diploma in accounting 2010edit (3)

Diploma in

Accounting

D1071

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Diploma in Accounting

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Diploma in

Accounting

Unit 1: Introduction of Financial

Accounting

Module 1: Purposes of Accounting and Records

Module 2: Verification of Records – Accounts and

Balance Sheets



Diploma in

Accounting


Accounting

Module 1: Purposes of Accounting and Records



INTRODUCTION TO FINANCIAL ACCOUNTING

INTRODUCTION

Your learning will be built up from the basis of this module, as you will study the principles

of double entry bookkeeping, how to make the proper entries in the accounts and record the

transactions. You will also develop skills in correction of errors and how they affect the Profit

and Loss account and the Balance Sheet. By the end of the lesson you should be able to

prepare Final Accounts for a business.

Do not worry about the terminology used in the module as it will be explained and by the end

of the module you will become familiar with it. A glossary of accounting terms has been

included at the start of the module so that you can refer to it every time you need to.

This module is an introduction to what it is going to be the foundations of your knowledge

and skills throughout this course. It is very important that you understand how the principles

work and how to apply them in practice correctly. Make sure you cover the different topics of

the module and do the questions proposed, as accounting requires a lot of practice too.

At first you may find the module a little bit difficult, but if you work through the examples

and complete the exercises it will become easier. You will find step by step explanations of

how to record transactions, balance the accounts, correct errors, etc.



Learning objectives:

Understanding why it is important to keep records

Listing the main users of accounting information and what they are interested in

Listing the books of original entry and explaining the principle of double-entry

bookkeeping

Recording transactions from prime documents

Entering a series of transactions into T-accounts

How the double entry system follows the rules of the accounting equation

How to reconcile the business bank account with the bank statement

Balancing the accounts

How to draw up a trial balance

Preparing Financial Statements: Profit and Loss Account and Balance Sheet

Making adjustments to the accounts at the year end.

How to correct errors in the accounts



LESSON 1. PURPOSES OF ACCOUNTING

1.1 . Introduction.

Accounting affects people in their personal lives just as much as it affects very large

organisations. We all use accounting ideas when we plan what we are going to do with our

money. We can do that by writing down a plan (budget) or by simply keeping it in our heads.

However, businesses have too much financial data and it would be very difficult for an owner

or a manager to keep all the details in their heads. Therefore, they need to keep records,

accounting records.

Failing to keep proper records means that there is no way of checking the financial position

of the business. In some cases it may lead to a penalty charged by HM Revenue & Customs

or to a prosecution under the Insolvency Act. A Limited Company is bound by law to keep

financial accounts in accordance with the Companies Act.

1.2 . Why we need to keep records.

The business must at all times know what its financial position is and this will be evident

when records can be produced showing the amount owing to the business and the amount of

money it owes to other people. Records of payments made and received are very important.

These enable us to ensure these payments are made on time and to know when a customer

paid us.

The reasons for keeping records are numerous:

To provide a permanent record of financial transactions.

To provide information from which financial statements can be prepared.

To provide information from which management report can be prepared.

To provide a means of controlling assets.

To provide information for decision making.

To comply with statutory regulations.

These accounting records will contain details of all cash received and paid, goods bought and

sold, assets bought to be used not sold, and so on.

To be useful to the business, when accounting data is being recorded, it has to be classified

and then summarised. It can then be discovered how much profit or loss is being made, what

is owned by the business, and what is owed by it.



It is this information that is available in part or in whole to the range of users.

1.3 . Who is interested in the accounting records?

Apart from the management of an organisation, there are other groups, each of which may

believe it has a reasonable right to obtain information about an organisation. These groups

include the owners, shareholders, employees, lenders, suppliers, customers, competitors,

government and its branches, and the public interest. Those in the wider interest groups are

sometimes referred to as stakeholders.

Owners

They want to be able to see whether or not the business is profitable. They also want to know

what the financial resources of the business are. They need the information as quickly as

possible, as it is their responsibility to employ the resources of the business in an efficient

way and to meet the objectives of the business. The information needed to carry out this

responsibility ought to be of high quality and in an understandable form so far as the owners

are concerned.

Where the ownership is separate from the management of the business, as it is the case with a

limited liability company, the owners are more appropriately viewed as investors who entrust

their money to the company and expect something in return, usually a dividend and a growth

in the value of their investment as the company prospers. As providing money to fund a

business is a risky act, they need information to help them decide whether they should buy,

hold or sell, so that they can have a return on their investment. They are also interested in

information on the entity‟s financial performance and financial position that helps them to

assess its cash-generation abilities.

Shareholders

Year end accounts have to be supplied to all shareholders and investors. These accounts will

confirm whether or not the business is a good investment. Shareholders are interested in

evaluating the performance of the entity; assessing the effectiveness of the entity in achieving

objectives and its liquidity, its present or future requirements for additional working capital,

and its ability to raise long-term and short-term finance; estimating the future prospects of the

entity, including its capacity to pay dividends, and predicting future levels of investment.

Employees

They are interested in information about the stability and profitability of their employers.

They are also interested in information that helps them to assess the ability of the entity to

provide remuneration, retirement benefits and employment opportunities.



The matters which are likely to be of interest to employees include: the ability of the

employer to meet wage agreements; management‟s intention regarding employment levels,

locations and working conditions; job security; pay rise.

Lenders

Lenders are interested in information that enables them to determine whether their loans, and

the related interest, will be paid when due.

Loan creditors provide finance on a longer-term basis; therefore, they wish to assess the

economic stability and vulnerability of the borrower. They are particularly concerned with

the risk of default and its consequences. They may impose conditions which require the

business to keep its overall borrowing within acceptable limits. Banks will ask for cash flow

projections showing how the business plans to repay, with interest, the money borrowed.

Suppliers

Suppliers of goods and services (trade creditors) are interested in information that enables

them to decide whether to sell to the entity and to determine whether amounts owing to them

will be paid when due.

Trade creditors have very little protection if the entity fails because there are insufficient

assets to meet all liabilities. So they have to exercise caution in finding out whether the

business is able to pay and how much risk of non-payment exists. They may obtain the

information from the local press and trade journals and the Chamber of Trade, apart from the

financial statements, which may confirm the information obtained from other sources.

Customers

Customers have an interest in information about the continuance of an entity, especially when

they have a long-term involvement with, or are dependent upon, its prosperity. They need

information concerning the current and future supply of goods and services offered, price and

other product details, and conditions of sale. Much of the information may be obtained from

sales literature or form sales staff of the enterprise, or form trade and consumer journals.

The financial statements provide useful confirmation of the reliability of the enterprise itself

as continuing source of supply. They also confirm the capacity of the entity in terms of fixed

assets and working capital and give some indication of the strength of the entity to meet any

obligations under guarantees or warranties.

Competitors

They want as much pertinent information as they can get. In particular, they will want access

to the internal financial information concerning costs. They are interested in the financial

performance of the enterprise, its cash flow strength to carry out further investment or

expansion, its price structure and margins in order to assess its competitiveness and share

market, and its products.



Government

Government and their agencies are interested in the allocation of resources and, therefore, in

the activities of the entities. They also require information in order to regulate the activities of

entities, assess taxation and provide a basis for national income.

Acting on behalf of the UK government‟s Treasury Department, HM Revenue and Customs

collects taxes from businesses based on profit calculated according to commercial accounting

practices. They want to know how much tax a business should be paying, whether it is

complying with the VAT regulations, etc.

The public

They have different interests from the other stakeholders groups. They want assurance about

the behaviour and practices of the business.

All these different people may need access to the accounts of a business:

LESSON 2. ACCOUNTING RECORDS

2.1.Primary Accounting Records and the Ledgers.

When a transaction takes place, we need to record as much information as possible

about the transaction. For example, if we sold two printers on credit to ABC Ltd for

£100 each, we want to record that we sold two printers for £100 each to ABC Ltd on

credit. We will need to record the address and contact details of the company and the

date of the transaction.



A) The Books of prime, or original, entry are the books in which we first record

transactions, such as the sale of the two printers. There is a separate book for each

kind of transaction. These books are known as „journals‟ or „day books‟.

The commonly used books of original entry are:

Sales Day Book. Records all credit terms invoices sent out from the business.

Purchase Day Book. Records all credit items invoices received by the

business.

Returns Inwards Day Book. Record all Credit Notes received (Purchases Returns).

Returns Outwards Day Book. Record all Credit Notes given (Sales Returns).

Cash Book. This records incoming and outgoing payments of bank and cash.

General Journal. It is used for other items. It will be explained in more detail

later on in this lesson.

Entries are made in the books of original entry. The entries are then summarized and

the summary information is entered, using double entry, to accounts kept in the

various ledgers of the business.

When we enter transactions in these books we record:

- The date of the transaction

- The details relating to the sale or purchase

- The folio entry for cross-reference back to the original „source document‟

(invoice, credit note)

- The amount of the transaction

The Sales Day Book is simply a list of transactions, the total of which, at the end of the day, week or month, is transferred to sales account. Bear in mind

that the Day Book is not part of double-entry bookkeeping, but it is used as a

primary accounting record to give a total which is then entered into the

accounts. The most common used of a Sales Day Book is to record credit sales

from invoices issued.

Let‟s see an example:

On 1 June 2008 you sold goods for £100 on credit to E. Jones, invoice No 101

On 8 June 2008 you sold goods for £150 on credit to M. White, invoice No

102

On 15 June 2008 you sold goods for £250 on credit to T. Young, invoice No

103

Your Sales Day Book will be written up like this:

Sales Day Book

Date Details Invoice Folio Amount £



01/06/2008 E. Jones 101 SL10 100.00 08/06/2008 M. White 102 SL20 150.00 15/06/2008 T. Young 103 SL22 250.00

30/06/2008 Total for the month 500.00

The total net credit sales for the month of £500 will be transferred to sales

account in the general ledger.

The Sales Day Book incorporates a folio column which cross-references each

transaction to the personal account of each debtor, where each credit sales

transactions is recorded forming part of the Sales Ledger.

The Purchases Day Book lists the transactions for credit purchases from invoices received and, at the end of the day, week or month, the total is

transferred to purchases account.

Let‟s see an example:

On 3 June 2008 you bought goods for £80 on credit from P. Doyle, invoice No

2345

On 10 June 2008 you bought goods for £100 on credit from T. Rice, invoice

No 456

On 18 June 2008 you bought goods for £200 on credit from T. Rice, invoice

No 486

Your Purchases Day Book will be written up like this:

Purchases Day Book


03/06/2008 P. Doyle 2345 PL10 80.00 10/06/2008 T. Rice 456 PL20 100.00 18/06/2008 T. Rice 486 PL20 200.00


The total net credit purchases for the month of £380 will be transferred to

purchases account in the general ledger.

As in the Sales Day Book, the folio column gives a cross-reference to the

creditors‟ accounts and provides an audit trail. The credit purchases

transactions are recorded in the personal accounts of creditors in the Purchase

Ledger.

Returns Day Books:



The Sales Returns Day Book is for goods previously sold on credit and now

being returned to the business by its customers.

The Purchases Returns Day Book is for goods purchased on credit by the

business, and now being returned to the suppliers.

The Returns Day Books are primary accounting records and do not form part

of the double-entry bookkeeping system. The transactions are recorded from

prime documents (credit notes issued for sales returns, and credit notes

received for purchases returns). Then the information form the Day Book must

be transferred to the appropriate account in the ledger.

From the previous examples of Sales Day Book and Purchases Day Book, we

now have the following information:

On 20 June 2008 M. White returned goods for £50, credit note No CN1001

issued

On 25 June 2008 we returned goods for £100 to T. Rice, credit note No 123

received

The Sales and Purchases Returns Day Book will be written up like this:

Sales Returns Day Book

Date Details Credit Note Folio Amount £

20/06/2008 M. White CN1001 SL20 50.00


Purchases Returns Day Book


25/06/2008 T. Rice CN123 PL20 100.00


The total net sales returns and net purchases returns will be transferred to the

sales and purchases returns accounts respectively in the general ledger. And

the amounts of sales returns are credited to the debtors‟ personal accounts in

the sales ledger; in the same way, the purchases returns are debited to the

creditors‟ accounts in the purchases ledger.

Cash books. It records all transactions for bank account and cash account



Petty Cash Book. It records low-value cash payments, e.g. expenses, that are

too small to be entered in the main cash book or because there is a box in the

office with a small amount of cash for those expenses: fuel, cleaning, etc.

You are not required to prepare a Petty Cash Book in the examination.

B) The different types of Ledgers are:

Sales Ledger. It contains details of sales made to customers on credit terms. It

records:

Sales made on credit to customers of the business

Sales returns by customers

Payment received from debtors

Cash discount allowed for prompt settlement

The sales ledger does not record cash sales. It contains an account for each

debtor and records the transaction for that debtor.

Purchase Ledger. This is for details of all items which are bought on credit

terms. It contains the accounts of creditors, and records:

Purchases made on credit from suppliers of the business

Purchases returns made by the business

Payments made to creditors

Cash discount received for prompt settlement

The purchase ledger does not record cash purchases. It contains an account for

each creditor and records the transactions with that creditor.

Cash books. It records all transactions for bank account and cash account

The cash book performs two functions within the accounting system:

1. It is a primary accounting record for cash/bank transactions

2. It forms part of the double-entry bookkeeping system.

CASH BOOK

Debit Credit

Cash and bank receipts. From prime

documents:

Receipts issued

Bank paying-in slips

Bank giro credits received

BACS payment received

Credit card vouchers received

Cash and bank payments. From prime

documents:

Cheque book counterfoils

Standing order and direct debits

Debit advice from the bank: bank

charges, interest.



General Ledger. This contains the remaining double entry accounts, nominal

accounts, such as those relating to expenses, fixed assets, and capital. It

contains the accounts to record the double entry for all the items for which the

first entry has been made in any of the above Ledger sections:

Nominal Accounts:

- Sales account (cash and credit sales), sales returns

- Purchases account (cash and credit purchases), purchases returns

- Expenses and income, loans, capital, drawings

- Value Added Tax (where the business is VAT registered)

- Profit and loss

- Fixed assets: machinery, vehicles, office equipment

- Stock

You will not be required to understand the VAT system or make accounting

records of VAT.

2.2.Documents used in business transactions.

Business documents are important because they are the prime source for the recording

of

business transactions.

We have learnt earlier the different books used to record the transactions which take

place in a business: the books of prime entry. However, we do not know how to

obtain the information for those transactions.

Now you are going to study the different documents which take part in any credit

transaction and in which book that information is recorded. A credit transaction is

where goods are purchased, sold and returned without a payment being made or

received at that particular time.

When an order placed by the buyer, using a purchase order, is received by the seller, it

will be processed; at the time of supplying the goods or services a delivery note is

received by the buyer, which will contain details of the goods or services delivered,

the price charged and the quantity. The seller will request payment by issuing an

invoice, which will contain the details of the buyer, date, the goods supplied, the

quantity and total amount due and the credit terms.

A purchase order is prepared by the buyer, and is sent to the seller. The details

included in a purchase order are: number of purchase order, for tracking; name and

address of buyer; name and address of seller; full description of the goods, reference

numbers, quantity required and unit price; date issue and signature of person

authorised to issue the order.



When the goods are despatched to the buyer, a delivery note is prepared. This

delivery note accompanies the goods and gives details of what is being delivered.

When the goods are received by the buyer, a check will need to be made:

To make sure that the goods have been received

To be certain that the goods received are those that were ordered

To ensure that the correct price has been charged

To confirm that the goods are not damaged

To ensure that the proper discount has been given if appropriate

An invoice is issued to advise the customer of goods or services supplied. It is

prepared by the seller and is sent to the buyer. The invoice contains details of the

goods supplied, and states the amount to be paid by the buyer. The information

included in an invoice is: invoice number, name and address of seller, name and

address of buyer, date of sale, delivery address (if different from the invoice address),

date that goods were supplied, quantity supplied and unit price, total amount due,

details of trade discount (if any) and the credit terms.

The information is taken forma copy of the invoice and used to write up the Sales Day

Book. This starts the credit sales bookkeeping procedure.

We have mentioned „credit terms‟ and „trade discount‟. Let‟s explain what they mean:

Credit terms are stated on an invoice to indicate the date by which the invoice

amount is to be paid, e.g. „net 30 days‟ means that the amount is payable

within 30 days of the invoice date.

Trade discount is a reduction on the list price of goods. It is the amount

allowed as a reduction when goods are supplied to other businesses, but not to

the general public. The trade discount is never shown in the accounts, only the

amount after the deduction of trade discount is recorded.

Another type of discount is cash discount, which is a reduction given for

prompt payment, e.g. 5% discount for payment within seven days. The buyer

can choose whether to take up the cash discount by paying promptly, or

whether to take longer to pay without cash discount. When cash discount is

taken it needs to be recorded in the accounts.

Goods are sometimes found to be defective or wrongly priced, or over supplied. If this

is the case then the goods are likely to be returned to the seller, who will then issue a

credit note which tells the purchaser that his account is being credited with the cost

of the goods.

A statement of account will be sent out to each debtor at the end of each month. This

statement is prepared by the seller and gives a summary of the transactions that have

taken place and are still owed or outstanding. The details on a statement are: name

and address of seller, name and address of the debtor (who is the buyer), the date of

the statement, details of the transactions along with their reference number and the

amount, and the balance currently due.



From all the documents aforementioned the invoice and credit note are the ones used

to record the transactions in the Sales or Purchases Day Book, which will be the

starting point from where the total amounts will be transferred to the appropriate

Ledger: the Sales Ledger or the Purchases Ledger. In the next section you will learnt

the double entry principle and how to do entries into the Accounts.

Payments

Once we have recorded the invoices and credit notes issued and received the next step

is to request and make payment for balance shown on the accounts for each customer

and supplier when the payment becomes due.

The most common method of payment is the cheque.

Cheques are written orders from account holders instructing their banks to pay

specified sums of money to named beneficiaries. They are not legal tender but are

legal documents and their use is governed by the Bills of Exchange Act 1882, and the

Cheques Acts of 1957 and 1992.

If a cheque has counterfoil attached, it can be filled in at the same time as the cheque,

showing the information what was entered on the cheque. The counterfoil is then kept

as a note of what was paid, to whom, and when. Cheques as usually supplied in

books.

If you look at the cheque above, the drawer is Mr Mamom, and the payee will be the

person or company who the cheque is made payable to: you will write their names on

the „Pay‟ line, and below that the amount in words. The use of the double crossed

lines along with the words „A/c Payee only‟ means the cheques should be paid only

into the account of the payee named. It is impossible for this cheque to be paid into

any bank account other than that of the named payee.

If the crossing does not contain any of these three terms, „A/c Payee only‟, a cheque

received by someone can be endorsed over to someone else. The person then



receiving the cheque could bank it. For example, John Smith receives a cheque from

Tom Rice, he can „endorse‟ the cheque and hand it to Anthony Jones as payment of

money by Smith to Jones. Jones can then pay it into his bank account. Smith would

write the words „Pay A Jones or order‟ on the reverse side of the cheque and then sign

underneath it, and that is how you endorse a cheque.

Bankers' drafts are cheques drawn directly on the account of a bank rather than the

account of a customer. The comfort they provide is that it is highly unlikely they

would be returned unpaid due to lack of fund

When we want to pay money into a current account, either cash or cheques, or both,

we use a pay-in slip. The counterfoil of the pay-in slip is stamped and initialled by

the bank‟s cashier and returned to the customers a receipt. The pay-in slips used by a

business are usually in a book, with the counterfoil remaining in the book as a

permanent record.

Pay-in slips and cheque books will be furnished by the bank to the customer in order

to action movements on a bank current account. Other transactions documents

include: Standing Order and Direct Debit.

There are two main types of bank accounts:

Current Account which is used for regular payments into and out of a bank

account. They earn little or no interest.

Deposit Account is intended for funds that will not be accessed on a frequent

or regular basis. They earn more interest than current accounts.

Standing Orders are an instruction by an account holder to their bank, to pay regular

amounts of money at stated dates to defined persons or firms.

Direct Debits are an authorisation by the account holder to the creditor to obtain the

money direct from the account holder‟s bank.

BACS (an acronym for Bankers' Automated Clearing Services) is a United

Kingdom scheme for the electronic processing of financial transactions. Direct Debits

and BACS Direct Credits are made using the BACS system. BACS payments take

three working days to clear: they are entered into the system on the first day,

processed on the second day, and cleared on the third day.

The cash receipts and the till rolls contain the information of all the cash sales made

by the business on a daily, weekly or monthly basis. That information will be used to

make entries in the Cash Book Account and the Sales Account.

A bank statement is a document issued by a bank to its customers, listing details of

debit and credit transactions over a given period with a resultant balance of the

account. These statements are issued to cover a range of accounts including current

accounts, loan accounts and deposit accounts.



In the bank statement you will find information on bank charges, interest paid and

interest received. Those transactions will need to be recorded in the Cash Book

Account and the appropriate ledger.

As you can see there are a number of documents from where to extract the

information that will be used in the business to record the transactions in business

Accounts.

2.3. Initial entries. Double entry system.

The double entry system was first written down by a mathematician called Luca

Pacioli. His book was published in Venice in 1494 and was called the Summa de

Arithmetica, Geometria, Proportioni et Proportionalitia. Although the double entry

accounting has been in use for years before Pacioli wrote about it, his book is thought

to be the first printed explanation of the double entry system.

What is double entry?

It is a method of cross-checking accounting transactions. It is also a method of

describing accounting processes.

All transactions are entered into Ledger Accounts. The Account is divided into two

identical sections:

Left Hand – this is name the Debit (DR) side

Right Hand – this is named the Credit (CR) side.

The double entry principle states that every transaction must be entered in the books

twice: on the DEBIT side of one account and on the CREDIT side of another account.

For example, when you buy something you write down the value of the goods you

receive and your write down the value of the cheque that you give to the supplier. The

two values should be same. So, you are entering the amount twice = double entry.

For each transaction it is essential to identify which part is entered on the Debit side

and which part is entered on the Credit side of the two ledger accounts involved. To

work this out we must follow the “IN” and “OUT” rule.

The ”IN” part of the transaction is entered on the DEBIT side of an account.

The “OUT” part of the transaction is entered on the CREDIT side of another account.

Let‟s see this rule with an example. Example 1:

John Smith started a business on January 1st and his transactions for the first month

are as follows:



January 1st. He started with Capital of £5,000 paid into his business bank account

2nd

. He buys a van for £3,000 paid by cheque

3rd

. He purchased stock for resale for £750 by cheque

7th

. He sold goods for £250 – the money is paid into the bank

10th

. He sells more goods for £750 and the money is paid into the bank

11th

. He pays £200 rent by cheque

We draw up a table showing for each transaction the account titles to be used for the

Debit and Credit parts and the reason why are “IN” and “OUT”.

DEBIT – IN CREDIT – OUT

Jan Account Title Reason Account Title Reason

1 Bank Money received Capital Money

from owner

2 Vehicle Assets received Bank Cheque

paid

3 Purchases Stock received Bank Cheque

paid

7 Bank Money received Sales Stock

delivered

10 Bank Money received Sales Stock

delivered

11 Rent Value received

from use of

premises

Bank Cheque

paid

If you enter the amount for each transaction at each side of the table and you add them

up at the bottom you will see that they balance. The reason for this is based on the

accounting equation, and it is usually shown as:

Capital represents what the owners have invested in the business. It must equal what

the business owns (its assets) minus what it owes (its liabilities).

The rules for debits and credits are:

Debit entry (Dr) – the account which gains value, or records an asset, or an expense

Credit entry (Cr) – the account which gives value, or records a liability, or an income item

Capital = Assets – Liabilities



Dr First Account Cr

£ £

Account which gains value

or records an asset, or an

expense

Dr Second Account Cr

£ £

Account which gives value

or records an liability, or

income/revenue

When one entry has been identified as a debit or credit, the other entry will be on the opposite

side of the other account.

You can see from the picture above how the shape resembles a „T‟; that is why they are

commonly referred to as T-accounts.

For example, if you paid £10 by cheque for a book, you will enter £10 on the left hand (i.e.

debit, DR) side of the book account and on the right-hand (i.e. credit, CR) side of the bank

account:

Dr Book account Cr Dr Bank account Cr

Bank £10 Book £10

The description used is to be able to cross reference the two accounts affected. If you look at

your book account you will be able to see that you paid for your book by drawing a cheque

from your bank account. Likewise, if you look at the bank account, you can see that you took

money out of your bank account to buy a book.

At this point you need to understand that transactions increase or decrease assets, liabilities

and capital. Therefore,

To increase an asset we make a DEBIT entry

To decrease an asset we make a CREDIT entry



To increase a liability or capital account we make a CREDIT entry

To decrease a liability or capital account we make a DEBIT entry

Accounts To record Entry in the account

Assets An increase

A decrease

Debit

Credit

Liabilities An increase

A decrease

Credit

Debit

Capital An increase

A decrease

Credit

Debit

CASH BOOK

Debit Credit

Cash and bank receipts. From prime

documents:

Receipts issued

Bank paying-in slips

Bank giro credits received

BACS payment received

Credit card vouchers received

Cash and bank payments. From prime

documents:

Cheque book counterfoils

Standing order and direct debits

Debit advice from the bank: bank charges, interest.

DOUBLE ENTRY BOOKKEEPING

Sales Ledger or General Ledger Purchases Ledger or General Ledger

Debtors‟ account nominal account creditors‟ account nominal account

(money received) (interest received) (amounts paid) (rent account)

Example 2. Anthony Brown started a business on January 1st, and he has the following

transactions in the month:

1. Started with capital of £2,000 paid into the business bank account

2. Paid a cheque for £500 for the rent of the shop

3. Bought equipment for £600, paid by cheque

4. Purchased stock for resale and paid £450 by cheque

5. Returned some equipment unused. A cheque for £200 was received and paid into the

bank

7. Sold goods for £75; the money was paid into the bank

9. Bought business stationery for £12 and paid by cheque

17. Received a loan of £500 from A Finance; the cheque was banked

24. Sold more stock for £320 and the money was paid into the bank

Credit

edit:

Debit:



27. Paid wages of £35 by cheque

27. The telephone bill of £18 was paid by cheque

30. Drew a cheque for personal use for £300

You are required:

a) To draw up a table showing (for each transaction) the account titles to be used for the

Debit and Credit parts and the reasons why they are “IN” or “OUT”.

b) To write up a set of ledger accounts, which you must balance.

a) DEBIT – IN CREDIT – OUT

Jan Account Title Reason Account Title Reason

1 Bank Money received Capital Money from

owner

2 Rent Value received Bank Cheque paid

From use of premises

3 Equipment Assets received Bank Cheque paid

4 Purchases Stock received Bank Cheque paid

5 Bank Cheque received Equipment Asset returned

7 Bank Money received Sales Stock delivered

9 Stationery Goods received Bank Cheque paid

17 Bank Cheque Received Loan from Money paid

A Finance

24 Bank Money received Sales Stock delivered

27 Wages Value received Bank Cheque paid

28 Telephone Service received Bank Cheque paid

30 Drawings Money received Bank Cheque paid

(Note: Goods or stock bought for resale are called „Purchases‟, money drawn for personal

use is called „drawings‟)

b) Ledger Accounts



BANK ACCOUNT

Debit

Credit

Date Detail £ Date Detail £

Jan 1 Capital 2,000.00 Jan 2 Rent 500.00

Jan 5 Equipment 200.00 Jan 3 Equipment 600.00

Jan 7 Sales 75.00 Jan 4 Purchases 450.00

Jan 17 Loan – A Finance 500.00 Jan 9 Stationery 12.00

Jan 24 Sales 320.00 Jan 27 Wages 35.00

Jan 28 Telephone 18.00

Jan 30 Drawings 300.00

Jan 31 Balance c/d 1,180.00

3,095.00 3,095.00

Feb 1 Balance b/d 1,180.00

CAPITAL

Debit

Credit


Jan 31 Balance c/d 2,000.00 Jan 1 Bank 2,000.00


RENT

Debit

Credit


Jan 2 Bank 500.00 Jan 31 Balance c/d 500.00

Feb 1 Balance c/d 500.00



EQUIPMENT

Debit

Credit


Jan 3 Bank 600.00 Jan 5 Bank 200.00

Jan 31 Balance c/d 400.00

600.00 600.00

Feb 1 Balance b/d 400.00

PURCHASES

Debit

Credit




SALES

Debit

Credit


Jan 31 Balance c/d 395.00 Jan 7 Bank 75.00

Jan 24 Bank 320.00

395.00 395.00


STATIONERY

Debit

Credit






LOAN - A FINANCE

Debit

Credit


Jan 31 Balance c/d 500.00 Jan 17 Bank 500.00


WAGES

Debit

Credit



Feb 1 Balance 35.00

TELEPHONE

Debit

Credit



Feb 1 Balance 18.00

DRAWINGS

Debit

Credit



Feb 1 Balance 300.00



2.4. Balancing the account

At regular intervals, often at the end of each month, accounts are balanced in order to show

the amounts of purchases, sales, purchases returns, sales returns, fixed assets (premises,

machinery), etc.

How do we balance the accounts?

Balancing the accounts is done in five stages:

1. Add up both sides to find out their totals, but do not write anything in the accounts

yet.

2. Deduct the smaller total from the larger total to find the balance.

3. Now enter the balance on the side with the smallest total. This is the balance to be

carried down (c/d). Do not forget to enter the last day of the period.

4. Enter totals on a level with each other.

5. The balance is then brought down (b/d), on the other side, below the totals. This is

the starting amount for the next period. Do not forget to enter the first day of the next

period.

BANK ACCOUNT

Debit

Credit


Jan 1 Capital 2,000.00 Jan 2 Rent 500.00

Jan 5 Equipment 200.00 Jan 3 Equipment 600.00

Jan 7 Sales 75.00 Jan 4 Purchases 450.00

Jan 17 Loan – A Finance 500.00 Jan 9 Stationery 12.00

Jan 24 Sales 320.00 Jan 27 Wages 35.00

Jan 28 Telephone 18.00

Jan 30 Drawings 300.00

Jan 31 Balance c/d 1,180.00

3,095.00 3,095.00


This is the balance

to be carried down These are the totals on

a level with each other



Diploma in

Accounting


Accounting

Module 2: Verification of Records – Accounts and

Balance Sheets



LESSON 3. VERIFICATION OF ACCOUNTING RECORDS

3.1. The trial balance

You have learnt that under the principle of double entry bookkeeping that for each debit entry

there is a credit entry, and for each credit entry there is a debit entry.

At the end of an accounting period, which is usually 12 months, a trial balance is extracted from

the accounting records in order to check the arithmetical accuracy of the double-entry

bookkeeping, i.e. that the debit entries equal the credit entries.

A trial balance is a list of the balances of every account forming the ledger, distinguishing

between those accounts which have debit balances and those which have credit balances.

The intervals at which a trial balance can be extracted are usually at the end of the month and/or

at the end of the accounting period (usually 12 months).

How to prepare a trial balance?

The Trial Balance is not an account, it is a list of accounts which have a balance.

The first step in preparing a trial balance is to go through the Ledger and balance all the

accounts, including the Cash Book.

The balance is always brought down, and the side on which it is brought down is the side it is

entered into the Trial Balance.



Example:

B&N Ltd

Trial Balance as at 31 December 2007

£ £

Dr Cr

Stock at 31 Dec

4,000.00 Capital

8,680.00

Bank

825.00 Purchases

7,280.00

Cash

150.00

Wages

950.00 Sales

9,670.00

Fixtures and Fittings 1,050.00 Motor vehicles

2,000.00

Office Equipment

435.00 Insurance

275.00

Advertising

350.00 Debtors

2,035.00

Creditors

1,000.00

19,350.00 19,350.00

Usually, Debit balances are Assets or Expenses; Credit balances are Liabilities (including

Capital) or Incomes.

If the total debits agree with the total credits then the Trial Balance is balanced. This does not

necessarily means that no errors have been made, because there are certain types of errors which

do not show up in the Trial Balance. These will be explained later.

When the Trial Balance does not balance it indicates that one or more entries are missing or

incorrect.

Always total each side of the Trial Balance and calculate the difference. That could be the amount has been omitted.

The error could be an incorrect addition or a transposition, where you intend to write for instance 145 but instead you enter 154.

Alternatively it may help to halve the difference and then see if it has been put in the

wrong side.

If the amount is exactly divisible by 9, this could be as a result of transposition.



Check that the balance of each account has been correctly entered in the trial balance, and under the correct heading, i.e. debit or credit.

Check the calculation of the balance of each account.

If the error is still not found, it is necessary to check the bookkeeping transactions since the date of the last trial balance, by going back to the original documents and primary

accounting records.

Practice: Now go back to Example 2 in section 2.3 above and extract the Trial Balance.

3.2. The general journal

The Journal is the last of the Books of Original Entry. Any entries which do not go through the

day books, cash books or petty cash book should be entered in the Journal.

The Journal is the book of Prime, or Original, Entry for items for which there is no Day Book,

for example:

Opening entries

Purchase and sale of fixed assets on credit (e.g. cars, plant and machinery, office equipment)

Introduction o f assets to the business by the owner

Entries for period-end and year-end adjustments

Transfer of year end balances following preparation of Final Accounts

Corrections of errors

The Journal provides a written record of the details of a transaction and enables an explanation to

be recorded. It is a primary accounting record; it is not part of the double-entry bookkeeping

system. The journal is used to list the transactions that are then to be put through the accounts.

What are the reasons for using a journal?

The reasons are:

To provide a primary accounting record for non-regular transactions

To eliminate the need for remembering why non-regular transactions were put through

the accounts – the journal acts as a notebook

To reduce the risk of fraud, by making it difficult for unauthorised transaction to be entered in the accounting system

To reduce the risk of errors, by listing the transactions that are to be put into the double-entry accounts

To ensure that entries can be traced back to a prime document, thus providing an audit

trail for non-regular transactions



Look at the layout of the journal:

Journal

Date Details Folio Dr Cr

01-Jan-08 Bank CB 10,000.00

Capital GL 10,000.00 Opening capital introduced

Remember:

All items must be dated.

The account to be debited is always entered before the account to be credited.

The account to be credited should be written a little to the right under the name of the account to be debited.

Each entry must have a supporting narrative, with reference to whatever document

supports the entry, such as „invoice number‟ or „management instructions‟

The folio column cross-references to the division of the ledger where each account will be found

A journal entry always balances, i.e. debit and credit entries are for the same amount or total.

The Journal is not a double entry account. Once the journal entry is made, the entry in the

double entry accounts can then be made.



Examples of journal entries:

Journal J1

Date Details Folio Dr Cr

Sept 3 Motor vehicle account GL4 14,500.00

Carlan Ltd PL7 14,500.00 Purchase of Fleet car Invoice No 0246

Sept 4 C. Chapman SL8 135.00 Equipment Account GL5 135.00 Sale of computer cover

Invoice No 123

Sept 5 Machinery account GL3 6,800.00 Machine Tool Co. PL8 Buy printer Invoice No MTC/47

Sept 6 Bank CB1 800.00 Capital GL10 800.00

Owner introduces £800 into business

After the journal entry has been made, the transaction can be recorded in the double-entry

accounts:

BANK ACCOUNT CB1

Date Details Folio £ Date Details Folio £

Sept 6 Capital J1 800.00

MOTOR VEHICLE ACCOUNT GL4


Sept 3 Carland Ltd J1 14,500.00



MACHINERY ACCOUNT GL3


Sept 5 Machine Tool Co J1 6,800.00

C. CHAPMAN SL8


Sept 4 Computer Cover J1 135.00

CAPITAL ACCOUNT G10


Sept 6 Bank J1 800.00

CARLAND LTD G10


Sept 3 Fleet Car J1 14,500.00

EQUIPMENT ACCOUNT GL5


Sept 4 C. Chapman J1 135.00



MACHINE TOOL COMPANY PL8


Sept 5 Machinery account J1 6,800.00

If the trial balance does not balance, i.e. the two totals are different, there is an error or more than

one error: either in the addition of the trial balance and/or in the double-entry bookkeeping.

3.3. Checking the ledger.

As mentioned earlier in this course, a trial balance does not prove the complete accuracy of the

accounting records. There are six types of errors that are not shown by a trial balance:

1. Error of omission

2. Reversal of entries

3. Error of commission

4. Error of principle

5. Error of original entry (or transcription)

6. Compensating error

1. Error of omission. Entry missed out completely

An invoice for a transaction may be omitted completely, as in the case of a purchase

invoice not being entered into the purchases day books. The entry is then not made into

the credit side of the supplier‟s account, e.g. a transaction is made for £200 but the

invoice is not entered into the system. The day book and nominal ledger totals will be the

same but will be the amount of the invoice short. The trial balance will also balance but

again will be that amount short.

2. Reversal of entries. This happens when the entry is posted to the wrong side of the

account, e.g. P. Long buys goods to the value of £150 but this amount is credited to his

account instead of being debited. The same amount is debited to the sales account. The

double entry is complete but the entries are in reverse. Correcting this type of error

involves doubling the amount – once to eliminate the error and again to put in the correct

item.

3. Error or commission. The amount to be posted has been entered into the wrong specific

account but into an account of the same general type, e.g. D. West has been credited with

£20 instead of D. J. West. Both of these accounts are personal accounts in the Purchases

ledger and in this case the double entry has been completed.



4. Error of principle. The amount posted has not only gone to the wrong account but that

account is a different type of account. An example of this is where, after the purchase of a

motor van for £1,800, the amount has been posted to the Motor Expenses Account

(nominal ledger) instead of the Motor Van account (capital account). Here, capital

expenditure has been treated as revenue.

5. Error of original entry. The wrong figure has been used in both the postings. An example

of this is when an invoice is over or understated when entered into the system, e.g. D.

Smith bought goods for £150 but the amount entered into the sales day book was £105.

The amount of £105 from the sales day book will be posted to the sales account which

will result in both accounts being understated by £45.

6. Compensating error. This is where one error cancels out another of the same value but is

not connected, e.g. the wages account is overstated by £200 and the purchases account is

understated by £200. This will mean that the errors will cancel one another out when the

totals are transferred to the trial balance.

As you can see now, all these errors may occur and yet the Trial Balance will still balance. A

trial balance that balances only confirms that the arithmetic is correct but all the entries may not

be.

3.4. Bank Reconciliation

The bank account kept by the business is unlikely to show the same balance as the bank

statement. Why do you think this is?

Probably you are thinking that there is an error, as it would be the first thing most people would

think. The error may have been made either by the business or by the bank. Nevertheless, that is

not normally the case, although there may be discrepancies in some of the items in the bank

statement and the bank account kept by the business.

Apart from the event of a possible error made, there are other reasons which explain why the

balance is different:

The bank may make entries which the business has not taken into account, e.g. bank

charges or bank interest. Those amounts may not be known until the statement is

received. However, with established business accounts the banks will now often advise

the charges and interest in advance before the transaction date. This gives the customer

the advantage of being able to discuss the charges with the bank and make any savings on

the type of transactions he or she uses.

Payments may be made to the business, or on behalf of the business, by means of standing orders or direct debits. With standing order. We instruct the bank as to how



much is to be paid. With a direct debit we give the third party the right to let the bank

know how much is to be debited.

There may be differences due to the timing of transactions. Cheques are received and paid into the bank, these are recorded and added to the bank account, by the business. At

this time the bank may not have cleared them. Cheques paid-out will have to be sent to

the creditor, paid-into the creditors‟ bank and then processed; this means a delay of

several days.

There are two things to notice regarding the statement:

1. It uses the running balance format

2. The entries are the opposite to the Cash Book Accounts in the company‟s books of

account, i.e., the Debit side is for Payments, the Credit side is for Receipts.

This is because, from the bank‟s point of view, the business is a creditor of the bank, unless the

account is overdrawn).

Some abbreviations used on a bank statement are explained at the foot of the page, but I have

listed examples of some of the most common ones;

SO = standing order

DD = direct debit

TR = transfer

OD = balance overdrawn

Stages in the reconciliation

1. When studying the bank account and the bank statement majority of entries will agree:

these you need to tick off, so that you can concentrate on finding the entries which do not

agree.

Remember: you are looking for receipts which you have entered in the debit side of your

cash book bank account and which also appear on the credit side of the bank statement.

Likewise, payments will have been entered on the credit side of your cash book bank

account and on the debit column of the bank statement.

2. When that stage is complete, you may have some items unticked in both the cash book

bank account and the statement.

The items left unticked on the statement will be amounts that have been recorded by the

bank but not the business. The cash book needs to be updated with this information

before the account can finally be balanced off. The account will normally have been left

“open” so that these adjustments can be made when the statement arrives.

These items may include bank charges or interest, etc.



3. We are now left with the items left unticked in the cash book. These differences are

probably due to the time delay. These differences need to be reconciled with the bank

statement. This is done by means of a bank reconciliation statement showing the effective

date of this action.

Let‟s see how it is done with an example. We will start with the balance of the bank statement

and reconcile it to the Cash Book:

CASH BOOK BANK ACCOUNT


Apr 1 E. Slater 540.00 Apr 2 F. Keeble 24.00

Apr 12 B. Brockle 600.00 Apr 7 J. Wessley 252.00 Apr 20 B. Young 926.00 Apr 14 R. Hull 74.00

Apr 27 K. Palm 69.00 Apr 26 D. Rogers 418.00 Apr 30 J. Bow 700.00 Apr 30 C. Holme 370.00

Apr 30 Balance c/d 1,697.00

2,835.00

2,835.00 Apr 30 Balance b/d 1,697.00

BANK STATEMENT

Date Detail Dr Cr Balance

Apr 2 E. Slater 540.00 540.00 CR

Apr 6 F. Keeble 24.00 516.00 CR Apr 11 J. Wessley 252.00 264.00 CR s/o W. Tyre 100.00 164.00 CR Apr 13 B. Brockle

600.00 764.00 CR

Apr 17 R. Hull 74.00 690.00 CR

d/d W. Tebb 125.00 565.00 CR

Apr 20 B. Young

926.00 1,491.00 CR Tr. K. Robb

50.00 1,541.00 CR

Apr 27 K. Palm

69.00 1,610.00 CR Apr 30 Bank Charges 10.00 1,600.00 CR K. Palm. Cheque returned 69.00 1,531.00 CR

Required: Prepare a bank reconciliation statement as at 30 April with the information provided.

1. Tick off the common items.

2. Now you should be left with:



Bank Account: J. Bow

D. Rogers

C. Holme

Statement: s/o W. Tyre

d/d W. Tebb

tr. K. Robb

Bank charges

K. Palm. Returned cheque

3. Update the Bank Account – DR balance £1,443, as illustrated below

4. Prepare the Statement of Reconciliation.

CASH BOOK BANK ACCOUNT


Apr 30 Balance b/d 1,697.00 Apr 11 W. Tyre 100.00

Apr 20 tr. K Robb 50.00 Apr 17 W. Webb 125.00

Apr 30 Bank charges 10.00

Apr 30 K. Palm. Returned cheque 69.00

Apr 30 Balance c/d 1,443.00

1,747.00

1,747.00

May 1 Balance b/d 1,443.00



BANK RECONCILIATION STATEMENT

AS AT 30TH

APRIL

£ £

Balance per Bank Statement 1531

ADD outstanding lodgement

30th

April – J. Bow 700

2231

Deduct cheques not presented

26th

April – D. Rogers 418

29th

April – C. Holme 370

788

Total 1443

Balance per Cash Book 1443

A bank reconciliation statement is important because, in its preparation, the transactions in the

bank columns of the cash book are compared with those recorded on the bank statement. In this

way, any errors in the cash book or bank statement will be found and can be corrected (or

advised to the bank, if the bank statement is wrong).

The bank statement is an independent accounting record, therefore it will assist in deterring fraud

by providing a means of verifying the cash book balance.

By writing the cash book up-to-date, the organisation has an amended figure for the bank balance

to be shown in the trial balance.

Unpresented cheques over six months old – out-of-date cheques – can be identified and written

back in the cash book (any cheque dated more than six month‟s ago will not be paid by the

bank).

It is good practice to prepare a bank reconciliation statement each time a bank statement is

received. The reconciliation statement should be prepared as quickly as possible so that any

queries – either with the bank statement or in the firm‟s cash book – can be resolved. Many firms

will specify to their accounting staff the timescales for preparing bank reconciliation statements

– as a guideline, if the bank statement is received weekly, then the reconciliation statement

should be prepared within five working days.

If the bank account is overdrawn, the reconciliation should be carried out in the same way but

with the balance in the minus, e.g.:

Bank statement balance: £100 OD

In the Bank Reconciliation statement your will enter:



£ £

Balance per Bank Statement -100 or (100)

3.5. Control Accounts

As a business grows and the number of Debtors and Creditors increase, a far tighter check must

be kept on the Total Balances and also the accuracy of the double-entry.

Control accounts enable us to do this and to speed up the job of calculating total balances for

both Creditors and Debtors.

Control account, like the Trial Balance and Bank Reconciliation, acts a checking device for the

individual accounts which it controls. Thus, control accounts act as an aid to locating errors: if

the control account and subsidiary accounts agree, then the error is likely to lie elsewhere. In this

way the control account acts as an intermediate checking device – proving the arithmetical

accuracy of the ledger section.

The two commonly-used control accounts are:

Sales ledger control account – the total of the debtors

Purchases ledger control account – the total of the creditors

The layout of a sales ledger control account (or debtors‟ control) is shown below:

Dr Sales Ledger Control Account Cr

£ £

Balance b/d (large amount) Balance b/d (small amount)

Credit sales Cash/cheques received from debtors

Returned cheques Cash discount allowed

Interest charged to debtors Sales returns

Balances c/d (small amount) Bad debts written off

Set-off/contra entries

Balance c/d (large amount)

Balances b/d (large amount) Balances b/d (small amount)



Balance b/d. The usual balance on a debtor‟s account is debit and so this will form the large

balance on the debit side. However, it is possible for some debtors to have a credit balance on

their accounts because they has paid for goods and then returned them, or because they have

overpaid in error.

Credit sales. Only credit sales, and not cash sales, are entered in the control account because it is

this transaction that is recorded in the debtors‟ accounts. The total sales of the business will

comprise both credit and cash sales.

Returned cheques. If a debtor‟s cheque is returned unpaid by the bank, i.e. the cheque has

„bounced‟, then entries have to be made in the bookkeeping system to record this. These entries

are:

Debit debtor‟s account

Credit bank account

As the transaction has been made in a debtor‟s account, then the amount must also be recorded in

the sales ledger control account, on the debit side.

Interest charged to debtors. Sometimes a business will charge a debtor for slow payment of an

account. As a debit transaction has been made in the debtor‟s account, so a debit entry must be recorded in the control account.

Bad debts written off. The entries are:

Debit bad debts written off account

Credit debtor‟s account

As a credit entry has been made in a debtor‟s account, the transaction must also be recorded as a

credit transaction in the control account.

Set-off/contra entries. These entries occur when the same person or business has an account in

both sales and purchases ledger, i.e. they are both customer and supplier. To save having to write

out a cheque to send to each other, it is possible to set-off one account against the other.

