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CAT Intermediate Paper 3Maintaining Financial Records International Stream

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First edition 2005Fifth edition January 2009

ISBN 9780 7517 5785 9 (Previous edition 9780 7517 4792 8)

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A catalogue record for this book is available from the British Library

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BPP Learning Media Ltd, BPP House, Aldine Place, London W12 8AA

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Page iii

Welcome to BPP Learning Media’s new CAT Passcards.

� They save you time. Important topics are summarised for you.

� They incorporate diagrams to kick start your memory.

� They follow the overall structure of the BPP Learning Media Interactive Texts, but BPP Learning Media’snew CAT Passcards are not just a condensed book. Each card has been separately designed for clearpresentation. Topics are self contained and can be grasped visually.

� CAT Passcards are just the right size for pockets, briefcases and bags.

� CAT Passcards focus on the exam you will be facing.

Run through the complete set of Passcards as often as you can during your final revision period. The daybefore the exam, try to go through the Passcards again! You will then be well on your way to completing yourexam successfully.

Good luck!

ContentsPreface

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ContentsPreface

Page1 Assets, liabilities and the accounting equation 12 Statement of financial position and income

statement 113 Recording and summarising transactions 174 Posting transactions, balancing accounts

and the trial balance 235 Accounting concepts and standards 336 Control accounts and the correction of errors 377 Accruals and prepayments, receivables and

irrecoverable debts 41

Page8 Cost of goods sold and the treatment

of inventories 499 Non-current assets and depreciation 5510 Extended trial balance 6711 The accounts of sole traders 7112 Incomplete records 7713 Partnerships 85

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1: Assets, liabilities and the accountingequation

Topic List

Assets and liabilities

Double entry

Payables and receivables

The accounting equation

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The accountingequation

Payables andreceivables

Doubleentry

Assets andliabilities

AssetsAn item of value which a business owns or hasthe use of

LiabilitiesSomething which is owed to someone else

Eg:

� Land and buildings� Vehicles� Inventories� Cash

A receivable is an asset. A receivable representsmoney owed to the business.

Eg:

� Bank loan/overdraft� Amounts owed to trade payables (suppliers)� Tax

A payable is a liability. A payable represents moneyowed by the business.


1: Assets, liabilities and the accounting equationPage 3

Non-current asset: an asset acquired for use withinthe business over more than one accounting period

Current liabilities: debts which must be settledwithin one year

Current assets: items owned by the business withthe intention of turning them into cash

Non-current liabilities: debts which are notpayable within one year

Cash is used to buy goods which are sold. Sales oncredit create receivables, but eventually cash isearned from the sales. Some of the cash will then beused to replenish inventories.

The cash cycle

Cash

pay buys

Receivables Inventories of goods

Sales on credit




Doubleentry


Basic principles

The rules of double entry bookkeepingare best learnt by considering the cashbook.

� A credit entry indicates a paymentmade by the business; the matchingdebit entry is then made in an accountdenoting an expense paid, an assetpurchased or a liability settled

� A debit entry in the cash bookindicates cash received by thebusiness; the matching credit entry isthen made in an account denotingrevenue received, a liability created oran asset sold

Double entry bookkeepingDouble entry bookkeeping is based on the same idea as theaccounting equation.� Every accounting transaction has two equal but opposite

effects� Equality of assets and liabilities is preserved

In a system of double entry bookkeeping every accountingevent must be entered in ledger accounts both as a debit andas an equal but opposite credit.

DebitAn increase in an expenseAn increase in an assetA decrease in a liability

CreditAn increase in incomeAn increase in a liabilityA decrease in an asset



D DEBITIncreases in

E EXPENSES

eg incur advertising costs

A ASSETSeg new office equipment

D DRAWINGS

eg the owner takes cash for his own use

Decreases in liabilities, capital or

income

Left hand side

C CREDITIncreases in

L LIABILITIES

eg buy goods on credit

I INCOME

eg make a sale

C CAPITAL

eg owner pays in personal money

Decreases in assets, drawings or expenses

Right hand side




Doubleentry


Every transaction has a debit and a credit.

If a business buys goods for resale with cashthen:

DEBIT PurchasesCREDIT Cash

Cash sales result in:

DEBIT CashCREDIT Sales

Accounting equationAssets = Liabilities + Capital

Total debits = Total credits

Profit = Income - Expenditure



SALES

by the business to a customer

creates an

ACCOUNT RECEIVABLE

a customer who owes money to the business

recorded as an

ASSET

of the business

settled when the business

RECEIVES CASH

PURCHASES

by the business from a supplier

creates an

ACCOUNT PAYABLE

a supplier who is owed money by the business

recorded as a

LIABILITY

of the business

settled when the business

PAYS CASH



Doubleentry





Doubleentry


What is a business?A business exists to make a profit. Profit is theexcess of income over expenditure.

Separate entityA business must always be treated as a separateentity from its owner when preparing accounts.

Business equationP = I + D – C

P is profit earned in current period

I is increase (or decrease) in net assets in currentperiod

D is drawings in current period

C is capital introduced in current period

This derives from the accountingequation: Assets = Capital + Liabilities.

Net assets = total assets less totalliabilities

Drawings = capital withdrawn fromthe business by theowner(s)



Accounting equation

Accounting equation 1Assets = Capital + Liabilities

Accounting equation 2Assets - Liabilities = Capital

Accounting equation 3Net assets = Capital introduced + retained profits - drawings. Also known as the Business equation.

Capital: amount invested in the business by the owner(s). It is owed to the owners(s) and so is a liability.


