Accounting Course Book 3

Accounting Course – Book 3

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Exercise Extract a trading and profit and loss account for the year ended 30th June 2006 for F. Kidd. The trial balance as at 30th June 2006 after his first year of trading was as follows:

Trial Balance as at Account Name Debit Credit Rent 1560 Insurance 305 Lighting and heating expenses 516 Motor expenses 1960 Salaries and wages 4850 Sales 35600 Purchases 30970 Sundry expenses 806 Vans 3500 Creditors 3250 Debtors 6810 Fixtures 3960 Buildings 28000 Cash at bank 1134 Drawings 6278 Capital 51799 90649 90649

Stock at 30th June 2006 was £9960

F. Kidd Trading and Profit and Loss Account for year ended 30th June 2006

£ £ Sales 35600 Purchases 30970 Less Closing Stock (9960) Cost of goods sold (21010) Gross Profit 14590 Less Expenses Rent 1560 Insurance 305 Lighting & Heating 516 Motor Expenses 1960 Salaries & Wages 4850 Sundry 806 Total expenses 9997 Net Profit 4593


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We are now going to learn the following:

1. Why balance sheets are not part of the double entry system 2. Why it is important that account balances are shown under appropriate

headings in the balance sheet 3. The meanings of the terms FIXED ASSET, CURRENT ASSET,

CURRENT LIABILITY and LONG TERM LIABILITY 4. How to describe the sequence in which each of the five main

categories of items appears in the balance sheet 5. How to describe the sequence in which each fixed asset is entered in

the balance sheet 6. How to How to describe the sequence in which each current asset is

entered in the balance sheet 7. How to draw up a balance sheet from information given in a trial

balance Early in the course we learnt that balance sheets contain details of assets, liabilities and capital. The amounts and items in the balance sheet are to be found in the accounting books and as shown at the end of Book 2 only those accounts with balances, NOT included in the Trading and Profit and Loss account are included. All these accounts must be ASSETS, LIABILITIES and CAPITAL. From a previous exercise in Book 2 for B. Swift we must now allow for adjustments of the Capital, (after we have run the Trading and Profit and Loss Statement), and then use this in the trial balance. The stock is an asset so this also added into our calculations. We also remove the accounts that were in the Trading and Profit and Loss account, as follows:

B Swift Trial Balance as at 31st December 2005

Dr Cr Sales Purchases Rent Lighting expenses General expenses Fixtures & fittings Debtors Creditors Bank Cash Drawings Capital

£

2900 240 150 60 500 680

1510 20 700

£ 3850

910

2000 6760 6760


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This will become:


Dr Cr Fixtures & fittings Stock Debtors Creditors Bank Cash Capital

£ 500 300 680

1510 20

£

910

2100 3010 3010 We can now create the Balance Sheet:

B. Swift

Balance Sheet as at 31/12/05 Assets £ Fixtures and Fittings 500 Stock 300 Debtors 680 Bank 1510 Cash 20 3010 Less liabilities Creditors (910) Capital 2100

Capital amount has now been adjusted

Stock has been added because it is an Asset


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�There is no double entry in the Balance Sheets Why? It is not part of the double entry system. The balance sheet is a ‘snapshot’ in time as to what the business has in assets, liabilities and capital. It can be drawn at any time. We are not entering into accounts or making any transfers, i.e. we are creating a list. When we draw up accounts such as cash, rent, sales etc we are writing them up as part of the double entry system and we make entries to the debit and credit side of these accounts. In drawing up a balance sheet we do not enter anything in the accounts and we don’t actually transfer any balances. All we do is LIST the assets, capital and liabilities and none of the accounts is closed off and nothing is entered in the ledger accounts. The key word is ACCOUNT. If the word account is present then it is part of the double entry system, if not then it does not form part of the double entry system. The Trial Balance also does not form part of the double entry system. The Trading and Profit and Loss statement is a special case. Strictly speaking it does not form part of the double entry system but it has elements of transferring from one account to another in the double entries created beforehand between the Trading ‘T’ account and the Profit and Loss ‘T’ account. The Balance Sheet Layout


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Balance sheets are intended to be useful and easy to use. They should clearly show helpful information and allow comparisons to be made between different balance sheets. In the previous example we used a very simple balance sheet layout which lumped together assets – we are now going to separate them out as illustrated below: Fixed Assets Fixed assets are those that are used in the running and operating of the business that it will retain for at least a year, e.g. land, buildings, equipment, fixtures and fittings and vehicles. Another type of fixed asset is goodwill. This is any advantage that enables a company to earn better profits than its competitors, such as a well-regarded brand name, this is called an ‘intangible asset’ because it has only a hypothetical value. e.g. Buildings We write them in order of how long they Fixtures & fittings will last Machinery Motor vehicles Current Assets Current assets are those that the business uses on a day-to-day basis and that can be quickly be converted into cash. Aka liquid assets as they can be quickly liquidated into cash, e.g. cash in hand, money in the bank, debtors, stock and work in progress. e.g. Stock These are written in order of how quickly they can Debtors converted into cash, called Liquidity.

Bank Cash

Current Liabilities These are those that are due for payment within a relatively short period of time. They include your creditors, overdrafts and hire purchase or lease payments due within the next 12 months. Long Term Liabilities These are obligations that will not become due for a comparatively long period of time, usually not within the next 12 months. They include mortgages, other loans and hire purchase, lease agreements that do not have to be paid within one year. One final consideration is CAPITAL and the reasons why it has changed during the period. So on our balance sheet we must show cash introduced and add Net Profit, (or Net Loss). So taking all these issues into account we can now draw up the balance sheet for B. Swift again.


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CAPITAL

Creditors (910)

0LESS LONG TERM LIABILITIESNET ASSETS (Fixed + Net Current) 2100

LESS CURRENT LIABILITIES

Balance Sheet as at 31/12/05

Fixtures and Fittings 500

B.Swift

£ £

NET CURRENT ASSETS 1600

Stock 300

FIXED ASSETS

CURRENT ASSETS

Debtors 680

Cash 20 2510Bank 1510

Cash Introduced 2000add Net Profit 800 2800less Drawings (700)

2100


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Exercises Create Balance Sheets for the previous examples in Book 2 for B. Webb, C. Worth, F. Chaplin and the one at the start of this book, F. Kidd.

