Diploma in Accounting 2010edit

Diploma in Accounting
Diploma in
Accounting
D1071
Oxford Learning 2007

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Diploma in
Accounting
Unit 1: Introduction of Financial
Accounting
Module 1: Purposes of Accounting and Records
Module 2: Verification of Records Accounts and
Balance Sheets
Diploma in
Accounting
Accounting
Module 1: Purposes of Accounting and Records
INTRODUCTION TO FINANCIAL ACCOUNTING
INTRODUCTION
Your learning will be built up from the basis of this module, as you will study the principles
of double entry bookkeeping, how to make the proper entries in the accounts and record the
transactions. You will also develop skills in correction of errors and how they affect the Profit
and Loss account and the Balance Sheet. By the end of the lesson you should be able to
prepare Final Accounts for a business.
Do not worry about the terminology used in the module as it will be explained and by the end
of the module you will become familiar with it. A glossary of accounting terms has been
included at the start of the module so that you can refer to it every time you need to.
This module is an introduction to what it is going to be the foundations of your knowledge
and skills throughout this course. It is very important that you understand how the principles
work and how to apply them in practice correctly. Make sure you cover the different topics of
the module and do the questions proposed, as accounting requires a lot of practice too.
At first you may find the module a little bit difficult, but if you work through the examples
and complete the exercises it will become easier. You will find step by step explanations of
how to record transactions, balance the accounts, correct errors, etc.
Learning objectives:
Understanding why it is important to keep records
Listing the main users of accounting information and what they are interested in
Listing the books of original entry and explaining the principle of double-entry
bookkeeping
Recording transactions from prime documents
Entering a series of transactions into T-accounts
How the double entry system follows the rules of the accounting equation
How to reconcile the business bank account with the bank statement
Balancing the accounts
How to draw up a trial balance
Preparing Financial Statements: Profit and Loss Account and Balance Sheet
Making adjustments to the accounts at the year end.
How to correct errors in the accounts
LESSON 1. PURPOSES OF ACCOUNTING
1.1 . Introduction.
Accounting affects people in their personal lives just as much as it affects very large
organisations. We all use accounting ideas when we plan what we are going to do with our
money. We can do that by writing down a plan (budget) or by simply keeping it in our heads.
However, businesses have too much financial data and it would be very difficult for an owner
or a manager to keep all the details in their heads. Therefore, they need to keep records,
accounting records.
Failing to keep proper records means that there is no way of checking the financial position
of the business. In some cases it may lead to a penalty charged by HM Revenue & Customs
or to a prosecution under the Insolvency Act. A Limited Company is bound by law to keep
financial accounts in accordance with the Companies Act.
1.2 . Why we need to keep records.

The business must at all times know what its financial position is and this will be evident
when records can be produced showing the amount owing to the business and the amount of
money it owes to other people. Records of payments made and received are very important.
These enable us to ensure these payments are made on time and to know when a customer
paid us.
The reasons for keeping records are numerous:
To provide a permanent record of financial transactions.
To provide information from which financial statements can be prepared.
To provide information from which management report can be prepared.
To provide a means of controlling assets.
To provide information for decision making.
To comply with statutory regulations.
These accounting records will contain details of all cash received and paid, goods bought and
sold, assets bought to be used not sold, and so on.
To be useful to the business, when accounting data is being recorded, it has to be classified
and then summarised. It can then be discovered how much profit or loss is being made, what
is owned by the business, and what is owed by it.
It is this information that is available in part or in whole to the range of users.
1.3 . Who is interested in the accounting records?

Apart from the management of an organisation, there are other groups, each of which may
believe it has a reasonable right to obtain information about an organisation. These groups
include the owners, shareholders, employees, lenders, suppliers, customers, competitors,
government and its branches, and the public interest. Those in the wider interest groups are
sometimes referred to as stakeholders.
Owners
They want to be able to see whether or not the business is profitable. They also want to know
what the financial resources of the business are. They need the information as quickly as
possible, as it is their responsibility to employ the resources of the business in an efficient
way and to meet the objectives of the business. The information needed to carry out this
responsibility ought to be of high quality and in an understandable form so far as the owners
are concerned.
Where the ownership is separate from the management of the business, as it is the case with a
limited liability company, the owners are more appropriately viewed as investors who entrust
their money to the company and expect something in return, usually a dividend and a growth
in the value of their investment as the company prospers. As providing money to fund a
business is a risky act, they need information to help them decide whether they should buy,
hold or sell, so that they can have a return on their investment. They are also interested in
information on the entitys financial performance and financial position that helps them to
assess its cash-generation abilities.
Shareholders
Year end accounts have to be supplied to all shareholders and investors. These accounts will
confirm whether or not the business is a good investment. Shareholders are interested in
evaluating the performance of the entity; assessing the effectiveness of the entity in achieving
objectives and its liquidity, its present or future requirements for additional working capital,
and its ability to raise long-term and short-term finance; estimating the future prospects of the
entity, including its capacity to pay dividends, and predicting future levels of investment.
Employees
They are interested in information about the stability and profitability of their employers.
They are also interested in information that helps them to assess the ability of the entity to
provide remuneration, retirement benefits and employment opportunities.
The matters which are likely to be of interest to employees include: the ability of the
employer to meet wage agreements; managements intention regarding employment levels,
locations and working conditions; job security; pay rise.
Lenders
Lenders are interested in information that enables them to determine whether their loans, and
the related interest, will be paid when due.
Loan creditors provide finance on a longer-term basis; therefore, they wish to assess the
economic stability and vulnerability of the borrower. They are particularly concerned with
the risk of default and its consequences. They may impose conditions which require the
business to keep its overall borrowing within acceptable limits. Banks will ask for cash flow
projections showing how the business plans to repay, with interest, the money borrowed.
Suppliers
Suppliers of goods and services (trade creditors) are interested in information that enables
them to decide whether to sell to the entity and to determine whether amounts owing to them
will be paid when due.
Trade creditors have very little protection if the entity fails because there are insufficient
assets to meet all liabilities. So they have to exercise caution in finding out whether the
business is able to pay and how much risk of non-payment exists. They may obtain the
information from the local press and trade journals and the Chamber of Trade, apart from the
financial statements, which may confirm the information obtained from other sources.
Customers
Customers have an interest in information about the continuance of an entity, especially when
they have a long-term involvement with, or are dependent upon, its prosperity. They need
information concerning the current and future supply of goods and services offered, price and
other product details, and conditions of sale. Much of the information may be obtained from
sales literature or form sales staff of the enterprise, or form trade and consumer journals.
The financial statements provide useful confirmation of the reliability of the enterprise itself
as continuing source of supply. They also confirm the capacity of the entity in terms of fixed
assets and working capital and give some indication of the strength of the entity to meet any
obligations under guarantees or warranties.
Competitors
They want as much pertinent information as they can get. In particular, they will want access
to the internal financial information concerning costs. They are interested in the financial
performance of the enterprise, its cash flow strength to carry out further investment or
expansion, its price structure and margins in order to assess its competitiveness and share
market, and its products.
Government
Government and their agencies are interested in the allocation of resources and, therefore, in
the activities of the entities. They also require information in order to regulate the activities of
entities, assess taxation and provide a basis for national income.
Acting on behalf of the UK governments Treasury Department, HM Revenue and Customs
collects taxes from businesses based on profit calculated according to commercial accounting
practices. They want to know how much tax a business should be paying, whether it is
complying with the VAT regulations, etc.
The public
They have different interests from the other stakeholders groups. They want assurance about
the behaviour and practices of the business.
All these different people may need access to the accounts of a business:
LESSON 2. ACCOUNTING RECORDS
2.1.Primary Accounting Records and the Ledgers.

When a transaction takes place, we need to record as much information as possible
about the transaction. For example, if we sold two printers on credit to ABC Ltd for
100 each, we want to record that we sold two printers for 100 each to ABC Ltd on
credit. We will need to record the address and contact details of the company and the
date of the transaction.
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A) The Books of prime, or original, entry are the books in which we first record
transactions, such as the sale of the two printers. There is a separate book for each
kind of transaction. These books are known as journals or day books.
The commonly used books of original entry are:
Sales Day Book. Records all credit terms invoices sent out from the business.
Purchase Day Book. Records all credit items invoices received by the
business.
Returns Inwards Day Book. Record all Credit Notes received (Purchases
Returns).
Returns Outwards Day Book. Record all Credit Notes given (Sales Returns).
Cash Book. This records incoming and outgoing payments of bank and cash.
General Journal. It is used for other items. It will be explained in more detail
later on in this lesson.
Entries are made in the books of original entry. The entries are then summarized and
the summary information is entered, using double entry, to accounts kept in the
various ledgers of the business.
When we enter transactions in these books we record:
The date of the transaction

The details relating to the sale or purchase
The folio entry for cross-reference back to the original source document
(invoice, credit note)
The amount of the transaction
The Sales Day Book is simply a list of transactions, the total of which, at the
end of the day, week or month, is transferred to sales account. Bear in mind
that the Day Book is not part of double-entry bookkeeping, but it is used as a
primary accounting record to give a total which is then entered into the
accounts. The most common used of a Sales Day Book is to record credit sales
from invoices issued.
Lets see an example:
On 1 June 2008 you sold goods for 100 on credit to E. Jones, invoice No 101
On 8 June 2008 you sold goods for 150 on credit to M. White, invoice No
102
On 15 June 2008 you sold goods for 250 on credit to T. Young, invoice No
103
Your Sales Day Book will be written up like this:
Sales Day Book

Date
Details
Invoice
Folio
Amount
11
01/06/2008
08/06/2008
15/06/2008
30/06/2008
E. Jones
M. White
T. Young
Total for the month
101
102
103
SL10
SL20
SL22
100.00
150.00
250.00
500.00
The total net credit sales for the month of 500 will be transferred to sales
account in the general ledger.
The Sales Day Book incorporates a folio column which cross-references each
transaction to the personal account of each debtor, where each credit sales
transactions is recorded forming part of the Sales Ledger.
The Purchases Day Book lists the transactions for credit purchases from
invoices received and, at the end of the day, week or month, the total is
transferred to purchases account.
Lets see an example:
On 3 June 2008 you bought goods for 80 on credit from P. Doyle, invoice No
2345
On 10 June 2008 you bought goods for 100 on credit from T. Rice, invoice
No 456
On 18 June 2008 you bought goods for 200 on credit from T. Rice, invoice
No 486
Your Purchases Day Book will be written up like this:
Date
03/06/2008
10/06/2008
18/06/2008
30/06/2008
Purchases Day Book

Details
Invoice
P. Doyle
2345
T. Rice
456
T. Rice
486
Total for the month
Folio
PL10
PL20
PL20
Amount
80.00
100.00
200.00
380.00
The total net credit purchases for the month of 380 will be transferred to
purchases account in the general ledger.
As in the Sales Day Book, the folio column gives a cross-reference to the
creditors accounts and provides an audit trail. The credit purchases
transactions are recorded in the personal accounts of creditors in the Purchase
Ledger.
Returns Day Books:
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The Sales Returns Day Book is for goods previously sold on credit and now
being returned to the business by its customers.
The Purchases Returns Day Book is for goods purchased on credit by the
business, and now being returned to the suppliers.
The Returns Day Books are primary accounting records and do not form part
of the double-entry bookkeeping system. The transactions are recorded from
prime documents (credit notes issued for sales returns, and credit notes
received for purchases returns). Then the information form the Day Book must
be transferred to the appropriate account in the ledger.
From the previous examples of Sales Day Book and Purchases Day Book, we
now have the following information:
On 20 June 2008 M. White returned goods for 50, credit note No CN1001
issued
On 25 June 2008 we returned goods for 100 to T. Rice, credit note No 123
received
The Sales and Purchases Returns Day Book will be written up like this:
Sales Returns Day Book
Credit Note
CN1001
Date
20/06/2008
Details
M. White
30/06/2008
Total for the month
Purchases Returns Day Book

Invoice
CN123
Date
25/06/2008
Details
T. Rice
30/06/2008
Total for the month
Folio
SL20
Amount
50.00
50.00
Folio
PL20
Amount
100.00
100.00
The total net sales returns and net purchases returns will be transferred to the
sales and purchases returns accounts respectively in the general ledger. And
the amounts of sales returns are credited to the debtors personal accounts in
the sales ledger; in the same way, the purchases returns are debited to the
creditors accounts in the purchases ledger.
Cash books. It records all transactions for bank account and cash account
13
Petty Cash Book. It records low-value cash payments, e.g. expenses, that are
too small to be entered in the main cash book or because there is a box in the
office with a small amount of cash for those expenses: fuel, cleaning, etc.
You are not required to prepare a Petty Cash Book in the examination.
B) The different types of Ledgers are:

Sales Ledger. It contains details of sales made to customers on credit terms. It
records:
Sales made on credit to customers of the business
Sales returns by customers
Payment received from debtors
Cash discount allowed for prompt settlement
The sales ledger does not record cash sales. It contains an account for each
debtor and records the transaction for that debtor.
Purchase Ledger. This is for details of all items which are bought on credit
terms. It contains the accounts of creditors, and records:
Purchases made on credit from suppliers of the business

Purchases returns made by the business
Payments made to creditors
Cash discount received for prompt settlement
The purchase ledger does not record cash purchases. It contains an account for
each creditor and records the transactions with that creditor.
Cash books. It records all transactions for bank account and cash account
The cash book performs two functions within the accounting system:
1. It is a primary accounting record for cash/bank transactions
2. It forms part of the double-entry bookkeeping system.
CASH BOOK
Debit
Cash and bank receipts. From prime
documents:
Receipts issued
Bank paying-in slips
Bank giro credits received
BACS payment received
Credit card vouchers received
Credit
Cash and bank payments. From prime
documents:
Cheque book counterfoils

Standing order and direct debits
Debit advice from the bank: bank
charges, interest.
14
General Ledger. This contains the remaining double entry accounts, nominal
accounts, such as those relating to expenses, fixed assets, and capital. It
contains the accounts to record the double entry for all the items for which the
first entry has been made in any of the above Ledger sections:
Nominal Accounts:
-
Sales account (cash and credit sales), sales returns

Purchases account (cash and credit purchases), purchases returns
Expenses and income, loans, capital, drawings
Value Added Tax (where the business is VAT registered)
Profit and loss
Fixed assets: machinery, vehicles, office equipment
Stock
You will not be required to understand the VAT system or make accounting
records of VAT.
2.2.Documents used in business transactions.

Business documents are important because they are the prime source for the recording
of
business transactions.
We have learnt earlier the different books used to record the transactions which take
place in a business: the books of prime entry. However, we do not know how to
obtain the information for those transactions.
Now you are going to study the different documents which take part in any credit
transaction and in which book that information is recorded. A credit transaction is
where goods are purchased, sold and returned without a payment being made or
received at that particular time.
When an order placed by the buyer, using a purchase order, is received by the seller, it
will be processed; at the time of supplying the goods or services a delivery note is
received by the buyer, which will contain details of the goods or services delivered,
the price charged and the quantity. The seller will request payment by issuing an
invoice, which will contain the details of the buyer, date, the goods supplied, the
quantity and total amount due and the credit terms.
A purchase order is prepared by the buyer, and is sent to the seller. The details
included in a purchase order are: number of purchase order, for tracking; name and
address of buyer; name and address of seller; full description of the goods, reference
numbers, quantity required and unit price; date issue and signature of person
authorised to issue the order.
15
When the goods are despatched to the buyer, a delivery note is prepared. This
delivery note accompanies the goods and gives details of what is being delivered.
When the goods are received by the buyer, a check will need to be made:
To make sure that the goods have been received

To be certain that the goods received are those that were ordered
To ensure that the correct price has been charged
To confirm that the goods are not damaged
To ensure that the proper discount has been given if appropriate
An invoice is issued to advise the customer of goods or services supplied. It is

prepared by the seller and is sent to the buyer. The invoice contains details of the
goods supplied, and states the amount to be paid by the buyer. The information
included in an invoice is: invoice number, name and address of seller, name and
address of buyer, date of sale, delivery address (if different from the invoice address),
date that goods were supplied, quantity supplied and unit price, total amount due,
details of trade discount (if any) and the credit terms.
The information is taken forma copy of the invoice and used to write up the Sales Day
Book. This starts the credit sales bookkeeping procedure.
We have mentioned credit terms and trade discount. Lets explain what they mean:
Credit terms are stated on an invoice to indicate the date by which the invoice
amount is to be paid, e.g. net 30 days means that the amount is payable
within 30 days of the invoice date.
Trade discount is a reduction on the list price of goods. It is the amount

allowed as a reduction when goods are supplied to other businesses, but not to
the general public. The trade discount is never shown in the accounts, only the
amount after the deduction of trade discount is recorded.
Another type of discount is cash discount, which is a reduction given for
prompt payment, e.g. 5% discount for payment within seven days. The buyer
can choose whether to take up the cash discount by paying promptly, or
whether to take longer to pay without cash discount. When cash discount is
taken it needs to be recorded in the accounts.
Goods are sometimes found to be defective or wrongly priced, or over supplied. If this
is the case then the goods are likely to be returned to the seller, who will then issue a
credit note which tells the purchaser that his account is being credited with the cost
of the goods.
A statement of account will be sent out to each debtor at the end of each month. This
statement is prepared by the seller and gives a summary of the transactions that have
taken place and are still owed or outstanding. The details on a statement are: name
and address of seller, name and address of the debtor (who is the buyer), the date of
the statement, details of the transactions along with their reference number and the
amount, and the balance currently due.
16
From all the documents aforementioned the invoice and credit note are the ones used
to record the transactions in the Sales or Purchases Day Book, which will be the
starting point from where the total amounts will be transferred to the appropriate
Ledger: the Sales Ledger or the Purchases Ledger. In the next section you will learnt
the double entry principle and how to do entries into the Accounts.
Payments
Once we have recorded the invoices and credit notes issued and received the next step
is to request and make payment for balance shown on the accounts for each customer
and supplier when the payment becomes due.
The most common method of payment is the cheque.
Cheques are written orders from account holders instructing their banks to pay
specified sums of money to named beneficiaries. They are not legal tender but are
legal documents and their use is governed by the Bills of Exchange Act 1882, and the
Cheques Acts of 1957 and 1992.
If a cheque has counterfoil attached, it can be filled in at the same time as the cheque,
showing the information what was entered on the cheque. The counterfoil is then kept
as a note of what was paid, to whom, and when. Cheques as usually supplied in
books.
If you look at the cheque above, the drawer is Mr Mamom, and the payee will be the
person or company who the cheque is made payable to: you will write their names on
the Pay line, and below that the amount in words. The use of the double crossed
lines along with the words A/c Payee only means the cheques should be paid only
into the account of the payee named. It is impossible for this cheque to be paid into
any bank account other than that of the named payee.
If the crossing does not contain any of these three terms, A/c Payee only, a cheque
received by someone can be endorsed over to someone else. The person then
17
receiving the cheque could bank it. For example, John Smith receives a cheque from
Tom Rice, he can endorse the cheque and hand it to Anthony Jones as payment of
money by Smith to Jones. Jones can then pay it into his bank account. Smith would
write the words Pay A Jones or order on the reverse side of the cheque and then sign
underneath it, and that is how you endorse a cheque.
Bankers' drafts are cheques drawn directly on the account of a bank rather than the
account of a customer. The comfort they provide is that it is highly unlikely they
would be returned unpaid due to lack of fund
When we want to pay money into a current account, either cash or cheques, or both,
we use a pay-in slip. The counterfoil of the pay-in slip is stamped and initialled by
the banks cashier and returned to the customers a receipt. The pay-in slips used by a
business are usually in a book, with the counterfoil remaining in the book as a
permanent record.
Pay-in slips and cheque books will be furnished by the bank to the customer in order
to action movements on a bank current account. Other transactions documents
include: Standing Order and Direct Debit.
There are two main types of bank accounts:
Current Account which is used for regular payments into and out of a bank
account. They earn little or no interest.
Deposit Account is intended for funds that will not be accessed on a frequent
or regular basis. They earn more interest than current accounts.
Standing Orders are an instruction by an account holder to their bank, to pay regular
amounts of money at stated dates to defined persons or firms.
Direct Debits are an authorisation by the account holder to the creditor to obtain the
money direct from the account holders bank.
BACS (an acronym for Bankers' Automated Clearing Services) is a United
Kingdom scheme for the electronic processing of financial transactions. Direct Debits
and BACS Direct Credits are made using the BACS system. BACS payments take
three working days to clear: they are entered into the system on the first day,
processed on the second day, and cleared on the third day.
The cash receipts and the till rolls contain the information of all the cash sales made
by the business on a daily, weekly or monthly basis. That information will be used to
make entries in the Cash Book Account and the Sales Account.
A bank statement is a document issued by a bank to its customers, listing details of
debit and credit transactions over a given period with a resultant balance of the
account. These statements are issued to cover a range of accounts including current
accounts, loan accounts and deposit accounts.
18
In the bank statement you will find information on bank charges, interest paid and
interest received. Those transactions will need to be recorded in the Cash Book
Account and the appropriate ledger.
As you can see there are a number of documents from where to extract the
information that will be used in the business to record the transactions in business
Accounts.
2.3. Initial entries. Double entry system.
The double entry system was first written down by a mathematician called Luca
Pacioli. His book was published in Venice in 1494 and was called the Summa de
Arithmetica, Geometria, Proportioni et Proportionalitia. Although the double entry
accounting has been in use for years before Pacioli wrote about it, his book is thought
to be the first printed explanation of the double entry system.
What is double entry?
It is a method of cross-checking accounting transactions. It is also a method of
describing accounting processes.
All transactions are entered into Ledger Accounts. The Account is divided into two
identical sections:
Left Hand this is name the Debit (DR) side

Right Hand this is named the Credit (CR) side.
The double entry principle states that every transaction must be entered in the books
twice: on the DEBIT side of one account and on the CREDIT side of another account.
For example, when you buy something you write down the value of the goods you
receive and your write down the value of the cheque that you give to the supplier. The
two values should be same. So, you are entering the amount twice = double entry.
For each transaction it is essential to identify which part is entered on the Debit side
and which part is entered on the Credit side of the two ledger accounts involved. To
work this out we must follow the IN and OUT rule.
The IN part of the transaction is entered on the DEBIT side of an account.
The OUT part of the transaction is entered on the CREDIT side of another account.
Lets see this rule with an example. Example 1:
John Smith started a business on January 1st and his transactions for the first month
are as follows:
19
January 1st. He started with Capital of 5,000 paid into his business bank account
2nd. He buys a van for 3,000 paid by cheque
3rd. He purchased stock for resale for 750 by cheque
7th. He sold goods for 250 the money is paid into the bank
10th. He sells more goods for 750 and the money is paid into the bank
11th. He pays 200 rent by cheque
We draw up a table showing for each transaction the account titles to be used for the
Debit and Credit parts and the reason why are IN and OUT.
DEBIT IN
CREDIT OUT
Jan
1
Account Title
Bank
Reason
Money received
Account Title
Capital
Vehicle
Assets received
Bank
Purchases
Stock received
Bank
Bank
Money received
Sales
10
Bank
Money received
Sales
11
Rent
Value received
from use of
premises
Bank
Reason
Money
from owner
Cheque
paid
Cheque
paid
Stock
delivered
Stock
delivered
Cheque
paid
If you enter the amount for each transaction at each side of the table and you add them
up at the bottom you will see that they balance. The reason for this is based on the
accounting equation, and it is usually shown as:
Capital = Assets Liabilities
Capital represents what the owners have invested in the business. It must equal what
the business owns (its assets) minus what it owes (its liabilities).
The rules for debits and credits are:
Debit entry (Dr) the account which gains value, or records an asset, or an
expense
Credit entry (Cr) the account which gives value, or records a liability, or an
income item
20
Dr
First Account
Cr
Second Account
Cr
Account which gains value

or records an asset, or an
expense
Dr
Account which gives value

or records an liability, or
income/revenue
When one entry has been identified as a debit or credit, the other entry will be on the opposite
side of the other account.
You can see from the picture above how the shape resembles a T; that is why they are
commonly referred to as T-accounts.
For example, if you paid 10 by cheque for a book, you will enter 10 on the left hand (i.e.
debit, DR) side of the book account and on the right-hand (i.e. credit, CR) side of the bank
account:
Dr
Book account
Bank
Cr
10
Dr
Bank account
Book
Cr
10
The description used is to be able to cross reference the two accounts affected. If you look at
your book account you will be able to see that you paid for your book by drawing a cheque
from your bank account. Likewise, if you look at the bank account, you can see that you took
money out of your bank account to buy a book.
At this point you need to understand that transactions increase or decrease assets, liabilities
and capital. Therefore,
To increase an asset we make a DEBIT entry

To decrease an asset we make a CREDIT entry
21
To increase a liability or capital account we make a CREDIT entry

To decrease a liability or capital account we make a DEBIT entry
Accounts
Assets
Liabilities
Capital
To record
An increase
A decrease
An increase
A decrease
An increase
A decrease
Entry in the account

Debit
Credit
Credit
Debit
Credit
Debit
CASH BOOK
Debit
Cash and bank receipts. From prime
documents:
Receipts issued
Bank paying-in slips
Bank giro credits received
BACS payment received
Credit card vouchers received
Credit
Cash and bank payments. From prime
documents:
Cheque book counterfoils

Standing order and direct debits
Debit advice from the bank: bank
charges, interest.
DOUBLE ENTRY BOOKKEEPING
Credit
Sales Ledger or
Debtors account
(money received)
Debit:
General Ledger
nominal account
(interest received)
Purchases Ledger or General Ledger

creditors account
nominal account
(amounts paid)
(rent account)
Example 2. Anthony Brown started a business on January 1st, and he has the following
transactions in the month:
edit:
Started with capital of 2,000 paid into the business bank account
Paid a cheque for 500 for the rent of the shop
Bought equipment for 600, paid by cheque
Purchased stock for resale and paid 450 by cheque
Returned some equipment unused. A cheque for 200 was received and paid into the
bank
7. Sold goods for 75; the money was paid into the bank
9. Bought business stationery for 12 and paid by cheque
17. Received a loan of 500 from A Finance; the cheque was banked
24. Sold more stock for 320 and the money was paid into the bank
1.
2.
3.
4.
5.
22
27. Paid wages of 35 by cheque