Notes


2: Statement of financial position and income statement

Topic List

Statement of financial position

Income statement

Capital and revenue

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Capital andrevenue

Incomestatement

Statement offinancial position

Statement of financial positionA statement of the assets, liabilities and capital ofa business at a given time

Income statementA statement of revenue earned and costs incurredin earning it

The income statement usually highlights gross profitand net profit.

The first part shows the gross profit for the period.

Gross profit = Sales – Cost of goods sold

The gross profit is then adjusted to show the netprofit for the period.

Net profit = Gross profit + Other income – Otherexpenses

The statement of financial positiondemonstrates the accounting equation:

Assets (A) = Capital (B) + Liabilities (C).


2: Statement of financial position and income statementPage 13

PROFORMA STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X5£ £

Non-current assetsLand and buildings XPlant and machinery XFixtures and fittings X

XCurrent assetsInventories XReceivables XCash at bank and in hand X Total assets X

A Equity and liabilitiesEquityProprietor’s capital XRetained earnings X

B Non-current liabilities X Current liabilitiesTrade payables XBank overdraft X X

A


Capital andrevenue

Incomestatement


INCOME STATEMENT FOR THE PERIOD ENDED 31 MARCH 20X5

$ $Sales XCost of sales (X)Gross profit XDistribution costs XAdministrative expenses X

(X)Profit for the year X


Capital andrevenue

Incomestatement


2: Statement of financial position and income statementPage 15

Capital and revenue items

Alert. You must be able to identify, record and account for capital and revenue items accurately.

Capital expenditureResults in the acquisition of non-current assets oran improvement in an existing non-current asset’searning capacity.

Capital incomeProceeds from the sale of non-current assets

Revenue expenditureExpenditure incurred during trading activities or tomaintain current earning capacity (ie repairs)

Revenue incomeProceeds from sale of goods or rent, interest anddividends earned from non-current assets


Notes


3: Recording and summarising transactions

Topic List

The role of source documents

Sales and purchase day books

Cash books

This chapter covers the main sources of data and thefunction each source or record has.

We will see how the documents are recorded in books ofprime entry to reflect business transactions.


Cashbooks

Sales and purchaseday books

The role of sourcedocuments

Source documents Books of prime entryBusiness transactions are nearly always recorded ona document. These documents are the source of theinformation in the accounts. Such documents includethe following:

� Sales order

� Purchase order

� Invoice

� Credit note

� Debit note

� Goods received note

� Remittance advice

� Cheque stubs

� Petty cash vouchers

The source documents are recorded in books ofprime entry.

� Sales day book

� Purchases day book

� Sales returns day book

� Purchases returns day book

� Cash book

� Petty cash book

� Journal (see Chapter 6)


Cashbooks



3: Recording and summarising transactionsPage 19

Sales day bookThe sales day book is used to keep a list of all invoicessent out to customers each day. Here is an example.

SALES DAY BOOK

Invoice Receivables ledger TotalDate number Customer ref. invoiced

$3.3.X9 207 ABC SL12 4,000

208 XYZ SL59 1,2005,200

Purchases day bookThis is used to keep a record of invoices which abusiness receives. Here is an example.

PURCHASES DAY BOOK

Payables TotalDate Supplier ledger ref. invoiced

£3.4.X9 RST PL31 21510.4.X9 JMU PL19 1,80415.4.X9 DDT PL24 758

2,777

There are also sales and purchase returns day books, which record goods returned by customers / to suppliers.


Cashbooks



Cash bookCash receipts and payments are recorded in the cash book.

Cash receipts are recorded as follows, with the total column analysed into itscomponent parts.

CASH RECEIPTS

Discounts Receivables CashDate Narrative Total allowed ledger sales Sundry

$ $ $ $ $3.3.X9 Cash sale 150 150

Receivable:ABC 1,000 50 1,050(discount taken)

1,150 50 1,050 150 –


3: Recording and summarising transactionsPage 21

Cash payments are recorded in a similar way.

CASH PAYMENTS

Note that for accounting purposes ‘cash’ includes cheques, unless specified as ‘cash inhand’ or ‘petty cash’ (see next page).

Discounts Payables Cash PettyDate Narrative Total received ledger purchases Cash

$ $ $ $ $3.3.X9 DEF 300 – 300 –

Petty Cash 100 – – – 100400 – 300 – 100


Cashbooks



Petty cash bookMost businesses keep a small amount of cash on the premises for small payments, eg stamps,coffee. Petty cash payments and receipts are recorded in a petty cash book.

PETTY CASH BOOK

RECEIPTS PAYMENTSDate Narrative Total Date Narrative Total Stationery Coffee

$ Date $ $ $3.3.X9 Bank 50 3.3.X9 Paper 10 10

Coffee 5 550 15 10 5

Under the ‘imprest system’: $Cash still held in petty cash XPlus voucher payments X__Must equal the agreed sum or float X____


4: Posting transactions, balancing accountsand the trial balance

Topic List

The general ledger

The journal and imprest system

Day book analysis

The receivables and payables ledgers

Accounting for sales tax

The trial balance

This chapter looks at ledger accounting.

The balances on the ledgers help provide the businesswith information about what it is doing.

Sale tax is a general consumer expenditure tax. It is nota major area of the syllabus but may appear in MCQs.


Thegeneral ledger

The journal andimprest system

The trialbalance

Accountingfor sales tax

The receivablesand payables ledgers

Day bookanalysis

A ledger account or ‘T’ account looks like this.

NAME OF ACCOUNT

$ $DEBIT SIDE CREDIT SIDE

Ledger accountingis the process by which a business keeps a recordof its transactions:

� In chronological order

� Built up in cumulative totals

The general ledgeris an accounting record which summarises thefinancial affairs of a business. Accounts within thenominal ledger include the following.