B. Webb

Balance Sheet as at 31st December 2005

£ £

FIXED ASSETS Premises 1500 Motor Vehicles 1200 2700

CURRENT ASSETS Stock 2548 Debtors 1950 Cash at Bank 1654 Cash in Hand 40 6192 LESS CURRENT LIABILITIES Creditors ( 1538 ) NET CURRENT ASSETS 4654 LESS LONG TERM LIABILITIES 0 NET ASSETS (Fixed + Net Current) 7354

CAPITAL Cash Introduced 5424 add Net Profit 2825 8249 less Drawings ( 895 ) 7354


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C. Worth

Balance Sheet as at 30th June 2006

£ £

FIXED ASSETS Buildings 50000 Fixtures 1000 Vans 5500 56500

CURRENT ASSETS Stock 4166 Debtors 3166 Cash at Bank 3847 11179 LESS CURRENT LIABILITIES Creditors ( 1206 ) NET CURRENT ASSETS 9973 LESS LONG TERM LIABILITIES 0 NET ASSETS (Fixed + Net Current) 66473

CAPITAL Cash Introduced 65900 add Net Profit 2973 less Drawings ( 2400 ) 66473


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F. Chaplin


£ £

FIXED ASSETS Premises 20000 Motor Vehicle 2800 22800

CURRENT ASSETS Stock 4960 Debtors 4090 Cash at Bank 1375 Cash in Hand 25 10450 LESS CURRENT LIABILITIES Creditors ( 5160 ) NET CURRENT ASSETS 5290 LESS LONG TERM LIABILITIES 0 NET ASSETS (Fixed + Net Current) 28090



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F. Kidd

Balance Sheet as at 30th June 2006

£ £

FIXED ASSETS Buildings 28000 Fixtures 3960 Vans 3500 35460

CURRENT ASSETS Stock 9960 Debtors 6810 Cash at Bank 1134 17904 LESS CURRENT LIABILITIES Creditors ( 3250 ) NET CURRENT ASSETS 14654 LESS LONG TERM LIABILITIES 0 NET ASSETS (Fixed + Net Current) 50114



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⊗ Another name for Net Current Assets is Working Capital.

Returns Inwards and Outwards The idea of different accounts for movements of stock was introduced previously. To recap, there are four accounts involved:

1. The Sales Account – deals with goods sold to customers 2. Returns Inwards – deals with goods returned by the customers 3. The Purchases Account – deals with goods purchased from

suppliers 4. Returns Outwards – deals with goods returned to suppliers

When we prepared our Trading Account we left out returns inwards and returns outwards just to make things easier! Question Why do organisations bother with two returns accounts? Why don’t they just debit sales returned to the sales account and credit purchases returned to the purchases account? Answer It is a way of making sure that our sales and expense accounts accurately reflect the movement of goods. For example, we can see what goods are being returned which may highlight a fault in them. Returns Everyone at sometime returns goods to shops, (returns inwards) and likewise firms often return goods to their suppliers, (returns outwards). When GROSS PROFIT is calculated these returns will have to come into these calculations. Below is an extract of an amended version of the trial balance of B. Swift.

B. Swift Trial Balance as at 31 December 2005 (extract)

Account Name Debit Credit Sales 4000 Purchases 3120 Returns Inwards 150 Returns Outwards 220


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Comparing the original trial balance, (below), with this one we notice that the Sales and Purchases amounts are different.

• The Sales figure has now been broken down to take into account the goods returned to us, (Returns Inwards), to give us a new figure of £4000.

£3850 + £150 = £4000

• The Purchases figure has now been broken down to take into account the goods returned by us, (Returns Outwards), to give us a new figure of £3120.

£2900 + £220 = £3120


Dr Cr Sales Purchases Rent Lighting expenses General expenses Fixtures & fittings Debtors Creditors Bank Cash Drawings Capital

£

2900 240 150 60 500 680

1510 20 700

£ 3850

910

2000 6760 6760

Both of the Returns Accounts are included in the calculation of gross profit which now becomes: Gross Profit = (Sales less Returns Inwards) — (Cost of goods sold less Returns Outwards) The Gross Profit is therefore unaffected and is calculated at £1250 as below: £ £ Sales 4000 Less Returns Inwards (150) Net Sales 3850 Purchases 3120 Less Returns Outwards (220) Net Purchases 2900 Less Closing Stock (300) Cost of goods sold (2600) Gross Profit 1250


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Carriage If you have ever bought anything over the internet, you have probably been charged “postage and packing”. This is an ADDITIONAL charge to customers and is called CARRIAGE.

When we are charged for the delivery of goods purchased from a supplier it is called CARRIAGE INWARDS.

When we charge carriage out of our business to customers it is called CARRIAGE OUTWARDS.

When goods are purchased, the cost of carriage is part of the price paid. As a result, in order to ensure the true cost of our goods for resale carriage is ALWAYS added to the cost of purchases in the TRADING ACCOUNT. Carriage outwards is NOT part of the selling price to customers, (some may decide to buy and collect the goods in person). Carriage outwards is ALWAYS entered in the PROFIT & LOSS ACCOUNT. It is NEVER included in the calculation of gross profit. Looking again at B. Swift Suppose that the goods had been bought for the same total figure of £3120 but £200 was for carriage inwards the Trial Balance, (extract), and the Trading & Profit and Loss Account would look as follows:

B. Swift Trial Balance as at 31 December 2005 (extract)

Account Name Debit Credit Sales 4000 Purchases 2920 Returns Inwards 150 Returns Outwards 220 Carriage Inwards 200

Note we have broken down the previous Purchases figure of £3210 to take account of Carriage Inwards of £200, leaving £2920.


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B. Swift Trading and Profit and Loss Account for year ended 31st December 2005

£ £ Sales 4000 Less Returns Inwards (150) Net Sales 3850 Purchases 2920 Less Returns Outwards (220) Carriage Inwards 200 Net Purchases 2900 Less Closing Stock (300) Cost of goods sold (2600) Gross Profit 1250 It can be seen that all three versions of the trial balance have all been concerned with the same overall amount of goods bought and sold by the business at the same overall prices and the gross profit is still £1,250. It has just been broken down into its respective elements so that we can have a detailed analysis and accurate record of transactions. The second year of business B. Swift has now drawn up a new trial balance at the end of the second year of trading.

