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July 2012 Session

Financial Accounting (F3/FFA)

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Syllabus Structure

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Main capabilities

On su ccessfu l complet ion o f th is paper, candidates s hould beable to:

A. Explain the context and purpose of financial reportingB. Define the qualitative characteristics of financial information

C. Demonstrate the use of double-entry and accounting systems

D. Record transactions and events

E. Prepare trial balance including identifying and correcting errors

F. Prepare basic financial statements for incorporated andunincorporated entities

G. Prepare simple consolidated financial statements

H. Interpretation of financial statements

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Detailed syllabus

A. The context and purpose of financial

reporting The scope and purpose of, financial

statements for external reporting Users and stakeholders needs

The main elements of financial reports The regulatory framework Duties and responsibilities of those charged

with governance.

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Continues

B. The qualitative characteristics of financial

information

The qualitative characteristics of financial information

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Continues

C. The use of double-entry and accounting systems

Double entry bookkeeping principles including themaintenance of accounting records and sources ofinformation.

Ledger accounts, books of prime entry, and journals

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Continues

D. Recording transactions and events

Sales

Cash

Inventory

Tangible non-current assets

Depreciation

Intangible non-current assets and amortisation

Accrual and prepayments Receivables and payables

Provisions and contingencies

Capital structure and finance costs

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Continues

E. Preparing trial balance

Trial balance Correction of errors Control accounts and reconciliations

Bank reconciliations Suspense accounts

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Continues

F. Preparing basic financial statements

Statements of financial position Income statements and statements of

comprehensive income

Disclosure notes

Events after the reporting period Statements of cash flows

Incomplete records

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Continues

G. Preparing simple consolidated financial

statements Subsidiaries

Associates

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Continues

H. Interpretation of financial statements

Importance and purpose of analysis of financialstatements

Ratios

Analysis of financial statements

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Examination Approach

The syllabus is assessed by a two hour paper

based or computer-based examination.Questions will assess all parts of the syllabusand will include both computational and non-computational elements. The examination will

consist of 50 two mark questions.

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News!!!!

From December 2011, Paper F3/FFA saw two main

new examinable areas added to its syllabus thepreparation of simple consolidated financialstatements and the interpretation of financialstatements.

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What is Accounting?

Accounting is the process of collecting, recording,summarising and communicating financial information.

There are many purposes of accounting. You may have

considered the following. Control over the use of resources

Knowledge of what the business owes and owns

Calculation of profits and losses

Cash budgeting Effective financial planning

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Objectives of a business - Financial

Profit maximisation

Growth and market

sustainabilitySurvival

Discourage competitors

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Non-financial

Welfare of employees

Customer satisfaction

Welfare of managementSupplier relationship

Responsibility to society

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Users and stakeholders needs

Users of financial statements need relevant andreliable information.

To provide such information, the profession has

developed a set of principles and guidelines called

Conceptual Framework.

The framework is to be the foundation for building a

set of coherent accounting standards and rules.

Also to be a reference of basic accounting theory for

solving emerging practical problems of reporting.

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User groups of financial Statements

Accounting information is required for a wide range of usersboth within and outside the business.

Managers

Shareholders

Suppliers

Lenders

The tax authorities

Employees

Government

The Public

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Continues

User Group Explanation

The Tax authorities Want to know about business profits in order to assessthe tax payable by the company.

Employees Need to know about the company's financial situation

because their future careers and the level of theirwages and salaries depend on it.

Government Interested in the allocation of resources and in theactivities of enterprises. Also require information inorder to provide a basis for national statistics.

The Public Want information because enterprises affect them inmany ways, e.g. by providing jobs and using localsuppliers, or by affecting the environment (e.g.pollution).

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Management accounting and financial accounting

Management accounts are produced for internalpurposesthey provide information to assistmanagers in running the business.

Financial accounts are produced to satisfy theinformation requirements of external users.

Financial accounting is the preparation of accountingreports for external use.

Management accounting is the preparation ofaccounting reports for internal use.

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Continues

Management accountants produce information which is forward-looking,and used to prepare budgets and make decisions about the futureactivities of a business.

They also compare actual performance with budget and try to takecorrective action where necessary.

Financial accountants, however, are usually solely concerned withsummarising historical data, often from the same basic records asmanagement accountants but in a different way. This difference arisespartly because external users have different interests from managementand do not need very detailed information.

In addition, financial statements are prepared under constraints (such asInternational Financial Reporting Standards and company law) which donot apply to management accounts.

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Sole Trader, Partnership and LimitedLiabilities companies

Types of business entity

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Sole Trader/Proprietorship A sole proprietorship business is owned by one

person who is called a sole proprietor.

Since the sole proprietor is not a legal entity, theowner is entitled to all profits generated from the

business. However, the owners liability is unlimited, not just

when the business is having financial difficulty, butalso when the business fails and he faces bankruptcy.

In this case, the creditors may sue him for debtsincurred and also obtain a court order to claim againsthis personal assets, including his house.

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Continues Normally, a persons ability to run a sole

proprietorship business is limited to his area ofexpertise, which means he relies mainly on himself.