27. The telephone bill of 18 was paid by cheque
30. Drew a cheque for personal use for 300
You are required:
a) To draw up a table showing (for each transaction) the account titles to be used for the
Debit and Credit parts and the reasons why they are IN or OUT.
b) To write up a set of ledger accounts, which you must balance.
a) DEBIT IN
Jan
Account Title
1
Bank
owner
2
Rent
CREDIT OUT
Reason
Account Title Reason
Money received
Capital
Money from
Bank
Cheque paid
Bank
Bank
Equipment
Sales
Bank
Loan from
A Finance
Sales
Bank
Bank
Bank
Cheque paid
Cheque paid
Asset returned
Stock delivered
Cheque paid
Money paid
3
4
5
7
9
17
Equipment
Purchases
Bank
Bank
Stationery
Bank
Value received
From use of premises
Assets received
Stock received
Cheque received
Money received
Goods received
Cheque Received
24
27
28
30
Bank
Wages
Telephone
Drawings
Money received
Value received
Service received
Money received
Stock delivered
Cheque paid
Cheque paid
Cheque paid
(Note: Goods or stock bought for resale are called Purchases, money drawn for personal
use is called drawings)
b) Ledger Accounts
23
BANK ACCOUNT
Debit
Date
Jan 1
Jan 5
Jan 7
Jan 17
Jan 24
Feb 1
Credit
Detail
Capital
Equipment
Sales
Loan A Finance
Sales
2,000.00
200.00
75.00
500.00
320.00
Balance b/d
3,095.00
1,180.00
Date
Jan 2
Jan 3
Jan 4
Jan 9
Jan 27
Jan 28
Jan 30
Jan 31
Detail
Rent
Equipment
Purchases
Stationery
Wages
Telephone
Drawings
Balance c/d
500.00
600.00
450.00
12.00
35.00
18.00
300.00
1,180.00
3,095.00
CAPITAL
Date
Jan 31
Debit
Detail
Balance c/d
Date
2,000.00 Jan 1
Feb 1
Credit
Detail
Bank
2,000.00
Balance b/d
2,000.00
RENT
Date
Jan 2
Feb 1
Debit
Detail
Bank
Balance c/d
Date
500.00 Jan 31
500.00
Credit
Detail
Balance c/d
500.00
24
EQUIPMENT
Date
Jan 3
Debit
Detail
Bank
Feb 1
Balance b/d
Date
600.00 Jan 5
Jan 31
600.00
Credit
Detail
Bank
Balance c/d
200.00
400.00
600.00
400.00
PURCHASES
Date
Jan 4
Feb 1
Debit
Detail
Bank
Balance b/d
Date
450.00 Jan 30
450.00
Credit
Detail
Balance c/d
450.00
SALES
Date
Jan 31
Debit
Detail
Balance c/d
Date
395.00 Jan 7
Jan 24
395.00
Feb 1
Credit
Detail
Bank
Bank
75.00
320.00
395.00
Balance b/d
395.00
STATIONERY
Date
Jan 9
Feb 1
Debit
Detail
Bank
Balance b/d
Date
12.00 Jan 31
12.00
Credit
Detail
Balance c/d
12.00
25
Date
Jan 31
Debit
Detail
Balance c/d
LOAN - A FINANCE
Credit
Date
Detail
Jan
17
500.00
Bank
Feb 1
Balance b/d
500.00
500.00
WAGES
Date
Jan 27
Feb 1
Debit
Detail
Bank
Balance
Date
35.00 Jan 31
35.00
Credit
Detail
Balance c/d
Credit
Detail
Balance c/d
Credit
Detail
Balance c/d
35.00
TELEPHONE
Date
Jan 28
Feb 1
Debit
Detail
Bank
Balance
Date
18.00 Jan 31
18.00
18.00
DRAWINGS
Date
Jan 30
Feb 1
Debit
Detail
Bank
Balance
Date
300.00 Jan 31
300.00
300.00
26
2.4. Balancing the account

At regular intervals, often at the end of each month, accounts are balanced in order to show
the amounts of purchases, sales, purchases returns, sales returns, fixed assets (premises,
machinery), etc.
How do we balance the accounts?
Balancing the accounts is done in five stages:
1. Add up both sides to find out their totals, but do not write anything in the accounts
yet.
2. Deduct the smaller total from the larger total to find the balance.
3. Now enter the balance on the side with the smallest total. This is the balance to be
carried down (c/d). Do not forget to enter the last day of the period.
4. Enter totals on a level with each other.
5. The balance is then brought down (b/d), on the other side, below the totals. This is
the starting amount for the next period. Do not forget to enter the first day of the next
period.
BANK ACCOUNT
Debit
Date
Jan 1
Jan 5
Jan 7
Jan 17
Jan 24
Credit
Detail
Capital
Equipment
Sales
Loan A Finance
Sales
2,000.00
200.00
75.00
500.00
320.00
Date
Jan 2
Jan 3
Jan 4
Jan 9
Jan 27
Jan 28
Jan 30
Jan 31
3,095.00
Feb 1
Balance b/d
500.00
600.00
450.00
12.00
35.00
18.00
300.00
1,180.00
3,095.00
1,180.00
These are the totals on

a level with each other
Detail
Rent
Equipment
Purchases
Stationery
Wages
Telephone
Drawings
Balance c/d
This is the balance

to be carried down
27
Diploma in
Accounting
Accounting
Module 2: Verification of Records Accounts and
Balance Sheets
28
LESSON 3. VERIFICATION OF ACCOUNTING RECORDS
3.1. The trial balance
You have learnt that under the principle of double entry bookkeeping that for each debit entry
there is a credit entry, and for each credit entry there is a debit entry.
At the end of an accounting period, which is usually 12 months, a trial balance is extracted from
the accounting records in order to check the arithmetical accuracy of the double-entry
bookkeeping, i.e. that the debit entries equal the credit entries.
A trial balance is a list of the balances of every account forming the ledger, distinguishing
between those accounts which have debit balances and those which have credit balances.
The intervals at which a trial balance can be extracted are usually at the end of the month and/or
at the end of the accounting period (usually 12 months).
How to prepare a trial balance?
The Trial Balance is not an account, it is a list of accounts which have a balance.
The first step in preparing a trial balance is to go through the Ledger and balance all the
accounts, including the Cash Book.
The balance is always brought down, and the side on which it is brought down is the side it is
entered into the Trial Balance.
29
Example:
B&N Ltd
Trial Balance as at 31 December 2007
Stock at 31 Dec
Capital
Bank
Purchases
Cash
Wages
Sales
Fixtures and Fittings
Motor vehicles
Office Equipment
Insurance
Advertising
Debtors
Creditors
Dr
4,000.00
Cr
8,680.00
825.00
7,280.00
150.00
950.00
9,670.00
1,050.00
2,000.00
435.00
275.00
350.00
2,035.00
1,000.00
19,350.00
19,350.00
Usually, Debit balances are Assets or Expenses; Credit balances are Liabilities (including
Capital) or Incomes.
If the total debits agree with the total credits then the Trial Balance is balanced. This does not
necessarily means that no errors have been made, because there are certain types of errors which
do not show up in the Trial Balance. These will be explained later.
When the Trial Balance does not balance it indicates that one or more entries are missing or
incorrect.
Always total each side of the Trial Balance and calculate the difference. That could be the
amount has been omitted.
The error could be an incorrect addition or a transposition, where you intend to write for
instance 145 but instead you enter 154.
Alternatively it may help to halve the difference and then see if it has been put in the
wrong side.
If the amount is exactly divisible by 9, this could be as a result of transposition.
30
Check that the balance of each account has been correctly entered in the trial balance, and
under the correct heading, i.e. debit or credit.
Check the calculation of the balance of each account.
If the error is still not found, it is necessary to check the bookkeeping transactions since
the date of the last trial balance, by going back to the original documents and primary
accounting records.
Practice: Now go back to Example 2 in section 2.3 above and extract the Trial Balance.
3.2. The general journal

The Journal is the last of the Books of Original Entry. Any entries which do not go through the
day books, cash books or petty cash book should be entered in the Journal.
The Journal is the book of Prime, or Original, Entry for items for which there is no Day Book,
for example:
Opening entries
Purchase and sale of fixed assets on credit (e.g. cars, plant and machinery, office
equipment)
Introduction o f assets to the business by the owner
Entries for period-end and year-end adjustments
Transfer of year end balances following preparation of Final Accounts
Corrections of errors
The Journal provides a written record of the details of a transaction and enables an explanation to
be recorded. It is a primary accounting record; it is not part of the double-entry bookkeeping
system. The journal is used to list the transactions that are then to be put through the accounts.
What are the reasons for using a journal?
The reasons are:
To provide a primary accounting record for non-regular transactions

To eliminate the need for remembering why non-regular transactions were put through
the accounts the journal acts as a notebook
To reduce the risk of fraud, by making it difficult for unauthorised transaction to be
entered in the accounting system
To reduce the risk of errors, by listing the transactions that are to be put into the doubleentry accounts
To ensure that entries can be traced back to a prime document, thus providing an audit
trail for non-regular transactions
31
Look at the layout of the journal:

Journal
Date
Details
01-Jan-08 Bank
Capital
Opening capital introduced
Folio Dr
Cr
CB
10,000.00
GL
10,000.00
Remember:
All items must be dated.

The account to be debited is always entered before the account to be credited.
The account to be credited should be written a little to the right under the name of the
account to be debited.
Each entry must have a supporting narrative, with reference to whatever document
supports the entry, such as invoice number or management instructions
The folio column cross-references to the division of the ledger where each account will
be found
A journal entry always balances, i.e. debit and credit entries are for the same amount or
total.
The Journal is not a double entry account. Once the journal entry is made, the entry in the
double entry accounts can then be made.
32
Examples of journal entries:

Journal J1
Date
Sept 3
Sept 4
Sept 5
Sept 6
Details
Motor vehicle account
Carlan Ltd
Purchase of Fleet car
Invoice No 0246
C. Chapman
Equipment Account
Sale of computer cover
Invoice No 123
Machinery account
Machine Tool Co.
Buy printer
Invoice No MTC/47
Bank
Capital
Folio
GL4
PL7
Dr
Cr
14,500.00
14,500.00
SL8
GL5
135.00
GL3
PL8
6,800.00
CB1
GL10
135.00
800.00
800.00
Owner introduces 800 into

business
After the journal entry has been made, the transaction can be recorded in the double-entry
accounts:
Date
Sept 6
Date
Sept 3
BANK ACCOUNT CB1

Date
Details
800.00
Details
Capital
Folio
J1
Details
Carland Ltd
MOTOR VEHICLE ACCOUNT GL4

Folio
Date
Details
J1
14,500.00
Folio
Folio
33
Details
Machine Tool Co
MACHINERY ACCOUNT GL3

Folio
Date
Details
J1
6,800.00
Folio
Date
Sept 4
Details
Computer Cover
Folio
J1
C. CHAPMAN SL8
Date
Details
135.00
Folio
Date
Details
Folio
Date
Sept 5
Date
Date
CAPITAL ACCOUNT G10

Date
Details
Sept 6 Bank
CARLAND LTD G10

Date
Details
Sept 3 Fleet Car
Details
Folio
Details
EQUIPMENT ACCOUNT GL5

Folio
Date
Details
Sept 4 C. Chapman
Folio
J1
800.00
Folio
J1
14,500.00
Folio
J1
135.00
34
Date
Details
MACHINE TOOL COMPANY PL8

Folio
Date
Details
Sept 5 Machinery account
Folio
J1
6,800.00
If the trial balance does not balance, i.e. the two totals are different, there is an error or more than
one error: either in the addition of the trial balance and/or in the double-entry bookkeeping.
3.3. Checking the ledger.

As mentioned earlier in this course, a trial balance does not prove the complete accuracy of the
accounting records. There are six types of errors that are not shown by a trial balance:
1.
2.
3.
4.
5.
6.
Error of omission
Reversal of entries
Error of commission
Error of principle
Error of original entry (or transcription)
Compensating error
1. Error of omission. Entry missed out completely

An invoice for a transaction may be omitted completely, as in the case of a purchase
invoice not being entered into the purchases day books. The entry is then not made into
the credit side of the suppliers account, e.g. a transaction is made for 200 but the
invoice is not entered into the system. The day book and nominal ledger totals will be the
same but will be the amount of the invoice short. The trial balance will also balance but
again will be that amount short.
2. Reversal of entries. This happens when the entry is posted to the wrong side of the
account, e.g. P. Long buys goods to the value of 150 but this amount is credited to his
account instead of being debited. The same amount is debited to the sales account. The
double entry is complete but the entries are in reverse. Correcting this type of error
involves doubling the amount once to eliminate the error and again to put in the correct
item.
3. Error or commission. The amount to be posted has been entered into the wrong specific
account but into an account of the same general type, e.g. D. West has been credited with
20 instead of D. J. West. Both of these accounts are personal accounts in the Purchases
ledger and in this case the double entry has been completed.
35
4. Error of principle. The amount posted has not only gone to the wrong account but that
account is a different type of account. An example of this is where, after the purchase of a
motor van for 1,800, the amount has been posted to the Motor Expenses Account
(nominal ledger) instead of the Motor Van account (capital account). Here, capital
expenditure has been treated as revenue.
5. Error of original entry. The wrong figure has been used in both the postings. An example
of this is when an invoice is over or understated when entered into the system, e.g. D.
Smith bought goods for 150 but the amount entered into the sales day book was 105.
The amount of 105 from the sales day book will be posted to the sales account which
will result in both accounts being understated by 45.
6. Compensating error. This is where one error cancels out another of the same value but is
not connected, e.g. the wages account is overstated by 200 and the purchases account is
understated by 200. This will mean that the errors will cancel one another out when the
totals are transferred to the trial balance.
As you can see now, all these errors may occur and yet the Trial Balance will still balance. A
trial balance that balances only confirms that the arithmetic is correct but all the entries may not
be.
3.4. Bank Reconciliation

The bank account kept by the business is unlikely to show the same balance as the bank
statement. Why do you think this is?
Probably you are thinking that there is an error, as it would be the first thing most people would
think. The error may have been made either by the business or by the bank. Nevertheless, that is
not normally the case, although there may be discrepancies in some of the items in the bank
statement and the bank account kept by the business.
Apart from the event of a possible error made, there are other reasons which explain why the
balance is different:
The bank may make entries which the business has not taken into account, e.g. bank
charges or bank interest. Those amounts may not be known until the statement is
received. However, with established business accounts the banks will now often advise
the charges and interest in advance before the transaction date. This gives the customer
the advantage of being able to discuss the charges with the bank and make any savings on
the type of transactions he or she uses.
Payments may be made to the business, or on behalf of the business, by means of
standing orders or direct debits. With standing order. We instruct the bank as to how
36
much is to be paid. With a direct debit we give the third party the right to let the bank
know how much is to be debited.
There may be differences due to the timing of transactions. Cheques are received and
paid into the bank, these are recorded and added to the bank account, by the business. At
this time the bank may not have cleared them. Cheques paid-out will have to be sent to
the creditor, paid-into the creditors bank and then processed; this means a delay of
several days.
There are two things to notice regarding the statement:

1. It uses the running balance format
2. The entries are the opposite to the Cash Book Accounts in the companys books of
account, i.e., the Debit side is for Payments, the Credit side is for Receipts.
This is because, from the banks point of view, the business is a creditor of the bank, unless the
account is overdrawn).
Some abbreviations used on a bank statement are explained at the foot of the page, but I have
listed examples of some of the most common ones;
SO = standing order
DD = direct debit
TR = transfer
OD = balance overdrawn
Stages in the reconciliation
1. When studying the bank account and the bank statement majority of entries will agree:
these you need to tick off, so that you can concentrate on finding the entries which do not
agree.
Remember: you are looking for receipts which you have entered in the debit side of your
cash book bank account and which also appear on the credit side of the bank statement.
Likewise, payments will have been entered on the credit side of your cash book bank
account and on the debit column of the bank statement.
2. When that stage is complete, you may have some items unticked in both the cash book
bank account and the statement.
The items left unticked on the statement will be amounts that have been recorded by the
bank but not the business. The cash book needs to be updated with this information
before the account can finally be balanced off. The account will normally have been left
open so that these adjustments can be made when the statement arrives.
These items may include bank charges or interest, etc.
37
3. We are now left with the items left unticked in the cash book. These differences are
probably due to the time delay. These differences need to be reconciled with the bank
statement. This is done by means of a bank reconciliation statement showing the effective
date of this action.
Lets see how it is done with an example. We will start with the balance of the bank statement
and reconcile it to the Cash Book:
Date
Apr 1
Apr 12
Apr 20
Apr 27
Apr 30
Detail
E. Slater
B. Brockle
B. Young
K. Palm
J. Bow
Apr 30
Balance b/d
Date
Apr 2
Apr 6
Apr 11
Apr 13
Apr 17
Apr 20
Apr 27
Apr 30
CASH BOOK
BANK ACCOUNT
Date
540.00 Apr 2
600.00 Apr 7
926.00 Apr 14
69.00 Apr 26
700.00 Apr 30
Apr 30
2,835.00
1,697.00
Detail
E. Slater
F. Keeble
J. Wessley
s/o W. Tyre
B. Brockle
R. Hull
d/d W. Tebb
B. Young
Tr. K. Robb
K. Palm
Bank Charges
K. Palm. Cheque returned
BANK STATEMENT
Dr
Detail
F. Keeble
J. Wessley
R. Hull
D. Rogers
C. Holme
Balance c/d
Cr
540.00
24.00
252.00
100.00
600.00
74.00
125.00
926.00
50.00
69.00
10.00
69.00
Balance
540.00
516.00
264.00
164.00
764.00
690.00
565.00
1,491.00
1,541.00
1,610.00
1,600.00
1,531.00
24.00
252.00
74.00
418.00
370.00
1,697.00
2,835.00
CR
CR
CR
CR
CR
CR
CR
CR
CR
CR
CR
CR
Required: Prepare a bank reconciliation statement as at 30 April with the information provided.
1. Tick off the common items.
2. Now you should be left with:
38
Bank Account:
J. Bow
D. Rogers
C. Holme
Statement:
s/o W. Tyre
d/d W. Tebb
tr. K. Robb
Bank charges
K. Palm. Returned cheque
3. Update the Bank Account DR balance 1,443, as illustrated below

4. Prepare the Statement of Reconciliation.
Date
Apr 30
Apr 20
Detail
Balance b/d
tr. K Robb
May 1
Balance b/d
CASH BOOK
BANK ACCOUNT
Date
Detail
1,697.00 Apr 11 W. Tyre
50.00 Apr 17 W. Webb
Apr 30 Bank charges
Apr 30 K. Palm. Returned cheque
Apr 30 Balance c/d
1,747.00
100.00
125.00
10.00
69.00
1,443.00
1,747.00
1,443.00
39
BANK RECONCILIATION STATEMENT

AS AT 30TH APRIL
Balance per Bank Statement

ADD outstanding lodgement
30th April J. Bow
Deduct cheques not presented
26th April D. Rogers
29th April C. Holme
1531
700
2231
418
370
Total
788
1443
Balance per Cash Book
1443
A bank reconciliation statement is important because, in its preparation, the transactions in the
bank columns of the cash book are compared with those recorded on the bank statement. In this
way, any errors in the cash book or bank statement will be found and can be corrected (or
advised to the bank, if the bank statement is wrong).
The bank statement is an independent accounting record, therefore it will assist in deterring fraud
by providing a means of verifying the cash book balance.
By writing the cash book up-to-date, the organisation has an amended figure for the bank balance
to be shown in the trial balance.
Unpresented cheques over six months old out-of-date cheques can be identified and written
back in the cash book (any cheque dated more than six months ago will not be paid by the
bank).
It is good practice to prepare a bank reconciliation statement each time a bank statement is
received. The reconciliation statement should be prepared as quickly as possible so that any
queries either with the bank statement or in the firms cash book can be resolved. Many firms
will specify to their accounting staff the timescales for preparing bank reconciliation statements
as a guideline, if the bank statement is received weekly, then the reconciliation statement
should be prepared within five working days.
If the bank account is overdrawn, the reconciliation should be carried out in the same way but
with the balance in the minus, e.g.:
Bank statement balance: 100 OD
In the Bank Reconciliation statement your will enter:
40
-100 or (100)
Balance per Bank Statement
3.5. Control Accounts

As a business grows and the number of Debtors and Creditors increase, a far tighter check must
be kept on the Total Balances and also the accuracy of the double-entry.
Control accounts enable us to do this and to speed up the job of calculating total balances for
both Creditors and Debtors.
Control account, like the Trial Balance and Bank Reconciliation, acts a checking device for the
individual accounts which it controls. Thus, control accounts act as an aid to locating errors: if
the control account and subsidiary accounts agree, then the error is likely to lie elsewhere. In this
way the control account acts as an intermediate checking device proving the arithmetical
accuracy of the ledger section.
The two commonly-used control accounts are:
Sales ledger control account the total of the debtors

Purchases ledger control account the total of the creditors
The layout of a sales ledger control account (or debtors control) is shown below:
Dr
Sales Ledger Control Account
Balance b/d (large amount)

Balance b/d (small amount)
Credit sales
Cash/cheques received from debtors
Returned cheques
Cash discount allowed
Interest charged to debtors
Sales returns
Balances c/d (small amount)
Bad debts written off
Set-off/contra entries
Balance c/d (large amount)
Balances b/d (large amount)
Cr
Balances b/d (small amount)
41
Balance b/d. The usual balance on a debtors account is debit and so this will form the large
balance on the debit side. However, it is possible for some debtors to have a credit balance on
their accounts because they has paid for goods and then returned them, or because they have
overpaid in error.
Credit sales. Only credit sales, and not cash sales, are entered in the control account because it is
this transaction that is recorded in the debtors accounts. The total sales of the business will
comprise both credit and cash sales.
Returned cheques. If a debtors cheque is returned unpaid by the bank, i.e. the cheque has
bounced, then entries have to be made in the bookkeeping system to record this. These entries
are:
Debit debtors account

Credit bank account
As the transaction has been made in a debtors account, then the amount must also be recorded in
the sales ledger control account, on the debit side.
Interest charged to debtors. Sometimes a business will charge a debtor for slow payment of an
account. As a debit transaction has been made in the debtors account, so a debit entry must be
recorded in the control account.
Bad debts written off. The entries are:
Debit bad debts written off account

Credit debtors account
As a credit entry has been made in a debtors account, the transaction must also be recorded as a
credit transaction in the control account.
Set-off/contra entries. These entries occur when the same person or business has an account in
both sales and purchases ledger, i.e. they are both customer and supplier. To save having to write
out a cheque to send to each other, it is possible to set-off one account against the other.
The layout of a purchases ledger control account (or creditors control account) is shown below:
Dr
Purchases Ledger Control Account
Balance b/d (small amount)

Balance b/d (large amount)
Cash/cheques paid to creditors
Credit purchases
Cash discount received
Interest charged by creditors
Purchases returns
Balances c/d (small amount
Set-off/contra entries
Balance c/d (large amount)
_________
________
_________
Balances b/d (small amount)
Cr
________
Balances b/d (large amount)
42
Balances b/d. For purchases ledger, containing the accounts of creditors, the large balance b/d is
always on the credit side. However, if a creditor has been overpaid, there may be a small debit
balance b/d.
Credit purchases. Only credit purchases, and not cash purchases, are entered in the control
account. However, the total purchases of the business will comprise both credit and cash
purchases.
Interest charged by creditors. If creditors charge interest because of slow payment, this must
be recorded on both the creditors account and the control account.
Set-off/contra entries. See the explanation given above under Sales Ledger Control Account.
Control accounts use totals. Those totals come from a number of sources in the accounting
system:
Sales ledger control accounts:
total credit sales (including VAT), from the gross column of the sales day book
total sales returns (including VAT), from the gross column of the sales returns day book
total cash/cheques received from debtors, from the cash book
total discount allowed, from the discount allowed column of the cash book, or from
discount allowed account
bad debts, from the journal, or bad debts written off account
purchases ledger control accounts:
total credit purchases (including VAT), from the gross column of the purchases day
book
total purchases returns (including VAT), from the gross column of the purchases returns
day book
total cash/cheques paid to creditors, from the cash book
total discount received, from the discount received column of the cash book, or from
discount received account.
Whilst many businesses merely use Control Accounts as a checking device there are businesses
which actually integrate Control Accounts into their double entry bookkeeping system. In such
circumstances the individual accounts of debtors and creditors are kept only as memorandum
accounts, and the balances of the sales ledger control account and the purchase ledger control
account are recorded in the trial balance as the figures for debtors and creditors respectively.
43
3.6. Suspense accounts and errors

Whist certain errors will not be disclosed by the Trial Balance (error of omission, commission,
principle, original entry, reversal of entries and compensating errors), there are of course errors
of an arithmetical nature which the Trial Balance is designed to detect. Such errors include:
Entries are posted without completing double entry. There may be debits without
corresponding credits or vice versa.
Different amounts are posted as debit and credit entries.
An account is incorrectly totalled or balanced.
Balances shown on the Trial Balance have been listed incorrectly there may be
omissions, duplications or transpositions.
Where the total columns of the Trial Balance fail to agree an investigation into the reason(s) for
the imbalance will have to be carried out. As a temporary measure we will open a Suspense
Account, and by posting the difference in books amount to it, bring the books into balance.
In addition to using the Suspense Account to deal with errors the Suspense Account may also be
used as a holding account. This usually occurs in cases where the correct posting of a
transaction is uncertain due to lack of information, or where a transaction is of a complicated or
unusual nature. This should only be used as a temporary measure until further information
becomes available, following which the posting can be removed from the Suspense Account and
posted correctly.
If the errors are not found before the financial statements are prepared, the suspense account
balance will be included in the balance sheet. Where the balance is a credit balance, it should be
included on the capital and liabilities side of the balance sheet. When the balance is a debit
balance it should be shown on the assets side of the balance sheet. You will learn about assets
and liabilities and the balance sheet in the final section of this unit.
Remember: when the errors are found they must be corrected, using double entry. Each
correction must first have an entry in the journal describing it, and then be posted to the accounts
concerned.
The Trial Balance on 31 December 2007 had a difference of 168. It was a shortage on the debit
side.
A suspense account is opened, and the difference of 168 is entered on the debit side. On 31 May
2008 the error was found. We had made a payment of 168 to K Lee to close his account. It was
correctly entered in the Cash Book, but was not entered in K Lees account.
44
First of all, the account of K Lee is debited with 168, as it should have been in 2007:
K Lee
May 31
Bank
168
Jan 1
Balance b/d
168
Second, the suspense account is credited with 168 so that the account can be closed:
Jan 1
Suspense Accounts
Difference per trial balance
168 May 31
K Lee
168
And the Journal entry is:

The Journal
Dr
May 31
K Lee
Suspense
Correction of non-entry of payment last year
in K Lees account
Cr
168
168
The effect of errors on profits:

Some of the errors will have meant that original profits calculated will be wrong. Other errors
will have no effect upon profits.
If an error affects items only in the balance sheet, then the original calculated profit will not need
altering. For example, an error involving a creditors account.
If an error is in one of the figures shown in the trading and profit and loss account, then the
original profit will need altering. For example, an undercast of sales account, when corrected,
will increase gross and net profits and consequently the profit figure shown in the balance sheet.
45
Example:
T Mortons Trading and Profit and Loss Account for the year ended 31 December 2007 shows a
profit of 1,600, the Balance Sheet has a suspense account with a debit balance of 60. On 31
March 2008 you discovered that the debit balance of 60 was because the rent account was
added up incorrectly. The journal entries to correct it are:
The Journal
Dr
March 31
Rent
Suspense
Correction of rent undercast last year
Cr
60
60
Rent last year should have been increased by 60. This would have reduced net profit by 60. A
statement to correct profit for the year is now shown:
T Morton
Statement of Corrected Net Profit for the year ended 31 December 2007
Net profit per the accounts
Less Rent understated
1,600
(60)
1,540
Note: Only those errors which make the trial balance totals different form each other ca be
corrected via the suspense account.
Summary of the effect on profit and balance sheet:
Look at the diagram below which shows the effect of errors when corrected on gross profit, net
profit and the balance sheet:
46
TRADING ACCOUNT
Correction of error
Gross profit Net profit
Balance sheet
Sales undercast/understated
Sales overcast/overstated
Purchases undercast/understated
Purchases overcast/overstated
Opening stock undervalued
Opening stock overvalued
Closing stock undervalued
increase
decrease
decrease
increase
decrease
increase
increase
increase
decrease
decrease
increase
decrease
increase
increase
Closing stock overvalued
decrease
decrease
net profit increase

net profit decrease
net profit decrease
net profit increase
net profit decrease
net profit increase
net profit increase
Stock increase
net profit decrease
Stock decrease
PROFIT AND LOSS ACCOUNT

Correction of error
Expense undercast/understated
Expense overcast/overstated
Income undercast/understated
Income overcast/overstated

-
decrease
increase
increase
decrease
Balance sheet
decrease in net profit
increase in net profit
increase in net profit
decrease in net profit
BALANCE SHEET
Correction of error
Asset undercast/understated
Asset overcast/overstated
Liability undercast/understated
Liability overcast/overstated

-
Balance sheet
increase asset
decrease asset
increase liability
decrease liability
47
LESSON 4. FINAL ACCOUNTS
4.1 Introduction.
At the end of each financial year various financial statements are prepared on behalf of a
business organisation. Such statements, which give details of its operating activities and financial
standing, are commonly referred to as Final Accounts.
Many businesses, however, prepare financial statements on an ongoing basis say monthly,
quarterly or half-yearly. These can be used to monitor, plan and control the activities of the
business, and are known as Management Accounts or Periodic Financial Statements.
The financial statements usually consist of a:
Trading Account
Profit and Loss Account
Balance Sheet
Where a business provides only a service, rather than trades (buys and sells), it will prepare only
a Profit and Loss Account and Balance Sheet.
Where a business manufactures the goods in which it trades then it will prepare a Manufacturing
Account in addition to the Trading and Profit and Loss Account and Balance Sheet.
In practice the financial statements are prepared either by transferring appropriate balances from
accounts within the ledgers, or by listing account balances appearing within the ledgers.
The Trading and Profit and Loss Accounts are used to calculate profit or loss. The Balance Sheet
reflects the financial position of the business as at the end of the financial period and is drawn up
by listing and categorising all balances on accounts as at a particular point in time.
What is profit?
Essentially, it is revenue from the sale of goods and services minus expenditures incurred
in the creation of those goods and services
The starting point for preparing final accounts is the trial balance. All the figures recorded on the
trial balance are used in the final accounts. The trading account and the profit and loss account
are both accounts in terms of double-entry bookkeeping. This means that amounts recorded in
these accounts must also be recorded elsewhere in the bookkeeping system. By contrast, the
balance sheet is not an account, but is simply a statement of account balances remaining after the
trading and profit and loss accounts have been prepared.
48
Remember that apart from the owner of the business there are other parties who will need to
know whether the company is profitable or whether it has been running at a loss. The people
interested in this information would include:
The Bank
Shareholders
Creditors
Revenue & Customs
The Final Accounts must be accurate. Mistakes should be discovered and the corrections made.
These accounts are based on figures provided by all the other accounts kept by the business and
the trial balance must have been balanced before you can proceed any further.
4.2 Profit and Loss account. Gross and net profit.