The layout of a purchases ledger control account (or creditors‟ control account) is shown below:

Dr Purchases Ledger Control Account Cr

£ £

Balance b/d (small amount) Balance b/d (large amount)

Cash/cheques paid to creditors Credit purchases

Cash discount received Interest charged by creditors

Purchases returns Balances c/d (small amount

Set-off/contra entries

Balance c/d (large amount)

_________ ________

_________ ________

Balances b/d (small amount) Balances b/d (large amount)



Balances b/d. For purchases ledger, containing the accounts of creditors, the large balance b/d is

always on the credit side. However, if a creditor has been overpaid, there may be a small debit

balance b/d.

Credit purchases. Only credit purchases, and not cash purchases, are entered in the control

account. However, the total purchases of the business will comprise both credit and cash

purchases.

Interest charged by creditors. If creditors charge interest because of slow payment, this must

be recorded on both the creditor‟s account and the control account.

Set-off/contra entries. See the explanation given above under Sales Ledger Control Account.

Control accounts use totals. Those totals come from a number of sources in the accounting

system:

Sales ledger control accounts:

- total credit sales (including VAT), from the „gross‟ column of the sales day book

- total sales returns (including VAT), from the „gross‟ column of the sales returns day book

- total cash/cheques received from debtors, from the cash book

- total discount allowed, from the discount allowed column of the cash book, or from

discount allowed account

- bad debts, from the journal, or bad debts written off account

purchases ledger control accounts:

- total credit purchases (including VAT), from the „gross‟ column of the purchases day

book

- total purchases returns (including VAT), from the „gross‟ column of the purchases returns

day book

- total cash/cheques paid to creditors, from the cash book

- total discount received, from the discount received column of the cash book, or from

discount received account.

Whilst many businesses merely use Control Accounts as a checking device there are businesses

which actually integrate Control Accounts into their double entry bookkeeping system. In such

circumstances the individual accounts of debtors and creditors are kept only as memorandum

accounts, and the balances of the sales ledger control account and the purchase ledger control

account are recorded in the trial balance as the figures for debtors and creditors respectively.



3.6. Suspense accounts and errors

Whist certain errors will not be disclosed by the Trial Balance (error of omission, commission,

principle, original entry, reversal of entries and compensating errors), there are of course errors

of an arithmetical nature which the Trial Balance is designed to detect. Such errors include:

Entries are posted without completing double entry. There may be debits without

corresponding credits or vice versa.

Different amounts are posted as debit and credit entries.

An account is incorrectly totalled or balanced.

Balances shown on the Trial Balance have been listed incorrectly – there may be

omissions, duplications or transpositions.

Where the total columns of the Trial Balance fail to agree an investigation into the reason(s) for

the imbalance will have to be carried out. As a temporary measure we will open a Suspense

Account, and by posting the difference in books amount to it, bring the books into balance.

In addition to using the Suspense Account to deal with errors the Suspense Account may also be

used as a „holding account‟. This usually occurs in cases where the correct posting of a

transaction is uncertain due to lack of information, or where a transaction is of a complicated or

unusual nature. This should only be used as a temporary measure until further information

becomes available, following which the posting can be removed from the Suspense Account and

posted correctly.

If the errors are not found before the financial statements are prepared, the suspense account

balance will be included in the balance sheet. Where the balance is a credit balance, it should be

included on the capital and liabilities side of the balance sheet. When the balance is a debit

balance it should be shown on the assets side of the balance sheet. You will learn about assets

and liabilities and the balance sheet in the final section of this unit.

Remember: when the errors are found they must be corrected, using double entry. Each

correction must first have an entry in the journal describing it, and then be posted to the accounts

concerned.

The Trial Balance on 31 December 2007 had a difference of £168. It was a shortage on the debit

side.

A suspense account is opened, and the difference of £168 is entered on the debit side. On 31 May

2008 the error was found. We had made a payment of £168 to K Lee to close his account. It was

correctly entered in the Cash Book, but was not entered in K Lee‟s account.



First of all, the account of K Lee is debited with £168, as it should have been in 2007:

K Lee

May 31 Bank £168 Jan 1 Balance b/d £168

Second, the suspense account is credited with £168 so that the account can be closed:

Suspense Accounts

Jan 1 Difference per trial balance £168 May 31 K Lee £168

And the Journal entry is:

The Journal

Dr Cr

May 31 K Lee 168

Suspense 168

Correction of non-entry of payment last year

in K Lee‟s account

The effect of errors on profits:

Some of the errors will have meant that original profits calculated will be wrong. Other errors

will have no effect upon profits.

If an error affects items only in the balance sheet, then the original calculated profit will not need

altering. For example, an error involving a creditor‟s account.

If an error is in one of the figures shown in the trading and profit and loss account, then the

original profit will need altering. For example, an undercast of sales account, when corrected,

will increase gross and net profits and consequently the profit figure shown in the balance sheet.



Example:

T Morton‟s Trading and Profit and Loss Account for the year ended 31 December 2007 shows a

profit of £1,600, the Balance Sheet has a suspense account with a debit balance of £60. On 31

March 2008 you discovered that the debit balance of £60 was because the rent account was

added up incorrectly. The journal entries to correct it are:

The Journal

Dr Cr

March 31 Rent 60

Suspense 60

Correction of rent undercast last year

Rent last year should have been increased by £60. This would have reduced net profit by £60. A

statement to correct profit for the year is now shown:

T Morton

Statement of Corrected Net Profit for the year ended 31 December 2007

£

Net profit per the accounts 1,600

Less Rent understated (60)

1,540

Note: Only those errors which make the trial balance totals different form each other ca be

corrected via the suspense account.

Summary of the effect on profit and balance sheet:

Look at the diagram below which shows the effect of errors when corrected on gross profit, net

profit and the balance sheet:



TRADING ACCOUNT

Correction of error Gross profit Net profit Balance sheet

Sales undercast/understated increase increase net profit increase

Sales overcast/overstated decrease decrease net profit decrease

Purchases undercast/understated decrease decrease net profit decrease

Purchases overcast/overstated increase increase net profit increase

Opening stock undervalued decrease decrease net profit decrease

Opening stock overvalued increase increase net profit increase

Closing stock undervalued increase increase net profit increase

Stock increase

Closing stock overvalued decrease decrease net profit decrease

Stock decrease

PROFIT AND LOSS ACCOUNT


Expense undercast/understated - decrease decrease in net profit

Expense overcast/overstated - increase increase in net profit

Income undercast/understated - increase increase in net profit

Income overcast/overstated - decrease decrease in net profit

BALANCE SHEET


Asset undercast/understated - - increase asset

Asset overcast/overstated - - decrease asset

Liability undercast/understated - - increase liability

Liability overcast/overstated - - decrease liability



LESSON 4. FINAL ACCOUNTS

4.1 Introduction.

At the end of each financial year various financial statements are prepared on behalf of a

business organisation. Such statements, which give details of its operating activities and financial

standing, are commonly referred to as Final Accounts.

Many businesses, however, prepare financial statements on an ongoing basis say monthly,

quarterly or half-yearly. These can be used to monitor, plan and control the activities of the

business, and are known as Management Accounts or Periodic Financial Statements.

The financial statements usually consist of a:

Trading Account

Profit and Loss Account

Balance Sheet

Where a business provides only a service, rather than trades (buys and sells), it will prepare only

a Profit and Loss Account and Balance Sheet.

Where a business manufactures the goods in which it trades then it will prepare a Manufacturing

Account in addition to the Trading and Profit and Loss Account and Balance Sheet.

In practice the financial statements are prepared either by transferring appropriate balances from

accounts within the ledgers, or by listing account balances appearing within the ledgers.

The Trading and Profit and Loss Accounts are used to calculate profit or loss. The Balance Sheet

reflects the financial position of the business as at the end of the financial period and is drawn up

by listing and categorising all balances on accounts as at a particular point in time.

What is profit?

Essentially, it is revenue from the sale of goods and services minus expenditures incurred

in the creation of those goods and services

The starting point for preparing final accounts is the trial balance. All the figures recorded on the

trial balance are used in the final accounts. The trading account and the profit and loss account

are both „accounts‟ in terms of double-entry bookkeeping. This means that amounts recorded in

these accounts must also be recorded elsewhere in the bookkeeping system. By contrast, the

balance sheet is not an account, but is simply a statement of account balances remaining after the

trading and profit and loss accounts have been prepared.



Remember that apart from the owner of the business there are other parties who will need to

know whether the company is profitable or whether it has been running at a loss. The people

interested in this information would include:

The Bank

Shareholders

Creditors

Revenue & Customs

The Final Accounts must be accurate. Mistakes should be discovered and the corrections made.

These accounts are based on figures provided by all the other accounts kept by the business and

the trial balance must have been balanced before you can proceed any further.

4.2 Profit and Loss account. Gross and net profit.

The main reason why people set up businesses is to make profits. However, if the business is not

successful, it will incur losses instead.

The owners want to know the actual profits of the business, which will help them in planning

ahead, obtaining loans from banks or private individuals, in calculating the correct amount of tax

that has to be paid to the Revenue.

The profits are calculated by drawing up a special account called Trading and Profit and Loss

Account. Nowadays it is simply called „Profit and Loss Account‟.

The account in which profit is calculated is split into two sections:

One in which the gross profit is found: Trading Account

the next section in which the net profit is calculated: Profit and Loss Account

1. The Trading Account. This account, prepared by transferring the balances on other

accounts within the General Ledger, is used to calculate the Gross Profit of the business

for a particular period of trading.

Gross Profit is the excess of sales revenue over the cost of goods sold. Where the cost of

goods sold is greater than the sales revenue, the result is a gross loss. The calculation

being:

Income from Net Sales (sales less sales returns)

Less Cost of Goods Sold = Gross Profit



The cost of goods sold figure is made up of a combination of account balances which

normally includes:

Opening stock

Add purchases

Less purchase returns

Add carriage inwards

Less closing stock

= Costs of Goods Sold

2. The Profit and Loss Account. This also an account prepared by transferring balances

from General Ledger accounts. The objective is to calculate the net profit or loss of the

business for a defined period of business activity. To do so we add to the Gross Profit for

the period any revenue income earned, but from non-trading activities, and then deduct

the revenue expenses associated with selling, distribution and administration:

Gross Profit (from Trading Account)

Add other non-trading income

Less expenses

= Net Profit / Loss

Remember: Before drawing up a trading and profit and loss account you should prepare the trial

balance, after all the adjustments have been made. (You will learn about those adjustments later

in this unit.)

The layout of the Profit and Loss Account:

[Business Name]

Trading and Profit and Loss Account for the year ended [accounting period date]

£ £

Sales X

Less: Cost of sales

Opening stock (+) X

Purchases (+) X

X

Closing stock (-) (X)

[subtotal of cost of sales] (X)

Gross profit [sales minus cost of sales subtotal] X

Less: Expenses

[category of expenses] (+) X



[subtotal of expenses] (X)



Net profit / (loss) [gross profit minus subtotal of expenses] X

Here is an example of the Profit and Loss Account of Swift, a trader:

Swift

Trading and Profit and Loss Account for the year ended June 30, 2008

£ £

Sales 150,000

Less: Costs of sales

Opening stock 18,000

Purchases 107,000

125,000

Closing stock (20,000)

(105,000)

Gross profit 45,000

Less: Expenses

Rent 12,000

Wages 10,000

Advertising 8,000

(30,000)

Net profit 15,000

Click on the link below and on the right-hand side of the page you will see different headings

which summarise what you have learnt about Profit and Loss Account. You will also find an

example of Mark and Spencer‟s Profit and Loss Account.:

http://www.tutor2u.net/business/presentations/accounts/profitlossaccount/default.html.

Revision P&L Account

You can try your understanding of this topic by trying a quiz on Profit and Loss Account in the

following link: http://www.tutor2u.net/business/quizzes/as/profit_and_loss/quizmaker.htm.

Quiz on P&L



http://www.tutor2u.net/business/presentations/accounts/profitlossaccount/default.html

http://www.tutor2u.net/business/quizzes/as/profit_and_loss/quizmaker.htm

4.3 Balance Sheet. Fixed assets, current assets, current liabilities.

We have seen earlier that the trading and profit and loss account shows two types of profit (gross

profit and net profit) for the financial year. However, the balance sheet is not an account but a list

of assets and a list of liabilities and capital to show the financial position of the business at a

particular point in time, but is not part of the double-entry bookkeeping system. It also contains

the capital account that represents the owner‟s interest in the business.

In drawing up a balance sheet, we do not enter anything in the various accounts. We do not

actually transfer the fixtures and fittings balance or the creditors balance, or any of the other

balances, to the balance sheet.

All we do is to list the asset, capital and liabilities balances so as to form a balance sheet.

However, nothing is entered in the ledger accounts and when the next accounting period starts,

these accounts are still open and they all contain balances.



Here is the general layout of the Balance Sheet:

[Business Name]

Balance Sheet as at [last day of accounting period]

£ £ £

Fixed assets

[category] (+) X

[category] (+) X

X

Current assets

Stock (closing stock) X

Debtors X

Bank X

[current assets total] X

Current liabilities

Creditors X

Bank overdraft X

[current liabilities total] (X)

Net current assets [current assets total – current liabilities total] X

X

Long-term liabilities

Bank loan (X)

Net assets [assets minus liabilities] AX

Capital account

Opening balance X

Net profit for the year X

X

Less drawings (X)

BX



Here is the Balance Sheet for Swift:

Swift

Balance Sheet as at June 30, 2008

£ £ £

Fixed assets

Office equipment 15,000

Motor vehicles 85,000

100,000

Current assets

Stock 21,000

Debtors 30,000

51,000

Current liabilities

Creditors 15,000

Bank overdraft 16,000

(31,000)

Net current assets 20,000

120,000

Long-term liabilities

Bank loan (50,000)

Net assets A

Capital account

Opening balance 80,000

Net profit for the year 15,000

95,000

Drawings (25,000)

B

If the Balance Sheet has been constructed correctly, the total at A and B will be the same.

Remember: if they are not the same, you have made an error somewhere! But do not worry, it

will get easier once you have worked through a few examples.

70,000

70,000



Assets

Assets are items or amounts owned or owed to the business, and are normally listed in increasing

order of liquidity, i.e. the most permanent assets are listed first, i.e., those the business will keep

the longest are listed first, down to those which will not be kept so long:

Fixed Assets:

Land and buildings

Fixtures and fittings

Machinery

Motor vehicles

Fixed Assets are long-term assets. They are assets that are to be used in the business for a

long time but were not bought primarily to be sold. They are divided between tangible

fixed assets, which have material substance, e.g.: buildings, machinery motor vehicles,

fixtures and fittings; and intangible fixed assets, which do not have material substance,

but belong to the business and have value, e.g., goodwill. Goodwill is where a business

has bought another business and paid an agreed amount for the existing reputation and

customer connections.

Intangible fixed assets are listed before the tangible fixed assets.

Current Assets are short-term assets which are likely to change from day-to-day. They

include items held for resale, amounts owed by debtors, cash in the bank. They are listed

in increasing order of liquidity. Examples: stock, debtors, bank (if not overdrawn) and

cash. We start with the asset furthest away from being turned into cash:

Current Assets: Stock

Debtors

Cash at bank

Cash in hand

Net current asset is a very useful figure. A typical business will have a stock of

materials, money owing to it (debtors) and some funds in the bank. Those are the current

assets, as you have just learnt. They represent those things the business has used its

capital to acquire that are constantly changing. There are other things that do not belong

to the business but which it has temporally and which help it to continue working. These

can include amounts owed to suppliers (creditors) and an overdrawn bank account.



All these items, both those that belong to the business and those that it has temporally,

change on a day-to-day basis and they are known as working capital.

In the Balance Sheet, the ones that belong to the business are called current assets and

those that it has temporary use of are called current liabilities. When you subtract the

current liabilities from the current assets, you get the net current assets or working

capital figure:

Working capital = current assets – current liabilities

If the value of working capital is low or negative, the business might have financial

problems if it had to pay back its current liabilities. This is why the net current asset

figure is important.

Liabilities

Liabilities are items or amounts owed by the business. There are two categories of liabilities:

current liabilities and long-term liabilities.

Current liabilities are amounts owing at the balance sheet date and due for repayment

within 12 months or less, e.g., creditors, bank overdraft.

Long-term liabilities are borrowings where repayment is due in more than 12 months,

e.g., bank loans, loans from other businesses.

Capital

Capital is money owed by the business to the owner. If you look back to the example of Balance

Sheet you will see that we showed the owner‟s investment at the start of the year (opening

balance), then we added up the profit for the year and we deducted drawings for the year; this

equals the owner‟s investment at the end of the balance sheet‟s date.

For a revision of the Balance Sheet, click on the following link and use the headings on the right-

hand side of the web page:

www.tutor2u.net/business/presentations/accounts/balancesheet/default.html. Revision of the

Balance Sheet.

Now try the following quiz on Balance Sheet:

http://www.tutor2u.net/business/quizzes/as/balance_sheet/quizmaker.htm. Quiz on Balance

Sheet



http://www.tutor2u.net/business/presentations/accounts/balancesheet/default.html

http://www.tutor2u.net/business/quizzes/as/balance_sheet/quizmaker.htm

4.4 Adjustments: prepayments, accruals, bad debts, depreciation (straight-

line method)

The Trading and Profit and Loss Account should provide the reader with a „true and fair‟ account

of the operational activities, in terms of the profit or loss, of a business for a particular period of

business activity.

The Balance Sheet should provide the reader with a „true and fair view‟ of the financial standing

of a business as at the end of a particular period of business activity.

In order that the financial statements (Profit and Loss and Balance Sheet) are „true and fair‟,

account balances within the books may have to be adjusted to reflect the operating activities of a

business, and its financial standing. Such adjustments include accounting for prepayments and

accruals, depreciation, debtor adjustments, stock (you will learn about stock valuation in

module three)

The fundamental accounting concept known as matching requires that the profit/loss calculation

for a trading period be the result of Income earned in a trading period less expenses incurred

during the same period.

The calculation of profit/loss merely by deducting cash paid out in a period from cash received in

a period is not an acceptable method of calculating profit/loss.

Period end adjustments are necessary because some of the information required for the

preparation of financial statements only becomes available after the end of the accounting period.

In addition, some things are either paid early (e.g. telephone line rental, rent, insurance) or paid

late (e.g. electricity, telephone call charges) and certain judgements need to be made concerning

the use of fixed assets, the status of debtors and the valuation of closing stock.

Prepayments are amounts paid in advanced of the accounting period to which it relates.

Accruals are amounts due in an accounting period which is unpaid at the end of that period.

As a result of accounting for prepayments and accruals the correct amount, in terms of income

earned and expense incurred during a period of trading, will be transferred from the General

Ledger to the Trading and Profit and Loss Account. Furthermore, any prepayment or accrual

adjustment appearing on an income or expenditure account in the General Ledger, at the

financial period end, will be listed on the Balance Sheet as either a current asset or current

liability.

Adjustments may be necessary to account for items of income and expense in terms of:

Amounts paid in advance.

Amounts received in advance.



Amounts payable in arrears.

Amounts receivable in arrears.

Examples:

Accruals:

Assume that a business has a 31 December year end. It received quarterly gas bills of £200 on 31

August, £250 on 30 November and £360 on 28 February. What is its gas expense for the year?

To start we open up a T account and show the bills of £200 and £250, which have occurred

during the period have been paid from the bank account on those dates.

Gas expense

August 31 Bank 200

November 30 Bank 250

The business received a gas bill for £360 for the three months to the end of February. One of the

three months is December, so the accrual is 1/3rd

of the £360, which is £120. This accrual is

debited in the T account for gas and credited to an „accruals‟ T account (a Balance Sheet

creditor).

Gas expense

August 31 Bank 200


December 31 Accruals 120

Accruals

December 31 Gas 120

We now balance the gas account with a balancing figure of £570 which is transferred to the

profit and loss account:

Gas expense

August 31 Bank 200


December 31 Accruals 120 P&L A/c 570

570 570

Accruals



December 31 Balance c/d 120 December 31 Gas 120

December 31 Balance b/d 120

The closing balance of £120 appears in the balance sheet as a creditor due within one year.

At the start of the next accounting period this accrual must be transferred back to the gas expense

account because this outstanding gas expenses will actually be paid during the next accounting

period.

Prepayments:

The same business paid rates on 1 April 2007 for the year ended 31 March 2008.

We start off by opening up the rates ledger account and posting the payments on the debit side.

Rates expense

April 1 Bank 4,400

Now we calculate the prepayment. The business has prepaid for January, February and March of

2008, which is 3 months, so the prepayment is 3/12th

of £4,400 which is £1,100

The prepayment of £1.100 is debited to a „prepayments‟ T account (a Balance Sheet asset, like a

debtor) and credited to the rates T account thus reducing the rates expense in 2007.

Rates expense

April 1 Bank 4,400

December 31 Prepayments 1,100

Prepayments

December 31 Rates expenses 1,100

We are now in position to balance off the rates expense account. The balancing figure comes to

£3,300, which is taken to the Profit and Loss Account.

Rates expense

April 1 Bank 4,400 P&L A/c 3,300

December 31 Prepayments 1,100

4,400 4,400



Prepayments

December 31 Rates expenses 1,100 December 31 Balance c/d 1,100

December 31 Balance b/d 1,100

The closing prepayment of £1,100 appears in the Balance Sheet as a current asset.

At the start of the next accounting period this prepayment must be transferred back to the rates

expense account because it represents the rates expense that the business will incur in January,

February and March of 2008.

Bad debts

When a business is unable to collect a debt from a credit customer (trade debtor) the result is

reduced profit.

Despite the best efforts of a business regarding credit control it is inevitable that where a

business gives credit to customers bad debts will follow.

A bad debt materialises when an amount due from a credit customer is deemed to be

uncollectible. At this point in time the business has given up trying to collect the debt and is

being prudent by recognising that a loss has been incurred.

A bad debt is a debt owing to a business which it considers will never be paid.

The accounting for a bad debt is as follows:

You will transfer the amount uncollectible from the customer account in the Sales

Ledger, where it represents an asset, to a Bad Debts Account in the General Ledger,

where now represents an expense. The balance on the Bad Debts Account will then be

transferred at the financial year end to the Profit and Loss Account. Both transactions

need to be supported by Journal entries.

Provision for doubtful debts

A provision is the estimate of likely loss, which it is anticipated may result from debtors, who

currently owe the business money, failing to pay at some time in the future.

Whereas a bad debt occurs in circumstances where the customer who defaults on payment is

known, this is not the case when making a provision for doubtful debts.

You will not be required to do entries for the provision of doubtful debts. Therefore, we are not

going to spend any more time on this.



Example:

Michelle has debtors of £15,000. However, Charlie, who owes £800, has just been declared

bankrupt so Michelle decides to write off the debt.

We start off with a debit balance in our debtors‟ account of £15,000. The double entry in respect

of the debt to be written off is to debit the bad debt expense account £800 and credit debtors

£800. As consequence, our debtors total falls to £14,200. At the end of the accounting period, we

post the bad debt expense to the Profit and Loss Account.

Debtors

Balance b/d 15,000 Bad debt expense - Charlie 800

Balance c/d 14,200

15,000 15,000

Balance b/d 14,200

Bad debt expense

Debtors – Charlie 800 P&L A/c 800

Depreciation

Before you learn the calculation and accounting for depreciation it is important to understand the

two types of business expenditure: revenue expenditure and capital expenditure.

Revenue expenditure. It has a short tem effect on the profit making capacity of the

business and does not add to the value of fixed assets. As a result it is transferred each

year to Trading and Profit and Loss Account, e.g. repairs to a van.

Capital expenditure. It has a long term effect on the profit making capacity of the

business. It included the acquisition costs of fixed assets, along with other costs which

may be incurred in making a fixed asset operational or/and improving its profit making

capacity. Included in such amounts will be legal costs of acquiring the fixed asset and

carriage inwards.

As there is a benefit derived from the use of fixed assets over several accounting periods, their

costs is spread as fairly as possible over the accounting periods which benefit from their use.



Depreciation is a way of measuring the amount of the fall in value of fixed assets over a period

of time. It is an estimate of likely loss in value.

Factors causing depreciation:

Physical deterioration: assets such as plan and machinery, vehicles, equipment, etc., are subject to loss in value due to usage and wear and tear.

Time: assets such as leases, patents and copyrights are depreciated by the passing of time.

Economic reasons: obsolescence, e.g. computers and hi-tech equipment are constantly under development; inadequacy, e.g. a piece of equipment no longer meets the needs of

the business.

Consumption/Depletion: assets such as quarries, mines and forests are depreciated based on the fact that they are of a wasting nature.

Methods of calculating depreciation:

The two most common methods of calculating depreciation are:

Straight-line method

Reducing balance method

We are going to focus on the straight-line method. With this method, a fixed percentage is

written off the original cost of the asset each year. The annual depreciation charge is calculated

as:

Cost of asset – estimated residual value

Number of years‟ expected use of asset

For example, a machine bought for £2,000 is expected to have a residual value of £400 after an

useful economic life of 4 years, do the depreciation amount will be:

£2,000 - £400 = £400 per year

4 years



Self Assessment Examination Preparation (SAP)

SAP’s are designed to familiarise students with their materials and prepare you to

formulate answers when you take your online examinations.

These questions are ‘active learning’ and submission to the tutor department is optional.

Question 1

1) Jonathan started a business selling medals on June 1, 2008. The transactions for his first

month of trading are as follows:

June:

2 Opened a business bank account and deposited £10,000 of his own money as capital.

2 Installed a safe and paid the supplier £2,400 by cheque.

3 Bought medals on credit for £4,350.

3 Paid an insurance premium of £650 by cheque.

4 Bought medals by cheque for £653.

5 Bought stationery costing £611 and paid by cheque.

8 Paid advertising costs of £1,000 by cheque.

10 Sold medals for £3,050 and received a cheque from the customer for the full amount.

12 Sold medals on credit for £2,000.

15 Bought medals on credit for £6,892.

16 Medals with a selling price of £350 were returned by a credit customer.

17 Paid an agency £650 for administrative assistance.

19 Paid £340 for car hire.

22 Received £1,000 from debtors.

23 Sold medals on credit for £2,060.

24 Returned medals that had originally cost £706 to a credit supplier.

25 Paid business telephone bills of £80.

29 Sold medals for £830, which was settled by cheque on the same day.

30 Paid creditors £7,800.

Required:

a) Write up the above transactions in ‘T’ accounts and balance the accounts at April 30,

2008.

(10 marks)



(for quality of presentation: plus 1 mark)

b) Extract a Trial Balance as at April 30, 2008.

(10 marks)


2) Explain what interest each of the following stakeholders may have in the accounts of a

business:

a) Government (2 marks)

b) Lenders (2 marks)

c) Customers (2 marks)

d) Suppliers (2 marks)

Total for this question: 30

Question 2

Tina has extracted the following Trial Balance from the accounting records of her livery business at 31

December 2007:

£



Motor vehicles – cost 70,000

Motor vehicles – accumulated depreciation 45,000

Rent 5,500

Insurance 1,236

Sales 41,028

Stock 532

Wages 15,123

Drawings 8,561

Bank 2,060

Creditors 1,040

Debtors 2,300

Purchases 12,000

Sundry expenses 332

Capital 30,576

Additional information not yet recorded in the books of account at 31 December 2007:

1) Stock at December 31, 2007 had originally cots £620.

2) A demand for rent of £3,000 for the period December 1, 2007 to March 1, 2008 had not

been paid by December 31, 2007.

3) During the year, an insurance premium of £600 was paid for the year ending 31 March,

2008.

4) Fixed assets are depreciated at a rate of 25% per annum using the straight line method.

Tina would like you to prepare her accounts for the year ending December 31, 2007.

Required:

a) Prepare a Trading and Profit and Loss Account for the year ending December 31, 2007.

(20 marks)




b) Prepare a Balance Sheet as at December 31, 2007.

(12 marks)


Total for this question: 34 marks

Question 3

1) Anthony is preparing the financial statements for his business, which buys and sells

fireworks. His accounting year ended on March 31, 2008. His Trial Balance at March 31,

2008 included the following items:

£

Sales 19,572,002

Purchases 5,871,601

Stock at April 1, 2007 12,673,007

Anthony conducted a stock count after the close of business on March 31, 2008. He established

that he was holding stock valued at £13,131,131.

Required:

a) Calculate Anthony’s gross profit for the year based on the information given above.

b) You have now discovered that a fire broke out in Andrew’s warehouse on March 31,

2008. All the stock was destroyed.

Calculate Anthony’s gross profit for the year in the light of this additional

information.

c) On further investigation, it transpires that stocks that originally cost Anthony

£5,780,444 cam be salvaged. These have been damaged by water from the firemen’s

hoses, but can be sold to domestic customers. The damaged fireworks are expected to

be sold for £4,500,000.

Calculate Anthony’s gross profit for the year in the light of this additional

information. (9 marks)


2) You are given the following Trial Balance:



R. Thomson Trial Balance as at 31st December 2007

Dr Cr

£ £

Capital 42,294

Drawings 1,000

Premises 20,400

Plant and Machinery 1,700

Fixtures and Fittings 900

Motor Vehicles 1,250

Sales 9,562

Purchases 4,831

Advertising 260

Stationery 565

Insurance 724

Wages 4,650

Motor expenses 900

Debtors 2,073

Creditors 3,061

Cash 62

Bank 6,093

Rates 629

Heating and Lighting 1,484

Sundries 1,023

Opening Stock 6,089

54,633 54,917

On investigating the difference in the Trial Balance you discover the following errors:

1. Cash sales of £276 on 6th

April have not been entered in the Sales account.

2. A Purchase Day Book total has been entered as £1,260 instead of £1,620.

3. Goods to the value of £100, returned by a customer, were entered to the credit of the

Returns Outward Account.

Required:

Write up the Journal entries. Open a Suspense Account, starting with the difference in the Trial

Balance and then show that your Journal entries clear this account.

(4 marks)


3) The Cash Book of J. Smith for the month of December is as follows:

CASH BOOK

BANK ACCOUNT




Dec 1 Balance b/d 107.00 Dec 2 F. Wood 170.00

Dec 5 D. Jones 214.00 Dec 10 A. Patel 83.00

Dec 12 S. Milton 197.00 Dec 15 E. Roberts 205.00

Dec 17 J. Mathews 272.00 Dec 29 R. Singh 789.00

Dec 31 B. Rix 503.00 Dec 31 Balance c/d 46.00

1,293.00

1,293.00

Jan 1 Balance b/d 46.00

The bank statement is received:

BANK STATEMENT

Date Detail Dr Cr Balance

Dec 1 Balance b/d 107.00

Dec 5 F. Wood 170.00 63.00 OD

Dec 7 D. Jones

214.00 151.00

Dec 12 A. Patel 83.00 68.00

Dec 13 S. Milton

197.00 265.00

Dec 18 E. Roberts 205.00 60.00

Dec 18 J. Mathews

272.00 332.00

Dec 26 Credit transfer 76.00 256.00

Dec 31 Bank Charges 23.00 233.00

Required:

Prepare a Bank Reconciliation Statement as at December 31st.

(4 marks)





Question 4

1) Control Accounts. You have received the following information:

Balances at the beginning of the year 2007:

Purchase Ledgers Balances £10,624

Sales Ledgers Balances £18,210

The totals for the year:

Purchases Day Book £172,860

Sales Day Book £317,621

Returns Outward Day Book £1,073

Returns Inward Day Book £893

Cheques paid to Suppliers £175,000

Petty Cash paid to Suppliers £65

Cheques received from Customers £302,601

Discounts Allowed £5,041

Discounts Received £2,671

Bad Debts Written off £814

Dishonoured cheques from customers £563

Amount to be Set Off between Purchases

and Sales Ledger Accounts £1,021

Required:

From the above information prepare and balance the Sales Ledger and Purchase Ledger Control

Accounts for the year 2007.

(9 marks)


2) Explain what control accounts are and how they can be used to keep order in the

accounting system.

(6 marks)




Diploma in

Accounting Unit 2: Financial and Management

Accounting

Module 3: Types of Business Organisations, Accounting

Concepts and Further Aspects

Module 4: Internal Final Accounts of Limited

Companies, Ratio Analysis and the Assessment of

Business Performance

Module 5: Introduction to Budgeting and Budget

Controle – ICT in Accounting



Diploma in

Accounting

Unit 2: Financial and Management

Accounting

Module 3: Types of Business Organisations, Accounting

Concepts and Further Aspects



FINANCIAL AND MANAGEMENT ACCOUNTING

INTRODUCTION

You will learn the different types of business entities and their differences, how to prepare

financial statements for sole traders and limited companies after making adjustments to their

final accounts.

You will be introduced to the accounting concepts and why they are important when

preparing financial statements.

In this module you will also learn how to analyse the performance of a business and

recommend a course of action which will benefit the business; you will evaluate their

financial strengths and weaknesses.

An introduction to budgeting will give you an understanding of the purposes of it and you

will learn how to prepare a cash budget.

Finally you will learn the application of ICT in accounting and how they can benefit to a

business.



Learning objectives:

Understanding financial accounting

Developing the ability to produce final accounts for sole traders and limited

companies.

Understanding the concepts which underlie the preparation of financial statements and

how they are applied.

Understanding the differences of a sole trader, a partnership and a limited company

and how their financial structure differs.

Evaluating the performance of sole traders and limited companies.

Understanding the purposes of budgeting

Preparing cash budgets.

Developing skills on making adjustments to final accounts, using the accounting

concepts to prepare financial statements, and reporting the performance of a business

by making recommendations and explaining the consequences.

Developing a good understanding of what information financial statements can

provide and their limitations.



LESSON 5. TYPES OF BUSINESS ORGANISATION

1.1 Introduction.

Why is it important to understand the different types of business organisations?

Depending on the business organisation there will be different organisational structure and

different legal requirements. Each one of them will have its advantages and disadvantages

and the type of business entity chosen by an individual or group of individuals will be based

on many different reasons: the level of liability, adequacy to the type of business, the size of

the business, etc.

A business organisation or a business entity is a business that exists independently of those

who own the business.

In this lesson you will study the three main categories of business entities, which are: sole

trader, partnership and limited liability company. We will cover each one of them and the

differences between them.

Before you continue reading the next sections, take out a business telephone directory or the

yellow pages, or do a search on internet. Write down the names of five different businesses or

organisations. Then while you are reading the sections attempt to match your list against the

information provided in each. If you find that you have the same type of business

organisation in your list, go back and search again for a different type of business. Also find

out more information about the business or organisation.

1.2 Sole Trader.

A sole trader is an individual who enters into business alone, either selling goods or

providing a service. It is the most common form of ownership in the UK. It may have one or

more employees.

The reasons why some people decide to set up as a sole trader vary. The sole trader may

have a good idea which appears likely to make a profit, and he or she has the cash needed to

buy all the resources to start the business. The start up is cheap and easy, as there are only a

few forms to fill in and to start trading the sole trader only needs to set up a bank account and

inform the tax office.

Although this is the form in which many businesses have started, it is one which is difficult to

expand because the sole trader will find it difficult to arrange additional finances for

expansion.



If the business is not successful and the sole trader is unable to meet obligations to pay

money to others, then those persons may ask a court of law to authorise the sale of the

personal possessions, and even the family home, of the sole trader.

For accounting purposes, the business is regarded as a separate economic entity, of which the

sole trader is the owner who takes the risk of the bad times and the benefit of the good times.

However, a sole trader is liable for any debts that the business incurs.

If you remember when you studied Module One, in Lesson One we covered the stakeholders

who are interested in accounting information. Think of who would be interested in the

accounting information of a sole trader.

The owner may hardly feel any need for accounting information because he or she knows the

business very closely, however, other persons or entities may need accounting information of

the business. For example, the government, in the form of HM Revenue and Customs, for

tax collecting purposes; the bank, for the purposes of lending money to the business; another

sole trader, partnership or limited company who are intending to buy the business.

On the other hand, the business accounts do not need to be filed with Companies House, what

means that they are not made available to the public, there is not access to the accounting

information of a sole trader. Thus, competitors cannot see what you are earning, how the

business works and if it is making a profit or a loss.

What are the advantages of setting up as a sole trader?

Total control of the business by the owner.

It is cheap and easy to start up.

The business affairs are private.

The owner keeps all the profits.

A sole trader has also legal requirements to meet:

They must keep proper business accounts and records for Revenue and Customs, who

collect the tax on profits, and for VAT, if the business is registered.

They must comply with legal requirements concerning protection of the public (e.g.

Public Liability Insurance), the customer (e.g. Sale of Goods Act), the employees, if

they have them (e.g. Employer‟s Liability Insurance, contract of employment)

Although a sole trader would be the easiest and cheapest type of entity to start up a business

and the formalities are reduced to a minimum, it is not always the most advantageous one.

There are some disadvantages of being a sole trader; the main ones to bear in mind are the

following:

Unlimited liability. A sole trader is personally liable for any debts that the business

incurs. He or she will respond with their own personal possessions to pay creditors

and debtors if the business continues making a loss. They not only lose the money

they invested into the business but also they will personally liable for any outstanding

debt of the business.



Difficulty to raise finance. As they are small, banks will not lend them large sums

unless they secure the loans with their own homes or a guarantor.

Continuity. There is a problem of continuity if the sole trader retires or dies.

Difficulty to enjoy economies of scale. A sole trader may not be able to buy in bulk

and enjoy the same discounts as larger businesses.

Despite those disadvantages there are reasons why sole traders are successful. They can offer

specialist and personalised services to customers; they can be more sensitive to the needs of

customers, as they are closer to the customer and can react more quickly, because they are the

decision makers too; they can cater for the needs of local people, they are personally closer to

the local community as the owner is the person people can see and not some far off town,

which will build up trust in the community.

Do you know any sole trader in your area? What type of business they run?

1.3 Partnership.

A partnership is a business where there are two or more owners of the enterprise. It is one

method by which the business of a sole trader may expand. It is governed by the Partnership

Act 1890.

A partnership is defined as grouping of, in general, between 2 and 20 people, “carrying on

business in common with a view of profit”.

Most partnerships are, in general, between two and twenty members; however, there are some

exceptions:

For firms of accountants, solicitors or Stock Exchange members there

is no limit.

For Banks, there is a maximum of 10 partners.

What are the reasons for joining together in partnership?

The reasons why they may want to join are because they wish to combine:

a) Capital. A combined amount of capital will make a business more effective.

b) Expertise. Each member or partner has expertise in different areas. For example, two

lawyers may form a partnership, one an expert in conveyancing, one an expert in wills

and trusts.



c) Responsibility. In partnership, decisions and responsibility for them will be shared. It

is helpful to discuss difficult situations with others.

However, in a partnership, as with a sole trader, partners are each liable to the full extent of

their personal possessions for the debts of the partnership. If the business is unsuccessful, the

consequences are similar to those for the sole trader. Persons to whom money is owed by the

business may ask a court of law to authorise the sale of the personal property of the partners

in order to meet the obligation.

A partnership may be established as a matter of fact by two persons starting to work together

with the intention of making a profit and sharing it between them. It is usual to have a formal

partnership agreement legally drawn up, that agreement is called Deed of Partnership. This

will cover such matters as:

o How the profit are to be split

o Capital to be contributed by the partners

o How Goodwill is to be valued

o Arrangements covering the retirement or death of a partner

o Rules on how to take on a new partner

o How the partnership is brought to an end, or how a partner leaves

In the case that there is no partnership agreement the provisions of the Partnership Act 1890

apply.

For accounting purposes the partnership is seen as a separate economic entity, owned by the

partners. The owners may feel that accounting information is not very important for them.

Nevertheless, each partner may wish to be sure that he or she is receiving a fair share of the

partnership profits. Other persons requesting accounting information are HM Revenue and

Customs, banks who provide finance, and individuals who may be invited to join the

partnership so that it may expand even further.

The advantages of a sole trader becoming a partnership are:

Spreads the risk across more people; so if the business gets into difficulty then there

are more people to share the burden of debt

Partner may bring money and resources to the business

Partner may bring other skills and ideas to the business, complementing the work

already done by the original partner

Increased credibility with potential customers and suppliers, who may see dealing

with the business as less risky than trading with just a sole trader

The main disadvantages of becoming a partnership are:

Have to share the profits



Less control of the business for the invidual

Disputes over workload

Problems if partners disagree over the direction of business

1.4 Limited liability company.

Historically, as the UK changed from a predominantly agricultural to a predominantly

industrial economy in the nineteenth century, it became apparent that owners needed the

protection of limited liability. This meant that if the business failed, then the owners might

lose all the money they had put into the business but their personal wealth would be safe.

As you can see the main risk attached to a sole trader or a partnership is that of losing

personal property and possessions, including the family home, if the business fails. For

people or businesses who have a claim against the company, „limited liability‟ means that

they can only recover money from the existing assets of the business; they can not claim the

personal assets of the owners to recover amounts owed by the company.

A limited liability company, commonly known as limited company (abbreviated to „Ltd’),

is a business that is owned by its shareholders, run by the directors and whose liability is

limited.

„Limited liability‟ means that the investors can only lose the money they have invested and

no more.

There are two forms of a limited liability company:

1. The private limited company has the word „Limited‟ or abbreviated „Ltd‟ in its

name: King Limited or King Ltd. It is prohibited by law from offering its shares to the

public, so it is a form of limited liability appropriate to a family-controlled business.

2. The public limited company has the abbreviation „plc‟ in its name: British Telecom

plc. It is permitted to offer its shares to the public. In return it has to satisfy more

onerous regulations. Where the shares of a public limited company are bought and

sold on a stock exchange, the public limited company is called a listed company

because the shares of the company are on a list of shares prices.

The owners, in either type of company, are called shareholders because they share the

ownership and the profits and losses of the company. They have the obligation to pay in full

for their shares, but they face no further risk of being asked to contribute to meeting any

obligations of the business. The share of the profit that the shareholders receive is called

dividend.

The persons running the business on a day-to-day basis are called the directors. In the case

of a very small company, the owners may run the business themselves; therefore, the

shareholder and the director will be the same person. However, if the company is larger, then

they may prefer to pay someone else to run the business; in this case, the directors will have

to report to the shareholders in the Annual General Meeting.



Limited companies are required to produce annual accounts which will be sent to their

shareholders. They are also lodged with the Registrar of Companies where they can be

viewed and copied by any member of the public. They become public knowledge.

As you studied in the first module there will be many people other than the shareholders who

will be interested in looking at a company‟s accounts. These include competitors,

Government, employees, loan creditors, shareholders and analysts. Others that will be

looking at the accounts include customers, potential shareholders and trade creditors. They

will want as much information as possible regarding their particular interest area.

The legal requirements concerning the formation, running and reporting of companies are

found in the Companies Act 1985 (as amended by the 1989 Act). The new Companies Act

2006 will come in force in 2009.

To set up as a limited company, a company has to register with Companies House and is

issued with a Certificate of Incorporation. Each company is governed by two documents,

known as the Memorandum of Association and the Articles of Association. The

memorandum consists of five clauses for private companies, and six for public companies,

which contain the following details:

The name of the company.

The part of the UK where the registered office will be situated.

The objects of the company.

A statement (if a limited liability company) that the liability of its members is limited.

Details of the share capital which the company is authorised to issue.

A public limited company will also have a clause stating that the company is a public

limited company.

The Articles of Association will cover such matters as:

Rights of shareholders

Voting rights

Powers and duties of directors

Borrowing powers

Accounts and audit

The memorandum is said to be the document which discloses the conditions which govern

the company‟s relationship with the outside world; and the Articles of Association govern the

internal relationships and regulations.

For accounting purposes the company is a separate „legal entity‟, with an existence separate

from the owners.



1.5 Summary.

The table below shows the differences between a partnership and a limited liability company

that are relevant for accounting purposes:

Partnership Limited liability company

Formation Formed by two or more persons,

usually with written agreement

but not necessarily in writing.

Formed by a number of persons

registering the company under the

Companies Act, following legal

formalities. In particular there must

be a written memorandum and

articles of association setting out the

powers allowed to the company.

Running the

business

All partners are entitled to share

in the running of the business.

Shareholders must appoint directors

to run the business (although

shareholders may appoint

themselves as directors).

Accounting

information

Partnerships are not obliged to

make accounting information

available to the wider public.

Companies must make accounting

information available to the public

through the Registrar of Companies.

Meeting

obligations

All members of a general

partnership are jointly and

severally liable for money owed

by the firm.

The personal liability of the owners

is limited to the amount they have

agreed to pay for shares.

Powers to

carry out

activities

Partnerships may carry out any

legal business activities agreed

by the partners.

The company is seen in law as a

separate person, distinct from its

members. This means that the

company can own property, make

contracts and take legal action or be

the subject of legal action.

The table below identifies the differences between the public limited company and the private

limited company that are relevant for accounting purposes:

Public company Private company

Running the

business

Minimum of two directors. Minimum of one director.

Must have a company secretary

who holds a relevant

qualification (responsible for

ensuring the company complies

with the requirements of

company law).

The sole director may also act as the

company secretary and is not

required to have a formal

qualification.

Ownership Shares may be offered to the

public, inviting subscription.

Shares must not be offered to the

public. May only be sold by private

arrangements.



Minimum share capital £50,000

No minimum share capital.

Accounting

information

Extensive information required

on transactions between

directors and the company.

Less need for disclosures of

transactions between directors and

the company.

Information must be made public through the Registrar of Companies.

Provision of financial information to the public is determined by size of

company, more information being required of medium and large

companies.

Accounting information must be sent to all shareholders.

LESSON 6. ACCOUNTING CONCEPTS

As you have learnt so far there are different parties interested in the affairs of a business and

they require different kind of information. All have different needs from the financial

statements (Trading and Profit and Loss Accounts and Balance Sheet) they read.

The financial statements need to be accurate, true and fair in order to be reliable and of value

to those using them. The Trading and Profit and Loss Account should present a true and fair

view of the operating activities of a business for a particular period of trading, whilst the

Balance Sheet should present a true and fair picture of the financial standing of a business as

at a particular point in time.

How is this objective achieved? There is set of rules and guidelines which have been

developed and they are set out in various statements of Standard Accounting Practice

(SSAPs) and Financial Reporting Standards (FRSs). These rules produced by the main

accountancy bodies are used when recording financial information and preparing financial

statements.

Whilst the accounting standards are not themselves legally binding, the Companies Act 1989

brought in the requirement that Accounts must state whether they have been prepared in

accordance with applicable accounting standards. In addition the Act requires that any

departures from the standards must be detailed with the reasons for the departure.

The more general rules which apply to the recording and treatment of financial information

are known as accounting concepts. These rules provide parameters within which the

accountant may exercise judgement when processing financial information and preparing

financial statements.

These concepts are derived from experience and reason and that is why they are flexible and

subject to ongoing development and revision. The concepts are known as Generally

Accepted Accounting Practices.



Fundamental accounting concepts:

These comprise a set of concepts considered so important that they have been enforced

through accounting standards and/or through the Companies Act.