B. Swift Trial Balance as at 31st December 2006

Account Name Debit Credit Sales 6700 Purchases 4260 Lighting and Heating 190 Rent 240 Wages: Shop Assistant 520 General Expenses 70 Carriage Outwards 110 Buildings 2000 Fixtures and Fittings 750 Debtors 1200 Creditors 900 Bank 120 Cash 40 Drawings 900 Capital 3100 Stock (at 31st December 2005) 300 10700 10700


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Adjustments needed for stock So far we have only looked at new businesses which have no stock brought forward. When preparing the Trading & Profit and Loss Account for the second year we can see the difference – there is a closing stock figure of £300 from the TP & L 2005. This will be the OPENING STOCK for the New Year that will have to be incorporated in the trading account.

Closing stock for one period is ALWAYS brought forward as the opening stock for the next period, in this case 2006. Swift did a stock take at 31st December 2006 and valued closing stock at £550. So a summary of the stock from the start of 2005 is as follows: Stock Account Let’s look at the stock account for both years:

You can see that there is both a DEBIT and a CREDIT double entry made at the end of the period to the Trading Account. Firstly, the Stock Account is credited with the opening stock amount of £300 and the Trading Account is debited with the same. Secondly, the Stock is debited with the closing stock amount of £550 and the Trading Account is credited with the same.

Year to Dec 05 Year to Dec 05Opening Stock 01/01/05 0Closing Stock 31/12/05 300Opening Stock 01/01/06 300Closing Stock 31/12/06 550

2005 2005Dec 31 Trading 300 Dec 31 Balance c/d 300

2006 2006Jan 1 Balance b/d 300 Dec 31 Trading 300

Dec 31 Trading 550 Dec 31 Balance c/d 550

Stock


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Now are going to calculate the Cost of Goods Sold, (COGS), as follows: £ Stock at start of year 300 Add Purchases 4260 Total goods available for sale 4560 Less closing stock (at year end) 550 = Cost of Goods Sold 4010 The calculation of gross profit can now be done. We know from the Trial Balance that sales were £6700 and from the above calculation we also know the COGS figure. To calculate the Gross Profit we can draw up the Trading & Profit and Loss Account and Balance Sheet for B. Swift as at 31st December 2006 as follows:

B. Swift Trading and Profit and Loss Account for year ended 31st December 2006

£ £ Sales 6700 Opening Stock 300 Plus Purchases 4260 Less Closing Stock (550) Cost of goods sold (4010) Gross Profit 2690 Less Expenses Lighting and Heating 190 Rent 240 Wages 520 General Expenses 70 Carriage Out 110 Total Expenses 1130 Net Profit 1560


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CAPITAL

Creditors ( 900 )

LESS LONG TERM LIABILITIES

NET ASSETS (Fixed + Net Current)

750 2750

Debtors 1200

CURRENT ASSETS


Buildings 2000FIXED ASSETS

B. Swift

£ £


Fixtures and Fittings

Stock 550

Bank 120Cash 40 1910

3760

Cash Introduced 3100add Net Profit 1560less Drawings ( 900 )

37600



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Financial Statements is the term given to all the summary statements produced at the end of an accounting period. They used to be called Final Accounts although the term is misleading. Some people still call them this or just “the accounts”.

Carriage Inwards and Carriage Outwards are always in the Debit side of the Trial Balance.

Carriage Inwards is NOT an Expense but is treated similarly as it is put in the Debit column. It is always added to the cost of Purchases in the Trading Account. It is used in the calculation of Gross Profit.

Carriage Outwards IS an Expense and so is put in the Debit column. It is always entered in the Profit & Loss Account. It is never used in the calculation of Gross Profit.


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Exercises

T. Clarke

Trading Account for year ended 31st December 2007 £ £ Sales 38742 Less Returns Inwards (890) Net Sales 37852 Purchases 33333 Less Returns Outwards (495) Carriage Inwards 670 Net Purchases 33508 Less Closing Stock (7489) Cost of goods sold (26019) Gross Profit 11833

K. Taylor

Trading Account for year ended 31st March 2008 £ £ Sales 54600 Less Returns Inwards (1372) Net Sales 53228 Purchases 53397 Less Returns Outwards (2896) Carriage Inwards 1122 Net Purchases 51623 Less Closing Stock (1372) Cost of goods sold (50251) Gross Profit 2977


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R. Graham Trading & Profit and Loss Account for year ended 30th September 2009

£ £ Sales 18600 Less Returns Inwards (205) Net Sales 18395 Opening Stock 2368 Purchases 11874 Less Returns Outwards (322) Carriage Inwards 310 Net Purchases 14230 Less Closing Stock (2946) Cost of goods sold (11284) Gross Profit 7111 Less Expenses Lighting and Heating 166 Rent 304 Salaries & Wages 3862 General Expenses 314 Insurance 78 Motor Expenses 664 Office Expenses 216 Carriage Outwards 200 Total Expenses 5804 Net Profit 1307


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R. Graham

Balance Sheet as at 30th September 2009

£ £

FIXED ASSETS Premises 5000 Fixtures and Fittings 350 Motor Vehicles 1800 7150

CURRENT ASSETS Stock 2946 Debtors 3896 Cash at Bank 482 7324 LESS CURRENT LIABILITIES Creditors (1731)NET CURRENT ASSETS 5593 LESS LONG TERM LIABILITIES 0 NET ASSETS (Fixed + Net Current) 12743

CAPITAL Cash Introduced 12636 add Net Profit 1307 less Drawings (1200) 12743


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B. Jackson Trading & Profit and Loss Account for year ended 30th April 2007

£ £ Sales 18600 Less Returns Inwards (440) Net Sales 18160 Opening Stock 3776 Purchases 11556 Less Returns Outwards (355) Carriage Inwards 234 Net Purchases 15211 Less Closing Stock (4998) Cost of goods sold (10213) Gross Profit 7947 Less Expenses Rent 576 Salaries & Wages 2447 Motor Expenses 664 Sundry 1202 Carriage Outwards 326 Total Expenses 5215 Net Profit 2732