� Plant and machinery (non current asset)

� Inventories (current asset)

� Sales (income)

� Rent (expense)

� Total payables (current liability)


4: Posting transactions, balancing accounts and the trial balancePage 25

Thegeneral ledger


The trialbalance



Day bookanalysis

Journal

Journal entries are often required in an examwhere you would not use the journal in practice,to save you the time that would be involved indrawing up ‘T’ accounts.

Format of journal entries is as follows.Date Debit Credit

$ $DEBIT A/c to be debited XCREDIT A/c to be credited XNarrative to explain transaction

Imprest systemThe double entry for topping up the petty cash is asfollows:

$ $DEBIT Petty cash XCREDIT Cash at bank X

JournalJournals are used to record source information that isnot contained within the other books of prime entry.They record the following:

Period end adjustments

Correction of errors

Large / unusual transactions


Thegeneral ledger


The trialbalance



Day bookanalysis

Day booksNote that day books are often analysed as in the following extract (date and customer name not shown).

Total invoiced CD sales Cassette sales$ $ $

340 160 180120 70 50600 350 250_____ ___ ___

1,060 580 480_____ ___ ________ ___ ___

To identify sales by product, total sales would be entered (‘posted’) as follows.

$ $DEBIT Receivables a/c 1,060CREDIT Sales: CDs 580

Sales: Cassettes 480

Other books of prime entry are analysed in a similar way.



Thegeneral ledger


The trialbalance



Day bookanalysis

Receivables and payables ledgersTo keep track of individual customer and supplierbalances it is common to maintain subsidiaryledgers called the receivables ledger and thepayables ledger. Each account in these ledgersrepresents the balance owed by or to an individualcustomer or supplier.

Note that these receivables and payables ledgersare kept purely for reference and are thereforeknown as memorandum records. They do not formpart of the double entry system.

Entries to the receivables ledger are made as follows.

� When making an entry in the sales day book, anentry is then made on the debit side of thecustomer’s account in the receivables ledger

� When cash is received and an entry made in thecash book, an entry is also made on the creditside of the customer’s account in the receivablesledger

The payables ledger operates in much the same way.


Thegeneral ledger


The trialbalance



Day bookanalysis

Tax on purchases made by thebusiness

Is an indirect tax levied on thesale of goods and services

Tax charged by the business ongoods/services

UK (VAT):Standard rate 17.5%Reduced rate 5%

Each country has itsown rates

Administered by the tax authority

Greater than input?

Pay difference to taxauthority

Greater than output?

Refund due to business

Output tax

Input tax

Sales tax



Credit sales(i) Include sales tax in sales day book; show it

separately(ii) Include gross receipts from customers in

cashbook; no need to show sales tax separately(iii) Exclude sales tax element from income

statement(iv) Credit sales tax payable with output tax element

of sales invoices

Credit purchases(i) Include sales tax in purchases day book; show it

separately(ii) Include gross payments in cashbook; no need to

show sales tax separately(iii) Exclude recoverable sales tax from income

statement(iv) Include irrecoverable sales tax in income

statement(v) Debit sales tax creditor with recoverable input

tax element of payable credit purchases

a b


Thegeneral ledger


The trialbalance



Day bookanalysis

Cash sales(i) Include gross receipts in cashbook; show sales

tax separately(ii) Exclude sales tax element from income

statement(iii) Credit sales tax payable with output tax element

of cash sales

Cash purchases(i) Include gross payments in cashbook: show sales

tax separately(ii) Exclude recoverable sales tax from income

statement(iii) Include irrecoverable sales tax in income

statement(iv) Debit sales tax payable with recoverable input

tax element of cash purchases

c d



SALES TAX PAYABLE$ $

Input tax 8,000 Output tax (credit sales) 15,000Amount due to tax Output tax authority (cash paid) 9,000 (cash sales) 2,000

17,000 17,000


Thegeneral ledger


The trialbalance



Day bookanalysis

Trial balanceA trial balance is a list of ledger balances shown

in debit and credit columns.

The debits should equal the credits.

� Complete omission of a transaction

� Error of commission: posting to the wrongaccount

� Compensating errors

� Errors of principle

Errors not highlighted by trial balance

If the trial balance does not balance, you need to setup a suspense account.

Suspense account. This is a temporaryaccount set up to make the trial balance work.Errors need to be found and corrected, clearing thesuspense account, before the final accounts are

prepared


5: Accounting concepts and standards

Topic List

Accounting concepts

Development of accounting standards

Relevant accounting standards

This chapter deals with the conceptual basis of accountspreparation, the ‘why?’ as opposed to the ‘how?’.


Relevantaccounting standards

Development ofaccounting standards

Accountingconcepts

What are accounting concepts?

Accounting concepts are the assumptions underlying the financial accounts. The most important accountingconcepts are going concern and accruals.

Assumes that the business will continue to operateinto the foreseeable future at its current level ofactivity.

Transactions should be recognised when theyoccur, not as cash is received or paid.

Going concern Accruals (matching)


5: Accounting concepts and standardsPage 35

Other concepts

Only material items should appear inthe financial statements.

Items are material if their omission ormisstatement would affect the impact ofthe financial statements on the reader.

Context important

Some items are 'sensitive'

Borrowing should not be 'netted off’against cash balances

Similar items should begiven similar treatment

The same treatment shouldbe applied from one periodto another

Where there is a choice ofprocedures or valuations, the oneselected should give the mostcautious presentation of thebusiness results.