Five concepts have been enforced through the Companies Act:

1. Going concern concept

2. Consistency concept

3. Prudence concept

4. Accruals concept

5. The separate determination concept

A sixth concept has been enforced through an accounting standard, FRS 5:

6. Reporting the substance of transactions

1. Going concern.

The going concern concept implies that the business will continue to operate for the

foreseeable future.

When preparing financial statements, values are based on the assumption that the business

will continue into the foreseeable future. However, there are cases where the going concern

assumption should not hold:

If the business is going to close down in the near future.

If a shortage of cash makes it almost certain that the business will have to cease trading.

If a large part of the business will almost certainly have to be closed down

because of a shortage of cash.

As you can see, a far different valuation would be placed on assets from which the business

will benefit fully in the long term as it continues to operate in the normal way than would be

placed on those same assets should the business be forced into liquidation or had to reduce

the scale of its activities. That is why it is necessary that the validity of the going concern

assumption is established, as it has a significant affect on the valuation placed on certain

assets, stocks and fixed assets in particular.

2. Consistency.

The consistency concept requires that, when a business adopts particular accounting

methods, it should continue to use such methods consistently.

Each business must choose the approach that gives the most reliable picture of the business,

not just for this period, but over time also. There must be consistency of accounting treatment

of like items within each accounting period and from one period to the next. The application

of consistent procedures facilitates a valid comparison of performance from period to period.



Example: a business decides to make a provision for depreciation on machinery at twenty per

cent per annum, using the straight-line method. That business should continue to use that

percentage and method for future final accounts for that asset.

However, that does not mean that the business has to follow the method until it closes down.

A change in procedure, method or policy can be make provided there are good reasons for so

doing, and a note to the final accounts would explain what has happened, e.g., when the

outcome is a fairer and more reliable measure of business events.

Other examples of the use of the consistency concept are: stock valuation and the application

of the materiality concept (which you will study later in this lesson).

3. Prudence

The prudence concept also known as „conservatism‟ requires that a cautious approach is

adopted when processing and using financial information. It is the accountant‟s duty to

endeavour to present accurate facts in the financial statements. Assets must not be value too

highly; nor should amounts owed by a business be understated.

The prudence concept requires that all losses (costs) are recognised immediately they become

known whereas all gains (revenue) should be recognised only when they are realised (certain

to be received). As a result, profits are not to be anticipated and should only be recognised

when it is reasonably certain that they will be realised; at the same time all know liabilities

should be provided for.

An example of the prudence concept is where a provision is made for bad debts (you will

learn more in the next lesson): it is expected, from experience, that a certain percentage of the

debtors will eventually need to be written off as bad debts; for that reason, it is prudent to

provide for bad debts as a percentage of the amount owed to the business by its customers.

The valuation of stock (which you will study in module 3 of the A Level) also follows the

prudence concept.

4. Accruals (or matching) concept

Profit or loss calculated on the basis of cash accounting, i.e. the result of cash received in a

period less cash paid out in a period, whilst it would be completely objective as a measure of

profit is not normally acceptable. Instead the accountant is required to calculate profit or loss

resulting from:

Revenue income earned within a defined period of trading less revenue expenditure incurred

during the same defined period.

Determining the expenses used up to obtain the revenues is referred to as matching expenses

against revenue. The key to the application of the concept is that all income and charges

relating to the financial period to which the financial statement relate should be taken into

account without regard to the date of receipt or payment.

If you remember in the previous module you studied how expenses and revenues were

adjusted in the Profit and Loss account to take note of prepayments and accruals. This



concept is also used in the adjustments for closing stocks, depreciation of fixed assets,

provision for doubtful debts and writing-off bad debts.

5. Separate determination concept

In the financial statements, all similar items are grouped together. For example, all the motor

vehicles are grouped together under one heading, „motor vehicles‟. When calculating the

aggregate amount of each asset or liability, the amount of each individual asset or liability

should be determined separately from all other assets and liabilities.

For example, if you have three machines, the amount at which machinery is shown in the

financial statements should be the sum of the valued calculated individually for each of the

three machines. Only when individual values have been derived should a total be calculated.

Underlying accounting concepts and conventions:

There are a number of accounting concepts which have been applied ever since financial

statements were first produced for external reporting purposes.

The historical cost concept

It means that assets are normally shown in the financial statements at a value based on their

original cost.

This concept derives from the principle of objectivity in that the valuation shown in the

accounts is documented by the invoice as proof of the amount paid to acquire an asset or in

payment of an expense. There are no valuations to apply, which are subjective and may vary

depending on the circumstances. As there is a prime document (e.g. invoice) that confirms

the amount recorded in the accounts, it is verifiable.

Valuing assets at their cost to you is objective, as you are adhering to and accepting the facts.

You are not placing your own interpretation on the facts. As a result, everyone else knows

where the value came from and can see that there is very good evidence to support its

adoption.

For example, a vehicle costing £12,500 is recorded at that amount; stock of goods for resale

which cost £5,000 is recorded at that historical cost.

This concept is the most commonly used method for asset valuation.

However, what will happen to falls in value of an asset? This is dealt with by using

depreciation methods in the accounts. It is a subjective technique, but is well-recognised in

accounting; your need to use your own judgement to arrive at a cost. Also the effects of

inflation is a disadvantage of the historical cost concept, as there is no definite way for

dealing with it in the accounts.

This concept is an extension of money measurement, which you will learn next.

Money measurement concept

Accounting information has traditionally been concerned only with those facts that:



- Can be measured in financial terms, and

- Most people will agree to the financial value of the transaction.

This means that, in the final accounts, all items are expressed in the common denominator of

money. Therefore, accounting can never tell you everything about a business, as it has

difficulty in recording the more qualitative or intangible factors of a business. For example,

the expertise or motivation of the workforce; the relationships between managers and

workforce; and between them and the outside world. Such factors, although they may be of

benefit or to the detriment of a business, cannot be evaluated in monetary terms and are not

reflected within the accounts.

Business entity concept

The business is assumed to have its own identity which is separate from that of its owners.

Transactions recorded in the books are those which are relevant to the business only, and

relate to business activities. Fund or goods taken out of a business by its owners are treated as

a reduction in their investment in the business, not as an expense of the business. The main

links between the business and the owner‟s personal funds are capital and drawings.

Dual aspect concept

This states that there are two aspects of every transaction, one representing the assets of the

business entity and the other the claims against the business entity. These two aspects must

always be equal, i.e. what the business entity owns it also owes. This can be expressed by the

accounting equation:

Assets = Capital + Liabilities

It is this duality concept which forms the basis of double-entry book-keeping, whereby books

are maintained by recognising that for every business transactions there is a „giver‟ and a

„receiver‟. (Remember what you learnt in the previous module about the double-entry system

in practice).

Materiality concept

In processing financial information and preparing financial statements, there may be a point

at which the effort of providing exact and detailed information is out of all proportion to the

cost, in terms of time and money, of doing so.

Materiality allows that in circumstances where ignoring other rules will not significantly

effect the financial information provided as a result, then it would be acceptable to do so.

Some items in accounts have such a low monetary value that it is not worthwhile recording

them separately, i.e. they are not „material‟. For example: low-costs fixed assets are often

charged as an expense in profit and loss account, instead of being classed as capital

expenditure, e.g. a stapler, waste-paper basket. Strictly, these should be treated as fixed assets

and depreciated each year over their estimated life; in practice, because the amounts involved

are not material, they are treated as profit and loss account expenses.



Materiality is a „common sense concept‟, as it is largely concerned with the significance of a

particular item in the financial statements in the context of the business organisation as a

whole. What is material to a sole trader business is not necessarily material to a large

company.

The Realisation concept

This concept determines when a transaction is to be recorded in the books of account.

Normally this is when goods or services are delivered, as it is seen as being the point in time

at which legal title passes from the supplier to the customer.

To process a transaction when an order is placed would not be prudent as the order may be

cancelled before it is fulfilled, or the business may not be able to meet the order.

The realisation concept where credit is given or taken often results in the transaction being

recorded in one particular accounting period with the payment being made or received in a

later accounting period.

Objectivity concept

It is suggested that subjectivity should be minimised whilst objectivity should be maximised.

Therefore, where possible, financial statements should be prepared free from personal bias.

Now click on the link below and try the interactive worksheet for accounting concepts to help

you understand the accounting concepts:

www.bized.co.uk/learn/accounting/infosystems/bait/work06.htm



http://www.bized.co.uk/learn/accounting/infosystems/bait/work06.htm

Diploma in

Accounting


Accounting

Module 4: Internal Final Accounts of Limited

Companies, Ratio Analysis and the Assessment of

Business Performance



LESSON 7. FINAL ACCOUNTS: FURTHER ASPECTS

1.1 Capital expenditure and revenue expenditure.

When preparing final accounts it is important to distinguish between capital expenditure and

revenue expenditure.

1. Capital expenditure

Capital expenditure can be defined as expenditure incurred on the purchase, alteration or

improvements of fixed assets. Costs included are:

- Acquiring fixed assets

- Bringing them into the business

- Installation of fixed assets

- Improvement of fixed assets, but not repairs

- Legal costs or buying buildings

- Carriage inwards on machinery bought

- Any other costs needed to get a fixed asset ready for use.

Benefit is derived from the use of fixed assets over several accounting periods and their cost

is spread over the accounting periods which benefit from their use. The loss in value of fixed

assets is accounted for over the period of their useful economic life by applying depreciation.

Capital expenditure is shown on the Balance Sheet.

2. Revenue expenditure

Revenue expenditure is expenditure incurred in running expenses. Costs included are:

- Maintenance and repair of fixed assets

- Administration of the business

- Motor expenses (e.g. cost of petrol, service)

- Selling and distributing the goods or products in which the business trades

Benefit is derived from such expenditure within one accounting period. As a result revenue

expenditure is transferred each year to Trading and Profit and Loss Account where, in the

calculation of profit each year, it is matched against the income it has helped generate.

It is important to classify these types of expenditure correctly in the accounting system.

Getting the classification wrong affects the profits reported and the capital account and assets

values in the financial statements. It is, therefore, important that this classification is correctly

done.

If, for example, capital expenditure is incorrectly treated as revenue expenditure or revenue

expenditure is incorrectly treated as capital expenditure, then both the Balance Sheet figures



and Trading and Profit Loss Account figures will be incorrect. The net profit figure will be

incorrect.

Now you are going to try a few examples in order to help you understand the difference and

the different treatment in the accounts.

Classify the expenditure in the following examples between revenue and capital. Example 1

has been done for you.

Example 1.

Cost of building an extension to the factory £30,000, which includes £1,000 for

repairs to the existing factory.

- Capital expenditure: £29,000

- Revenue expenditure: £1,000

As you can see, sometime one item of expenditure will need to be divided between

capital and revenue expenditure. In this case, £1,000 is for repairs to an existing fixed

asset, the factory.

Example 2.

A plot of land has been bought for £20,000, the legal costs are £750.

- Capital expenditure:

- Revenue expenditure:

Example 3.

The business’ own employees are used to install a new air conditioning system: wages

£1,000, materials £1,500.

- Capital expenditure:

- Revenue expenditure:

Example 4.

Own employees used to repair and redecorate the premises: wages £500, materials

£750:

- Capital expenditure

- Revenue expenditure

Example 5.

Purchase of a new machine £10,000, payment for installation and setting up £250.

- Capital expenditure

- Revenue expenditure



Only by allocating capital expenditure and revenue expenditure correctly between the

Balance Sheet and the Profit and Loss Account can the final accounts reflect accurately the

financial state of the business.

Be aware that ‘capital expenditure’ has nothing to do with the owner’s Capital Account.

While both are, in a sense, long-term investments, one made by the business, the other made

by the owner, they are, by definition, two very different things.

Solution to the examples:

Example 2: capital expenditure £20,750, because the legal costs are included in the capital

expenditure, as they are the cost of acquiring the fixed asset.

Example 3: capital expenditure £2,500, as it is an addition to the property.

Example 4: revenue expenditure £1,250, because repairs and redecoration are running

expenses.

Example 5: capital expenditure £10,250, as costs of installation of a fixed asset are included

in the capital expenditure.

1.2 Depreciation.

Depreciation is that part of the original cost of a fixed asset that is consumed during its period

of use by the business. The annual charge to profit and loss for depreciation is based upon an

estimate of how much of the overall economic usefulness of a fixed asset has been used up in

that accounting period. Because it is charged as an expense to the profit and loss account,

depreciation reduces net profit. That expense is called ‘provision for depreciation of fixed

assets’.

For example, a machine cost £2,000 and was expected to be used for four years. At the end of

the first year, a fourth of its overall usefulness has been consumed. Depreciation would then

be charged at an amount equal to one-fourth of the cost of the machine, i.e. £500. Therefore,

profit will be reduced by £500 and the value of the machine in the balance sheet is reduced

from £2,000 to £1,500.

Depreciation is affected by the fundamental accounting concepts of going concern, prudence,

matching and consistency; it is also a further application of the accruals concept, because we

are recognising the timing difference between payment for the fixed asset and the asset’s fall

in value.

As a going concern, the business will make use of its fixed assets over a number of years.

Therefore, any loss in value of a fixed asset is charged as an expense against income in the

periods which will benefit from its use. That charge also follows the matching concept, as



depreciation is allocated in the proportion of the cost of the asset to each accounting period

expected to benefit from its use.

The prudence concept requires that we recognise that fixed assets will lose value period by

period, and that this loss in value represents a charge against income that must be accounted

for.

As there a number of methods of calculating depreciation, one of them must be chosen and

applied consistently from accounting period to accounting period, in application of the

consistency concept.

The main factors which cause fixed assets to depreciate are:

Wear and tear through use, e.g. vehicles, machinery, etc

Passage of time, e.g. the lease on a building, patents and copyrights

Depletion: assets such as quarries, mines and forests are depreciated based on the fact that they are of a wasting nature.

Obsolescence. This is the process of becoming out-of-date, e.g. a new design of machine which does the job better and faster makes the old machine obsolete.

Inadequacy. This arises when an asset is no longer used because of the growth and changes in the size of the business, e.g. a machine no longer has the volume capacity

to meet the needs of the business.

1.2.1. Methods of calculating depreciation:

The two most common methods of calculating depreciation are:

Straight-line method

Reducing balance method

a) Straight line method

By this method, the number of years of use is estimated and a fixed percentage is written off

the original cost of the asset each year. The percentage is based on what it is considered to be

the useful economic life of the asset. Thus the cost is divided by the number of years, to give

the depreciation charge each year.

For example, a machine was bought for £2,000 and it is expected to have a useful economic

life of four years with a nil residual value at the end of the four years, the depreciation to be

charged each year would be:

£2,000 = £500 per year

4 years

i.e.: 25%: £2,000 x 25% = £500

Now let’s assume that the machine is expected to have a residual value of £400, so the

depreciation amount would be:



£2,000 - £400 = £400 per year

4 years

The method of calculating straight-line depreciation is:

b) Reducing balance method

A fixed percentage for depreciation is deducted from the cost in the first year. In the

following years the same percentage is taken of the reduced balance (cost less depreciation

already charged).

For example, a machine is bought for £10,000 and depreciation is to be charged at 20%, the

calculation would be as follows:

Cost £10,000

First year depreciation at 20% (£2,000)

£8,000

Second year: 8,000 x 20% (£1,600)

£6,400

The formula to calculate the percentage of reducing balance depreciation is:

In this formula:

r = the rate of depreciation to be applied

n = number of years

s = residual value

c = cost of the asset

Using the figures from the previous example

n = 4 years

s = residual value £4,096

c = cost £10,000

Cost of asset – estimated residual value

Number of years’ expected used of asset



4 4096

10000r = 1 -

r = 0.2 or 20%

If you apply that percentage to the remaining years you will see that it will leave a residual

value of £4.096. Now complete the example for year 3 and 4.

The purpose of depreciation is to spread the total cost of a fixed asset over the periods in

which it is to be used. The choice of a suitable method is arbitrary, but the requirement is that

the depreciation method used should reflect as fairly as possible the pattern in which the

assets economic benefits are consumed by the entity.

If, therefore, the main value is to be obtained from the asset in its earlier years, it may be

appropriate to use the reducing balance method, which charges more in the early years. If, on

the other hand, the benefits are to be gained evenly over the years, then the straight line

method would be more appropriate.

Having chosen a suitable method for calculating the depreciation charge we are then faced

with applying the method in circumstances where fixed assets are purchased partway through

a financial year. Two options are available:

1. The full year basis: in the year of acquisition, we ignore the date on which the fixed assets was purchased. We charge the full year’s depreciation in the year of acquisition

irrespective of when, within the financial year, the asset was purchased. In applying

the full year basis we charge no depreciation to the Profit and Loss Account in the

year of disposal of a fixed aseet.

2. The month for month basis: depreciation is calculated and charged to the Profit and

Loss Account according to the period of time for which the fixed asset is owned each

financial year. Depreciation using this basis is charged in the year of acquisition of the

fixed asset and in the year of disposal (provided in the year of disposal the asset has

not already been written down to a nil residual value).

1.2.2. Accounting for depreciation. Double entry.

Once the depreciation charge has been calculated it must be recorded in the books of account.

The method used involves maintaining each fixed asset at its cost in the ledger account while

operating another ledger account where the depreciation to date is recorded. This account is

known as the provision for depreciation account.



The depreciation charge is supported by an entry in the Journal. The transaction entered in the

Journal in respect of the depreciation charge each year is:

Debit – Profit and Loss Account – with depreciation in year

Credit – Provision for Depreciation Account – with depreciation in year

The Provision for Depreciation Account is balanced off at the end of each financial year to

show the accumulated depreciation charge (depreciation to date). The accumulated

depreciation is deducted from the cost of the fixed asset on the Balance Sheet to show the

written down value of the asset. The written down value therefore represents the remaining

value of the asset, to the business, to be spread over the remaining years of the assets life to

the business.

The following example shows the calculation of depreciation and the processing of double

entries necessary to account for depreciation:

Example:

A business has a financial year which ends on 31 March each year. On 1 July 2007 a delivery

vehicle is purchased at a cost of £27,500 and is paid for by cheque.

It is estimated that the delivery vehicle will have a life of five years to the business, with a

residual value of £2,500.

It has been decided that depreciation should be provided for using the straight line method

applied on a full year basis:

Depreciation calculation:

£27,500 - £2,500 = £5,000 per year

5

Journal entries to account for depreciation:

Journal

Date Details Debit Credit

31 March Profit and Loss 5,000

Delivery Vehicle Provision for Depreciation 5,000

Depreciation on delivery vehicle for the year

ended 31 March 2008. Straight-line method.

Full year basis.



Ledger Accounts

General Account

DR Delivery Vehicle Cost CR

Date Details £ Date Details £

1/7/07 Bank 27,500

DR Provision for Depreciation CR


31/3/08 Balance c/d 5,000 31/3/08 Profit & Loss 5,000

5,000 5,000 01/4/08 Balance b/d 5,000

Profit and Loss Account (Extract) for the year ended 31 March 2008

Expenses: £

Provision for Depreciation 5,000

Balance Sheet (Extract) as at 31 March 2008

Fixed Asset Cost (Less)Accumulated NBV

depreciation

Delivery vehicle 27,500 5,000 22,500

(NBV = Net Book Value, which is the difference between the original cost of the asset less

the accumulated depreciation).

Practice exercise

Now try the following exercise:

Quick Delivery has a financial year which ends on 30 June each year. A motorcycle was

bought on 1 August 2007 to carry out the urgent delivery of small parcels over short

distances. The motorcycle purchased cost £8,000 and was paid for by cheque.



It was estimated that the motorcycle would have a life of 5 years to the business, with a

residual value of £500.

It was decided that the motorcycle would be depreciated using the straight-line method

applied on a full year basis.

Required:

a) Calculate the annual depreciation charge.

b) Show the Journal entries to account for depreciation for the first two years of the asset

life.

c) Make the entries in the appropriate accounts showing the balance

d) Prepare extracts of the Profit and Loss Account and Balance Sheet for the years ended

30 June 2008.

1.2.3 Disposal of a fixed asset.

When a fixed asset is purchased it is necessary, for the purpose of calculating the annual

depreciation charge, to estimate its economic life to the business, and residual value at the

end of its life. We must then account for loss in value (depreciation) over the period of the

life of the fixed asset.

The item may be disposed of at any time within its life and there is no guarantee that on

disposal the fixed asset item will realise a value which coincides with the original residual

value estimated at the time of its acquisition. It may attract a value which exceeds, or falls

short of, the original residual value estimated. The disposal of a fixed asset is a commercial

transaction and as such needs to be recorded in the books of account. The objective being is

to calculate and account for any profit or loss on disposal of the fixed asset.

Once a fixed asset has been sold, it must be removed from the ledger accounts. Therefore, the

cost of that asset needs to be taken out of the asset account. In addition, the accumulated

depreciation on the asset which has been sold will have to be taken out of the accumulated

provision. Finally, the profit and loss on sale, if any, will have to be calculated and posted to

the Profit and Loss Account.

The profit or loss on disposal of a fixed asset is calculated by comparing the value received

on disposal as against its net book value (cost less accumulated depreciation to date).

Where the disposal value (income from disposal less any costs incurred in disposing of the

fixed asset item), exceed the item’s net book value then the business has made a profit on

disposal.

Where the disposal value is less than the net book value of the item, the business has made a

loss on disposal.

To record the transaction relevant to the disposal of a fixed asset in the books we must:

o Open a Fixed Asset Disposal Account



o Collect the information relevant to the fixed asset item disposed of within the account.

This includes;

- Its original cost

- Accumulated depreciation

- Income received on disposal

o Transfer the balance on the Fixed Asset Disposal Account to the Profit and Loss

Account at the financial year end. A debit balance on the account representing a loss

on disposal, with a credit balance representing a profit on disposal.

Remember, at the financial year end the depreciation on remaining fixed assets has to be

calculated in accordance with the depreciation policy of the business.

On the disposal of the fixed asset the following entries are needed:

1) Transfer the cost price of the asset sold to the Assets Disposal Account

Debit – Fixed Asset Disposal Account

Credit – Asset account with original cost

2) Transfer the depreciation already charged to the Assets Disposal Account

Debit – Provision for Depreciation Account

Credit – Fixed Asset Disposal Account

(the amount is the accumulated depreciation to date of the asset disposed of )

3) Record the amount received on disposal

Debit – Cash Book/Bank


4) Transfer the difference (i.e. the amount needed to balance the Fixed Assets Disposal

Account) to the Profit and Loss Account.

a) If it is a loss (i.e. debit balance):

Debit – Profit and Loss Account


b) If it is a profit (i.e. credit balance):

Debit – Fixed Asset Disposal Account

Credit – Profit and Loss Account

Let’s see an example to understand how it works.



Example:

Let us assume that Blyth Chemical Ltd, at 31 December 2006 had a balance on its Motor

Vehicles Account of £100,000. This balance represents the vehicles at cost. The balance on

the depreciation provision account was £40,000.

On 31 December 2007 the company sold one of its delivery vans for £1,500. It had been

purchased five years earlier on 1 January 2003, for £15,000, at which time the company had

estimated its useful economic life at five years and its residual value after that time of £1,000.

The company policy is to write off such vehicles at 20% straight line. The vehicle had been

subject to a depreciation charge of (£15,000 - £1,000)/5 = £2,800 per annum. The company

policy is also to depreciate assets in the year of purchase but not in the year of sale.

There is a need to determine the profit or loss on disposal and the current year must reflect

that.

This is determined as:

£

Purchase Cost (1 January 2003) 15,000

Depreciation 4 years x £2,800 11,200

Net Book Value 31 December 2006 3,800

Sale Proceeds 1,500

Loss on Disposal £2,300

To account for this disposal the company would make the following entries to the accounts:

the original cost of the vehicle disposed is transferred from Motor Vehicles account to a

‘Disposal of Motor Vehicles Account’;

the cumulative depreciation on the vehicle to the end of the previous year is transferred from the Provision for Depreciation account to the Disposal account;

the Disposal of the Asset account is credited with the proceeds and the resulting balance

represents the profit or loss on disposal – and is transferred at the year end to the Profit and

Loss account.

The entries for the full procedure would appear thus:

NB: The depreciation charge for 2007 was agreed as 20% straight line on £85,000 ie £17,000.



Motor Vehicles Account

1 Jan 07 Balance b/d 100,000 31 Dec 07 Disposal a/c 15,000

31 Dec 07 Balance c/d 85,000

£100,000

£100,000

1 Jan 08 Balance b/d 85,000

Provision for Depreciation Account

31 Dec 07 Disposal a/c 11,200 1 Jan 07 Balance b/d 40,000

31 Dec 07 Balance c/d 45,800 31 Dec 07 Depreciation a/c 17,000

£57,000

£57,000

1 Jan 08 Balance b/d 45,800

Disposal Account

31 Dec 07 Motor Vehicles a/c 15,000 31 Dec 07 Provision for

Depreciation a/c £11,200

Proceeds 1,500

Loss on Disposal 2,300

£15,000

£15,000

Extract from Profit and Loss a/c for Year:

Depreciation 17,000

Loss on disposal of vehicle 2,300



Extract from Balance Sheet

Fixed Assets Cost Depreciation NBV

Motor Vehicles 85,000 48,000* 39,200

Motor Vehicles 85,000 48,000* 39,200

*NB: the provision to previous year end

11,200

Additional Depreciation for current year

17,000

57,000

Less accumulated depreciation on disposal of vehicle

11,200

£45,800

1.3 Final Accounts

Bad debts recovered

In module one you learnt how to make entries to record a bad debt written off. However, it is

possible that a debt written off in previous years is recovered some time in the future. When

this happens you need to make the following entries:

1. You reinstate the debt:

Dr – debtor’s account

Cr – bad debts recovered account

2. Enter payment received:

Dr – cash/bank

Cr – debtor’s account

The credit balance in the bad debts recovered account is transferred to the bad debts account

at the end of the financial year. The bad debts account will be transferred to the Profit and

Loss Account at the end of the financial year.

You can see that a bad debt written-off was transferred to the debit side of the Profit and Loss

Account; the recovered of the bad debt written-off is transferred to the credit side of the Profit

and Loss Account.

Click on the link below and do the multiple-choice exercise on bad debt: http://www.accounting2u.com/badebts.htm

Income received in advance and income due

Income received in advance is money (cash or cheque) received in advance. This is a

prepayment of income.



http://www.accounting2u.com/badebts.htm

They are actually liabilities to the business as the business has still not earned the revenue

because goods or services have still not been provided to the customers.

The portion that goods have been delivered or services being provided during the accounting

period are treated as income in the Trading and Profit and Loss Account whilst those not

earned yet are treated as a current liability which is called prepaid revenues, deferred

revenues and unearned revenues.

Examples are: advanced payment of rent, unearned fee from advertising services.

Revenues received in advance are recognised as income in the Trading and Profit and Loss

Account for only the portion of goods delivered or services/work-done being rendered. This

is based on the prudence concept.

Based on this concept, only the ascertained portion is taken up as revenue/income, the

balance of goods not delivered or work not yet done is taken up in the Balance Sheet. Only

when work being done or goods actually being delivered, can they be matched and taken up

into the Trading and Profit and Loss Account.

In the final accounts, income received in advanced or prepayment of income is:

Deducted from the income amount from the trial balance before listing it in the Profit and Loss Account

Shown as a current liability in the Balance Sheet at the year end.

Income due or accrual of income is the income unpaid at the end of the financial year but

due in that year. For example, commission for the year received after the end of the financial year to which it relates.

In the final accounts, income due or accrual of income is:

Added to the income amount from the trial balance before listing it in the Profit and

Loss Account.

Shown as a current asset in the Balance Sheet at the year end.

Provision for doubtful debts

Provision for doubtful debts is the estimate by a business of the likely percentage of its

debtors which may go bad during any one accounting period.

Bad debts and provision for bad debts is an application of the prudence concept. The amount

of the provision will vary from business to business, depending on the past experience of

receiving payment, the nature of the business and the current economic climate.

The percentage chosen will be applied to the total figure for debtors reducing its figure (after

writing off bad debts).

Once the business estimates the percentage of its debtors which may go bad, the provision is calculated. The accounting entries needed for the provision for doubtful debts are:



Debit – Profit and Loss Account with the amount of the provision (as an expense named ‘provision for doubtful debts’)

Credit – Provision for Doubtful Debts Account

For example:

The debtors figure after deducting bad debts was £5,000. The provision for doubtful debts is

2%. The accounts will show:

Profit and Loss Account (extract)

£

Gross profit 50,000

Expenses:

Provision for doubtful debts (100)

In the Balance Sheet the balance on the provision for doubtful debts will be deducted from

the total of debtors.

Provision for Doubtful Debts

Dr Cr

Profit and Loss Account 100

Balance Sheet

£ £

Current assets

Debtors 5,000

Provision for doubtful debts (100)

4,900

Note: After the deduction of the figure of debtors in the Balance Sheet at the year end, we get

a net figure, which represents a more accurate figure of the value of debtors.

Preparing Financial Statements

Try the following activity before you look at the solution. Once you have finished check

your answers and review what you did not understand. Do not forget that your tutor is

there to help you.

Terry Hamilton is a wine merchant. He has prepared his Trial Balance as at December 31,

2007.



Terry Hamilton

Trial Balance as at December 31, 2007

Dr Cr

£ £

Bank 70,600

Capital account 38,600

Drawings 32,000

Insurance 3,600

Long-term loan from bank 100,000

Loan interest 15,000

Miscellaneous expenses 15,400

Office equipment – cost 10,000

Accumulated depreciation 4,750

Fixtures and Fittings – cost 70,000


Provision for doubtful debts 4,000

Purchases 640,000

Rent and rates 20,000

Sales 744,000

Stock at 1 January 2007 72,000

Debtors 186,000

Creditors 210,000

1,134,600 1,134,600

Additional information:

1) The value of his closing stock at December 31, 2007 was £136,000

2) Rates of £4,000 were not paid and he paid insurance of £400 in advanced.

3) Office equipment has a useful life of four years and residual value of £500. It is

depreciated on a straight-line basis.

4) Fixtures and fittings are to be depreciated at a rate of 20% on a reducing balance

basis.

5) One of his customers has just gone out of business owing Terry £26,000.

6) The provision for doubtful debts is to be set at 10% of the outstanding debtors as at

December 31, 2007.

Required:

a) Prepare a Profit and Loss Account for the year ending December 31, 2007.

b) Prepare a Balance Sheet as at December 31, 2007.



Solution:

a)

Terry Hamilton

Profit and Loss Account for the year ending December 31, 2007

£ £

Sales 744,000

Less Cost of sales


Add purchases 640,000

712,000

Less closing stock (136,000)

(576,000)

Gross profit 168,000

Less expenses

Insurance 3,200

Loan interest 15,000

Miscellaneous expenses 15,400


Depreciation: (1)

Office equipment 2,375

Fixtures and fittings 7,350

Bad debts 26,000

Increase in doubtful debts provision (2) 12,000

(105,325)

Net profit 62,675

b)

Terry Hamilton

Balance Sheet as at December 31, 2007

Cost Accumulated NVB

Depreciation

£ £ £

Fixed assets:

Office equipment 10,000 7,125 2,875

Fixtures and fittings 70,000 40,600 29,400

80,000 47,725 32,275

Current assets:

Stock 136,000

Debtors 160,000

Less provision for doubtful debts (2) (16,000)

144,000

Prepayments 400



Bank 70,600

351,000

Current liabilities:

Creditors 210,000

Accruals 4,000

(214,000)

137,000

169,275

Long-term liabilities:

Bank loan (100,000)

Net assets 69,275

Capital account:

Opening balance 38,600

Profit for the year 62,675

101.275

Less drawings (32,000)

69,275

Workings:

(1) Depreciation:

Office equipment:

(10,000 – 500) / 4 = 2,375

Fixtures and fittings:

(70,000 – 32,250) x 20% = 7,350

(2) Provision for doubtful debts:

(186,000 – 26,000) x 10% = 16,000

The provision in the previous year was £4,000. The difference between last period’s

provision and the provision for this period is: 16,000 – 4,000 = 12,000. Therefore,

£12,000 is the increase of the provision for this year and it is shown in the Profit and Loss

Account.

The revised provision of £16,000 appears on the Balance Sheet. The doubtful debt

provision for this year replaces last year’s doubtful debt provision in the Balance Sheet. It

is not added to it.



1.4 Final Accounts of Limited Companies.

In module 1 we learnt the preparation of financial statements for sole traders. In this section

we are going to concentrate on the financial statements of a limited company.

A limited company is a separate legal entity normally owned by a number of individuals,

shareholders, and run by directors. The financial contribution required of the shareholders is

limited to the amount they originally invested in the company, limited liability. Therefore,

the shareholders (members) of a company can only lose the amount of their investment, being

the money paid already, together with any money unpaid on their shares (unpaid instalments

on new share issues, for example). Thus no matter what financial difficulty a company runs

into, the owners or shareholders are not legally required to contribute more funds in order to

pay off the company’s debts. Their personal assets, unless pledged as security to a lender are

not available to the company’s creditors. The limited company is responsible for paying its

own debts as it is regarded as being a separate legal entity from its owners.

1.4.1. Capital structure of a Limited Company. The authorised share capital is stated in the Memorandum of Association and is the

maximum share capital that the company is allowed to issue. The authorised share capital

may not be the same as the issued share capital; under company law the issued capital cannot

exceed the amount authorised.

The capital structure normally comprises:

Share capital

Loan capital

Reserves

Share Capital

Individuals who wish to invest in a limited company do so by purchasing shares in that

company. This investment is known as the share capital and the investors are known as the

shareholders. Each shareholder receives a share certificate showing the number of shares they

have purchased. Generally shareholders are entitled to a share in the profits of a company

(called dividends) and a share in its assets on winding up.

There are two main types of shares:

1) Ordinary shares

2) Preference shares

1) Ordinary shares



These are the most common type in issue. They do not carry the right to receive a fixed

return by way of a dividend. However, ordinary shareholders are entitled to receive a

share of the profits which remain after the preference dividend has been paid.

Bear in mind that not all remaining profits will be distributed, some will be kept in the

company to help finance future operations. The portion kept within a company is known

as reserves and is owned by the ordinary shareholders.

Ordinary dividends, therefore, fluctuate year to year depending on the operating success

of the company and on the reinvestment policy. Ordinary shares generally do carry voting

rights. The ordinary shareholders are therefore the owners of the company, and, in the

event of the company becoming insolvent, will be the last to receive any repayment of

their investment: other creditors will be paid off first.

2) Preference shares

These shares carry the right to receive a fixed return on the investment by way of a

dividend. This right is often expressed as a percentage of the nominal value of the share,

e.g. 5% £1 preference share carries the right to an annual dividend of 5p per share.

Preference dividends must be paid before any other dividend can be paid. Preference

shares do not normally carry any voting rights. This means that generally preference

shareholders have no authority in, for example, the appointing of directors. In the event of

a company ceasing to trade, the ‘preference’ will also extend to repayment of capital

before the ordinary shareholders.

It is important that you are able to distinguish between the following terms:

Authorised Share Capital: the total of the share capital which the company is allowed to issue.

Issued Share Capital: the total of the share capital actually issued by the company.

Called Up Capital: where only part of the amount payable for each share has been

asked for, the called up capital is the total amount requested.

Uncalled Capital: this is the total amount to be received in the future that hasn’t yet been asked for.

Calls in Arrears: this is the total amount that has been asked for that hasn’t yet been paid by the shareholders.

Paid Up Capital: the total amount paid by the shareholders.

Each share has a nominal value (or face value) which is entered in the accounts. Shares may

be issued with nominal values of 5p, 10p, 25p, 50p or £1, or any other amount. For example:

100,000 ordinary shares of 50p each £50,000

50,000 10% preference shares of £1 each £50,000

£100,000

In this example the company has an authorised share capital of £100,000 divided up as shown

above.

The market value of the shares is the price an individual is willing to pay for the shares.



The issue price is the price at which shares are issued to shareholders by the company, either

when the company is set up, or at a later date when it needs to raise more funds. The issue

price is either at par (i.e. the nominal value), or above nominal value. In the latter case, the

amount of the difference between issue price and nominal value is known as a share

premium. For example: nominal value £1.00; issue price £1.50; therefore, share premium is

50p per share.

Loan capital

Loan capital is generally known as debentures and is the money received by the company by

way of a loan. Debentures are normally shown in the Balance Sheet under the heading long

term liabilities as the company will eventually have to repay the loan at some future point in

time. There are two types of debentures;

a) Redeemable: repayable by a particular date.

b) Unredeemable: repayable only when the company is terminated.

All loan capital or debentures carry a fixed rate of return known as debenture interest which

must be paid annually irrespective of whether the company makes a profit or a loss. As loan

and debenture interest is a business expense, this is shown in the Profit and Loss Account

along with all other expenses. In the event of the company ceasing to trade, loan and

debenture-holders would be repaid before any shareholders.

If the company fails to repay the loan at the specified date the debenture holders have the

legal right to seize the asset on which the loan is secured and sell it to recoup the amount

owing to them, as often their loan is secured on the assets of the company. This type of

debenture is known as secured debenture.

Reserves

A limited company rarely distributes all its profits to its shareholders. Instead, it will often

keep part of the profits earned each year in the form of reserves. There are two categories of

reserves:

1. Capital reserves

2. Revenue reserves

1. Capital reserves.

Capital reserves are not available for distribution and therefore cannot be used to pay

dividends. There are two categories of capital reserves:

a) Revaluation reserve. These are the reserves related to unrealised capital gains. This is

required where a company wishes to revalue its fixed assets from historic cost to

current cost. For example, suppose that a company wishes to revalue its buildings to



current value which leads to an increase in value of £75,000. This would be recorded

as:

Dr – Building – cost: £75,000

Cr – Revaluation Reserve: £75,000

Note, however, that this is purely a ‘book’ adjustment, no cash has changed hands. It

increases the value of the shareholders’ investment in the company.

b) Share premium. It arises when additional shares are issued to the public at a higher

amount (premium) than the nominal value. For example, if a company is seeking

finance for further expansion it will issue additional ordinary shares. The shares have

a nominal value of £1 each but they are issued at £1.50 each. Of this amount, £1 is

recorded in the issued share capital section, and the extra 50p is the share premium.

2. Revenue reserves.

Revenue reserves comprise the undistributed profit of the company. As mentioned earlier,

companies do not generally pay out all of the available annual profits as dividends.

Generally part of the available profit is used in this way with the remainder remaining in

the company, so over a period of years the revenue reserves are likely to build up into a

substantial amount.

The main purposes of building up such reserves are:

To fun future expansion.

To enable the business to deal with any unexpected future events. A business with reasonable reserves is in a position to sustain losses incurred.

To ensure that dividends can be paid to ordinary shareholders in years when poor

profits are made by using past years profits retained in reserves.

To finance asset replacements.

It should be noted that reserves, both capital and revenue, have no direct relationship with

cash, however, they are represented by assets shown on the Balance Sheet. The reserves

record the fact that the assets belong to the shareholders via their ownership of the company.

Now study the layout of the Profit and Loss Account and Balance Sheet showing ordinary

and preference shares, debentures, retained profit and corporation tax. Remember that you are

not required to calculate corporation tax, that figure will be given to you.

Tools Ltd

Trading and Profit and Loss Account for the year ended 31 December 20xx

£ £

Sales 725,000




Purchases 381,000

426,000

Less closing stock (50,000)

376,000


Less expenses:

Directors’ remuneration 75,000

Debenture interest 6,000 Other overheads 225,000

(306,000)

Net profit for the year before taxation 43,000 Less corporation tax (15,000)

Profit for the year after taxation 28,000

Less interim dividends paid

Ordinary shares 5,000

Preference shares 2,000

Final dividends proposed

Ordinary shares 10,000

Preference shares 2,000

19,000

Retained profit for the year 9,000

Add retained profits brought forward 41,000

Retained profits carried forward to next year

Tools Ltd

Balance Sheet as at 31 December 20xx

Fixed Assets Cost Acc. Depn. NBV

£ £ £

Intangible

Goodwill 50,000 20,000 30,000

Tangible

Freehold land and buildings 180,000 20,000 160,000

Machinery 230,000 90,000 140,000


560,000 155,000 405,000

Current Assets

Stock 50,000

Debtors 38,000

Bank 22,000

Cash 2,000

112,000

50,000



Less Current Liabilities

Creditors 30,000

Proposed dividends 12,000

Corporation tax 15,000

57,000


460,000

Less Long-term Liabilities

10% debentures 60,000

Net Assets 400,000

Financed by:

Authorised Share Capital

100,000 10% preferences shares of £1 each 100,000

600,000 ordinary shares of £1 each 600,000

700,000

Issued Share Capital

40,000 10% preference shares of £1 each, fully paid 40,000

300,000 ordinary shares of £1 each, fully paid 300,000

340,000

Capital Reserve

Share premium account 10,000

Revenue Reserve

Profit and loss account

Shareholders’ funds 400,000

1.4.2. Increase of share capital of limited companies

Rights issue

A limited company may, if so authorised by its articles, increase its share capital by new

shares.

The costs of making a new issue of shares can be quite high. A way to reduce the costs of

raising new long-term capital in the form of issuing shares may be by way of a rights issue.

A rights issue is the issue of shares to existing shareholders at a price lower than the ruling

market price of the shares. The company contacts the existing shareholders and informs them

of the new issue to be made and the number of shares which each one of them is entitled to

buy of the new issue.

For example, a company has 8,000 shares of £1 each and declares a rights issue of one for

every eight held at a price of £1.50 per share. The market price of the shares is quoted at

£2.50. Let’s assume that all the rights issue were taken up. In this case the number of shares

50,000



taken up will be 1,000 (i.e. 8,000 / 8), and the amount paid for them will be £1,500. The

journal entries will be:

Journal

Dr Cr

Cash 1,500

Share capital 1,000

Share premium 500

Being the rights issue of 1 for every 8 shares

held at a price of £1.50 nominal value being £1.00

Note that because the nominal value of each share is £1.00 while £1.50 was paid, the extra

50p constitutes a share premium to the company. Before the rights issue there were 8,000

shares at a price of £2.50, giving a market capitalisation of £20,000. After the issue there are

9,000 shares (8,000 plus 1,000 taken up) and the assets have increased by £1,500.

Bonus shares

If authorised by its articles, a company may resolve to use any undistributed profits, or any

sum credited to the company’s ‘share premium account’ or ‘capital redemption reserve’ to

finance an issue of wholly or partly paid up 'bonus' shares to the members in proportion to

their existing holdings. The shareholders to whom the shares are issued pay nothing. The

terms 'scrip' or scrip issue are also used to describe such shares.

Therefore, bonus shares are ‘free’ shares issued to shareholders without their having to pay

anything for them. The reserves (e.g. accumulated profits held in the Profit and Loss

Account and shown in the Balance Sheet) are utilised for the purpose.

For example, the extract of ‘Y Ltd’s’ Balance Sheet as at 31 December 2007 is shown as:

Y Ltd

Balance Sheet as at 31 December 2007

(before bonus share are issued)

£

Fixed assets 5,000

Current assets less current liabilities 5,000

10,000

Share capital 1,000

Reserves (including profit and loss appropriation balance) 9,000



10,000

It has 1,000 ordinary shares of £1 each and £1,000 in the bank. The company has constantly

had to retain a proportion of its profits to finance its operations, thus diverting them from

being used for cash dividend purposes. Such a policy has conserved working capital.

If an annual profit of £1,500 was now being made, this being 15 per cent on capital

employed, and £1,000 could be paid annually as cash dividends, then the dividend declared

each year would be 100 per cent, i.e. a dividend of £1,000 on shares of £1,000 nominal value.

If it is considered that £7,000 of the reserves could not be used for dividend purposes, due to

the fact that the net assets should remain at £8,000, made up of fixed assets £5,000 and

working capital £3,000, then besides the £1,000 share capital which cannot be returned to the

shareholders there are also £7,000 reserves which cannot be rationally returned to them.

Instead of this £7,000 being called reserves, it might as well be called capital, as it is needed

by the business on a permanent basis.

To remedy this position bonus shares were envisaged. The reserves are made non-returnable

to the shareholders by being converted into share capital. Each holder of one ordinary share

of £1 each will receive seven bonus shares of £1 each.

The accounting entries necessary are to debit the reserve accounts utilised, and to credit a

bonus account. The shares are then issued and the entry required to record this is to credit the

share capital account and to debit the bonus account. The journal entries would be:

Journal

Dr Cr

£ £

Reserve account (show each account separately) 7,000

Bonus account 7,000

Transfer of an amount equal to the bonus payable in fully

paid shares

Bonus account 7,000

Share capital account 7,000

Allotment and issue of 7,000 shares of £1 each,

in satisfaction of the bonus declared

The Balance Sheet would then appear:

Y Ltd


(after bonus shared are issued)

£

Fixed assets 5,000

Current assets less current liabilities 5,000



10,000

Share capital (£1,000 + £7,000) 8,000

Reserves (£9,000 - £7,000) 2,000

10,000

Try the following question:

Activity

1. A firm has issued ordinary share capital of 60,000 £1 shares. The current market price

of these shares is £5. The firm decides to make a rights issues of 1 share for every 3

held by existing shareholders for the price of £4. Assuming the rights issues is fully

taken up (paid in cash), show the journal entry needed to record the rights issue.

2. The following is a balance sheet of Keown Ltd.

Keown Ltd – Balance Sheet

£

Fixed assets 16,000


20,000

Share capital (£1 each) 2,000

Revenue reserves 18,000

20,000

The directors of Keown Ltd have deicide to make a bonus issue of shares. It has been decided

to issue a bonus share in the proportion of 5 for every 1 share held. Show the balance sheet of

Keown Ltd after the bonus issue has been made. Show the journal entries needed to record

this bonus issue.

Answers

Answer to Question 1

The Journal

£ £

Cash 80,000

Share capital 20,000



Share premium 60,000

Rights issue of 1 for very 3 held – at premium of £3 (i.e. issued for £4 each)

Answer to Question 2

Keown Ltd – Balance Sheet

£

Fixed assets 16,000


20,000

Share capital (£1 each) 12,000


20,000

The Journal

£ £


Bonus account 10,000

Bonus account 10,000

Share capital account 10,000

1.4.3. Revaluation of fixed assets

The most likely asset to be revalued, in practice, is property.

A revaluation of fixed assets is a technique that may be required to accurately describe the

true value of the capital goods a business owns.

Fixed assets are held by an enterprise for the purpose of producing goods or rendering

services, as opposed to being held for resale in the normal course of business. For example,

machines, buildings, patents or licences can be fixed assets of a business.

The purpose of a revaluation is to bring into the books the fair market value of fixed assets.

This may be helpful in order to decide whether to invest in another business. If a company

wants to sell one of its assets, it is revalued in preparation for sales negotiations.

Reasons for revaluation

It is common to see companies revaluing their fixed assets. The purposes are varied:

To show the true rate of return on capital employed.

To conserve adequate funds in the business for replacement of fixed assets at the end

of their useful lives. Provision for depreciation based on historic cost will show

inflated profits and lead to payment of excessive dividends.



