisions 360
limited companies 13–15
acquisition
of partnership 379–82
of sole trader’s business 376–8
advantages and disadvantages 14–15
annual general meeting 332, 355,
356
annual return 332
capital structure 169–71
corporate report 332
directors see separate entry
financial statements of see separate
entry
limited liability 13
merger of sole trader businesses
372–5
partnership: admit new partner or
convert 190
shareholders see separate entry
sources of finance 15–17, 169–70,
172–3, 189
rights issues 178–80, 182
limited liability partnerships 12
liquidity 337, 338
ratios 196, 197, 198, 201–2, 204–5,
206, 393, 394
loans, bank 16, 309
long-term planning 422
loose tools 75
M
make or buy
factory profit 321–4
marginal costing 250–2, 260
management decision-making 333
absorption costing 234–5, 260
activity based costing 402
budgeting 448–9
cost-volume-profit analysis 258–60
investment appraisal 468–70
marginal costing 250–8, 260
non-financial factors 235, 258, 260,
419–20, 448–9, 469–70
social implications 363–5
standard costing 419–20
management function 367, 368, 421–2
manufacturing account 310, 311–18,
319–20
carriage inwards 312, 315
depreciation 75
expenses split 321
factory manufacturing profit 321–4
factory overheads 311, 313, 314
prime cost 311–13, 314
raw materials 311–16
work in progress 316–17
manufacturing business 310–31
expenses split 321
finished goods 316, 317
elimination of unrealised profit
from unsold inventory 325–31
inventory 312, 316–17, 325–31
manufacturing account see separate
entry
purchase or manufacture 321–4
statement of financial position 316,
317–19, 327
statement of profit or loss 310, 316,
317–21, 327, 328, 329–31
unrealised profit 325–31
see also costing
marginal costing 235, 237–58
break-even chart 243–5, 258–9
break-even point 238–40
contribution to sales method 241–2
cost and profit statements 246–8
cost-volume-profit analysis 258–60
decision-making 250–8, 260
limiting factors 256–7, 258
505
IndeX
margin of safety 238–40
reconciliation of profits under
absorption and 248–9
target profit 240–1, 257, 258
unit contribution method 238–40
uses and limitations 257–8
break-even analysis 245
mark-up 199, 233
incomplete records 148–9
matching/accruals concept 58, 59–60,
68, 121, 122, 217, 298, 424, 437
materiality 58–9
memorandum accounts 102, 110
memorandum columns 41–2
merger see acquisition or merger
middle managers 61
mnemonics 54, 83
money measurement 57, 364
mortgage debentures 172
mortgages 17, 142
N
net book value 71, 79
net present value 452, 460–6, 469
net working assets to revenue 390
non-current asset turnover 202–3
non-current assets 141, 336, 451
definition 66
depreciation see separate entry
error of principle 66
IAS 16 57, 74, 358–60
intangible 141, 335, 361
goodwill see separate entry
mortgage debentures 172
profit or loss on disposal of 76–9,
156, 339, 342–4, 360
real accounts 66
revaluation 57, 177–8, 268–72, 344,
359, 360, 361
schedule of 350–1
statement of cash flows 339, 341–4
tangible 141
see also investment appraisal
non-current liabilities 336
debentures see separate entry
life membership fund 307
O
objectivity 59
omission, errors of 83, 116
operating expenses to revenue ratio 200
operational planning 422
see also budgeting and budgetary
control
original entry
books of see prime entry, books
errors of 84, 116
overdrafts 16, 309, 336, 339
overhead absorption rates (OAR) 227–31
direct labour cost rate 229
direct labour hour rate 227, 228
direct material cost rate 230
machine hour rate 227–9
506
prime cost rate 230
products passing through several
departments 230–1
under and over absorption 231–2
unit produced rate (cost unit rate)
230
overheads, factory 311, 313, 314
overheads and mark-up 233
P
partnerships 12–13, 14
accounting records 56, 63
acquisition by limited company
379–82
agreement 160, 168–9, 295
business name 169
capital accounts of partners see
under financial statements of
partnerships
changes in 168–9, 263–97, 383
current accounts of partners 164–8,
272
dissolution of 167, 287
realisation account and 288–95
financial statements of see separate
entry
merger
of sole trader businesses 370–2
of sole trader’s business with existing partnership 375
new partner, admission of 264–6
or convert to limited company 190
during accounting year 295–7
goodwill 266, 273, 276–84
retiring partner and 287
revaluation of assets 266, 268–72,
280–4
Partnership Act 1890 12, 160, 168, 263
retirement of partner 285–7
payback method 452, 453–7, 469
penetration pricing 417
performance bonus 448
performance evaluation 195
planning 422
prepayments 122, 123–4
general ledger 124, 126–7
price/earnings (P/E) ratio 392, 394
pricing and costing method 399–400,
401–2, 417, 420
penetration pricing 417
primary ratio 198
prime cost 311–13, 314
rate 230
prime entry, books of 27
cash book 31
control accounts 103, 106, 113
purchases journal 29–30
purchases returns journal 30–1
sales journal 28
sales returns journal 29
to ledger accounts 46–9
principle, errors of 66, 83–4
private limited companies 14, 15, 17,
169
production budgets 425–6
profit margin 200, 205
profitability ratios 196, 197, 198–200,
204–5, 393, 394
expenses to revenue ratio 200
gross margin 199
mark-up 199
operating expenses to revenue ratio
200
profit margin 200, 205
return on capital employed (ROCE)
198–9, 205
profitability versus social costs 364
profit(s) 193
calculating sole trader
changes in capital 143–7, 151
incomple