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B. Jackson

Balance Sheet as at 30th April 2007

£ £

FIXED ASSETS Fixtures and Fittings 600 Motor Vehicles 2400 3000

CURRENT ASSETS Stock 4998 Debtors 4577 Cash at Bank 3876 Cash in Hand 120 13571 LESS CURRENT LIABILITIES Creditors (3045)NET CURRENT ASSETS 10526 LESS LONG TERM LIABILITIES 0 NET ASSETS (Fixed + Net Current) 13526

CAPITAL Cash Introduced 12844 add Net Profit 2732 less Drawings (2050) 13526


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J. Smailes

Trading & Profit and Loss Account for year ended 31st March 2009 £ £ Sales 92340 Less Returns Inwards (0) Net Sales 92340 Opening Stock 18160 Purchases 69185 Less Returns Outwards (640) Carriage Inwards 420 Net Purchases 87125 Less Closing Stock (22390) Cost of goods sold (64735) Gross Profit 27605 Less Expenses Rent & Rates 3015 Wages & Salaries 10240 Sundry 318 Communication Expenses 624 Commissions Payable 216 Insurance 405 Carriage Outwards 1570 Total Expenses 16388 Net Profit 11217


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J. Smailes

Balance Sheet as at 31st March 2009

£ £

FIXED ASSETS Buildings 20000 Fixtures 2850 22850

CURRENT ASSETS Stock 22390 Debtors 14320 Cash at Bank 2970 Cash in Hand 115 39795 LESS CURRENT LIABILITIES Creditors (8160)NET CURRENT ASSETS 31635LESS LONG TERM LIABILITIES 0 NET ASSETS (Fixed + Net Current) 54485

CAPITAL Cash Introduced 50888add Net Profit 11217less Drawings (7620) 54485


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L Stokes drew up the following trial balance as at 30 September 2008. You are to draft the trading and profit and loss account for the year ended 30 September 2008 and a balance sheet as at that date.

Dr Cr

£ £ Capital 30,955 Drawings 8,420 Cash at bank 3,115 Cash in hand 295 Debtors 12,300 Creditors 9,370 Stock 30 September 2007 23,910 Van 4,100 Office equipment 6,250 Sales 130,900 Purchases 92,100 Returns inwards 550 Carriage inwards 215 Returns outwards 307 Carriage outwards 309 Motor expenses 1,630 Rent 2,970 Telephone charges 405 Wages and salaries 12,810 Insurance 492 Office expenses 1,377 Sundry expenses 284

171,532 171,532

Stock at 30th September 2008 was £27,475

L. Stokes

Trading & Profit and Loss Account for year ended 30th Sept 2008 £ £ Sales 130900 Less Returns Inwards (550) Net Sales 130350 Opening Stock 23910 Purchases 92100 Less Returns Outwards (307) Carriage Inwards 215 Net Purchases 115918 Less Closing Stock (27475) Cost of goods sold (88443) Gross Profit 41907 Less Expenses Motor Expenses 1630 Rent 2970 Telephone Charges 405 Wages & Salaries 12810 Insurance 492 Office Expenses 1377 Sundry Expenses 284 Carriage Outwards 309 Total Expenses 20277 Net Profit 21630


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0


less Drawings ( 8420)

44165

44165

Cash Introduced 30955add Net Profit 21630

Cash at Bank 3115Cash in Hand 295 43185

L. Stokes

£ £


Van

Stock 27475

Balance Sheet as at 30th September 2008

Office Equipment 6250FIXED ASSETS

4100 10350

Debtors 12300

CURRENT ASSETS

CAPITAL

Creditors (9370 )

LESS LONG TERM LIABILITIES

NET ASSETS (Fixed + Net Current)


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Accounting Concepts Introduction

So far we have looked at transactions in the books of accounts which are based on certain assumptions.

Now we are going to consider these assumptions which are known as CONCEPTS OF ACCOUNTING.

A Common Framework

Financial Statements are of interest to many people both inside and outside of the business.

Even though businesses vary in size and legal status, it is important that there is a common framework for preparation and presentation of accounting information.

One Set of Final Accounts for All Purposes

This means that no matter who requests the accounts, identical copies of the financial statements will be sent.

Examples of people who may wish to see them include: Investors; Banks, (if the business wants a loan); Stakeholders; Inland Revenue, and; Companies House, (if the business is a limited company).

Assumptions

All those using the financial statements have to believe the assumptions on which they are based are VALID and APPROPIATE.

This is known as the HISTORICAL COST CONCEPT. The Historical Cost is the value at cost it cost you.

Objectivity and Subjectivity

When valuing something it is based on fact, i.e. what was actually paid – this is said to be OBJECTIVE.

If you used your own judgement then the value would be based on your biased view and preference – this is said to be SUBJECTIVE.

OBJECTIVITY is at the heart of Financial Accounting. The Accounting Concepts

To achieve objectivity and CONSISTENCY there must be rules. These are known as Accounting Concepts and a group of these have

become known as Fundamental Accounting Concepts or Accounting Principles.


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Enforcement

The rules are enforced through their incorporation in ACCOUNTING STANDARDS issued on behalf of accounting bodies and by inclusion in relevant legislation, (law), governing companies: The Companies Act.

Accounting Standards and Financial Reporting Standards

Once there used to be many different ways of calculating profit. So the accounting bodies formed the Accounting Standards

Committee, (ASC), which issued the Statements of Standard Accounting Practice.

In 1990 the ASC was replaced by the Accounting Standards Board, (ASB), and the standards are now known as FINANCIAL REPORTING STANDARDS, (FRS’s).

A Time of Change

By 2001 nineteen FRS’s had been issued and ten SSAP’s were still in force.

Now and then the ASB issues Urgent Issue Task Force Abstracts, (UITF’s), which are used whilst a standard is prepared. They are weighted along side standards and are compulsory.

Financial Reporting for Smaller Entities, (FRSSE)

The third category of standard was issued in 1997 – known as FRSSE and were specially for smaller concerns and reduced the rules.

It should be noted that accounting standards do not mean that identical businesses will show exactly the same figures – but will reduce very large variations.

Accounting Standards and Law

They are drafted to comply with UK, Republic of Ireland Laws and EU directives.