To show the fair market value of assets which have considerably appreciated since

their purchase such as land and buildings.

To negotiate fair price for the assets of the company before merger with or acquisition

by another company.

To enable proper internal reconstruction, and external reconstruction.

To issue shares to existing shareholders (rights issue) or for an external issue of shares

(public issue of shares).

To get fair market value of assets, in case of sale and leaseback transaction.

When the company intends to take a loan from banks/financial institutions by

mortgaging its fixed assets. Proper revaluation of assets would enable the company to

get a higher amount of loan.

Sale of an individual asset or group of assets.

After an asset has been revalued, depreciation is calculated on the revalued amount. There are

different methods of revaluation of fixed assets, but it is not part of this course.

When a fixed asset is revalued, a reserve is created which adds to the value of the owner’s

capital. The double-entry is:

Debit fixed asset account

Credit capital account

Example:

The premises of a business have been revalued on 31 December 2007 at £150,000 and it has

been decided to record this value in the accounting system. The original cost of the premises

shown in the accounts on 1 January 2007 is £100,000. The balance on the capital account on

31 December 2007 is £200,000 before the revaluation is recorded.

The double entry would be:

Dr Premises Account Cr

1 Jan Balance b/d 100,000

31 Dec Capital account 50,000

Dr Capital Account Cr


31 Dec Premises account 50,000

Note that both premises account and the capital account have been increased by the amount

of the revaluation. The capital account balance is now £250,000. There is no new cash in the

business. The revaluation is not recorded in the Profit and Loss Account because it is a

capital transaction rather than a revenue transaction.



1.4.4. Preparing final accounts of limited companies

The Profit and Loss Account is a modification of the sole trader profit and loss account. The

two main expenses that would be found only in company accounts are directors’

remuneration and debenture interest.

As directors are legally employees of the company, appointed by the shareholders, and exist

only in companies, their remuneration is charged to the Profit and Loss Account.

Debenture interest is charged as an expense in the Profit and Loss Account for the use of the

money, and it is payable whether profits are made or not.

Apart from those expenses which are only include in company accounts, everything else is

the same as a sole trader accounts until we get to net profit. After this, the net profit is sliced

up into a bit for corporation tax, a bit for dividends distributable to the shareholders, and a bit

retained by the company.

The company Balance Sheet will include creditors for taxation and dividends. The capital

account is replaced by share capital and reserves.

It is normal that dividends are paid twice a year. An interim dividend is paid during the year

and a final dividend is paid once the annual profit is known.

In the case of preference shares, the total dividend that should be paid is the percentage rate

of dividend multiplied by the nominal value of the issued preference share capital.

Tax unpaid at the year-end it is included in current liabilities in the Balance Sheet.

The appropriation account

The appropriation account shows how the net profits are to be used (appropriated). This

section is under the Profit and Loss Account, after taxation has been deducted from the profit

for the year.

If you are required to prepare an appropriation account in the examination, bear in mind that

you must start from the net profit; you do not need to prepare a full Profit and Loss Account,

unless you are asked to do so.



Worked example:

Try to do as much as you can to complete the Final Accounts before you look at the solution.

Then check your answers with the solution provided. Review anything you did not

understand and if you need help, contact your tutor.

The following trial balance is extracted from the books of Wilson Ltd as on 31 December

2006:

Wilson Ltd

Trial Balance as on 31 December 2006

Debit Credit

£ £

Bank 85,000

200,000 ordinary shares of £1 each 200,000

80,000 10% preferences shares of £1 each 80,000

Freehold property 225,150

Office expenses 43,750

Wages & salaries 81,250

Directors’ remuneration 187,500

Purchases 350,000

Sales 901,300

Share premium account 150,000

Debtors 175,000

Creditors 45,000

Motor vehicles at cost 87,500


Plant & Equipment at cost 212,500


Profit and Loss Account (retained profits) 111,600

Stock at 31.12.05 62,500

Preference dividend paid 4,000

Ordinary dividend paid 12,500

1,526,650 1,526,650


1) The authorised share capital is 250,000 £1 ordinary shares and 100,000 10%

preference shares of £1 each.

2) It has been decided that the freehold property will not be depreciated.

3) The corporation tax charge for the year is £125,000. It was not paid until after the year

end.

4) Depreciation is to be provided as follows:

a) Motor vehicles: 20% on cost

b) Plant and equipment 10% on the reducing balance

5) It has been decided to pay a final dividend of 25p per ordinary share, which won’t be

paid until the following year.



Note: the debit of £12,500 in this year’s trial balance represents an interim dividend

already paid. Only half of the annual preference dividend has been paid, the

remainder will be paid during the next year.

6) Stock at December31, 2006 was £70,000.

Required:

Prepare a Profit and Loss Account for the year ended December 31, 2006 and a Balance

Sheet at that date.

Note: the authorised share capital figure is included in the Balance Sheet for information and

it is not recorded under the double entry system.

Solution:

Wilson Ltd

Profit and Loss Account for the year ending December 31, 2006

£ £

Sales 901,300

Less: Cost of sales:


Add: Purchases 350,000

412,500

Less: Closing stock (70,000)

(342,500)


Less: expenses:

Office expenses 43,750

Wages & Salaries 81,250

Directors’ Remuneration 187,500

Depreciation:

Motor vehicles (1) 17,500

Plant & Machinery (2) 19,125

(349,125)

Net profit before tax 209,675

Taxation (125,000)

Profit after tax 84,675

Less dividends:

Ordinary dividends:

paid 12,500

payable (3) 50,000

Preference dividends:

Paid 4,000

Payable 4,000

(70,500)

Retained profit for the year 14,175

Add balance of retained profit brought forward 111,600



Retained profit carried forward 125,775

Wilson Ltd


£ £ £

Fixed Assets Cost Acc Depn NBV

Freehold property 225,150 - 225,150

Motor vehicles 87,500 35,000 52,500

Plant & equipment 212,500 40,375 172,125

525,150 75,375 449,775

Current Assets

Stock 70,000

Debtors 175,000

Bank 85,000

330,000

Current Liabilities

Creditors 45,000

Taxation 125,000

Dividends payable:

Ordinary 50,000

Preference 4,000

(224,000)

Net Current Assets 106,000

Net Assets 555,775

Share Capital Authorised Issued

Ordinary Shares of £1 each 250,000 200,000

10% Preference Shares of £1 each 100,000 80,000

350,000 280,000

Reserves

Share Premium Account 150,000

Profit and Loss Account 125,775 275,775

555,775

Workings:

(1) Motor vehicles depreciation:

£87,500 x 20% = £17,500

(2) Plant & equipment depreciation:

(£212,500 - £21,250) x 10% = £19,125

(3) Ordinary dividends payable:

200,000 x 25p = £50,000



LESSON 8. ANALYSIS OF PERFORMANCE.

8.1. Introduction

Information is data organised for a purpose. Information contained in financial statements is

organised to enable users of the financial statements to draw conclusions concerning the

financial well-being and performance of the reporting entity. However, financial statements

whilst informative provide limited information about a business. In order that we can

examine, analyse and interpret financial information, accounting ratios are calculated which

determine relationships between various figures which appear within the financial statements.

The results of ratio analysis can be used as the basis of decision making and provide a

benchmark against which performance can be measured and comparisons made.

In this lesson you will learn how to calculate and interpret the most commonly used

accounting ratios. You will learn how to asses an organisation’s profitability, liquidity,

efficiency, and capital structure using ratio analysis.

8.2 Ratios

Ratio analysis makes it possible to compare:

Performance within the current year against performance in previous years. As a result trends can be established to determine which areas of the business are

expanding and which are contracting.

Performance within the current year against the budgeted or planned performance for the year.

Performance of the business against the performance of other businesses.

It is important to note that you can only sensibly compare like with like. There is not much

point in comparing the net profit percentage of a restaurant and a jeweller’s shop. Similarly,

figures are only comparable if they have been built up on a similar basis. A company might

change its methods of valuation between two different time periods.

Another important point is to understand the relationships between ratios: one ratio may give

an indication of the state of the business, but this needs to be supported by other ratios. Ratios

indicate symptoms, but the cause will then need to be investigated.

As you learnt in Module 1, there are different parties interested in the financial information of

a business. Bearing that in mind, you can realised that the same parties will be the users of the

financial ratios, but they will be interested in different things:



General management of the business, who need to make financial decisions affecting the future development of the business.

Trade creditors and banks, who use ratios to assess the creditworthiness of the

business when making ‘lending’ decisions.

Shareholders of a limited company, who wish to be assured that their investment is sound.

Prospective investors in a limited company, who wish to compare comparative strengths and weakness.

The main themes covered by the interpretation or analysis of accounts are:

1. Profitability. The relationship between profit and sales turnover, assets and capital

employed.

2. Solvency/liquidity. It considers the stability of the business on both a short-term and

long-term basis.

3. Asset utilisation. The effective and efficient use of assets.

4. Investment ratios. They examine the returns to shareholders in companies.

8.2.1. Categories of ratio:

1. Profitability ratios

Profitability ratios are used to determine the ability of a business to generate profit, and

include:

Return on Capital Employed

Gross profit as percentage of sales

Net profit as percentage of sales

a) Return on Capital Employed (ROCE)

This is regard as being the primary ratio and is the most important of the ratios. It

measures the profit of the business as compared to the ‘monies’ invested in it long term,

and, therefore, assess profits in relation to the size of the business.

An adequate return on capital employed is why people invested their money in a business

in the first place.

The formula for calculating this ratio, which should be expressed as a percentage, is:

ROCE Net profit (before tax) x 100

Capital Employed 1

Note:

The net profit is the operating profit (net profit before interest and tax)



Capital employed = net assets (fixed assets + current assets – current assets)

However, there is no universally agreed definition of return on capital employed for

companies. It is necessary to distinguish between the ordinary shareholders’ investment

(the equity) and the capital employed by the company, which included preference shares

and debentures/long-term loans.

These different definitions of capital employed give further accounting ratios:

i) Return on capital employed by ordinary shareholders (equity).

In a limited company this is known as Return on Owners’ Equity (ROOE) or, more

commonly, Return on Shareholders’ Funds (ROSF). Ordinary share capital +

Reserves = Equity. The ‘Return’ is the net profit for the period.

ii) Return on capital employed by all long-term suppliers of capital. This is often

known as ‘Return on Capital Employed’ (ROCE). In this case the word ‘Return’

means net profit + any preference share dividends + debentures and long-term

loan interest. The word ‘Capital’ means Ordinary Share Capital + Reserves

including Profit and Loss Account + Preference Shares + Debentures and Long-

term loans.

For example:

Two business A and B have made the same profit, but they have employed

different capitals

Balance Sheets

A B

Net assets 10,000 10,000

Capital accounts

Opening balance 8,000 14,000

Net profit 3,600 3,600

11,600 17,600

Drawings (1,600) (1,600)

10,000 16,000

Return on capital employed (ROCE) is:

Net profit x 100

Capital employed

Therefore,

Business A: 3,600 x 100 = 36%

10,000

Business B: 3,600 x 100 = 22.5%



16,000

Business A has made far better use of its capital, achieving a return of £36 net

profit for every £100 invested, whereas B has received only a net profit of

£22.50 per £100. By only looking at the net profit of the two businesses we

would not have been able to see how well the capital had been employed. This

is a key factor for the shareholders and potential investors.

Now we have the Balance Sheets and Profit and Loss Account of two companies, A

Ltd and B Ltd:

Balance Sheets as at 31 March 2008

A Ltd B Ltd

Fixed assets 5,200 8,400

Net current assets 2,800 1,600

8,000 10,000

10% debentures - (1,200)

8,000 8,800

Share capital (ordinary) 3,000 5,000

Reserves 5,000 3,800

8,000 8,800

Profit and Loss Account for year ended 31 March 2008

A Ltd B Ltd

Net profit 2,200 3,800

Dividends (1,200) (1,800)

1,000 2,000

Return on Shareholders’ Funds (ROSF):

A Ltd: 2,200 x 100 = 27.5 %

8,000

B Ltd: 3,800 x 100 = 43.2 %

8,800

Return on Capital Employed (ROCE):

A Ltd: 2,200 x 100 = 27.5 %

8,000

(ROCE = ROSF, as it has no debentures)

(Net profit before interest, dividends and taxes)



B Ltd: 3,800 + 120 x 100 = 39.2 %

8,800 + 1,200

(The debenture interest, i.e. 10% of 1,200 = £120, must be added back, as it was an

expense in calculating the £3,800 net profit. In capital employed we add back

Debentures of £1,200)

b) Gross profit as percentage of sales

This ratio indicates the extent to which costs of goods sold are being controlled in relation

to sales income. It is also known as gross margin. This expresses, as a percentage, the

gross profit (sales minus cost of sales) in relation to sales.

The formula for calculating this ratio is:

Gross Profit x 100

Sales 1

This ratio is used as a test of the profitability of the sales. Just because sales revenue has

increased does not, of itself, mean that the gross profit will increase.

Gross margins are likely to be affected by:

The nature of the business

Its pricing policy

Leakage of stock due to wastage, damage, or theft of goods by customers or staff

Absorbing purchase price increases to remain competitive rather than passing them on to customers.

Selling goods at lower prices to clear them from stock

For example:

A business has the following Trading Accounts for the years 2006 and 2007:

Trading Accounts for the year ended 31 December

2006 2007

Sales 7,000 8,000

Less Cost of sales:

Opening stock 500 900

Add Purchases 6,000 7,200

6,500 8,100

Less Closing stock (900) (1,100)

(5,600) (7,000)

Gross profit 1,400 1,000

Therefore, in the year 2006,



Gross profit as percentage of sales: 1,400 x 100 = 20%

7,000

In the year 2007,

Gross profit as percentage of sales: 1,000 x 100 = 12.5%

8,000

Sales had increased but, as the gross profit percentage had fallen, the gross profit has

fallen. There can be many reasons for such a fall. Think of some of the possible

reasons for that.

c) Net profit as percentage of sales

This ratio shows net profit in relation to sales. It is also referred to as net profit margin.

When compared to the gross profit of sales it shows how expenses (selling, distribution

and administration) have impacted on sales.


Net profit (before tax) x 100

Sales 1

Net profit percentage should, ideally, increase from year-to-year, which indicates that the

profit and loss account costs are being kept under control. Any significant fall should be

investigated to see if it has been caused by a fall in gross profit percentage and/or an

increase in one particular expense, e.g. wages and salaries, advertising, etc.

2. Liquidity ratios

Liquidity ratios measure the ability of a business to meet its short term commitments as

they fall due. It is also known as solvency ratio.

It is important for a business to know if it will be able to pay its creditors, expenses, loans

falling due, etc at the correct times. Failure to ensure that these payments are covered

effectively could mean that the business would have to be close down. Being able to pay

one’s debts as they fall due is known as being ‘liquid’.

On the other hand, it is also essential to be aware if a customer or borrower is at risk of

not repaying the amount due.

Therefore, when it comes to the liquidity of a business, both its own ability to pay its

debts when due and the ability of its debtors to pay the amount they owe to the business

are very important.

The two ratios that are affected most by these two aspects of liquidity are:

Current ratio or working capital ratio



Acid test ratio or quick assets ratio

a) Current ratio (net current asset ratio)

Current ratio uses figures from the Balance Sheet and measures the relationship between

current assets and current liabilities. It is intended to indicate whether there are sufficient

short-term assets to meet the short-term liabilities by comparing assets which will become

liquid within twelve months (total current assets) with liabilities which will be due for

payment in the same period (total current liabilities).

The formula for calculating this ratio, which is expressed as a ratio, is:

Current ratio = Current assets

Current liabilities

Although there is no ideal current ratio, an acceptable ratio is about 2:1, i.e. £2 of current

assets to every £1 of current liabilities.

As you can see, when calculated, the ratio may be expressed as either a ratio to 1, as

above, with current liabilities being set to 1, or as a ‘number of times’, representing the

relative size of the amount of total current assets compared with total current liabilities.

Once you have performed the calculation, you need to decide what it tells you. The

acceptable ratio may be useless or misleading if you do not consider the result in its

context. For example, a business in the retail trade may be able to work with a lower ratio,

e.g. 1.5: 1 or even less, because it deals mainly in sales for cash and so does not have a

large figure for debtors.

If the current ratio is above 3:1 an investigation of the make-up of current assets and

current liabilities is needed. It may be that the business has too much stock, too many

debtors, or too much cash at the bank, or even too few creditors.

b) Acid test ratio (liquid capital ratio)

The acid ratio uses the current assets and current liabilities from the Balance Sheet, but

stock is omitted. This is because stock is the most illiquid current asset: it has to be sold,

turned into debtors, and then the cash has to be collected from the debtors. Also, some of

the stock may be unsaleable or obsolete.

The formula for calculating this ratio, which is expressed as a ratio, is:

Acid test ratio = current assets - stock

current liabilities

The balance between liquid assets, i.e. debtors and cash/bank, and current liabilities

should, ideally, be about 1:1, i.e. £1 of liquid assets to each £1 of current liabilities. At

this ratio a business is expected to be able to pay its current liabilities from its liquid



assets. However, a cash based business, such as a supermarket chain, may operate

efficiently with a much lower ratio.

Example:

Let’s look at two businesses with similar profitability. Sales for both businesses amounted

to £150,000, and gross profits were identical: £50,000.

Balance Sheets

A B

Fixed assets 40,000 70,000

Current assets

Stock 30,000 50,000

Debtors 45,000 9,000

Bank 15,000 1,000

90,000 60,000

Less Current liabilities:

Creditors (30,000) (30,000)

60,000 30,000

100,000 100,000

Capital

Opening capital 80,000 80,000

Net profit 36,000 36,000

116,000 116,000

Drawings (16,000) (16,000)

100,000 100,000

Now we will calculate the two ratios which we has just learnt:

Current ratio:

A = 90,000 = 3 B = 60,000 = 2

30,000 30,000

Acid test ratio:

A = 60,000 = 2 B = 10,000 = 0,33

30,000 30,000

This reveals that B, although it is profitable, may find difficult to pay its current

liabilities on time. If liquidity becomes a problem it may make the business fail.

This is an example of two profitable businesses with a vast difference in liquidity.



3. Efficiency ratios/Asset utilisation

Efficiency ratios are used to show how effective the business has been in controlling its

expenses, turning over its stock, collecting monies due from its trade debtors, and using

credit available from suppliers. It is affected by the way that the assets of a business are

used.

Ratios within this category include:

Expenses percentage of sales

Stock turnover

Debtors’ collection period

Creditors’ payment period

a) Expenses percentage of sales

Businesses use expense ratios to assess how efficiently overheads are being controlled in

relation to sales. They may calculate and express each expense item as a percentage of

sales, or total expenses as a percentage of sales, or group together expense items and

express them as a percentage of sales.

For example, the relationship between advertising and sales might be 10% one year, but

20% the following year. That means that there was an increase in advertising costs but it

has not been reflected in sales. Further investigation will be required to find out the

reason for the percentage increase.

The formula for calculating expense ratios is:

Total expenses x 100

Sales 1

Expense item x 100

Sales 1

Group of expenses items x 100

Sales 1

b) Stock turnover

Stock turnover measures how efficient a business is at maintaining an appropriate level of

stock. The objective being to turnover stock as many times as possible within a financial

year. Provided the stock is priced out correctly, the more times the stock is turned over

the more profit the business will generate.



A reduction in stock turnover can mean that the business is slowing down. Stocks may be

piling up and not being sold. This could lead to a liquidity crisis, as money may be being

taken out of the bank simply to increase stocks which are not then sold quickly enough.

Different types of businesses have different periods of stock turnover. For example, a

supermarket would probably turnover its stock 12 times a year, however, a jeweller might

only turnover his stock one or twice a year or longer.

The average stock turnover period may give a useful indication of trading difficulties

facing a particular firm by comparing it with the average for previous periods. A fall in

the ratio may indicate a degree of obsolescence in the firm’s products, adverse marketing

circumstances or stiffening competition.

This ratio can also be classified as a liquidity ratio.

The formula for calculating this ratio, which is expressed in terms of the number of times

the stock is turned over, is:

Stock turnover = costs of sales

average stock

Note: average stock = opening stock + closing stock / 2

For example, a business A has a closing stock of £30,000, the costs of sales was

£96,000 and the opening stock was £34,000, then using the average of the opening

and closing stocks, the stock turnover, would be:

96,000 = 3 times

(34,000 + 30,000) / 2

For you to be able to compare the result you need to be able to compare it against

similar business or previous years.

c) Debtors’ collection period

This ratio indicates the average period of credit being taken by credit customers, i.e. it

measures how efficient the business has been in collecting amounts due from its trade

debtors. The period of credit being taken needs to be compared to the normal period of

credit the business offers to its credit customers.

The formula to calculate this ratio, expressed in terms of number of days, is:

Trade debtors x 365 days

Credit sales

For example, at an accounting year end the closing trade debtors totals £36,000 and the

total credit sales for the year are £400,000, the debtors ratio would be:

36,000 x 365 = 32.85 days



400,000

This gives us the average credit period taken by debtors before clearing their debts, in this

case 32.85 days. Extended credit taken by customers can be costly as it requires

additional working capital; it can also be indicative of a breakdown in the credit system

collection system of a business. The longer the average collection period the greater will

be the likelihood of bad debts.

d) Creditors’ payment period

The creditor payment period indicates how efficiently the business is using trade credit,

and shows the average period of credit being taken from suppliers. A business should

itself abide with the terms of credit allowed by its suppliers and pay on time, just as a

business wishes to collect on time from its customers.

Ideally, a business would want to minimise its debtors’ collection time and maximise its

creditors’ payment time as far as it can, as creditors can be a useful temporary source of

finance; however, delaying payment too long may cause problems and may detriment the

relations with its suppliers: the business may lose creditworthiness and jeopardise future

supplies.


Trade creditors x 365 days

Credit purchases

For example, at an accounting year end the closing trade creditors totals £42,000 and

the total credit purchases for the year are £420,000, the creditors ratio would be:

42,000 x 365 = 36.5 days

420,000

This gives us the average credit period allowed by the business’s creditors as 36.5

days.

Generally, we would expect to see the creditor days period longer than the debtor

days, i.e. money is being received from debtors before it is paid out to creditors.

4. Capital structure. Gearing ratio

The relationship of equity shares (ordinary shares) to other forms of long-term financing

(long-term loans plus preference shares) can be extremely important.

This ratio provides the proportion of a company’s total capital that has a prior claim to

profits over those of ordinary shareholders.



The gearing ratio can be found by dividing the prior capital (i.e. preference capital,

debentures and long-term loans, regarded as prior because they come before the ordinary

capital) by the ordinary share capital. The formula is:

Long-term loans + Preference shares x 100

Ordinary share capital + Reserves + Preference shares + Long-term liabilities

This formula is sometime abbreviated to:

Prior charge capital x 100

Total capital

Long-term loans include debentures.

For example:

We have two companies, A Ltd and B Ltd, which have been trading for five years. We

want to calculate their gearing from the extracted Balance Sheet shown below:

Year 5. Extracted Balance Sheet

A Ltd B Ltd

10% debentures 10,000 100,000

10% preference shares 20,000 50,000

Ordinary shares 100,000 20,000

Reserves 70,000 30,000

200,000 200,000

Gearing ratios:

A Ltd: 10,000 + 20,000 x 100 = 15% (low gearing)

10,000 + 20,000 + 100,000 + 70,000

B Ltd: 100,000 + 50,000 x 100 = 75% (high gearing)

100,000 + 50,000 + 20,000 + 30,000

A company with a high percentage gearing ratio is said to be high geared, whereas one

with a low percentage gearing is said to be low geared.

This means that people investing in ordinary shares in a high geared company are taking a

far greater risk with their money than if they had invested instead in a low geared

company. In good times, the shareholders will enjoy a far higher return than in a low

geared company; however, in bad times, very little might be left over for ordinary

shareholders, as the rate of debt (i.e. long-term loans and preference shares) is high.



5. Mark-up and margin

The purchase costs, gross profit and selling price of goods or services may be shown as:

Cost price + Gross profit = Selling price

The gross profit is known as the mark-up when shown as a percentage of the cost price.

However, when shown as a percentage of the selling price is known as the margin.

Therefore,

Mark-up = Gross profit

Cost price

Margin = Gross profit

Selling price

Fox example:

Cost price = £4

Gross profit = £1

Selling price = £5

Then,

Mark-up = 1 / 4, as a percentage it would be: 1 / 4 x 100 = 25%

Margin = 1 / 5, as a percentage it would be: 1 / 5 x 100 = 20%



8.2.2. Limitations of ratio analysis

Although accounting ratios can usefully highlight strengths and weaknesses, they should be

considered as part of the overall assessment of a business, rather than as a whole. However,

the ratio analysis does have its pitfall and limitations:

1. Care should be exercised when selecting ratios as the basis for analysis. A

representative selection should be made avoiding over emphasis of a single ratio.

2. When using ratios for comparison purposes differences in types of business entity

may cause problems. The rate of stock turnover of a supermarket chain, for example,

would be vastly different to that of a construction or engineering company.

3. When the accounts of a business are compared, either with previous years, or with a

similar business, there is a danger that the comparative accounts are not drawn up on

the same basis due to different accounting policies, which may result in distortion and

invalid comparisons. For example, different accounting policy in respect of

depreciation and/or stock valuation.

4. Particular care must be taken when interpreting accounting ratios for a seasonal

business.

5. Limited access to the detailed information on which the ratio calculated was based to

those outside the firm if a much deeper analysis is necessary.

6. There is a danger of relying too heavily on suggested standards for accounting ratios

(e.g. 2:1 for the working capital ratio) without considering the nature of the business

or other factors in the Balance Sheet. An example would be a business with a low

current ratio which sells the majority of its goods for cash and consequently has a

very low debtors figure (e.g. retail companies).

7. As financial statements are prepared on an historic cost basis (assets and liabilities

are recorded at their original cost), inflation may prove a problem when comparing

figures from one year to the next.

For a summary and overview of the ratio analysis, click on the following link:

http://www.bized.co.uk/educators/16-19/business/accounting/presentation/ratio_map.htm



http://www.bized.co.uk/educators/16-19/business/accounting/presentation/ratio_map.htm

Question A

1) What would you deduce from the following figures taken from the balance sheet of

two different companies at the same time?

Company A Company B

Stock £50,000 £300,000

Cash and debtors £50,000 £20,000

£100,000 £320,000

Current liabilities £50,000 £270,000

Working capital £50,000 £50,000

2) What does the debtors ratio indicate?

3) What does the creditors ratio indicate?

Question B

Given the Trading and Profit and Loss Account and Balance Sheet of the company Smith Ltd

for the years ended 31 December 2007 and 2006:

Smith Ltd

Trading and Profit and Loss Account for the years ended 31 December

2006 2007

£’000 £’000 £’000 £’000 £’000 £’000

Sales 1,077 1,598

Cost of sales:

Opening stock 63 65

Purchases 713 1159

776 1,224

Closing stock 65 74

711 1,150

Gross profit 366 448

Expenses 291 314

Net profit (before tax) 75 134

Tax 26 46

Net profit (after tax) 49 88

Dividend proposed 20 25

Undistributed profit 29 63

Undistributed profit b/f 75 104

Undistributed profit c/f 104 167

Note: All purchases and sales are on credit.



Smith Ltd

Balance Sheets as at 31 December

2006 2007

£’000 £’000 £’000 £’000 £’000 £’000

Fixed assets (WDV) 183 280

Current assets:

Stock 65 74

Trade Debtors 158 176

Bank 54 50

277 300

Current liabilities:

Trade creditors 60 92

Tax 26 46

Dividends 20 25

106 163

171 137

354 417

Financed by:

Ordinary Share Capital 250 250

Reserves 104 167

Undistributed profit 354 417

Required:

1) calculate the following ratios:

a) Return on capital employed

b) Gross profit as percentage of sales

c) Net profit as percentage of sales

d) Total expenses as percentage of sales

e) Stock turnover ratio

f) Debtor payment period

g) Creditor payment period

h) Current ratio

i) Acid test ratio

2) Comment on the profitability and liquidity of the business in each of the years making

references to the relevant ratios.



Diploma in

Accounting


Accounting

Module 5: Introduction to Budgeting and Budget Control

– ICT in Accounting



LESSON 9. INTRODUCTION TO BUDGETING

9.1. Introduction

Management accounting is concerned with providing information for planning and

control so that organisations can achieve their objectives. One of the central supporting

devices of both of these aims is budgeting.

The various activities within a company should be coordinated by the preparation of

plans of actions for future periods. These detailed plans are usually referred to as

budgets.

Therefore, when a plan is expressed quantitatively it is known as a budget and the

process of converting plans into budgets is known as budgeting.

In this lesson we will focus on the role of budgeting within the planning process of a

business organisation and you will learn the need for budgeting in business organisations

and the benefits of budgetary control. You will also learn how to prepare cash budgets.

9.2. Budgeting and functions of budgets

Budgeting is concerned with the implementation of the long-term plan for the year ahead.

However, budgets represent the short-term planning developed within the context of

ongoing business and is ruled by previous decisions that have been taken within the long-

term planning process.

The budgeting process cannot be viewed as being purely concerned with the current year,

it must be considered as an integrated part of the long-term planning process. It is an

integral part of both planning and control. Budgeting is about making plans for the future,

implanting those plans and monitoring activities to see whether they conform to the plan.

In the planning process there are different stages:

Stage 1: Establishing objectives. It is an essential pre-requisite of the planning process. It is important for all parts of the organisation to have a good

understanding of what it is trying to achieve.

Stage 2: Identify potential strategies. In this stage it is important to identify a range of possible courses of action (or strategies) that might enable the company’s

objectives to be achieved. It is necessary to undertake a strategic analysis to

become better informed about the organisation’s present strategic situation. After

that, the next stage is to identify alternative strategies.



The identification of strategies should take into account:

- The generic strategy to be pursued

- The alternative directions in which the organisation may wish to develop.

Stage 3: Evaluation of strategic options. The alternative strategies should be examined based on the following criteria:

1. Suitability, which seeks to ascertain the extent to which the proposed

strategies fit the situation identified in the strategic analysis.

2. Feasibility, which focuses on whether the strategy can be implemented in

resource terms. E.g.: can the strategy be funded?

3. Acceptability, which is concerned with whether a particular strategy is

acceptable. E.g. is the level of risk acceptable?

Stage 4: Select a course of action. Long-term plans should be created to

implement the strategies. They are a statement of preliminary targets and

activities required to achieve the strategic plans of the organization.

Stage 5: Implementation of the long-term plans. When the activities are initially approved for inclusion in the long-term plan, they are based on uncertain

estimates that are projected for several years. These proposals must be reviewed

and revised in the light of more recent information, which takes place as part of

the annual budgeting process, as budgeting is an integrated part of the long-term

planning process.

Stage 6 and 7: Monitor actual outcomes and respond to divergencies from planned outcomes. These stages represent the control process of budgeting.

Budgets serve a number of useful purposes:

1. Planning annual operations

2. Coordinating the activities of the various parts of the organization

3. Communicating plans to the various responsibility centre managers

4. Motivating managers to strive to achieve the organizational goals

5. Controlling activities

6. Evaluating the performance of managers



1. Planning.

The budgeting process ensures that managers do plan for future operations, and that

they consider how conditions in the next year might change and what steps they

should take now to respond to these changed conditions. This process encourages

managers to anticipate problems before they arise.

2. Coordination.

The budget serves as a vehicle through which the actions of the different parts of an

organization can be brought together and reconciled into a common plan. Without

coordination, managers, believing that they are working in the best interest of the

organization, may make their own decisions independently. Budgeting, therefore,

compels managers to examine the relationship between their own operations and

those of other departments, and to identify and resolve conflicts.

3. Communication.

All parts of the organization must be kept fully informed of the plans and the policies,

and constraints, to which the organization is expected to conform. Top management

communicates its expectations to lower level management, so that everyone in the

organization has a clear understanding of what is expected from them their activities

can be coordinated to attain them.

4. Motivation.

The budget can be used as a device to influence and motivate managers to perform in

line with the organizational objectives.

5. Control.

By comparing the actual results with the budgeted amounts for different categories of

expenses, managers can ascertain which costs do not conform to the original plan and

thus require their attention. When the reasons for the inefficiencies have been found,

appropriate control action should be taken to remedy the situation.

6. Performance evaluation.

A manger’s performance is often evaluated by measuring his or her success in

meeting the budgets. The budget thus provides a useful means of informing managers

of how well they are performing in meeting targets that they have previously helped

to set.



9.3. Cash budgets

A cash budget is one of the most important budgets prepared in an organisation. It

shows, in summary form, the expected cash receipts and expected cash payments

during the budget period. Liquidity and cash flow management are key factors in the

successful operation of any organisation and it should receive close attention.

Why is cash so important? Cash is the lifeblood of the business. Not only is it

important to get the amounts of cash right, we also need to get the timing right. For

example:

John buys 500 widgets for £10,000 on 1 January and agrees to pay for these on 1

February. He sells the widgets on 2 January for £15,000 and agrees to be paid on 1

March.

In simple accounting terms, John has made a healthy profit of £5,000, but, in cash

flow terms, he is bankrupt! This is because, although John has sold the widgets for a

profit, this profit will not be realised until 1 March when he is paid. However, John

has agreed to pay £10,000 on 1 February, which (unless he has other funds) he cannot

pay.

This example illustrates a very important principle: it is possible to trade profitably in

the long term provided there is sufficient cash in the system to meet short term debts

as they become due. Neglecting cash can bankrupt an otherwise profitable business.

The objective of the cash budget is to ensure that sufficient cash is available at all

times to meet the level of operations that are outlined in the various budgets.

The cash budget shows the effect of budgeted activities: selling, buying, paying

wages, investing in capital equipment and so on, on the cash flow of the organisation.

It is important to understand how cash moves within a business. This movement of

cash is best illustrated by the ‘working capital cycle’, which you can find by clicking

on the following link:

http://tutor2u.net/business/finance/workingcapital_cycle.htm

A cash budget must contain every type of cash inflow or receipt and every type of

cash outflow or payment. In addition to the amounts, the timings of receipts and

payments must also be forecast.

Receipts: cash sales, receipts from debtors, sales of fixed assets, receipts of interest

and dividends, issues of new shares and loan stock



http://tutor2u.net/business/finance/workingcapital_cycle.htm

Payments: payments to creditors for stock and material purchases, wages and salaries,

payments for overhead and expense items, purchase of fixed assets, payments of

dividends, interest and taxation, loan repayments.

It is important to realise that cash receipts and payments are not the same as sales and

costs of sales found in the Profit and Loss Account because:

Not all cash receipts affect profit and loss account income, e.g. issue of new shares results in a cash inflow but would not be shown in the Profit

and Loss Account.

Not all cash payments affect the costs shown in the Profit and Loss

Account, e.g. the purchase of a fixed asset.

Some profit and loss items are derived from accounting conventions and are not cash flows, e.g. depreciation.

The timing of cash receipts and payments does not coincide with the profit and loss accounting period, e.g. sales are recognised when the invoices are

raised although the payment may not be received until some time later.

A cash budget is simply a forecast of:

- Where your expect your cash to come from

- Where you expect your cash to go to.

You also need to decide when money will change hands. For that you will prepare a

cash flow forecast. Once everyone becomes committed to achieving that forecast, it

becomes your cash budget.



9.3.1. Format of cash budgets

The typical cash budget has the general form shown below:

Cash budget

Period 1 Period 2 Period 3

Opening cash balance b/f

+ receipts from debtors

+ sales of fixed assets

+ any loans received

+ proceeds for share issues

+ any other cash receipts

XXXX YYYY ZZZZ

= total cash available

- payments to creditors

- cash purchases

- wages and salaries

- loan repayments

- capital expenditure

- dividends

- taxation

- any other cash disbursments

= closing cash balance c/f YYYY ZZZZ AAAA

Note: The opening balance could be in the third section above ‘closing cash balance

c/f’.

As you can see there are three sections. The first section is for receipts, the second is

for payments and the third is the cash balance to be carried forward.

When you compare the budgeted cash forecast with the actual you will find that there

is normally a difference. The difference between the two figures is known as

variance.

The variance can be:

1. a favourable variance, where the actual figure is better than the budget

figure.

2. an adverse variance, where the actual figure is worse than the budget

figure.



Example:

You have the following information regarding a business:

a) Opening cash balance: £800.

b) Receipts from debtors: July £2,000, August £2,600, September £5,000, October

£7,000, November £8,000, December £15,000.

c) Payments: July £2,500, August £2,700, September £6,900, October £7,800,

November £9,900, December £10,300.

Required:

Prepare a cash budget for the months of July, August, September, October, November

and December.

Cash budget

July August September October November December

Opening

balance

800

300 200 (1,700) (2,500) (4,400)

Receipts 2,000 2,600 5,000 7,000 8,000 15,000

Total cash

available

2,800 2,900 5,200 5,300 5,500 10,600

Payments 2,500 2,700 6,900 7,800 9,900 10,300

Closing

cash

balance c/f

300 200 (1,700) (2,5000) (4,400) 300

Click on the link below and use the different headings on the left hand side of the

page where you will find a summary of what you have learnt on Cash budget:

http://tutor2u.net/business/presentations/accounts/cashbudget/default.html Cash budget

summary



http://tutor2u.net/business/presentations/accounts/cashbudget/default.html

Question 9.A

The opening cash balance on 1st January was expected to be £30,000. The sales budgeted

were as follows:

November £80,000

December £90,000

January £75,000

February £75,000

March £80,000

Payments received from debtors are: 60% within the month of sale, 25% the month

following, 15% the month following.

The purchases budgeted were as follows:

December £60,000

January £55,000

February £45,000

March £55,000

All purchases are on credit and 90% are settled in the month of purchase and the balance

settled the month after.

Wages are £15,000 per month and overhead of £20,000 per month (including £5,000

depreciation) are settled monthly.

Taxation of £8,000 has to be settled in February and the company will receive settlement

of an insurance claim of £25,000 in March.

Required:

Prepare a cash budget for January, February and March.

Solution

Cash Budget

January February March

Opening Balance

Receipts from sales

Insurance claim

30,000

79,500

24,000

77,250

17,250

78,000

25,000

Total cash available 109,500 101,250 120,250

Payments:



Purchases Wages

Overheads

Taxation

55,000 15,000

15,000

46,000 15,000

15,000

8,000

54,000 15,000

15,000

Total payments 85,500 84,000 84,000

Closing balance c/d 24,000 17,250 36,250

Workings:

Receipts from sales:

January cash

November (15% x 80,000) £12,000

December (25% x 90,000) £22,500

January (60% x 75,000) £45,000

£79,500

February cash

December (15% x 90,000) £13,500

January (25% x 75,000) £18,750

February (60% x 75,000) £45,000

£77,250

March cash

January (15% x 75,000) £11,250

February (25% x 75,000) £18,750

March (60% x 80,000) £48,000

£78,000

Payments for purchases:

January cash

December (10% x 60,000) £6,000

January (90% x 55,000) £49,500

£55,500

February cash

January (10% x 55,000) £5,500

February (90% x 45,000) £40,500

£46,000

March cash

February (10% x 55,000) £4,500

March (90% x 55,000) £49,500

£54,000



Question 9.B

Click on the link below and try the quiz on ratios, ‘analysing financial performance’:

http://tutor2u.net/business/quizzes/as/analysing_financial_performance/quizmaker.htm

LESSON 10. THE IMPACT OF ICT IN ACCOUNTING

10.1. Computerised system

There are currently very few businesses which do not use a computer for some of their

data processing tasks.

Computers may be used for most or even all the accounting tasks. However, it is

important to understand how data is entered and processed so that the figures produced

can be reliable, valid and meaningful.

The technology when computers are used in an accounting system will vary in size to

meet the volume of data processing required by a business: a large and powerful central

computer or PCs for all accounting purposes.

When a central computer is used, the terminals need to be networked (i.e. linked together

through wires that run from their workstations to the central computer or via a router in a

wireless connection). Being linked together has the advantage that data and information

can be passed directly from one computer to another. Although they can operate

independently of any other computer, PC-based systems may also be connected together

on a local area network (LAN, i.e. internal to the location) and a wide area network

(WAN, i.e. connected outwith the location of the workstation to, for example, a computer

located at the business’s head office in another city).

Most financial accounting and bookkeeping programs are purchased off-the-shelf, as they

are flexible enough to be adapted to meet the major needs of most businesses.

Apart from using the accounting system for recording transactions, adjustments and

producing financial statements, there are other matters will be tackled, such as forecasting

the cash flows of a business, stock ordering, sales volume, costing. For such purposes, a

PC-based spreadsheet may be used, such as Excel.

The number of businesses which use a computerised system has increased substantially

lately. Most of those businesses will find very difficult to process the same volume of

data by reverting to a manual system.



http://tutor2u.net/business/quizzes/as/analysing_financial_performance/quizmaker.htm

When computers are used for all aspects of the accounting system, they can do everything

that can be done with a manual system; however, computers will do them faster, more

accurately and more efficiently. It saves time with respect to transaction processing and

the production of a whole series of reports. For example, if a business computerises its

stock records, the operator will save time in producing details of stock items that may be

in short supply and check items not yet received and chase up suppliers for those items

not delivered on time.

Another important point to bear in mind is that all computer systems will need to supply

information in a form that management can use to assist in its decision-making.

One of the most important principles in computing is the discipline of backing-up data

held on computer. This serves the purpose that, if anything ever goes wrong with the

data, then the business can always revert to a back-up copy of the data. Therefore, the

more often a business backs up its data, the less work is needed in the event of data loss.

When computers are being used along with an accounting package, it is normally

possible for passwords to be set up to restrict which personnel have access to certain parts

of the computerised elements of the accounting system. It increases security and assists

management in maintaining tighter control on the system.

Spreadsheets

The spreadsheet is the software tool most used by accountants. The name derives from

the appearance of the computer ‘spreading’ accounts on a ‘sheet’, allowing the user to

directly enter numbers, formulae or text into the cells.

Any figure can be changed at any time and the new results will instantly and

automatically be shown when you use formulae in a spreadsheet. And it is this facility of

being able to quickly recalculate formulae that makes the spreadsheet a powerful, useful

and popular analytical tool.

Some of the uses of the spreadsheets:

Financial plans and budgets can be represented as a table, with columns for time periods and rows for different elements of the plan (e.g. costs, revenue)

Investment and loan calculations

Currency conversion

Timesheets and roster planning for staff within the organisation

Statistics using built-in functions such as averages, standard deviations, time series and regression analysis can be calculated.

Financial statements can easily be produced.



10.2. Computerised accounting systems

Most businesses now use computers to handle their accounting data. They think that

anybody can use a computerised accounting system because it has very little to learn in

order to use it.

You must bear in mind that the methods adopted in computer-based accounting adhere to

the fundamental principles of accounting. Therefore, those in control need bookkeeping

and accounting knowledge in order to prepare journal entries, to correct errors and to

understand how an entry is going to affect the financial statements and why it is

important not to erase the original entry.

Thus, computerised accounting systems do not remove the need for some accounting

knowledge among those who use the output from the accounting systems or from those

who are responsible for accounting tasks. Knowledge of accounting principles is needed

to best convert a business from manual to computer-based accounting and also some

accounting knowledge is required to help understand the significance of many of the

outputs from a computerised accounting system.

10.2.1. Benefits of using a computerised accounting system

Speed

It is quicker to enter the data into a computerised system as the double entry is

automatically performed by the system itself once the operator has selected the

different ledgers where the transactions should be recorded. A manual system will

require entering the data separately; that may cause unbalance in the accounts if one

of the entries is omitted. Each transaction is entered only once and the software

automatically completes the double entry.

Reports are produced automatically what speeds up the process as it does not require

preparatory analysis of data

Accuracy

Improved accuracy is one of the most obvious benefits of any kind of computerised

accounting system. The accounts will always balance although the amount may have

been entered incorrectly, as the transaction is entered only once.



Consistency

The various ledgers and accounts maintained in a computerised accounting system

mimic those kept in a manual system. The General Ledger, for example, will adhere

to the basic rules of double entry bookkeeping in that each debit has a corresponding

credit entry. For example, if a customer is issued with an invoice, the transaction will

be stored in the credit sales records and then the double entry is made by crediting

sales accounts and debiting a debtor’s account.

Enhanced reporting

Effective reporting is often required in order to improve the decision-making process.

The task of producing reports on a regular basis can be time-consuming and tedious.

A computerised accounting system speeds up the process as it is done automatically.

In many cases, businesses can use computer printouts or electronic output, instead of

having to manually complete official or standard forms.

Flexibility

The information stored is available instantly and can be used to produce statements,

ledger account details, analysis of aged debtors, etc immediately it is requested.

10.2.2. Knowledge of double entry

In order to use a computerised accounting system efficiently and effectively, someone

with both accounting skills and a good knowledge of the business will be required to

organise the accounts and ledgers in the first instance. It may be necessary to override the

default account codes and create or to use the business’s own account code list.

Correction of errors will require a full knowledge of the relevant part of the accounting

system as well as bookkeeping and accounting principles.

On the other hand, the system will not overcome some errors and omissions such as the

operator misreading an amount on an invoice or crediting a payment to a wrong customer

account.

Sales order processing

Sales order processing allows an order to be placed into the system and can then be used

at a later stage to generate an invoice. It offers the advantage of being able to avoid orders

being left overdue or late. It can produce outstanding order reports very quickly.



Purchase order processing

The purchase order processing allows instant access to information about what is on order

and allows an operator to print an order to send off to a supplier. By entering stock on

order against various stock records, it reduces the likelihood of issuing multiple orders for

stock unnecessarily.

Stock control

Stock control offers the benefit of keeping very close tabs on stock levels. Once an

invoice has been raised, the recorded stock levels fall accordingly, the sales ledger is

updated and the nominal entries are made by crediting sales and debiting debtors’ control.

Orders received will be recorded and the level of stock will consequently be updated. The

level of stock will be checked against the actual level of stock physically counted, and

any difference will be investigated.

The computerised system will allow you to keep records of stock kept in different

locations much easier than a manual system would.







Question 1 1)

Bell Ltd made a bonus issue of ordinary shares on 31 May 2008. The shares were issued on the basis of 1

share for every 4 held. The directors of the company wish to retain its reserves in their most distributable

form.

The capital and reserves extract from the Balance Sheet, before the issue, is shown below:

£000

Capital and reserves

Issued ordinary shares of 10p each 1600

Share premium account 250

Revaluation reserves 140

Profit and loss account 240

2230

Required:

a) Prepare the capital and reserves extract from the Balance Sheet after the bonus issue.

(7 marks) (for quality of presentation: plus 1 mark)

b) Explain one reason why a company might choose to make a bonus issue of shares.

(3 marks)




2)

The trading and profit and loss account of Poole Catering Ltd for the year ended 31 December 2006 has

been completed and the following balances remain on the books:

Dr Cr

£ £

10% preference shares of £1 each fully paid 10,000

5% debentures (repayable 2015) 60,000

Balance at bank 4,000

Trade creditors 12,000

Trade debtors 15,000

Ordinary shares of 50p each fully paid 75,000

Premises 215,000

Profit and loss account at 1 January 2006 96,000

Stock at 31 December 2006 38,000

Net profit for the year after taxation 11,000

268,000 268,000

The directors recommend the following:

(1) Payment of 4p dividends per share on the ordinary shares;

(2) Payment of the full dividend due on the 10% preference shares.