Where a loss is foreseen it shouldbe accounted for

Profit should not be accounted foruntil it is realised

Prudence Consistency Materiality


Relevantaccounting standards

Development ofaccounting standards

Accountingconcepts

Development of accounting standards Relevant standards for Paper 3

1. A discussion document about the topic is published

2. Following public comment an exposure draft ispublished

3. Following further comment and consultation, astandard is issued by the IASB.

IAS 16 Property, plant and equipment

IAS 1 Presentation of financial statements

IAS 2 Inventories

Important conceptsRelevanceReliabilityComparabilityUnderstandability

Accounting standard:A set of rules which prescribe the methods bywhich accounts should be prepared andpresented.


6: Control accounts and the correction oferrors

Topic List

Control accounts

Sales tax

Errors


ErrorsSalestax

Controlaccounts

Control accountsA control account is the grand total of similaritems (usually receivables or payables) recorded inthe main ledger.

The control account value should agree with thetotal of the individual balances.

The main control accounts are:

� Receivables ledger control account(receivables)

� Payables ledger control account (payables)

Other control accounts can be used for:

� Inventories � Wages and salaries � Sales tax


ErrorsSalestax

Controlaccounts

6: Control accounts and the correction of errorsPage 39

Accounting for sales tax

Output taxTax on goods or services sold.

DEBIT Cash (or receivables)$1,175CREDIT Sales $1,000CREDIT Sales tax account $175

Input taxTax on goods or services purchased.

DEBIT Purchases £800DEBIT Sales tax account £140CREDIT Trade payables £940

Each quarter the balance on the sales tax account (output tax less input tax) is calculated to establish theamount owed to (or by) the tax authority.

Sales tax is a tax on the sale of goods and services. Gross price = Net price + sales tax.

Sales tax is calculated on the discounted price, even if the discount is not taken.

Receivables and payables shown in the statement of financial position include sales tax.

Sales and purchases shown in the income statement exclude sales tax.


ErrorsSalestax

Controlaccounts

JournalThe journal records transactions not covered by other booksof original entry.

The format of a journal entry is:

Date Reference $

DEBIT Account to be debitedCREDIT Account to be credited

Narrative to explain the transaction

Journals can be used to correct errors. Theerror must have a debit equal in value tothe credit.

Types of error

� Errors of transpositioneg writing $381 instead of $318

� Errors of omission eg do not record aninvoice

� Errors of principle eg treating capitalexpense as revenue

� Errors of commission eg recordingtelephone expenses as electricity costs

� Compensating errors eg telephone costsunderstated by $342 and electricity costoverstated by $342


7: Accruals and prepayments, receivables and irrecoverable debts

Topic List

Accruals and prepayments

Irrecoverable debts and allowances

You’ve met the concept of accruals before - this chaptertells you how to deal with them in practice.

You also cover the treatment of irrecoverable debts andallowances for receivables.


Accruals andprepayments

Irrecoverable debtsand allowances

AccrualsMatching concept

An unpaid expense charged to the period becauseit was incurred in the period

Review accruals listing for previous year.

Review every income and expenditure account.

Review all invoices received after the year end.

Calculate the relevant accruals.

12

3

4A payment made in one period but charged to thelater period to which it relates

Accrual:

Prepayment:


7: Accruals and prepayments, receivables and irrecoverable debtsPage 43

PrepaymentsReview list of prepayments from previous year.

Review all expense accounts for the year.

Calculate and list all prepayments.

12

3

Accounting entries

Accruals:

DEBIT ExpensesCREDIT Accruals

Prepayments:

DEBIT PrepaymentsCREDIT Expenses




$

Electricity/gas X

Telephone X

Rent X

Salaries X

Salesmen's expenses X

Purchases X

X

Estimate based on previous bills (accrual)

Calls estimate (accrual); rental is prepaid

One month's accrual if paid in arrears?

Specific expense claims (accrual)

Goods received not invoiced (accrual)

Is rent paid in advance (prepayment) orarrears (accrual)?

Types of accrual and prepayment





Irrecoverable debts and allowances

Irrecoverable debts If definitely irrecoverable, the prudence conceptdictates that it should be written off to the incomestatement as an irrecoverable debt.

DEBIT Irrecoverable debts expense (income statement)

CREDIT Receivables ledger control

A receivable should only be classed as an asset if it is recoverable.

AllowancesIf uncertainty exists as to the recoverability of thedebt, prudence dictates that an allowance should beset up. This is offset against the receivables balanceon the statement of financial position.

DEBIT Irrecoverable debts expenseCREDIT Allowance for receivables

Allowances can either be specific, against a particular receivable, or general, against a proportion of allreceivables not specifically allowed for.




When calculating the general allowance to be made,the following order applies.

$Receivables balance per receivables ledger control XLess: irrecoverable debts written off (X)

amounts specifically allowed (X)Balance on which general allowance is calculated X

Note. Only the movement in the general allowanceneeds to be accounted for.

$Allowance required XExisting allowance (X)Increase/(decrease) required X/(X)

Accounting entriesDR CR

(1) Write off irrecoverable debts Irrecoverable debt expense Receivables ledger control

(2) Write back irrecoverable debts paid in period Receivables ledger control Irrecoverable debt expense

(3) Set up general allowance Irrecoverable debts expense Allowance for receivables

(4) Increase general allowance Irrecoverable debts expense Allowance for receivables

(5) Reduce general allowance Allowance for receivables Irrecoverable debts expense



Subsequent recovery of debtsIf an irrecoverable debt isrecovered, having previouslybeen written off, then:DEBIT Receivables ledger controlCREDIT Irrecoverable debts expense

or, if written off in a previousaccounting period,

DEBIT CashCREDIT Sundry income

If a debt previously provided foris recovered, then:DEBIT CashCREDIT Receivables ledger control

DEBIT Allowance for receivablesCREDIT Irrecoverable debts expense

If a debt that was provided for inthe prior year turns irrecoverable,then:DEBIT Allowance for receivablesCREDIT Receivables ledger control


Notes


8: Cost of goods sold and the treatment of inventories

Topic List

Cost of goods sold

Accounting for opening and closinginventories

Counting inventory

Valuing inventories

Valuation and profit: IAS 2

This is an important chapter. It covers inventory which isa key figure in both the income statement and thebalance sheet.