The main reason why people set up businesses is to make profits. However, if the business is not
successful, it will incur losses instead.
The owners want to know the actual profits of the business, which will help them in planning
ahead, obtaining loans from banks or private individuals, in calculating the correct amount of tax
that has to be paid to the Revenue.
The profits are calculated by drawing up a special account called Trading and Profit and Loss
Account. Nowadays it is simply called Profit and Loss Account.
The account in which profit is calculated is split into two sections:
One in which the gross profit is found: Trading Account

the next section in which the net profit is calculated: Profit and Loss Account
1. The Trading Account. This account, prepared by transferring the balances on other
accounts within the General Ledger, is used to calculate the Gross Profit of the business
for a particular period of trading.
Gross Profit is the excess of sales revenue over the cost of goods sold. Where the cost of
goods sold is greater than the sales revenue, the result is a gross loss. The calculation
being:
Income from Net Sales (sales less sales returns)
Less Cost of Goods Sold = Gross Profit
49
The cost of goods sold figure is made up of a combination of account balances which
normally includes:
Opening stock
Add purchases
Less purchase returns
Add carriage inwards
Less closing stock
= Costs of Goods Sold
2. The Profit and Loss Account. This also an account prepared by transferring balances
from General Ledger accounts. The objective is to calculate the net profit or loss of the
business for a defined period of business activity. To do so we add to the Gross Profit for
the period any revenue income earned, but from non-trading activities, and then deduct
the revenue expenses associated with selling, distribution and administration:
Gross Profit (from Trading Account)

Add other non-trading income
Less expenses
= Net Profit / Loss
Remember: Before drawing up a trading and profit and loss account you should prepare the trial
balance, after all the adjustments have been made. (You will learn about those adjustments later
in this unit.)
The layout of the Profit and Loss Account:
[Business Name]
Trading and Profit and Loss Account for the year ended [accounting period date]
Sales
Less: Cost of sales
Opening stock (+)
Purchases
(+)
Closing stock (-)
[subtotal of cost of sales]
Gross profit [sales minus cost of sales subtotal]
Less: Expenses
[category of expenses] (+)
[subtotal of expenses]
X
X
X
(X)
(X)
X
X
X
X
(X)
50
Net profit / (loss) [gross profit minus subtotal of expenses]
Here is an example of the Profit and Loss Account of Swift, a trader:
Swift
Trading and Profit and Loss Account for the year ended June 30, 2008
Sales
150,000
Less: Costs of sales

Opening stock
Purchases
Closing stock
18,000
107,000
125,000
(20,000)
(105,000)
45,000
Gross profit
Less: Expenses
Rent
Wages
Advertising
Net profit
12,000
10,000
8,000
(30,000)
15,000
Click on the link below and on the right-hand side of the page you will see different headings
which summarise what you have learnt about Profit and Loss Account. You will also find an
example of Mark and Spencers Profit and Loss Account.:
http://www.tutor2u.net/business/presentations/accounts/profitlossaccount/default.html.
Revision P&L Account
You can try your understanding of this topic by trying a quiz on Profit and Loss Account in the
following link: http://www.tutor2u.net/business/quizzes/as/profit_and_loss/quizmaker.htm.
Quiz on P&L
51
4.3 Balance Sheet. Fixed assets, current assets, current liabilities.

We have seen earlier that the trading and profit and loss account shows two types of profit (gross
profit and net profit) for the financial year. However, the balance sheet is not an account but a list
of assets and a list of liabilities and capital to show the financial position of the business at a
particular point in time, but is not part of the double-entry bookkeeping system. It also contains
the capital account that represents the owners interest in the business.
In drawing up a balance sheet, we do not enter anything in the various accounts. We do not
actually transfer the fixtures and fittings balance or the creditors balance, or any of the other
balances, to the balance sheet.
All we do is to list the asset, capital and liabilities balances so as to form a balance sheet.
However, nothing is entered in the ledger accounts and when the next accounting period starts,
these accounts are still open and they all contain balances.
52
Here is the general layout of the Balance Sheet:
[Business Name]
Balance Sheet as at [last day of accounting period]
Fixed assets
[category]
[category]
(+)
(+)
X
X
X
Current assets
Stock (closing stock)
Debtors
Bank
[current assets total]
X
X
X
X
Current liabilities
Creditors
X
Bank overdraft
X
[current liabilities total]
Net current assets [current assets total current liabilities total]
(X)
X
X
Long-term liabilities
Bank loan
Net assets [assets minus liabilities]
(X)
AX
Capital account
Opening balance
Net profit for the year
Less drawings
X
X
X
(X)
BX
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Here is the Balance Sheet for Swift:

Swift
Balance Sheet as at June 30, 2008
Fixed assets
Office equipment
Motor vehicles
15,000
85,000
100,000
Current assets
Stock
Debtors
21,000
30,000
51,000
Current liabilities
Creditors
Bank overdraft
15,000
16,000
(31,000)
Net current assets
20,000
120,000
Long-term liabilities
Bank loan
Net assets
Capital account
(50,000)
A
Opening balance
Net profit for the year
70,000
80,000
15,000
95,000
(25,000)
Drawings
B
70,000
If the Balance Sheet has been constructed correctly, the total at A and B will be the same.
Remember: if they are not the same, you have made an error somewhere! But do not worry, it
will get easier once you have worked through a few examples.
54
Assets
Assets are items or amounts owned or owed to the business, and are normally listed in increasing
order of liquidity, i.e. the most permanent assets are listed first, i.e., those the business will keep
the longest are listed first, down to those which will not be kept so long:
Fixed Assets:
Land and buildings
Fixtures and fittings
Machinery
Motor vehicles
Fixed Assets are long-term assets. They are assets that are to be used in the business for a
long time but were not bought primarily to be sold. They are divided between tangible
fixed assets, which have material substance, e.g.: buildings, machinery motor vehicles,
fixtures and fittings; and intangible fixed assets, which do not have material substance,
but belong to the business and have value, e.g., goodwill. Goodwill is where a business
has bought another business and paid an agreed amount for the existing reputation and
customer connections.
Intangible fixed assets are listed before the tangible fixed assets.
Current Assets are short-term assets which are likely to change from day-to-day. They
include items held for resale, amounts owed by debtors, cash in the bank. They are listed
in increasing order of liquidity. Examples: stock, debtors, bank (if not overdrawn) and
cash. We start with the asset furthest away from being turned into cash:
Current Assets:
Stock
Debtors
Cash at bank
Cash in hand
Net current asset is a very useful figure. A typical business will have a stock of
materials, money owing to it (debtors) and some funds in the bank. Those are the current
assets, as you have just learnt. They represent those things the business has used its
capital to acquire that are constantly changing. There are other things that do not belong
to the business but which it has temporally and which help it to continue working. These
can include amounts owed to suppliers (creditors) and an overdrawn bank account.
55
All these items, both those that belong to the business and those that it has temporally,
change on a day-to-day basis and they are known as working capital.
In the Balance Sheet, the ones that belong to the business are called current assets and
those that it has temporary use of are called current liabilities. When you subtract the
current liabilities from the current assets, you get the net current assets or working
capital figure:
Working capital = current assets current liabilities
If the value of working capital is low or negative, the business might have financial
problems if it had to pay back its current liabilities. This is why the net current asset
figure is important.
Liabilities
Liabilities are items or amounts owed by the business. There are two categories of liabilities:
current liabilities and long-term liabilities.
Current liabilities are amounts owing at the balance sheet date and due for repayment
within 12 months or less, e.g., creditors, bank overdraft.
Long-term liabilities are borrowings where repayment is due in more than 12 months,
e.g., bank loans, loans from other businesses.
Capital
Capital is money owed by the business to the owner. If you look back to the example of Balance
Sheet you will see that we showed the owners investment at the start of the year (opening
balance), then we added up the profit for the year and we deducted drawings for the year; this
equals the owners investment at the end of the balance sheets date.
For a revision of the Balance Sheet, click on the following link and use the headings on the righthand side of the web page:
www.tutor2u.net/business/presentations/accounts/balancesheet/default.html. Revision of the
Balance Sheet.
Now try the following quiz on Balance Sheet:
http://www.tutor2u.net/business/quizzes/as/balance_sheet/quizmaker.htm. Quiz on Balance
Sheet
56
4.4 Adjustments: prepayments, accruals, bad debts, depreciation (straightline method)

The Trading and Profit and Loss Account should provide the reader with a true and fair account
of the operational activities, in terms of the profit or loss, of a business for a particular period of
business activity.
The Balance Sheet should provide the reader with a true and fair view of the financial standing
of a business as at the end of a particular period of business activity.
In order that the financial statements (Profit and Loss and Balance Sheet) are true and fair,
account balances within the books may have to be adjusted to reflect the operating activities of a
business, and its financial standing. Such adjustments include accounting for prepayments and
accruals, depreciation, debtor adjustments, stock (you will learn about stock valuation in
module three)
The fundamental accounting concept known as matching requires that the profit/loss calculation
for a trading period be the result of Income earned in a trading period less expenses incurred
during the same period.
The calculation of profit/loss merely by deducting cash paid out in a period from cash received in
a period is not an acceptable method of calculating profit/loss.
Period end adjustments are necessary because some of the information required for the
preparation of financial statements only becomes available after the end of the accounting period.
In addition, some things are either paid early (e.g. telephone line rental, rent, insurance) or paid
late (e.g. electricity, telephone call charges) and certain judgements need to be made concerning
the use of fixed assets, the status of debtors and the valuation of closing stock.
Prepayments are amounts paid in advanced of the accounting period to which it relates.
Accruals are amounts due in an accounting period which is unpaid at the end of that period.
As a result of accounting for prepayments and accruals the correct amount, in terms of income
earned and expense incurred during a period of trading, will be transferred from the General
Ledger to the Trading and Profit and Loss Account. Furthermore, any prepayment or accrual
adjustment appearing on an income or expenditure account in the General Ledger, at the
financial period end, will be listed on the Balance Sheet as either a current asset or current
liability.
Adjustments may be necessary to account for items of income and expense in terms of:
Amounts paid in advance.

Amounts received in advance.
57
Amounts payable in arrears.

Amounts receivable in arrears.
Examples:
Accruals:
Assume that a business has a 31 December year end. It received quarterly gas bills of 200 on 31
August, 250 on 30 November and 360 on 28 February. What is its gas expense for the year?
To start we open up a T account and show the bills of 200 and 250, which have occurred
during the period have been paid from the bank account on those dates.
August 31
November 30
Bank
Bank
Gas expense
200
250
The business received a gas bill for 360 for the three months to the end of February. One of the
three months is December, so the accrual is 1/3rd of the 360, which is 120. This accrual is
debited in the T account for gas and credited to an accruals T account (a Balance Sheet
creditor).
August 31
November 30
December 31
Bank
Bank
Accruals
Gas expense
200
250
120
Accruals
December 31
Gas
120
We now balance the gas account with a balancing figure of 570 which is transferred to the
profit and loss account:
August 31
November 30
December 31
Bank
Bank
Accruals
Gas expense
200
250
120
P&L A/c
570
570
570
Accruals
58
December 31
Balance c/d
120
December 31
Gas
120
December 31
Balance b/d
120
The closing balance of 120 appears in the balance sheet as a creditor due within one year.
At the start of the next accounting period this accrual must be transferred back to the gas expense
account because this outstanding gas expenses will actually be paid during the next accounting
period.
Prepayments:
The same business paid rates on 1 April 2007 for the year ended 31 March 2008.
We start off by opening up the rates ledger account and posting the payments on the debit side.
Rates expense
April 1
Bank
4,400
Now we calculate the prepayment. The business has prepaid for January, February and March of
2008, which is 3 months, so the prepayment is 3/12th of 4,400 which is 1,100
The prepayment of 1.100 is debited to a prepayments T account (a Balance Sheet asset, like a
debtor) and credited to the rates T account thus reducing the rates expense in 2007.
April 1
Bank
Rates expense
4,400
December 31 Prepayments
December 31
Rates expenses
1,100
Prepayments
1,100
We are now in position to balance off the rates expense account. The balancing figure comes to
3,300, which is taken to the Profit and Loss Account.
April 1
Bank
Rates expense
4,400
P&L A/c
December 31 Prepayments
4,400
3,300
1,100
4,400
59
December 31
Rates expenses
Prepayments
1,100
December 31 Balance c/d
December 31
Balance b/d
1,100
1,100
The closing prepayment of 1,100 appears in the Balance Sheet as a current asset.
At the start of the next accounting period this prepayment must be transferred back to the rates
expense account because it represents the rates expense that the business will incur in January,
February and March of 2008.
Bad debts
When a business is unable to collect a debt from a credit customer (trade debtor) the result is
reduced profit.
Despite the best efforts of a business regarding credit control it is inevitable that where a
business gives credit to customers bad debts will follow.
A bad debt materialises when an amount due from a credit customer is deemed to be
uncollectible. At this point in time the business has given up trying to collect the debt and is
being prudent by recognising that a loss has been incurred.
A bad debt is a debt owing to a business which it considers will never be paid.
The accounting for a bad debt is as follows:
You will transfer the amount uncollectible from the customer account in the Sales
Ledger, where it represents an asset, to a Bad Debts Account in the General Ledger,
where now represents an expense. The balance on the Bad Debts Account will then be
transferred at the financial year end to the Profit and Loss Account. Both transactions
need to be supported by Journal entries.
Provision for doubtful debts
A provision is the estimate of likely loss, which it is anticipated may result from debtors, who
currently owe the business money, failing to pay at some time in the future.
Whereas a bad debt occurs in circumstances where the customer who defaults on payment is
known, this is not the case when making a provision for doubtful debts.
You will not be required to do entries for the provision of doubtful debts. Therefore, we are not
going to spend any more time on this.
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Example:
Michelle has debtors of 15,000. However, Charlie, who owes 800, has just been declared
bankrupt so Michelle decides to write off the debt.
We start off with a debit balance in our debtors account of 15,000. The double entry in respect
of the debt to be written off is to debit the bad debt expense account 800 and credit debtors
800. As consequence, our debtors total falls to 14,200. At the end of the accounting period, we
post the bad debt expense to the Profit and Loss Account.
Debtors
Bad debt expense - Charlie
Balance c/d
15,000
Balance b/d
15,000
Balance b/d
14,200
Debtors Charlie
Bad debt expense

800
P&L A/c
800
14,200
15,000
800
Depreciation
Before you learn the calculation and accounting for depreciation it is important to understand the
two types of business expenditure: revenue expenditure and capital expenditure.
Revenue expenditure. It has a short tem effect on the profit making capacity of the
business and does not add to the value of fixed assets. As a result it is transferred each
year to Trading and Profit and Loss Account, e.g. repairs to a van.
Capital expenditure. It has a long term effect on the profit making capacity of the
business. It included the acquisition costs of fixed assets, along with other costs which
may be incurred in making a fixed asset operational or/and improving its profit making
capacity. Included in such amounts will be legal costs of acquiring the fixed asset and
carriage inwards.
As there is a benefit derived from the use of fixed assets over several accounting periods, their
costs is spread as fairly as possible over the accounting periods which benefit from their use.
61
Depreciation is a way of measuring the amount of the fall in value of fixed assets over a period
of time. It is an estimate of likely loss in value.
Factors causing depreciation:
Physical deterioration: assets such as plan and machinery, vehicles, equipment, etc., are
subject to loss in value due to usage and wear and tear.
Time: assets such as leases, patents and copyrights are depreciated by the passing of time.
Economic reasons: obsolescence, e.g. computers and hi-tech equipment are constantly
under development; inadequacy, e.g. a piece of equipment no longer meets the needs of
the business.
Consumption/Depletion: assets such as quarries, mines and forests are depreciated based
on the fact that they are of a wasting nature.
Methods of calculating depreciation:

The two most common methods of calculating depreciation are:
Straight-line method
Reducing balance method
We are going to focus on the straight-line method. With this method, a fixed percentage is
written off the original cost of the asset each year. The annual depreciation charge is calculated
as:
Cost of asset estimated residual value
Number of years expected use of asset
For example, a machine bought for 2,000 is expected to have a residual value of 400 after an
useful economic life of 4 years, do the depreciation amount will be:
2,000 - 400 = 400 per year
4 years
62
Self Assessment Examination Preparation (SAP)

SAPs are designed to familiarise students with their materials and prepare you to
formulate answers when you take your online examinations.
These questions are active learning and submission to the tutor department is optional.
Question 1
1) Jonathan started a business selling medals on June 1, 2008. The transactions for his first
month of trading are as follows:
June:
2
2
3
3
4
5
8
10
12
15
16
17
19
22
23
24
25
29
30
Opened a business bank account and deposited 10,000 of his own money as capital.
Installed a safe and paid the supplier 2,400 by cheque.
Bought medals on credit for 4,350.
Paid an insurance premium of 650 by cheque.
Bought medals by cheque for 653.
Bought stationery costing 611 and paid by cheque.
Paid advertising costs of 1,000 by cheque.
Sold medals for 3,050 and received a cheque from the customer for the full amount.
Sold medals on credit for 2,000.
Bought medals on credit for 6,892.
Medals with a selling price of 350 were returned by a credit customer.
Paid an agency 650 for administrative assistance.
Paid 340 for car hire.
Received 1,000 from debtors.
Sold medals on credit for 2,060.
Returned medals that had originally cost 706 to a credit supplier.
Paid business telephone bills of 80.
Sold medals for 830, which was settled by cheque on the same day.
Paid creditors 7,800.
Required:
a) Write up the above transactions in T accounts and balance the accounts at April 30,
2008.
(10 marks)
63
(for quality of presentation: plus 1 mark)
b) Extract a Trial Balance as at April 30, 2008.

(10 marks)
2) Explain what interest each of the following stakeholders may have in the accounts of a
business:
a)
b)
c)
d)
Government
Lenders
Customers
Suppliers
(2 marks)
(2 marks)
(2 marks)
(2 marks)
Total for this question: 30
Question 2
Tina has extracted the following Trial Balance from the accounting records of her livery business at 31
December 2007:
64
Motor vehicles cost

Motor vehicles accumulated depreciation
Rent
70,000
45,000
5,500
Insurance
1,236
Sales
41,028
Stock
532
Wages
15,123
Drawings
8,561
Bank
2,060
Creditors
1,040
Debtors
2,300
Purchases
12,000
Sundry expenses
Capital
332
30,576
Additional information not yet recorded in the books of account at 31 December 2007:
1) Stock at December 31, 2007 had originally cots 620.

2) A demand for rent of 3,000 for the period December 1, 2007 to March 1, 2008 had not
been paid by December 31, 2007.
3) During the year, an insurance premium of 600 was paid for the year ending 31 March,
2008.
4) Fixed assets are depreciated at a rate of 25% per annum using the straight line method.
Tina would like you to prepare her accounts for the year ending December 31, 2007.
Required:
a) Prepare a Trading and Profit and Loss Account for the year ending December 31, 2007.
(20 marks)
65
b) Prepare a Balance Sheet as at December 31, 2007.

(12 marks)
Total for this question: 34 marks
Question 3
1) Anthony is preparing the financial statements for his business, which buys and sells
fireworks. His accounting year ended on March 31, 2008. His Trial Balance at March 31,
2008 included the following items:
19,572,002
5,871,601
12,673,007
Sales
Purchases
Stock at April 1, 2007
Anthony conducted a stock count after the close of business on March 31, 2008. He established
that he was holding stock valued at 13,131,131.
Required:
a) Calculate Anthonys gross profit for the year based on the information given above.
b) You have now discovered that a fire broke out in Andrews warehouse on March 31,
2008. All the stock was destroyed.
Calculate Anthonys gross profit for the year in the light of this additional
information.
c) On further investigation, it transpires that stocks that originally cost Anthony
5,780,444 cam be salvaged. These have been damaged by water from the firemens
hoses, but can be sold to domestic customers. The damaged fireworks are expected to
be sold for 4,500,000.
Calculate Anthonys gross profit for the year in the light of this additional
information.
(9 marks)
2) You are given the following Trial Balance:
66
R. Thomson Trial Balance as at 31st December 2007

Dr
Capital
Drawings
Premises
Plant and Machinery
Motor Vehicles
Sales
Purchases
Advertising
Stationery
Insurance
Wages
Motor expenses
Debtors
Creditors
Cash
Bank
Rates
Heating and Lighting
Sundries
Opening Stock
Cr
42,294
1,000
20,400
1,700
900
1,250
9,562
4,831
260
565
724
4,650
900
2,073
3,061
62
6,093
629
1,484
1,023
6,089
54,633
54,917
On investigating the difference in the Trial Balance you discover the following errors:
1. Cash sales of 276 on 6th April have not been entered in the Sales account.
2. A Purchase Day Book total has been entered as 1,260 instead of 1,620.
3. Goods to the value of 100, returned by a customer, were entered to the credit of the
Returns Outward Account.
Required:
Write up the Journal entries. Open a Suspense Account, starting with the difference in the Trial
Balance and then show that your Journal entries clear this account.
(4 marks)
3) The Cash Book of J. Smith for the month of December is as follows:

CASH BOOK
BANK ACCOUNT
Date
Detail
Date
Detail
67
Dec 1
Balance b/d
107.00 Dec 2
F. Wood
170.00
Dec 5
D. Jones
214.00 Dec 10
A. Patel
83.00
Dec 12
S. Milton
197.00 Dec 15
E. Roberts
205.00
Dec 17
J. Mathews
272.00 Dec 29
R. Singh
789.00
Dec 31
B. Rix
503.00 Dec 31
Balance c/d
46.00
1,293.00
Jan 1
Balance b/d
1,293.00
46.00
The bank statement is received:

BANK STATEMENT
Date
Detail
Dr
Cr
Balance
Dec 1
Balance b/d
Dec 5
F. Wood
Dec 7
D. Jones
Dec 12
A. Patel
Dec 13
S. Milton
Dec 18
E. Roberts
Dec 18
J. Mathews
Dec 26
Credit transfer
76.00
256.00
Dec 31
Bank Charges
23.00
233.00
107.00
170.00
63.00 OD
214.00
83.00
151.00
68.00
197.00
205.00
265.00
60.00
272.00
332.00
Required:
Prepare a Bank Reconciliation Statement as at December 31 st.
(4 marks)
68

Question 4
1) Control Accounts. You have received the following information:
Balances at the beginning of the year 2007:
Purchase Ledgers Balances
Sales Ledgers Balances
10,624
18,210
The totals for the year:

Purchases Day Book
Sales Day Book
Returns Outward Day Book
Returns Inward Day Book
Cheques paid to Suppliers
Petty Cash paid to Suppliers
Cheques received from Customers
Discounts Allowed
Discounts Received
Bad Debts Written off
Dishonoured cheques from customers
Amount to be Set Off between Purchases
and Sales Ledger Accounts
172,860
317,621
1,073
893
175,000
65
302,601
5,041
2,671
814
563
1,021
Required:
From the above information prepare and balance the Sales Ledger and Purchase Ledger Control
Accounts for the year 2007.
(9 marks)
2) Explain what control accounts are and how they can be used to keep order in the
accounting system.
(6 marks)
69
Diploma in
Accounting
Unit 2: Financial and Management
Accounting
Module 3: Types of Business Organisations, Accounting
Concepts and Further Aspects
Module 4: Internal Final Accounts of Limited
Companies, Ratio Analysis and the Assessment of
Business Performance
Module 5: Introduction to Budgeting and Budget
Controle ICT in Accounting
70
Diploma in
Accounting
Accounting
Module 3: Types of Business Organisations, Accounting
Concepts and Further Aspects
71
FINANCIAL AND MANAGEMENT ACCOUNTING
INTRODUCTION
You will learn the different types of business entities and their differences, how to prepare
financial statements for sole traders and limited companies after making adjustments to their
final accounts.
You will be introduced to the accounting concepts and why they are important when
preparing financial statements.
In this module you will also learn how to analyse the performance of a business and
recommend a course of action which will benefit the business; you will evaluate their
financial strengths and weaknesses.
An introduction to budgeting will give you an understanding of the purposes of it and you
will learn how to prepare a cash budget.
Finally you will learn the application of ICT in accounting and how they can benefit to a
business.
72
Learning objectives:
Understanding financial accounting

Developing the ability to produce final accounts for sole traders and limited
companies.
Understanding the concepts which underlie the preparation of financial statements and
how they are applied.
Understanding the differences of a sole trader, a partnership and a limited company
and how their financial structure differs.
Evaluating the performance of sole traders and limited companies.
Understanding the purposes of budgeting
Preparing cash budgets.
Developing skills on making adjustments to final accounts, using the accounting
concepts to prepare financial statements, and reporting the performance of a business
by making recommendations and explaining the consequences.
Developing a good understanding of what information financial statements can
provide and their limitations.
73
LESSON 5. TYPES OF BUSINESS ORGANISATION
1.1 Introduction.
Why is it important to understand the different types of business organisations?
Depending on the business organisation there will be different organisational structure and
different legal requirements. Each one of them will have its advantages and disadvantages
and the type of business entity chosen by an individual or group of individuals will be based
on many different reasons: the level of liability, adequacy to the type of business, the size of
the business, etc.
A business organisation or a business entity is a business that exists independently of those
who own the business.
In this lesson you will study the three main categories of business entities, which are: sole
trader, partnership and limited liability company. We will cover each one of them and the
differences between them.
Before you continue reading the next sections, take out a business telephone directory or the
yellow pages, or do a search on internet. Write down the names of five different businesses or
organisations. Then while you are reading the sections attempt to match your list against the
information provided in each. If you find that you have the same type of business
organisation in your list, go back and search again for a different type of business. Also find
out more information about the business or organisation.
1.2 Sole Trader.