He has the freedom to use his entrepreneurial skills to

the maximum, make his own decisions and run thebusiness as he wishes.

However, to be a successful entrepreneur, he willneed to get relevant advice from experts in fields he is

unfamiliar with. This expertise is sometimes unavailable when one

operates as a sole proprietor.

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Advantages Easy and cheap to set up since there is a limited

paperwork.

The owner is in full control of the business

He/she takes all the rewards alone

Relax compliance for reporting obligations

It is usually flexible

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Disadvantages His capital is limited to the availability of his funds andthe profit generated from the business, this would be

the reason why many sole proprietorship businessesnever take off in a big way.

In many cases, even when a sole proprietorship

business is successful, all profits generated are taxedon a personal basis and tax exemptions are limited topersonal and family matters.

Very often in sole-proprietorship operations, there isno business succession plan and the business mayno longer operates with the retirement or demise ofthe sole proprietor.

The owners liability is unlimited, in the event ofbankruptcy.

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Partnership

As its name suggests, this form of entity is when two ormore persons come together to carry out a business.However, the maximum number of persons allowed in apartnership is 20.

Examples include an accountancy/audit firm, a medicalpractice and legal practice and they are generally formed

by contractual agreement which is legally binding on allpartners.

In the UK, the provisions of the Partnership Act 1890 applywhere no partnership agreement exists.

Partnerships are not separate legal entities from their

owners and they have unlimited personal liability for debtsof the business. A new form of partnership called Limited liability

partnership (LLP) has emerged in some jurisdictions.

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Advantages This form of business is cheap, easy to set up, with

minimal documentation and paperwork.

There are much fewer guidelines and formalitieswherein there is no requirement to appoint auditors,company secretary or tax agents.

They do not need to disclose their financialstatements to the general public.

Access to wider pull of resourcesadditional capital,skills and expertise.

Division of roles and responsibilities. Risk is spread among partners.

No company tax on the business

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Disadvantages Partners have unlimited liability in the case the

business runs into trouble.

There are costs to be incurred in setting up thepartnership agreements.

In the event of the death or illness of partners, thepartnership may cease to exist.

Consensus between partners are required whentaking decisions and this could lead to slower decisionmaking.

In the absence of any agreement to the contrary, theresignation of one partner automatically terminatesthe partnership agreement.

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Limited liability companies The meaning of limited companies is that the

liabilities of its members are limited to the amountof shares they hold in the company.

Members/shareholders are not responsible for

debts of the company unless if there is anypersonal guarantee.

Shareholders may be individuals or othercompanies.

Company Act 2006 is the legislation applicable inthe UK.

A LLC is a separate entity from its owners.

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Agency theory The principals (shareholders) appoint some

agents (directors) to run the business on theirbehalf.

Shareholders are the ownersthey provide

capital and receive a return usually inform ofdividends.

Declaration of dividends is at the discretion of thedirectors.

In some cases directors could also beshareholders.

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The reporting requirements for LLCs in the UK

Must be registered at Companies House There must be MoA and AoA deposited with the

Registrar of Companies

Have at least one director for Private LLC and two for

Public LLC who may also be the shareholder(s) Financial statements must be prepared for filing to

Companies House

Large companies should have audited financial

reports The financial should be available to the shareholders

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Advantages

The most obvious advantage is the liability

protection to its shareholders which limits theirexposures to the amount of share capital that theysubscribed for.

Another advantage is the simplicity to transfer existingshares or issue additional shares to new investors.

Unlike sole proprietors or partnerships, there is noneed to wind up the company in the event of death ofits shareholders or directors.

They have access to wider pull of resources Tax advantages to being a LLC. The company tax

rate may be lower than income tax rate for individuals. LLC is a separate entity from its owners which may

sue or be sued separately.

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Disadvantages

The companys financial affairs will be accessible by

the public. Compliance with the Companies Act. Although

complying itself is not a disadvantage, the amount ofeffort required to comply with the Act is much morethan a sole proprietor/partnership.

The company had to perform annual audits on itsfinancial statements. At least one company secretary is required to manage

its statutory submissions and returns as well asattending and preparing minutes for board andshareholdersmeetings.

Incorporation cost is high, and there are yearlyrecurring fees to be paid such as audit, accounting,company secretarial and tax fees.

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Quiz time!!!

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Lecture 2The qualitative characteristics of financialinformation

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Statements of Financial Accounting Concepts

SFAC No.1: Objectives of Financial Reporting (Business)

SFAC No.2: Qualitative Characteristics of Accounting Information

SFAC No.6. Elements of Financial Statements - defines the broadclassifications of items found in financial statements and replaces

SFAC No.3, expanding its scope to include not-for profitorganisations

SFAC No.4: Objectives of Financial Reporting (Non-Business) Guidelines for Non-for-profit and governmental entities

SFAC No.5: Recognition and Measurement Criteria in FinancialStatements

SFAC No.7: Using Cash Flows information and Present Value inAccounting Measurements

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Overview of the conceptual Framework

Basic Objectives:

The basic objectives of financial reporting are to provideinformation that is:-

1. Useful to those making investment and credit decisions whohave a reasonable understanding of business andeconomic activities