Any accounts prepared to show a ‘True and Fair View’ must observe the rules laid down in accounting standards.


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Underlying Concepts

Historical Cost – value at cost! Money Measurement Concept – information only included if a value

in monetary units can be applied and most people will agree to the monetary value of the transaction.

The limitations of this concept may be illustrated when considering the reputation of a business, goodwill, customer loyalty and the recognition of a brand name.

The Business Entity Concept – implies that the affairs of a business are to be treated as separate to the, (non-business), affairs of the owner.

The Dual Aspect Concept – the accounting equation and double entry.

The Time Interval Concept – that financial statements should be prepared at regular intervals of one year – although this may be more frequently for internal use.

Fundamental Accounting Concepts

Going Concern – the business will continue. Consistency – once a method is chosen it should always be used. Prudence – gains and losses must not be overstated or understated. Realisation – this is part of prudence in that profit can only be taken

into account when received or is very likely to be received. Accruals

The Accruals Concept says that net profit is the difference between revenues and the expenses incurred in generating those revenues and that these are taken into account in the correct financial period and not when actually received.

Materiality

Financial transactions should be shown separately if it avoids misleading users, however do not waste time in elaborate recording of trivial items.


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Accounting Concepts – extract taken from the times100 website Accounts are records of financial transactions. Information that is used in accounts is initially entered into books of prime entry, which may simply be paper or computer records. From there the information will be entered into a double entry system in a book (or computer programme) called the ledger. Each account is kept on a separate page in the ledger, and every account has two sides - a debit and a credit side. Information will then be extracted so that it can be presented in a financial report. The accounting equation An essential component of accounting is what is referred to as the accounting equation, which in a nutshell means that the assets of the organisation (what it owns or is owed by others) is equal to the liabilities of the organisation (what it owes). In this country (and internationally) there are a variety of accounting conventions and standards which must be adhered to. In preparing final accounts there are a number of key accounting concepts which you need to be familiar with: 1.

The going concern concept: an assumption that the business will continue to trade into the foreseeable future.

2. The consistency concept: that the same principles for constructing accounts will be maintained from one set of accounts to the next.

3. The concept of prudence: that in valuing a transaction, a conservative approach will be used, i.e. not to value at highest possible estimate.

4. The accruals concept: that revenues and costs are recorded when they occur rather than when the cash is received or paid.

5. The materiality concept: that financial transactions should be shown separately if by lumping them together with other transactions the user of the accounts might be misled. If you examine the financial statements of well known UK public limited companies such as Cadbury Schweppes, etc, you will notice that there is consistency in the way the accounts are presented from one year to the next, enabling you to easily compare one year's figures with another. These figures will be presented in a prudent way so as not to mislead the reader, e.g. by not underestimating costs or falsely inflating revenues.


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Example

If a firm believes that some of its debtors may "default" it should act on this by making

sure that all possible losses are recorded in the books. This is an example of the

prudence

concept in operation. The fact that a business is separate and

distinguishable from its owner is best exemplified by the business entit

concept.

Everything a firm owns, it also owes out to somebody. This co-incidence is explained by

the dual aspect

concept. If a cashier buys a cash book in which to keep his firms

books, he would not try to account for every single sheet of paper in the book because

of the materiality

concept. The consistency

concept states that if (say) the

straight-line method of depreciation is used in one year, then it should also be used

next year. A firm may hold stock which is heavily in demand. Consequently the market

value of this stock may be increasing. Normal accounting procedure is to ignore this

because of the cost

concept. If we receive an order for goods we would not

include the value of it in our sales figures (yet) owing to the realisation

concept/convention. A business makes a loss for the second year running, but the

going concern

concept tells us that it will carry on trading unless we are notified to the

contrary. Profit calculation is based on expenses incurred during the period rather than

those paid. This statement effectively describes the accruals

concept. The

management of "DUNFOR plc" are remarkably incompetent, but the firms accountants

cannot take this into account when preparing the books because of the money

measurement concept. The research and development section of "RAKINITIN plc"

however is doing so well that they anticipate a huge upturn in sales next year. The

accountants cannot increase the book value of the patents held though, because of the

prudence

concept. The book-keeper for Parker Ceramics would only be concerned

with the total value of Parkers drawings, not with how he had spent it because of the

business entity concept.


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Why are some types of Error not revealed in the Trial Balance? Using a manual accounting system, you are more likely to find errors in the trial balance, e.g. where the trial balance does not balance. Although the Trial Balance is proof of the arithmetic accuracy of the accounting records, there may be errors in the Trial Balance (irrespective of whether you use a manual accounting system or any other computerised accounting system), which may not be revealed, since the Trial Balance is in balance. These errors are mainly caused by omissions and incorrect entries into the batches (subsidiary journals) or entries in the ledger after transactions have been posted or updated to the ledger. These errors are usually corrected in the General Journal. The most common errors can be classified as follows:

• Errors of complete omission

A complete transaction has been omitted and not entered in the respective batch. Subsequently, the transaction is not posted or updated to the ledger. Both the debit and the credit transaction have been omitted.

To correct this, you need to access the respective batch, enter the transaction and post or update the batch to the ledger.

• Posting to the incorrect account

A debit side of a transaction was posted correctly as a debit to the general ledger, but to the incorrect account. For instance, an expense for petrol is incorrectly posted to the stationery account, etc.

To correct this, you need to access the General Journal batch, enter the transaction (e.g. Debit the petrol account and Credit the stationery account ) and post or update the batch to the ledger.

• Errors of principle

A transaction is posted to the incorrect account in the accounting equation. An example would be if an expense for motor vehicles, such as petrol or repairs were posted to the motor vehicle assets, account, etc. These transaction entries are not correct according to the accounting principles. (e.g. since an expense is recorded as an asset).

To correct this, you need to access the General Journal batch, enter the transaction (e.g. Debit the petrol or repairs expense account and Credit the motor vehicle assets account) and post or update the batch to the ledger.

• Errors of reverse posting

Transactions have been debited incorrectly as a credit, and the credit part of the transaction has been credited incorrectly as a debit. An example would be where petrol is purchased for cash, and the expense account is credited and the bank account debited incorrectly.