A sole trader is an individual who enters into business alone, either selling goods or
providing a service. It is the most common form of ownership in the UK. It may have one or
more employees.
The reasons why some people decide to set up as a sole trader vary. The sole trader may
have a good idea which appears likely to make a profit, and he or she has the cash needed to
buy all the resources to start the business. The start up is cheap and easy, as there are only a
few forms to fill in and to start trading the sole trader only needs to set up a bank account and
inform the tax office.
Although this is the form in which many businesses have started, it is one which is difficult to
expand because the sole trader will find it difficult to arrange additional finances for
expansion.
74
If the business is not successful and the sole trader is unable to meet obligations to pay
money to others, then those persons may ask a court of law to authorise the sale of the
personal possessions, and even the family home, of the sole trader.
For accounting purposes, the business is regarded as a separate economic entity, of which the
sole trader is the owner who takes the risk of the bad times and the benefit of the good times.
However, a sole trader is liable for any debts that the business incurs.
If you remember when you studied Module One, in Lesson One we covered the stakeholders
who are interested in accounting information. Think of who would be interested in the
accounting information of a sole trader.
The owner may hardly feel any need for accounting information because he or she knows the
business very closely, however, other persons or entities may need accounting information of
the business. For example, the government, in the form of HM Revenue and Customs, for
tax collecting purposes; the bank, for the purposes of lending money to the business; another
sole trader, partnership or limited company who are intending to buy the business.
On the other hand, the business accounts do not need to be filed with Companies House, what
means that they are not made available to the public, there is not access to the accounting
information of a sole trader. Thus, competitors cannot see what you are earning, how the
business works and if it is making a profit or a loss.
What are the advantages of setting up as a sole trader?
Total control of the business by the owner.

It is cheap and easy to start up.
The business affairs are private.
The owner keeps all the profits.
A sole trader has also legal requirements to meet:

They must keep proper business accounts and records for Revenue and Customs, who
collect the tax on profits, and for VAT, if the business is registered.
They must comply with legal requirements concerning protection of the public (e.g.
Public Liability Insurance), the customer (e.g. Sale of Goods Act), the employees, if
they have them (e.g. Employers Liability Insurance, contract of employment)
Although a sole trader would be the easiest and cheapest type of entity to start up a business
and the formalities are reduced to a minimum, it is not always the most advantageous one.
There are some disadvantages of being a sole trader; the main ones to bear in mind are the
following:
Unlimited liability. A sole trader is personally liable for any debts that the business
incurs. He or she will respond with their own personal possessions to pay creditors
and debtors if the business continues making a loss. They not only lose the money
they invested into the business but also they will personally liable for any outstanding
debt of the business.
75
Difficulty to raise finance. As they are small, banks will not lend them large sums
unless they secure the loans with their own homes or a guarantor.
Continuity. There is a problem of continuity if the sole trader retires or dies.
Difficulty to enjoy economies of scale. A sole trader may not be able to buy in bulk
and enjoy the same discounts as larger businesses.
Despite those disadvantages there are reasons why sole traders are successful. They can offer
specialist and personalised services to customers; they can be more sensitive to the needs of
customers, as they are closer to the customer and can react more quickly, because they are the
decision makers too; they can cater for the needs of local people, they are personally closer to
the local community as the owner is the person people can see and not some far off town,
which will build up trust in the community.
Do you know any sole trader in your area? What type of business they run?
1.3 Partnership.
A partnership is a business where there are two or more owners of the enterprise. It is one
method by which the business of a sole trader may expand. It is governed by the Partnership
Act 1890.
A partnership is defined as grouping of, in general, between 2 and 20 people, carrying on
business in common with a view of profit.
Most partnerships are, in general, between two and twenty members; however, there are some
exceptions:
For firms of accountants, solicitors or Stock Exchange members there
is no limit.
For Banks, there is a maximum of 10 partners.
What are the reasons for joining together in partnership?

The reasons why they may want to join are because they wish to combine:
a) Capital. A combined amount of capital will make a business more effective.
b) Expertise. Each member or partner has expertise in different areas. For example, two
lawyers may form a partnership, one an expert in conveyancing, one an expert in wills
and trusts.
76
c) Responsibility. In partnership, decisions and responsibility for them will be shared. It

is helpful to discuss difficult situations with others.
However, in a partnership, as with a sole trader, partners are each liable to the full extent of
their personal possessions for the debts of the partnership. If the business is unsuccessful, the
consequences are similar to those for the sole trader. Persons to whom money is owed by the
business may ask a court of law to authorise the sale of the personal property of the partners
in order to meet the obligation.
A partnership may be established as a matter of fact by two persons starting to work together
with the intention of making a profit and sharing it between them. It is usual to have a formal
partnership agreement legally drawn up, that agreement is called Deed of Partnership. This
will cover such matters as:
o
o
o
o
o
o
How the profit are to be split

Capital to be contributed by the partners
How Goodwill is to be valued
Arrangements covering the retirement or death of a partner
Rules on how to take on a new partner
How the partnership is brought to an end, or how a partner leaves
In the case that there is no partnership agreement the provisions of the Partnership Act 1890
apply.
For accounting purposes the partnership is seen as a separate economic entity, owned by the
partners. The owners may feel that accounting information is not very important for them.
Nevertheless, each partner may wish to be sure that he or she is receiving a fair share of the
partnership profits. Other persons requesting accounting information are HM Revenue and
Customs, banks who provide finance, and individuals who may be invited to join the
partnership so that it may expand even further.
The advantages of a sole trader becoming a partnership are:
Spreads the risk across more people; so if the business gets into difficulty then there
are more people to share the burden of debt
Partner may bring money and resources to the business
Partner may bring other skills and ideas to the business, complementing the work
already done by the original partner
Increased credibility with potential customers and suppliers, who may see dealing
with the business as less risky than trading with just a sole trader
The main disadvantages of becoming a partnership are:

Have to share the profits
77
Less control of the business for the invidual

Disputes over workload
Problems if partners disagree over the direction of business
1.4 Limited liability company.

Historically, as the UK changed from a predominantly agricultural to a predominantly
industrial economy in the nineteenth century, it became apparent that owners needed the
protection of limited liability. This meant that if the business failed, then the owners might
lose all the money they had put into the business but their personal wealth would be safe.
As you can see the main risk attached to a sole trader or a partnership is that of losing
personal property and possessions, including the family home, if the business fails. For
people or businesses who have a claim against the company, limited liability means that
they can only recover money from the existing assets of the business; they can not claim the
personal assets of the owners to recover amounts owed by the company.
A limited liability company, commonly known as limited company (abbreviated to Ltd),
is a business that is owned by its shareholders, run by the directors and whose liability is
limited.
Limited liability means that the investors can only lose the money they have invested and
no more.
There are two forms of a limited liability company:
1. The private limited company has the word Limited or abbreviated Ltd in its
name: King Limited or King Ltd. It is prohibited by law from offering its shares to the
public, so it is a form of limited liability appropriate to a family-controlled business.
2. The public limited company has the abbreviation plc in its name: British Telecom
plc. It is permitted to offer its shares to the public. In return it has to satisfy more
onerous regulations. Where the shares of a public limited company are bought and
sold on a stock exchange, the public limited company is called a listed company
because the shares of the company are on a list of shares prices.
The owners, in either type of company, are called shareholders because they share the
ownership and the profits and losses of the company. They have the obligation to pay in full
for their shares, but they face no further risk of being asked to contribute to meeting any
obligations of the business. The share of the profit that the shareholders receive is called
dividend.
The persons running the business on a day-to-day basis are called the directors. In the case
of a very small company, the owners may run the business themselves; therefore, the
shareholder and the director will be the same person. However, if the company is larger, then
they may prefer to pay someone else to run the business; in this case, the directors will have
to report to the shareholders in the Annual General Meeting.
78
Limited companies are required to produce annual accounts which will be sent to their
shareholders. They are also lodged with the Registrar of Companies where they can be
viewed and copied by any member of the public. They become public knowledge.
As you studied in the first module there will be many people other than the shareholders who
will be interested in looking at a companys accounts. These include competitors,
Government, employees, loan creditors, shareholders and analysts. Others that will be
looking at the accounts include customers, potential shareholders and trade creditors. They
will want as much information as possible regarding their particular interest area.
The legal requirements concerning the formation, running and reporting of companies are
found in the Companies Act 1985 (as amended by the 1989 Act). The new Companies Act
2006 will come in force in 2009.
To set up as a limited company, a company has to register with Companies House and is
issued with a Certificate of Incorporation. Each company is governed by two documents,
known as the Memorandum of Association and the Articles of Association. The
memorandum consists of five clauses for private companies, and six for public companies,
which contain the following details:
The name of the company.

The part of the UK where the registered office will be situated.
The objects of the company.
A statement (if a limited liability company) that the liability of its members is limited.
Details of the share capital which the company is authorised to issue.
A public limited company will also have a clause stating that the company is a public
limited company.
The Articles of Association will cover such matters as:
Rights of shareholders
Voting rights
Powers and duties of directors
Borrowing powers
Accounts and audit
The memorandum is said to be the document which discloses the conditions which govern
the companys relationship with the outside world; and the Articles of Association govern the
internal relationships and regulations.
For accounting purposes the company is a separate legal entity, with an existence separate
from the owners.
79
1.5 Summary.
The table below shows the differences between a partnership and a limited liability company
that are relevant for accounting purposes:
Formation
Partnership
Formed by two or more persons,
usually with written agreement
but not necessarily in writing.
Running the
business
All partners are entitled to share

in the running of the business.
Accounting
information
Partnerships are not obliged to

make accounting information
available to the wider public.
All members of a general
partnership are jointly and
severally liable for money owed
by the firm.
Partnerships may carry out any
legal business activities agreed
by the partners.
Meeting
obligations
Powers to
carry out
activities
Limited liability company

Formed by a number of persons
registering the company under the
Companies Act, following legal
formalities. In particular there must
be a written memorandum and
articles of association setting out the
powers allowed to the company.
Shareholders must appoint directors
to run the business (although
shareholders may appoint
themselves as directors).
Companies must make accounting
information available to the public
through the Registrar of Companies.
The personal liability of the owners
is limited to the amount they have
agreed to pay for shares.
The company is seen in law as a
separate person, distinct from its
members. This means that the
company can own property, make
contracts and take legal action or be
the subject of legal action.
The table below identifies the differences between the public limited company and the private
limited company that are relevant for accounting purposes:
Running the
business
Ownership
Public company
Minimum of two directors.
Must have a company secretary
who holds a relevant
qualification (responsible for
ensuring the company complies
with the requirements of
company law).
Private company
Minimum of one director.
The sole director may also act as the
company secretary and is not
required to have a formal
qualification.
Shares may be offered to the

public, inviting subscription.
Shares must not be offered to the

public. May only be sold by private
arrangements.
80
Accounting
information
Minimum share capital 50,000
No minimum share capital.
Extensive information required

on transactions between
directors and the company.
Less need for disclosures of

transactions between directors and
the company.
Information must be made public through the Registrar of Companies.

Provision of financial information to the public is determined by size of
company, more information being required of medium and large
companies.
Accounting information must be sent to all shareholders.
LESSON 6. ACCOUNTING CONCEPTS
As you have learnt so far there are different parties interested in the affairs of a business and
they require different kind of information. All have different needs from the financial
statements (Trading and Profit and Loss Accounts and Balance Sheet) they read.
The financial statements need to be accurate, true and fair in order to be reliable and of value
to those using them. The Trading and Profit and Loss Account should present a true and fair
view of the operating activities of a business for a particular period of trading, whilst the
Balance Sheet should present a true and fair picture of the financial standing of a business as
at a particular point in time.
How is this objective achieved? There is set of rules and guidelines which have been
developed and they are set out in various statements of Standard Accounting Practice
(SSAPs) and Financial Reporting Standards (FRSs). These rules produced by the main
accountancy bodies are used when recording financial information and preparing financial
statements.
Whilst the accounting standards are not themselves legally binding, the Companies Act 1989
brought in the requirement that Accounts must state whether they have been prepared in
accordance with applicable accounting standards. In addition the Act requires that any
departures from the standards must be detailed with the reasons for the departure.
The more general rules which apply to the recording and treatment of financial information
are known as accounting concepts. These rules provide parameters within which the
accountant may exercise judgement when processing financial information and preparing
financial statements.
These concepts are derived from experience and reason and that is why they are flexible and
subject to ongoing development and revision. The concepts are known as Generally
Accepted Accounting Practices.
81
Fundamental accounting concepts:

These comprise a set of concepts considered so important that they have been enforced
through accounting standards and/or through the Companies Act.
Five concepts have been enforced through the Companies Act:
1.
2.
3.
4.
5.
Going concern concept

Consistency concept
Prudence concept
Accruals concept
The separate determination concept
A sixth concept has been enforced through an accounting standard, FRS 5:

6. Reporting the substance of transactions
1. Going concern.
The going concern concept implies that the business will continue to operate for the
foreseeable future.
When preparing financial statements, values are based on the assumption that the business
will continue into the foreseeable future. However, there are cases where the going concern
assumption should not hold:
If the business is going to close down in the near future.

If a shortage of cash makes it almost certain that the business will have to
cease trading.
If a large part of the business will almost certainly have to be closed down
because of a shortage of cash.
As you can see, a far different valuation would be placed on assets from which the business
will benefit fully in the long term as it continues to operate in the normal way than would be
placed on those same assets should the business be forced into liquidation or had to reduce
the scale of its activities. That is why it is necessary that the validity of the going concern
assumption is established, as it has a significant affect on the valuation placed on certain
assets, stocks and fixed assets in particular.
2. Consistency.
The consistency concept requires that, when a business adopts particular accounting
methods, it should continue to use such methods consistently.
Each business must choose the approach that gives the most reliable picture of the business,
not just for this period, but over time also. There must be consistency of accounting treatment
of like items within each accounting period and from one period to the next. The application
of consistent procedures facilitates a valid comparison of performance from period to period.
82
Example: a business decides to make a provision for depreciation on machinery at twenty per
cent per annum, using the straight-line method. That business should continue to use that
percentage and method for future final accounts for that asset.
However, that does not mean that the business has to follow the method until it closes down.
A change in procedure, method or policy can be make provided there are good reasons for so
doing, and a note to the final accounts would explain what has happened, e.g., when the
outcome is a fairer and more reliable measure of business events.
Other examples of the use of the consistency concept are: stock valuation and the application
of the materiality concept (which you will study later in this lesson).
3. Prudence
The prudence concept also known as conservatism requires that a cautious approach is
adopted when processing and using financial information. It is the accountants duty to
endeavour to present accurate facts in the financial statements. Assets must not be value too
highly; nor should amounts owed by a business be understated.
The prudence concept requires that all losses (costs) are recognised immediately they become
known whereas all gains (revenue) should be recognised only when they are realised (certain
to be received). As a result, profits are not to be anticipated and should only be recognised
when it is reasonably certain that they will be realised; at the same time all know liabilities
should be provided for.
An example of the prudence concept is where a provision is made for bad debts (you will
learn more in the next lesson): it is expected, from experience, that a certain percentage of the
debtors will eventually need to be written off as bad debts; for that reason, it is prudent to
provide for bad debts as a percentage of the amount owed to the business by its customers.
The valuation of stock (which you will study in module 3 of the A Level) also follows the
prudence concept.
4. Accruals (or matching) concept
Profit or loss calculated on the basis of cash accounting, i.e. the result of cash received in a
period less cash paid out in a period, whilst it would be completely objective as a measure of
profit is not normally acceptable. Instead the accountant is required to calculate profit or loss
resulting from:
Revenue income earned within a defined period of trading less revenue expenditure incurred
during the same defined period.
Determining the expenses used up to obtain the revenues is referred to as matching expenses
against revenue. The key to the application of the concept is that all income and charges
relating to the financial period to which the financial statement relate should be taken into
account without regard to the date of receipt or payment.
If you remember in the previous module you studied how expenses and revenues were
adjusted in the Profit and Loss account to take note of prepayments and accruals. This
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concept is also used in the adjustments for closing stocks, depreciation of fixed assets,
provision for doubtful debts and writing-off bad debts.
5. Separate determination concept
In the financial statements, all similar items are grouped together. For example, all the motor
vehicles are grouped together under one heading, motor vehicles. When calculating the
aggregate amount of each asset or liability, the amount of each individual asset or liability
should be determined separately from all other assets and liabilities.
For example, if you have three machines, the amount at which machinery is shown in the
financial statements should be the sum of the valued calculated individually for each of the
three machines. Only when individual values have been derived should a total be calculated.
Underlying accounting concepts and conventions:
There are a number of accounting concepts which have been applied ever since financial
statements were first produced for external reporting purposes.
The historical cost concept
It means that assets are normally shown in the financial statements at a value based on their
original cost.
This concept derives from the principle of objectivity in that the valuation shown in the
accounts is documented by the invoice as proof of the amount paid to acquire an asset or in
payment of an expense. There are no valuations to apply, which are subjective and may vary
depending on the circumstances. As there is a prime document (e.g. invoice) that confirms
the amount recorded in the accounts, it is verifiable.
Valuing assets at their cost to you is objective, as you are adhering to and accepting the facts.
You are not placing your own interpretation on the facts. As a result, everyone else knows
where the value came from and can see that there is very good evidence to support its
adoption.
For example, a vehicle costing 12,500 is recorded at that amount; stock of goods for resale
which cost 5,000 is recorded at that historical cost.
This concept is the most commonly used method for asset valuation.
However, what will happen to falls in value of an asset? This is dealt with by using
depreciation methods in the accounts. It is a subjective technique, but is well-recognised in
accounting; your need to use your own judgement to arrive at a cost. Also the effects of
inflation is a disadvantage of the historical cost concept, as there is no definite way for
dealing with it in the accounts.
This concept is an extension of money measurement, which you will learn next.
Money measurement concept
Accounting information has traditionally been concerned only with those facts that:
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Can be measured in financial terms, and

Most people will agree to the financial value of the transaction.
This means that, in the final accounts, all items are expressed in the common denominator of
money. Therefore, accounting can never tell you everything about a business, as it has
difficulty in recording the more qualitative or intangible factors of a business. For example,
the expertise or motivation of the workforce; the relationships between managers and
workforce; and between them and the outside world. Such factors, although they may be of
benefit or to the detriment of a business, cannot be evaluated in monetary terms and are not
reflected within the accounts.
Business entity concept
The business is assumed to have its own identity which is separate from that of its owners.
Transactions recorded in the books are those which are relevant to the business only, and
relate to business activities. Fund or goods taken out of a business by its owners are treated as
a reduction in their investment in the business, not as an expense of the business. The main
links between the business and the owners personal funds are capital and drawings.
Dual aspect concept
This states that there are two aspects of every transaction, one representing the assets of the
business entity and the other the claims against the business entity. These two aspects must
always be equal, i.e. what the business entity owns it also owes. This can be expressed by the
accounting equation:
Assets = Capital + Liabilities
It is this duality concept which forms the basis of double-entry book-keeping, whereby books
are maintained by recognising that for every business transactions there is a giver and a
receiver. (Remember what you learnt in the previous module about the double-entry system
in practice).
Materiality concept
In processing financial information and preparing financial statements, there may be a point
at which the effort of providing exact and detailed information is out of all proportion to the
cost, in terms of time and money, of doing so.
Materiality allows that in circumstances where ignoring other rules will not significantly
effect the financial information provided as a result, then it would be acceptable to do so.
Some items in accounts have such a low monetary value that it is not worthwhile recording
them separately, i.e. they are not material. For example: low-costs fixed assets are often
charged as an expense in profit and loss account, instead of being classed as capital
expenditure, e.g. a stapler, waste-paper basket. Strictly, these should be treated as fixed assets
and depreciated each year over their estimated life; in practice, because the amounts involved
are not material, they are treated as profit and loss account expenses.
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Materiality is a common sense concept, as it is largely concerned with the significance of a

particular item in the financial statements in the context of the business organisation as a
whole. What is material to a sole trader business is not necessarily material to a large
company.
The Realisation concept
This concept determines when a transaction is to be recorded in the books of account.

Normally this is when goods or services are delivered, as it is seen as being the point in time
at which legal title passes from the supplier to the customer.
To process a transaction when an order is placed would not be prudent as the order may be
cancelled before it is fulfilled, or the business may not be able to meet the order.
The realisation concept where credit is given or taken often results in the transaction being
recorded in one particular accounting period with the payment being made or received in a
later accounting period.
Objectivity concept
It is suggested that subjectivity should be minimised whilst objectivity should be maximised.

Therefore, where possible, financial statements should be prepared free from personal bias.
Now click on the link below and try the interactive worksheet for accounting concepts to help
you understand the accounting concepts:
www.bized.co.uk/learn/accounting/infosystems/bait/work06.htm
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Diploma in
Accounting
Accounting
Module 4: Internal Final Accounts of Limited
Companies, Ratio Analysis and the Assessment of
Business Performance
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LESSON 7. FINAL ACCOUNTS: FURTHER ASPECTS

1.1 Capital expenditure and revenue expenditure.
When preparing final accounts it is important to distinguish between capital expenditure and
revenue expenditure.
1. Capital expenditure
Capital expenditure can be defined as expenditure incurred on the purchase, alteration or
improvements of fixed assets. Costs included are:
-
Acquiring fixed assets

Bringing them into the business
Installation of fixed assets
Improvement of fixed assets, but not repairs
Legal costs or buying buildings
Carriage inwards on machinery bought
Any other costs needed to get a fixed asset ready for use.
Benefit is derived from the use of fixed assets over several accounting periods and their cost
is spread over the accounting periods which benefit from their use. The loss in value of fixed
assets is accounted for over the period of their useful economic life by applying depreciation.
Capital expenditure is shown on the Balance Sheet.
2. Revenue expenditure
Revenue expenditure is expenditure incurred in running expenses. Costs included are:
-
Maintenance and repair of fixed assets

Administration of the business
Motor expenses (e.g. cost of petrol, service)
Selling and distributing the goods or products in which the business trades
Benefit is derived from such expenditure within one accounting period. As a result revenue
expenditure is transferred each year to Trading and Profit and Loss Account where, in the
calculation of profit each year, it is matched against the income it has helped generate.
It is important to classify these types of expenditure correctly in the accounting system.
Getting the classification wrong affects the profits reported and the capital account and assets
values in the financial statements. It is, therefore, important that this classification is correctly
done.
If, for example, capital expenditure is incorrectly treated as revenue expenditure or revenue
expenditure is incorrectly treated as capital expenditure, then both the Balance Sheet figures
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and Trading and Profit Loss Account figures will be incorrect. The net profit figure will be
incorrect.
Now you are going to try a few examples in order to help you understand the difference and
the different treatment in the accounts.
Classify the expenditure in the following examples between revenue and capital. Example 1
has been done for you.
Example 1.
Cost of building an extension to the factory 30,000, which includes 1,000 for
repairs to the existing factory.
-
Capital expenditure: 29,000

Revenue expenditure: 1,000
As you can see, sometime one item of expenditure will need to be divided between
capital and revenue expenditure. In this case, 1,000 is for repairs to an existing fixed
asset, the factory.
Example 2.
A plot of land has been bought for 20,000, the legal costs are 750.
-
Capital expenditure:
Revenue expenditure:
Example 3.
The business own employees are used to install a new air conditioning system: wages
1,000, materials 1,500.
-
Capital expenditure:
Revenue expenditure:
Example 4.
Own employees used to repair and redecorate the premises: wages 500, materials
750:
- Capital expenditure
- Revenue expenditure
Example 5.
Purchase of a new machine 10,000, payment for installation and setting up 250.
-
Capital expenditure
Revenue expenditure
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Only by allocating capital expenditure and revenue expenditure correctly between the
Balance Sheet and the Profit and Loss Account can the final accounts reflect accurately the
financial state of the business.
Be aware that capital expenditure has nothing to do with the owners Capital Account.
While both are, in a sense, long-term investments, one made by the business, the other made
by the owner, they are, by definition, two very different things.
Solution to the examples:

Example 2: capital expenditure 20,750, because the legal costs are included in the capital
expenditure, as they are the cost of acquiring the fixed asset.
Example 3: capital expenditure 2,500, as it is an addition to the property.
Example 4: revenue expenditure 1,250, because repairs and redecoration are running
expenses.
Example 5: capital expenditure 10,250, as costs of installation of a fixed asset are included
in the capital expenditure.
1.2 Depreciation.
Depreciation is that part of the original cost of a fixed asset that is consumed during its period
of use by the business. The annual charge to profit and loss for depreciation is based upon an
estimate of how much of the overall economic usefulness of a fixed asset has been used up in
that accounting period. Because it is charged as an expense to the profit and loss account,
depreciation reduces net profit. That expense is called provision for depreciation of fixed
assets.
For example, a machine cost 2,000 and was expected to be used for four years. At the end of
the first year, a fourth of its overall usefulness has been consumed. Depreciation would then
be charged at an amount equal to one-fourth of the cost of the machine, i.e. 500. Therefore,
profit will be reduced by 500 and the value of the machine in the balance sheet is reduced
from 2,000 to 1,500.
Depreciation is affected by the fundamental accounting concepts of going concern, prudence,
matching and consistency; it is also a further application of the accruals concept, because we
are recognising the timing difference between payment for the fixed asset and the assets fall
in value.
As a going concern, the business will make use of its fixed assets over a number of years.
Therefore, any loss in value of a fixed asset is charged as an expense against income in the
periods which will benefit from its use. That charge also follows the matching concept, as
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depreciation is allocated in the proportion of the cost of the asset to each accounting period
expected to benefit from its use.
The prudence concept requires that we recognise that fixed assets will lose value period by
period, and that this loss in value represents a charge against income that must be accounted
for.
As there a number of methods of calculating depreciation, one of them must be chosen and
applied consistently from accounting period to accounting period, in application of the
consistency concept.
The main factors which cause fixed assets to depreciate are:
Wear and tear through use, e.g. vehicles, machinery, etc

Passage of time, e.g. the lease on a building, patents and copyrights
Depletion: assets such as quarries, mines and forests are depreciated based on the fact
that they are of a wasting nature.
Obsolescence. This is the process of becoming out-of-date, e.g. a new design of
machine which does the job better and faster makes the old machine obsolete.
Inadequacy. This arises when an asset is no longer used because of the growth and
changes in the size of the business, e.g. a machine no longer has the volume capacity
to meet the needs of the business.
1.2.1. Methods of calculating depreciation:

The two most common methods of calculating depreciation are:
Straight-line method
Reducing balance method
a) Straight line method

By this method, the number of years of use is estimated and a fixed percentage is written off
the original cost of the asset each year. The percentage is based on what it is considered to be
the useful economic life of the asset. Thus the cost is divided by the number of years, to give
the depreciation charge each year.
For example, a machine was bought for 2,000 and it is expected to have a useful economic
life of four years with a nil residual value at the end of the four years, the depreciation to be
charged each year would be:
2,000 = 500 per year
4 years
i.e.: 25%: 2,000 x 25% = 500
Now lets assume that the machine is expected to have a residual value of 400, so the
depreciation amount would be:
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2,000 - 400 = 400 per year

4 years
The method of calculating straight-line depreciation is:
Cost of asset estimated residual value

Number of years expected used of asset
b) Reducing balance method

A fixed percentage for depreciation is deducted from the cost in the first year. In the
following years the same percentage is taken of the reduced balance (cost less depreciation
already charged).
For example, a machine is bought for 10,000 and depreciation is to be charged at 20%, the
calculation would be as follows:
Cost
First year depreciation at 20%
Second year: 8,000 x 20%
10,000
(2,000)
8,000
(1,600)
6,400
The formula to calculate the percentage of reducing balance depreciation is:
In this formula:
r = the rate of depreciation to be applied
n = number of years
s = residual value
c = cost of the asset
Using the figures from the previous example
n = 4 years
s = residual value 4,096
c = cost 10,000
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r=1-
4096
10000
r = 0.2 or 20%
If you apply that percentage to the remaining years you will see that it will leave a residual
value of 4.096. Now complete the example for year 3 and 4.
The purpose of depreciation is to spread the total cost of a fixed asset over the periods in
which it is to be used. The choice of a suitable method is arbitrary, but the requirement is that
the depreciation method used should reflect as fairly as possible the pattern in which the
assets economic benefits are consumed by the entity.
If, therefore, the main value is to be obtained from the asset in its earlier years, it may be
appropriate to use the reducing balance method, which charges more in the early years. If, on
the other hand, the benefits are to be gained evenly over the years, then the straight line
method would be more appropriate.
Having chosen a suitable method for calculating the depreciation charge we are then faced
with applying the method in circumstances where fixed assets are purchased partway through
a financial year. Two options are available:
1. The full year basis: in the year of acquisition, we ignore the date on which the fixed
assets was purchased. We charge the full years depreciation in the year of acquisition
irrespective of when, within the financial year, the asset was purchased. In applying
the full year basis we charge no depreciation to the Profit and Loss Account in the
year of disposal of a fixed aseet.
2. The month for month basis: depreciation is calculated and charged to the Profit and
Loss Account according to the period of time for which the fixed asset is owned each
financial year. Depreciation using this basis is charged in the year of acquisition of the
fixed asset and in the year of disposal (provided in the year of disposal the asset has
not already been written down to a nil residual value).
1.2.2. Accounting for depreciation. Double entry.