2. Helpful to present and future investors, creditors and otherusers in assessing future cash flows

3. About economic resources, the claims on those resourcesand the changes in them

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Qualitative Characteristics

The IASB has identified the qualitativecharacteristics of accounting information thatdistinguish better (more useful) information frominferior (less useful) information for decision making

purposes Primary qualities are relevance and reliability of

accounting information

Secondary qualities are comparability andconsistency of reported information

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Primary qualities - Relevance

To be relevant, accounting information must be capable ofmaking a difference in a decision

For information to be relevant, it should have predictive or

feedback value, and it must be presented on a timely basis

Predictive value helps users make predictions aboutultimate outcome of past, present and future events

Feedback value - helps users confirm or correct priorexpectations

Timeliness- available to decision makers before it loses itscapacity to influence their decisions

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Primary qualities - Reliability

Information is reliable when it can be relied on to represent thetrue situation

For accounting information to be reliable, it should be verifiable, isa faithful representation, and it is reasonably free of error and bias

Verifiability when given the same information and using thesame measurement methods, independent users can obtain thesame results

Representational faithfulness - when it represents what reallyexisted or happened

Neutralitywhen it is factual, truthful and unbiased

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Secondary qualities - Comparability

Comparability and consistency of reported information

Information about an enterprise is more useful if it can becompared with similar information about another enterprise(comparability) and with similar information about the same

enterprise at other points in time (consistency)

For information to be comparable, it must be

1. Measured and reported in a similar manner for different

enterprises2. Useful to users in identifying real similarities and

differences between enterprises

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Secondary qualities - Consistency

Entity is considered to be consistent in its use of accountingstandards when it applies the same accounting treatment tosimilar events from period to period

Companies can change methods, if the change results inbetter reporting

Disclosure for change :-

1. Nature of the change

2. Effect of the change3. Justification for the change

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Basic Elements of Financial StatementsBalance Sheet

Assets: Probable futureeconomic benefits resultingfrom past transactions

Liabilities: Probable futuresacrifices of economic benefitsresulting from past transactions

Equity/Net assets: Residualinterest in assets afterdeducting liabilities orownership interest

Investment by Owners:Increases in net assets

Distributions to Owners:Decreases in net assets

Income Statement

Comprehensive Income: Allchanges in equity fromnon-owner sources

Revenues: Inflows from

entitys ongoing operationsExpenses: Outflows from

entitys ongoing operations

Gains: Increases in equityfrom incidental transactions

Losses: Decreases inequity from incidentaltransactions

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Basic Principles Historical Cost Principle - Acquisition cost is the most objective and

verifiable basis upon which to account for assets and liabilities of a business

enterprise. Cost has been found to be more definite and determinable thanother suggested valuation methods.

RevenueRecognition Principle - Revenue is recognised when the earningprocess is virtually complete and an exchange transaction has occurred.Generally, this takes place when a sale to another individual or independent

entity has been confirmed. Confirmation is usually accomplished by atransfer of ownership in an exchange transaction.

Matching Principle - Accountants attempt to match expenses incurred whileearning revenues with the related revenues. Use of accrual accountingprocedures assists the accountant in allocating revenues and expensesproperly among the fiscal periods that compose the life of a business

enterprise.

Full Disclosure Principle - In the preparation of financial statements, theaccountant should include sufficient information to permit the knowledgeablereader to make an informed judgment about the financial condition of theenterprise in question.

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The regulatory framework

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The Regulatory framework of accounting

The main objective of accounting is to presentfinancial information to users. Users need to beable to rely on the information provided in thosefinancial statements to enable them to makeappropriate decisions.

Accountants need some guidance in the way inwhich they prepare the financial statements. Weshall look at some of the ways in which

accountants take decisions on methods ofaccounting and valuation for certain items in futurelectures.

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Accounting Conventions/concepts/principles

Going concern - Going concern implies that thebusiness will continue in operation for the foreseeablefuture, and that there is no intention to put thecompany into liquidation or to make drastic cutbacks tothe scale of operations.

Accruals - The accruals concept states that, incomputing profit, amounts are included in the accountsin the period when they are earned or incurred, notreceived or paid.

Prudence - Prudence is the concept that specifies, insituations where there is uncertainty, appropriatecaution is exercised in recognising transactions infinancial records.

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Continues

Consis tency - The consistency convention is

that the accounting treatment of like items shouldbe consistently applied from one accountingperiod to the next.

Material i ty - A matter is material if its omissionor misstatement would reasonably influence thedecisions of a user of the accounts. In preparingaccounts it is important to decide what is material

and what is not, so that time and money are notwasted in the pursuit of excessive detail.

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Continues

Substance over form - Substance over form is the

principle that transactions and other events areaccounted for and presented in accordance with theirsubstance and economic reality and not merely theirlegal from.

Business ent i ty (the entity concept) - This conventionseparates the individual(s) behind a business from thebusiness itself, and only records transactions in theaccounts that affect the business.

Money m easurement - This limits the recognition ofaccounting events to those that can be expressed inmoney terms.