Required:

a) Prepare a profit and loss appropriation account for the year ended 31 December 2006.

(3 marks)

b) Prepare a balance sheet as at 31 December 2006.

(13 marks)

c) The directors of Poole Catering Ltd have decided to revalue the premises at £300,000.

Explain how this revaluation will affect the balance sheet.

(3 marks)





Question 2

The directors of Hull Ltd have made a rights issue on the basis of 1 share for every 2 held at an issue price

of £1.50 each. The rights issue was fully subscribed.

An extract from the Balance Sheet immediately before the issue is shown below:

Balance Sheet extract at 1 December 2007

Hull Ltd

£000

Creditors: amount falling due after more than one year

Loan 200


Issued ordinary shares of £1 each fully paid 100

Share premium account 50

Profit and loss account 25

175

The directors have used all the funds generated by the rights issue to repay part of the loan.

Required:

a) Prepare the capital and reserves section of the Balance Sheet of Hull Ltd showing the

effect of the rights issue.

(8 marks)


b) State the value of the loan outstanding after the rights issue.

(3 marks)

c) Explain the differences between a rights issue and a bonus issue of shares.

(9 marks)





Question 3

Rock Ltd had the following Balance Sheets in two successive years:

Rock Ltd

Balance Sheet as at October 31, 2007

2007 2006

£000 £000

Tangible fixed assets 7326 7610

Current assets

Stock 629 440

Debtors 1430 1170

Bank 431 1522

2490 3132

Current liabilities

Creditors 839 621

Taxation ---- 192

839 813

Long term liabilities 4000 4000

Net assets 4977 5929

Required:

a) Calculate the following ratios for both Balance Sheets, on the basis that sales were

£1,600,000 in both years and the gross margin was 25%:

- Stock turnover (days)

- Debtor turnover (days)

- Creditor turnover (days)

- Gearing ratio

- Current ratio

(5 marks)

b) Using the information given and your ratios, discuss what seems to have happened to the

company during 2007. Put forward possible explanations for what you have observed.

(10 marks)




Question 4

William would like you to prepare his accounts for the year ending September 30, 2007. He has extracted

the following Trial Balance from the accounting records of his corporate wardrobe business at September

30, 2007:

Dr Cr

£ £

Motor vehicles – cost 70,000

Motor vehicles – accumulated depreciation 45,000

Rent 5,500

Insurance 1,236

Sales 41,028

Stock 532

Wages 15,123

Drawings 8.561

Bank 2.060

Creditors 1,040

Debtors 2,300

Purchases 12,000

Provision for doubtful debts 50

Sundry expenses 382

Capital 30,576

117,694 117,694

You are given the following additional information:

1) Stock at September 30, 2007 had originally cost £620

2) A demand for rent of £3,000 for the period September 1, 2007 to March 1, 2008 has not

been paid by September 30, 2007.

3) During the year, an insurance premium of £600 was paid for the year ending 31 March,

2008.

4) Fixed assets are depreciated at a rate of 25% using the reducing balance method.

5) The provision for doubtful debts would be 5% of the year end debtors balance.

Required:

a) Prepare a Profit and Loss Account for the year ending September 30, 2007.

(7 marks)

b) Prepare a Balance Sheet as at September 30, 2007.

(7 marks)

c) Write a memorandum to William advising him of one advantage and one disadvantage of

computerising the company’s accounting records.

(4 marks)





Question 5

Ian hopes to start a new business on 1 March selling surfboards. His balance at bank on that day will be

£3,200.

He intends to sell each surfboard for £160. On 1 June, the price will increase to £190 per surfboard.

The variable cost per surfboard is expected to be £85.

In preparation for the summer season Ian intends his stock level to be 60 surfboards by 1 June. Thereafter,

he will only produce enough to satisfy demand.

Note: Assume each month consists of 4 weeks.

Ian hopes to employ his brother, Malcolm, to help out in the workshop for 3 months from 1 March.

Malcolm will be paid £40 per day for 5 days a week.

With Malcolm’s help, Ian hopes to make up to a maximum of 10 surfboards a week, whereas he can only

make up to 6 surfboards alone.

Expected sales are:

1 March to 30 April May 1 June onwards

4 surfboards a week 7 surfboards a week 10 surfboards a week

The stock on 31 July is expected to be 28 surfboards.

His fixed overheads, excluding depreciation, are expected to be £500 a month.

Any bank surplus over £1,000 at the end of each month will be taken as Ian’s personal drawings.

All transactions will be on a cash basis.

Required:

Prepare a cash budget for each of the 5 months ending 31 July. Include the maximum amount that Ian can

withdraw for personal use.

(12 marks)



Diploma in

Accounting

Unit 3: Further Aspects of Financial

Accounting

Module 6: Stock Valuation, Incomplete Records and

Sources of Finance

Module 7: Accounting Standards, Published Accounts

and Partnership Accounts



Diploma in

Accounting


Accounting

Module 6: Stock Valuation, Incomplete Records and

Sources of Finance



FURTHER ASPECTS OF FINANCIAL ACCOUNTING

LESSON 11. STOCK VALUATION

11.1 Introduction.

The control and valuation of stock is an important aspect in the efficient management of a

business. Manual or computer records are used to show the amount of stock held and its

value at any time during the year. However, at the end of the financial year is essential for a

business to make a physical stock-take for use in the final accounts. This involves stock

control personnel going into the stores, the shop, or the warehouse and accounting each item.

The value of stock at the beginning and end of the financial year is used to calculate the

figure for cost of sales. Therefore, the stock value has an effect on profit for the year.

In practice a stock valuation method which is fair and suitable should be selected. The

management of a business are expected to choose a method of stock valuation which provides

‘the fairest possible approximation of the expenditure incurred in bringing a product to its

present location and condition’.

Once a particular method of stock valuation has been selected it then becomes the business

policy in respect of stock valuation and should be applied consistently from accounting

period to accounting period. The consistency concept prevents a change in policy being

introduced just to show information in a more favourable light.



11.2 Valuation of stock.

Let us consider the following case:

During its financial year ended 31 March 2007 a business purchased goods for resale at a cost

of £350,000. Sales to customers during the same period were £450,000. The gross profit was

therefore calculated in the Trading Account as follows:

Trading Account for the year ended 31 March 2007

£

Sales 450,000

Less Purchases 350,000

Gross Profit 100,000

Let us now assume that the business does not in fact sell all the goods it purchases during the

year to 31 March 2007. At the year end the business had goods which cost £50,000 remaining

in stock.

In such a case it would be unfair to charge the cost of all goods purchased in a period against

income earned from selling only some of them.

If we now apply the matching concept and make an adjustment to account for closing stock

the gross profit calculation is revised as follows:


£ £

Sales 450,000

Less Cost of Goods Sold Purchases 350,000

Less Closing Stock 50,000

Cost of Sales 300,000


(Remember that the matching concept requires that in calculating profit or loss for a

period we must deduct costs and expenses incurred in the period from the income earned

in that same period.)

The closing stock of one period end becomes the opening stock of the following accounting

period. This has further implications when calculating gross profit.

In the financial year ended 31 March 2008 the business referred to above purchased goods for

resale costing £400,000. Sales in the year were £570,000, and stock remaining at the year end

was counted and valued at its cost to the business, this being £70,000.

At this point we will have an opening stock from the previous year. When we now calculate

gross profit in applying the matching concept we must take into account both the opening and

closing stocks. The Trading Account would now be prepared as follows:




£ £ £

Sales 570,000

Less Cost of Goods Sold Opening Stock 50,000

Add Purchases 400,000

450,000


Cost of Sales 380,000


With regard to stock valuation the matching concept requires ‘The cost of unsold or

unconsumed goods at the end of an accounting period should be carried forward to future

accounting periods in the anticipation of future sale revenue’



11.3 Methods

Stock is valued at:

Either what it cost the business to buy the stock (including additional costs to bring

the product or service to its present location and condition, such as delivery charges)

Or the net realisable value – the actual or estimated selling price (less any further costs, such as selling and distribution)

The stock valuation is often described as being at the lower of cost and net realisable value.

This valuation applies the prudence concept.

Thus two different stock values are compared:

Cost, including additional costs such as delivery charges

Net realisable value (the amount the stock will sell for), less any further costs such as

selling and distribution.

In practice it is often difficult for many businesses to ascertain the actual cost of a particular

item. This is due to the fact that many businesses take numerous deliveries of identical goods

during an accounting period, often paying a different purchase price for each consignment. At

the end of the accounting period it is often impossible to match individual units of a particular

line of stock to their actual purchase price. In order to solve this problem a number of

theoretical models have been devised for valuing stock. These include:

FIFO (First in First Out). This method assumes that goods are issued in chronological

order, i.e. the oldest goods are issued first. This means that the goods that remain in stock at

the end of an accounting period are assumed to be the goods that were purchased last. This

method of stock valuation appears logical in that most businesses would wish to sell their

oldest goods first to guard against deterioration or obsolescence.

LIFO (Last in First Out). This method assumes that the goods issued first are those that

were purchased last, therefore the items that remain in stock at the end of an accounting

period are assumed to be the oldest goods and are therefore valued at the oldest purchase

price. This method is not generally used when preparing financial statements and you will not

be expected to use it in the exam.

AVCO (Average Cost). Stock is valued at its average cost. This involves dividing the total

value of stock by the total quantity of stock to arrive at the average price which is then used

to value an issue of stock. A new average price must be calculated every time there is a

receipt of goods into stock at a price which is higher or lower than the prevailing average

price.



In order to be able to calculate accurately the price at which stocks of materials are issued to

production, and to ascertain quickly a valuation of closing stock, the following method of

recording stock data is suggested:

Date Receipts Issues Balance

Quantity Price Value Quantity Price Value Quantity Price Value

£ £ £ £ £ £

Note: the price is the cost price to the business, not the selling price.

Now we are going to calculate the stock values using the FIFO and AVCO methods in turn.

For that we will use the following data:

January Opening stock of 40 units at a cost of £3.00 each

February Bought 20 units at a cost of £3.60 each

March Sold 36 units for £6 each

April Bought 20 units at a cost of £3.75 each

May Sold 25 units for £6 each

FIFO

STORES LEDGER RECORD



£ £ £ £ £ £

Jan Balance 40 3.00 120.00

Feb 20 3.60 72.00 40 3.00 120.00

20 3.60 72.00

60 192.00

March 36 3.00 108.00 4 3.00 12.00

20 3.60 72.00

24 84.00

April 20 3.75 75.00 4 3.00 12.00

20 3.60 72.00

20 3.75 75.00

44 159.00

May 4 3.00 12.00

20 3.60 72.00

1 3.75 3.75 19.00 3.75 71.25



AVCO

STORES LEDGER RECORD



£ £ £ £ £ £

Jan Balance 40 3.00 120.00

Feb 20 3.60 72.00 40 3.00 120.00

20 3.60 72.00

60 192.00

March 36 3.20 115.20 24 3.20 76.80

April 20 3.75 75.00 24 3.20 76.80

20 3.75 75.00

44 3.45 151.80

May 25 3.45 86.25 19 3.45 65.55

In January the balance was 40 units at £3.00 each, which gives us a value of £120

Under the FIFO method, you must account for the price at which the units are bought.

Therefore, in February 20 units at £3.60 each were bought. Now the balance is 60 units,

however, 40 units were bought at £3.00 and 20 units at £3.60; that will give us a balance of

£192.

Now we sold 36 units in March. As it is First In First Out, we must deduct 20 units at £3 each

from the opening stock in January. We had 40 units, we deduct 36 units sold at £3 (36 x £3 =

£108), therefore, there are 4 units at £3 each left, plus 20 units at £3.60 each bought in

February. The new balance is 24 units (4 @ £3 and 20 @ £3.60) with a value of £84.

And you continue in the same way.

The Average cost (AVCO) is calculated by dividing the quantity held in stock into the value

of the stock. For example, at the end of February, the average cost is £192 ÷ 60 units = £3.20.

The closing stock valuations at the end of May under each method show cost prices of:

FIFO £71.25

AVCO £65.55

You can see that there is quite a difference by using one method or the other. How does effect

have on profit?



EFFECT ON PROFIT

In the example above, the selling price was £6 per unit. The effect on gross profit of using

different stock valuations is shown in the following trading accounts:

FIFO AVCO

£ £

Sales: 61 units at £6 366.00 366.00

Opening stock: 40 units at £3 120.00 120.00

Purchases: 20 units at £3.60

20 units at £3.75 147.00 147.00

267.00 267.00

Less Closing stock: 19 units 71.25 65.55

Cost of Goods Sold 195.75 201.45

Gross profit 170.25 164.55

366.00 366.00

In times of rising prices, FIFO produces the highest profit.



11.4 Advantages and Disadvantages

1. FIFO (First in, First out)

Advantages:

Realistic; it assumes that goods are issued in order of receipt

It is easy to calculate

Stock valuation comprises actual prices at which items have been bought

The closing stock valuation is close to the most recent prices.

Disadvantages:

Prices at which goods are issued are not necessarily the latest prices

In times of rising prices, profits will be higher than with other methods (resulting in

more tax to pay)

2. AVCO (Average cost)

Advantages:

Over a number of accounting periods reported profits are smoothed: both high and

low profits are avoided.

Fluctuations in purchase price are evened out so that issues do not vary greatly.

It assumes that identical units, even when purchases at different times, have the same value.

Closing stock valuation is close to current market values (in times of rising prices, it will be below current market values)

Disadvantages:

Difficult to calculate and calculations may be to several decimal places.

Issues and stock valuation are usually at prices which never existed.

Issues may not be at current prices and, in times of rising prices, will be below current prices.



11.5 Questions

Question 1.

A furniture shop sells coffee tables amongst the lines that it sells. The stock movements for

coffee tables in February 2008 were:

1 February Stock of 10 tables brought forward at a cost of £30 each

4 February Sold 2 tables


10 February Bought 12 tables at £32 each



20 February Bought 8 tables at £31 each



Each table sells at £50. Stock is valued on the FIFO (first in, first out) basis.

You are to calculate the value of:

a) Sales for February

b) Closing stock at 28 February

c) Costs of sales for February

Question 2.

A business buys twenty units of a product in January at a cost of £3.00 each; it buys ten more

in February at £3.50 each, and ten in April at £4.00 each. Eight units are sold in March, and

sixteen are sold in May.

You are to calculate the value of closing stock at the end of May using:

a) FIFO

b) AVOC



LESSON 12. INCOMPLETE RECORDS

12.1 Introduction

The books of account of many businesses, small sole trader type organisation in particular,

are kept on a single entry basis. Such records are known as incomplete records.

A single entry bookkeeping system usually consists of a Cash Book which is used to record

and analyse liquid fund (Cash and Bank) receipts and payments. The Cash Book is set out to

provide an analysis of transactions in terms of: date of transaction, details of transaction,

amount received, amount paid, analysis of source of income and as to the nature of the

expenditure.

To prepare financial statements (the Trading and Profit and Loss Account and Balance Sheet)

from the Cash Book further analysis and additional information is usually required. For

example:

Receipts and payment postings have to be analysed and categorised as being capital or

revenue.

Details which allow the Cash Book postings to be adjusted in accordance with the matching concept must be provided. These include details of:

Prepayments and accruals

Debtors and creditors

Cash discounts allowed and received

Bad debts

Stocks

Depreciation policy

To prepare financial statements from incomplete records it is advised to convert the single

entry records to double entry records. This can be done by creating appropriate accounts with

an accounts worksheet.

Initially the worksheet accounts are set up by posting balances from an opening Balance

Sheet, or by establishing the opening financial position of the business. Double entry using

the Cash Book postings as the basis of the periods business transactions are then processed,

with adjustments, again using double entry principles, being made in respect of additional

information made available.

In preparing financial statements form incomplete records the problem areas include:

Establishing the opening financial position (where an opening Balance Sheet is not given).

Calculating sales, purchases and expenses from incomplete information.

Calculating drawings from incomplete information.

Such areas need to be studied and practised.



12.2 The Opening Financial Position

The accounts worksheet mentioned above, which should be used to convert single entry

records to double entry records, is set up by establishing the opening financial position of the

business. This information is then used to post opening balances to accounts set up within the

accounts worksheet.

Where an opening Balance Sheet is provided, which would normally be the case if the

business has been trading for several years, then it is a simple procedure to open working

accounts by:

Debiting accounts with Asset Values

Crediting accounts with Capital and Liabilities

If a Balance Sheet is not provided then we must establish the financial position by applying

the accounting equation:

Assets = Capital (+) Liabilities

Therefore, we take the financial information that is available and, using the tools of

accounting, we construct the accounts that are required. The tools of accounting that may be

needed are:

The use of an opening trial balance, or statement of assets and liabilities.

The construction of a cash account and/or bank account

The use of control accounts – sales ledger control account and purchases ledger control account.

In addition, the following may be of use:

The accounting equation, as mentioned earlier ( assets – liabilities = capital)

Gross profit mark-up and margin

The format of the Trading and Profit and Loss Account and Balance Sheet.



Let us look at the following example:

Worked example 1:

The following information has been taken from the incomplete records of Jayne Perry, who

runs a small stationery supplies business:

List of Assets and Liabilities

1 Jan 2008 31 Dec 2008

£ £

Shop fittings 8,000 8,000

Stock 25,600 29,800

Debtors 29,200 20,400

Bank balance 5,000 not known

Creditors 20,800 16,000

Expenses owing 200 300

Bank Summary for 2008

£

Receipt from debtors 127,800

Payments to creditors 82,600

Drawings 12,500

Business expenses 30,600

From the information above the capital contribution would be calculated as follows:

Calculation of Capital as at 1 January 2008

£ £

Assets

Shop fitting 8,000

Stock 25,600

Debtors 29,200

Bank balance 5,000

67,800

Less Liabilities

Creditors 20,800

Expenses owing 200

21,000

Capital at 1 January 2008 46,800



Note:

Look out for the bank balance; here the bank balance is an asset; if it was marked as an

overdraft, it would be included amongst the liabilities.

Now let us look at the information provided above from Jayne Perry in the worked example.

We are going to calculate the missing figure for the bank balance at 31 December 2008. For

that we prepare a cash book from the cash book summary.

Jayne Perry

Cash Book (bank columns)

Dr Cr

2008 £ 2008 £

1 Jan Balance b/d 5,000 Payments to creditors 82,600

Receipts from debtors 127,800 Drawings 12,500

Expenses 30,600

31 Dec Balance c/d 7,100

132,800 132,800

2009 2009


The bank balance of £7,100 on 31 December 2008 is calculated by filling the missing figure.

Receipts form debtors is money in, therefore, a debit entry in the Cash Book; payments to

creditors, drawings and expenses are money out, therefore, a credit entry in the Cash Book.

The balance b/d at 1 January 2008 was provided within the list of assets and liabilities.

When preparing a Cash Book summary, look out for an opening bank balance that is

overdrawn; this is entered on the credit side. At the end of the Cash Book summary, a credit

balance brought down is an overdraft.

Try the following question:

Missing figure



Question 12.2.1

Lisa was able to provide the following information regarding her business as at 1 April 2001:

£

Fixtures and fittings 10,000

Stock 15,500

Trade creditors 3,600

Rent repaid 400

Bank loan 5,000

Cash 500

Bank (overdraft) 1,000

Required:

Calculate the capital contribution (the opening capital).

Your answer should be: £16,800



12.3 Calculating Sales

Where goods are sold on credit to customers sales income for the accounting period can be

calculated by drawing up a Debtors Control Account. The information necessary to make

such a calculation includes:

Opening and closing trade debtors.

Receipts from customers (cash and credit customers) in the period under review.

Any bad debts to be written off.

Cash discounts allowed to customers.

Goods at selling price taken by the proprietor as personal drawings.

If we go back to Jayne Perry’s business, the sales figures will be:

Sales = £127,800 - £29,200 + £20,400 = £119,000

Sales = receipts from debtors in the year, less debtors at the beginning of the year, plus

debtors at the end of the year.

The use of control accounts is recommended for calculating sales in incomplete records

questions.

If we prepare a control accounts based on the information from Jayne Perry’s business, the

sales figure can be calculated:

Debtors Control Account

Dr Cr

2008 £ 2008 £

1 Jan Balance b/d 29,200 Receipts from debtors 127,800

Sales (missing figure) 119,000 31 Dec Balance c/d 20,400

148,200 148,200

2009

1 Jan Balance c/d 20,400

Do not forget that the control accounts give the figures for credit sales: cash sales need to be

added, where applicable, to obtain total sales for the year.

The following information is available regarding the trading activities of Catering Supplies

for the year ended 31 March 2001. The business, owned by Tina Tate, supplies catering

equipment and catering goods on a credit and cash and carry basis:

£

1 April 2000 - Trade debtors 8,450

31 March 2001 - Receipts from cash customers in year 24,160

31 March 2001 - Cheques received from trade debtors in year 142,410

31 March 2001 - Trade debtors 9,480

31 March 2001 - Drawings at sales value in year 2,400



Other information:

i) Cash discounts of £1,450 were allowed to trade debtors for prompt payment in the

year.

ii) Of the debts outstanding as at 1 April 2000 £500 remains uncollected and is to be

written off as a bad debt.

The sales for the year can be calculated as follows:

Debtors Control Account

Dr Cr

£ £

1/4/00 Balance b/f 8,450 31/3/01 Bank (Cash Book) 142,410

31/3/01 Sales 145,390 31/3/01 Discount allowed 1,450

31/3/01 Bad debts 500

31/3/01 Balance c/d 9,480

153,840 153,840

31/3/01 Balance b/d 9,480

Sales

Dr Cr

£ £

31/3/01 Trading 171,950 31/3/01 Cash (Cash book) 24,160

31/3/01 Drawings 2,400

31/3/01 Debtors Control 145,390

171,950 171,950



12.4 Calculating Purchases

Where credit is taken from suppliers purchases for the period under review are best calculated

using a creditors’ Control Account. To make the calculation the following information is

required:

Opening and closing trade creditors.

Payments to creditors and cash payments for goods bought for resale.

Cash discounts received from trade creditors for prompt payment.

Goods at cost price taken by the proprietor as personal drawings.

If we now go back to the information from Jayne Perry’s business, we can calculate the

purchases for the year:

Purchases = £82,600 – £20,800 + £16,000 = £77,800

Purchases = payments to creditors in the year, less creditors at the beginning of the year, plus

creditors at the end of the year.

If we prepare a control accounts based on the information from Jayne Perry’s business, the

purchases figure can be calculated:

Creditors Control Account

Dr Cr

2008 £ 2008 £

Payments to creditors 82,600 1 Jan Balance b/d 20,800

31 Dec Balance c/d 16,000 Purchases 77,800

98,600 98,600

2009 2009


Do not forget that the control accounts give the figures for credit purchases: cash purchases

need to be added, where applicable, to obtain total purchases for the year.

Now try the following question:

Missing figure



Question 12.4.1:

The following information is available regarding the trading activities of The Angling Centre

for the year ended 31 March 2001:

1 April 2000 - Trade creditors 4,260

31 March 2001 - Payments for cash purchases in year 2,120

31 March 2001 - Cheques paid to trade creditors in year 87,180

31 March 2001 - Trade creditors 3,840

Other information:

Cash discounts of £1,180 were received from trade creditors for prompt payment in

year.

Required:

Calculate the purchases for the year.

Your answer should be: £90,060 (purchases for the year)



12.5 Calculating expenses

Expenses incurred within a given period may also have to be calculated from incomplete

data. To do this the following information is required:

Expense amounts prepaid at beginning and end of accounting period.

Expense amounts accrued at beginning and end of accounting period.

Expense amount paid in accounting period.

Let see how it works with an example:

The following information is available regarding the expenses of Ground Rent and Heat and

Light of Carefree Caravans for the year ended 31 March 2001:

£

1 April 2000 - Ground rent prepaid 1,200

1 April 2000 - Heat and light accrued 180

31 March 2001 - Ground rent paid in year 7,300

31 March 2001 - Heat and light paid in year 840

31 March 2001 - Ground rent prepaid 1,300

31 March 2001 - Heat and light accrued 210

The expenses of ground rent and heat and light incurred in the year ended 31 March 2001 can

be calculated as follows:

Ground Rent

Dr Cr

1/4/00 Balance b/d 1,200 31/3/01 Profit and loss 7,200

31/3/01 Bank 7,300 31/3/01 Balance c/d 1,300

8,500 8,500

31/3/01 Balance c/d 1,300

Heat and Light

Dr Cr

31/3/01 Bank 840 1/4/00 Balance b/f 180

31/3/01 Balance c/d 210 31/3/01 Profit and loss 870

1,050 1,050

31/3/01 Balance b/d 210

Missing figure

Missing figure



12.6 Drawing up financial statements

We have calculated the figures for purchases, sales, expenses and opening capital. Now we

can begin to prepare the Trading and Profit and Loss Account.

Based on the business information from Jayne Perry (our worked example) we are going to

prepare the gross profit section:

Jayne Perry

Trading and Profit and Loss Account

For the year ended 31 December 2008

£ £

Sales 119,000


Purchases 77,800

103,400


Cost of Goods Sold 73,600

Gross profit 45,400

Less:

Expenses (Working 1) (30,700)

Net profit 14,700

Working 1:

The relevant information from the Worked Example is:

Bank payments for expenses during year, £30,600

Expenses owing at 1 January 2008, £200

Expenses owing at 31 December 2008, £300

Like the calculation of purchases and sales, we must take note of cash payments along with

accruals and prepayments; we can not simply use the bank payments figure for expenses.

Expenses for year = bank and cash payments less accruals at the beginning of the year (or

plus prepayments), plus accruals at the end of the year (or less prepayments).

Thus the figure for Jayne Perry’s business is:

£30,600 - £200 + £300 = £30,700



The Balance Sheet can now be prepared using the assets and liabilities from the Worked

Example:

Jayne Perry

Balance Sheet

As at 31 December 2008

Fixed Assets £ £ £

Shop fittings 8,000

Current Assets

Stock 29,800

Debtors 20,400

Bank 7,100

57,300


Creditors 16,000

Accruals 300

16,300

Working Capital 41,000

Net Assets 49,000

Financed by:

Capital

Opening capital 46,800

Add net profit 14,700

Less drawings 12,500

49,000



12.7 The use of Gross Profit mark-up and margin

When preparing final accounts from incomplete records it is often necessary to use

accounting ratios and percentages.

There are two main percentages used for incomplete records accounting:

1. Gross profit mark-up

2. Gross profit margin

The difference between the two is that:

Mark-up is a profit percentage added to buying or cost price

Margin is a percentage profit based on the selling price

1. Mark-up

The mark-up is: gross profit x 100 Cost price 1

2. Margin

The margin is: gross profit x 100

Selling price 1

In incomplete records accounting, mark-up or the margin percentages can be used to calculate

either cost of goods sold (which, if opening stock and closing stock are known, will enable

the calculation of purchases) or sales.

If a product is bought by a retailer at a cost of £100 and the retailer sells it for £125, what is

the mark-up? And what is the margin?

Mark-up = 25 % (25/100 x 100)

Margin = 20 % (25/125 x 100)

Mark-up or the margin percentages can be used to calculate either cost of goods sold or sales.

Therefore, if opening stock and closing stock are known, we can calculate purchases.

For example:

Given the following information calculate sales:

Cost of goods sold is £150,000. The mark-up is 40 %

40/100 = gross profit / 150,000 ; 150,000 x 40/100 = £60,000



Sales = cost of goods sold + gross profit; 150,000 + 60,000 = £210,000

Now we have been provided with the following information:

Sales are £450,000; the margin is 20%; the opening stock is £40,000 and the closing stock is

£50,000. What are the purchases?

Gross profit = £450,000 x 20/100 = £90,000

Cost of goods sold = sales – gross profit; £450,000 - £90,000 = £360,000

The purchase calculation is;

Opening stock + purchases – closing stock = cost of goods sold

Purchases = £360,000 + £50,000 - £40,000 = £370,000

(purchases = costs of goods sold + closing stock – opening stock)



12.8 Questions

Question 1

Jane does not keep a full set of accounting records; however, the following information has

been produced for the first year of trading, which ended on 31 December 2008:

Summary of the business bank account for the year ended 31 December 2008:

£

Capital introduced 60,000

Receipts from sales 153,500

Payments to suppliers 95,000

Advertising 4,830

Wages 15,000


General expenses 5,000

Shop fittings 50,000

Drawings 15,020

Summary of assets and liabilities as at 31 December 2008:

£

Shop fittings at cost 50,000

Stock 73,900

Debtors 2,500

Creditors 65,000

Other information:

Jane wishes to depreciate the shop fittings at 20% per year using the straight-line

method

At 31 December 2008, rent is prepaid by £250, and wages of £550 are owing

Required:

a) Calculate the amount of sales during the year

b) Calculate the amount of purchases during the year

c) Calculate the figures for

Rent and rates

Wages To be shown in the Profit and Loss Account for the year ended 31 December 2008

d) Prepare Jane’s Profit and Loss Account of the year ended 31 December 2008.

e) Draw p Jane’s Balance Sheet as at 31 December 2008.



Question 2

J Evans has kept records of his business transactions in a single entry form, but he did not

realise that he had to record cash drawings. His bank account for the year 2008 is as follows:

£ £

Balance 1/1/2008 1,890 Cash withdrawals from bank 5,400

Receipts from debtors 44,656 Trade Creditors 31,695

Loan from T Hughes 2,000 Rent 2,750

Rates 1.316

Drawings 3,095

Sundry expenses 1,642

Balance 31/12/2008 2,648

48,546 48,546

Records of cash paid were:

Sundry expenses £122

Trade creditors: £642

Cash sales amounted to £698

The following information is also available:

31.12.2007 31.12.2008

£ £

Cash in hand 48 93

Trade creditors 4,896 5,091

Debtors 6,013 7,132

Rent owing - 250

Rates in advance 282 312

Van (at valuation) 2,800 2,400

Stock 11,163 13,021

Required:

Draw up a Profit and Loss Account and a Balance Sheet for the year ended 31 December

2008. Show all of your workings.



LESSON 13. SOURCES OF FINANCE

13.1 Introduction

When examining the various sources of finance available to a business, it is useful to

distinguish between:

- External sources; and

- internal sources

External sources are those which require the agreement of someone beyond the directors and

managers of the business. For example: finance from an issue of new shares; it requires the

agreement of potential shareholders.

Internal sources do not require agreement from other parties and arise from management

decisions. For example, retained profits; the directors have the power to retain profits without

the agreement of the shareholders.

Within external sources of finance we can find:

- long-term sources of finance; and

- short-term sources of finance.

We will consider long-term finance a source of finance that is due after a year, whereas short-

term finance will be a source of finance that is due within a year.



13.2 External sources

The major sources of long-term external finance are:

Ordinary shares

Preference shares

Loans and debentures

Finance leases (not required for the exam)

The major sources of short-term external finance are:

Bank overdrafts

Debt factoring

Invoice discounting



13.2.1 Long-term sources of external finance

Ordinary shares

Ordinary share capital represents a business’s risk capital. Ordinary shareholders will receive

a dividend only if profits available for distribution still remain after other investors

(preference shareholders and lenders) have received their returns in the form of dividend

payments or interest. Because of the high risks associated with this form of investment,

ordinary shareholders will normally require the business to provide a comparatively high rate

of return.

Ordinary shareholders exercise control over the business through their voting rights. This

gives them the power both to elect the directors and to remove them from office.

From the business’s perspective, ordinary shares can be a valuable form of financing as, at

times, it is useful to be able to avoid paying a dividend. For example, an expanding business

may prefer to retain funds in order to fuel future growth; a business in difficulties may need

the funds to meet its operating costs and so may find making a dividend a real burden.

Although a business financed by ordinary shares can avoid making cash payments to

shareholders when it is not prudent to do so, the market value of the shares may go down.

The cost to the business of financing through ordinary shares may become higher if

shareholders feel uncertain about future dividends.

Preference shares

Preference shares offer investors a lower level of risk than ordinary shares. Preference shares

will normally be given a fixed rate of dividend each year and preference dividends will be

paid before ordinary dividends are paid, provided there are sufficient profits available.

Preference shareholders are not usually given voting rights, although these may be granted

where the preference dividend is in arrears.

There are various types of preference shares that may be issues:

cumulative preference shares give investors the right to receive arrears of dividends

that have arisen as a result of there being insufficient profits in previous periods. The

unpaid amounts will accumulate and will be paid when sufficient profits have been

generated.

Non-cumulative preference shares do not give investors this right. Thus, if a

business is not in a position to pay the preference dividend due for a particular period,

the preference shareholder loses the right to receive that dividend

Participating preference shares give investors the right to a further share in the

profits available for dividend after they have been paid their fixed rate and after

ordinary shareholders have been awarded a dividend.



Redeemable preference shares allow the business to buy back the shares from

shareholders at some agreed future date.

Preference share capital is similar to loan capital in so far as both offer investors a fixed rate

of return. However, preference share capital is a far less popular form of fixed-return capital

than loan capital. An important reason for this is that dividends paid to preference

shareholders are not allowable against the taxable profits of the business, whereas interest

paid to lenders is allowable.

Loans and debentures

Loans

Most businesses rely on loans, as well as share capital, to finance operations. Lenders enter

into a contract with the business in which the rate of interest, dates of interest payments,

capital repayments and security for the loan are clearly stated.

A term loan is a type of loan offered by banks and other financial institutions, and is usually

tailored to the needs of the client business.

The amount of the loan, the time period, the repayment terms and the interest payable are all

open to negotiation and agreement.

The major risk facing those who invest in loan capital is that the business will default on

interest payments and capital repayments. To protect themselves against this risk, lenders

often seek some form of security from the business, so, in the event of default, they have the

right to seize the assets pledged and sell these in order to obtain the amount owing.

Debentures

This is simply a loan that is evidenced by a trust deed. The debenture loan is frequently

divided into units and investors are invited to purchase the number of units they require. The

debenture loan may be redeemable or irredeemable.

A convertible loan (or debenture) gives an investor the right to convert a loan into ordinary

shares at a given future date and at a specified price. The investor remains a lender to the

business and will receive interest on the amount of the loan until such time as the conversion

takes place. The investor is not obliged to convert the loan or debenture to ordinary shares.

This will be done if the market price of the shares at the conversion date exceeds the agreed

conversion price.



Mortgages

A mortgage is a form of loan that is secured on an asset, typically freehold property.

Financial institutions such as banks, insurance businesses and pension funds are often

prepared to lend to businesses on this basis. The mortgage may be over a long period (20

years or more).



13.2.2 Short-term sources of external finance

Bank overdrafts

A bank overdraft enables a business to maintain a negative balance on its bank account. It

represents a very flexible form of borrowing as the size of an overdraft can (subject to bank

approval) be increased or decreased according to the financing requirements of the business.

The rate of interest charged on an overdraft will vary according to how creditworthy the

customer is perceived to be by the bank. The banks may ask for forecast cash flow statements

from the business to see when the overdraft will be repaid and how much finance is required.

One potential drawback with this form of finance is that it is repayable on demand. This may

pose problems for a business that is illiquid.

This form of borrowing, though in theory regarded as short term, can often become a long-

term source of finance.

Debt factoring

Debt factoring is a service offered by a financial institution known as a factor. It involves the

factor taking overt the debt collection for a business.

The factor is usually prepared to make an advance to the business of up to around 80 per cent

of approved trade debtors, or as high as 90 per cent. This advance is paid immediately after

the goods have been supplied to the customer. The balance of the debt, less any deductions

for fees and interest, will be paid after an agreed period or when the debt is collected. The

charge made for the factoring service is based on total turnover and is often around 2-3 per

cent of turnover. Any advances made to the business by the factor will attract a rate of

interest similar to the rate charged on bank overdrafts.

Although many businesses find a factoring arrangement very convenient, as it can result in

savings in credit management and can create more certain cash flows, however, not all

businesses will find factoring arrangements the answer to their financing problems.

Factoring agreements may not be possible to arrange for very small businesses because the

high set-up costs. In addition, businesses engaged in certain sectors such as retailers or

building contractors, where trade disputes are part of the business culture, may find that

factoring arrangements are simply not available.

When considering a factoring agreement, the costs and likely benefits arising must be

identified and carefully weighed.



Invoice discounting

Invoice discounting involves a business approaching a factor or other financial institution for

a loan based on a proportion of the face value of credit sales outstanding. If the institution

agrees, the amount advanced is usually 75-80 per cent of the value of the approved sales

invoices outstanding. The business must agree to repay the advance within a relatively short

period – perhaps 60 or 90 days. The responsibility for collecting the trade debts outstanding

remains with the business and repayments of the advance is not dependent on the trade debts

being collected.

It may be a one-off arrangement whereas debt factoring usually involves a longer-term

arrangement between the client and the financial institution.



13.3 Internal sources

Internal sources of finance usually have the advantage that they are flexible. They may also

be obtained quickly – particularly working capital sources – and do not require the

permission of other parties.

The major sources of internal finance are:

Retained profits

Reduced stock levels

Retained profits

Retained profits are the major source of finance (internal or external) for most businesses. By

retaining profits within the business rather than distributing them to shareholders in the form

of dividends, the funds of the business are increased.

The reinvestment of profit rather than the issue of new shares can be a useful way of raising

finance from ordinary shares investors. There are no issue costs associated with retaining

profits and the amount raised is certain once the profit has been made. When issuing new

shares, the issue costs may be substantial and there may be uncertainty over the success of the

issue.

Retaining profits will have no effect on the control of the business by existing shareholders.

However, where new shares are issued to outside investors there will be some dilution of

control suffered by existing shareholders.

The retention of profit is something that is determined by the directors of the business. They

may find easier to retain profits rather than to ask investors to subscribe to a new share issue.

A problem with the use of profits as a source of finance, however, is that the timing and level

of future profits cannot always be reliably determined.

Reduced stock levels

Holding stocks imposes an opportunity cost on a business as the funds tied up cannot be used

for other opportunities. By holding less stock, funds become available for those opportunities.

However, sufficient stocks must be available to meet future sales demand otherwise the

business will suffer a loss of sales revenue and customer goodwill.

A balance needs to be found for each business, as the form of finance may not be suitable for

all type of businesses. Sometimes overstock is the result of poor buying decisions.



Diploma in

Accounting


Accounting

Module 7: Accounting Standards, Published Accounts

and Partnership Accounts



LESSON 14. ACCOUNTING STANDARDS

14.1 Introduction

International Accounting Standards (IAS) are now renamed International Financial Reporting

Standards (IFRS). However, we are going to use the terms International Accounting

Standards (IAS) in this course.

An accounting standard is a statement on how certain transactions or items are to be treated in

financial statements in order that the statements give a true and fair view.

Accounting standards are used in the preparation of financial statements. They are the rules

for the treatment of certain items that appear in financial statements.

The objective of financial statements is to provide information about the financial position,

performance, and changes in financial position of an entity that is useful to a wide range of

users in making economic decisions. Users include present and potential investors,

employees, lenders, suppliers and other trade creditors, customers and government and their

agencies, and the public.

There are two assumptions underlying the preparation and presentation of financial

statements:

1. The accrual basis. The effects of transactions and other events are recognized when

they occur (not a cash or its equivalent is received or paid), and they are recorded in

the accounting records and reported in the financial statements of the periods to which

they relate.

2. The going concern. It is assumed that the entity has neither the intention nor the need

to liquidate materially the scale of its operations, but will continue in operation for the

foreseeable future.

The standards, together with the various Companies Acts, set the parameters that company

directors have to adhere to when choosing the accounting practices to be used in the

preparation of the financial statements.



14.2 Presentation of financial statements. IAS 1

Financial statements provide stakeholders with information about the entity‟s financial

position, financial performance, and cash flows by providing information about its assets,

liabilities, equity, income and expenses, other changes in equity, and cash flows.

This standard sets out how financial statements are to be presented. This ensures that

financial statements can be compared with accounting statements prepared by the company in

previous accounting periods and that accounting statements can be compared with other

companies.

The standard states that a company must prepare a complete set of financial statements

comprising:

An income statement

A balance sheet

A cash flow statement

A statement showing changes in equity

A statement of accounting policies and explanatory notes

This standard addresses certain accounting concepts which must be applied in the preparation

of the financial statements:

The going concern concept. Financial statements should be prepared on the basis

that the company will continue to operate into the foreseeable future unless

management intends to liquidate the entity or cease trading or has no realistic option

but to do so. When upon assessment it becomes evident that there are material

uncertainties regarding the ability of the business to continue as a going concern,

those uncertainties should be disclosed.

The accruals concept. Excluding the cash flow statement, all other financial

statements must be prepared on an accrual basis, whereby assets and liabilities are

recognised when they are receivable or payable rather than when actually received

and paid.

Consistency. Entities are required to retain their presentation and classification of

items in successive periods unless an alternative would be more appropriate or if so

required by a standard.

Materiality. Each material class of similar items shall be presented separately in the

financial statements. Material items that are dissimilar in nature or function should be

separately disclosed. However, some items of expenditure are so low in value that to

record them separately would be inappropriate. This allows aggregation of similar

items rather than showing them separately in the financial statements, e.g.

classification of assets as non-current or current.

In addition, there are other considerations that ought to be taken into account in the

preparation of financial statements:



Offsetting. Assets and liabilities, income and expenses cannot be offset against each other unless required or permitted by a Standard.

Comparative information. Comparative information (including narrative

disclosures) relating to the previous period should be reported alongside current

period disclosure, unless otherwise required. In case there is a change in the

presentation or classification of items in the financial statements, the comparative

information needs to be appropriately reclassified, unless it is impracticable to do so.

We can not forget the other concepts used in the preparation of financial statements:

Prudence. Financial statements should take a conservative approach where there is

any doubt in the reporting of profits or the valuation of assets.

Business entity. Financial statement should not include the personal expenses or

incomes or record personal assets or liabilities for any of the personnel involved in the

ownership or running of the company.

Money measurement. Only transactions that can be measured in monetary terms

should be included in financial records or in financial statements.

Historical cost. All financial transactions are to be recorded using the actual cost of

purchase.

Duality. There are always two ways of looking at every accounting transaction. One considers the assets of the company, and the other considers any claims against the

assets.

Structure and Content

IAS 1 requires that:

1. Financial statements should be clearly identified from other information in the same

published document (such as an annual report).

2. The name of the company is displayed.

3. The period covered by the financial statements is shown.

4. The currency used and its magnitude is shown (i.e. £ or £000, etc).

Financial statements should be presented at least annually. In all other cases, that is, when a

shorter or a longer period than one year is used, the reason for using a different period and

lack of total comparability with previous period information must be disclosed.

Income Statement

All items that qualify as income or expense should be included in the profit or loss

calculation for the period, unless stated otherwise.

Material income and expense should be disclosed separately with their nature and amount.

Analysis of expenses can be classified on the basis of their nature or function.

The minimum line items to be included in the income statement are:



Revenue

Finance costs

Share of the profit or loss of associates and joint ventures accounted for using the equity method

The total of the post-tax profit or loss of discontinued operations, post-tax gain or loss recognized on the disposal of the assets or disposal group(s) constituting the

discontinued operation.

Profit and loss

Tax expense

The amount of total and per-share dividends distributable to equity holders should be disclosed in the income statement, the statement of changes of equity, or the notes.

Additionally, the income statement should disclose the share of profit attributable to minority interest and equity shareholders of the parent.

The layout that you will encounter in future examination questions and you should be

familiar with, is shown below:

ABC plc

Income statement for the year ended 31 July 2008

£000 £000

Revenue 35,000

Cost of sales

Inventories 1 August 2007 4,900

Purchases 17,100

22,000

Inventories 31 March 2008 5,600 (16,400)

Gross profit 18,600

Distribution expenses (840)

Sales and marketing expenses (560)

Administrative expenses (630) 2,030

Profit/(loss) from operations 16,570

Finance costs (70)

Profit/(loss) before tax 16,500

Tax (4,250)

Profit/(loss) for the year attributable to equity holders 12,250

Statement showing changes in equity

Balance 1 August 2007 32.650

Profit for the year 12,250

44,900

Dividends paid 5,400

Balance at 31 July 2008 39,500

Also included under this heading would be any new issues of shares and any unrealised

profits, for example, an upward revaluation of property.



Statement of Changes in Equity

The company is required to present a statement of changes in equity consisting of:

Profit or loss for the period

Each item of income and expense for the period that is recognized directly in equity, and the total of those items.

Total income and expense for the period, showing separately the total amounts attributable to equity holders of the parent and to minority interest.

For each component of equity, the effects of changes in accounting policies and

corrections of errors.

These amounts may also be presented either in the preceding statement of in the notes:

Capital transactions with owners

The balance of accumulated profits at the beginning and at the end of the period, and the movements for the period.

A reconciliation between the carrying amount of each class of equity capital and each

reserve at the beginning and end of the period, disclosing each movement.

Balance Sheet

IAS 1 requires a certain amount of information to be shown on the Balance Sheet:

Property, plant and equipment

Investment property

Intangible assets

Financial assets

Investments accounted for using the equity method

Biological assets

Inventories

Trade and other receivables

Cash and cash equivalents

Trade and other payables

Provisions

Financial liabilities

Liabilities and assets for current tax

Deferred tax liabilities and deferred tax assets

Minority interest, presented within equity

Issued capital and reserves attributable to equity holders of the parent

Current and non-current assets and liabilities should be separately classified.



Other disclosures include:

Number of shares authorized, issued and fully paid, and issued but not fully paid

Reconciliation of shares outstanding at the beginning and the end of the period

Description of rights, preferences, and restrictions

Treasury shares, including shared held by subsidiaries and associates

Shares reserved for issuance under options and contracts

A description of the nature or purpose of each reserve within owners‟ equity

Nature and purpose of each reserve



An example is shown below:

ABC plc

Balance Sheet at 31 July 2008

£000 £000 £000 £000

Non-current assets Valuation Cost Aggregate Net

Depreciation

Intangible

Goodwill 1,500 500 1,000


Freehold land and buildings 59,000 6,240 52,760

Machinery 24,000 8,400 15,600


59,000 33,000 18,140 73,860

Current assets

Inventories 5,600

Trade receivables 2,970

Cash and cash equivalents 820

9,390

Total assets 83,250

Current liabilities

Trade payables (2,000)

Tax liabilities (4,250)

(6,250)


77,000

Net current liabilities

7% debentures (2058) (1,000)

Total liabilities 7,250

Net assets 76,000

Equity £000 £000

Authorised share capital

200,000,000 Ordinary shares of 50 pence each 10,000

Issued share capital

60,000,000 Ordinary shares of 50 pence each fully paid 30,000

Capital reserves Share premium account 5,000

Revaluation reserve 1,500 6,500

Revenue reserve

Retained earnings 39,500

Total equity 76,000



Other Disclosures

A company shall disclose in the notes:

Amount of dividends proposed or declared before the financial statements were

authorized for issue but not recognized as a distribution to equity holders during the

period, and the related amount per share.