Once the depreciation charge has been calculated it must be recorded in the books of account.
The method used involves maintaining each fixed asset at its cost in the ledger account while
operating another ledger account where the depreciation to date is recorded. This account is
known as the provision for depreciation account.
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The depreciation charge is supported by an entry in the Journal. The transaction entered in the
Journal in respect of the depreciation charge each year is:
Debit Profit and Loss Account with depreciation in year
Credit Provision for Depreciation Account with depreciation in year
The Provision for Depreciation Account is balanced off at the end of each financial year to
show the accumulated depreciation charge (depreciation to date). The accumulated
depreciation is deducted from the cost of the fixed asset on the Balance Sheet to show the
written down value of the asset. The written down value therefore represents the remaining
value of the asset, to the business, to be spread over the remaining years of the assets life to
the business.
The following example shows the calculation of depreciation and the processing of double
entries necessary to account for depreciation:
Example:
A business has a financial year which ends on 31 March each year. On 1 July 2007 a delivery
vehicle is purchased at a cost of 27,500 and is paid for by cheque.
It is estimated that the delivery vehicle will have a life of five years to the business, with a
residual value of 2,500.
It has been decided that depreciation should be provided for using the straight line method
applied on a full year basis:
Depreciation calculation:
27,500 - 2,500 = 5,000 per year
5
Journal entries to account for depreciation:
Journal
Date
Details
Debit
31 March
Profit and Loss

Delivery Vehicle Provision for Depreciation
5,000
Credit
5,000
Depreciation on delivery vehicle for the year

ended 31 March 2008. Straight-line method.
Full year basis.
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Ledger Accounts
General Account
DR
Date
Details
1/7/07
Bank
DR
Date
Details
31/3/08
Balance c/d
Delivery Vehicle Cost
Date
Details
CR
27,500
Provision for Depreciation
Date
Details
5,000
5,000
31/3/08
Profit & Loss
01/4/08
Balance b/d
CR
5,000
5,000
5,000
Profit and Loss Account (Extract) for the year ended 31 March 2008
Expenses:
Provision for Depreciation
5,000
Balance Sheet (Extract) as at 31 March 2008

Fixed Asset
Cost
(Less)Accumulated
depreciation
NBV
Delivery vehicle
27,500
5,000
22,500
(NBV = Net Book Value, which is the difference between the original cost of the asset less
the accumulated depreciation).
Practice exercise
Now try the following exercise:
Quick Delivery has a financial year which ends on 30 June each year. A motorcycle was
bought on 1 August 2007 to carry out the urgent delivery of small parcels over short
distances. The motorcycle purchased cost 8,000 and was paid for by cheque.
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It was estimated that the motorcycle would have a life of 5 years to the business, with a
residual value of 500.
It was decided that the motorcycle would be depreciated using the straight-line method
applied on a full year basis.
Required:
a) Calculate the annual depreciation charge.
b) Show the Journal entries to account for depreciation for the first two years of the asset
life.
c) Make the entries in the appropriate accounts showing the balance
d) Prepare extracts of the Profit and Loss Account and Balance Sheet for the years ended
30 June 2008.
1.2.3 Disposal of a fixed asset.

When a fixed asset is purchased it is necessary, for the purpose of calculating the annual
depreciation charge, to estimate its economic life to the business, and residual value at the
end of its life. We must then account for loss in value (depreciation) over the period of the
life of the fixed asset.
The item may be disposed of at any time within its life and there is no guarantee that on
disposal the fixed asset item will realise a value which coincides with the original residual
value estimated at the time of its acquisition. It may attract a value which exceeds, or falls
short of, the original residual value estimated. The disposal of a fixed asset is a commercial
transaction and as such needs to be recorded in the books of account. The objective being is
to calculate and account for any profit or loss on disposal of the fixed asset.
Once a fixed asset has been sold, it must be removed from the ledger accounts. Therefore, the
cost of that asset needs to be taken out of the asset account. In addition, the accumulated
depreciation on the asset which has been sold will have to be taken out of the accumulated
provision. Finally, the profit and loss on sale, if any, will have to be calculated and posted to
the Profit and Loss Account.
The profit or loss on disposal of a fixed asset is calculated by comparing the value received
on disposal as against its net book value (cost less accumulated depreciation to date).
Where the disposal value (income from disposal less any costs incurred in disposing of the
fixed asset item), exceed the items net book value then the business has made a profit on
disposal.
Where the disposal value is less than the net book value of the item, the business has made a
loss on disposal.
To record the transaction relevant to the disposal of a fixed asset in the books we must:
o Open a Fixed Asset Disposal Account
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o Collect the information relevant to the fixed asset item disposed of within the account.
This includes;
-
Its original cost

Accumulated depreciation
Income received on disposal
o Transfer the balance on the Fixed Asset Disposal Account to the Profit and Loss
Account at the financial year end. A debit balance on the account representing a loss
on disposal, with a credit balance representing a profit on disposal.
Remember, at the financial year end the depreciation on remaining fixed assets has to be
calculated in accordance with the depreciation policy of the business.
On the disposal of the fixed asset the following entries are needed:
1) Transfer the cost price of the asset sold to the Assets Disposal Account
Debit Fixed Asset Disposal Account
Credit Asset account with original cost
2) Transfer the depreciation already charged to the Assets Disposal Account
Debit Provision for Depreciation Account
Credit Fixed Asset Disposal Account
(the amount is the accumulated depreciation to date of the asset disposed of )
3) Record the amount received on disposal
Debit Cash Book/Bank
4) Transfer the difference (i.e. the amount needed to balance the Fixed Assets Disposal
Account) to the Profit and Loss Account.
a) If it is a loss (i.e. debit balance):
Debit Profit and Loss Account
b) If it is a profit (i.e. credit balance):
Debit Fixed Asset Disposal Account
Credit Profit and Loss Account
Lets see an example to understand how it works.
97
Example:
Let us assume that Blyth Chemical Ltd, at 31 December 2006 had a balance on its Motor
Vehicles Account of 100,000. This balance represents the vehicles at cost. The balance on
the depreciation provision account was 40,000.
On 31 December 2007 the company sold one of its delivery vans for 1,500. It had been
purchased five years earlier on 1 January 2003, for 15,000, at which time the company had
estimated its useful economic life at five years and its residual value after that time of 1,000.
The company policy is to write off such vehicles at 20% straight line. The vehicle had been
subject to a depreciation charge of (15,000 - 1,000)/5 = 2,800 per annum. The company
policy is also to depreciate assets in the year of purchase but not in the year of sale.
There is a need to determine the profit or loss on disposal and the current year must reflect
that.
This is determined as:
Purchase Cost (1 January 2003)

15,000
Depreciation 4 years x 2,800
11,200
Net Book Value 31 December 2006 3,800
Sale Proceeds
1,500
Loss on Disposal
2,300
To account for this disposal the company would make the following entries to the accounts:
the original cost of the vehicle disposed is transferred from Motor Vehicles account to a
Disposal of Motor Vehicles Account;
the cumulative depreciation on the vehicle to the end of the previous year is transferred
from the Provision for Depreciation account to the Disposal account;
the Disposal of the Asset account is credited with the proceeds and the resulting balance
represents the profit or loss on disposal and is transferred at the year end to the Profit and
Loss account.
The entries for the full procedure would appear thus:

NB: The depreciation charge for 2007 was agreed as 20% straight line on 85,000 ie 17,000.
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Motor Vehicles Account

1 Jan 07 Balance b/d 100,000 31 Dec 07 Disposal a/c 15,000
31 Dec 07 Balance c/d 85,000
100,000
100,000
1 Jan 08 Balance b/d 85,000
Provision for Depreciation Account
31 Dec 07 Disposal a/c 11,200 1 Jan 07 Balance b/d
40,000
31 Dec 07 Balance c/d 45,800 31 Dec 07 Depreciation a/c 17,000
57,000
57,000
1 Jan 08 Balance b/d
45,800
Disposal Account
31 Dec 07 Motor Vehicles a/c 15,000 31 Dec 07 Provision for
Depreciation a/c 11,200
Proceeds
1,500
Loss on Disposal 2,300
15,000
15,000
Extract from Profit and Loss a/c for Year:

Depreciation
17,000
Loss on disposal of vehicle 2,300
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Extract from Balance Sheet

Fixed Assets
Motor Vehicles
Motor Vehicles
*NB: the provision to previous year end
Additional Depreciation for current year
Cost Depreciation NBV

85,000 48,000*
39,200
85,000 48,000*
39,200
11,200
17,000
57,000
Less accumulated depreciation on disposal of vehicle
11,200
45,800
1.3 Final Accounts
Bad debts recovered

In module one you learnt how to make entries to record a bad debt written off. However, it is
possible that a debt written off in previous years is recovered some time in the future. When
this happens you need to make the following entries:
1. You reinstate the debt:
Dr debtors account
Cr bad debts recovered account
2. Enter payment received:
Dr cash/bank
Cr debtors account
The credit balance in the bad debts recovered account is transferred to the bad debts account
at the end of the financial year. The bad debts account will be transferred to the Profit and
Loss Account at the end of the financial year.
You can see that a bad debt written-off was transferred to the debit side of the Profit and Loss
Account; the recovered of the bad debt written-off is transferred to the credit side of the Profit
and Loss Account.
Click on the link below and do the multiple-choice exercise on bad debt:
http://www.accounting2u.com/badebts.htm
Income received in advance and income due

Income received in advance is money (cash or cheque) received in advance. This is a
prepayment of income.
100
They are actually liabilities to the business as the business has still not earned the revenue
because goods or services have still not been provided to the customers.
The portion that goods have been delivered or services being provided during the accounting
period are treated as income in the Trading and Profit and Loss Account whilst those not
earned yet are treated as a current liability which is called prepaid revenues, deferred
revenues and unearned revenues.
Examples are: advanced payment of rent, unearned fee from advertising services.
Revenues received in advance are recognised as income in the Trading and Profit and Loss
Account for only the portion of goods delivered or services/work-done being rendered. This
is based on the prudence concept.
Based on this concept, only the ascertained portion is taken up as revenue/income, the
balance of goods not delivered or work not yet done is taken up in the Balance Sheet. Only
when work being done or goods actually being delivered, can they be matched and taken up
into the Trading and Profit and Loss Account.
In the final accounts, income received in advanced or prepayment of income is:
Deducted from the income amount from the trial balance before listing it in the Profit
and Loss Account
Shown as a current liability in the Balance Sheet at the year end.
Income due or accrual of income is the income unpaid at the end of the financial year but
due in that year. For example, commission for the year received after the end of the financial
year to which it relates.
In the final accounts, income due or accrual of income is:
Added to the income amount from the trial balance before listing it in the Profit and
Loss Account.
Shown as a current asset in the Balance Sheet at the year end.

Provision for doubtful debts is the estimate by a business of the likely percentage of its
debtors which may go bad during any one accounting period.
Bad debts and provision for bad debts is an application of the prudence concept. The amount
of the provision will vary from business to business, depending on the past experience of
receiving payment, the nature of the business and the current economic climate.
The percentage chosen will be applied to the total figure for debtors reducing its figure (after
writing off bad debts).
Once the business estimates the percentage of its debtors which may go bad, the provision is
calculated. The accounting entries needed for the provision for doubtful debts are:
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Debit Profit and Loss Account with the amount of the provision (as an expense
named provision for doubtful debts)
Credit Provision for Doubtful Debts Account
For example:
The debtors figure after deducting bad debts was 5,000. The provision for doubtful debts is
2%. The accounts will show:
Profit and Loss Account (extract)
50,000
Gross profit
Expenses:
(100)
In the Balance Sheet the balance on the provision for doubtful debts will be deducted from
the total of debtors.
Provision for Doubtful Debts

Dr
Cr
100
Balance Sheet
Current assets
Debtors
5,000
(100)
4,900
Note: After the deduction of the figure of debtors in the Balance Sheet at the year end, we get
a net figure, which represents a more accurate figure of the value of debtors.
Preparing Financial Statements

Try the following activity before you look at the solution. Once you have finished check
your answers and review what you did not understand. Do not forget that your tutor is
there to help you.
Terry Hamilton is a wine merchant. He has prepared his Trial Balance as at December 31,
2007.
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Terry Hamilton
Trial Balance as at December 31, 2007
Bank
Capital account
Drawings
Insurance
Long-term loan from bank
Loan interest
Miscellaneous expenses
Office equipment cost
Fixtures and Fittings cost
Purchases
Rent and rates
Sales
Stock at 1 January 2007
Debtors
Creditors
Dr
70,600
Cr
38,600
32,000
3,600
100,000
15,000
15,400
10,000
4,750
70,000
33,250
4,000
640,000
20,000
744,000
72,000
186,000
1,134,600
210,000
1,134,600
Additional information:
1) The value of his closing stock at December 31, 2007 was 136,000
2) Rates of 4,000 were not paid and he paid insurance of 400 in advanced.
3) Office equipment has a useful life of four years and residual value of 500. It is
depreciated on a straight-line basis.
4) Fixtures and fittings are to be depreciated at a rate of 20% on a reducing balance
basis.
5) One of his customers has just gone out of business owing Terry 26,000.
6) The provision for doubtful debts is to be set at 10% of the outstanding debtors as at
December 31, 2007.
Required:
a) Prepare a Profit and Loss Account for the year ending December 31, 2007.
b) Prepare a Balance Sheet as at December 31, 2007.
103
Solution:
a)
Terry Hamilton
Profit and Loss Account for the year ending December 31, 2007
Sales
744,000
Less Cost of sales
Opening stock
72,000
Add purchases
640,000
712,000
Less closing stock
(136,000)
(576,000)
Gross profit
168,000
Less expenses
Insurance
Loan interest
Miscellaneous expenses
Rent and rates
Depreciation: (1)
Office equipment
Bad debts
Increase in doubtful debts provision (2)
3,200
15,000
15,400
24,000
2,375
7,350
26,000
12,000
(105,325)
62,675
Net profit
b)
Terry Hamilton
Balance Sheet as at December 31, 2007
Cost
Accumulated
Depreciation
Fixed assets:
Office equipment
10,000
70,000
80,000
Current assets:
Stock
Debtors
160,000
Less provision for doubtful debts (2) (16,000)
Prepayments
7,125
40,600
47,725
NVB
2,875
29,400
32,275
136,000
144,000
400
104
Bank
Current liabilities:
Creditors
Accruals
70,600
351,000
210,000
4,000
(214,000)
137,000
169,275
Long-term liabilities:
Bank loan
Net assets
Capital account:
Opening balance
Profit for the year
Less drawings
(100,000)
69,275
38,600
62,675
101.275
(32,000)
69,275
Workings:
(1) Depreciation:
Office equipment:
(10,000 500) / 4 = 2,375
Fixtures and fittings:
(70,000 32,250) x 20% = 7,350
(2) Provision for doubtful debts:

(186,000 26,000) x 10% = 16,000
The provision in the previous year was 4,000. The difference between last periods
provision and the provision for this period is: 16,000 4,000 = 12,000. Therefore,
12,000 is the increase of the provision for this year and it is shown in the Profit and Loss
Account.
The revised provision of 16,000 appears on the Balance Sheet. The doubtful debt
provision for this year replaces last years doubtful debt provision in the Balance Sheet. It
is not added to it.
105
1.4 Final Accounts of Limited Companies.

In module 1 we learnt the preparation of financial statements for sole traders. In this section
we are going to concentrate on the financial statements of a limited company.
A limited company is a separate legal entity normally owned by a number of individuals,
shareholders, and run by directors. The financial contribution required of the shareholders is
limited to the amount they originally invested in the company, limited liability. Therefore,
the shareholders (members) of a company can only lose the amount of their investment, being
the money paid already, together with any money unpaid on their shares (unpaid instalments
on new share issues, for example). Thus no matter what financial difficulty a company runs
into, the owners or shareholders are not legally required to contribute more funds in order to
pay off the companys debts. Their personal assets, unless pledged as security to a lender are
not available to the companys creditors. The limited company is responsible for paying its
own debts as it is regarded as being a separate legal entity from its owners.
1.4.1. Capital structure of a Limited Company.

The authorised share capital is stated in the Memorandum of Association and is the
maximum share capital that the company is allowed to issue. The authorised share capital
may not be the same as the issued share capital; under company law the issued capital cannot
exceed the amount authorised.
The capital structure normally comprises:
Share capital
Loan capital
Reserves
Share Capital
Individuals who wish to invest in a limited company do so by purchasing shares in that
company. This investment is known as the share capital and the investors are known as the
shareholders. Each shareholder receives a share certificate showing the number of shares they
have purchased. Generally shareholders are entitled to a share in the profits of a company
(called dividends) and a share in its assets on winding up.
There are two main types of shares:
1) Ordinary shares
2) Preference shares
1) Ordinary shares
106
These are the most common type in issue. They do not carry the right to receive a fixed
return by way of a dividend. However, ordinary shareholders are entitled to receive a
share of the profits which remain after the preference dividend has been paid.
Bear in mind that not all remaining profits will be distributed, some will be kept in the
company to help finance future operations. The portion kept within a company is known
as reserves and is owned by the ordinary shareholders.
Ordinary dividends, therefore, fluctuate year to year depending on the operating success
of the company and on the reinvestment policy. Ordinary shares generally do carry voting
rights. The ordinary shareholders are therefore the owners of the company, and, in the
event of the company becoming insolvent, will be the last to receive any repayment of
their investment: other creditors will be paid off first.
2) Preference shares
These shares carry the right to receive a fixed return on the investment by way of a
dividend. This right is often expressed as a percentage of the nominal value of the share,
e.g. 5% 1 preference share carries the right to an annual dividend of 5p per share.
Preference dividends must be paid before any other dividend can be paid. Preference
shares do not normally carry any voting rights. This means that generally preference
shareholders have no authority in, for example, the appointing of directors. In the event of
a company ceasing to trade, the preference will also extend to repayment of capital
before the ordinary shareholders.
It is important that you are able to distinguish between the following terms:
Authorised Share Capital: the total of the share capital which the company is
allowed to issue.
Issued Share Capital: the total of the share capital actually issued by the company.
Called Up Capital: where only part of the amount payable for each share has been
asked for, the called up capital is the total amount requested.
Uncalled Capital: this is the total amount to be received in the future that hasnt yet
been asked for.
Calls in Arrears: this is the total amount that has been asked for that hasnt yet been
paid by the shareholders.
Paid Up Capital: the total amount paid by the shareholders.
Each share has a nominal value (or face value) which is entered in the accounts. Shares may
be issued with nominal values of 5p, 10p, 25p, 50p or 1, or any other amount. For example:
100,000 ordinary shares of 50p each
50,000 10% preference shares of 1 each
50,000
50,000
100,000
In this example the company has an authorised share capital of 100,000 divided up as shown
above.
The market value of the shares is the price an individual is willing to pay for the shares.
107
The issue price is the price at which shares are issued to shareholders by the company, either
when the company is set up, or at a later date when it needs to raise more funds. The issue
price is either at par (i.e. the nominal value), or above nominal value. In the latter case, the
amount of the difference between issue price and nominal value is known as a share
premium. For example: nominal value 1.00; issue price 1.50; therefore, share premium is
50p per share.
Loan capital
Loan capital is generally known as debentures and is the money received by the company by
way of a loan. Debentures are normally shown in the Balance Sheet under the heading long
term liabilities as the company will eventually have to repay the loan at some future point in
time. There are two types of debentures;
a) Redeemable: repayable by a particular date.
b) Unredeemable: repayable only when the company is terminated.
All loan capital or debentures carry a fixed rate of return known as debenture interest which
must be paid annually irrespective of whether the company makes a profit or a loss. As loan
and debenture interest is a business expense, this is shown in the Profit and Loss Account
along with all other expenses. In the event of the company ceasing to trade, loan and
debenture-holders would be repaid before any shareholders.
If the company fails to repay the loan at the specified date the debenture holders have the
legal right to seize the asset on which the loan is secured and sell it to recoup the amount
owing to them, as often their loan is secured on the assets of the company. This type of
debenture is known as secured debenture.
Reserves
A limited company rarely distributes all its profits to its shareholders. Instead, it will often
keep part of the profits earned each year in the form of reserves. There are two categories of
reserves:
1. Capital reserves
2. Revenue reserves
1. Capital reserves.
Capital reserves are not available for distribution and therefore cannot be used to pay
dividends. There are two categories of capital reserves:
a) Revaluation reserve. These are the reserves related to unrealised capital gains. This is
required where a company wishes to revalue its fixed assets from historic cost to
current cost. For example, suppose that a company wishes to revalue its buildings to
108
current value which leads to an increase in value of 75,000. This would be recorded
as:
Dr Building cost:
Cr Revaluation Reserve:
75,000
75,000
Note, however, that this is purely a book adjustment, no cash has changed hands. It
increases the value of the shareholders investment in the company.
b) Share premium. It arises when additional shares are issued to the public at a higher
amount (premium) than the nominal value. For example, if a company is seeking
finance for further expansion it will issue additional ordinary shares. The shares have
a nominal value of 1 each but they are issued at 1.50 each. Of this amount, 1 is
recorded in the issued share capital section, and the extra 50p is the share premium.
2. Revenue reserves.
Revenue reserves comprise the undistributed profit of the company. As mentioned earlier,
companies do not generally pay out all of the available annual profits as dividends.
Generally part of the available profit is used in this way with the remainder remaining in
the company, so over a period of years the revenue reserves are likely to build up into a
substantial amount.
The main purposes of building up such reserves are:
To fun future expansion.

To enable the business to deal with any unexpected future events. A business with
reasonable reserves is in a position to sustain losses incurred.
To ensure that dividends can be paid to ordinary shareholders in years when poor
profits are made by using past years profits retained in reserves.
To finance asset replacements.
It should be noted that reserves, both capital and revenue, have no direct relationship with
cash, however, they are represented by assets shown on the Balance Sheet. The reserves
record the fact that the assets belong to the shareholders via their ownership of the company.
Now study the layout of the Profit and Loss Account and Balance Sheet showing ordinary
and preference shares, debentures, retained profit and corporation tax. Remember that you are
not required to calculate corporation tax, that figure will be given to you.
Tools Ltd
Trading and Profit and Loss Account for the year ended 31 December 20xx
Sales
725,000
Opening stock
45,000
109
Purchases
381,000
426,000
(50,000)
Less closing stock
376,000
349,000
Gross profit
Less expenses:
Directors remuneration
Debenture interest
Other overheads
75,000
6,000
225,000
(306,000)
43,000
(15,000)
28,000
Net profit for the year before taxation

Less corporation tax
Profit for the year after taxation
Less interim dividends paid
Ordinary shares
Preference shares
5,000
2,000
Final dividends proposed

Ordinary shares
Preference shares
10,000
2,000
19,000
9,000
41,000
Retained profit for the year

Add retained profits brought forward
Retained profits carried forward to next year
Fixed Assets
Tools Ltd
Balance Sheet as at 31 December 20xx
Cost
Acc. Depn.
Intangible
Goodwill
Tangible
Freehold land and buildings
Machinery
Current Assets
Stock
Debtors
Bank
Cash
50,000
NBV
50,000
20,000
30,000
180,000
230,000
100,000
560,000
20,000
90,000
25,000
155,000
160,000
140,000
75,000
405,000
50,000
38,000
22,000
2,000
112,000
110
Less Current Liabilities

Creditors
Proposed dividends
Corporation tax
30,000
12,000
15,000
57,000
Net current assets

Less Long-term Liabilities
10% debentures
Net Assets
55,000
460,000
60,000
400,000
Financed by:
Authorised Share Capital
100,000 10% preferences shares of 1 each
600,000 ordinary shares of 1 each
Issued Share Capital
40,000 10% preference shares of 1 each, fully paid
300,000 ordinary shares of 1 each, fully paid
Capital Reserve
Share premium account
Revenue Reserve
Profit and loss account
Shareholders funds
100,000
600,000
700,000
40,000
300,000
340,000
10,000
50,000
400,000
1.4.2. Increase of share capital of limited companies

Rights issue
A limited company may, if so authorised by its articles, increase its share capital by new
shares.
The costs of making a new issue of shares can be quite high. A way to reduce the costs of
raising new long-term capital in the form of issuing shares may be by way of a rights issue.
A rights issue is the issue of shares to existing shareholders at a price lower than the ruling
market price of the shares. The company contacts the existing shareholders and informs them
of the new issue to be made and the number of shares which each one of them is entitled to
buy of the new issue.
For example, a company has 8,000 shares of 1 each and declares a rights issue of one for
every eight held at a price of 1.50 per share. The market price of the shares is quoted at
2.50. Lets assume that all the rights issue were taken up. In this case the number of shares
111
taken up will be 1,000 (i.e. 8,000 / 8), and the amount paid for them will be 1,500. The
journal entries will be:
Journal
Dr
Cash
Cr
1,500
Share capital
Share premium
1,000
500
Being the rights issue of 1 for every 8 shares

held at a price of 1.50 nominal value being 1.00
Note that because the nominal value of each share is 1.00 while 1.50 was paid, the extra
50p constitutes a share premium to the company. Before the rights issue there were 8,000
shares at a price of 2.50, giving a market capitalisation of 20,000. After the issue there are
9,000 shares (8,000 plus 1,000 taken up) and the assets have increased by 1,500.
Bonus shares
If authorised by its articles, a company may resolve to use any undistributed profits, or any
sum credited to the companys share premium account or capital redemption reserve to
finance an issue of wholly or partly paid up 'bonus' shares to the members in proportion to
their existing holdings. The shareholders to whom the shares are issued pay nothing. The
terms 'scrip' or scrip issue are also used to describe such shares.
Therefore, bonus shares are free shares issued to shareholders without their having to pay
anything for them. The reserves (e.g. accumulated profits held in the Profit and Loss
Account and shown in the Balance Sheet) are utilised for the purpose.
For example, the extract of Y Ltds Balance Sheet as at 31 December 2007 is shown as:
Y Ltd
Balance Sheet as at 31 December 2007
(before bonus share are issued)
Fixed assets
Current assets less current liabilities
Share capital
Reserves (including profit and loss appropriation balance)
5,000
5,000
10,000
1,000
9,000
112
10,000
It has 1,000 ordinary shares of 1 each and 1,000 in the bank. The company has constantly
had to retain a proportion of its profits to finance its operations, thus diverting them from
being used for cash dividend purposes. Such a policy has conserved working capital.
If an annual profit of 1,500 was now being made, this being 15 per cent on capital
employed, and 1,000 could be paid annually as cash dividends, then the dividend declared
each year would be 100 per cent, i.e. a dividend of 1,000 on shares of 1,000 nominal value.
If it is considered that 7,000 of the reserves could not be used for dividend purposes, due to
the fact that the net assets should remain at 8,000, made up of fixed assets 5,000 and
working capital 3,000, then besides the 1,000 share capital which cannot be returned to the
shareholders there are also 7,000 reserves which cannot be rationally returned to them.
Instead of this 7,000 being called reserves, it might as well be called capital, as it is needed
by the business on a permanent basis.
To remedy this position bonus shares were envisaged. The reserves are made non-returnable
to the shareholders by being converted into share capital. Each holder of one ordinary share
of 1 each will receive seven bonus shares of 1 each.
The accounting entries necessary are to debit the reserve accounts utilised, and to credit a
bonus account. The shares are then issued and the entry required to record this is to credit the
share capital account and to debit the bonus account. The journal entries would be:
Journal
Reserve account (show each account separately)

Bonus account
Transfer of an amount equal to the bonus payable in fully
paid shares
Bonus account
Share capital account
Allotment and issue of 7,000 shares of 1 each,
in satisfaction of the bonus declared
Dr
7,000
Cr
7,000
7,000
7,000
The Balance Sheet would then appear:

Y Ltd
(after bonus shared are issued)
Fixed assets
Current assets less current liabilities
5,000
5,000
113
10,000
Share capital (1,000 + 7,000)
Reserves (9,000 - 7,000)
8,000
2,000
10,000
Try the following question:

Activity
1.
A firm has issued ordinary share capital of 60,000 1 shares. The current market price
of these shares is 5. The firm decides to make a rights issues of 1 share for every 3
held by existing shareholders for the price of 4. Assuming the rights issues is fully
taken up (paid in cash), show the journal entry needed to record the rights issue.
2.
The following is a balance sheet of Keown Ltd.