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Continues

Histor ical cos t The historical cost of an asset is theoriginal amount paid for an asset when it was acquiredand thus non-current assets should be stated in theirhistorical costs less accumulated depreciation.

The dual aspect - This convention is the basis of double-

entry bookkeeping and it means that every transactionentered into has a double effect on the position of theentity as recorded in the ledger accounts at the time ofthat transaction.

The real isat ion con vention - This convention states thatwe recognise sales revenue as having been earned atthe time when goods or services have been supplied anda sales invoice issued.

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The theory of capital expenditure

Current purchasing power (CPP) accounting - This

method of accounting considers the effects of changingprice levels by reference to an index, for examplemovements in the retail price index (RPI) in the UK. Itdistinguishes between monetary and non-monetary

items.RPI - The RPI is a measure of inflation published each

month. It is based on the prices of items bought by theaverage family.

Monetary items - Examples of monetary items includecash and bank balances, receivables and payables.These are valued in a currencysuch as dollar, yen orsterlingregardless of the changes in the price level.

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Non-monetary assets

These are items that do not suffer a loss in value in a

period of changing price levels. They include non-current assets, inventories and shareholders equity(ordinary shares and reserves).

Holding gains/losses - The holding of monetary items

will, in periods of inflation, give rise to holding gains orlosses.

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Current cost accounting

Current cost accounting (CCA) is a method of adjusting

historical cost accounts for the effects of changingprice levels by using indices specific to theorganisation. Thus CCA attempts to measure theactual rate of inflation experienced by the business

whereas CPP attempts to measure the rate of inflationexperienced by the business owners.

Fair Value - fair value may be defined as the value ofan asset in an arms length transaction between

knowledgeable buyer and seller of that asset.

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Duties and responsibilities of those charged withgovernance

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Duties

Those charged with governing a company areresponsible for the preparation of the financialstatements.

Corporate governance (CG) is the system used indirecting and controlling a company.

This is necessitated because the management andownership of a company reside in the hands ofdifferent people and this could lead to conflicts ofinterest.

The board of directors (BOD) of a company areusually charged with governance of a company sincethey are the top echelons.

The duties and responsibilities of directors are usuallylaid down in law and are wide ranging.

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Legal responsibilities of directors

Directors have a duty of care to show reasonablecompetence in the discharge of their duties andmay have to indemnify the company against losscaused by their negligence.

Directors also have fiduciary duty to the companywhich means that they must act in the bestinterest of the company, in utmost good faith andhonesty.

The Company Act 2006 in the UK sets out 7statutory duties of directors as shown below:

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Directors should:

Act within their powers Promote the success of the company

Exercise independent judgement

Exercise reasonable skill, care and diligence

Avoid conflicts of interest

Not accept benefits from their parties

Declare an interest in a proposed transaction orarrangement

The primary aim is create wealth for the shareholders

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Responsibility for the financial statements

The responsibility to the preparations of financialstatements lies with the directors. This preparation must be in accordance with the applicable

financial reporting framework such as IFRS. Directors are responsible for the internal controls

necessary to forestall any material misstatement to due to

error or fraud in the preparation of the financial statements. They are also responsible for the prevention and detection

of fraud. It is also their responsibility to ensure that company

complies with relevant laws and regulations.

This responsibility should be stated in the financialstatements. The company should be reported as going concern unless

if there is any information to the contrary.

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Quiz time

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Solution

1. C2. C

3. D

4. A

5. B6. C

7. C

8. C

9. A

10. B

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Lecture 3The books of prime entry

B k f i

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Books of prime entry

Books of prime entry are used to list andsummarise the information on sourcedocuments.

Sales day book - all credit sales are

recorded in the sales day book. Sales returns day book any credit sales

returned by the customers are recorded in the

sales returns day book. Purchase day book all credit purchases

are recorded in the purchase day book.

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Continues

Purchase returns day book any credit purchasesreturned to the suppliers are record in the purchasereturns day book.

Cash book All cash transaction are recorded in thecash book.

Petty cash book lists all cash payments for smallitems, and occasional small receipts.

Journal is a record of unusual transactions. It isused to record any double entries made which do notarise from the other books of prime entry.

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Continues

The column called sales ledger ref is a referenceto the sales ledger which is a record of what eachcustomer owes the business. It means, forexample, that the sale to Jones & Co for $105 is

also recorded on page 14 of the sales ledger.

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The Purchase day book The purchase day book list all invoices from suppliers.

Purchase Day Book

Date Supplier Purchase

ledger ref

Total

amount

invoiced

Purchases Electricity

Mar 15 Abbey PL 31 315.00 315.00

Ahmad PL 46 29.40 29.40

TEN PL 42 116.80 116.80

Emmy PL 12 100.00 100.00

561.20 444.40 116.80

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Continues

The purchase ledger reference is a referenceto the purchase ledger which is a record ofwhat each supplier is owed.

The purchase day book analyses the invoices

which have been received. In this example,three of the invoices related to goods whichthe business intends to re-sell (called

purchases) and the other invoice was anelectricity bill.

Sales and purchase returns day

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Sales and purchase returns daybooks

The sales returns day book lists goods (or servicesreturned (or rejected) by customers for which creditnotes are issued.