The amount of cumulative preference dividends not recognized.

Interim dividends are paid part way through the financial year. They are based on half-yearly

profits reported by the company.

Final dividends are paid on the profits based on the results of the whole year being

considered. They will be paid in the early part of the next financial year.

Only dividends that have actually been paid are to be recorded in the financial statements.

This means that last year‟s proposed final dividend (provided it has been approved by the

shareholders and has been paid) and this year‟s interim dividend paid will be included in the

current year‟s financial statements.

For example:

Notes to the Financial Statements

Dividends

Equity dividends on ordinary shares

Amounts recognised as distributions to equity holders during the year:

£000

Final dividend for the year ended 31 March 2007 of 6p per share 3.6

Interim dividend for the year ended 31 March 2008 of 2p per share 1.2

4.8

Proposed final dividend for the year ended 31 March 2008 of 3p per share 1.8

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 summary of significant accounting policies in the notes should include the measurement

bases used in the financial statements and all other accounting policies required for further

understanding. Furthermore, it should include significant judgement made by management

while applying the accounting policies.

Once accounting policies are adopted, managers of a company must apply the policies

consistently.

The notes to the financial statements should disclose the basis of preparation of financial

statements, significant accounting policies, information required by IAS but not disclosed in



the statements, and additional information not present in the statements but required for

further comprehension. Notes should be systematically presented, and each item in the

statements should be cross-referenced to the relevant note.

Directors’ report

As part of the published accounts, the directors must report to the shareholders.

The directors‟ report contains details of:

The principal activities of the company

A review of the activities of the company over the past year

Likely developments that will affect the company in the future including research and development

The names of directors and their shareholdings in the company

Proposed dividends

Any significant differences between the market value and the book value of land and buildings

Political and charitable contributions

Actions taken on employee involvement and consultation

The company‟s policies on: o Employment of disabled people

o Health and safety at work

o Payment of suppliers

Auditors’ report

Larger companies must have their published accounts audited. The auditors are appointed by

the shareholders and their report is printed in the published accounts.

The auditors’ report has three main sections:

The respective responsibilities of directors and auditors

The basis of audit opinion

The opinion

The opinion may be “unqualified” if the auditors are of the opinion that:

- The financial statements have been properly prepared

- They give a true and fair view of the company‟s affairs in accordance with the IFRS

as adopted by the European Union and

- The information given in the directors‟ report is consistent with the financial

statements



The auditors‟ report may be “qualified” if the auditors feel that certain parts of the financial

statements have not been dealt with correctly and that this is important enough to be brought

to the attention of any of the users of the accounts.

14.3 Inventories. IAS 2

The Standard prescribes the accounting treatment for inventories. The main issue is the

amount of cost to be recognised as an asset.

In general, inventories are valued at the lower of cost and net realisable value.

The cost of inventories comprises all costs of purchase, costs of conversion and other costs

incurred in bringing the inventories to their present location and condition.

The costs of purchase constitute all of:

The purchase price

Import duties

Transportation costs

Handling costs directly pertaining to the acquisition of the goods

(Trade discounts and rebates are deducted when arriving at the cost of purchase of inventory)

The cost of inventories should be measured using either:

The FIFO method; or

The weighted-average cost method.

The net realisable value is the estimated selling price less estimated costs incurred to get the

product into a condition necessary to complete the sale.



14.4 Cash flow statements. IAS 7

This part is fully examinable. And you will learn more in Lesson 15.

IAS 1 makes it incumbent upon companies preparing financial statements under IFRS to

present a cash flow statement as an integral part of the financial statements.

IAS 7 lays down rules regarding cash flow statement preparation and reporting. The cash

flow statement provides information about a company‟s cash receipts and cash payments for

the period for which the financial statements are presented.

IAS 7 requires that a cash flow statement should be classified into four components:

1. Operating activities

2. Investing activities

3. Financing activities

4. Cash and cash equivalents

IAS 7 requires that companies prepare a cash flow statement in the format described in the

Standard.



An example of a cash flow statement is shown below:

ABC Limited

Cash flow statement for the year ended 31 July 2008

£000 £000

Net cash from operating activities 88

Cash flows from investing activities

Purchase of non-current assets (170)

Proceeds of sales from non-current assets 20

Interest received 13

Dividends received 2

Net cash from investing activities (135)

Cash flows from financing activities

Proceeds of issue of equity share capital 370

Repayment of share capital (30)

Proceeds from long term borrowings 100

Repayment of long term borrowings (60)

Dividends paid (25)

Net cash from financing activities 355

Net increase in cash and cash equivalents 308

Cash and cash equivalents at beginning of the year 668

Cash and cash equivalents at end of year 976

Reconciliation of profit from operations to net cash flow from operating activities.

£000

Profit from operations 100

Adjustments for:

Depreciation for the year 14

Increase in inventories (3)

Decrease in trade receivables 7

Decrease in trade payables (10)

Cash from operations 108

Interest paid (12)

Income taxes paid (8)

Net cash from operating activities 88

(The information will be provided from the Balance Sheets prepared at the end of two

consecutive years)



14.5 Net profit or loss for the period – fundamental errors and changes in

accounting procedures. IAS 8

IAS 8 prescribes criteria for selecting and changing accounting policies and the disclosures

thereof and also sets out the requirements and disclosures for changes in accounting estimates

and corrections of errors. It purports to achieve these objectives:

To enhance the relevance and reliability of an entity‟s financial statements; and

To ensure the comparability of the financial statements of an entity over time as well

as with financial statement of other companies.

Accounting policies are essential for a proper understanding of the information contained in

the financial statements prepared by the management of a company. A company should

clearly outline all significant accounting policies it has used in preparing the financial

statements

For example, under IAS 2 a company has the choice of the weighted-average method or the

FIFO method in valuing its inventory. If the company does not disclose the method of inventory valuation used in the preparation of its financial statements, user of the financial

statements would not be able to use the financial statements to make relative comparisons

with other entities.

Once selected, an accounting policy must be applied consistently for similar transactions;

however, an accounting policy may be changed only if the change is required by a Standard

or results in financial statements providing reliable and more relevant information.

A change in accounting policy required by a Standard shall be applied in accordance with the

transitional provisions therein. If a Standard contains no transitional provisions or if an

accounting policy is changed voluntarily, the change shall be applied retrospectively.

The practical impact is that corresponding amounts presented in financial statements must be

restated as if the new policy had always been applied. The impact of the new policy on the

retained earnings prior to the earliest period presented should be adjusted against the opening

balance of retained earnings.

Accounting estimates may change as circumstances change. Thus a change in estimate does

not warrant restating the financial statements of a prior period because it is not a correction of

an error. Common examples of accounting estimates are bad debts, inventory obsolescence,

useful lives of property, plant and equipment.

Discovery of material errors relating to prior periods shall be corrected by restating

comparative figures in the financial statements for the year in which the error is discovered,

unless it is “impracticable” to do so.



14.6 Events after balance sheet date. IAS 10

Events that occur up to the balance sheet date are critical in arriving at a company‟s financial

results and the financial position. However, sometimes events occurring after the balance

sheet date may provide additional information about events that occurred before and up to the

balance sheet date. This information may have an impact on the financial results and the

financial position of the company. Therefore, it is imperative that those post-balance sheet

events up to the authorization date be taken into account in preparing the financial statements

for the year ended and as at the balance sheet.

The authorization date is the date which the financial statements could be considered legally

authorised for issuance. Once the financial statements are authorised for issue no alterations

can be made.

IAS 10 provides guidance on accounting and disclosure of post-balance sheet events, which

are categorised into “adjusting” and “non-adjusting” events.

Adjusting events.

Adjusting events are those post-balance sheet events that provide evidence of conditions that

actually existed at the balance sheet date, albeit they were not known at the time. Financial

statements should be adjusted to reflect adjusting events after the balance sheet date.

Typical examples of adjusting events are:

The bankruptcy of a customer after the balance sheet date usually suggests a loss of trade receivable at the balance sheet date.

A liability that existed at the year-end, the value of which became clear after the balance sheet date.

Non-adjusting events.

Non-adjusting events are conditions that arose after the balance sheet date. No adjustment is

necessary in the financial statements. If such events are material then they are disclosed by

way of notes to the accounts. These notes would explain the nature of the event and if

possible the likely financial consequences of the event.

Examples might include:

A major restructuring of the business;

Significant business commitments entered into after the balance sheet date.

Dividends on equity shares proposed or declared after the balance sheet date should not be

recognised as a liability at the balance sheet date. Such declaration is a non-adjusting

subsequent event and footnote disclosure is required, unless immaterial.

IAS 10 requires these three disclosures:

1) The date when the financial statements were authorised for issue and who gave that

authorisation.



2) If information is received after the balance sheet about conditions that existed at the

balance sheet date, disclosures that relate to those conditions should be updated in the

light of the new information.

3) Where non-adjusting events after the balance sheet date are of such significance that

non-disclosure would affect the ability of the users of financial statements to make

proper evaluations and decisions, disclosure should be made for each such significant

category of non-adjusting event regarding the nature of the event and an estimate of

its financial effect or a statement that such an estimate cannot be made.



14.7 Property, plant and equipment. IAS 16

IAS 16 prescribes rules regarding the recognition, measurement and disclosures relating to

property, plant and equipment (fixed assets) that would enable users of financial statements to

understand the extent of an entity‟s investment in such assets and the movements therein.

The principal issues involved relate to the recognition of items of property, plant and

equipment, determining their costs, and assessing the depreciation and impairment losses that

need to be recognised.

An item of property, plant and equipment should be recognised initially at its cost. The cost

comprises:

Purchase price, including import duties, non-refundable purchase taxes, less trade

discounts and rebates.

Costs directly attributable to bringing the asset to the location and condition necessary for it to be used.

Estimated costs of dismantling and removing the asset at the end of its life. After the initial acquisition, the asset should be measured using either the cost model or the

revaluation model. Once selected, the policy shall apply to an entire class of property, plant

and equipment.

The cost model requires an asset to be carried at cost less accumulated depreciation and

impairment losses.

The revaluation model requires an asset to be measured at a revalued amount, which is its

fair value less subsequent depreciation and impairment losses. When an asset is revalued, any

increase in carrying amount should be credited to a revaluation reserve in equity.

Depreciation is to be charged on all non-current assets with the exception of freehold land.

Such depreciation charge shall be charged to the income statement.

The depreciable amount takes account of the expected residual value of the assets. They

should be reviewed annually

The method used (straight-line method or reducing balance method) should be reviewed at

least annually in order to consider whether the method used is still the most appropriate

method.



14.8 Revenue. IAS 18

IAS 18 prescribes the requirements for the recognition of revenue in a company‟s financial

statements. Revenue can take various forms, such as sales of goods, provision of services,

royalty fees, franchise fees, management fees, dividends, interest, subscriptions, and so on.

The principal issue in the recognition of revenue is its timing. It is critical that the point of

recognition of revenue is properly determined. The decision as to when and how revenue

should be recognised has a significant impact on the determination of “net income” for the

year.

Revenue includes sales of goods, rendering of services and the receipts of interest, royalties

and dividends.



14.9 Impairment of assets. IAS 36

IAS 36 ensures that assets are carried at no more than their recoverable amount. If an asset‟s

carrying value exceeds the amount that could be received through use or through selling the

asset, then the asset is impaired and IAS 36 requires a company to make provision for the

impairment loss.

The Standard applies to non-current assets:

Subsidiaries, associates and joint ventures


Investment property carried at cost

Intangible assets and goodwill

Assets need to be reviewed at each Balance Sheet date to judge whether there is evidence of

any impairment. Some of the events that might indicate that an asset is impaired are:

- External sources, such as a decline in market value, increases in market interest rates,

economic, legal or technological changes that have an adverse affect on the company.

- Internal sources of information, such as physical damage to an asset, or its

obsolescence, or an asset becoming idle.

If there is an indication that an asset is impaired, the asset‟s useful life, depreciation, or

residual value may need adjusting.

The recoverable amount of an asset is the higher of the asset‟s fair value less costs to sell and

its value in use.

If there is an impairment loss, the asset should be shown on the Balance Sheet at its

recoverable amount and the impairment loss should be shown on the income statement as an

expense.



14.10 Provisions, contingent liabilities and contingent assets. IAS 37

IAS 37 seeks to ensure consistency of treatment of provisions, contingent liabilities and

contingent assets. The bases of treatment are disclosed in the notes to the financial

statements.

Provisions should be recognised if, and only if, all of these conditions are met:

a) A company has a present obligation resulting from a past event;

b) It is probable that an outflow of resources embodying economic benefits would be

required to settle the obligations; and

c) A reliable estimate can be made of the amount of the obligation.

Only present obligations resulting for a past obligating event give rise to a provision. An

obligation could either be a legal obligation or a constructive obligation.

Provisions differ from other liabilities in that the amounts are set aside out of profits for a

known expense, the amount of which is uncertain.

When one of the prescribed conditions is not satisfied, then a provision cannot be recognised.

It is then a contingent liability and needs to be disclosed in footnotes, unless the probability

of the outflow embodying economic benefits is remote (in which case it does not even have

to be disclosed).

A contingent liability is a possible obligation arising from past events, the outcome of which

will be confirmed only on the occurrence or non-occurrence of one or more uncertain future

events. If the probability of the outflow of the future economic benefits changes to more

likely than not, then the contingent liability may develop into an actual liability and would

need to be recognised as a provision.

For each class of contingent liability a company should disclose at the balance sheet date a

brief description of the nature of the contingent liability.

Contingent assets are possible assets that arise from a past event and whose existence is

confirmed only by the occurrence or non-occurrence of one or more uncertain future events

not wholly within the control of the entity.



14.11 Intangible assets. IAS 38

IAS 38 prescribes the recognition and measurement criteria for intangible assets that are not

covered by other Standards

The principal issues involved relate to the nature and recognition of intangible assets,

determining their costs, and assessing the amortization and impairment losses that need to be

recognised.

In order to meet the definition of an intangible asset, expenditure on an item must be

separately identifiable in order to distinguish it from goodwill.

An asset must be capable of being separated from the company and sold, transferred, licensed

or renter either individually or in combination with a related contract, asset or liability.

Intangible assets are either:

Purchased; or

Internally generated.

Only purchased intangible assets can be recognised in the financial statements, so internally

generated goodwill or brand names cannot be recognised.

The Standards states that, after recognition, intangible assets may be measured using either a

cost model or a revaluation model. If the cost model is selected, then after initial recognition,

an intangible asset shall be carried at cost less accumulated amortization and impairment

losses. If the revaluation model is selected, the intangible asset shall be carried at its fair

value less subsequent accumulated amortization and impairment losses.

Like tangible assets, intangible assets are amortised (depreciated) using the straight-line

method.



LESSON 15. PUBLISHED ACCOUNTS

15.1 Introduction

When a company draws up its own financial statements for internal use it can draft them in

any way it wishes.

When it comes to publication, i.e. when the financial statements are sent to the shareholders

or to the Registrar of Companies, the Companies Acts lay down the information which must

be shown.

Remember that your tutor is there to help if something is not clear or you need more

questions for practice.

15.2 Published reports

An annual report is a document produced annually by companies. It intends to give a true a

fair view of the company‟s annual performance, with audited financial statements prepared in

accordance with company law and other regulatory requirements, and also containing other

non-financial information.

The Companies Act 1985/89 requires companies to publish their annual report and accounts.

That includes:

- A Profit and Loss Account

- A Balance Sheet

- A Cash Flow Statement

- Notes to the accounts

- Accounting policies

- A Director‟s Report

- Auditors‟ Report

- Operating and financial review. This is a statement in the annual report which

provides a formalised, structures explanation of financial performance. The operating

review covers items such as operating results, profit and dividend. The financial

review discusses items such as capital structure and treasury policy.

The Stakeholders in the annual report are:

Shareholders, who are the owners of the business

Potential shareholders

Managers and employees

Creditors and potential creditors

Suppliers (credit suppliers)



Employees and their trade unions

The government – for tax purposes

The directors are responsible for the preparation of the accounts which must give a true and

fair view. A true and fair view is one where accounts reflect what has happened and do not

mislead the readers. The accounts must be prepared in accordance with relevant accounting

standards.

The functions of the annual report are to provide information about the performance and

changes in the financial position of the company and to provide shareholders with financial

information so that they can make decisions such as buying or selling shares.



15.3 Cash Flow Statements

The presentation of cash flow statements by companies is guided by IAS 7, Cash Flow

Statements.

The benefits of cash flow information are explained in IAS 7. A cash flow statement, when

used in conjunction with the rest of the financial statements, provides users with information

on solvency and liquidity. It shows how cash is generated in the business and helps users to

understand how much flexibility is available to adapt to changing circumstances and

opportunities.

The cash flow statement presents three classifications of cash flows:

Operating activities

Investing activities

Financing activities

Operating activities. They are the principal revenue-producing activities of the entity and

other activities that are not investing or financing activities.

The net cash inflow from operating activities is calculated by using figures from the profit

and loss account and balance sheet as follows:

Operating profit (i.e. net profit, before deduction of interest)

Add depreciation for the year

Add decrease in debtors, or deduct increase in debtors

Add increase in creditors, or deduct decrease in creditors

Add decrease in stock, or deduct increase in stock

Depreciation is added to profit because depreciation is a non-cash expense, that is, no money

is paid out by the business in respect of depreciation charged to profit and loss account.

Investing activities. They are the acquisition and disposal of long-term assets and other

investments not included in cash equivalents.

Financing activities. They are activities that result in changes in the size and composition of

the contributed equity and borrowings of the entity.

The cash comprises cash on hand and demand deposits.

Cash equivalents are short-term, highly liquid investments that are readily convertible to

known amounts of cash and which are subject to an insignificant risk of changes in value.

There are two approaches to presenting the cash flows arising from operations:

1. The direct method. It presents cash inflows from customers and cash outflows to

suppliers and employees, taken from the entity‟s accounting records of cash receipts

and payments.

2. The indirect method. It starts with the operating profit and makes a series of

adjustments to convert profit to cash.



You will learn the indirect method following the format given in IAS7.

Layout of a Cash Flow Statement:

CASH FLOW STATEMENT

Cash flows from operating activities

Operating profit (i.e. net profit before deduction of interest)

Depreciation charge for the year

Profit or loss on sale of fixed assets

Changes in debtors, creditors and stock

Outflows: interest paid,

Outflow: corporation tax paid by limited companies during the year

Net cash from operating activities


Inflows: sale proceeds from non-current assets

Outflows: purchase of non-current assets

Interest received

Net cash from investing activities


Inflows: receipts from increase in capital/share capital, raising/increase of loans

Outflows: repayment of capital/share capital/loans

Proceeds from long term borrowings

Repayment of long term borrowings

Dividends paid

Net cash from financing activities

Net increase/(decrease) in cash and cash equivalents

Cash and cash equivalents at beginning of the year

Cash and cash equivalents at end of year



The following information is used to illustrate the indirect method:

Income Statement Year 2

£000

Revenue 246

Cost of sales (110)

Gross profit 136

Investment income – interest received 4

Gain on disposal of equipment 5

Depreciation (30)

Administrative and selling expenses (10)

Operating profit before interest 105

Interest expense (15)

Profit after deducting interest 90

Taxation (30)

Profit after tax 60

Balance Sheets at 31 December

Year 2 Year 1

Non-current assets £000 £000 £000 £000

Property, plant and equipment at cost 150 100

Accumulated depreciation 40 + 30 – 10 (60) (40)

90 60

Investments 100 100

Current assets

Inventory (stock) 20 15

Trade receivables (debtors) 18 16

Cash and cash equivalents 32 5

70 36

Current liabilities

Trade payables (creditors) (14) (13)

Interest payable (6) (7)

Taxes payable (8) (7)

(28) (27)

42 9

Non-current liabilities

Long-term loans (20) (15)

Net assets 212 154


Share capital 140 130

Share premium 20 18

Retained earnings 52 6

212 154



Further information:

1. The dividend paid during Year 2 was £14m. The retained earnings increased by £60m

profit of the period and decreased by the amount of the dividend £14m.

2. During Year 2 the company acquired property, plant and equipment costing £80m.

3. During Year 2 the company sold property, plant and equipment that had an original

cost of £30m and accumulated depreciation of £10m. The proceeds of sale were

£25m.

Required:

Prepare a cash flow statement using the indirect method.

Answer:

Cash flow statement for the year ended 31 December

£000 £000

Net cash inflows from operating activities (Note 1) 75


Purchase of non-current assets (80)

Proceeds from sale of non-current assets 25

Interest received 4

Net cash used in investing activities (51)


Proceeds from issue of share capital 12

Proceeds from long-term borrowing 5

Dividends paid (14)

Net cash used in financing activities 3

Increase/(decrease) in cash and cash equivalents 27

Cash and cash equivalents at the start of the year 5

Cash and cash equivalents at the end of the year 32

Note 1:

Reconciliation of operating profit to net cash inflow(outflow) from operating activities:

£000

Operating profit 101

Depreciation charges 30

Gain on disposal of equipment (5)

(Increase) in inventories (stocks) (5)

(Increase) in trade receivables (2)

Increase in trade payables 1

Interest paid (16)

Taxes paid (29)

75



Explanatory notes:

Operating profit (before taxes) 90

Is there any interest expense included in this figure?

If so add it back to arrive at: 15

Operating profit before deducting interest payable and taxes 105

Is there any interest received/receivable or any dividends received in

this figure? If so deduct it to arrive at: (4)

Operating profit before deducting interest payable and taxes and before

including interest receivable and dividends received 101

The depreciation is seen in the income statement (profit and loss account). It is added back to

exclude the effect of a non-cash item.

The gain on disposal is seen in the income statement (profit and loss account). It is added

back to exclude the effect of a non-cash item.

There is an increase in inventory (stock) seen by comparing the balance sheets at the end of

year 1 and year 2. This decreases the cash flow.

There is an increase in trade receivables (debtors) seen by comparing the balance sheets at the

end of year 1 and year 2. This decreases the cash flow.

There is an increase in trade payables (creditors) seen by comparing the balance sheets at the

end of year 1 and year 2. This has a positive effect on the cash flow by increasing the amount

unpaid.

Interest paid is calculated from the profit and loss account expense £15m plus the unpaid

interest at the start of the year £7m minus the unpaid interest at the end of the year, £6m.

Taxes paid are calculated from the profit and loss account charge £30m plus the unpaid

liability at the start of the year £7m minus the unpaid liability at the end of the year £8m.

The purchase cost of non-current assets is given in the further information. It can be checked

by taking the cost at the start of the year £100m, adding £80m and deducting the £30m cost

of the disposal to leave £150m as shown in the balance sheet at the end of the year.

The proceeds of sale £25m are given in the further information. This can be checked by

taking the net book value of the asset sold (£30m - £10m = £20m) and adding the gain on

disposal £5m shown in the income statement.

The interest received is taken from the income statement. There is no interest receivable

shown in the balance sheet so the profit and loss account figure must be the same as the cash

figure.

The proceeds from the share issue are the total of the increase in share capital £10m plus the

increase in share premium £2m.



The proceeds from long-term borrowings are the increase in long-term loans calculated by

comparing the opening and closing balance sheets.

The dividend paid is given in the further information. It can be checked by taking the retained

earnings at the start of the period £6m, add the profit of the period £60m and deduct dividend

£14m to arrive at the retained earnings at the end of the period, £52m.

The cash and cash equivalents at the start and end of the year are taken from the balance

sheet.

Comment on cash flow statement:

The cash flow from operating activities amounted to £75m. The purchase of non-current

(fixed) assets cost £80m but this was offset by £25m proceeds of sale of non-current assets no

longer required and was also helped by the £4m interest received from investments. The net

outflow from investments was £51m. This left £24m of cash flow available to increase cash

resources but £14m was required for dividend payments. The remaining £10m was added to

the proceeds of a share issue, £12m and an increase in long-term loans, £5m, giving an

overall cash inflow of £27m.



15.4 Duties of Directors

Under the Companies Act the directors of a company have a series of duties which are owed

to the company:

A director must act in accordance with the company‟s constitution, and only exercise powers for the purposes for which they are conferred.

A director must act in the way he considers, in good faith, would be most likely to

promote the success of the company for the benefit of its members as a whole.

A director must exercise independent judgment.

He must exercise reasonable care, skill and diligence.

He must avoid conflict of interest

He must not accept a benefit from a third party conferred by reason of being a director

or his doing (or not doing) anything as director



15.5 Duties of Auditors

Under the Companies Act the auditors have a series of duties owed to the company:

A company‟s auditor, in preparing his report, must carry out such investigation as will enable him to form an opinion as to:

o Whether adequate accounting records have been kept by the company and

returns adequate for their audit have been received

o Whether the company‟s individual accounts are in agreement with the

accounting records and returns, and

o In the case of a quoted company, whether the auditable part of the company‟s

directors‟ remuneration report is in agreement with the accounting records and

returns.

If the auditor is of the opinion that the company has not complied with the above the

auditor shall state that fact in his report.

If the auditor fails to obtain all the information and explanations which, to the best of his knowledge and belief, are necessary for the purposes of his audit, he shall state

that fact in his report.

If the directors of the company have prepared accounts and reports in accordance with the small companies regime and in the auditor‟s opinion they were not entitled so to

do, the auditor shall state that fact in his report.



15.6 Non-current Assets

A schedule of non-current assets need to be prepared as a note to the accounts.

The format will be:


Net book value at beginning of the year 1,000

Additions at cost 1,000

Disposals (it will be with a minus (-)) (500)

Depreciation for the year (-) (300)

At the end of the year (total) 2,200



LESSON 16. PARTNERSHIP ACCOUNTS

16.1 Introduction

The term „Partnership‟ is defined in the Partnership Act 1890 as:

‘The relation which subsists between persons carrying on business in common with a view of

profit’.

In a Partnership a number of individuals will contribute to the capital of the business and

share the responsibility of running the business. As the share of capital contributed by each

partner, and the involvement of each individual partner in the management of the business

may vary partners are advised to draw up a legally binding Partnership Agreement.

This agreement sets out the legal entitlements of each partner in respect of all aspects of the

business relationship and will cover such items as:

Interest on capital

Partners‟ salaries

Interest on drawings

Profit sharing ratio

Interest on loans

Partners joining or leaving

The accounting requirements of a partnership are:

Either to follow the rules set out in the Partnership Act 1980

Or for the partners to agree amongst themselves, by means of the partnership

agreement to follow different accounting rules.

Unless the partners agree otherwise, the Partnership Act 1980 states the following accounting

rules:

Profits and losses are to be shared equally between the partners

No partner is entitled to a salary

Partners are not entitled to receive interest on their capital

Interest is not to be charged on partners‟ drawings

When a partner contributes more capital than agreed, he or she is entitled to receive

interest at 5% per annum on the excess



16.2 Financial Statements for partnership

A partnership prepares the same type of year end accounts as a sole trader business:

Trading and Profit and Loss Account

Balance Sheet

In addition to the Trading and Profit and Loss Account an Appropriation Account also

prepared. The Appropriation Account is an extension to the Profit and Loss Account and is

used to apply the terms of the Partnership Agreement and therefore deal with the distribution

between partners of the net profit and loss.

It is common to keep separate fixed Capital Accounts for each partner. The balance on the

partners‟ Capital Account normally remains fixed unless the partner specially increases or

decreases his capital investment in the business. A Current Account is also kept for each

partner through which we process non Capital Account transactions but which will effect a

partners claim on the business. These include:

Drawings taken by a partner

Interest charged on drawings

Interest given on capital invested

Partnership salaries

Interest payable on a loan from a partner

Share of profit or loss

An example of sharing profits will be as follows:

Brent, Jakes and Ranns are partners sharing profits and losses equally; their profit and loss

account for the current year shows a net profit of £60,000. The appropriation of profits

appears as:

Brent, Jakes and Ranns

Profit and Loss Appropriation Account

For the year ended……….

£

Net profit 60,000

Share of profits:

Brent 20,000

Jakes 20,000

Ranns 20,000

60,000

This is a simple appropriation of profits. Throughout this lesson you will learn how to prepare

a full Profit and Loss Account along with the Appropriation Account of a partnership.



16.2.1 Capital Accounts and Current Accounts

Unlike a sole trader, in a partnership each partner usually has a capital account and a current

account. The capital account is usually fixed unless there is a permanent increase or decrease

in capital contributed by the partner.

However, the current account is fluctuating and it is to this account that:

Share of profits is credited

Share of loss is debited

Salary (if any), or commissions, are credited

Drawings are debited

Interest charged on partners‟ drawings is debited

Partner A: Current Account

Dr Cr

£ £

Drawings Balance b/d

Interest charged on drawings Share of net profit

Balance c/d Salary (or commissions)

Interest allowed on capital

The normal balance on a partner‟s account is credit, however when the partner has drawn out

more than his or her share of the profits, then the balance will be debit.

The initial entries in the capital account for each partner will be:

Debit: Bank Account

Credit: Partner‟s Capital Account

However, it is possible to have a fluctuating capital account where the distribution of

profits would be credited and the drawings and interest on drawings debited. Therefore the

balance on the capital account will change each year, i.e. it will fluctuate.

The keeping of fixed capital accounts plus current accounts is considered preferable to

fluctuating capital accounts. When partners are taking out greater amounts that the share of

the profits that they are entitled to, this is shown up by a debit balance on the current account

and so acts as a warning.



16.2.2 Appropriation of profits

The appropriation account follows the Profit and Loss Account and shows how net profits has

been divided amongst the partners.

The example which follows shows the additional account, the Appropriation Account. You

will learn how to process the transactions through the Appropriation Account and the partners

current account.

Brent, Jakes and Ranns have been in partnership for several years. The following information

is available, the Trading and Profit and Loss Account for the year ended 30 April 2001

having already been prepared:

1 Brent Jakes Ranns

£ £ £

Capital Account Balance 1 May 2000 60,000 50,000 40,000

Current Account Balance 1 May 2000 2,150 CR 1,550 CR 750 CR

Loan Account Balance 1 May 2000 20,000

Drawings Account Balance 30 April 2001 12,000 16,000 14,000

2 Net Profit in the year to 30 April 2001: £52,000

3

Interest is charged on partners‟ drawings for the year ended 30 April 2001. Charges are to be

Brent £1,000, Jakes £1,200 and Ranns £1,100.

Interest is given on partners‟ Capital Account balances at the rate of 8% per annum.

Brent receives a partnership salary of £5,000 per annum.

Robins receives interest on his loan at the rate of 10% per annum.

Profits/(Losses) are to be shared in the ratio of Brent, Jakes and Ranns 3:3:2 respectively.

The following is the Appropriation Account for the year ended 30 April 2001 and the Current

Accounts for the partners:



Brent, Jakes and Ranns

Appropriation Account for the Year Ended 30 April 2001

£ £

Net Profit 52,000

Add Interest on Drawings: Brent 1,000

Jakes 1,200

Ranns 1,100

3,300

55,300

Less Interest on Capital: Brent (£60,000 x 8%) 4,800

Jakes (£50,000 x 8%) 4,000

Ranns (£40,000 x 8%) 3,200

(12,000)

43,300

Less Salary: Brent (5,000)

38,300

Less Share of Profit: Brent (£38,300 x 3/8) 14,363

Jakes (£38,300 x 3/8) 14,362

Ranns (£38,300 x 2/8) 9,575

38,300

The interest on loan does not appear in the Appropriation Account. The loan interest of

£2,000 for the year ended 30 April 2001 will have been debited as an expense to the Profit

and Loss Account. The net profit of £52,000 will already have been adjusted therefore to

account for loan interest. The loan interest however will be credited to Ranns Current

Account.

Note that all of the available profit, after allowing for any salary, and interest charged and

allowed, is shared amongst the partners, in the ratio in which they share profit and losses.

The partner‟s current accounts for the year appears as:

Dr

Partners Current Accounts

Cr

Date Details Brent Jakes Ranns Date Details Brent Jakes Ranns

01/05/2000 Balance b/f 750.00 01/05/2000 Balance b/f 2,150.00 1,550.00

30/04/2001 Interest on Drawings 1,000.00 1,200.00 1,100.00 30/04/2001 Interest on Capital 4,800.00 4,000.00 3,200.00

30/04/2001 Drawings 13,313.00 2,712.00 30/04/2001 Salary 5,000.00

30/04/2001 Balance c/d 13,313.00 2,712.00 30/04/2001 Interest on Loan 2,000.00

30/04/2001 Share of Profit 14,363.00 14,362.00 9,575.00

30/01/2001 Balance c/d 1,075.00

26,313.00 19,912.00 15,850.00 26,313.00 19,912.00 15,850.00

30/04/2001 1,075.00 13,313.00 2,712.00



16.2.3 Balance Sheet

Within the Balance Sheet of a partnership must be shown the year end balances on each

partner‟s capital and current account. The other sections of the Balance Sheet (fixed assets,

current assets and current liabilities) are presented in the same way as for a sole trader.

If we continue with our previous examples we will extract the „Financed by‟ section of the

Balance Sheet (the other sections are not shown):

Balance Sheet (Extract) as at 30 April 2001

£ £ £

Financed by:

Capital Accounts

Brent 60,000

Jakes 50,000

Ranns 40,000

150,000

Current Accounts

Brent 13,313

Jakes 2,712

Ranns (1,075)

14,950

164,950

Under the long term liability section of the Balance Sheet we will show the loan to Ranns:

Long Term Liability:

Ranns - Loan 20,000

Note that an examination question will call either for the preparation of the partners’ current

accounts or for a detailed Balance Sheet extract, in which case you will need to show the

current account opening balance and add salary, interest on capital and share of profit and

deduct drawings and interest on drawings, to reach the same answer as if we had prepared

the partners’ current accounts and transfer their balances to the ‘Financed by’ section of the

Balance Sheet as shown on our example above.



16.3 Changes in partnerships

16.3.1 Goodwill

Any changes made in respect of a partnership, such as the introduction of a new partner or a

change in the profit sharing ratio, mean an end to the „old‟ partnership on the commencement

of a „new‟ partnership.

When changes are made to a partnership such as the introduction of a new partner, it is usual

for the assets to be revalued, and also for a valuation to be made for goodwill if it is

considered to be appropriate.

Goodwill can be defined in accounting terms as:

The difference between the value of a business as a whole, and the aggregate (total) of the

value of its separate assets, less liabilities.

It is the value of that part of the business that is not tangible, for example, the reputation of

the business, the skill of the workforce, the trade that has built up and the success at

developing new products.

Any partners coming into the existing business will be „charged‟ for a share in this goodwill.

Valuation of goodwill

The actual value of the goodwill can be arrived at in a number of ways, usually based on

some aspects of the business. It is always subject to negotiation between the people

concerned if, for example, a partnership is to be sold.

Two commonly used methods of valuing goodwill are:

Average profits. Goodwill is valued at the average net profit over the last, say, five years multiplied by, say, four, to give a goodwill figure being “4 years purchase of net

profits”.

Net profit: £10,000 (2001), £12,000 (2002), £14,000 (2003), £12,000 (2004), £14,000

(2005).

Goodwill is to be valued at five times the average profit of the last four years:

£12,400 x 4 = £49,600

Super profits. It takes the annual profit less any remuneration that the partners might have earned elsewhere and less any interest that would have been earned if the capital

had been invested elsewhere, then it is multiplied by an agree factor.



For example:

The capital of a partnership is £100,000; the profits after payment of a salary to each

partner are £15,000 per year; the general level of interest for savers is 10%, gross of

tax; and goodwill is to be valued at five times the super profits.

Thus, £100,000 x 10% interest = £10,000 (interest that would have been earned if

invested). The profit of the partnership is £15,000. Therefore, £15,000 - £10,000 =

£5,000, which is the amount of super profits.

Goodwill, therefore, is valued at £5,000 x 5 = £25,000.

Once a figure has been agreed for any goodwill the partners‟ Capital Accounts will be

adjusted accordingly as a credit entry in their profit-sharing ratio and that amount is

temporally debited to goodwill account. The „old‟ partners who created the goodwill being

given credit for this, and any „new‟ partners being charged for a share in this. After the

change in the partnership the partners‟ capital accounts are debited and goodwill account is

credited.

In a Balance Sheet, goodwill is shown as an intangible fixed asset. It is only recorded on the

Balance Sheet when it has been purchased, e.g. a sole trader or a partnership purchasing

goodwill when taking over another business.

The goodwill should then either be depreciated (or amortised) to Profit and Loss Account

over its estimated economic life (generally up to a maximum of twenty years), or, if the

estimated economic life is deemed to be indefinite, the goodwill need not be amortised.



16.3.2 Admission of a new partner

A new partner can only be admitted with the consent of all existing partners and is charged a

premium for goodwill.

The reason for the charge for goodwill is because the new partner will start to share in the

profits of the business immediately and will benefit from the goodwill established by the

existing partners.

We use a goodwill account which is opened by the old partners with the agreed valuation of

goodwill and, immediately after the admission of the new partner, is closed by transfer to the

partners‟ capital accounts, including that of the new partner.

The calculation is done in four stages:

1. Show value of goodwill divided between old partners in old profit and loss sharing

ratios.

2. Show value of goodwill divided between partners (including new partner) in new

profit and loss sharing ratio.

3. Goodwill gain shown: charge these partners for the gain

4. Goodwill loss shown: give these partners an allowance for their losses.

Let‟s see this with an example:

Al and Ben are in partnership sharing profits and losses equally. Col is admitted as a new

partner, with a new profit-sharing ratio of 2:2:1. Goodwill has been agreed at a valuation of

£25,000. Col will bring £20,000 of cash into the business as his capital and premium of

goodwill. The capital balances before Col was admitted were £45,000 Al, and £35.000 Ben.

Partners Old profit Share of New profit Share of

Shares goodwill shares goodwill

Al 1/2 12,500 2/5 10,000 2,500 loss Cr Al capital

Ben 1/2 12,500 2/5 10,000 2,500 loss Cr Ben capital

Col 2/5 5,000 5,000 gain Dr Col capital

25,000 25,000

The capital accounts of the partners, after the above transactions have been recorded, appear

as:

Dr Partners’ Capital Accounts Cr

Al Ben Col Al Ben Col

£ £ £ £ £ £

Goodwill

Written off 10,000 10,000 5,000 Balances b/d 45,000 35,000

Balances c/d 47,500 37,500 15,000 Goodwill 12,500 12,500

Bank 20,000

57,500 47,500 20,000 47,500 37,500 20,000

Balances b/d 47,500 37,500 15,000



The Balance Sheet, following the admission of Col, appears as;

Balance Sheet of Al, Ben and Col (Extract)

£

Net assets 100,000

Capital accounts:

Al (£45,000 + £12,500 - £10,000) 47,500

Ben (£35,000 + £12,500 - £10,000) 37,500

Col (£20,000 + £5,000) 15,000

100,000

In this way, the new partner has paid the existing partners a premium of £5,000 for a one-fifth

share of the profits of a business with a goodwill value of £25,000. Note that, although a

goodwill account has been used, it has been fully utilised and, therefore, does not appear on

the Balance Sheet.



16.3.3 Retirement of a partner

When a partner retires it is necessary to calculate how much is due to the partner in respect of

capital and profits. It is similar to the admission of a new partner.

Old partners:

- Debit goodwill with the amount of goodwill

- Credit partners‟ capital accounts (in their old profit-sharing ratio) with the amount of

goodwill

- Credit goodwill with the amount of goodwill

For the remaining partners:

- Debit partners‟ capital accounts (in their new profit-sharing ratio) with the amount of

goodwill

- Credit goodwill with the amount of goodwill.

The effect of this is to credit the retiring partner with the amount of the goodwill built up

whilst he or she was a partner.

Example

The following example will show you the procedure:

Jan, Kay and Lil are in partnership sharing profit and losses in the ratio of 2:2:1 respectively.

Jan decides to retire. At that point the partnership Balance Sheet is as follows:

Balance Sheet of Jan, Kay and Lil

£

Net assets 100,000

Capital accounts:

Jan 35,000

Kay 45,000

Lil 20,000

100,000

Goodwill is agreed at a valuation of £30,000. Kay and Lil are to continue in partnership and

will share profits and losses in the ratio of 2:1 respectively. Jan agrees to leave £20,000 of the

amount due to her as a loan to the new partnership.



Answer

Old partners:

- Debit goodwill: £30,000

- Credit capital accounts (in the old profit-sharing ratio of 2:2:1)

o Jan £12,000

o Kay £12,000

o Lil £6,000

Remaining partners:

- Debit capital accounts (in their new profit-sharing ratios of 2:1)

o Kay £20,000

o Lil £10,000

- Credit goodwill £30,000

Jan‟s capital balance is £47,000 (£35,000 + £12,000 goodwill). Jan will receive £27,000 from

the partnership bank account, as £20,000 will be retained in the business as a loan.

The Balance Sheet will now be:

Balance Sheet of Kay and Lil

£

Net assets (£100,000 - £27,000 paid to Jan) 73,000

Less Loan account of Jan 20,000

53,000

Capital accounts:

Kay (£45,000 + £12,000 + £20,000) 37,000

Lil (£20,000 + £6,000 - £10,000) 16,000

53,000

The effect of this is that the remaining partners have bought out Jan‟s £12,000 share of

goodwill of the business, i.e. it has cost Kay £8,000 (£45,000 - £37,000) and Lil £4,000

(£20,000 - £16,000).



16.3.4 Changes in profit-sharing ratios

The profit-sharing ratios of partners may change, from time to time, if necessary. That

requires the agreement of all partners.

The change in profit-sharing ratios involves establishing a figure for goodwill in order to

know how much goodwill was built up while they shared profits in their old ratios. Each

partner will receive a value for the goodwill based on the old profit-sharing ratio.

Example

Partners Exe, Why and Zed have been sharing profits equally but have now agreed to change

the profit sharing ratio to 2:2:1 (Exe 2/5, Why 2/5, and Zed 1/5). The balances on their

Capital Accounts at the date of the change were as follows:

Exe £5,000 CR

Why £6,000 CR

Zed £3,000 CR

Goodwill was agreed to be valued at £4,500.

Answer

We open a Goodwill account:

DR – Goodwill Account (with value of goodwill)

CR – Individual partners Capital Accounts in old profit sharing ratio

Dr Goodwill Cr

Details £ Details £

Capital Exe 1,500 Balance c/d 4,500

Why 1,500

Zed 1,500

4,500 4,500

Balance b/d 4,500

Dr Capital Cr

Details Exe Why Zed Details Exe Why Zed

£ £ £ £ £ £

Balance c/d 6,500 7,500 4,500 Balance b/f 5,000 6,000 3,000

Goodwill 1,500 1,500 1,500

6,500 7,500 4,500 6,500 7,500 4,500

Balance b/d 6,500 7,500 4,500



If it is then decided to close the Goodwill Account, the goodwill will be written off to the

„new‟ partners in the new profit sharing ratio.

DR – Individual partners Capital Accounts in new profit sharing ratio

CR – Goodwill Account (sharing goodwill in new profit sharing ratio)

Dr Goodwill Cr

Details £ Details £

Balance b/d 4,500 Capital - Exe 1,800

Why 1,800

Zed 900

4,500 4,500

Dr Capital Cr

Details Exe Why Zed Details Exe Why Zed

£ £ £ £ £ £

Goodwill 1,800 1,800 900 Balance b/d 6,500 7,500 4,500

Balance c/d 4,700 5,700 3,600

6,500 7,500 4,500 6,500 7,500 4,500

Balance b/d 4,700 5,700 3,600



16.3.5 Revaluation of assets

On the introduction of a new partner or any other change in the partnership it is usual to

revalue the assets of the business. This is done by opening a Revaluation Account and

adjusting any change in asset values through this account.

An increase in an asset value will be adjusted as:

o Debit asset account with the amount of the increase

o Credit revaluation account with the amount of the increase

A decrease in value of an asset will be adjusted as:

o Debit revaluation account with the amount of the decrease

o Credit asset account with the amount of the decrease

The overall increase/decrease (that is, the balance on the revaluation account) is then

transferred to the partners‟ capital accounts in their profit-sharing ratio, the old profit-sharing

ratio.

Example

Tee and Ewe are in partnership sharing profits and losses equally. The Balance Sheet of the

partnership on 31 December 2000 is:


£

Fixtures and Fittings 30,000

Stock 12,000

Debtors 10,000

Bank 5,000

57,000

Capital: Tee 25,000

Ewe 32,000

57,000

On 1 January 2001 Vee is to join the partnership and the assets are to be revalued as below:

£


Stock 10,000

Debtors and Bank are to remain at previous values

Goodwill is valued at £42,000

No goodwill account is to be kept



Vee is to introduce £30,000 as capital and profits are to be shared equally by the 3 new partners.

Answer

What do you need to do? Follow the steps below:

1- Open a Revaluation Account and make necessary adjustments for the change in value

of relevant assets.

2- Share any balance, following revaluation, on the Revaluation Account between „old‟

partners in the old profit sharing ratio.

3- Create goodwill and share it between the „old‟ partners in the old profit-sharing ratio.

Delete goodwill by sharing it between „new‟ partners in the new profit-sharing ratio.

Dr Fixtures and Fittings Cr

Date Details £ Date Details £ 31/12/2000 Balance b/f 30,000.00 01/01/2001 Balance c/d 40,000.00 01/01/2001 Revaluation 10,000.00

40,000.00

40,000.00

01/01/2001 Balance b/d 40,000.00

Dr Stock Cr

Date Details £ Date Details £ 01/12/2000 Balance b/f 12,000.00 01/01/2001 Revaluation 2,000.00

01/01/2001 Balance c/d 10,000.00

12,000.00

12,000.00

01/01/2001 Balance b/d 10,000.00

Dr Bank Cr

Date Details £ Date Details £ 31/12/2000 Balance b/f 5,000.00 01/01/2001 Balance c/d 35,000.00 01/01/2001 Capital - Vee 30,000.00

35,000.00

35,000.00

01/01/2001 Balance b/d 35,000.00

Dr Revaluation Cr


01/01/2001 Stock 2,000.00 01/01/2001 Fixtures and Fittings 10,000.00

01/01/2001 Capital - Vee *4,000.00

Ewe *4,000.00

10,000.00

10,000.00

*Profit on revaluation shared between „old‟ partners in old profit-sharing



Dr

Capital

Cr

Date Details Tee Ewe Vee Date Details Tee Ewe Vee

01/01/2001 Goodwill Adjm't 14,000.00 31/12/2000 Balance b/f 25,000.00 32,000.00

01/01/2001 Balance c/d 36,000.00 43,000.00 16,000.00 01/01/2001 Bank 30,000.00

01/01/2001 Revaluation 4,000.00 4,000.00

01/01/2001 Goodwill Adjm't 7,000.00 7,000.00

36,000.00 43,000.00 30,000.00 36,000.00 43,000.00 30,000.00

01/01/2001 Balance c/d 36,000.00 43,000.00 16,000.00

Workings

Creation and Deletion of Goodwill

Creation Deletion Net Adjustment

£ £ £

Tee 21,000 CR 14,000 DR 7,000 CR

Ewe 21,000 CR 14,000 DR 7,000 CR

Vee 14,000 DR 14,000 DR

42,000 CR 42,000 DR NIL

A revised Balance Sheet could now be prepared for the „new‟ partnership as follows:

Balance Sheet as at 1 January 2001

£


Stock 10,000

Debtors 10,000

Bank 35,000

95,000

Capital - Tee 36,000

Ewe 43,000

Vee 16,000

95,000

In the event of some assets may have fallen in value and provisions for depreciation and/or

bad debts may have been too much or too little and adjustments have not been made on the

accounts, the procedure is:

Increase in provision for depreciation/bad debts will be adjusted as:

o Debit revaluation account with he amount of the increase

o Credit provision account with the amount of the increase



Reduction in provision for depreciation/bad debts:

o Debit provision account with the amount of the reduction

o Credit revaluation account the amount of the reduction

Example

The Balance Sheet of Matt, Nia and Olly on 31 December 2008 is as follows:

Balance Sheet of Matt, Nia and Olly as at 31 December 2008

£ £ £

Fixed Assets Cost Depn to date Net

Premises 100,000 - 100,000

Machinery 50,000 10,000 40,000

150,000 10,000 140,000

Current Assets

Stock 30,000

Debtors 20,000

Bank 5,000

55,000

Less Current Liabilities Creditors 25,000


NET ASSETS 170,000

FINANCED BY:

Capital accounts Matt 60,000

Nia 60,000

Olly 50,000

170,000

They share profits and losses equally. Olly decides to retire at 31 December 2008; Matt and

Nia are to continue the partnership and will share profits and losses equally. The following

valuations are agreed;

Goodwill £30,000

Premises £150,000

Machinery £30,000

Stock £21,000

A provision for bad debts equal to 5% of debtors is to be made.