You also cover the calculation of cost of goods sold.


Cost ofgoods sold

Valuation andprofit: IAS 2

Valuinginventories

Countinginventory

Accounting for openingand closing inventories

Formula for the cost of goods sold$

Opening inventory value XAdd purchases (or production costs) X

XLess closing inventory value (X)Cost of goods sold X

� Cost paid by purchaser of having goodstransported to his business.

� Added to cost of purchases.

Carriage inwards

� Cost to the seller, paid by the seller, of havinggoods transported to customer.

� Is a selling and distribution expense.

Carriage outwards


Cost ofgoods sold


Valuinginventories

Countinginventory


8: Cost of goods sold and the treatment of inventoriesPage 51

Entries during the yearDuring the year, purchases are recorded by thefollowing entry.DEBIT Purchases $ amount boughtCREDIT Cash or payables $ amount bought

The inventory account is not touched at all.

Entries at year-endThe first thing to do is to transfer the purchasesaccount balance to the income statement:DEBIT Income statement $ total purchasesCREDIT Purchases $ total purchases

The exact reverse entry is made for the closinginventory (which will be next year’s openinginventory):DEBIT Inventory $ closing inventoryCREDIT Income statement $ closing inventory

The balance on the inventory account is still theopening inventory balance. This must also betransferred to the income statement:DEBIT Income statement $ opening inventoryCREDIT Inventory $ opening inventory


Cost ofgoods sold


Valuinginventories

Countinginventory


Some businesses keep detailed records of inventorycoming in and going out, so as not to have to counteverything on the last day of the year. These recordsare not part of the double entry system.

Counting inventoryIn order to make the entry for the closing inventorywe need to know what is in inventory at the year-end. We find this out not from the accountingrecords, but by going into the warehouse andactually counting the boxes on the shelves.


Cost ofgoods sold


Valuinginventories

Countinginventory


8: Cost of goods sold and the treatment of inventoriesPage 53

A dealer in, say, kitchen appliances, may know fromcounting his inventory that he has 350 toasters ininventory at the year-end. He then needs to knowwhat cash value to place on each toaster. This is theproblem of valuation.

Identification rulesIf we are using cost, and units have been bought atdifferent prices during the year, we need to decidewhich items are left in inventory at the year-end.

The possible rules are as follows. Only the first twoshould be used for financial accounts (as opposed tomanagement accounts).

� FIFO: first in, first out� Average cost� LIFO: last in, first out

Your syllabus does not require you to apply LIFO.

PricesThe price used to value an item of inventory mightbe any of a number of possibilities, eg sellingprice, replacement cost. However, we use thelower of the following.

� The cost of buying it� The net realisable value (NRV): the expected

selling price less future costs in getting the itemready for sale and selling it


Cost ofgoods sold


Valuinginventories

Countinginventory


IAS 2� Inventory should be valued at the lower of cost

and net realisable value – the comparisonbetween the two should ideally be madeseparately for each item

� Cost is the cost incurred in the normal course ofbusiness in bringing the product to its presentlocation and condition, including productionoverheads and some other overheads

� Net realisable value is selling price less costsfrom now to completion and costs of marketing,selling and distribution

� FIFO and average cost may be used, but notLIFO

Valuation and profitDifferent inventory valuations produce different cost ofsales figures and therefore different profits. This is atemporary difference.

Remember. The higher the closing inventoryvalue, the higher the profit.


9: Non-current assets and depreciation

Topic List

The basics

Acquisitions

Non-current assets register

Depreciation

Disposals

Reconciliation

This is a very important chapter. It covers capitaltransactions, which you are very likely to come across,both in the workplace and in your exam.


The basics Acquisitions Non-currentassets register

Depreciation Disposals Reconciliation

Non-current assets: the basics

Property, plant and equipmentA physically present non-current asset:

� Plant and machinery

� Motor vehicles

� Land and buildings

Intangible non-current assetA non-current asset with no physical existence:

� Patent right

� Database

� Trademark

Generally only material assets are capitalised.

Non-current asset:Acquired and retained within the business with aview to earning profits, normally used over morethan one accounting period.




Page 57

Funding

Step 1 Record inflow of funds.

Step 2 Record outflow of funds and acquisitionof the asset.

Authorisation: Any capital expenditure above acertain amount must be authorised; usually a capitalexpenditure authorisation form records this.

� Liquidity. The purchase of a non-currentasset may seriously affect cash flow

� Staffing/training. A new machine may needskilled operatives

� Productivity/profitability. New machineryshould improve productivity and profitability

� Marketing. Existing customers informedand new customers found in order to fullyutilise asset

� Running expenses. Most non-currentassets require fuel and/or maintenance

� Premises. Is there room for more non-current assets?

Organisational implications


� Cash � Leasing

� Borrowing � Part exchange

� Hire purchase




Recording capital acquisitionsThe acquisition may be recorded in the cash bookor in the purchase day book.

However, the acquisition is more likely to berecorded with a journal.