Sales returns day bookDate Customer Goods Sales ledger

ref

Amount

30 April Emily 3 pairs ofboots

SL 82 135.00

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The purchase returns day book

The purchase returns day book lists goods (orservices) returned to suppliers (or rejected) forwhich credit notes have been received or areexpected.

Purchase returns day book

Date Supplier Goods Purchase

ledger ref

Amount

29 April Boxes Ltd 300 boxes PL 123 46.60

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The cash book

The cash book lists all money received into and paidout of the business bank account.

The cash book records transactions involving the bankaccount, such as cheque payments, lodgements of

cash and cheques into the bank account, standingorders, direct debits and bank charges.

Some cash, in notes and coins, is usually kept on thepremises in order to make occasional payments for

small items of expense. This cash is accounted forseparately in a petty cash book (which we will look atshortly).

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C ti

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Continues

e) Cheque received for cash to provide a short-termloan from Len Dinger $1,800

f) Second cash salereceipts of $150

g) Cash received for sale of machine $200

h) Payment to supplier Kew $120

i) Payment to supplier Hare $310

j) Payment of telephone bill $400

k) Payment of gas bill $280l) $100 in cash withdrawn from bank for petty cash

m) Payment of $1,500 to Hess for new plant andmachinery

Solution

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SolutionThe receipts part of the cash book for 1 September would look like this.

CASH BOOK (RECEIPTS)

Date Narrative Total

2011 $

1 Sept Balance b/d* 900

Cash sale 80

Receivable: Hay 380Receivable: Been 720

Receivable: Seed 140

Loan: Len Dinger 1,800

Cash sale 150

Sale of non-current asset 200

4,370

2 Sept Balance b/d* 1,660

* 'b/d' = brought down (i.e. brought forward)

Continues

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Continues

The cash received in the day amounted to $3,470.Added to the $900 at the start of the day, this comesto $4,370.

However this is not the amount to be carried forward

to the next day. First we have to subtract all thepayments made during 1 September.

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Continues

Payments during 1 September totalled $2,710. Weknow that the total of receipts was $4,370. That meansthat there is a balance of $4,370$2,710 = $1,660 tobe 'carried down' to the start of the next day.

As you can see this 'balance carried down' is noted atthe end of the payments column, so that the receiptsand payments totals show the same figure of $4,370 atthe end of 1 September.

And if you look to the receipts part of this example, youcan see that $1,660 has been brought down ready forthe next day.

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Continues15 Hood paid us in cash RM 960.

16 Owner withdrew by cheque RM 1,000.

19 We repaid a previous loan taken from Robertson RM5,000 by cheque.

21 Goods for resale were purchased. This was paid by cash, RM 1,300.

22 Cash sales paid direct into the bank RM 1,220.

25 Paid wages by cash RM 2,760.

26 Paid a fine to the government by cheque RM 750.

30 Withdrew RM 2,000 from the bank account for personal use of theowner.

31 Paid consultancy fees in cash RM 3,200.

Hood paid us in cash RM 960.

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SolutionCash book

Bank

(RM)

Cash

(RM)

Bank

(RM)

Cash

(RM)

Balance b/d 600 10,000 Building rent 2,300

Kong 20,000 Mehdi 8,600

Sales 1,900 Moore 920

Kwai 340 Vehicle repairs 460

Sales 1,510 Drawings 1,000

Hood 960 Robertson 5,000

Sales 1,220 Purchases 1,300

Wages 2,760

Fine 750

Drawings 2,000

Consultancy fee 3,200

Balance c/d 5,860 2,380

23,670 12,860 23,670 12,860

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Bank statements

Weekly or monthly, a business will receive a bankstatement.

Bank statements are used to check that the balanceshown in the cash book agrees with the amount on

the bank statement. This agreement or 'reconciliation' is the subject of a

later chapter.

P tt h b k

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Petty cash book The petty cash book lists all cash payments for small

items, and occasional small receipts. Most businesses keep a small amount of cash on the

premises to make occasional small payments in cashe.g. to buy a few postage stamps etc.

This is often called the cash float or petty cashaccount.

Petty cash can also be used for occasional smallreceipts, such as cash paid by a visitor to make a

phone call or to take some photocopies.

There are usually more payments than receipts andpetty cash must be 'topped up' with cash from thebusiness bank account.

C ti

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Continues

Under what is called the imprest system, the amount ofmoney in petty cash is kept at an agreed sum or 'float'(say $100).

Expense items are recorded on vouchers as they

occur.$

Cash still held in petty cash X

Plus voucher payments X

Must equal the agreed sum/float X

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Continues

The total float is made up regularly (to $100,orwhatever the agreed sum is) by means of a cashpayment from the bank account into petty cash.

The amount paid into petty cash will be the total

of the voucher payments since the previous top-up.

The format of a petty cash book is the same as

for the cash book, with analysis columns for itemsof expenditure.

The Journal

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The Journal

The journal is a record of unusual transactions. It isused to record any double entries made which do notarise from the other books of prime entry.

Whatever type of transaction is being recorded, theformat of a journal entry is as follows.