Keown Ltd Balance Sheet
16,000
4,000
20,000
Fixed assets
Net current assets
Share capital (1 each)

Revenue reserves
2,000
18,000
20,000
The directors of Keown Ltd have deicide to make a bonus issue of shares. It has been decided
to issue a bonus share in the proportion of 5 for every 1 share held. Show the balance sheet of
Keown Ltd after the bonus issue has been made. Show the journal entries needed to record
this bonus issue.
Answers
Answer to Question 1
The Journal
80,000
Cash
Share capital
20,000
114
Share premium
Rights issue of 1 for very 3 held at premium of 3 (i.e. issued for 4 each)
60,000
Answer to Question 2
Keown Ltd Balance Sheet
16,000
4,000
20,000
Fixed assets
Net current assets
Share capital (1 each)

Revenue reserves
12,000
8,000
20,000
The Journal
Revenue reserves
Bonus account
Bonus account
Share capital account
10,000
10,000
10,000
10,000
1.4.3. Revaluation of fixed assets

The most likely asset to be revalued, in practice, is property.
A revaluation of fixed assets is a technique that may be required to accurately describe the
true value of the capital goods a business owns.
Fixed assets are held by an enterprise for the purpose of producing goods or rendering
services, as opposed to being held for resale in the normal course of business. For example,
machines, buildings, patents or licences can be fixed assets of a business.
The purpose of a revaluation is to bring into the books the fair market value of fixed assets.
This may be helpful in order to decide whether to invest in another business. If a company
wants to sell one of its assets, it is revalued in preparation for sales negotiations.
Reasons for revaluation
It is common to see companies revaluing their fixed assets. The purposes are varied:
To show the true rate of return on capital employed.

To conserve adequate funds in the business for replacement of fixed assets at the end
of their useful lives. Provision for depreciation based on historic cost will show
inflated profits and lead to payment of excessive dividends.
115
To show the fair market value of assets which have considerably appreciated since
their purchase such as land and buildings.
To negotiate fair price for the assets of the company before merger with or acquisition
by another company.
To enable proper internal reconstruction, and external reconstruction.
To issue shares to existing shareholders (rights issue) or for an external issue of shares
(public issue of shares).
To get fair market value of assets, in case of sale and leaseback transaction.
When the company intends to take a loan from banks/financial institutions by
mortgaging its fixed assets. Proper revaluation of assets would enable the company to
get a higher amount of loan.
Sale of an individual asset or group of assets.
After an asset has been revalued, depreciation is calculated on the revalued amount. There are
different methods of revaluation of fixed assets, but it is not part of this course.
When a fixed asset is revalued, a reserve is created which adds to the value of the owners
capital. The double-entry is:
Debit fixed asset account

Credit capital account
Example:
The premises of a business have been revalued on 31 December 2007 at 150,000 and it has
been decided to record this value in the accounting system. The original cost of the premises
shown in the accounts on 1 January 2007 is 100,000. The balance on the capital account on
31 December 2007 is 200,000 before the revaluation is recorded.
The double entry would be:
Dr
1 Jan
31 Dec
Premises Account
Balance b/d
100,000
Capital account
50,000
Dr
Capital Account
1 Jan
31 Dec
Cr
Balance b/d
Premises account
Cr
200,000
50,000
Note that both premises account and the capital account have been increased by the amount
of the revaluation. The capital account balance is now 250,000. There is no new cash in the
business. The revaluation is not recorded in the Profit and Loss Account because it is a
capital transaction rather than a revenue transaction.
116
1.4.4. Preparing final accounts of limited companies

The Profit and Loss Account is a modification of the sole trader profit and loss account. The
two main expenses that would be found only in company accounts are directors
remuneration and debenture interest.
As directors are legally employees of the company, appointed by the shareholders, and exist
only in companies, their remuneration is charged to the Profit and Loss Account.
Debenture interest is charged as an expense in the Profit and Loss Account for the use of the
money, and it is payable whether profits are made or not.
Apart from those expenses which are only include in company accounts, everything else is
the same as a sole trader accounts until we get to net profit. After this, the net profit is sliced
up into a bit for corporation tax, a bit for dividends distributable to the shareholders, and a bit
retained by the company.
The company Balance Sheet will include creditors for taxation and dividends. The capital
account is replaced by share capital and reserves.
It is normal that dividends are paid twice a year. An interim dividend is paid during the year
and a final dividend is paid once the annual profit is known.
In the case of preference shares, the total dividend that should be paid is the percentage rate
of dividend multiplied by the nominal value of the issued preference share capital.
Tax unpaid at the year-end it is included in current liabilities in the Balance Sheet.
The appropriation account
The appropriation account shows how the net profits are to be used (appropriated). This
section is under the Profit and Loss Account, after taxation has been deducted from the profit
for the year.
If you are required to prepare an appropriation account in the examination, bear in mind that
you must start from the net profit; you do not need to prepare a full Profit and Loss Account,
unless you are asked to do so.
117
Worked example:
Try to do as much as you can to complete the Final Accounts before you look at the solution.
Then check your answers with the solution provided. Review anything you did not
understand and if you need help, contact your tutor.
The following trial balance is extracted from the books of Wilson Ltd as on 31 December
2006:
Wilson Ltd
Trial Balance as on 31 December 2006
Debit
Bank
200,000 ordinary shares of 1 each
80,000 10% preferences shares of 1 each
Freehold property
Office expenses
Wages & salaries
Directors remuneration
Purchases
Sales
Debtors
Creditors
Motor vehicles at cost
Plant & Equipment at cost
Profit and Loss Account (retained profits)
Stock at 31.12.05
Preference dividend paid
Ordinary dividend paid
85,000
Credit
200,000
80,000
225,150
43,750
81,250
187,500
350,000
901,300
150,000
175,000
45,000
87,500
17,500
212,500
21,500
111,600
62,500
4,000
12,500
1,526,650
1,526,650
1) The authorised share capital is 250,000 1 ordinary shares and 100,000 10%
preference shares of 1 each.
2) It has been decided that the freehold property will not be depreciated.
3) The corporation tax charge for the year is 125,000. It was not paid until after the year
end.
4) Depreciation is to be provided as follows:
a) Motor vehicles: 20% on cost
b) Plant and equipment 10% on the reducing balance
5) It has been decided to pay a final dividend of 25p per ordinary share, which wont be
paid until the following year.
118
Note: the debit of 12,500 in this years trial balance represents an interim dividend
already paid. Only half of the annual preference dividend has been paid, the
remainder will be paid during the next year.
6) Stock at December31, 2006 was 70,000.
Required:
Prepare a Profit and Loss Account for the year ended December 31, 2006 and a Balance
Sheet at that date.
Note: the authorised share capital figure is included in the Balance Sheet for information and
it is not recorded under the double entry system.
Solution:
Wilson Ltd
Profit and Loss Account for the year ending December 31, 2006
Sales
Less: Cost of sales:
Opening stock
Add: Purchases
901,300
62,500
350,000
412,500
(70,000)
Less: Closing stock
(342,500)
558,800
Gross profit
Less: expenses:
Office expenses
Wages & Salaries
Directors Remuneration
Depreciation:
Motor vehicles (1)
Plant & Machinery (2)
43,750
81,250
187,500
17,500
19,125
(349,125)
209,675
(125,000)
84,675
Net profit before tax

Taxation
Profit after tax
Less dividends:
Ordinary dividends:
paid
payable (3)
12,500
50,000
Preference dividends:
Paid
Payable
Add balance of retained profit brought forward
4,000
4,000
(70,500)
14,175
111,600
119
Retained profit carried forward
125,775
Wilson Ltd
Cost
Acc Depn
Fixed Assets
Freehold property
Motor vehicles
Plant & equipment
225,150
87,500
212,500
525,150
35,000
40,375
75,375
NBV
225,150
52,500
172,125
449,775
Current Assets
Stock
Debtors
Bank
70,000
175,000
85,000
330,000
Current Liabilities
Creditors
Taxation
Dividends payable:
45,000
125,000
Ordinary
Preference
50,000
4,000
(224,000)
Net Current Assets

Net Assets
106,000
555,775
Share Capital
Ordinary Shares of 1 each
10% Preference Shares of 1 each
Authorised Issued
250,000
200,000
100,000
80,000
350,000
280,000
Reserves
Share Premium Account
150,000
125,775
275,775
555,775
Workings:
(1) Motor vehicles depreciation:
87,500 x 20% = 17,500
(2) Plant & equipment depreciation:
(212,500 - 21,250) x 10% = 19,125
(3) Ordinary dividends payable:
200,000 x 25p = 50,000
120
LESSON 8. ANALYSIS OF PERFORMANCE.
8.1. Introduction
Information is data organised for a purpose. Information contained in financial statements is
organised to enable users of the financial statements to draw conclusions concerning the
financial well-being and performance of the reporting entity. However, financial statements
whilst informative provide limited information about a business. In order that we can
examine, analyse and interpret financial information, accounting ratios are calculated which
determine relationships between various figures which appear within the financial statements.
The results of ratio analysis can be used as the basis of decision making and provide a
benchmark against which performance can be measured and comparisons made.
In this lesson you will learn how to calculate and interpret the most commonly used
accounting ratios. You will learn how to asses an organisations profitability, liquidity,
efficiency, and capital structure using ratio analysis.
8.2 Ratios
Ratio analysis makes it possible to compare:
Performance within the current year against performance in previous years. As a

result trends can be established to determine which areas of the business are
expanding and which are contracting.
Performance within the current year against the budgeted or planned performance for
the year.
Performance of the business against the performance of other businesses.
It is important to note that you can only sensibly compare like with like. There is not much
point in comparing the net profit percentage of a restaurant and a jewellers shop. Similarly,
figures are only comparable if they have been built up on a similar basis. A company might
change its methods of valuation between two different time periods.
Another important point is to understand the relationships between ratios: one ratio may give
an indication of the state of the business, but this needs to be supported by other ratios. Ratios
indicate symptoms, but the cause will then need to be investigated.
As you learnt in Module 1, there are different parties interested in the financial information of
a business. Bearing that in mind, you can realised that the same parties will be the users of the
financial ratios, but they will be interested in different things:
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General management of the business, who need to make financial decisions affecting
the future development of the business.
Trade creditors and banks, who use ratios to assess the creditworthiness of the
business when making lending decisions.
Shareholders of a limited company, who wish to be assured that their investment is
sound.
Prospective investors in a limited company, who wish to compare comparative
strengths and weakness.
The main themes covered by the interpretation or analysis of accounts are:

1. Profitability. The relationship between profit and sales turnover, assets and capital
employed.
2. Solvency/liquidity. It considers the stability of the business on both a short-term and
long-term basis.
3. Asset utilisation. The effective and efficient use of assets.
4. Investment ratios. They examine the returns to shareholders in companies.
8.2.1. Categories of ratio:

1. Profitability ratios
Profitability ratios are used to determine the ability of a business to generate profit, and
include:
Return on Capital Employed

Gross profit as percentage of sales
Net profit as percentage of sales
a) Return on Capital Employed (ROCE)

This is regard as being the primary ratio and is the most important of the ratios. It
measures the profit of the business as compared to the monies invested in it long term,
and, therefore, assess profits in relation to the size of the business.
An adequate return on capital employed is why people invested their money in a business
in the first place.
The formula for calculating this ratio, which should be expressed as a percentage, is:
ROCE
Net profit (before tax) x 100

Capital Employed
1
Note:
The net profit is the operating profit (net profit before interest and tax)
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Capital employed = net assets (fixed assets + current assets current assets)
However, there is no universally agreed definition of return on capital employed for
companies. It is necessary to distinguish between the ordinary shareholders investment
(the equity) and the capital employed by the company, which included preference shares
and debentures/long-term loans.
These different definitions of capital employed give further accounting ratios:
i) Return on capital employed by ordinary shareholders (equity).
In a limited company this is known as Return on Owners Equity (ROOE) or, more
commonly, Return on Shareholders Funds (ROSF). Ordinary share capital +
Reserves = Equity. The Return is the net profit for the period.
ii) Return on capital employed by all long-term suppliers of capital. This is often
known as Return on Capital Employed (ROCE). In this case the word Return
means net profit + any preference share dividends + debentures and long-term
loan interest. The word Capital means Ordinary Share Capital + Reserves
including Profit and Loss Account + Preference Shares + Debentures and Longterm loans.
For example:
Two business A and B have made the same profit, but they have employed
different capitals
Balance Sheets
Net assets
Capital accounts
Opening balance
Net profit
Drawings
A
10,000
B
10,000
8,000
3,600
11,600
(1,600)
10,000
14,000
3,600
17,600
(1,600)
16,000
Return on capital employed (ROCE) is:

Net profit
Capital employed
x 100
Therefore,
Business A:
Business B:
3,600 x 100 = 36%

10,000
3,600 x 100 = 22.5%
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16,000
Business A has made far better use of its capital, achieving a return of 36 net
profit for every 100 invested, whereas B has received only a net profit of
22.50 per 100. By only looking at the net profit of the two businesses we
would not have been able to see how well the capital had been employed. This
is a key factor for the shareholders and potential investors.
Now we have the Balance Sheets and Profit and Loss Account of two companies, A
Ltd and B Ltd:
Fixed assets
Net current assets
10% debentures
Balance Sheets as at 31 March 2008

A Ltd
5,200
2,800
8,000
8,000
Share capital (ordinary)

Reserves
3,000
5,000
8,000
Profit and Loss Account for year ended 31 March 2008

A Ltd
Net profit
2,200
Dividends
(1,200)
1,000
B Ltd
8,400
1,600
10,000
(1,200)
8,800
5,000
3,800
8,800
B Ltd
3,800
(1,800)
2,000
Return on Shareholders Funds (ROSF):

A Ltd:
2,200 x 100 = 27.5 %

8,000
B Ltd:
3,800 x 100 = 43.2 %

8,800
Return on Capital Employed (ROCE):

A Ltd:
2,200 x 100 = 27.5 %

8,000
(ROCE = ROSF, as it has no debentures)

(Net profit before interest, dividends and taxes)
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B Ltd:
3,800 + 120 x 100 = 39.2 %

8,800 + 1,200
(The debenture interest, i.e. 10% of 1,200 = 120, must be added back, as it was an
expense in calculating the 3,800 net profit. In capital employed we add back
Debentures of 1,200)
b) Gross profit as percentage of sales
This ratio indicates the extent to which costs of goods sold are being controlled in relation
to sales income. It is also known as gross margin. This expresses, as a percentage, the
gross profit (sales minus cost of sales) in relation to sales.
The formula for calculating this ratio is:
Gross Profit x 100
Sales
1
This ratio is used as a test of the profitability of the sales. Just because sales revenue has
increased does not, of itself, mean that the gross profit will increase.
Gross margins are likely to be affected by:
The nature of the business

Its pricing policy
Leakage of stock due to wastage, damage, or theft of goods by customers or staff
Absorbing purchase price increases to remain competitive rather than passing
them on to customers.
Selling goods at lower prices to clear them from stock
For example:
A business has the following Trading Accounts for the years 2006 and 2007:
Trading Accounts for the year ended 31 December
2006
Sales
Less Cost of sales:
Opening stock
Add Purchases
Less Closing stock
Gross profit
7,000
500
6,000
6,500
(900)
2007
8,000
900
7,200
8,100
(1,100)
(5,600)
1,400
(7,000)
1,000
Therefore, in the year 2006,
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Gross profit as percentage of sales: 1,400 x 100 = 20%

7,000
In the year 2007,
Gross profit as percentage of sales: 1,000 x 100 = 12.5%
8,000
Sales had increased but, as the gross profit percentage had fallen, the gross profit has
fallen. There can be many reasons for such a fall. Think of some of the possible
reasons for that.
c) Net profit as percentage of sales

This ratio shows net profit in relation to sales. It is also referred to as net profit margin.
When compared to the gross profit of sales it shows how expenses (selling, distribution
and administration) have impacted on sales.
Net profit (before tax) x 100
Sales
1
Net profit percentage should, ideally, increase from year-to-year, which indicates that the
profit and loss account costs are being kept under control. Any significant fall should be
investigated to see if it has been caused by a fall in gross profit percentage and/or an
increase in one particular expense, e.g. wages and salaries, advertising, etc.
2. Liquidity ratios
Liquidity ratios measure the ability of a business to meet its short term commitments as
they fall due. It is also known as solvency ratio.
It is important for a business to know if it will be able to pay its creditors, expenses, loans
falling due, etc at the correct times. Failure to ensure that these payments are covered
effectively could mean that the business would have to be close down. Being able to pay
ones debts as they fall due is known as being liquid.
On the other hand, it is also essential to be aware if a customer or borrower is at risk of
not repaying the amount due.
Therefore, when it comes to the liquidity of a business, both its own ability to pay its
debts when due and the ability of its debtors to pay the amount they owe to the business
are very important.
The two ratios that are affected most by these two aspects of liquidity are:
Current ratio or working capital ratio
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Acid test ratio or quick assets ratio
a) Current ratio (net current asset ratio)

Current ratio uses figures from the Balance Sheet and measures the relationship between
current assets and current liabilities. It is intended to indicate whether there are sufficient
short-term assets to meet the short-term liabilities by comparing assets which will become
liquid within twelve months (total current assets) with liabilities which will be due for
payment in the same period (total current liabilities).
The formula for calculating this ratio, which is expressed as a ratio, is:
Current ratio = Current assets
Current liabilities
Although there is no ideal current ratio, an acceptable ratio is about 2:1, i.e. 2 of current
assets to every 1 of current liabilities.
As you can see, when calculated, the ratio may be expressed as either a ratio to 1, as
above, with current liabilities being set to 1, or as a number of times, representing the
relative size of the amount of total current assets compared with total current liabilities.
Once you have performed the calculation, you need to decide what it tells you. The
acceptable ratio may be useless or misleading if you do not consider the result in its
context. For example, a business in the retail trade may be able to work with a lower ratio,
e.g. 1.5: 1 or even less, because it deals mainly in sales for cash and so does not have a
large figure for debtors.
If the current ratio is above 3:1 an investigation of the make-up of current assets and
current liabilities is needed. It may be that the business has too much stock, too many
debtors, or too much cash at the bank, or even too few creditors.
b) Acid test ratio (liquid capital ratio)

The acid ratio uses the current assets and current liabilities from the Balance Sheet, but
stock is omitted. This is because stock is the most illiquid current asset: it has to be sold,
turned into debtors, and then the cash has to be collected from the debtors. Also, some of
the stock may be unsaleable or obsolete.
The formula for calculating this ratio, which is expressed as a ratio, is:
Acid test ratio = current assets - stock
current liabilities
The balance between liquid assets, i.e. debtors and cash/bank, and current liabilities
should, ideally, be about 1:1, i.e. 1 of liquid assets to each 1 of current liabilities. At
this ratio a business is expected to be able to pay its current liabilities from its liquid
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assets. However, a cash based business, such as a supermarket chain, may operate
efficiently with a much lower ratio.
Example:
Lets look at two businesses with similar profitability. Sales for both businesses amounted
to 150,000, and gross profits were identical: 50,000.
Fixed assets
Current assets
Stock
Debtors
Bank
Less Current liabilities:
Creditors
Balance Sheets
A
40,000
B
70,000
30,000
45,000
15,000
90,000
50,000
9,000
1,000
60,000
(30,000)
(30,000)
60,000
100,000
30,000
100,000
80,000
36,000
116,000
(16,000)
100,000
80,000
36,000
116,000
(16,000)
100,000
Capital
Opening capital
Net profit
Drawings
Now we will calculate the two ratios which we has just learnt:
Current ratio:
A = 90,000 = 3
30,000
B = 60,000 = 2
30,000
Acid test ratio:

A = 60,000 = 2
30,000
B = 10,000 = 0,33
30,000
This reveals that B, although it is profitable, may find difficult to pay its current
liabilities on time. If liquidity becomes a problem it may make the business fail.
This is an example of two profitable businesses with a vast difference in liquidity.
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3. Efficiency ratios/Asset utilisation

Efficiency ratios are used to show how effective the business has been in controlling its
expenses, turning over its stock, collecting monies due from its trade debtors, and using
credit available from suppliers. It is affected by the way that the assets of a business are
used.
Ratios within this category include:
Expenses percentage of sales

Stock turnover
Debtors collection period
Creditors payment period
a) Expenses percentage of sales

Businesses use expense ratios to assess how efficiently overheads are being controlled in
relation to sales. They may calculate and express each expense item as a percentage of
sales, or total expenses as a percentage of sales, or group together expense items and
express them as a percentage of sales.
For example, the relationship between advertising and sales might be 10% one year, but
20% the following year. That means that there was an increase in advertising costs but it
has not been reflected in sales. Further investigation will be required to find out the
reason for the percentage increase.
The formula for calculating expense ratios is:
Total expenses x 100
Sales
1
Expense item x 100
Sales
1
Group of expenses items x 100
Sales
1
b) Stock turnover
Stock turnover measures how efficient a business is at maintaining an appropriate level of
stock. The objective being to turnover stock as many times as possible within a financial
year. Provided the stock is priced out correctly, the more times the stock is turned over
the more profit the business will generate.
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A reduction in stock turnover can mean that the business is slowing down. Stocks may be
piling up and not being sold. This could lead to a liquidity crisis, as money may be being
taken out of the bank simply to increase stocks which are not then sold quickly enough.
Different types of businesses have different periods of stock turnover. For example, a
supermarket would probably turnover its stock 12 times a year, however, a jeweller might
only turnover his stock one or twice a year or longer.
The average stock turnover period may give a useful indication of trading difficulties
facing a particular firm by comparing it with the average for previous periods. A fall in
the ratio may indicate a degree of obsolescence in the firms products, adverse marketing
circumstances or stiffening competition.
This ratio can also be classified as a liquidity ratio.
The formula for calculating this ratio, which is expressed in terms of the number of times
the stock is turned over, is:
Stock turnover = costs of sales
average stock
Note: average stock = opening stock + closing stock / 2
For example, a business A has a closing stock of 30,000, the costs of sales was
96,000 and the opening stock was 34,000, then using the average of the opening
and closing stocks, the stock turnover, would be:
96,000
(34,000 + 30,000) / 2
= 3 times
For you to be able to compare the result you need to be able to compare it against
similar business or previous years.
c) Debtors collection period
This ratio indicates the average period of credit being taken by credit customers, i.e. it
measures how efficient the business has been in collecting amounts due from its trade
debtors. The period of credit being taken needs to be compared to the normal period of
credit the business offers to its credit customers.
The formula to calculate this ratio, expressed in terms of number of days, is:
Trade debtors x 365 days
Credit sales
For example, at an accounting year end the closing trade debtors totals 36,000 and the
total credit sales for the year are 400,000, the debtors ratio would be:
36,000
x 365 = 32.85 days
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400,000
This gives us the average credit period taken by debtors before clearing their debts, in this
case 32.85 days. Extended credit taken by customers can be costly as it requires
additional working capital; it can also be indicative of a breakdown in the credit system
collection system of a business. The longer the average collection period the greater will
be the likelihood of bad debts.
d) Creditors payment period
The creditor payment period indicates how efficiently the business is using trade credit,
and shows the average period of credit being taken from suppliers. A business should
itself abide with the terms of credit allowed by its suppliers and pay on time, just as a
business wishes to collect on time from its customers.
Ideally, a business would want to minimise its debtors collection time and maximise its
creditors payment time as far as it can, as creditors can be a useful temporary source of
finance; however, delaying payment too long may cause problems and may detriment the
relations with its suppliers: the business may lose creditworthiness and jeopardise future
supplies.
Trade creditors x 365 days
Credit purchases
For example, at an accounting year end the closing trade creditors totals 42,000 and
the total credit purchases for the year are 420,000, the creditors ratio would be:
42,000 x 365 = 36.5 days
420,000
This gives us the average credit period allowed by the businesss creditors as 36.5
days.
Generally, we would expect to see the creditor days period longer than the debtor
days, i.e. money is being received from debtors before it is paid out to creditors.
4. Capital structure. Gearing ratio

The relationship of equity shares (ordinary shares) to other forms of long-term financing
(long-term loans plus preference shares) can be extremely important.
This ratio provides the proportion of a companys total capital that has a prior claim to
profits over those of ordinary shareholders.
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The gearing ratio can be found by dividing the prior capital (i.e. preference capital,
debentures and long-term loans, regarded as prior because they come before the ordinary
capital) by the ordinary share capital. The formula is:
Long-term loans + Preference shares
x 100
Ordinary share capital + Reserves + Preference shares + Long-term liabilities
This formula is sometime abbreviated to:
Prior charge capital x 100
Total capital
Long-term loans include debentures.
For example:
We have two companies, A Ltd and B Ltd, which have been trading for five years. We
want to calculate their gearing from the extracted Balance Sheet shown below:
Year 5. Extracted Balance Sheet
A Ltd
10% debentures
10% preference shares
Ordinary shares
Reserves
10,000
20,000
100,000
70,000
200,000
B Ltd
100,000
50,000
20,000
30,000
200,000
Gearing ratios:
A Ltd:
10,000 + 20,000
10,000 + 20,000 + 100,000 + 70,000
B Ltd:
100,000 + 50,000
100,000 + 50,000 + 20,000 + 30,000
x 100 = 15% (low gearing)
x 100 = 75% (high gearing)
A company with a high percentage gearing ratio is said to be high geared, whereas one
with a low percentage gearing is said to be low geared.
This means that people investing in ordinary shares in a high geared company are taking a
far greater risk with their money than if they had invested instead in a low geared
company. In good times, the shareholders will enjoy a far higher return than in a low
geared company; however, in bad times, very little might be left over for ordinary
shareholders, as the rate of debt (i.e. long-term loans and preference shares) is high.
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5. Mark-up and margin

The purchase costs, gross profit and selling price of goods or services may be shown as:
Cost price + Gross profit = Selling price
The gross profit is known as the mark-up when shown as a percentage of the cost price.
However, when shown as a percentage of the selling price is known as the margin.
Therefore,
Mark-up = Gross profit
Cost price
Margin = Gross profit
Selling price
Fox example:
Cost price = 4
Gross profit = 1
Selling price = 5
Then,
Mark-up = 1 / 4, as a percentage it would be: 1 / 4 x 100 = 25%
Margin = 1 / 5, as a percentage it would be: 1 / 5 x 100 = 20%
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8.2.2. Limitations of ratio analysis

Although accounting ratios can usefully highlight strengths and weaknesses, they should be
considered as part of the overall assessment of a business, rather than as a whole. However,
the ratio analysis does have its pitfall and limitations:
1. Care should be exercised when selecting ratios as the basis for analysis. A
representative selection should be made avoiding over emphasis of a single ratio.
2. When using ratios for comparison purposes differences in types of business entity
may cause problems. The rate of stock turnover of a supermarket chain, for example,
would be vastly different to that of a construction or engineering company.
3. When the accounts of a business are compared, either with previous years, or with a
similar business, there is a danger that the comparative accounts are not drawn up on
the same basis due to different accounting policies, which may result in distortion and
invalid comparisons. For example, different accounting policy in respect of
depreciation and/or stock valuation.
4. Particular care must be taken when interpreting accounting ratios for a seasonal
business.
5. Limited access to the detailed information on which the ratio calculated was based to
those outside the firm if a much deeper analysis is necessary.
6. There is a danger of relying too heavily on suggested standards for accounting ratios
(e.g. 2:1 for the working capital ratio) without considering the nature of the business
or other factors in the Balance Sheet. An example would be a business with a low
current ratio which sells the majority of its goods for cash and consequently has a
very low debtors figure (e.g. retail companies).
7. As financial statements are prepared on an historic cost basis (assets and liabilities
are recorded at their original cost), inflation may prove a problem when comparing
figures from one year to the next.
For a summary and overview of the ratio analysis, click on the following link:
http://www.bized.co.uk/educators/16-19/business/accounting/presentation/ratio_map.htm
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Question A
1) What would you deduce from the following figures taken from the balance sheet of
two different companies at the same time?
Company A
Stock
Cash and debtors
Company B
50,000
50,000
100,000
50,000
50,000
Current liabilities
Working capital
300,000
20,000
320,000
270,000
50,000
2) What does the debtors ratio indicate?