Journal 113 Sept X2 DEBIT Motor vehicles a/c

$13,200

CREDIT Spiller $13,200

Being purchase of Peugeot 206LM23 OLE

Journal 213 Sept X2 DEBIT Plant & machinery $14,000

DEBIT Sales tax $2,450

CREDIT Cash $16,450

Being purchase of printing machine




Page 59

Non-current assets register

Likely details:Description and location of assetPurchase dateCostDepn method and estimated useful lifeAccumulated depn b/f and c/fDisposal date and proceedsProfit/loss on disposal

Not part of the double entryAn internal control


Listing of all assets owned by the organisation.




Depreciation

DEBIT Income statement Depn charge for the yearCREDIT Statement of financial position Accumulated depn

Depreciation is not a cash expense. Depreciation is not an asset replacement fund.

Depreciation is charged to allocate a fair proportionof the non-current asset’s cost to the periodbenefiting from its use.The measure of the use, wearing out and other

fall in useful life of a non-current asset. Depreciable amount = Cost – Expected residualvalue

Judgements must be made on:

� Estimated useful life� Method and rate of depreciation� Residual valueThe consistency concept demands that the same method of depreciation is used year on year.


Methods of depreciationStraight line

Cost of asset – residual valueExpected useful life of asset

The depreciation charge is the same year on year.

Reducing balancen% × The net book value of the asset.

The depreciation charge is higher in the first yearsof the asset's life.

Alert. Make sure that you learn both methods of depreciation. If you are given details of a non-current assetwhich is purchased in the middle of the year, remember to adjust the depreciation charge for the months it wasnot in use during the year.





Recording depreciation in the accountsBring the credit balance of the accumulated depreciation down.

Depreciation charge:

DEBIT Depreciation expense (income statement)CREDIT Allowance for depreciation a/c (accumulated depreciation)

Non-current asset accounts are unchanged, showing the cost of the non-current assets.

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Net book value = Non-current asset cost less accumulated depreciation




Page 63

Disposing of non-current assets $ $Sales proceeds XLess cost of making the sale (X)Net sale proceeds XCost of non-current asset XLess accumulated depreciation (X)Net book value (X)Profit/(loss) on disposal X/(X)

Calculate the profit/loss on disposal.

The following must appear in the disposals account.� Original cost of the asset (DR)� Accumulated depn (CR)� Net sales proceeds (CR)

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Ledger accounting entries:(a) DEBIT Disposal of non-current asset

accountCREDIT Non-current asset account

with cost of asset

(b) DEBIT Accumulated depn a/cCREDIT Disposal of non-current asset account

with accumulated depn(c) DEBIT Receivable account or cash book

CREDIT Disposal of non-current asset account

with proceeds of asset sale

The balance on the disposal account is the profit/loss whichis recorded in the income statement.

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DISPOSAL OF NON-CURRENT ASSET

$ $Non-current asset a/c 200 Acc. depn a/c 100Income statement a/c Cash/receivable a/c 130(profit) 30 ___

230 230______ ___

Alert. Disposals are a key area. Make sureyou can post the ledger entries correctly.


Part exchangeThis is an added complication.

The sales proceeds for the disposal is the partexchange value.

DEBIT The new non-current assets accountCREDIT The disposal accountwith the part exchange values

Any additional cost of the new asset is accountedfor by:

DEBIT The new non-current assets accountCREDIT Cash/payable

with the balance paid on the new asset

Disposals, like acquisitions, need to be authorised.





� The non-current assets register must reconcilewith both the general ledger and the assetsthemselves.

� The cost and accumulated depn totals in thenon-current assets register must be comparedto the general ledger accounts.

Reconciling physical assets ledgers accountsand register

� Discrepancies have to be investigated.� Items listed in the non-current assets register

must be physically inspected on a regularbasis.

� The non-current assets register must be keptup to date.

� Discrepancies need to be followed up.

Discrepancies


10: Extended trial balance

Topic List

Purpose

Preparing the ETB


Preparingthe ETB

Purpose

a worksheet used to record adjustments betweenthe trial balance and the final accounts

The ETB headings will look something like this.

Ledger account Trial balancefigure

Dr Cr$ $

Adjustments

Dr Cr$ $

IncomestatementDr Cr $ $

Statement of financial position Dr Cr$ $

Extended trial balance (ETB):


Preparingthe ETB

Purpose

10: Extended trial balancePage 69

Preparing the ETBDraw up the trial balance. Enter it on the ETB and add it up.

If debits don’t equal credits, check the entries are correct, then insert a suspense account.

Make the adjustments required:

� Accruals and prepayments� Adjustments to inventory figures� Other adjustments (eg depn and bad debts)

Check that the suspense a/c has been cleared by your adjustments.

Add the adjustments columns. Check the entries are correct and debits equal credits.

Add the figures across each line of the ETB and record total income statement or statement of financialpostion as appropriate.

Add the income statement debit and credits.

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2


Preparingthe ETB

Purpose

Take the profit or loss for the period to the statement of financial position columns.

� Profit = DEBIT INCOME STATEMENT = CREDIT B/S

� Loss = CREDIT INCOME STATEMENT = DEBIT B/S

Add up the debits and credits in the statement of financial position and ensure they are equal. Investigateand resolve any differences.

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11: The accounts of sole traders

Topic List

Purpose of an ETB

Preparing accounts

Legal status of sole traders

You need to be able to prepare accounts of a sole trader.This usually requires preparation of financial accountsfrom the trial balance or ETB.You must be familiar withthis type of question.


Legal status ofsole traders

Preparingaccounts

Purpose ofan ETB

An extended trial balance essentially records the adjustments which are required to the trial balance in order toproduce the final accounts.

Trial balance

List of allbalances in theledger accounts

Final accounts

Income statement


Extended trial balance

Keeps track of adjustments for

� Correction of errors

� Accruals and prepayments

� Allowance for depreciation,irrecoverable debts

� Closing inventory

The ETB is essentially a worksheet, representing all the ledger account balances and what happens to them.