To correct this, you need to access the respective batch, cancel the transaction (e.g. Debit the petrol or repairs expense account and Credit the bank account). You then need to enter the transaction correctly in the respective batch. Both these transactions must be posted or updated to the ledger.


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Bank Reconciliations

What is a Bank Reconciliation? It is a test of how accurate your cash book is compared to the bank statements. This will include checking that all cheques have been entered correctly and that all bank charges, interest and direct debits have been recorded. The bank balance per the cash book is unlikely to agree to the balance on the bank statement at the same date, due to cheque payments and deposits taking a few days to clear. The bank reconciliation shows how the difference can be explained. The reconciliation should be performed at least monthly, to ensure that any errors are corrected as soon as possible. Cash Book Errors There may be items that appear on the bank statement that are not in the cash book, such as bank interest, bank charges, or direct debits. This will usually be because they are not known about until the bank statement is received. The cash book therefore needs to be adjusted by adding these items. It will also need to be adjusted where there are other errors, such as the amount being recorded in the cash book being different to that on the bank statement. If, however, this is due to a bank error, the bank should be contacted, rather than amending the cash book. Timing Differences Most of the differences between the bank statement and the cash book balances will be due to timing differences. These may be cheque payments that have not yet cleared the bank and do not therefore appear on the statement. These are known as unpresented cheques. Amounts paid into the bank that have not cleared may also be part of the difference. These are known as uncleared deposits. In these situations the bank balance is out of date and must be adjusted to take these items into account. This is where a bank reconciliation will need to be prepared to show the true balance.


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Completing a Bank Reconciliation

1. Start by ticking each payment that is in the cash book and also on the bank statement. Tick both the cash book and the bank statement. Then do the same for all bank income. Only tick entries which appear on the bank statement up to the last day of the month for which the reconciliation is being prepared, not after.

2. Now look at the bank statement and identify any items that have not been

ticked. Enter these items into the cash book, then tick them off on the bank statement.

Every item that is on the bank statement is now in the cash book.

3. Then add up all the columns in the cash book and calculate the bank

balance at the end of the month. 4. Now go through the cash book and make a list of any items that have not

been ticked. These should all be unpresented cheques or uncleared deposits.

5. Finally, prepare the bank reconciliation. This should show the balance on

the bank statement at the end of the month, less any unpresented cheques, plus any uncleared deposits. The end balance should be equal to the cash book balance.

It is the balance at the end of the bank reconciliation and per the cash book that is the balance to be used in the year end accounts, rather than the balance shown on the actual bank statement. This is because it is the bank statement that is out of date.


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Books of Original Entry We will now look at the books in which details of accounting transactions are recorded. Day Books and Journals are used to record all transactions made on Credit. The Cash Book is used to record Cash and Bank transactions. The above entries are transferred from the books of original entry to a set of books called Ledgers. Each ledger is for a particular type of item. Having a set of ledgers means entries of a similar nature are recorded in the same place. Small businesses could just keep one book, a Ledger. As a business grows this would become impossibly big and the business may want more than one person working on the accounts. It makes it easier to use more books. When a transaction takes place it is important to record as much detail as possible. For example, if we sold four computers to Mr De Souza for £1000 plus VAT on credit, we would want to record all the detail. We would also record the address and contact information and the date of the transaction. Books of Original Entry are those in which we first record transactions such as the sale of the four computers. We have a separate book for each type of transaction. Therefore, the Sales are in one book, Purchases in another, Cash in another, etc. Details in these books include:

The date – transactions should be recorded in date order. Details of the sale are listed in the ‘details’ column. A folio column entry is made cross referencing back to the original

‘source document’. The monetary amounts are entered in columns in the books of original

entry for that purpose.


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Types of Books of Original Entry Books of original entry are known as Journals or Day Books. The most common ones are:

Sales Day Book, (or Sales Journal), for Credit Sales. Purchases Day Book, (or Purchases Journal), for Credit Purchases. Returns Inwards Day Book, (or Returns Inwards Journal). Returns Outwards Day Book, (or Returns Outwards Journal). Cash Book for receipts and payments of cash and cheques. General Journal, (or ‘Journal’ if the term ‘day book’ is applied to the other books of original entry), for other items.

The entries from the books of original entry are then summarised and entries are made, using double entry, to accounts kept in the various Ledgers - a set is usually kept to divide the work of recording between different bookkeepers. Types of Ledgers

Sales Ledger – for Customers’ personal accounts. Purchases Ledger – for Suppliers’ personal accounts. General Ledger – contains the remaining double entry accounts, e.g.

expenses, fixed assets and capital.


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A Diagram of the Books most commonly used


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Exam Questions

From the information given above:

a) Enter the balances in the trial balance as at 31st October 2004.

b) Calculate and enter her capital.

c) Show the final totals of the trial balance.


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a), b) & c)

REVENUES GO ON THE CREDIT SIDE BECAUSE IT INCREASES CAPITAL LIABILITY. IT IS TREATED THE SAME THE SAME WAY AS A SALE.

Helen JonesTrial Balance as at 31st October 2004

Account Name Debit Credit

Carriage InwardsCash at the bank

2455891

Buildings 55000

Creditors

Motor VehiclesPurchases

Sales

10000220004000

790

Rates

Returns inwardsReturns outwards

Stock at 1 November 2003 2745

Salaries 13500

115711Capital

46500

2670

115711

Debtors 1540

Rent receivable 2843

460

63000

VAT - amount due to HM Customs & Excise 238


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d) Prepare the trading and profit and loss account for the year ended 31st October 2004.

Stock as at 31st October 2004 was 2360.

Helen Jones Trading & Profit and Loss Account for year ended 31st October 2004

£ £ Sales 46500 Less Returns Inwards (790) Net Sales 45710 Opening Stock 2745 Purchases 22000 Less Returns Outwards (460) Carriage Inwards 245 Net Purchases 24530 Less Closing Stock (2360) Cost of goods sold (22170) Gross Profit 23540 Rent Receivable 2843 26383 Less Expenses Rates 4000 Salaries 13500 Total Expenses 17500 Net Profit 8883


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c) prepare the balance sheet as at 31st October 2004.