Date Debit Credit

$ $

Account to be debited XAccount to be credited X

(Narrative to explain the transaction)

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Continues

A narrative explanation must accompany eachjournal entry. It is required for audit and control, toindicate the purpose and authority of everytransaction which is not first recorded in a book of

prime entry.

Lecture example 3

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Lecture example 3

The following is a summary of the transactions of Abbey beauty salon1 January Put in cash of $2,000 as capital

Purchased brushes and combs for cash $50

Purchased hair driers from Gilroy Ltd on credit $150

30 January Paid three months rent to 31 March $300Collected and paid-in takings $600

31 January Gave Mrs Sullivan a perm, highlights etc on credit $80

Although these entries would normally go through the other books ofprime entry (eg the cash book), it is good practice for you to show thesetransactions as journal entries.

Solution

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JOURNAL

$ $

Dr. Cr.

1 January Cash account 2,000

Capital account 2,000

(Initial capital introduced)

1 January Brushes & combs a/c 50

Cash account 50

(The purchase for cash of brushes &combs as non-current assets)

1 January Hair dryer asset account 150

Sundry payables account * 150

(The purchase on credit of hair driers as non-current assets)

30 January Rent expense account 300

Cash account 300

(The payment of rent to 31 March)

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Continues

Dr. Cr.

30 January Cash account 600

Sales account 600

(Cash takings)

31 January Receivables account 80Sales account 80

(The provision of a hair-do on credit)

* Note. Payables who have supplied non-current assets are

included amongst sundry payables. Payables who have suppliedraw materials or goods for resale are trade payables. It is quitecommon to have separate payables accounts for trade andsundry payables.

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Quiz time

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Lecture 4Double entry and accounting system

Bookkeeping

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Bookkeeping

What is it? System of recording financial transactions

Known as double-entry bookkeeping Two sides to every transaction

Is part of and feeds into the financial reportingsystem.

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Aims

This lecture seeks to provide a introduction tobookkeepingwhat it is and how it is carried out.

To do this we will consider: The financial reporting system

Examine how records are kept Explain the transactions and how they are recorded

Consider how adjustments can be made

And how the records are used to generate month end

and year end figures

Lecture Content

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Lecture Content

The lecture will aim to cover: an introduction to financial reporting

terminology

the accounting process

the financial statements

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Financial Reporting

Definitions

Financial Reporting

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Financial Reporting

What is it? Financial reporting is the means of reporting what

has happened in the past in an organisation

It is part of the accountability system

It relates yesterdays activities in financial terms Reports

Annual Financial Statements

o Annual Report and Statutory Accounts

Monthly control reports

Example: Monthly Control Report

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Example: Monthly Control ReportCurrent Month As at 30th June Year to date

Budget Actual Variance Expenditure Budget to

Date

Actual to

Date

Variance

Supplies and

General Charges

40,000 43,000 -3,000 Basic pay 230,000 250,000 -20,000

25,000 26,000 -1,000 Part time basic 150,000 165,000 -15,000

15,000 14,500 500 Casual pay 90,000 80,000 10,000

20,000 19,000 1,000 Administrative staff 150,000 148,000 2,000

18,000 20,000 -2,000 Photocopy costs 100,000 110,000 -10,000

21,000 24,000 -3,000 Materials 120,000 125,000 -5,000

10,000 6,000 4,000 Books 50,000 56,000 -6,000

6,000 6,000 0 Heating Power & Light 39,000 40,000 -1,000

5,000 4,000 1,000 Cleaning 30,000 31,000 -1,000

1,000 1,500 -500 Fax 6,000 5,000 1,000

2,000 1,800 200 Telephone 12,000 10,000 2,000

1,000 2,000 -1,000 Consumables 6,000 6,000 0

500 500 0 Hospitality 9,000 10,000 -1,000

1,500 2,000 -500 Maintenance 6000 7000 -1,000800 700 100 Travelling Expenses 5,000 4,500 500

200 500 -300 Stationery 1,000 1,500 -500

700 100 600 Office Expenses 4,000 5,000 -1,000

200 - 2000 Office Equipment 1,000 1,500 -500

3,000 3,500 -500 Rent & Rates 20,000 19,000 1,000

1,000 1,000 0 Sundries 6,000 10,000 -4,000

171,900 176,100 -4,200 Su b To tal 1,029,000 1,077,500 -48,500

Key Terms

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Key Terms

assets liabilities/capital

expenses revenue/income

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What is an expense? An expense is a short term consumable,which will be

incurred repeatedly, for example the cost of atelephone call, a days pay, a box of bandages, a litre offuel

They are items which have a oneoff use..once boughtand useda second must be bought..and a third..etc

In general, expense items represent day-to-dayoperational activity.low value long term items .. such

as a mobile phone will also be included Expenses are recorded and totalled at the end of each

month and each year.

What is income?

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What is income?

Income is the sum earned for providing goods orservice, whether or not any payment has been

received.

It too represents monies from operational activity

and, items which are frequently repeated for

example, the sale of a chocolate bar or the price of

a bus ticket.

Income is totalled monthly and annually to reflect

what has been earned during that time period.

What is an asset?

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What is an asset?