Preparingaccounts

Purpose ofan ETB

11: The accounts of sole tradersPage 73

Accounts from the ETBIdeally it should be a straightforward matter to use thefigures in the last two columns of the extended trialbalance to draw up the statement of financial positionand income statement. However, bear in mind thefollowing points.

� You must know the format for an income statementand statement of financial position.

� You will need to produce workings to get the figuresin the ETB into a suitable format

� Sales and sales returns to be netted off� Cost of sales working: (opening inventory

plus purchases less closing inventory)� Distribution and admin costs, aggregating

figures in the ETB� NBV of all non-current assets for final

accounts. Note - total depreciation chargeto income statement

� Receivables - need to add in prepayments� Payables - need to add in accruals

Examples of workings

Some of these workings, eg cost of sales, can be shown on the face of the income statement or statementof financial position. Others may need to be shown separately. Use your judgement as to how complicatedthe working is likely to be.



Preparingaccounts

Purpose ofan ETB

You may have to deal with some post ETB adjustments. These will be set out in the form of journal entries.Here are the ones that are likely to come up most often.

Accrued accountancy feesThe accountant estimates that a further $330 needsto be accrued for finalising the accounts.

DEBIT Accountancy $330CREDIT Accruals $330

Drawings, not wagesThe owner realises that £500 in the wages accountwas actually drawn by her, not paid to a staffmember.

DEBIT Drawings $500CREDIT Wages $500

Bank chargesThe bank sends a letter stating that interest of $170and charges of $138 were accrued at the year end.

DEBIT Bank interest $170Bank charges $138

CREDIT Accruals $308

Write off of an irrecoverable debtA customer has gone bankrupt owing $5,000.

DEBIT Irrecoverable debt expense $5,000CREDIT Receivables ledger control $5,000


11: The accounts of sole tradersPage 75

You will normally do the journal entries before producing the final accounts.

Remember to take account of these adjustments, as well as the information on the ETB, in preparing your finalaccounts. For instance:

� Your payables figure may now include accountancy and bank interest accruals

� Your receivables may be less and your income statement bad debt expense will need to be increased

Accounts from other sources

You may be required to draft sole trader accounts from sources other than the ETB.

� You may have to write up the ledger accounts, extract a trial balance and include final adjustments

� You may be given a trial balance and a list of items to be adjusted

� A trial balance may include a suspense account to be cleared



Preparingaccounts

Purpose ofan ETB

The sole trader is liable for all the liabilities of a business to the extent of his or her personal wealth.

Contrast with limited liability companies: shareholders’ liability is limited to the extent of their shareholding in thecompany.

Advantages of sole traders

� Only simplified accounts

� No supervision from government departments

� Fewer rules to follow

� No audit

Disadvantages of sole traders

� Harder to raise capital

� Unlimited liability


12: Incomplete records

Topic List

Opening statement of financial position

Credit sales, purchases and cost ofsales

Stolen or destroyed goods

Cash book

Accruals, prepayments and drawings

This area is a very good test of your accountspreparation knowledge.

You need to know how the accounts fit together in orderto fill in the blanks.


Opening statement offinancial position

Accruals, prepaymentsand drawings

Cash bookStolen ordestroyed goods

Credit sales, purchasesand cost of sales

An incomplete records question may require competence indealing with one or more of the following.

� Preparation of accounts from information in the question

� Theft of cash (balance on the cash in hand account isunknown)

� Theft or destruction of inventory (closing inventory is theunknown)

� Estimated figures, eg 'drawings are between $15 and $20per week'

� Calculation of capital by means of net assets

� Calculation of profit by P = increase in net assets plusdrawings minus increase in capital

� Calculation of year end inventory when the count wasdone after the year end

Types of question Opening statement offinancial positionOften a question provides informationabout the assets and liabilities of abusiness at the beginning of a period,leaving you to calculate capital as thebalancing figure.

RememberAssets - liabilities = Proprietor's capital


12: Incomplete recordsPage 79





� The key lies in the formula linking sales, cashreceipts and receivables.

� RememberOpening receivables + sales – cash receipts = closingreceivables

� Alternatively put all the workings into a controlaccount to calculate the figure you want.

Credit sales and receivables

� Similarly you need a formula for linkingpurchases, cash payments and payables.

Opening payables + purchases – cash payments= closing payables

� Use a control account.

Purchases and trade payables

RECEIVABLES LEDGER CONTROL ACCOUNT$ $

Opening receivables X Cash receipts XSales X Closing receivables X

X X

PAYABLES LEDGER CONTROL ACCOUNT$ $

Cash payments X Opening payables XClosing payables X Purchases X

X X






Gross profit may be expressed either as a percentageof cost of sales or as a percentage of sales.

� In the example, gross profit is 25% of cost of sales(ie 25/100). The terminology is a 25% mark up

� Gross profit can also be expressed as 20% ofsales (ie 25/125). The terminology is a 20% grossmargin or gross profit percentage. The proformawould appear as follows

%Cost of sales 80

Plus Gross profit 20Equals Sales 100

Gross margins and mark upsOther incomplete records problems revolve aroundthe relationship between sales, cost of sales andgross profit. Bear in mind the crucial formula.

%Cost of sales 100

Plus Gross profit 25Equals Sales 125







$Cost of goods sold based on gross profit margin or mark up ACost of goods sold calculated using standard formula(ie opening inventory plus purchases less closing inventory) (B)Difference (lost/stolen inventory) C

Stolen goods or goods destroyed

� If no goods have been lost, A and B should be the same and therefore C should be nil

� If goods have been lost, B will be larger than A, because some goods which have been purchased wereneither sold nor remaining in inventory, ie they have been lost

� Stolen or lost inventory is accounted for in two ways depending on whether the goods were insured

The cost of goods stolen/destroyed can be calculated as follows.