Helen Jones

Balance Sheet as at 31st October 2004

£ £

FIXED ASSETS Buildings 55000 Motor Vehicles 10000 65000

CURRENT ASSETS Stock 2360 Debtors 1540 Cash at Bank 5891 9791 LESS CURRENT LIABILITIES Creditors 2670 VAT - due to Customs & Excise 238 (2908 )NET CURRENT ASSETS 6883 LESS LONG TERM LIABILITIES 0 NET ASSETS (Fixed + Net Current) 71883

CAPITAL Balance 63000 add Net Profit 8883 less Drawings (0) 71883


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Review Questions

1. Write down the accounting equation. Assets = Capital + Liabilities or Capital = Assets – Liabilities

2. Identify 3 possible users of accounting information Investors, the Owner, Inland Revenue.

3. What is CAPITAL? This is the source of funds or the resources put into the company by the owner(s).

4. Who are CREDITORS? They are those who the business owes money to for goods/services supplied.

5. What is meant by the term LIABILITY? There are two types of liability, Short term and Long term. They are amounts owed by the business for goods and services supplied to the business and expenses incurred that have not yet been paid for, (not forgetting funds borrowed by the business, i.e. loans).

6. What effect would the purchase of an asset have on the accounting equation?

It would increase the asset side of the equation.

7. What does a Balance Sheet show? The balance sheet shows a snapshot at that time of what the company owes and what it owns.

8. Classify the following into LIABILITIES and ASSETS

a) Motor Vehicles – Asset b) Owing to Bank – Liability c) Premises – Asset d) Cash in hand – Asset e) Creditors for goods – Liability f) Loan from D. Jones – Liability g) Stock of goods – Asset h) Machinery – Asset i) Debtors – Asset


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9. What are Returns Inwards? These are goods returned to us by the customer.

10. What is the difference between Sales and Purchases? Sales are the sale of goods in which the business normally deals. Income received from selling goods or a service. Purchases mean those goods which a business buys with the prime intention of selling.

11. Outline the different entries which would be made for a CASH sale and for a CREDIT sale.

A cash sale would be a debit posting to a cash account and a credit to a sales account. A credit sale would be a debit posting to a customer a/c, (debtor), and a credit to a sales a/c. When the customer pays we debit the bank or cash a/c and then credit the customer’s a/c.

12. What is PROFIT and how does it affect CAPITAL? Profit is the amount by which revenues are greater than expenses for a set of transactions. Profit increases Capital.

13. What is an EXPENSE? This is the cost value of all assets that have been used up to obtain the revenues.

14. What is REVENUE? This is sales value of goods and services to customers.

15. How might you tell a REVENUE account from an EXPENSE account?

Revenue a/c’s will say receivable and expense a/c’s will say payable, e.g. Rent receivable or Rent payable.

16. Expenses are DEBIT entries. TRUE or FALSE? True.

17. What are DRAWINGS? This is money taken out of the business by the owner for their personal use.


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18. When a balancing figure is used to make totals equal at the end of the month do we write c/d or b/d?

c/d

19. What is a TRIAL BALANCE? This is a list of the balances on all the accounts with debits on the left and credits on the right. The total of the debit column should equal the total of the credit column.

20. How is GROSS PROFIT calculated? Gross profit = Sales – Cost of Goods Sold

21. What are FIXED ASSETS? These are assets that the business will have for 12 months+/long term.

22. In order of liquidity note 3 current assets Stock Debtors Money in the Bank

23. What is CARRIAGE OUTWARDS? This is the charge to the business for getting goods to customers. It is a liability.

24. Is carriage outwards included in the calculation of gross profit? No, but carriage inwards is.

25. Explain how cost of goods sold is calculated? Opening Stock + Purchases — Closing Stock = COGS

26. What is meant by the Historical Cost Concept? This is the concept that the recorded cost is that at which it was value at cost.

27. What is meant by the Going Concern Concept? This is the concept that the business will continue next year and beyond.


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28. Identify 3 books of Original Entry Sales Day Book, Purchases Day Book, Returns Inwards Day Book.

29. Identify the 3 types of LEDGER Sales, Purchases & General.

30. Explain why consistency is such an important accounting concept.

It is important because we have to use the same methods year on year. Otherwise it could distort the value of some assets.


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Types of Accounts Personal or Impersonal

Personal - these are for debtors and creditors, (i.e. customers & suppliers).

Impersonal – divided between ‘Real’ accounts and ‘nominal’ accounts.

Real Accounts: accounts in which possessions are recorded. Examples are buildings, machinery, fixtures and stock.

Nominal Accounts: accounts in which expense, income and capital are recorded.

Nominal and Private Ledgers The ledger in which impersonal accounts are kept is known as the NOMINAL LEDGER or General Ledger. For owner privacy, the Capital Drawings and other similar accounts are sometimes kept in a PRIVATE LEDGER.

ACCOUNTS

Personal Accounts Impersonal Accounts

Debtors Accounts

Creditors Accounts

REAL Accounts for possessions

of all kinds

NOMINAL Accounts for expenses, income

and capital


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Review Questions What is BACS? Bank Automated Clearing Service. It has a common use with the Direct Debit system and wages/salaries What does ATM stand for? Automatic Telling Machine What is clearing? This is a system which enables cheques to be transmitted between banks (and between branches) in order to transfer funds Why does it take 3 days to clear a Cheque? Because there are 3 stages in the clearing cycle as follows:

1. Customer gives their bank the cheque and they send off to the clearing centre

2. The cheque is mechanically read and sorted and then sent electronically to the paying banks via the Inter Bank Data Exchange

3. Paying banks update their accounts and settle net amounts to one another across accounts at the Bank of England

How do we protect cheques when we write them? We cross the cheque with two parallel lines drawn in the middle of the cheque with the words ‘account payee only’ written in-between What are the ‘Personal Accounts’? Debtors & Creditors accounts What are the ‘Impersonal Accounts’? These are split into two types as follows:

1. Real – Possessions 2. Nominal – Expenses, Income & Capital

Why might we keep a Private Ledger? Because the owner may not want some people to see certain aspects of the account


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Cash Books At the end of this session you will be able to:

explain the format of two-column and three-column cash books enter up and balance off cash books use folio columns for cross-referencing purposes