An asset is an item owned by the organisation, it hasvalue and can be fixed or current.

Fixed assets provide benefit beyond a year and

current assets have a life less than one year.

Fixed assets are made up of physical and financialassets. Land, buildings, equipment, vehicles and

furniture and fittings make up the physical fixed

assets, which put in place the infrastructure through

which operational activity is conducted.

Stock, debtors and cash make up the current assets.

Wh t i li bilit ?

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What is a liability?

Liabilities are sums owed from the organisation.They can be short-term such as overdraft or sums

owed to suppliers, known as creditors, or long-term

such as loans, leases and mortgages.

These latter items contribute to long term funding,

without which, the organisation would not be able to

purchase assets.

All liabilities carry with them the obligation to repay

and many of them carry interest payments.

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What is capital?

Capital is the ownersoriginal investment although it is rarely repaid, it is technicallya debt.

Without this money the organisation would not exist.

Further investment from the owners increases thissum. A key way this sum is increased is through theIncome and Expenditure account. Any excess incomeover expenditure belongs to the owners and can beleft in the organisation by way of an increase in capital.

Without capital an organisation cannot begin itslife norgrow, as without money new assets cannot bepurchased.

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key terms..

assets liabilities/

capital

expenses

revenue

/income

balancesheet

incomestatement

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Income Statement

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Income Statement

The difference between costs & income

Profit & loss account / Income & expenditureaccount

Shows where the resource was spent

Covers a period of time

Matches expenses and income to time period

Expenses represent the cost INCURRED, resourceused or consumed in providing the service duringthe accounting period

Income is that which is EARNED from and relatedto the service provided

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The Accounting Process

B i f P ti

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Basis of Preparation

= Accrual Accounting

Income and expenditure based system Income and expenditure are matchedso that they are

allocated to the period in which the benefit /expense isincurred

Starting point: Transactions must be recorded. Basis of gathering accounting information is double-

entry bookkeeping

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The double entry system

Records transactions - two sides to each debit and credit side

Separate accountsuniquely identified called ledger accounts

based on chart of accounts

Ledgers - books of record general/nominal accounts payable

accounts receivable Trial balance

t

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..etc...

Trial Balance

Adjustments stock/inventory

depreciation

bad debts

accruals and prepayments

Annual Financial Statements

... but it begins with recording transactions.

The ledgers

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The ledgers

General /nominal Main list of all accounts Total balances maintained on this ledger

Accounts payable Records purchases

Links to suppliers / creditors / payables Also called purchase or bought ledger

Accounts receivable Records sales or income

Links to customers / debtors /receivables Also called sales ledger

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Lecture example 1

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The accounts of MSUreveal the following:

Capital 18 900Fixtures 3 500Loan 2 000

Stocks 4 950Debtors 3 280Creditors 1 600Vehicles 4 200Cash - bank 6 450

Cash - hand 120

Consider how the followingtransactions will affect theaccounts; MSU buys stocks of goods on

credit for 770.

One of the debtors pays 280in cash.

New fixtures are purchasedwith a cheque for 1000.

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Rules of Debit & Credit

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Every transaction effects two accounts

A debit increases an asset or expense account

decreases an income or liability account

A credit increases an income or liability account

decreases an asset or expense account

Types of accounts

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Types of accounts

Asset and liability accountsare ongoingaccounts Non Current (fixed) assets, loan and capital accounts once

establishedremain..

Current assets and liability accounts also remain but movevery regularly up and down as, for example, cash at bank

Income and expenditure accounts differ in thateach year we start with a zero balance andrecord all income and all expenditure into itsown separate account. The aim is to establisha total amount for each item, e.g. telephone

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But

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Through the year we record all the purchases of eachstock item at the end we then see how much wehave leftthis determines how much of the item we

have used..i.e. the expense incurred

But we may have had stock/inventory at the beginningopening

stock/inventory

sent goods backreturns outwards

been charged for deliverycarriage in

All the above help determine the value of the itemsused

Returns

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Returns..

When we send something back returns outwards When something comes back to us

returns inwards

Set up separate accounts for each

For a return outwards: reduce supplier account

increase returns outwards account

For a return inwards: reduce customer account

increase returns inwards account

d h h did ?

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..and how much did we use?

Opening Stock/Inventory X

+ Purchases X

- Returns outwards (X)

+ Carriage inwards X

- Closing Stock/Inventory (X)

= Cost of Goods Used X

Lecture example 2

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p

A hospital is trying to establish the cost ofcleaning materials used in a year.

Opening stock/inventory value 12,400

Purchases 87,300

Returns 7,600 Carriage inwards 1,200

Closing stock/inventory 14,250

What is the cost of the cleaning materialsused?

Balances on Accounts

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Each ledger account is balanced off all debit balances are assets or expenses all credit balances are liabilities or income

Balance sheet = asset & liability accounts The balances on these accounts are ongoing ie

closed and re-opened for the next accountingperiod

Income statement = income & expenses The closing balances on these accounts are

transferred out and the new accounting period

starts with zero balances.