If insured

DEBIT Insurance claim (receivable)CREDIT Purchases

If not insured

DEBIT Expenses (inventory losses)CREDIT Purchases






Cash bookIncomplete records problems often concern smallretail businesses where sales are mainly for cash.A two-column cash book is often the key topreparing final accounts.� The bank column records cheques drawn on

the business bank account and chequesreceived from customers and other sources

� The cash column records till receipts and anyexpenses or drawings paid out of till receiptsbefore banking

Debits (receipts) Credits (payments)

Cash Bank Cash Bank$ $ $ $

Don't forget that movements between cash and bank need tobe recorded by contra entries. This will usually be cashreceipts lodged in the bank (debit bank column, credit cashcolumn), but could also be withdrawals of cash from the bankto top up the till (debit cash column, credit bank column).Again, incomplete records problems will often feature anunknown figure to be derived. Enter in the credit of the cashcolumn all amounts known to have been paid from tillreceipts: expenses, drawings, lodgements into bank. Enter inthe debit of the cash column all receipts from cashcustomers or other cash sources.

� The balancing figure may then be a large debit,representing the value of cash sales if that is theunknown figure

� Alternatively it may be a credit entry that is needed tobalance, representing the amount of cash drawings or ofcash stolen







Accruals and prepaymentsWhen there is an accrued expense or prepayment,the charge to income statement can be calculatedfrom the opening balance, the cash movement andthe closing balance.

Sometimes it helps to use a ‘T’ account, eg as follows(for a rent payment).

RENT$ $

Prepayment: bal b/f 700 Income statement (bal fig) 9,000Cash 9,300 Prepayment: bal c/f 1,000

10,000 10,000

DrawingsNote two tricky points about drawings.� Owner pays personal income into business bank

accountDEBIT CashCREDIT Drawings

� Owner pays personal expenses out of businessbank account

DEBIT DrawingsCREDIT Cash


Notes


13: Partnerships

Topic List

Characteristics

Preparing partnership accounts

Partnership accounts have a lot in common with soletrader accounts. However, there are differences in theway profit is appropriated and the way capital ispresented in the statement of financial position.


Preparingpartnership accounts

Characteristics

Definition: A partnership is an arrangement between two or more individuals in which they undertake toshare the risks and rewards of a joint business operation.

There is usually a partnership agreement setting outthe financial arrangements, eg:

� The amount of capital to be provided by eachpartner

� The division of profits between partners. Profitsmight be earned in the form of salaries, intereston capital and residual profit share. Theagreement will usually specify a ratio (the profitsharing ratio) in which residual profits are to beshared by the partners

Partnership agreement

These are the UK rules - they will vary betweencountries

� Residual profits are shared equally between thepartners

� There are no partners’ salaries

� Partners receive no interest on the capital theyinvest in the business

� Partners are entitled to interest of 5% perannum on any loans they advance to thebusiness in excess of their agreed capital

No partnership agreement


13: PartnershipsPage 87

Advantages and disadvantages

Advantages

� Spread risk� Network of contacts� Partners bring in business, skills and experience� Easier to raise finance

Disadvantages

� Profits spread� Dilution of control� Disputes between partners

Partnership v sole trader

Advantages

� No need to comply with statutory requirementssuch as audit

� No need to comply with accounting standards

� No formation or registration fees

Disadvantage

� No limited liability

Partnership v limited liability company



Characteristics

Capital and current accounts

PROFORMA CURRENT ACCOUNT

X Y Z X Y Z$ $ $ $ $ $

Drawings X X X Balance b/f X X XInterest on drawings X X X Salary X X X

Interest on capital X X XBalance c/f X X X Profit share X X X

X X X X X X

It is usual to maintain both a capital account and a current account for each partner.

A partner’s capital account shows any cash or other assets brought by him into the business. He will usuallymake an initial capital contribution when he joins the partnership, but there may also be further injections (orwithdrawals) of capital later on.

While the balance on a partner’s capital account is likely to remain stable for long periods, his current accountbalance will fluctuate more rapidly.



Appropriation accountsAfter calculating the net profit earned by thebusiness an appropriation account must beprepared to determine the allocation of profitbetween the partners.

To discourage excessive drawings partnersoften agree to charge themselves interest onany sums withdrawn from the business.

Such interest is charged to the partnerconcerned (ie debited to his current account)and credited to the appropriation account,increasing the profit available for sharingbetween the partners.

The sum available for appropriation must nowbe shared amongst the partners and credited totheir current accounts.

Some partners may be entitled to a salary. Thisis credited to the partner concerned and takenout of the ‘pool’ available for appropriation.

Partners may be entitled to interest on theircapital account balances. Each partner iscredited with the appropriate amount and againthe ‘pool’ is reduced.

Finally, the residual ‘pool’ of profits is sharedamongst the partners in their profit sharingratio.

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Characteristics

PROFORMA APPROPRIATION ACCOUNT

$ $Net profit XAdd interest on drawings

A XB XC X__

X__X

Less: salary: A Xinterest on capital: A X

B XC X__

(X)__Profit X____



$ $Appropriation: A X

B XC X__

X____

When a partner makes a loan to the partnership he is a payable of the partnership. The loan is shownseparately from the partner’s capital as a long-term liability.

Remember:

Interest on a partner’s loan is an expense charged to the income statement not an appropriation. However, theinterest is added to the partner’s current account.

If no interest rate is specified, the rate is 5%. In an exam question, you will be told the rate.


Notes


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