Olly agrees that the money owing on retirement are to be retained in the business as a long-

term loan.



Required:

Show the revaluation account, and adjust the Balance Sheet at 1 January 2009.

Answer:

Dr Revaluation Cr

Date Details £ Date Details £ 31/12/2008 Provision for depn: 31/12/2008 Goodwill 30,000.00

Machinery 10,000.00

Premises 50,000.00

Stock 9,000.00

Provision for bad debts 1,000.00

Capital accounts:

Matt (1/3) 20,000.00

Nia (1/3) 20,000.00

Olly (1/3) 20,000.00

80,000.00

80,000.00

The amount of goodwill has been credited to revaluation account (and thus to the capital

accounts); it will, later, be debited to the capital accounts of the two remaining partners; in

this way it will not feature on the Balance Sheet.

Balance Sheet of Matt and Nia as at 1 January 2009

£ £ £

Fixed Assets Cost Depn to date Net

Premises 150,000 - 150,000

Machinery 50,000 20,000 30,000

200,000 20,000 180,000

Current Assets

Stock 21,000

Debtors 20,000

Les provision for bad debts (1,000)

19,000

Bank 5,000

45,000

Less Current Liabilities Creditors (25,000)


200,000

Les Long-term Liabilities Loan accounts of Olly (£50,000 + £20,000) (70,000)

Net Assets 130,000



FINANCED BY:

Capital accounts Matt (£60,000 + £20,000 - £15,000 goodwill debited) 65,000

Nia (£60,000 + £20,000 - £15,000 goodwill debited) 65,000

130,000



16.3.6 Dissolution of a partnership

A partnership may come to an end for a number of reasons. It may be, for example, that the

business for which the partnership was formed has come to the end of its natural life, or that

the partnership is unable to meet its financial obligations.

Reasons why a partnership may come to an end:

A partnership may be formed for a fixed term or for a specific purpose and, at the end

of that term or when that purpose has been achieved, it is dissolved.

A partnership might be dissolved as a result of bankruptcy, or because a partner retires or dies and no new partners can be found to keep the firm going.

Sales may fall due to changes in technology and product obsolescence, with the partners not feeling it is worthwhile to seek out and develop new products.

At the other end of the scale, the business might expand to such an extent that, in

order to acquire extra capital needed for growth, the partnership may be dissolved and

a limited company formed to take over its assets and liablities.

Whatever the reason the assets will be sold off, the liabilities settled, and the accounts will be

closed off.

It is possible that partners‟ may agree to any number of arrangements regarding the disposal

of the assets and the settling of the liabilities. For example, it might be agreed that a partner

takes one or more of the business assets as part settlement of the amount due to him/her.

Whatever the arrangement, the amount of cash remaining after all debts have been settled

should be sufficient to cover the amount due to each partner.

The necessary steps to account for the dissolution are:

1- Open a Realisation Account.

2- Transfer all asset balances except Bank/Cash to Realisation Account:

DR Realisation Account

CR Asset Accounts

3- For Disposal of Assets:

If taken by partners:

DR Partners Capital Account

CR Realisation Account

If sold:

DR Bank/Cash




4- Settlement of Liabilities:

If taken over by partners:

DR Liability Account

CR Partners Capital Account

If paid off:


CR Cash/Bank

Any gains (e.g. discounts) on settlement:



5- As expenses of realisation are incurred, they are paid from cash/bank account and

entered in realisation account:


CR Cash/Bank Account

The balance of realisation account, after all assets have been sold and all creditors have been paid, represents the profit and loss on realisation, and is transferred to the

partners‟ capital accounts in the proportion in which profits and losses are shared. If a

profit has been made, the transactions are:


CR Partners‟ Capital Accounts

Where a loss has been made, the entries are reversed

Partners‟ loan (if any) are paid:

DR Partners‟ Loan Accounts


Partners‟ current accounts are transferred to capital accounts:

DR Partners‟ Current Accounts

CR Partners‟ Capital Accounts

If a partner has a debit balance on current account, the entries will be reversed.

If any partner now has a debit balance on capital account, he or she must introduce cash to clear the balance:

DR Cash/Bank Account



CR Partners‟ Capital Account

The remaining cash and bank balances are used to repay the credit balances on partners‟ capital accounts;

DR Partners‟ Capital Accounts


Example

Dan, Eve and Fay are in partnership, sharing-profits and losses equally. As a result of falling

sales they decide to dissolve the partnership as from 31 December 2008. The Balance Sheet

at that date is shown below:

Balance Sheet of Dan, Eve and Fay as at 31 December 2008

£ £ £

Fixed Assets Cost Accum. Dep‟n NVB

Machinery 25,000 10,000 15,000

Delivery van 10,000 5,000 5,000

35,000 15,000 20,000

Current Assets

Stock 12,000

Debtors 10,000

Bank 3,000

25,000


Creditors 8,000


NET ASSETS 37,000

FINANCED BY:

Capital Accounts Dan 13,000

Eve 12,000

Fay 12,000

37,000

The sale proceeds of the assets are:

o Machinery £12,000

o Stock £8,000

o Debtors £9,000

Dan is to take over the delivery van at an agreed valuation of £30,000. The expenses of

realisation amount to £2,000.



Required:

Show the realisation account, partners‟ capital accounts and bank account to record the

dissolution of the partnership.

Answer

Dr Realisation Account

Cr

£

£

Machinery

25,000.00 Provisions for depreciation: Delivery van

10,000.00 machinery

10,000.00

Stock

12,000.00 delivery van

5,000.00

Debtors

10,000.00 Bank: machinery

12,000.00 Bank: realisation expenses 2,000.00 Bank: stock

8,000.00

Bank: debtors

9,000.00

Dan's captial account: van 3,000.00

Loss on realisation;

Dan (1/3)

4,000.00

Eve (1/3)

4,000.00

Fay (1/3)

4,000.00

59,000.00

59,000.00

Dr

Partners' Capital Accounts

Cr

Details Dan Eve Fay Details Dan Eve Jay

Realisation account: Balances b/d 13,000.00 12,000.00 12,000.00

delivery van 3,000.00

Realisation account:

loss 4,000.00 4,000.00 4,000.00

Bank 6,000.00 8,000.00 8,000.00

13,000.00 12,000.00 12,000.00 13,000.00 12,000.00 12,000.00

Now you can see that the assets have been realised, the liabilities paid, and the balances due

to the partners have been settled; the partnership has been dissolved.



Dr Bank Account Cr

£

£

Balance b/d

3,000.00 Realisation account: expenses 2,000.00 Machinery

12,000.00 Creditors

8,000.00

Stock

8,000.00 Capital accounts: Debtors

9,000.00

Dan

6,000.00

Eve

8,000.00

Fay

8,000.00

32,000.00

32,000.00

The ruling in Garner v. Murray

As we have mentioned earlier, the partner with a debit balance in their capital account will

pay in the amount to clear their indebtedness to the firm. However, sometimes he or she will

be unable to pay all, or part, of such a balance.

In the case of Garner v. Murray in 1904 (a case in England) the court ruled that, subject to

any agreement to the contrary, such a deficiency was to be shared by the other partners not in

their profit and loss sharing ratios but in the ratio of their „last agreed capitals‟. By „their last

agreed capitals‟ is meant the credit balances on their capital accounts in the normal Balance

Sheet drawn up at the end of their last accounting period.

Where a partnership deed is drawn up it is commonly found that agreement is made to use

normal profit and loss sharing ratios instead, thus rendering the Garner v. Murray rule

inoperative.

Example

The Balance Sheet, before making the final payments to the partners, but after completing the

realisation of all the assets, in respect of which a loss of £4,200 was incurred, appears as

follows:

Balance Sheet

£ £

Cash at bank 6,400

6,400

Capitals: R 5,800

S 1,400

T 400

7,600

Less Q (debit balance) (1,200)

6,400

6,400



The partners‟ capital account credit balances before the dissolution were:

Q: £600

R: £7,000

S: £2,000

T: £1,000

The profit and losses were shared:

Q: 3

R: 2

S: 1

T: 1

Q is unable to meet any part of his deficiency. Now we are going to calculate how each of the

other partners suffers the deficiency. It is calculated as follows:

Own capital per Balance Sheet before dissolution x Deficiency

Total of all solvent partners‟ capital per same Balance Sheet

Therefore,

R £7,000 x 1,200 = £840

£7,000 + £2,000 + £1,000

S £2,000 x 1,200 = £240

£7,000 + £2,000 + £1,000

T £1,000 x 1,200 = £120

£7,000 + £2,000 + £1,000 £1,200

When these amounts have been charged to the capital accounts, then the balances remaining

on them will equal the amount of the bank balance:

Credit balance b/d Share of deficiency Final credit balances

£ £ £

R 5,800 - 840 = 4,960

S 1,400 - 240 = 1,160

T 400 - 120 = 280

Equals the bank balance 6,400







Question 1 You have received the following Balance Sheet extracts from Bell plc:

At 31 December 2006 At 31 December 2007

£000 £000

Assets

Non current assets

Property, plant and equipment 4,217 4,301


(1) During the year ended 31 December 2007, property, plant and equipment which had

originally cost £1,634,000, was sold. The depreciation charge on these non-current assets

up to 31 December 2007 was £920,000. The loss on disposal amounted to £294,000.

(2) During the year ended 31 December 2007, additions to property, land and equipment cost

£930,000.

Required:

Prepare a detailed note to the accounts showing movements in property, land and equipment during the

year ended 31 December 2007.

(7 marks)

(for quality of presentation: plus 1 marks)

Total for this questions: 8 marks



Question 2

The directors of Troop plc have prepared the following draft Balance Sheet:

Troop plc

Balance Sheet at 31 December 2007

£000

Assets

Non-current assets

Property, plant and equipment 2,000

Current assets

Inventories 120

Trade receivables 16

Cash and cash equivalents 28

Suspense 200

364

2,364

Liabilities

Current liabilities

Trade payables (84)

Net assets 2,280

Shareholders’ equity

Called up share capital 1,500

Retained earnings and other reserves 780

2,280


After the preparation of the draft financial statements for the year ended 31 December 2007, the following

items were discovered. They all need consideration when redrafting the Balance Sheet at 31 December

2007.

(1) On 1 January 2007, Troop plc purchased the business Tomkins Ltd. As part of the assets

taken over, Troop plc paid £200,000 for the goodwill of Tomkins Ltd. It had been entered

in a suspense account. The directors of Troop plc estimate that the economic life of the

goodwill will be 5 years.

(2) Troop plc’s sales have doubled over the past few years and the directors believe that they

are now market leaders in their business sector. As a result, they propose to introduce a

further £560,000 as additional goodwill. It is estimated that the economic life of the

goodwill will be 8 years.

(3) On 1 January 2007, property, plant and equipment were revalued from a net book value

of £2,000,000 to £2,500,000. The revaluation had not been included in the company’s

books of account. Non-current assets are generally depreciated at 2% per annum, but no

depreciation had been charged for the year ended 31 December 2007.



(4) No provision has been made for doubtful debts. The directors feel that 3% of trade

receivables would be appropriate.

(5) The directors of Troop plc have valued all closing stock at cost. Included in the value of

closing stock were 10 microwave cookers that had been damaged. The microwave

cookers cost £20 each and would normally sell for £50 each. The damaged microwave

cookers could be sold for £30 each after the necessary repairs are carried out. The total

costs of repairing the damaged microwave cookers will be £125.

Required:

a) Identify the appropriate International Accounting Standard (IAS) for each of the

additional information items 1 – 5.

(5 marks)

b) Calculate the corrected retained earnings and other reserves balance at 31 December

2007, showing clearly the effect of each of the additional information items 1 – 5.

(8 marks)

c) Prepare a Balance Sheet at 31 December 2007 taking into account the additional

information items 1 – 5.

(12 marks)

d) Discuss the reasons why limited companies are required to comply with International

Accounting Standards (IAS).

(12 marks)




Question 3

Amanda sells one model of luxury mobile home. She provides the following information for March 2007.

At 1 March 2007 she had four in stock; they had been valued at their cost price of £26,000 each.

Date Purchases Sales

7 March 3 at £27,000

15 March 1 at £28,000

22 March 5 at £52,000

26 March 1 at £52,500

30 March 2 at £30,000

31 March 2 at £53,000

Total purchases Total sales

For the month = £169,000 for the month = £418,500

Amanda has prepared a trading account using the AVCO (weighted average cost) method of valuing her

stock. She has calculated her gross profit for the month at £202,125.

A friend has suggested that it might be better if Amanda changed her method of valuing stock to the FIFO

method (first in first out).

Required:

a) Prepare a trading account for the month ended 31 March 2007 using the FIFO method of

valuing stock.

(6 marks)

b) Advise Amanda whether or not she should change her current method of valuing stock.

Give reasons for your advice.

(12 marks)




Question 4

Dough, Ray and Mee were in partnership sharing profits and losses in the ratio 3:2:1 respectively.

Business profits have been falling consistently over the past few years and the partners have decided to

dissolve the partnership with effect from 31 December 2007.

The Balance Sheet of the partnership at 31 December 2007 was as follows:

£ £

Fixed assets

Premises at cost 100,000

Machinery at cost 40,000

Vehicles at cost 20,000

160,000

Current assets

Stock 7,000

Trade debtors 11,000

Bank 5,000

23,000

Current liabilities

Trade creditors 2,000 21,000

181,000

Capital accounts

Dough 120,000

Ray 60,000

Mee 1,000

181,000

Additional information at 31 December 2007

1) The debtors settled their outstanding debts for £10,000.

2) Trade creditors were settled. They allowed £500 cash discount.

3) Premises were sold to Loneta plc at an agreed purchase consideration of £140,000,

consisting of 50,000 ordinary shares of £1 each, £18,000 7% debentures and £14,000

cash. The shares were divided in the profit sharing ratio and the debentures were shared

equally between the partners.

4) The machinery, which was extremely old, was sold for £1,100 cash.

5) One vehicle was taken over by Dough at an agreed value of £3,000. A second vehicle

was taken over by Ray at an agreed value of £2,000. The third vehicle was sold for

£4,000 cash.

6) Ray took overt the stock at an agreed value of £6,000.

7) Dissolution expenses amounted to £5,400

8) All cash transactions were processed through the business bank account.

Required:



Prepare the following to show the closing entries in the partnership books of account:

a) A realisation account to dissolve the partnership

(10 marks)

b) The partners’ capital accounts.

(12 marks) Total for this questions: 22 marks

Question 5

Healthy Living Ltd has prepared the following financial statements:

Healthy Living Ltd

Profit and Loss Account for the year ending

December 31, 2003

£000

Sales 12,368

Cost of sales (3,209)

Gross profit 9,159

Distribution costs (3,306)

Administrative expenses (2,192)

Loss on disposal of fixed assets (924)

Profit on ordinary activities 2,737

Interest payable (941)

Profit on ordinary activities before taxation 1,796

Taxation (420)

Profit after tax 1,376

Dividends payable (500)

Retained profit for the year 876

Healthy Living Ltd


2003 2002

£000 £000

Fixed assets

Cost 25,676 24,176

Depreciation (16,288) (14,060)

Net book value 9,388 10,116

Current assets

Stock 249 273

Debtors 2,120 2,013

Bank 1,932 1,320

4,301 3,606

Current liabilities



Creditors 1,105 1,009

Taxation 235 280

Dividends 500 460

1,840 1,749

Long term liabilities (3,500) (4,500)

Net assets 8.349 7,473

Share Capital

Ordinary shares of £1 4,000 4,000

Reserves

Share Premium Account 1,300 1,300

Profit and Loss Account 3,049 2,173

8,349 7,473

During 2003 the company acquired a new fixed asset at a cost of £5,100,000. It sold a similar asset whose

original cost was £3,600,000 and whose net book value was £2,160,000.

Required

Calculate the net cash flow from operating activities and prepare a cash flow statement, using the indirect

method.

(15 marks)




Diploma in

Accounting

Unit 4: Further Aspects of

Management Accounting

Module 8: Manufacturing Accounts

Module 9: Costing

Module 10: Capital Investment Appraisal, Budgeting,

Further Considerations and Social Accounting



Diploma in

Accounting



Module 8: Manufacturing Accounts



LESSON 17: MANUFACTURING ACCOUNTS

17.1 Introduction

The manufacturing account is a statement of all costs incurred in the manufacture of goods

within a given period of time. It is prepared in addition to the Trading and Profit and Loss

Accounts. It is produced for internal use only.

The Trading Account will contain the cost of manufacturing the goods manufactured during

the period, instead of a figure for purchases (of finished goods. The manufacturing account is

used to calculate and show the cost of manufacturing those goods. The figure it produces that

is used in the trading account is known as the production cost.

The costs are divided into different types:

Prime cost

Production cost

Total cost

17.2 Prime costs

These are costs which can be associated directly with a unit of production. Prime costs are the

sum total of:

Direct Materials

Direct Wages

Direct Expenses

Direct materials

Direct materials are those materials from which the product is made. A combination of costs

are used to calculate the cost of direct materials consumed in the manufacture of finished

goods. For example:

£

Opening stock of raw materials x

Add purchases of raw materials x

Add carriage inwards on raw materials x

Less raw materials returned to suppliers x

x

Less closing stock of raw materials x

Direct materials consumed x



Direct wages

Direct wages are paid to those employees who operate production machinery, work on a

production line, or assemble the product.

Direct expenses

Direct expenses are more difficult to determine than direct materials and wages. They are

likely to include:

Royalties paid to the designer of a product.

The cost of hiring special tools or equipment to be used in the manufacture of a

product.

17.3 Production overheads

Production overheads or indirect manufacturing costs are all those costs which occur in

the factory or other place where production is being done, but which cannot easily be traced to the items being manufactured. Such costs include:

Factory rents, rates and insurances.

Maintenance of factory buildings, fixtures, fittings, plant and machinery, etc.

Salaries and wages paid to the factory manager, production foremen/supervisors, and factory administration staff.

Consumable materials such as gases, welding rods, lubricants, cleaning materials, etc.

Factory power, heat and light.

Depreciation on those fixed asset used in the place of manufacture, e.g., factory buildings, factory plant equipment and machinery, factory fixtures and fittings, and

any equipment within the factory administration office.

Production overheads are added to prime costs within the Manufacturing Account to give

Total Factory cost or Production (Manufacturing) Cost.

17.4 Cost of finished goods

The manufacturing account includes all purchases of raw materials, including the stock

adjustments for raw materials. It also includes stock adjustments for work in progress

(goods that are part-completed at the end of a period).

There are a series of steps you need to follow:

1. Add opening stock of raw materials to purchases and subtract the closing stock of raw

materials.

2. Add in all the direct costs to get the prime cost.

3. Add in all the indirect manufacturing costs.



4. Add the opening stock of work in progress and subtract the closing stock of work in

progress to get the production cost of all goods completed in the period.

When completed, the manufacturing account shows the total of production cost that relates to

those manufactured goods that have been available for sale during the period. This figure will

then be transferred down to the Profit and Loss Account where it will replace the entry for

purchases.

Format of the manufacturing account and the trading account:

Manufacturing Account

£

Production costs for the period

Direct materials xxx

Direct labour xxx

Direct expenses xxx

Prime cost xxx

Add Production (factory) overheads:

Indirect materials xxx

Indirect labour xxx

Rent of factory xxx

Depreciation xxx

Factory light and heat xxx

xxx

xxx

Add Opening stock of work-in-progress xxx

xxx

Less Closing stock of work-in-progress xxx

Production cost of goods completed xxx

Trading Account

£ £

Sales xxx

Less Production cost of goods sold:

Opening stock of finished goods (1) xxx

Add Production costs of goods completed xxx

xxx

Less Closing stock of finished goods (2) (xxx)

Cost of goods sold (xxx)

Gross profit xxx

Notes: (1) Is production costs of goods unsold in previous period.

(2) Is production costs of goods unsold at end of the current period.



Manufacturing businesses hold stocks of goods in three different forms:

Raw materials: commodities and components purchased from suppliers required in

manufacturing the finished product.

Work-in-progress: products in course of manufacture at a particular moment in time.

Finished goods: products on which the manufacturing process has been completed

and which are ready for sale.

The first two stocks appear in the manufacturing account, while finished goods stock is in the

trading account.

The Balance Sheet includes the closing stock valuation of all three forms of stock.

Example:

You have received the following information:

£

1 January 2007, stock of raw materials 800

31 December 2007, stock of raw materials 1,050

1 January 2007, work in progress 350

31 December 2007, work in progress 420

1 January 2007, stock of finished goods 3,500

31 December 2007, stock of finished goods 4,400

Year to 31 December 2007:

Sales of finished goods 25,000

Wages: Direct 3,960

Indirect 2,550

Purchase of raw materials 8,700

Fuel and power 990

Direct expenses 140

Lubricants 300

Carriage inwards on raw materials 200

Rent of factory 720

Depreciation of factory plant and machinery 420

Internal transport expenses 180

Insurance of factory buildings and plant 150

General factory expenses 330

Required:

Prepare the manufacturing account and the trading account for the year ended 31 December

2007.



Answer:

Manufacturing Account for the year ended 31 December 2007

£ £

Stock of raw materials 1.1.2007 800

Add Purchases 8,700

Add Carriage inwards 200

9,700

Less Stock of raw materials 31.12.2007 (1,050)

Cost of raw materials consumed 8,650

Direct wages 3,960

Direct expenses 140

Prime cost 12,750

Indirect manufacturing costs:

Fuel and power 990

Indirect wages 2,550

Lubricants 300

Rent 720

Depreciation of plant 420

Internal transport expenses 180

Insurance 150

General factory expenses 330

5.640

18,390

Add Work in progress 1.1.2007 350

18,740

Less Work in progress 31.12.2007 ( 420)

Production cost of goods completed c/d 18,320

Trading Account for the year ended 31 December 2007

£ £

Sales 25,000

Less cost of goods sold:

Stock of finished goods 1.1.2007 3,500

Add production cost of goods completed b/d 18,320

21,820

Less stock of finished goods 31.12.2007 (4,400)

(17,420)

Gross profit 7,580

The Profit and Loss Account is then constructed in the normal way. You do not need to

present the accounts separated in different parts, everything is part of one Account. In the



example above has been done in that way so that you can understand how the figures are

calculated.

You will learn how to prepare the full set of financial statements at the end of this lesson.

17.5 Unrealised profit

Some manufacturing businesses transfer completed goods from the factory to the warehouse

at factory cost plus a percentage (the transfer price). The objective in doing this is for the

factory to make a notional profit which is added into net profit at a later stage.

By showing a factory profit, the profit (or loss) from trading activities (as distinct from

manufacturing) can be identified separately.

The final net profit is unchanged, but the manufacturing cost is higher, and gross profit is

lower. The factory profit is added back in the Profit and Loss Account, after showing

separately the profit and loss from trading.

For example:

£ £

Production cost 115,500

Factory profit of 10% 11,550

Production cost of goods completed (including profit) 127,050

Sales 195,500

Opening stock of finished goods 6,500

Production cost of goods completed 127,050

133,550

Less Closing stock of finished goods 7,500

Cost of goods sold 126,050

Gross profit 69,450

Less non-production overheads:

Selling and distribution expenses 38,500

Administration expenses 32,000

Finance expenses 3,500

74,000

Loss from trading ( 4,550)

Add Factory profit 11,550

Net profit 7,000

Statement of Standard Accounting Practice No 9 (Stocks and long-term contracts) requires

that stocks should be shown in the Balance Sheet at cost price if purchased, or cost of

production if manufactured.

In order to comply with SSAP 9, it is necessary to account for the element of unrealised profit

included in the finished goods stock valuation. This is done through an account called

provision for unrealised profit.



If you look at the example above, the opening stock of finished goods is £6,500 and the

closing stock of finished goods is £7,500. Now the manufacturing profit is 10% of

manufacturing cost, therefore:

Opening stock: £6,500 x 10% (manufacturing profit) = £650

Closing stock: £7,500 x 10% (manufacturing profit) = £750

The provision for unrealised profit is £750. Thus, there has been an increase on the provision

for unrealised profit of £100: £750 - £650 = £100

Therefore:

Factory profit £11,550

Less increase in provision for unrealised profit £ 100

£11,450

Note that the increase in provision for unrealised profit of £100 is shown as an expense in

Profit and Loss Account. It is recorded as a deduction form factory profit shown in the Profit

and Loss Account.

If there is a fall in the value of finished goods stock during the year, then there will be a

decrease in the provision for unrealised profit, and this will be added to the factory profit

shown in the Profit and Loss Account.

The Balance Sheet for finished goods stocks shows the net value:

Finished goods stock £8,250

Less Provision for unrealised profit £ 750

Net value £7,500

As can be seen this reduces the closing stock value of finished goods to cost price, and

enables the Balance Sheet valuation to comply with SSAP 9.

Question

A manufacturer values the closing stock of finished goods at factory cost plus 20%. For 2008

the opening and closing stock (including profit of 20%) were £12,000 and £18,000

respectively.

Required:

Calculate the amount to be entered in the Profit and Loss Account for the provision for

unrealised profit for the year ended 31 December 2008.



17.6 Accounts preparation

Production cost is the final figure of the manufacturing account.

A manufacturing account forms one part of the year-end accounts for a manufacturing

business, and precedes the trading account. The latter is prepared in the usual way except that

production cost takes the place of purchases. However, some businesses both manufacture

goods and buy in finished goods, in which case the figures will be shown for both production

cost and purchases of goods for resale.

In the trading account, the opening and closing stocks are the finished goods held by a

business.

The layout of a manufacturing, trading and profit and loss account is shown below:

Manufacturing, Trading and Profit and Loss Account

£ £

Opening stock of raw materials xxx

Add purchases of raw materials xxx

xxx

Less closing stock of raw materials xxx

Cost of raw materials used xxx

Direct labour xxx

Direct expenses xxx

Prime cost xxx

Add Production (factory) overheads:

Indirect materials xxx

Indirect labour xxx

Rent of factory xxx

Depreciation xxx

Factory light and heat xxx

xxx

xxx

Add Opening stock of work-in-progress xxx

xxx

Less Closing stock of work-in-progress xxx

Production cost of goods completed xxx

Sales xxx

Less Production cost of goods sold:

Opening stock of finished goods xxx

Add Production costs of goods completed xxx

xxx

Less Closing stock of finished goods (xxx)

Cost of goods sold (xxx)

Gross profit xxx



Less non-production overheads:

Selling and distribution expenses xxx

Administration expenses xxx

Finance expenses xxx

xxx

Net profit xxx

The Balance Sheet follows on and includes the closing stock valuation of all three forms of

stock: raw materials, work-in-progress and finished goods.



Diploma in

Accounting



Module 9: Costing



LESSON 18: COSTING

18.1 Introduction

So far you have learnt about bookkeeping and the preparation of financial statements. The

information that is produced by financial accounting is usually historic, backward-looking

and for the use of decision-makers external to the organisation to which the data relates.

However, there is a second side to accounting: management accounting. This one is generally

forward-looking or capable of being used to aid managerial control, forecasting and planning.

It also consists of two components: one where costs are recorded and one where the data is

processed and converted into reports for managers and other decision-makers. The cost

recording component is called costs accounting and the processing and reporting component

is called management accounting

Management accounting produces the financial forecasts that guide planning. It embeds

controls into the flow of operating data and uses them to control activities within the context

of the plans. It evaluates performance and uses the information that is produced in order to

underpin the forecasts that guide planning.

This is the area that will be covered in this lesson. You will learn and understand the different

cost terms, how to calculate the break-even point and profit, evaluate variances and cost a

simple project.

18.2 Cost terms and concepts

A cost object is any activity for which a separate measurement of costs is desired. In other

words, if the users of accounting information want to know the cost of something, this

something is called the cost object. Examples of costs objects: cost of a product, the cost of

rendering a service to a bank customer or hospital patient, or anything for which one wants to

measure the cost of resources used.

Now we are going to explain the following cots terms and concepts:

Direct and indirect costs;

Period and product costs;

Cost behaviour in relation to volume of activity;

Relevant and irrelevant costs;

Avoidable and unavoidable costs;

Sunk costs;

Opportunity costs;

Incremental and marginal costs.



Direct and indirect costs

Costs that can be assigned to costs objects can be divided into two categories:

- Direct costs

- Indirect costs

Direct costs are those costs that can be specifically and exclusively identified with a

particular costs object.

Indirect costs cannot be identified specifically and exclusively with a given cost object.

Direct costs can be accurately traced because they can be physically identified with a

particular object whereas indirect costs cannot. And estimate must be made of resources

consumed by cost objects for indirect costs.

Sometimes, however, direct costs are treated as indirect because tracing costs directly to the

cost object is not cost-effective. For example, the nails used to manufacture a particular desk

can be identified specifically with the desk, but, because the cost is likely to be insignificant,

the expense of tracing such items does not justify the possible benefits from calculating more

accurate product costs.

Think of a desk that is manufactured by an organisation. In this case the wood used to

manufacture the desk can be specifically identified. Also the wages of operatives whose time

can be traced to the specific desk are a direct cost. However, the salaries of factory

supervisors or the rent of the factory cannot be specifically and exclusively traced to a

particular desk, therefore, those costs are indirect.

Remember what you learnt in the previous lesson about the manufacturing accounts and how

we classified the costs into direct and indirect costs for materials and labour to arrive to the

prime costs and the manufacturing overheads.

Period and product costs

Product costs are those costs that are identified with goods purchased or produced for resale.

In a manufacturing organisation the are costs that are attached to the product and that are

included in the inventory valuation for finished goods, or for partly completed goods (work in

progress), until they are sold.

Period costs are those costs that are not included in the inventory valuation and as a result

are treated as expenses in the period in which they are incurred.

In a manufacturing organisation all manufacturing costs are regarded as product costs and

non-manufacturing costs are regarded as period costs.



Cost behaviour in relation to volume of activity

A knowledge of how costs and revenues will vary with different levels of activity (or

volume) is essential for decision-making. Activity or volume may be measured in terms of

units of production or sales, hours worked, miles travelled, patients seen.

The terms „variable‟, „fixed‟, „semi-variable‟ and „semi-fixed‟ have been used to describe

how a cost reacts to changes in activity.

Variable costs vary in direct proportion to the volume of activity: doubling the level of

activity will double the total variable cost.

Fixed costs remain constant over wide ranges of activity for a specific time period. Examples

of fixed costs include depreciation of the factory building, supervisors‟ salaries. Total fixed

costs are constant for all levels of activities whereas unit fixed costs decrease proportionally

with the level of activity. If you divide the total fixed cost by the number of units you will

have the unit fixed costs. For example, the total fixed costs are £5,000 and the units produced

are 1, 10, 100 and 1,000, what are the fixed costs per unit? The answer is £5,000, £500, £50

and £5.

However, if production capacity expands to some critical level, additional workers might be

employed. Thus within a short-term period, such as one year, labour costs can change in

response to changes in demand. Costs that behave in this manner are described as semi-fixed

or step fixed costs. The distinguishing feature of step fixed costs is that within a given time

period they are fixed within specified activity levels, but they eventually are subject to step

increases or decreases by a constant amount at various critical activity levels.

Semi-variable costs (also known as mixed costs) include both a fixed and a variable

component. The cost of maintenance is semi-variable cost consisting of planned maintenance

that is undertaken whatever the level of activity, and a variable element that is directly related

to the level of activity. A typical example of semi-variable costs would be electricity charges

containing a fixed element, the standing charge, and a variable element, the cost per unit

consumed.

Relevant and irrelevant costs

For decision-making, costs can be classified according to whether they are relevant to a

particular decision.

Relevant costs are those future costs that will be charged by a decision, whereas irrelevant

costs are those that will not be affected by the decision. For example, if you are faced with a

choice of making a journey using your own car or by public transport, the car tax and

insurance costs are irrelevant, since they will remain the same whatever alternative is chosen.

However, petrol costs for the car will differ depending on which alternative is chosen, and

this cost will be relevant for decision-making.



Avoidable and unavoidable costs

Avoidable costs are those costs that may be saved by not adopting a given alternative,

whereas unavoidable costs cannot be saved. Therefore, only avoidable costs are relevant for

decision-making purposes.

Sometimes the terms avoidable and unavoidable costs are used instead of relevant and

irrelevant cost.

Sunk costs

Sunk costs are the cost of resources already acquired where the total will be unaffected by

the choice between various alternatives. They are costs that have been created by a decision

made in the past and that cannot be changed by any decision that will be made in the future,

i.e. they are costs which have already been incurred.

Sunk costs are irrelevant for decision-making, but they are distinguished from irrelevant costs

because not all irrelevant costs are sunk costs.

Opportunity costs

An opportunity cost is that measures the opportunity that is lost or sacrificed when the

choice of one course of action requires that an alternative course of action be given up.

It is important to note that opportunity costs only apply to the use of scarce resources. Where

resources are not scarce, no sacrifice exists from using these resources. Opportunity costs are

of vital importance for decision-making. If no alternative use of resources exist then the

opportunity cost is zero, but if resources have an alternative use, and are scarce, then an

opportunity cost does exist.

Incremental and marginal costs

Incremental costs are the difference between costs and revenues for the corresponding items

under each alternative being considered. For example, the incremental costs of increasing

output from 1000 to 1100 units per week are the additional costs of producing an extra 100

units per week.

Marginal costs represent the additional cost of one extra unit of output. Incremental cost

represents the additional cost resulting from a group of additional units of output.



18.3 Absorption and marginal costing

Marginal costing distinguishes between fixed costs and variable costs. The marginal cost of

a product is its variable cost.

Marginal cost = variable cost = direct labour + direct material + direct expense + variable

overheads

The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the

total marginal costs of a department or batch or operation.

There are two main uses for marginal costing:

a) As a basis for providing information to management for planning and decision

making. It is appropriate for short run decisions involving changes in volume or

activity and the resulting cost changes.

b) It can also be used in the routine cost accounting system for the calculation of costs

and the valuation of stocks.

An important concept in connection with variable costs is contribution. It is the difference

between the variable cost of sales and the sales revenue generated. It can be calculated at the

unit cost level or in aggregate for all production.

Contribution = sales – variable costs

With absorption costing, a share of the fixed production overheads is allocated to individual

products and is included in the products‟ production cost.

Look at the information below:

The cost of making a door is:

Material: 20Kg @ £4/Kg £80

Labour: 4 hours @ £6/hour £24

Machine: 4 hours @ £2/hour £8

Marginal cost £112

This marginal cost is the sum of the variable costs. However, there are other costs which you

will incur such as renting the factory, heating and cooling the factory, cleaning and

maintenance, production and administration. These are fixed costs which are not included in

the marginal costs. They are known as fixed production overheads, and unless some

account is taken of them, the cost of items produced may be understated.

However, it is more difficult to account for fixed costs than it is for variable costs, where the

extra cost of making an extra unit could be directly measured. Fixed costs do not increase as

more units are made so a fixed cost per unit cannot simply be measured.

One solution is to work out the overhead absorption rate, which is the fixed cost in period

divided by units produced in period.



Overhead absorption rate = Fixed cost in period

Units produced in period

Say that the fixed overhead production costs for a period were £500, and that in that period

10 doors were produced. What would it be the overhead absorption rate?

Here, the absorption rate is £50/unit, and this would be added to the marginal cost per unit to

give the total absorption cost per unit.

Thus, following the example above, the total absorption cost is £162 (£112 + £50).

Changes in the level of activity

When changes occur in the level of activity, the absorption costing approach may cause some

confusion.

For example, in a period, 20,000 units of Z were produced and sold. Costs and revenues

were:

£

Sales 100,000

Production costs:

Variable 35,000

Fixed 15,000

Administrative + Selling overheads:

Fixed 25,000

Using the absorption approach, the profit per unit and cost per unit can be calculated as

follows:

£

Selling Price per unit 5

(£100,000 / 20,000)

Less Total cost per unit = £75,000 3.75

20,000

Profit per unit £1.25

If these figures were used as guides to results at any activity level other than 20,000, they

would be incorrect and may mislead. For example, if the level of activity changed to 25,000

units, it might be assumed that the total profits would be 25,000 x £1.25 = £31,250

However, the results are likely to be as follows:



Operating Statement (Absorption approach)

£

Sales (25,000 x £5) 125,000

Less Production Cost (£35,000 x 125% + 15,000) 58,750

= Gross Profit 66,250

Less Admin + Selling overheads 25,000

= Net Profit £41,250

As you can see the difference is caused by the incorrect treatment of the fixed costs. In such

circumstances the use of the marginal approach presents a clearer picture. Based on the data

above the marginal cost per unit and the contribution per unit is calculated as follows:

Marginal cost/unit = Marginal cost = 35,000 = £1.75

Quantity 20,000

Contribution/unit = Sale price – Marginal cost/unit = £5 - £1.75 = £3.25

If the activity is increased to 25,000 units, the expected profit would be:

(25,000 units x Contribution / unit) – Fixed costs = (25,000 x £3.25) - £40,000 = £41,250

And the operating statement on marginal costing lines would be:

£

Sales 125,000

Less Marginal cost (25,000 x 1.75) 43,750

= Contribution £81,250

Less Fixed costs 40,000

Net profit £41,250

Acceptance of a special order

This is the case when a lower than normal price is quoted and there is spare capacity. In this

scenario we must consider whether to accept or reject the order which utilises spare capacity.

The following example will illustrate the procedure:

Wall Ltd manufacture and market a slimming drink which they sell for 20p per can. Current

output is 400,000 cans per month which represents 80% of capacity. They have the

opportunity to utilise their surplus capacity by selling their product at 13p per can to a

supermarket chain who will sell it as an „own label‟ product.

Total costs for the last month were £56,000 of which £16,000 were fixed costs. This

represented a total cost of 14p per can.



Based on the above data should Wall accept the supermarket order? What other factors

should be considered?

Solution

The present position is as follows:

£

Sales (400,000 x 20p) 80,000

Less Marginal cost (= 10p/can) 40,000

= Contribution 40,000

Less Fixed costs 16,000

= Net profit £24,000

If we assume that fixed costs will not change, the special order will produce the following

contribution:

£

Sales (100,000 x 13p) 13,000

Less Marginal costs (100,000 x 10p) 10,000

= Contribution £3,000

(100,000 is the 20% of spare capacity)

As you can see the special order looks worthwhile. It makes a contribution of £3,000, as the

fixed costs are already covered if they remain unchanged.

Another way to calculate the contribution would be by multiplying the quantity by the

contribution per can: 100,000 x 3p = £3,000.

Dropping a product

If a company has a range of products one of which is deemed to be unprofitable, it may

consider dropping the item from its range.

Example

A company produces three products. The operating statements are as follows:

Product X Product Y Product Z Total

£ £ £ £

Sales 32,000 50,000 45,000 127,000

Total costs 36,000 38,000 34,000 108,000

Net Profit (Loss) (£4,000) £12,000 £11,000 £19,000

The total costs comprise: 2/3 variable and 1/3 fixed.

The directors consider that as Product X shows a loss it would be discontinued.

Based on the above cost data should Product X be dropped? What other factors should be

considered?



Solution

First calculate the fixed costs:

1/3 (36,000) + 1/3 (38,000) + 1/3 (34,000) = £36,000 in total.

Now we will use the marginal costs to prepare the operating statement:

Product X Product Y Product Z Total

£ £ £ £

Sales 32,000 50,000 45,000 127,000

Less Marginal cost 24,000 25,333 22,667 72,000

= Contribution £8,000 £24,667 £22,333 £55,000

Less fixed costs 36,000

= Net Profit £19,000

Product X produces a contribution of £8,000. Should Product X be dropped the position

would be:

£

Contribution Product Y 24,667

Contribution Product Z 22,333

Total Contribution 47,000

Less Fixed Costs 36,000

= Net profit £11,000

As you can see it seems that dropping product X with an apparent loss of £4,000 reduces total

profits by £8,000 which is the amount of contribution loss from Product X.

We still need to consider other factors:

a) The assumption above was that the fixed costs were general fixed costs which would

remain even if X was dropped. If dropping X resulted in the reduction of fixed costs

by more than £8,000 then the elimination would be worthwhile.

b) More profitable products should be considered, as Product X provide some

contribution at a low rate.

Make or buy

In some cases businesses are faced with the decision whether to make a particular product or

component or whether to buy it in.

The decision is usually based on an analysis of the cost implications. The relevant cost

comparison is between the marginal cost of manufacture and the buying in price.

However, when manufacturing the component displaces existing production, the lost

contribution must be added to the marginal cost of production of the component before

comparison with the buying in price.



Example A

A firm manufactures component AB and the costs for the current production level of 50,000

units are:

Costs/unit

£

Materials 2.50

Labour 1.25

Variable overheads 1.75

Fixed overheads 3.50

Total Cost 9.00

Component AB could be bought in for £7.75 and, if so, the production capacity utilised at

present would be unused. Assuming that there are no overriding technical considerations,

should AB be bought in or manufactured?

Solution

If we compare the buying in price of £7.75 and the full cost of £9.00, we could conclude that

the component should be bought in.

Remember that the correct comparison is between the marginal cost of manufacture, £5.50

(£2.50 + £1.25 + £1.75) and the buying in price of £7.75. This indicates that the component

should be manufactured, not bought in.

Marginal cost:

Materials £2.50

Labour £1.25

Variable overheads £1.75

Total marginal cost £5.50

Now consider what will happen to the fixed costs of £175,000 (50,000 units at £3.50). The

fixed costs would probably continue and the fixed overheads would not be absorbed into

production, because the capacity would not be used.

Therefore, if AB was bought in, overall profits would fall by £112,500:

Buying in price £7.75

Less marginal cost £5.50

£2.25

50,000 units x £2.25 = £112,500

Being that the difference between buying in price and the marginal cost of manufacture.



Example B

A firm is considering whether to manufacture or purchase a particular component XY. The

marginal cost of manufacturing component XY is £4.75 per unit and the component would

have to be made on a machine which was currently working at full capacity. The manufacture

of component XY would be in batches of 10,000 and the buying in price would be £6.50.

If the component was manufactured, it is estimated that the sales of finished product FP

would be reduced by 1,000 units. FP has a marginal cost of £60/unit and sells for £80/unit.

Should the firm manufacture or purchase component XY?

Solution

If we simply compare the marginal cost of manufacturing and buying in price, we would

conclude that the component should be manufactured. However, such an approach is

insufficient in this situation, which is a more realistic situation. It is important to consider the

loss of contribution from the displaced product:

Cost analysis of Component XY

£

Marginal Cost of manufacture = £4.75/unit x 10,000 47,500

+ loss contribution for FP = £20/unit x 1,000 20,000

67,500

Buying in price = £6.50/ unit x 10,000 65,000

As you can see there is a saving of £2,500 per 10,000 batch by buying in rather than

manufacture.

Important note

The lost contribution of £20,000 is an example of an opportunity costs. This is defined as

the value of a benefit sacrificed in favour of an alternative course of action. Whenever there

are scarce resources, there are alternative uses which must be forgone and the benefit

sacrificed is the opportunity cost. Where there are no alternative uses for the resources, the

opportunity cost is zero and it can thus be ignored.



18.4 Cost-volume-profit analysis

Cost-volume-profit analysis (CVP) is the term given to the study of the interrelationships

between costs, volume and profit at various levels of activity. There is an alternative term

commonly used break-even analysis.

The break-even analysis uses many of the principles of marginal costing and is an important

tool in short-term planning. It explores the relationship which exists between costs, revenue,

output levels and resulting profit and is more relevant where the proposed changes in the

levels of activity are relatively small. For greater changes of activity and in the longer term

existing cost structures are likely to change, the break-even analysis or CVP analysis

becomes less appropriate.

Typical short run decisions where break-even analysis or CVP analysis can be useful include:

choice of sales mix, pricing policies, multi-shift working and special order acceptance.

One important concept to remember is contribution, which is defined as:

Sales value less variable costs of sale. It may be expressed as total contribution,

contribution per unit or as a percentage of sales.

CIMA, 1996

Contribution per unit = sales price per unit – variable costs per unit

You should remember that the contribution approach is often only used for decision making

and breakeven analysis or cost-volume-profit analysis (CVP).

Breakeven occur when there is neither a profit nor a loss. Once the breakeven point has

been reached and all costs, including fixed costs, have been covered, any extra contribution

generated is additional profit.

You do not need to produce different operating statements to calculate net profit or loss for

any level of sales. All you need to do is calculate how much the sales volume is above

(profit) or below (loss) the breakeven point and multiply the answer by the contribution per

unit.

When using breakeven analysis is important to recognise the assumptions implicit:

The relationship between the variables remain constant

Profits are calculated on a marginal costing basis

Linearity – variable costs and sales revenues change in direct proportion and in the same direction as changes in activity levels

Constant sales mix or single product or service



The breakeven point

The breakeven point is determined by simply dividing the total fixed costs by the contribution

per unit:

Total fixed costs = number of units sold to break even

Contribution per unit

It is possible to calculate the breakeven point in volume of sales:

Breakeven point (£ sales) = Fixed costs x Sales price/unit

Contribution/unit

Level of sales to result in target profit (in units) = Fixed costs + Target profit

Contribution/unit

Level of sales to result in target profit (£ sales) = (fixed cost + target profit) x sales price/unit

Contribution/unit

Question

A company makes a single product with a sales price of £10 and a marginal cost of

£6. Fixed costs are £60,000 p.a.