3) What does the creditors ratio indicate?
Question B
Given the Trading and Profit and Loss Account and Balance Sheet of the company Smith Ltd
for the years ended 31 December 2007 and 2006:
Smith Ltd
Trading and Profit and Loss Account for the years ended 31 December
Sales
2006
000 000 000
1,077
2007
000 000 000
1,598
Cost of sales:
Opening stock
Purchases
63
713
65
1159
Closing stock
776
65
1,224
74
Gross profit
711
366
1,150
448
Expenses
Net profit (before tax)
Tax
Net profit (after tax)
Dividend proposed
Undistributed profit
Undistributed profit b/f
Undistributed profit c/f
291
75
26
49
20
29
75
104
314
134
46
88
25
63
104
167
Note: All purchases and sales are on credit.
135
Smith Ltd
Balance Sheets as at 31 December
2006
000 000 000
Fixed assets (WDV)
Current assets:
Stock
Trade Debtors
Bank
2007
000 000 000
183
65
158
54
280
74
176
50
277
Current liabilities:
Trade creditors
Tax
Dividends
300
60
26
20
92
46
25
106
163
171
354
137
417
Financed by:
Ordinary Share Capital
Reserves
Undistributed profit
250
104
250
167
354
417
Required:
1) calculate the following ratios:
a)
b)
c)
d)
e)
f)
g)
h)
i)
Return on capital employed

Gross profit as percentage of sales
Net profit as percentage of sales
Total expenses as percentage of sales
Stock turnover ratio
Debtor payment period
Creditor payment period
Current ratio
Acid test ratio
2) Comment on the profitability and liquidity of the business in each of the years making
references to the relevant ratios.
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Diploma in
Accounting
Accounting
Module 5: Introduction to Budgeting and Budget Control
ICT in Accounting
137
LESSON 9. INTRODUCTION TO BUDGETING
9.1. Introduction
Management accounting is concerned with providing information for planning and
control so that organisations can achieve their objectives. One of the central supporting
devices of both of these aims is budgeting.
The various activities within a company should be coordinated by the preparation of
plans of actions for future periods. These detailed plans are usually referred to as
budgets.
Therefore, when a plan is expressed quantitatively it is known as a budget and the
process of converting plans into budgets is known as budgeting.
In this lesson we will focus on the role of budgeting within the planning process of a
business organisation and you will learn the need for budgeting in business organisations
and the benefits of budgetary control. You will also learn how to prepare cash budgets.
9.2. Budgeting and functions of budgets

Budgeting is concerned with the implementation of the long-term plan for the year ahead.
However, budgets represent the short-term planning developed within the context of
ongoing business and is ruled by previous decisions that have been taken within the longterm planning process.
The budgeting process cannot be viewed as being purely concerned with the current year,
it must be considered as an integrated part of the long-term planning process. It is an
integral part of both planning and control. Budgeting is about making plans for the future,
implanting those plans and monitoring activities to see whether they conform to the plan.
In the planning process there are different stages:
Stage 1: Establishing objectives. It is an essential pre-requisite of the planning

process. It is important for all parts of the organisation to have a good
understanding of what it is trying to achieve.
Stage 2: Identify potential strategies. In this stage it is important to identify a
range of possible courses of action (or strategies) that might enable the companys
objectives to be achieved. It is necessary to undertake a strategic analysis to
become better informed about the organisations present strategic situation. After
that, the next stage is to identify alternative strategies.
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The identification of strategies should take into account:
The generic strategy to be pursued

The alternative directions in which the organisation may wish to develop.
Stage 3: Evaluation of strategic options. The alternative strategies should be

examined based on the following criteria:
1. Suitability, which seeks to ascertain the extent to which the proposed
strategies fit the situation identified in the strategic analysis.
2. Feasibility, which focuses on whether the strategy can be implemented in
resource terms. E.g.: can the strategy be funded?
3. Acceptability, which is concerned with whether a particular strategy is
acceptable. E.g. is the level of risk acceptable?
Stage 4: Select a course of action. Long-term plans should be created to

implement the strategies. They are a statement of preliminary targets and
activities required to achieve the strategic plans of the organization.
Stage 5: Implementation of the long-term plans. When the activities are initially
approved for inclusion in the long-term plan, they are based on uncertain
estimates that are projected for several years. These proposals must be reviewed
and revised in the light of more recent information, which takes place as part of
the annual budgeting process, as budgeting is an integrated part of the long-term
planning process.
Stage 6 and 7: Monitor actual outcomes and respond to divergencies from planned
outcomes. These stages represent the control process of budgeting.
Budgets serve a number of useful purposes:

1.
2.
3.
4.
5.
6.
Planning annual operations

Coordinating the activities of the various parts of the organization
Communicating plans to the various responsibility centre managers
Motivating managers to strive to achieve the organizational goals
Controlling activities
Evaluating the performance of managers
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1. Planning.
The budgeting process ensures that managers do plan for future operations, and that
they consider how conditions in the next year might change and what steps they
should take now to respond to these changed conditions. This process encourages
managers to anticipate problems before they arise.
2. Coordination.
The budget serves as a vehicle through which the actions of the different parts of an
organization can be brought together and reconciled into a common plan. Without
coordination, managers, believing that they are working in the best interest of the
organization, may make their own decisions independently. Budgeting, therefore,
compels managers to examine the relationship between their own operations and
those of other departments, and to identify and resolve conflicts.
3. Communication.
All parts of the organization must be kept fully informed of the plans and the policies,
and constraints, to which the organization is expected to conform. Top management
communicates its expectations to lower level management, so that everyone in the
organization has a clear understanding of what is expected from them their activities
can be coordinated to attain them.
4. Motivation.
The budget can be used as a device to influence and motivate managers to perform in
line with the organizational objectives.
5. Control.
By comparing the actual results with the budgeted amounts for different categories of
expenses, managers can ascertain which costs do not conform to the original plan and
thus require their attention. When the reasons for the inefficiencies have been found,
appropriate control action should be taken to remedy the situation.
6. Performance evaluation.
A mangers performance is often evaluated by measuring his or her success in
meeting the budgets. The budget thus provides a useful means of informing managers
of how well they are performing in meeting targets that they have previously helped
to set.
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9.3. Cash budgets

A cash budget is one of the most important budgets prepared in an organisation. It
shows, in summary form, the expected cash receipts and expected cash payments
during the budget period. Liquidity and cash flow management are key factors in the
successful operation of any organisation and it should receive close attention.
Why is cash so important? Cash is the lifeblood of the business. Not only is it
important to get the amounts of cash right, we also need to get the timing right. For
example:
John buys 500 widgets for 10,000 on 1 January and agrees to pay for these on 1
February. He sells the widgets on 2 January for 15,000 and agrees to be paid on 1
March.
In simple accounting terms, John has made a healthy profit of 5,000, but, in cash
flow terms, he is bankrupt! This is because, although John has sold the widgets for a
profit, this profit will not be realised until 1 March when he is paid. However, John
has agreed to pay 10,000 on 1 February, which (unless he has other funds) he cannot
pay.
This example illustrates a very important principle: it is possible to trade profitably in
the long term provided there is sufficient cash in the system to meet short term debts
as they become due. Neglecting cash can bankrupt an otherwise profitable business.
The objective of the cash budget is to ensure that sufficient cash is available at all
times to meet the level of operations that are outlined in the various budgets.
The cash budget shows the effect of budgeted activities: selling, buying, paying
wages, investing in capital equipment and so on, on the cash flow of the organisation.
It is important to understand how cash moves within a business. This movement of
cash is best illustrated by the working capital cycle, which you can find by clicking
on the following link:
http://tutor2u.net/business/finance/workingcapital_cycle.htm
A cash budget must contain every type of cash inflow or receipt and every type of
cash outflow or payment. In addition to the amounts, the timings of receipts and
payments must also be forecast.
Receipts: cash sales, receipts from debtors, sales of fixed assets, receipts of interest
and dividends, issues of new shares and loan stock
141
Payments: payments to creditors for stock and material purchases, wages and salaries,
payments for overhead and expense items, purchase of fixed assets, payments of
dividends, interest and taxation, loan repayments.
It is important to realise that cash receipts and payments are not the same as sales and
costs of sales found in the Profit and Loss Account because:
Not all cash receipts affect profit and loss account income, e.g. issue of
new shares results in a cash inflow but would not be shown in the Profit
and Loss Account.
Not all cash payments affect the costs shown in the Profit and Loss
Account, e.g. the purchase of a fixed asset.
Some profit and loss items are derived from accounting conventions and
are not cash flows, e.g. depreciation.
The timing of cash receipts and payments does not coincide with the profit
and loss accounting period, e.g. sales are recognised when the invoices are
raised although the payment may not be received until some time later.
A cash budget is simply a forecast of:

-
Where your expect your cash to come from

Where you expect your cash to go to.
You also need to decide when money will change hands. For that you will prepare a
cash flow forecast. Once everyone becomes committed to achieving that forecast, it
becomes your cash budget.
142
9.3.1. Format of cash budgets

The typical cash budget has the general form shown below:
Cash budget
Opening cash balance b/f

+ receipts from debtors
+ sales of fixed assets
+ any loans received
+ proceeds for share issues
+ any other cash receipts
= total cash available
- payments to creditors
- cash purchases
- wages and salaries
- loan repayments
- capital expenditure
- dividends
- taxation
- any other cash disbursments
= closing cash balance c/f
Period 1
XXXX
Period 2
YYYY
Period 3
ZZZZ
YYYY
ZZZZ
AAAA
Note: The opening balance could be in the third section above closing cash balance
c/f.
As you can see there are three sections. The first section is for receipts, the second is
for payments and the third is the cash balance to be carried forward.
When you compare the budgeted cash forecast with the actual you will find that there
is normally a difference. The difference between the two figures is known as
variance.
The variance can be:
1. a favourable variance, where the actual figure is better than the budget
figure.
2. an adverse variance, where the actual figure is worse than the budget
figure.
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Example:
You have the following information regarding a business:
a) Opening cash balance: 800.
b) Receipts from debtors: July 2,000, August 2,600, September 5,000, October
7,000, November 8,000, December 15,000.
c) Payments: July 2,500, August 2,700, September 6,900, October 7,800,
November 9,900, December 10,300.
Required:
Prepare a cash budget for the months of July, August, September, October, November
and December.
Cash budget
Opening
balance
Receipts
Total cash
available
Payments
Closing
cash
balance c/f
July
800
August
300
September October
200
(1,700)
November
(2,500)
December
(4,400)
2,000
2,800
2,600
2,900
5,000
5,200
7,000
5,300
8,000
5,500
15,000
10,600
2,500
300
2,700
200
6,900
(1,700)
7,800
(2,5000)
9,900
(4,400)
10,300
300
Click on the link below and use the different headings on the left hand side of the
page where you will find a summary of what you have learnt on Cash budget:
http://tutor2u.net/business/presentations/accounts/cashbudget/default.html Cash budget
summary
144
Question 9.A
The opening cash balance on 1st January was expected to be 30,000. The sales budgeted
were as follows:
November
December
January
February
March
80,000
90,000
75,000
75,000
80,000
Payments received from debtors are: 60% within the month of sale, 25% the month
following, 15% the month following.
The purchases budgeted were as follows:
December
January
February
March
60,000
55,000
45,000
55,000
All purchases are on credit and 90% are settled in the month of purchase and the balance
settled the month after.
Wages are 15,000 per month and overhead of 20,000 per month (including 5,000
depreciation) are settled monthly.
Taxation of 8,000 has to be settled in February and the company will receive settlement
of an insurance claim of 25,000 in March.
Required:
Prepare a cash budget for January, February and March.
Solution
Cash Budget
Opening Balance
Receipts from sales
Insurance claim
Total cash available
Payments:
January
30,000
79,500
February
24,000
77,250
109,500
101,250
March
17,250
78,000
25,000
120,250
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Purchases
Wages
Overheads
Taxation
Total payments
Closing balance c/d
55,000
15,000
15,000
85,500
24,000
46,000
15,000
15,000
8,000
84,000
17,250
54,000
15,000
15,000
84,000
36,250
Workings:
Receipts from sales:
November (15% x 80,000)
December (25% x 90,000)
January (60% x 75,000)
December (15% x 90,000)

January (25% x 75,000)
February (60% x 75,000)
January (15% x 75,000)

February (25% x 75,000)
March (60% x 80,000)
January cash
12,000
22,500
45,000
79,500
February cash
13,500
18,750
45,000
77,250
March cash
11,250
18,750
48,000
78,000
Payments for purchases:
December (10% x 60,000)

January (90% x 55,000)
January cash
6,000
49,500
55,500
January (10% x 55,000)

February (90% x 45,000)
February cash
5,500
40,500
46,000
February (10% x 55,000)

March (90% x 55,000)
March cash
4,500
49,500
54,000
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Question 9.B
Click on the link below and try the quiz on ratios, analysing financial performance:
http://tutor2u.net/business/quizzes/as/analysing_financial_performance/quizmaker.htm
LESSON 10. THE IMPACT OF ICT IN ACCOUNTING
10.1. Computerised system

There are currently very few businesses which do not use a computer for some of their
data processing tasks.
Computers may be used for most or even all the accounting tasks. However, it is
important to understand how data is entered and processed so that the figures produced
can be reliable, valid and meaningful.
The technology when computers are used in an accounting system will vary in size to
meet the volume of data processing required by a business: a large and powerful central
computer or PCs for all accounting purposes.
When a central computer is used, the terminals need to be networked (i.e. linked together
through wires that run from their workstations to the central computer or via a router in a
wireless connection). Being linked together has the advantage that data and information
can be passed directly from one computer to another. Although they can operate
independently of any other computer, PC-based systems may also be connected together
on a local area network (LAN, i.e. internal to the location) and a wide area network
(WAN, i.e. connected outwith the location of the workstation to, for example, a computer
located at the businesss head office in another city).
Most financial accounting and bookkeeping programs are purchased off-the-shelf, as they
are flexible enough to be adapted to meet the major needs of most businesses.
Apart from using the accounting system for recording transactions, adjustments and
producing financial statements, there are other matters will be tackled, such as forecasting
the cash flows of a business, stock ordering, sales volume, costing. For such purposes, a
PC-based spreadsheet may be used, such as Excel.
The number of businesses which use a computerised system has increased substantially
lately. Most of those businesses will find very difficult to process the same volume of
data by reverting to a manual system.
147
When computers are used for all aspects of the accounting system, they can do everything
that can be done with a manual system; however, computers will do them faster, more
accurately and more efficiently. It saves time with respect to transaction processing and
the production of a whole series of reports. For example, if a business computerises its
stock records, the operator will save time in producing details of stock items that may be
in short supply and check items not yet received and chase up suppliers for those items
not delivered on time.
Another important point to bear in mind is that all computer systems will need to supply
information in a form that management can use to assist in its decision-making.
One of the most important principles in computing is the discipline of backing-up data
held on computer. This serves the purpose that, if anything ever goes wrong with the
data, then the business can always revert to a back-up copy of the data. Therefore, the
more often a business backs up its data, the less work is needed in the event of data loss.
When computers are being used along with an accounting package, it is normally
possible for passwords to be set up to restrict which personnel have access to certain parts
of the computerised elements of the accounting system. It increases security and assists
management in maintaining tighter control on the system.
Spreadsheets
The spreadsheet is the software tool most used by accountants. The name derives from
the appearance of the computer spreading accounts on a sheet, allowing the user to
directly enter numbers, formulae or text into the cells.
Any figure can be changed at any time and the new results will instantly and
automatically be shown when you use formulae in a spreadsheet. And it is this facility of
being able to quickly recalculate formulae that makes the spreadsheet a powerful, useful
and popular analytical tool.
Some of the uses of the spreadsheets:
Financial plans and budgets can be represented as a table, with columns for time
periods and rows for different elements of the plan (e.g. costs, revenue)
Investment and loan calculations
Currency conversion
Timesheets and roster planning for staff within the organisation
Statistics using built-in functions such as averages, standard deviations, time
series and regression analysis can be calculated.
Financial statements can easily be produced.
148
10.2. Computerised accounting systems

Most businesses now use computers to handle their accounting data. They think that
anybody can use a computerised accounting system because it has very little to learn in
order to use it.
You must bear in mind that the methods adopted in computer-based accounting adhere to
the fundamental principles of accounting. Therefore, those in control need bookkeeping
and accounting knowledge in order to prepare journal entries, to correct errors and to
understand how an entry is going to affect the financial statements and why it is
important not to erase the original entry.
Thus, computerised accounting systems do not remove the need for some accounting
knowledge among those who use the output from the accounting systems or from those
who are responsible for accounting tasks. Knowledge of accounting principles is needed
to best convert a business from manual to computer-based accounting and also some
accounting knowledge is required to help understand the significance of many of the
outputs from a computerised accounting system.
10.2.1. Benefits of using a computerised accounting system
Speed
It is quicker to enter the data into a computerised system as the double entry is
automatically performed by the system itself once the operator has selected the
different ledgers where the transactions should be recorded. A manual system will
require entering the data separately; that may cause unbalance in the accounts if one
of the entries is omitted. Each transaction is entered only once and the software
automatically completes the double entry.
Reports are produced automatically what speeds up the process as it does not require
preparatory analysis of data
Accuracy
Improved accuracy is one of the most obvious benefits of any kind of computerised
accounting system. The accounts will always balance although the amount may have
been entered incorrectly, as the transaction is entered only once.
149
Consistency
The various ledgers and accounts maintained in a computerised accounting system

mimic those kept in a manual system. The General Ledger, for example, will adhere
to the basic rules of double entry bookkeeping in that each debit has a corresponding
credit entry. For example, if a customer is issued with an invoice, the transaction will
be stored in the credit sales records and then the double entry is made by crediting
sales accounts and debiting a debtors account.
Enhanced reporting
Effective reporting is often required in order to improve the decision-making process.

The task of producing reports on a regular basis can be time-consuming and tedious.
A computerised accounting system speeds up the process as it is done automatically.
In many cases, businesses can use computer printouts or electronic output, instead of
having to manually complete official or standard forms.
Flexibility
The information stored is available instantly and can be used to produce statements,
ledger account details, analysis of aged debtors, etc immediately it is requested.
10.2.2. Knowledge of double entry

In order to use a computerised accounting system efficiently and effectively, someone
with both accounting skills and a good knowledge of the business will be required to
organise the accounts and ledgers in the first instance. It may be necessary to override the
default account codes and create or to use the businesss own account code list.
Correction of errors will require a full knowledge of the relevant part of the accounting
system as well as bookkeeping and accounting principles.
On the other hand, the system will not overcome some errors and omissions such as the
operator misreading an amount on an invoice or crediting a payment to a wrong customer
account.
Sales order processing

Sales order processing allows an order to be placed into the system and can then be used
at a later stage to generate an invoice. It offers the advantage of being able to avoid orders
being left overdue or late. It can produce outstanding order reports very quickly.
150
Purchase order processing

The purchase order processing allows instant access to information about what is on order
and allows an operator to print an order to send off to a supplier. By entering stock on
order against various stock records, it reduces the likelihood of issuing multiple orders for
stock unnecessarily.
Stock control
Stock control offers the benefit of keeping very close tabs on stock levels. Once an
invoice has been raised, the recorded stock levels fall accordingly, the sales ledger is
updated and the nominal entries are made by crediting sales and debiting debtors control.
Orders received will be recorded and the level of stock will consequently be updated. The
level of stock will be checked against the actual level of stock physically counted, and
any difference will be investigated.
The computerised system will allow you to keep records of stock kept in different
locations much easier than a manual system would.
151

Question 1
1)
Bell Ltd made a bonus issue of ordinary shares on 31 May 2008. The shares were issued on the basis of 1
share for every 4 held. The directors of the company wish to retain its reserves in their most distributable
form.
The capital and reserves extract from the Balance Sheet, before the issue, is shown below:
000
Capital and reserves
Issued ordinary shares of 10p each
Revaluation reserves
1600
250
140
240
2230
Required:
a) Prepare the capital and reserves extract from the Balance Sheet after the bonus issue.
(7 marks)
b) Explain one reason why a company might choose to make a bonus issue of shares.
(3 marks)
152
2)
The trading and profit and loss account of Poole Catering Ltd for the year ended 31 December 2006 has
been completed and the following balances remain on the books:
Dr
10% preference shares of 1 each fully paid

5% debentures (repayable 2015)
Balance at bank
Trade creditors
Trade debtors
Ordinary shares of 50p each fully paid
Premises
Profit and loss account at 1 January 2006
Stock at 31 December 2006
Net profit for the year after taxation
Cr
10,000
60,000
4,000
12,000
15,000
75,000
215,000
96,000
38,000
268,000
11,000
268,000
The directors recommend the following:
(1) Payment of 4p dividends per share on the ordinary shares;

(2) Payment of the full dividend due on the 10% preference shares.
Required:
a) Prepare a profit and loss appropriation account for the year ended 31 December 2006.
(3 marks)
b) Prepare a balance sheet as at 31 December 2006.

(13 marks)
c) The directors of Poole Catering Ltd have decided to revalue the premises at 300,000.
Explain how this revaluation will affect the balance sheet.
(3 marks)
153
Question 2
The directors of Hull Ltd have made a rights issue on the basis of 1 share for every 2 held at an issue price
of 1.50 each. The rights issue was fully subscribed.
An extract from the Balance Sheet immediately before the issue is shown below:
Balance Sheet extract at 1 December 2007
Hull Ltd
000
Creditors: amount falling due after more than one year
Loan
Issued ordinary shares of 1 each fully paid
200
100
50
25
175
The directors have used all the funds generated by the rights issue to repay part of the loan.
Required:
a) Prepare the capital and reserves section of the Balance Sheet of Hull Ltd showing the
effect of the rights issue.
(8 marks)
b) State the value of the loan outstanding after the rights issue.
(3 marks)
c) Explain the differences between a rights issue and a bonus issue of shares.
(9 marks)
154
Question 3
Rock Ltd had the following Balance Sheets in two successive years:
Rock Ltd
Balance Sheet as at October 31, 2007
2007
000
7326
Tangible fixed assets

Current assets
Stock
Debtors
Bank
Current liabilities
Creditors
Taxation
Long term liabilities
Net assets
2006
000
7610
629
1430
440
1170
431
2490
1522
3132
839
---839
4000
4977
621
192
813
4000
5929
Required:
a) Calculate the following ratios for both Balance Sheets, on the basis that sales were
1,600,000 in both years and the gross margin was 25%:
-
Stock turnover (days)

Debtor turnover (days)
Creditor turnover (days)
Gearing ratio
Current ratio
(5 marks)
b) Using the information given and your ratios, discuss what seems to have happened to the
company during 2007. Put forward possible explanations for what you have observed.
(10 marks)
155
Question 4
William would like you to prepare his accounts for the year ending September 30, 2007. He has extracted
the following Trial Balance from the accounting records of his corporate wardrobe business at September
30, 2007:
Dr
Cr
Motor vehicles cost

Motor vehicles accumulated depreciation
Rent
Insurance
Sales
Stock
Wages
Drawings
Bank
Creditors
Debtors
Purchases
Sundry expenses
Capital
70,000
45,000
5,500
1,236
41,028
532
15,123
8.561
2.060
1,040
2,300
12,000
50
382
117,694
30,576
117,694
You are given the following additional information:
1) Stock at September 30, 2007 had originally cost 620

2) A demand for rent of 3,000 for the period September 1, 2007 to March 1, 2008 has not
been paid by September 30, 2007.
3) During the year, an insurance premium of 600 was paid for the year ending 31 March,
2008.
4) Fixed assets are depreciated at a rate of 25% using the reducing balance method.
5) The provision for doubtful debts would be 5% of the year end debtors balance.
Required:
a) Prepare a Profit and Loss Account for the year ending September 30, 2007.
(7 marks)
b) Prepare a Balance Sheet as at September 30, 2007.

(7 marks)
c) Write a memorandum to William advising him of one advantage and one disadvantage of
computerising the companys accounting records.
(4 marks)
156
Question 5
Ian hopes to start a new business on 1 March selling surfboards. His balance at bank on that day will be
3,200.
He intends to sell each surfboard for 160. On 1 June, the price will increase to 190 per surfboard.
The variable cost per surfboard is expected to be 85.
In preparation for the summer season Ian intends his stock level to be 60 surfboards by 1 June. Thereafter,
he will only produce enough to satisfy demand.
Note: Assume each month consists of 4 weeks.
Ian hopes to employ his brother, Malcolm, to help out in the workshop for 3 months from 1 March.
Malcolm will be paid 40 per day for 5 days a week.
With Malcolms help, Ian hopes to make up to a maximum of 10 surfboards a week, whereas he can only
make up to 6 surfboards alone.
Expected sales are:
1 March to 30 April
May
1 June onwards
4 surfboards a week
7 surfboards a week
10 surfboards a week
The stock on 31 July is expected to be 28 surfboards.

His fixed overheads, excluding depreciation, are expected to be 500 a month.
Any bank surplus over 1,000 at the end of each month will be taken as Ians personal drawings.
All transactions will be on a cash basis.
Required:
Prepare a cash budget for each of the 5 months ending 31 July. Include the maximum amount that Ian can
withdraw for personal use.
(12 marks)
157
Diploma in
Accounting
Unit 3: Further Aspects of Financial
Accounting
Module 6: Stock Valuation, Incomplete Records and
Sources of Finance
Module 7: Accounting Standards, Published Accounts
and Partnership Accounts
158
Diploma in
Accounting
Accounting
Module 6: Stock Valuation, Incomplete Records and
Sources of Finance
159
FURTHER ASPECTS OF FINANCIAL ACCOUNTING
LESSON 11. STOCK VALUATION

11.1 Introduction.
The control and valuation of stock is an important aspect in the efficient management of a
business. Manual or computer records are used to show the amount of stock held and its
value at any time during the year. However, at the end of the financial year is essential for a
business to make a physical stock-take for use in the final accounts. This involves stock
control personnel going into the stores, the shop, or the warehouse and accounting each item.
The value of stock at the beginning and end of the financial year is used to calculate the
figure for cost of sales. Therefore, the stock value has an effect on profit for the year.
In practice a stock valuation method which is fair and suitable should be selected. The
management of a business are expected to choose a method of stock valuation which provides
the fairest possible approximation of the expenditure incurred in bringing a product to its
present location and condition.
Once a particular method of stock valuation has been selected it then becomes the business
policy in respect of stock valuation and should be applied consistently from accounting
period to accounting period. The consistency concept prevents a change in policy being
introduced just to show information in a more favourable light.
160
11.2 Valuation of stock.