The Cash Book consists of both the Cash account and the Bank account together in one book. Although previously separated on different pages, the Cash Book now puts the two sets of columns together to make things easier. This means that money can be recorded received and paid out on a particular date on one page. Example as follows:

02/08/06 T. Moore 33 08/08/06 Rent 2005/08/06 K. Charles 25 12/08/06 C. Potts 1915/08/06 F. Hughes 37 28/08/06 Wages 2530/08/06 K. Howe 18 31/08/06 Bal c/d 49

113 11301/09/06 Bal b/d 49

01/08/06 Capital 1000 07/08/06 Rates 10503/08/06 WP Limited 244 12/08/06 F. Small Ltd 9516/08/06 K. Noone 408 26/08/06 K French 26830/08/06 H. Sanders 20 31/08/06 Bal c/d 1204

1672 167201/09/06 Bal b/d 1204

Cash

Bank


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Date Cash Bank Date Cash Bank01/08/06 Capital 1000 07/08/06 Rates 10502/08/06 T. Moore 33 08/08/06 Rent 2003/08/06 WP Ltd 244 12/08/06 C. Potts 1905/08/06 K Charles 25 12/08/06 F. Small Ltd 9515/08/06 F Hughes 37 26/08/06 K. French 26816/08/06 K Noone 408 28/08/06 Wages 2530/08/06 H Sanders 20 31/08/06 Bal c/d 49 120430/08/06 H. Howe 18 113 1672

113 167201/09/06 Bal b/d 49 1204

CASH BOOK


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The bank column contains details of the payments made by cheque and direct transfer from the bank account and of money received and paid into the bank account. Periodically, when a Bank Statement is sent from the bank, the company will check it against the bank columns in the Cash Book to ensure that there are no errors. Cash paid into the Bank Let’s look at the position when customers pay their account in cash and later, a part of this cash is paid into the bank. The receipt of the cash is debited to the cash column on the date received, the credit entry being in customer’s personal account. The cash banked has the following effect needing action: Exercise 1 A Cash receipt of £100 from M. Davies on 1st August 2006 was followed by the banking on 3rd August 2006 of £80 of this amount. Show how this would appear in the Cash Book.

The details column shows entries against each item stating the name of the account in which completion of double entry has taken place. Against the cash payment of £80 appears the word “Bank”, meaning that the debit £80 is to be found in the bank column, and the opposite applies. Where the whole of the cash received is banked immediately the receipt can be treated in exactly the same manner as a cheque received, i.e. it can be entered directly into the bank column.

Effect ActionAsset of cash is decreased Credit the asset account, ie. the cash account which is

represented by the cash column in the Cash BookAsset of bank is increased Debit the asset account, i.e. the bank account which is

represented by the bank column in the Cash Book

Date Cash Bank Date Cash Bank01/08/06 M. Davies 100 03/08/06 Bank 8003/08/06 Cash 80

CASH BOOK


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Exercise 2 If the business requires cash, it may withdraw cash from the bank. Assuming this is done by use of a cheque, the business would write out a cheque to pay itself a certain amount in cash. This could also be done using a cash card. The effect on the accounts is the same – show

A withdrawal of £75 cash on 1st June 2006 from the bank would appear in the cash book as follows:

Both the debit and the credit entries for this item are in the same book. When this happens it is known as a Contra (C) Item.

Effect ActionAsset of bank is decreased Credit the bank accountAsset of cash is increased Debit the cash account

Date Details Cash Bank Date Details Cash Bank01/06/06 Bank 75 01/06/06 Cash 75

CASH BOOK


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The use of Folio Columns When many books are being used the details column may not provide sufficient information to find the other accounts quickly. More information may be given through using Folio Columns. The folio column is shown on the left of the money columns. In this column the name of the other book and the number of the page in the other book where the other part of the double entry was made is stated against each and every entry. The folio column should only be filled in when the double entry has been completed. For example, an entry for receipt of cash from C. Kelly, whose account was on pg 45 of the Sales Ledger and the cash recorded is on pg 37 of the Cash Book would have the following folio column entries:

In the Cash Book, the folio entry would be SL45 In the Sales Ledger, the folio entry would be CB37

Note how the titles of the books are abbreviated. Each of the Contra items would use the letter C in the folio column. There is no need for a page number in this case. Cash Sales go into the General Ledger, (GL), because you are not posting it to a personal, (named), debtor. Exercise 3 The act of using one book as a means of entering transactions into the accounts, so as to perform or complete the double entry is known as Posting. Give an example You would post items from the Sales Day book to the appropriate accounts in the Sales Ledger. You would post items from the Cash Book to the appropriate accounts in the Sales Ledger. Only one account is posted to from the Cash Book because unlike the others it is both a Day Book and a Ledger so we can keep it in the one/same book. To illustrate, from the Sales Day Book we must make 2 postings but from the Cash Book we can make one. Advantages of using a folio column:

It speeds up finding the other side of the double entry in the ledgers It highlights whether or not a double entry had been completed, (as we must only make a folio entry once this has been done).


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Exercise 4 Write up the following transactions with folio entries as if the double entries had been completed to the other accounts.


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Date Details Folio Cash Bank Date Details Folio Cash Bank01/09/06 Capital GL1 940 06/09/06 Rent GL65 3502/09/06 M. Boon SL98 115 07/09/06 Bank C 5004/09/06 Sales GL87 102 23/09/06 S. Wills PL23 27707/09/06 Cash C 50 29/09/06 Cash C 12015/09/06 Sales GL87 40 30/09/06 Wages GL39 11829/09/06 Bank C 120 30/09/06 Balance c/d 19 748

222 1145 222 114501/10/06 Balance b/d 19 748

CASH BOOK


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Cash Discounts As an incentive for customers to pay accounts quickly a business may accept a smaller sum in full settlement if payment is made within a certain period of time. The amount of reduction is known as a Cash Discount. It is called this even is payment is made by cheque or direct transfer. The discount is usually a Percentage and a common timeframe for payment is one month from the date of the original transaction. N.B. Cash discounts ALWAYS appear in the Profit and Loss Part of the Trading and Profit and Loss Account. They are NOT part of the cost of goods, nor are they a deduction from selling price. Cash Discounts are dealt with as an EXPENSE.

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Accounting Course Book 3

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