Required:

Calculate

a) Number of units to breakeven

b) Sales at breakeven point

c) What number of units will need to be sold to achieve a profit of £20,000 p.a.

d) What level of sales will achieve a profit of £20,000 p.a.

Solution

Contribution = £10 - £6 = £4

a) Breakeven point (units) = £60,000 = 15,000

£4

b) Breakeven point (£ sales) = £60,000 x £10 = £150,000

£4

c) Number of units for target profit = £60,000 + £20,000 = 20,000

£4



d) Sales for target profit = (£60,000 + £20,000) x £10 = £200,000

£4

Break-even chart The chart is drawn in the following way:

a. Draw the axes

o Horizontal showing levels of activity expressed as units of output or as

percentages of total capacity

o Vertical showing values in £‟s or £000s as appropriate, for costs and revenues

b. Draw the cost lines

o Fixed cost.

This will be a straight line parallel to the horizontal axis at the level of the

fixed costs.

o Total cost. This will start where the fixed cost line intersects the vertical axis

and will be a straight line sloping upward at an angle depending on the

proportion of variable cost in total costs.

c. Draw the revenue line

This will be a straight line from the point of origin sloping upwards at an angle

determined by the selling price.

200

0

50

100

150

200

250

300

350

400

450

0 50000 100000 150000 200000 250000 300000 350000 400000 450000

Break-even chart



In the chart below you will see what each line means:

In the chart above, the line OA represents the variation of income at varying levels of

production activity (“output”). OB represents the total fixed costs in the business. As output

increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase.

At low levels of output, Costs are greater than income. At the point of intersection, P, costs

are exactly equal to income, and hence neither profit nor loss is made.

When the volume is zero, there is a loss equal to the fixed costs.

Breakeven chart. Example:

A firm manufactures compact discs and has the following costs:

Fixed costs: £10,000

Variable costs: £ 2.00 per unit

Required:

Calculate the breakeven point by drawing a breakeven chart.



Solution

You first construct a chart with output (units) on the horizontal (x) axis, and costs and

revenue on the vertical (y) axis. On to this, you plot a horizontal fixed costs line (it is

horizontal because fixed costs don't change with output).

Then you plot a variable cost line from this point, which will, in effect, be the total costs line.

This is because the fixed cost added to the variable cost gives the total cost. To do this, you

multiply:

variable cost per unit × number of units

In this example of the CD manufacturing firm, you can assume that the variable cost per unit

is £2 and there are 2 000 units = £4,000

Once you have done this, you are ready to plot the total revenue line. To do this, you

multiply:

sales price × number of units (output)

If the sales price is £6.00 and 2.000 items were to be manufactured, the calculation is:

£6.00 × 2,000 = £12,000 total revenue

Where the total revenue line crosses the total costs line is the breakeven point (ie costs and

revenue are the same). Everything below this point is produced at a loss, and everything

above it is produced at a profit.



http://www.bbc.co.uk/schools/gcsebitesize/business/production/breakevenanalysisrev2.shtml

Fixed costs: £10,000, Variable costs: £2 per unit, Sales price: £6 per unit

If you read downwards, it tells you how many units you need to produce and sell at this price

to breakeven: 2,500 CDs

If you read across, it tells you how much money you must spend before you recover your

outlay: £15,000.

Limitations of breakeven and profit charts

1. As fixed costs are likely to change at different activity levels, a stepped fixed cost line

is probably the most accurate representation.

2. Variable costs and sales are unlikely to be linear. Extra discounts, overtime payments,

special delivery charges, etc, make it likely that variable cost and revenue lines are

some form of a curve rather than a straight line.

3. The charts depict relationships which are essentially short term. This makes them

inappropriate for planning purposes where the time scale stretches over several years.

4. The charts and breakeven analysis make the assumption that all variable costs vary

accordingly to the same activity indicator, usually sales or production. This is a gross

over-simplification and reduces the accuracy of the charts and breakeven analysis.

5. It does not take into account the stock levels. It is assumed that everything produced is

sold.

18.5 Activity-based costing

Activity-based costing (ABC) is an approach to absorption costing based on the notion that it

is activities that incur costs and, therefore, activities should be the basis for allocating such

costs.

A single measure of volume is used for each product or service cost centre in traditional

indirect cost absorption, for example:

Machine hours

Direct labour hours

Direct materials cost

Direct labour cost

These bases are often unjustifiable when the nature of the activity at the cost centre and the

nature of the item that is absorbing the cost is considered. The amount of cost incurred may



depend on any one of a range of factors. And appropriate basis for cost absorption ought to

truly, as possible, reflect the changes in costs arising from the activities.

Cost drivers are the factors that cause costs to be incurred.

A cost driver is an activity that generates cost. It may be related to:

A short-term variable expense, for example, machine running costs, where the cost is driven by production volume and the cost driver is volume-based, for example,

machine hours.

A long-term variable expense, for example, quality inspection costs, where the cost is

driven by the number of times the relevant activity occurs and the cost driver is

transaction-based, for example, number of inspections.

Activity-based costing is the process of using cost drivers as the basis for indirect cost

absorption. It involves attributing cost to units on the basis of benefit received from indirect

activities, e.g. ordering, setting up a machine, assuring quality.

Organisations that use ABC have to develop a new information system to provide that

information. ABC creates cost pools for each activity area where costs held are attributed to the units that pass through the cost centre on the basis of an appropriate cost driver.

A cost pool is a collection of individual costs within a single heading and in traditional

overhead absorption, cost pools are production cost centres. Under ABC, a cost pool is

created for each activity area.

The terms cost centres or cost pools are used to describe a location to which overhead costs

are initially assigned. Normally costs centres consist of departments, but in some cases they

consist of smaller segments such as groups of machines.

18.6 Standard costing and variance analysis

18.6.1 Standard costing

A standard cost is a carefully predetermined, and realistic, target cost that should be incurred

during normal efficient operating conditions. Therefore, if the normal operating conditions

change overt time, the standard costs applied to products and services have to be changed

accordingly.

Standard costs are used as the basis for a comparison with actual incurred costs. Instead of

tracing the actual costs to production, the standard costs are used.

Using standard costs has the following advantages:

Record keeping during the period is greatly simplified. As units pass from one

department to another, they are recorded on job cards, etc. at their standard costs. The

business normally needs to calculate actual costs only for control purposes, not for

individual job or batch pricing purposes.



By comparing standard costs to the actual costs, the business has a way of judging performance. Differences between actual and standard costs are known as variances.

it is also possible to extend the application of standard costing to overheads,

particularly indirect manufacturing costs. Standard costs may be used on marginal

costs, in which case they would not include an element of fixed overhead absorption.

The principal purposes of standard costing are to:

Provide management with performance benchmarks.

Call attention to areas of the firm‟s activities which do not fulfil the original plans.

Provide cost information for use in future planning.

Standards consist of two parts:

- A physical measure, such as the weight of material per unit or the hours of labour

required to make one unit; and

- A financial measurement, such as the cost per kilo of material or the cost per hour

of labour.

Types of standard There are three important types of standard:

1. Basic standards. These are standards that could remain unchanged over a long

period, perhaps even years. Their sole use is to show trends over time for such items

as material prices, labour rates and efficiency and the effect of changing methods.

2. Ideal standards. These standards take no account of wastage, breakdowns, natural

breaks or idle time. They are based on optimal operating conditions and are therefore

highly unlikely to ever be achieved in practice. This makes them unsuitable for use in

control systems.

3. Attainable standards. These standards are usually used within standard costing

systems. They should be attainable in that they are realistic, but they should also be

challenging and stimulating. They assume efficient levels of operation and include

allowance for normal loss, waste and machine downtime.

18.6.2 Variance analysis

Variances represent differences between actual and planned performance. They are

calculated by comparing actual costs (or revenue) with the standard costs (or revenue) there

would have been if everything had gone according to plan. When something goes better than

planned there will be a favourable variance. When something goes worse than planned there

will be an adverse variance.

Variance analysis is not concerned only with comparison of actual results with budgeted

results; its principal aim is to determine the reasons why the differences have occurred. This

provides management with the opportunity to look behind the numbers to establish what

factors have caused the changes in performance, and to see to what extent it has changed.



It is important to try to ascertain the causes of specific variances, as each one may require a

specific cure. The major causes of variances are as follows:

1) Inefficiency in operation, through inability or lack of motivation

2) Originally incorrect plans and standards, or originally correct plans and standards that

have been invalidated by environmental changes.

3) Poor communication of standards and budgetary goals.

4) If, in budgeting, the interdependence of departments has not been taken into account,

then action taken by one department may cause variances elsewhere within the firm.

These points illustrate the close link between budgeting and standard costing. They

emphasise that standard costing and variance analysis are, in reality, an extension to

budgeting. Variance analysis provides a practical system for mangers to exercise control over

all corporate activities.

Without the use of variance analysis, management may arrive at the wrong conclusions about

the cause of discrepancies. By analysing and interpreting the variances, management has the

opportunity to determine the underlying causes.

For example, a company‟s actual profit is lower than was forecast, despite the turnover being

higher. This could be due to:

1. The sale price per unit being reduced

2. The cost per unit increasing.

Both of these changes would result in a lower profit margin and potentially, therefore, a

lower actual profit.

The overall objective of variance analysis is to subdivide the total difference between

budgeted profit and actual profit for the period into the detailed differences (relating to

material, labour, overheads or sales) which go to make up to total difference.

Calculating variances Variance calculations fall into two groups:

Material, labour and variable overheads

These are all variable costs. As production increases or decreases you would expect

these costs to vary.

Fixed overheads and sales

Fixed costs are independent of the level of production. Therefore, actual fixed costs

and be compared with the original budget. Sales are also compared to the original

budget.



Material variances

Look at the following information:

Standard for materials

Cost = £5/Kg

Usage = 10 Kg/unit

Standard material cost per unit = £50

Actual materials

Cost = £72,000

Units made = 1,000

You can see that more has been spent then would have been if the business had kept to the

standard: 1,000 units should have cost £50,000 (1,000 x £50), so there has been an overspend

of £22,000. This would be known as adverse variance.

The two potential causes of the adverse variance would be:

1. A rise in the price per kilogram

2. A rise in the kilograms used per unit

What we are going to do now is to see how the total variance of £22,000 could be split up so

as to estimate how much has been caused by a raise in prices (price variance) and how much

by the raise in material per unit (usage variance).

1. Price variance

We need to know how much material was used. Let‟s assume that it was 12,000 Kg. Now we

can work out the actual cost per kilogram: £6/Kg (£72,000/12,000).

You can see that the business has bought and used 12,000 Kg at £6/Kg. If it had bought the

material at the standard cost, it should have cost only £5 per kilogram, so an extra £1 has

been spent on each kilogram. Therefore, the business has spent an extra £12,000 on the

12,000 kilograms because of the change in price.

Thus, the price variance is defined as:

Actual usage x (standard price per Kg – Actual price per Kg)

If we apply it to our example, we have:

12,000 x (£5 - £6) = - £12,000

Here, a negative sign indicates an adverse variance as the actual price is higher than the

standard price.



Remember that the total adverse variance was £22,000 and£12,000 of it has been accounted

for by the price variance, therefore, the usage variance must be £10,000.

2. Usage variance

The usage variance is calculated as:

Standard cost per Kg x (Standard usage for output achieved – Actual usage)

Thus, in our example that will be:

£5 x (1,000 x 10 - £12,000) = - £10,000

Note that usage variance is worked out using the standard cost of material. The actual usage

must be compared to the standard usage for the output achieved (the quantity that should

have been used for the output had the standard been kept to.

Do not forget that variance can be favourable as well as adverse.

Now you have the following information:

Standard for materials

Cost = £5/Kg

Usage = 10 Kg/unit

Standard material cost per unit = £50

Actual materials

Cost = £48,000

Units made = 1,000

Material = 12,000 Kg

Cost = £4/Kg

In this case the total variance is £2,000 favourable: actual cost £48,000 compared to the

standard cost of £50,000 for the actual production.

Price variance = 12,000 x (£5 - £4) = £12,000 (favourable)

Usage variance = £5 x (1,000 x 10 – 12,000) = £(10,000) (adverse)

Net variance = £2,000 (favourable)

Possible reasons for the favourable variance:

The price of the materials fell

Errors in estimating the price of materials when the budgets were set

A reduced price was charged by the supplier because the amount purchased increased



A different supplier was found who charged a lower price for the same or better quality of material

The supplier charged a lower price for a poorer quality of material

A different supplier was found who charged a lower price for a poorer quality of material.

Possible reasons for the adverse variance:

A change in manufacturing process resulted in higher material wastage than expected

Poorer quality workers caused a higher than expected level of wastage of materials during production

Higher than expected pilferage of raw material stocks

Errors in calculating the usage rate when the budgets were set

Poorer quality materials than anticipated from the supplier

Poorer quality materials as a result of buying cheaper materials than anticipated.

Labour variances

You are given the following standard cost information for labour:

Standard for labour

Cost = £5/h

Time = 10h/unit

Standard labour cost per unit = £50

Actual labour

Cost = £84,000

Units made = 1,000

When the resources used for a month are measured, you can see that more has been spent

than would have been if the business had kept to the standard: 1,000 units should have cost

£50,000 so there has been an overspend of £34,000: an adverse variance.

There are three potential causes of the adverse variance:

1. A rise in the labour rate per hour

2. A rise in the hours needed per unit

3. Idle time

Now we need to see how the total variance of £34,000 could be split up so as to estimate how

much has been caused by the rise in wage rates (rate variance), how much by the rise in time

taken per unit efficiency variance), and how much by idle time (idle time variance).

To make the split, we have to know how much time was paid for and how much of that was

worked: assume that it was 12,000 hours was paid for and that of that 11,000 were worked.



Then we can work out that the actual rate per hour must have been £7/h (£84,000/12,000).

Therefore, the business has paid for 12,000 h at £7/h. If it had paid the labour at the standard

rate, it should have cost only £5 per hour, so an extra £2 has been spent on each hour. This

will mean that the business has spent an extra £24,000 on the 12,000 hours because of the

change in price.

The labour rate variance is defined as:

Hours paid for x (standard rate per hour – actual rate per hour)

Thus,

12,000 x (£5 - £7) = - £24,000

The negative sign indicates an adverse variance as the actual rate is higher than the standard

rate.

The total adverse variance was £34,000 and £24,000 of it has been accounted for by the rate

variance. Idle time and efficiency variance must be £10,000. These can be worked out as:

Idle time variance:

Standard rate per hour x (hours worked – hours paid for)

Thus,

£5 x (11,000 – 12,000) = - £5,000

If the workforce is hanging around idle for 1,000 hours, yet being paid, there must be an

adverse variance. This is evaluated at the standard rate per hour.

The labour efficiency variance looks at how well people work whilst they are working; idle

time is excluded as work is not being done then. The labour efficiency variance is defined

as:

Standard rate per hour x (standard hour for output achieved – actual hours worked)

Thus,

£5 x (1,000 x 10 – 11,000) = - £5,000

When working, the workforce has spent 11,000 hours on production that should have taken

them only 10,000 hours. So they have been inefficient by 1,000 hours in addition to being

completely idle for another 1,000 hours.



Sales variances

You have the following budgeted sales information for a month and the actual results:

Sales budget

Selling price = £30/unit

Contribution = £10/unit

Budgeted volume = 1,000 units

Actual sales

Selling price = £32/unit

Budgeted volume = 1,100 units

You can see that more units have been sold and at a higher price; both of these effects will

give rise to favourable sales variances.

There are two potential causes of favourable sales variances:

A rise in the selling price per unit

A rise in the number of units sold

Note that sales variances consider sales prices and volumes only; any cost differences (from

material, labour and overheads will be ignored in the calculation of sales variances.

The sales price variance is defined as:

Actual sales x (actual price per unit – standard price per unit)

Thus,

1,100 x (£32 - £30) = £2,200

There is a favourable variance as the actual selling price is higher than the standard selling

price.

The sales volume variance is defined as:

Standard contribution per unit x (actual sales – budgeted sales)

In our example, this will give: £10 x (1,100 – 1,000) = £1,000

Here the volume variance is worked out using the standard contribution per unit. This is

correct if marginal costing is being used. If total absorption costing is being used, the volume

variance would be calculated in terms of standard profit per unit.



Variable overheads variances

You receive the following cost information for variable overheads:

Standard for variable overheads:

Cost = £3/h

Time = 10hs/unit

Standard variable overhead cost per unit = £30

However, when the resources used for a month are measured, the following is discovered:

Actual variable overheads:

Cost = £44,000

Units made = 1,000

Now you can see that more has been spent than would have been if the business had kept to

the standard: 1,000 units should have cost £30,000 so there has been an overspend of

£14,000: an adverse variance.

There are two potential causes of the variable overhead adverse variance:

A rise in the overhead rate per hour

A rise in the hours needed per unit

Note that idle time does not play a part, as the machines can be switched off and no costs

incurred.

The next step is to find out how the total variance of £14,000 could be split up so as to

estimate how much has been caused by the rise in overhead rates (rate or expenditure

variance) and how much by the rise in time taken per unit (efficiency variance).

To make the split, we have to know how much time was worked: assume that 11,000 hours

were worked.

Once you know that, you can then work out that the actual rate per hour must have been £4/h

(£44,000/11,000).

You can see that the business has paid for 11,000 h at £4/h. if it had paid variable overheads

at the standard rate, it should have cost only £3 per hour, so an extra £1 has been spent on

each hour. This will mean that the business has spent an extra £11,000 on the 11,000 hours

because of the change in price.

The rate (or expenditure) variance is defined as:

Hours worked x (standard rate per hour - actual rate per hour)



11,000 x (£3 - £4) = -£11,000

Here, a negative sign indicates an adverse variance as the actual rate is higher than the

standard rate.

The total adverse variance was £14,000, and £11,000 of it has been accounted for by the rate

variance. The efficiency variance must be £3,000. This can be worked out as:

Efficiency variance:

Standard rate per hour x (standard hours for output achieved - actual hours worked)

Therefore, the efficiency variance is:

£3 x (1,000 x 10 – 11,000) = -£3,000

The workforce has spent 11,000 hours on production that should have taken them only

10,000 hours. So they have been inefficient by 1,000 hours when running the machines at a

standard rate of £3/hour.

Note that once the rate variance accounts for the difference between standard and actual rates,

the remaining variance is evaluated at the standard rate per hour.

Example

The standard variable overhead rate is £9, and a unit should take 12 hours.

3,000 units were made for a cost of £363,600. Hours worked 36,000.

a) What is the total variable overhead variance?

b) What is the variable overhead rate variance?

c) What is the variable overhead efficiency variance?

Answer

a) 3,000 should have cost £324,000 (3,000 x 9 x12).

They did cost £363,600, so the total variance is £39,600 unfavourable.

b) 36,000 x (9 – 10.1) = -£39,600 unfavourable.

c) £9 x (36,000 – 36,000) = £0

Therefore:

Rate variance: 36,000 x (9 – 10.1) = -£39,600 unfavourable

Efficiency variance: 9 x (36,000 – 36,000) = 0

Total variance 324,000 – 363,600 = -£39,600 unfavourable



Fixed overheads variance

Under marginal costing we assume that fixed production overheads should not vary with

volume, so the only fixed overhead variance is an expenditure variance reflecting the

difference between budgeted and actual cost.

The fixed overhead expenditure variance is not very meaningful on its own. Any meaningful

analysis requires a comparison of actual expenditure for each individual item of fixed

overhead expenditure against the budget to find out which expenses cost more or less than

anticipated.

Reconciling budgeted profit and actual profit

Management will be interested in reasons why actual profit is different from the budgeted

profit. Variances can be used to explain this difference. We can prepare a summary statement

that adds the favourable cost and sales variances to the budgeted profit, and deducts the

adverse variances, to show how the actual profit is arrived at.

Operating statements use variances to reconcile budgeted results and actual results.

An example of a reconciliation of budget to actual profit is shown below:

Reconciliation of budgeted and actual profit

£ £ £ Original budgeted contribution 20,832

Sales volume variance (adverse) ( 832)

Flexed budgeted contribution 20,000

Less: budgeted fixed overheads (6,250)

Flexed profit 13,750

Variances Favourable Adverse

Selling price 2,400

Direct material price 1,890

Direct material usage (2,000)

Direct labour rate (1,800)

Direct labour efficiency 1,200

Variable overhead expenditure (2,400)

Variable overhead efficiency 800

Fixed overhead expenditure ( 250)

Total variances 6,290 (6,450) ( 160)

Actual profit 13,590



Diploma in

Accounting



Module 10: Capital Investment Appraisal, Budgeting,

Further Considerations and Social Accounting



LESSON 19: CAPITAL INVESTMENT APPRAISAL

19.1 Introduction

Capital investment appraisal is not simply an arithmetical calculation of financial

information, but a decision-making process that should also involve qualitative issues. It

should show how the proposed investment will further the aims of the enterprise and help to

meet its strategic objectives.

The financial appraisal is used to:

Show which investments from a range of alternative proposals are the most profitable

Show which investment opportunities will yield the greatest increase in present value to the business

Compare the expected return on an investment proposal with a minimum or standard rate of return requirement specified by the business

Assist in decisions on whether and how to finance a new investment proposal

Compare alternatives, for example: asset replacements or a major renovation, purchase or hire, and retention or divestment of a product facility

Capital investment appraisal compares expected future revenues arising from an investment

with the costs of that investment.

One technique of capital investment appraisal, accounting rate of return (ARR) takes an

entirely different approach from the others.

The other capital investment appraisal techniques are based on the marginal or incremental

cash flows that are forecast for the project under review. You only analyse the cash flows that

can be directly attributable to the project, which includes both inflows and outflows.

As depreciation does not form part of the cash flow profile, it must not be included in any

project-related cash flows. Depreciation is simply a non-cash expense that is reported in the

Profit and Loss Account and the Balance Sheet as the reduction of an asset’s value.

For ease of calculation, the convention is that all cash flows after the initial investment are

deemed to occur at the end of the year in which they arise. It is also normal to define the

initial investment as occurring at ‘Year 0’. ‘Year 1’ is one year later, ‘Year 2’ two years later,

and so on.

19.2 Payback

The payback period is the time that must elapse before the net cash flows from a project

result in the initial outlay being repaid in full in cash terms. It is argued that the shorter

payback period, the more attractive the project. It is a valid indicator for capital investment

appraisal, although it ignores inflation. It also gives no indication of the overall cash flow



benefits because it ignores all cash flows after payback has been achieved. It is for this reason

that it should never be used in isolation.

Payback can be defined as: The time required for the cash inflows from a capital investment

project to equal the cash outflows.

The usual decision rule is to accept the project with the shortest payback period.

Example

A project costing £10,000 is expected to have a projected cash flow over a 4-year period,

shown as follows. As normal in capital investment project appraisal, Year 0 represents the

time the investment is made at the start of the project.

The net cash flows for each year are shown below:

Year 0 Year 1 Year 2 Year 3 Year 4

£ £ £ £ £

(10,000) 2,000 3,000 4,000 5,000

Required:

Calculate the payback period

Solution

Year 0 Year 1 Year 2 Year 3 Year 4

£ £ £ £ £

Amount

outstanding b/f (10,000) (8,000) (5,000) (1,000)

Net cash flow (10,000) 2,000 3,000 4,000 5,000

Amount (10,000) (8,000) (5,000) (1,000) 4,000

Outstanding b/f

At the end of Year 4 the cumulative cash flow becomes positive. At this point, you need to

estimate when during Year 4 payback occurred. You do so by dividing the amount required at

the end of Year 3 to achieve payback by the net cash flow during Year 4 and then multiplying

the answer by 12 (representing 12 months):

Payback = payback year + payback month

3 years + (1,000 x 12) = 3 years + 2.4 months

5,000

The advantages of the payback are:



Simple to understand and calculate

Is more objectively based because it uses project cash flows rather than accounting

profits

Favours quick return projects which may produce faster growth for the firm and enhance liquidity

Choosing projects which payback quickest will tend to minimise time related risks. However, not all risks are related merely to time elapsed.

Disadvantages:

It ignores all cash flows after the payback period

It does not fully take into account the riskiness of the project, only that risk which is

time-related

It ignores the time value of money (money received in the future is not worth the same as money received today).

19.3 Net present value

The purpose of investment is to generate more cash in real terms than was consumed in

making it, therefore, it is necessary to consider cash flows relating to the investment. Non-

cash costs (such as depreciation) and costs that had already been incurred prior to the

investment decision should be ignored in the calculations.

Future cash flows must be discounted to arrive at their present value using an appropriate

discount factor:

1

1 + 𝑟 𝑛

Where ‘r’ is the rate at which monetary value is to be discounted over a number of ‘n’ years.

r = discount rate

n = number of years

The present value of any amount received after ‘n’ years is obtained by multiplying the

amount by the discount factor.

For example, calculate the present value of £1 receivable in three years time if the discount

rate is 15%.

Using the formula: 1 = £0.6575

1 + 0.15 3

Thus it will be worth about 2/3 of the value of £1 receivable now: £1 x £0.6575 = £0.6575

The rate applied to adjust (discount) future cash flows in order to arrive at their present value

is called the discount rate. It reflects the risk that future cash will be worth less by way of

inflation than current cash, the risk that the borrower or investment project may, for some



reason, fail to meet the repayment expectations, and the general cost of borrowing funds to

invest.

As you can see capital investment appraisal techniques require forecasts of future cash flows,

which do not include non-cash items, such as depreciation. Discounted cash flow takes

timing differences into account by adjusting all cash flows to their present values before

comparing amounts.

Outflows of cash are given a negative or minus sign; inflows are positive. The sum of the

present value of the outflows and inflows is known as the net present value (NPV).

If the net present value is positive, the present value of inflows exceeds the present value of

the outflows and you would become richer by taking on the project. Therefore, you should

accept it.

If the net present value is negative, the present value of outflows exceeds the present value of

the inflows and you would become poorer if you took on the project.

Example

Consider the following project:

A machine costs £20,000 and will yield net cash inflows of £8,000, £9,000 and £7,000 at the

end of each of the next three years. Is this a worthwhile investment if the discount rate is

10%?

Solution

If no account were paid to the timing differences, the project is worthwhile: it costs £20,000

and yields net cash inflows totalling £24,000. However, we know that it is not valid to

compare the cash flows without adjusting for the different timings.

Time Cash flow Discount factor Present value

0 (20,000) 1 (20,000)

1 8,000 1/1.1 7,273

2 9,000 1/1.12 7,438

3 7,000 1/1.13 5,259

Net present value (30)

Time 0 means now, which is normally assumed to be when the project starts. Brackets are

used to show negative cash flows (outflows). A discount factor of 1 means that the cash flow

is not discounted at all – which is appropriate if the cash flow is happening in the present.

At the end of the year, there is a net cash inflow of £8,000. This must be discounted by one

year to find its present value.

Two years after the start of the project, there is a cash inflow of £9,000; this has to be

discounted two years to find its present value.



Finally, in three year’s time, there is a cash inflow of £7,000, worth only £5,259 when

discounted for three years.

The present values are then added up to give a net present value of (£30). This means that the

present value of the outflows exceeds the present value of the inflows so this project should

not be undertaken as it would leave you poorer than would merely investing the £20,000 at

10% for three years.

£30 is a small amount when compared to the other figures in the calculation. However, a

small change in an estimate could make the net present value positive, implying that the

project should be accepted.

The advantage of the NPV method is that the final answer is expressed in financial terms,

which makes the comparison with other mutually exclusive project proposals easier to

achieve. The objective is to maximise the net present value of a firm’s future revenues. If

there is a choice between mutually exclusive proposals, then the proposal with the highest

NPV would be chosen.

The disadvantages are that the results are very sensitive to the rate of discount chosen, and it

is by no means easy to select an appropriate rate of discount.



LESSON 20: BUDGETING: FUTHER CONSIDERATIONS

20.1 Introduction

As you have learnt in this course, management control is needed to try to ensure that

organisations achieve their objectives. Once the objectives have been agreed, plans should be

drawn up so that the progress of the organisations can be directed towards the ends specified

in the objectives.

When a plan is expressed quantitatively it is known as a budget and the process of converting

plans into budgets is known as budgeting.

Budgets are prepared in order to try to guide the firm towards its objectives and are drawn up

for control purposes, that is, as an attempt to control the direction that the firm is taking.

20.2 Budgetary Control

When the budgets are being drawn up two main objectives must be uppermost in the mind of

top management:

Planning. This means a properly co-ordinated and comprehensive plan for the whole

business. Each part must interlock with the other parts.

Control. Control is exercised via the budgets, thus the name budgetary control. To do this means that the responsibility of managers and budgets must be so linked that

the responsible manager is given to help him to produce certain desired results, and

the actual achieved results can be compared against the expected, i.e. actual compared

with budget.

Therefore, the budgetary control is an integral part of both planning and control. Budgeting is

about making plans for the future, implementing those plans and monitoring activities to see

whether they conform to the plan. To do this successfully requires full top management

support, cooperative and motivated middle managers and staff, and well organised reporting

systems.

The following benefits of budgeting are those that can be derived from the full budgetary

process. They have to be worked for, as they do not accrue automatically:

Planning and coordination

Clarification of authority and responsibility

Communication

Control

Motivation

Planning and coordination. The formal process of budgeting works within the framework

of long term, overall objectives to produce operational plans for different sectors and facets

of the organisation. Planning is the key to success in business and budgeting forces planning



to take place. The budgeting process provides for the coordination of the activities and

departments of the organisation so that each facet of the operation contributes towards the

overall plan.

This is express in the form of a Master Budget which summarises all the supporting budgets.

The budget process forces managers to think of the relationship of their function or

department with others and how they contribute to the achievement of organisational

objectives.

Clarification of authority and responsibility. The process of budgeting makes it necessary

to clarify the responsibilities of each manager who has a budget. The authority and

responsibilities of each individual manager must be clearly defined and managers at every

level must be aware of their responsibilities for the performance of their departments within

the framework of the organisation’s objectives. Budgeting is integrally related to the

delegation of authority and responsibility.

Communication. As the budgetary process includes all levels of management, it is important

that communication exists between top and middle management regarding the organisation’s

objectives and the practical problems of implementing these objectives and, when the budget

is finalised, it communicates the agreed plans to all the staff involved. There must be also

communication between the sales and production functions to ensure that coordinated

budgets are developed.

Control. Actual results will be compared with planned results and the variation will be

reported. Then, deviations are noted so that corrective action can be taken.

Motivation. It is due to the involvement of lower and middle management with the

preparation of budgets and the establishment of clear targets against which performance can

be judged.

Therefore, budgetary control involves logging actual revenue and expenditure against the

appropriate budget headings and reporting regularly to budget holders about how the totals

for these compare with the levels of revenue and expenditure that had been expected. Such

reports allow budget holders to monitor their own progress and to identify areas where

significant differences have arisen between planned and actual revenue and expenditure.

Such differences are called variances.

A natural reaction when a variance is found is to seek an explanation, particularly where it is

large or unexpected. Where the variance is significant some form of action is called for and

this is in turn needs to be determined, and the response needs to be implemented.

Another important point to bear in mind is the limiting factor. It is that factor which, at any

given time, effectively limits the activities of an organisation. It may be customer demand,

production capacity, shortage of labour, materials, space or finance. Because such as a

constraint will have a pervasive effect on all plans and budgets, the limiting factor must be

identified and its effect on each of the budgets carefully considered during the budget

preparation process.



20.3 The interrelationship of budgets

The various budgets have to be linked together to draw up a master budget, which is really a

budgeted set of financial statements. The sales budget and the various budgets which make

up the cost of sales, e.g. material usage, wages, salaries, overheads and so on are used to

produce the budgeted operating statement and the budgets which deal with assets and

liabilities, e.g. capital expenditure, cash, stock, debtors and creditors and so on make up the

budgeted balance sheet.

The various budgets are called functional budgets. A functional budget is a budget for a

specific function within a business that summaries the policies and levels of performance

expected to be achieved by that function over the budget period.

Functional budgets are:

Sales budget – planned sales and revenues over the budget period

Production budget – planned production to achieve target sales

Production cost budget – planned spending on production incurred to achieve the production targets. This subsumes budgets for direct labour, direct materials and

production overheads.

Administration budget – planned spending on administration and other overheads, e.g. spending on the HR function.

Marketing budget – planned spending on marketing.

Distribution budget – planned spending on distribution.

The sales forecast is the starting point for budgeting, although it is not a plan or a budget. It is

necessary to take into account the productive capacity of the business, as there is no point in

budgeting for a level of sales that is beyond the capacity of the business. Once the sales

forecast is in place, plans can be devised to achieve the level of output and sales.

Example of sales budget:

Product Jan (£000) Feb (£000) March (£000) April (£000)

A 45 46 50 55

B 27 28 30 35

C 25 25 26 30

Total sales 97 99 106 120

Example of production costs budget:

Jan Feb March

£000 £000 £000

Direct materials 20 20 21

Direct labour 12 12 13

Production overheads 4 4 4

Production costs 36 36 38



The Master Budget

This is the final co-ordinated budget for the organisation as a whole which brings together the

functional budgets into forecast final accounts for the year. It incorporates:

Cash flow budget (cash flow forecast) – the forecast flow of cash into and out of the organisation

Budget profit and loss account – based on forecasts and plans this is what the Profit

and Loss Account is expected to be at the end of the budget period.

Forecast balance sheet – a forecast of the Balance Sheet at the end of the period.

These three budgets are identical in format to the equivalent statements in the financial

report – but budget statements refer to expectations and plans for the future.

Capital budget – covers the capital expenditure the organisation expects to make within a given period.

20.4 The profit and loss budget

As you have learnt earlier, preparation of the sales budget comes first, because expenditure

cannot be planned until the source and amounts of resource available have been estimated.

The first part of the sales budget, based on the forecast sales volume, reflects the owner’s

estimate of several factors, including:

The forecast growth of these markets

The selling prices of the products

Competition from other firms

The size of the markets for the company’s products

Let’s use a example to illustrate how the functional budgets interrelate:

Prestige Ltd is a small business making just one product. Each unit will sell for £65 and the

owner has estimated the orders for the first 15 months of trading:

Year 1 Sales volume

1st quarter 1,000

2nd

quarter 1,100

3rd

quarter 1,200

4th

quarter 1,500

Year 2

1st quarter 1,600



Therefore, the sales revenue budget for Year 1 will be as follows:

Q1 Q2 Q3 Q4 Total

Sales volume 1,000 1,100 1,200 1,500 4,800

Sales revenue £65,000 £71,500 £78,000 £97,500 £312,000

Once the sales budget has been drafted, the production plan can be prepared. The budgeted

level of production is calculated by adjusting the required sales volume for any opening and

closing stocks.

Prestige Ltd does not have any opening stock, as it is a new business. The owner has decided

to keep a stock at the end of each quarter equal to 10% of the anticipated sales for the next

quarter. This buffer stock represents the closing stock at the end of a quarter and the opening

stock for the quarter that follows.

Therefore, the production budget for Year 1 will be as follows:

Q1 Q2 Q3 Q4 Year

Sales volume 1,000 1,100 1,200 1,500 4,800

Less: opening stock ( 0) ( 110) ( 120) ( 150) ( 0)

1,000 990 1,080 1,350 4,800

Add: closing stock 110 120 150 160 160

Production required 1,110 1,110 1,230 1,510 4,960

Once the budgeted level of production has been established, the detailed labour budget,

materials (or purchases) budget and production overheads budget can be calculated. These

three components together make up the cost of production budget.

The direct cost of making each unit is as follows:

Direct materials £16

Direct labour £20

Production overhead costs will be £20,000 for the first year, including depreciation of £2,000

for the year on fixed assets. There will be no other expenditure incurred during the year.

First we must multiply the direct materials and labour costs per unit by the number of units

required by the production plan, we then add the fixed cost for the period. The production

overhead cost is found by dividing the annual production overhead cost into quarters.



Production costs budget for Year 1:

Q1 Q2 Q3 Q4 Year

Production

Required 1,110 1,110 1,230 1,510 4,960

£ £ £ £ £

Direct materials

Cost 17,760 17,760 19,680 24,160 79,360

Direct labour

Cost 22,200 22,200 24,600 30,200 99,200

Production

Overheads 5,000 5,000 5,000 5,000 5,000

Total production

Cost 44,960 44,960 49,280 59,360 198,560

Profit and Loss Budget for Prestige Ltd

£ £

Sales (4,800 x £65) 312,000

Less: cost of sales

Direct materials 79,360

Direct labour 99,200

Production overheads 20,000

198,560

Less closing stock

(£198,560 / 4,960 = £40 x 160) (6,400)

192,160

Budgeted gross profit 119,840



LESSON 21: SOCIAL ACCOUNTING

One of the problems associated with ‘social actions’, that is actions which do not have purely

financial implications, is the difficulty of identifying costs and measuring the effects of

factors (often intangible) that contribute to the ‘value’ of an organisation.

Providing ‘social’ information required under the Companies Act 1985 is not particularly

difficult; it requires information regarding employees to be presented in the financial

statements, including numbers of employees, wages and salaries data, and details regarding

the company’s policy on disabled persons. Also, even where ‘social’ actions are required by

legislation, they can often be cost reasonably accurately. For example, there are a large

number of European Union directives which have been implemented in the UK relating to

social and environmental policies, including the monitoring and control of air and water

pollution.

The costs of complying with these disclosure requirements and operational control measures

can be high and, as the number of regulations increase, these costs will become a basic and

essential part of financial statements. It will become increasingly important that not only the

costs are reported, but also the benefits, and this is where the difficulties arise: how can the

benefits of controlling pollution from a factory be evaluated? Indeed, should an attempt be

made to evaluate them at all? Would they be better reported in qualitative or non-financial

quantitative terms?

As soon as a company seeks to incorporate social criteria alongside other, more traditional

performance measures, problems of objectivity, comparability and usefulness arise. For

example, social criteria for a paper manufacturer may include environmental issues

concerning reforestation; and an oil extraction company would include the environmentally

safe disposal of oil rigs at the end of their useful economic lives among its social criteria.

Social accounting is concerned with how to report upon the application of the social policies

adopted by an organisation, and upon how they have impacted upon the organisation and its

environment. An organisation that does so effectively will not only be providing user groups

with rich information from which to form a view concerning its social ethos, it will also be

enhancing its ability to take decisions appropriate for its own longer-term survival and

prosperity.

The reporting of non-financial information usually takes the form of narrative disclosure,

sometimes supported by a statistical summary. Sometimes the issue is what to report, due to

the lack of standards governing what to include and how to present social reports.

Oil companies, for example, produce a notable amount of additional information in their

annual reports. This environmental information usually includes details about the company’s

waste disposal practices, attitudes towards pollution and natural resource depletion, as well as

the overall corporate environmental policy. However, many continue to avoid any non-

mandatory social reporting, and many instances have been reported of organisations claiming

to be socially responsible, when they were, in fact, anything but.

If we now look at the Gross National Product (GNP), which is the measure of the nation’s

productivity recorded in the accounts, we may think that an increase in GNP would seem to



indicate a betterment or progress in the state of affairs existing in the country. However, this

is not necessarily so.

Let’s think of a new chemical factory that is built in a town. Fumes are emitted during

production, what causes houses in the surrounding areas to suffer destruction of paintwork

and rotting woodwork, and it also causes extensive corrosion of bodywork on motor vehicles

in the neighbourhood. In addition it also affects the health of the people living nearby. An

increase in GNP results because the profit elements in the above add to GNP.

What do you think the profit elements will be?

They may include:

To construction companies and suppliers of building materials: profit made on construction of plant

To house paint dealers and paint manufacturers, painters and decorators, joiners and

carpenters: profit made on all work effected in extra painting, woodwork, etc.

To garages and car paint manufacturers: profit made on all extra work needed on motor vehicles

To chemists and medical requirement manufacturers: profit made on dealing with effects on residents’ health, because of extra medical purchases, etc.

As you can see the quality of life has been seriously undermined for many people; therefore,

in real terms one can hardly say that there has been progress.

As national income accounts do not record the ‘social’ well-being of a country, other national

measures have been proposed. The one most often mentioned is a system of ‘social

indicators’. These measure social progress in such ways as:

National life expectancies

Living conditions

Levels of disease

Nutritional levels

Amount of crime

Road deaths.

The main difficulty with this approach is that it cannot be measured in monetary terms.

Because of this, the national social income accounts cannot be adjusted to take account of

social indicators

While national social accounting would measure national social progress, many individuals

and organisations are interested in their own social progress. This form of social progress is

called ‘social responsibility’.

To identify activities to be measured, a ‘social audit’ is required, investigating: which of their

activities contribute to, or detract from, being socially responsible; measurement of those

activities; a report on the results disclosed by the investigation.

Social audits may be carried out b an organisation’s own staff or by external auditors. The

reports may be for internal use only or for general publication.



The matters that can be use for a ‘social audit’ are:

Employment of women

Employment of disabled people

Occupational safety

Occupational health

Benefits at pensionable age

Air pollution

Water pollution

Charitable activities

Help to developing countries

The idea is to discover how the organisation had performed in respect of those matters.

It is very important that an organisation comes to a compromise about how far it should look

after the interests of its shareholders and how far it should bother about social considerations.

For example, there may be instances that, no matter what the effects on profits, the expenses

just have to be incurred. That would be the case of a chemical plant which could easily

explode, causing widespread destruction and danger to people; then there cannot be any

justification for not spending the money either to keep the plant safe or to demolish it.

The organisation will need to bring all the facts of the particular case into account.

In other cases, the company may already have environmental policies in place. For example,

a company may have decided to have the following principles of environmental policy:

To comply with both governmental and community standards of environmental excellence.

To minimise waste

To get to as low a level as possible the discharge of pollutants

To research fully the ecological effect of the company’s products and packaging

To carry on business operations in an open, honest and co-operative manner

To ensure that the those principles are fully observed







Question 1 Tom Hill runs a manufacturing business and the following information is provided for the year ended 31

December 2007:

£

Stocks of raw materials at:

1 January 2007 (at cost) 14,700

31 December 2007 (at cost) 15,900

Stocks of work in progress (work in progress has decreased by £900 over the year)

Stock of finished goods at:

1 January 2007 (at cost plus 30%) 22,100

31 December 2007 (at cost plus 30%) 24,700

Sales 1,200,000

Purchases of raw materials 317,600

Carriage inwards 1,450

Carriage outwards 2,375

Wages 361,665

Manufacturing royalties 22,000

Factory rent, rates and insurances 16,200

General factory overheads 33,045

Manufacturing machinery at cost 300,000

Provision for depreciation of manufacturing machinery at 1 January 2007 180,000

Provision for unrealised profit at 1 January 2007 5,100

Additional information at 31 December 2007

1) Manufacturing royalties paid in advance amounted to £500

2) Wages are apportioned 2/3 to direct labour and 1/3 to indirect labour

3) Insurances paid in advance amounted to £900

4) Rates owed amounted to £850

5) Depreciation is to be charged at 10% per annum on a straight-line basis

Required:

a) Prepare a manufacturing account for the year ended 31 December 2007



(22 marks)

b) Tom has prepared a trading account using the information given. He has calculated his

gross profit on trading to be £214,600. Calculate the amount to be entered in the profit

and loss account for the provision for unrealised profit for the year ended 31 December

2007.

(5 marks)

(for quality of presentation: plus 1 marks)




Question 2

The trading, profit and loss account for Eat Ltd for the year ended 31 March 2007 was as follows:

£ £

Sales (12,000 units) 36,000

Opening stock (2,000 units) 40,000

Purchases (14,000 units) 210,000

Closing stock (4,000 units) (60,000)

Cost of sales (190,000)


Production costs 95,000

Non-production fixed costs 70,000 (165,000)

Net profit 5,000

The business expects the following changes to occur during the year ending 31 March 2008.

1) Sales should increase by 25% following an aggressive advertising campaign and a

decrease in price of 5% per unit.

2) The advertising campaign should cost £8,000.

3) Unfortunately, the supplier has increased his costs by 10% but the purchasing manager of

Eat Ltd has been able to arrange a discount of 2% by buying in bulk.

4) Closing stock is to be 20% of the total annual sales units.

5) Production costs are expected to rise to £110,000.

Required:

a) Prepare a budgeted trading, profit and loss account for Eat Ltd for the year ending 31

March 2008.

(15 marks)

b) Calculate the following for the year ending 31 March 2008 and the year ended 31 March

2007:

1. Gross profit margin (4 marks)

2. Net profit margin (in relation to turnover)

(4 marks)

3. Rate of stock turnover

(4 marks)

c) Write a report to the directors of Eat Ltd explaining the reasons for the expected changes



in b).

To……………………………………………………………………………

From…………………………………………………………………………

Date……………………………………

Subject……………………………………………………………………….

(7 marks)




Question 3

Hill Ltd needs to replace one of the assembly machines which will cost £200,000 payable on purchase.

The replacement machine is expected to last 4 years, but will need a complete maintenance check in year3

at a cost of £50,000.

The existing machine assembles 4,000 units a year. The number of units assembled by the replacement

machine is expected to be 25% lower in year 1 than the existing machine due to the time lost during

installation and testing. In year 2 it is expected that 4,500 units will be assembled and this will increase by

20% each year compared to the previous year.

The existing machine produces units at a cost of £26 each, whereas the replacement machine will produce

units at a cost of £24 each. The selling price is currently £42 per unit but with the improved quality

provided by the replacement machine this will increase to £45 per unit. From year 3, it is expected that

the cost of manufacture will increase by 25% each year and the selling price will increase by 30% each

year compared to the previous year.

The cost of capital is 14%.

The following is an extract from the present value table for £1.

14%

Year 1 0.877

Year 2 0.769

Year 3 0.675

Year 4 0.592

It is assumed that all units produced are sold.

Required:

a) Calculate the expected net cash flows for each year, using the replacement machine.

(12 marks)

b) Calculate the payback period for the replacement machine

(2 marks)

c) Calculate the net present value for the replacement machine using the expected net cash

flows. Assume that revenues are received and costs are paid at the end of each year.

(6 marks)

d) Compare the two methods of capital investment appraisal.

(4 marks)




Question 4

The following information relates to the month of May 2008 of Smith Ltd:

Budgeted Actual

Production 2,400 units 2,200 units

Direct material 5 kilos at £5.50 per kilo per unit £66,000 (13,200 kilos)

Direct labour 6 hours at £4.50 per hour per unit £70,400 (17,600 hours)

The budgeted profit for May 2008 was £26,000.

Required:

a) Calculate the material price and material usage variances.

(2 marks)

b) Calculate the labour rate and labour efficiency variances.

(2 marks)

c) Calculate the actual profit for Smith Ltd for the month ended May 2008.

(3 marks)

d) Explain two possible ways in which the variances will affect the current workforce.

(2 marks)




Question 5

Sue sells greeting cards. On average each card costs 50p to buy and is sold for £1.20. The annual business

fixed costs are £110,000. Sue has set a target profit for the year of £30,000.

Required:

a) Calculate the contribution per greeting card.

(2 marks)

b) Calculate the number of greeting cards which Sue needs to sell to achieve the target profit

of £30,000. State the formula used.

(3 marks)