Balancing off accounts

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Supplier A

10/5 Returns out 4024/5 Paid cash 300

bal c/d 416 756

1/5 Purchases 6904/5 Purchases 66

756

1/6 bal b/d 416

A balance on a supplier account is a credit balance which meanswe have a creditor (payable).For customer accounts, a debit balance means we have a debtor(receivable).

Trial Balance

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List of balances on ledgeraccounts

Total debit entries= total credit entries

Starting point for thederivation of the financialstatements

Adjustments to the trial

balance lead to the creationof the operating statementand the balance sheet

Dr CrIncome 155Purchases 60Expenses 25Wages 30Vehicle 120Fittings 70Capital 150

305 305

Preparing accounts

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Preparing accounts

From trial balance we prepare year end andmonth end figures..

Accrual basis4 main adjustments Stock/inventory

Depreciation of fixed assets

Bad debts

Accruals & prepayments

Fixed Assets

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Capital expenditure buildings, equipment, vehicles, fixtures and fittings

Provide benefit beyond the accounting period

Accruals system - match cost to benefit

- by depreciation

Depreciation

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Depreciation

Allocation of the cost of an asset to the years inwhich benefit is gained

Key

historic cost

useful life residual value method

main - straight line or reducing balance

Assets recorded at : Net Book Value = cost - accumulated depreciation

Lecture example 3

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An asset is bought for 100,000

It has an estimated useful life of 4 years

The residual value will be 20 000.

What depreciation - assuming the straight line

basis is appropriate - will be charged to theI&E accounts in each of the years and what isshown in the balance sheet?

Using a reducing balance of 33% recalculate

the above.

Entering the transactions

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g

Cost of asset is recorded when purchased Only removed when asset disposed of

Two accounts record depreciation

Depreciation expense Income Statement account

Depreciation provision (accumulated depreciation) Balance sheet account

Carry forward each year of assets life Offsets cost to give NBV on balance sheet

Bad Debts

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Bad Debts

Debtors are sums owing to usbut not yet paid Bad debt - money owed which is unlikely to be received

Treatments specific debts are written off

Dr bad debts expense account Cr debtor account

general provision is established as policy Dr bad debts expense Cr bad and doubtful debt provision

Provision is a balance sheet accountit offsets the debtors inthe BSthe account is carried forward and is adjusted eachyear based on debtors balanceany movement in the provisionis treated as an expense on the income statement.

The MonthEnd result

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Management accounts On-going figures on a monthly basis

Current month and year to date

Reports on individual cost centres Line items included

Compared to budgets - variances

Basis is accrualsprepayments and accruals

included

Example: Monthly Control ReportCurrent Month As at 30th June Year to date

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Current Month As at 30th June Year to date

Budget Actual Variance Expenditure Budget to

Date

Actual to

Date

Variance

Supplies andGeneral Charges

40,000 43,000 -3,000 Basic pay 230,000 250,000 -20,000

25,000 26,000 -1,000 Part time basic 150,000 165,000 -15,000

15,000 14,500 500 Casual pay 90,000 80,000 10,000

20,000 19,000 1,000 Administrative staff 150,000 148,000 2,000

18,000 20,000 -2,000 Photocopy costs 100,000 110,000 -10,000

21,000 24,000 -3,000 Materials 120,000 125,000 -5,000

10,000 6,000 4,000 Books 50,000 56,000 -6,000

6,000 6,000 0 Heating Power & Light 39,000 40,000 -1,000

5,000 4,000 1,000 Cleaning 30,000 31,000 -1,000

1,000 1,500 -500 Fax 6,000 5,000 1,000

2,000 1,800 200 Telephone 12,000 10,000 2,000

1,000 2,000 -1,000 Consumables 6,000 6,000 0

500 500 0 Hospitality 9,000 10,000 -1,000

1,500 2,000 -500 Maintenance

6000 7000 -1,000800 700 100 Travelling Expenses 5,000 4,500 500

200 500 -300 Stationery 1,000 1,500 -500

700 100 600 Office Expenses 4,000 5,000 -1,000

200 - 2000 Office Equipment 1,000 1,500 -500

3,000 3,500 -500 Rent & Rates 20,000 19,000 1,000

1,000 1,000 0 Sundries 6,000 10,000 -4,000

171,900 176,100 -4,200 Su b To tal 1,029,000 1,077,500 -48,500

The Year- End Result

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Accounting statements Operating Statement

Income and Expenditure

Profit and Loss Account

Income Statement

Balance SheetAccounting policies

Additional notes

Reportscontent in brief

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Income Statement

Income

Less

Expenses =

Profit/Loss

Balance Sheet

Own Assets

Non-Current

Current

Owe Liabilities

Long term

Current

Capital

Original Accumulated surpluss

Basic Income Statement

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Income 1000

Cost of goods sold (750)

Gross Profit 250

Expenses (50)

Net Profit to be retained 200 BalanceSheet

The Balance Sheet format

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The Balance Sheet - format

Non-Current Assets 1000

Current Assets

Inventory 150

Receivables 250

Cash 200

600

Total Assets 1600

Current Liabilities

Payables 150

Overdraft 250400

Long Term Liabilities 300

Net Assets 900

Capital

Owners Share Capital 700

R t i d fit 200