Let us consider the following case:
During its financial year ended 31 March 2007 a business purchased goods for resale at a cost
of 350,000. Sales to customers during the same period were 450,000. The gross profit was
therefore calculated in the Trading Account as follows:
Trading Account for the year ended 31 March 2007
450,000
350,000
100,000
Sales
Less Purchases
Gross Profit
Let us now assume that the business does not in fact sell all the goods it purchases during the
year to 31 March 2007. At the year end the business had goods which cost 50,000 remaining
in stock.
In such a case it would be unfair to charge the cost of all goods purchased in a period against
income earned from selling only some of them.
If we now apply the matching concept and make an adjustment to account for closing stock
the gross profit calculation is revised as follows:
Sales
Less Cost of Goods Sold
Purchases
Less Closing Stock
Cost of Sales
Gross Profit
450,000
350,000
50,000
300,000
150,000
(Remember that the matching concept requires that in calculating profit or loss for a
period we must deduct costs and expenses incurred in the period from the income earned
in that same period.)
The closing stock of one period end becomes the opening stock of the following accounting
period. This has further implications when calculating gross profit.
In the financial year ended 31 March 2008 the business referred to above purchased goods for
resale costing 400,000. Sales in the year were 570,000, and stock remaining at the year end
was counted and valued at its cost to the business, this being 70,000.
At this point we will have an opening stock from the previous year. When we now calculate
gross profit in applying the matching concept we must take into account both the opening and
closing stocks. The Trading Account would now be prepared as follows:
161
Sales
Less Cost of Goods Sold
Opening Stock
Add Purchases
Less Closing Stock
Cost of Sales
Gross Profit
570,000
50,000
400,000
450,000
70,000
380,000
190,000
With regard to stock valuation the matching concept requires The cost of unsold or
unconsumed goods at the end of an accounting period should be carried forward to future
accounting periods in the anticipation of future sale revenue
162
11.3 Methods
Stock is valued at:
Either what it cost the business to buy the stock (including additional costs to bring
the product or service to its present location and condition, such as delivery charges)
Or the net realisable value the actual or estimated selling price (less any further
costs, such as selling and distribution)
The stock valuation is often described as being at the lower of cost and net realisable value.
This valuation applies the prudence concept.
Thus two different stock values are compared:
Cost, including additional costs such as delivery charges

Net realisable value (the amount the stock will sell for), less any further costs such as
selling and distribution.
In practice it is often difficult for many businesses to ascertain the actual cost of a particular
item. This is due to the fact that many businesses take numerous deliveries of identical goods
during an accounting period, often paying a different purchase price for each consignment. At
the end of the accounting period it is often impossible to match individual units of a particular
line of stock to their actual purchase price. In order to solve this problem a number of
theoretical models have been devised for valuing stock. These include:
FIFO (First in First Out). This method assumes that goods are issued in chronological
order, i.e. the oldest goods are issued first. This means that the goods that remain in stock at
the end of an accounting period are assumed to be the goods that were purchased last. This
method of stock valuation appears logical in that most businesses would wish to sell their
oldest goods first to guard against deterioration or obsolescence.
LIFO (Last in First Out). This method assumes that the goods issued first are those that
were purchased last, therefore the items that remain in stock at the end of an accounting
period are assumed to be the oldest goods and are therefore valued at the oldest purchase
price. This method is not generally used when preparing financial statements and you will not
be expected to use it in the exam.
AVCO (Average Cost). Stock is valued at its average cost. This involves dividing the total
value of stock by the total quantity of stock to arrive at the average price which is then used
to value an issue of stock. A new average price must be calculated every time there is a
receipt of goods into stock at a price which is higher or lower than the prevailing average
price.
163
In order to be able to calculate accurately the price at which stocks of materials are issued to
production, and to ascertain quickly a valuation of closing stock, the following method of
recording stock data is suggested:
Date
Receipts
Quantity
Price
Value
Issues
Price
Quantity
Balance
Quantity
Price
Value
Value
Note: the price is the cost price to the business, not the selling price.
Now we are going to calculate the stock values using the FIFO and AVCO methods in turn.
For that we will use the following data:
January
February
March
April
May
Opening stock of 40 units at a cost of 3.00 each

Bought 20 units at a cost of 3.60 each
Sold 36 units for 6 each
Bought 20 units at a cost of 3.75 each
Sold 25 units for 6 each
FIFO
STORES LEDGER RECORD
Date
Jan
Feb
Receipts
Issues
Quantity Price
Value
Quantity Price
Balance
20
3.60
72.00
March
April
20
May
3.75
Value
36
3.00
108.00
4
20
3.00
3.60
12.00
72.00
3.75
3.75
75.00
Quantity
40
40
20
60
4
20
24
4
20
20
44
19.00
Balance
Price
Value
3.00 120.00
3.00 120.00
3.60
72.00
192.00
3.00
12.00
3.60
72.00
84.00
3.00
12.00
3.60
72.00
3.75
75.00
159.00
3.75
164
71.25
AVCO
STORES LEDGER RECORD
Date
Jan
Receipts
Quantity Price
Value
Balance
Feb
20
3.60
Issues
Quantity Price
72.00
March
36
April
20
3.75
May
Value
3.20
115.20
75.00
25
3.45
86.25
Balance
Quantity Price
Value
40
3.00 120.00
40
20
60
3.00
3.60
120.00
72.00
192.00
24
3.20
76.80
24
20
44
3.20
3.75
3.45
76.80
75.00
151.80
19
3.45
65.55
In January the balance was 40 units at 3.00 each, which gives us a value of 120
Under the FIFO method, you must account for the price at which the units are bought.
Therefore, in February 20 units at 3.60 each were bought. Now the balance is 60 units,
however, 40 units were bought at 3.00 and 20 units at 3.60; that will give us a balance of
192.
Now we sold 36 units in March. As it is First In First Out, we must deduct 20 units at 3 each
from the opening stock in January. We had 40 units, we deduct 36 units sold at 3 (36 x 3 =
108), therefore, there are 4 units at 3 each left, plus 20 units at 3.60 each bought in
February. The new balance is 24 units (4 @ 3 and 20 @ 3.60) with a value of 84.
And you continue in the same way.
The Average cost (AVCO) is calculated by dividing the quantity held in stock into the value
of the stock. For example, at the end of February, the average cost is 192 60 units = 3.20.
The closing stock valuations at the end of May under each method show cost prices of:
FIFO
AVCO
71.25
65.55
You can see that there is quite a difference by using one method or the other. How does effect
have on profit?
165
EFFECT ON PROFIT
In the example above, the selling price was 6 per unit. The effect on gross profit of using
different stock valuations is shown in the following trading accounts:
Sales: 61 units at 6
Opening stock: 40 units at 3
Purchases:
20 units at 3.60
20 units at 3.75
Less Closing stock: 19 units
Cost of Goods Sold
Gross profit
FIFO
366.00
AVCO
366.00
120.00
120.00
147.00
267.00
71.25
195.75
170.25
366.00
147.00
267.00
65.55
201.45
164.55
366.00
In times of rising prices, FIFO produces the highest profit.
166
11.4 Advantages and Disadvantages

1. FIFO (First in, First out)
Advantages:
Realistic; it assumes that goods are issued in order of receipt

It is easy to calculate
Stock valuation comprises actual prices at which items have been bought
The closing stock valuation is close to the most recent prices.
Disadvantages:
Prices at which goods are issued are not necessarily the latest prices
In times of rising prices, profits will be higher than with other methods (resulting in
more tax to pay)
2. AVCO (Average cost)

Advantages:
Over a number of accounting periods reported profits are smoothed: both high and
low profits are avoided.
Fluctuations in purchase price are evened out so that issues do not vary greatly.
It assumes that identical units, even when purchases at different times, have the same
value.
Closing stock valuation is close to current market values (in times of rising prices, it
will be below current market values)
Disadvantages:
Difficult to calculate and calculations may be to several decimal places.

Issues and stock valuation are usually at prices which never existed.
Issues may not be at current prices and, in times of rising prices, will be below current
prices.
167
11.5 Questions
Question 1.
A furniture shop sells coffee tables amongst the lines that it sells. The stock movements for
coffee tables in February 2008 were:
1 February
4 February
7 February
10 February
12 February
17 February
20 February
24 February
27 February
Stock of 10 tables brought forward at a cost of 30 each

Sold 2 tables
Sold 5 tables
Bought 12 tables at 32 each
Sold 6 tables
Sold 4 tables
Bought 8 tables at 31 each
Sold 4 tables
Sold 3 tables
Each table sells at 50. Stock is valued on the FIFO (first in, first out) basis.
You are to calculate the value of:
a) Sales for February
b) Closing stock at 28 February
c) Costs of sales for February
Question 2.
A business buys twenty units of a product in January at a cost of 3.00 each; it buys ten more
in February at 3.50 each, and ten in April at 4.00 each. Eight units are sold in March, and
sixteen are sold in May.
You are to calculate the value of closing stock at the end of May using:
a) FIFO
b) AVOC
168
LESSON 12. INCOMPLETE RECORDS
12.1 Introduction
The books of account of many businesses, small sole trader type organisation in particular,
are kept on a single entry basis. Such records are known as incomplete records.
A single entry bookkeeping system usually consists of a Cash Book which is used to record
and analyse liquid fund (Cash and Bank) receipts and payments. The Cash Book is set out to
provide an analysis of transactions in terms of: date of transaction, details of transaction,
amount received, amount paid, analysis of source of income and as to the nature of the
expenditure.
To prepare financial statements (the Trading and Profit and Loss Account and Balance Sheet)
from the Cash Book further analysis and additional information is usually required. For
example:
Receipts and payment postings have to be analysed and categorised as being capital or
revenue.
Details which allow the Cash Book postings to be adjusted in accordance with the
matching concept must be provided. These include details of:
Prepayments and accruals

Debtors and creditors
Cash discounts allowed and received
Bad debts
Stocks
Depreciation policy
To prepare financial statements from incomplete records it is advised to convert the single
entry records to double entry records. This can be done by creating appropriate accounts with
an accounts worksheet.
Initially the worksheet accounts are set up by posting balances from an opening Balance
Sheet, or by establishing the opening financial position of the business. Double entry using
the Cash Book postings as the basis of the periods business transactions are then processed,
with adjustments, again using double entry principles, being made in respect of additional
information made available.
In preparing financial statements form incomplete records the problem areas include:
Establishing the opening financial position (where an opening Balance Sheet is not
given).
Calculating sales, purchases and expenses from incomplete information.
Calculating drawings from incomplete information.
Such areas need to be studied and practised.
169
12.2 The Opening Financial Position

The accounts worksheet mentioned above, which should be used to convert single entry
records to double entry records, is set up by establishing the opening financial position of the
business. This information is then used to post opening balances to accounts set up within the
accounts worksheet.
Where an opening Balance Sheet is provided, which would normally be the case if the
business has been trading for several years, then it is a simple procedure to open working
accounts by:
Debiting accounts with Asset Values
Crediting accounts with Capital and Liabilities
If a Balance Sheet is not provided then we must establish the financial position by applying
the accounting equation:
Assets = Capital (+) Liabilities
Therefore, we take the financial information that is available and, using the tools of
accounting, we construct the accounts that are required. The tools of accounting that may be
needed are:
The use of an opening trial balance, or statement of assets and liabilities.

The construction of a cash account and/or bank account
The use of control accounts sales ledger control account and purchases ledger
control account.
In addition, the following may be of use:
The accounting equation, as mentioned earlier ( assets liabilities = capital)

Gross profit mark-up and margin
The format of the Trading and Profit and Loss Account and Balance Sheet.
170
Let us look at the following example:
Worked example 1:
The following information has been taken from the incomplete records of Jayne Perry, who
runs a small stationery supplies business:
List of Assets and Liabilities
1 Jan 2008
8,000
25,600
29,200
5,000
20,800
200
Shop fittings
Stock
Debtors
Bank balance
Creditors
Expenses owing
31 Dec 2008
8,000
29,800
20,400
not known
16,000
300
Bank Summary for 2008
127,800
82,600
12,500
30,600
Receipt from debtors

Payments to creditors
Drawings
Business expenses
From the information above the capital contribution would be calculated as follows:
Calculation of Capital as at 1 January 2008
Assets
Shop fitting
Stock
Debtors
Bank balance
Less Liabilities
Creditors
Expenses owing
Capital at 1 January 2008
8,000
25,600
29,200
5,000
67,800
20,800
200
21,000
46,800
171
Note:
Look out for the bank balance; here the bank balance is an asset; if it was marked as an
overdraft, it would be included amongst the liabilities.
Now let us look at the information provided above from Jayne Perry in the worked example.
We are going to calculate the missing figure for the bank balance at 31 December 2008. For
that we prepare a cash book from the cash book summary.
Jayne Perry
Cash Book (bank columns)
Dr
2008
1 Jan Balance b/d
Receipts from debtors
5,000
127,800
2008
Drawings
Expenses
31 Dec Balance c/d
132,800
2009
1 Jan Balance b/d
Cr
82,600
12,500
30,600
7,100
132,800
2009
7,100
Missing figure
The bank balance of 7,100 on 31 December 2008 is calculated by filling the missing figure.
Receipts form debtors is money in, therefore, a debit entry in the Cash Book; payments to
creditors, drawings and expenses are money out, therefore, a credit entry in the Cash Book.
The balance b/d at 1 January 2008 was provided within the list of assets and liabilities.
When preparing a Cash Book summary, look out for an opening bank balance that is
overdrawn; this is entered on the credit side. At the end of the Cash Book summary, a credit
balance brought down is an overdraft.
Try the following question:
172
Question 12.2.1
Lisa was able to provide the following information regarding her business as at 1 April 2001:

Stock
Trade creditors
Rent repaid
Bank loan
Cash
Bank (overdraft)
10,000
15,500
3,600
400
5,000
500
1,000
Required:
Calculate the capital contribution (the opening capital).
Your answer should be: 16,800
173
12.3 Calculating Sales

Where goods are sold on credit to customers sales income for the accounting period can be
calculated by drawing up a Debtors Control Account. The information necessary to make
such a calculation includes:
Opening and closing trade debtors.

Receipts from customers (cash and credit customers) in the period under review.
Any bad debts to be written off.
Cash discounts allowed to customers.
Goods at selling price taken by the proprietor as personal drawings.
If we go back to Jayne Perrys business, the sales figures will be:

Sales = 127,800 - 29,200 + 20,400 = 119,000
Sales = receipts from debtors in the year, less debtors at the beginning of the year, plus
debtors at the end of the year.
The use of control accounts is recommended for calculating sales in incomplete records
questions.
If we prepare a control accounts based on the information from Jayne Perrys business, the
sales figure can be calculated:
Debtors Control Account
Dr
2008
1 Jan Balance b/d
Sales (missing figure)
2009
1 Jan Balance c/d
29,200
119,000
148,200
2008
31 Dec Balance c/d
Cr
127,800
20,400
148,200
20,400
Do not forget that the control accounts give the figures for credit sales: cash sales need to be
added, where applicable, to obtain total sales for the year.
The following information is available regarding the trading activities of Catering Supplies
for the year ended 31 March 2001. The business, owned by Tina Tate, supplies catering
equipment and catering goods on a credit and cash and carry basis:
1 April 2000
31 March 2001
31 March 2001
31 March 2001
31 March 2001
Trade debtors
Receipts from cash customers in year
Cheques received from trade debtors in year
Trade debtors
Drawings at sales value in year
8,450
24,160
142,410
9,480
2,400
174
Other information:
i)
ii)
Cash discounts of 1,450 were allowed to trade debtors for prompt payment in the
year.
Of the debts outstanding as at 1 April 2000 500 remains uncollected and is to be
written off as a bad debt.
The sales for the year can be calculated as follows:

Debtors Control Account
Dr
Cr
1/4/00
31/3/01
Balance b/f
Sales
31/3/01
Balance b/d
8,450 31/3/01
145,390 31/3/01
31/3/01
31/3/01
153,840
9,480
Bank (Cash Book)

Discount allowed
Bad debts
Balance c/d
142,410
1,450
500
9,480
153,840
Sales
Dr
31/3/01
Cr
Trading
171,950
171,950
31/3/01
31/3/01
31/3/01
Cash (Cash book)

Drawings
Debtors Control
24,160
2,400
145,390
171,950
175
12.4 Calculating Purchases

Where credit is taken from suppliers purchases for the period under review are best calculated
using a creditors Control Account. To make the calculation the following information is
required:
Opening and closing trade creditors.

Payments to creditors and cash payments for goods bought for resale.
Cash discounts received from trade creditors for prompt payment.
Goods at cost price taken by the proprietor as personal drawings.
If we now go back to the information from Jayne Perrys business, we can calculate the
purchases for the year:
Purchases = 82,600 20,800 + 16,000 = 77,800
Purchases = payments to creditors in the year, less creditors at the beginning of the year, plus
creditors at the end of the year.
If we prepare a control accounts based on the information from Jayne Perrys business, the
purchases figure can be calculated:
Creditors Control Account

Dr
2008
31 Dec Balance c/d
2009
82,600
16,000
98,600
2008
1 Jan Balance b/d
Purchases
2009
1 Jan Balance b/d
Cr
20,800
77,800
98,600
16,000
Missing figure
Do not forget that the control accounts give the figures for credit purchases: cash purchases
need to be added, where applicable, to obtain total purchases for the year.
Now try the following question:
176
Question 12.4.1:
The following information is available regarding the trading activities of The Angling Centre
for the year ended 31 March 2001:
1 April 2000
31 March 2001
31 March 2001
31 March 2001
Trade creditors
Payments for cash purchases in year
Cheques paid to trade creditors in year
Trade creditors
4,260
2,120
87,180
3,840
Other information:
Cash discounts of 1,180 were received from trade creditors for prompt payment in
year.
Required:
Calculate the purchases for the year.
Your answer should be: 90,060 (purchases for the year)
177
12.5 Calculating expenses

Expenses incurred within a given period may also have to be calculated from incomplete
data. To do this the following information is required:
Expense amounts prepaid at beginning and end of accounting period.

Expense amounts accrued at beginning and end of accounting period.
Expense amount paid in accounting period.
Let see how it works with an example:

The following information is available regarding the expenses of Ground Rent and Heat and
Light of Carefree Caravans for the year ended 31 March 2001:
1 April 2000
1 April 2000
31 March 2001
31 March 2001
31 March 2001
31 March 2001
1,200
180
7,300
840
1,300
210
Ground rent prepaid

Heat and light accrued
Ground rent paid in year
Heat and light paid in year
Ground rent prepaid
Heat and light accrued
The expenses of ground rent and heat and light incurred in the year ended 31 March 2001 can
be calculated as follows:
Ground Rent
Dr
1/4/00
31/3/01
Balance b/d
Bank
Cr
31/3/01
Balance c/d
1,200 31/3/01
Profit and loss
7,300 31/3/01
Balance c/d
8,500
1,300
Missing figure
7,200
1,300
8,500
Heat and Light

Dr
31/3/01
31/3/01
Cr
Bank
Balance c/d
840
210
1,050
1/4/00
31/3/01
Balance b/f
Profit and loss
31/3/01
Balance b/d
180
870
1,050
210
Missing figure
178
12.6 Drawing up financial statements

We have calculated the figures for purchases, sales, expenses and opening capital. Now we
can begin to prepare the Trading and Profit and Loss Account.
Based on the business information from Jayne Perry (our worked example) we are going to
prepare the gross profit section:
Jayne Perry
Trading and Profit and Loss Account
For the year ended 31 December 2008
Sales
Opening stock
Purchases
Less Closing Stock
Cost of Goods Sold
Gross profit
Less:
Expenses (Working 1)
Net profit
119,000
25,600
77,800
103,400
29,800
73,600
45,400
(30,700)
14,700
Working 1:
The relevant information from the Worked Example is:
Bank payments for expenses during year, 30,600

Expenses owing at 1 January 2008, 200
Expenses owing at 31 December 2008, 300
Like the calculation of purchases and sales, we must take note of cash payments along with
accruals and prepayments; we can not simply use the bank payments figure for expenses.
Expenses for year = bank and cash payments less accruals at the beginning of the year (or
plus prepayments), plus accruals at the end of the year (or less prepayments).
Thus the figure for Jayne Perrys business is:
30,600 - 200 + 300 = 30,700
179
The Balance Sheet can now be prepared using the assets and liabilities from the Worked
Example:
Jayne Perry
Balance Sheet
As at 31 December 2008
Fixed Assets
Shop fittings
Current Assets
Stock
Debtors
Bank
Creditors
Accruals
8,000
29,800
20,400
7,100
57,300
16,000
300
16,300
Working Capital
Net Assets
Financed by:
Capital
Opening capital
Add net profit
Less drawings
41,000
49,000
46,800
14,700
12,500
49,000
180
12.7 The use of Gross Profit mark-up and margin

When preparing final accounts from incomplete records it is often necessary to use
accounting ratios and percentages.
There are two main percentages used for incomplete records accounting:
1. Gross profit mark-up
2. Gross profit margin
The difference between the two is that:
Mark-up is a profit percentage added to buying or cost price

Margin is a percentage profit based on the selling price
1. Mark-up
The mark-up is:
gross profit
Cost price
x 100
1
2. Margin
The margin is:
gross profit x 100

Selling price
1
In incomplete records accounting, mark-up or the margin percentages can be used to calculate
either cost of goods sold (which, if opening stock and closing stock are known, will enable
the calculation of purchases) or sales.
If a product is bought by a retailer at a cost of 100 and the retailer sells it for 125, what is
the mark-up? And what is the margin?
Mark-up = 25 %
(25/100 x 100)
Margin = 20 %
(25/125 x 100)
Mark-up or the margin percentages can be used to calculate either cost of goods sold or sales.
Therefore, if opening stock and closing stock are known, we can calculate purchases.
For example:
Given the following information calculate sales:
Cost of goods sold is 150,000. The mark-up is 40 %
40/100 = gross profit / 150,000 ;
150,000 x 40/100 = 60,000
181
Sales = cost of goods sold + gross profit; 150,000 + 60,000 = 210,000
Now we have been provided with the following information:

Sales are 450,000; the margin is 20%; the opening stock is 40,000 and the closing stock is
50,000. What are the purchases?
Gross profit = 450,000 x 20/100 = 90,000
Cost of goods sold = sales gross profit; 450,000 - 90,000 = 360,000
The purchase calculation is;
Opening stock + purchases closing stock = cost of goods sold
Purchases = 360,000 + 50,000 - 40,000 = 370,000
(purchases = costs of goods sold + closing stock opening stock)
182
12.8 Questions
Question 1
Jane does not keep a full set of accounting records; however, the following information has
been produced for the first year of trading, which ended on 31 December 2008:
Summary of the business bank account for the year ended 31 December 2008:
Capital introduced
Receipts from sales
Payments to suppliers
Advertising
Wages
Rent and rates
General expenses
Shop fittings
Drawings
60,000
153,500
95,000
4,830
15,000
8,750
5,000
50,000
15,020
Summary of assets and liabilities as at 31 December 2008:
Shop fittings at cost

Stock
Debtors
Creditors
50,000
73,900
2,500
65,000
Other information:
Jane wishes to depreciate the shop fittings at 20% per year using the straight-line
method
At 31 December 2008, rent is prepaid by 250, and wages of 550 are owing
Required:
a) Calculate the amount of sales during the year
b) Calculate the amount of purchases during the year
c) Calculate the figures for
Rent and rates
Wages
To be shown in the Profit and Loss Account for the year ended 31 December 2008
d) Prepare Janes Profit and Loss Account of the year ended 31 December 2008.
e) Draw p Janes Balance Sheet as at 31 December 2008.
183
Question 2
J Evans has kept records of his business transactions in a single entry form, but he did not
realise that he had to record cash drawings. His bank account for the year 2008 is as follows:
Balance 1/1/2008
Loan from T Hughes
1,890
44,656
2,000
Cash withdrawals from bank

Trade Creditors
Rent
Rates
Drawings
Sundry expenses
Balance 31/12/2008
48,546
5,400
31,695
2,750
1.316
3,095
1,642
2,648
48,546
Records of cash paid were:

Sundry expenses 122
Trade creditors: 642
Cash sales amounted to 698
The following information is also available:
Cash in hand
Trade creditors
Debtors
Rent owing
Rates in advance
Van (at valuation)
Stock
31.12.2007
48
4,896
6,013
282
2,800
11,163
31.12.2008
93
5,091
7,132
250
312
2,400
13,021
Required:
Draw up a Profit and Loss Account and a Balance Sheet for the year ended 31 December
2008. Show all of your workings.
184
LESSON 13. SOURCES OF FINANCE
13.1 Introduction
When examining the various sources of finance available to a business, it is useful to
distinguish between:
-
External sources; and

internal sources
External sources are those which require the agreement of someone beyond the directors and
managers of the business. For example: finance from an issue of new shares; it requires the
agreement of potential shareholders.
Internal sources do not require agreement from other parties and arise from management
decisions. For example, retained profits; the directors have the power to retain profits without
the agreement of the shareholders.
Within external sources of finance we can find:
-
long-term sources of finance; and

short-term sources of finance.
We will consider long-term finance a source of finance that is due after a year, whereas shortterm finance will be a source of finance that is due within a year.
185
13.2 External sources

The major sources of long-term external finance are:
Ordinary shares
Preference shares
Loans and debentures
Finance leases (not required for the exam)
The major sources of short-term external finance are:
Bank overdrafts
Debt factoring
Invoice discounting
186
13.2.1 Long-term sources of external finance

Ordinary shares
Ordinary share capital represents a businesss risk capital. Ordinary shareholders will receive
a dividend only if profits available for distribution still remain after other investors
(preference shareholders and lenders) have received their returns in the form of dividend
payments or interest. Because of the high risks associated with this form of investment,
ordinary shareholders will normally require the business to provide a comparatively high rate
of return.
Ordinary shareholders exercise control over the business through their voting rights. This
gives them the power both to elect the directors and to remove them from office.
From the businesss perspective, ordinary shares can be a valuable form of financing as, at
times, it is useful to be able to avoid paying a dividend. For example, an expanding business
may prefer to retain funds in order to fuel future growth; a business in difficulties may need
the funds to meet its operating costs and so may find making a dividend a real burden.
Although a business financed by ordinary shares can avoid making cash payments to
shareholders when it is not prudent to do so, the market value of the shares may go down.
The cost to the business of financing through ordinary shares may become higher if
shareholders feel uncertain about future dividends.
Preference shares
Preference shares offer investors a lower level of risk than ordinary shares. Preference shares
will normally be given a fixed rate of dividend each year and preference dividends will be
paid before ordinary dividends are paid, provided there are sufficient profits available.
Preference shareholders are not usually given voting rights, although these may be granted
where the preference dividend is in arrears.
There are various types of preference shares that may be issues:
cumulative preference shares give investors the right to receive arrears of dividends
that have arisen as a result of there being insufficient profits in previous periods. The
unpaid amounts will accumulate and will be paid when sufficient profits have been
generated.
Non-cumulative preference shares do not give investors this right. Thus, if a
business is not in a position to pay the preference dividend due for a particular period,
the preference shareholder loses the right to receive that dividend
Participating preference shares give investors the right to a further share in the
profits available for dividend after they have been paid their fixed rate and after
ordinary shareholders have been awarded a dividend.
187
Redeemable preference shares allow the business to buy back the shares from
shareholders at some agreed future date.
Preference share capital is similar to loan capital in so far as both offer investors a fixed rate
of return. However, preference share capital is a far less popular form of fixed-return capital
than loan capital. An important reason for this is that dividends paid to preference
shareholders are not allowable against the taxable profits of the business, whereas interest
paid to lenders is allowable.
Loans and debentures
Loans
Most businesses rely on loans, as well as share capital, to finance operations. Lenders enter
into a contract with the business in which the rate of interest, dates of interest payments,
capital repayments and security for the loan are clearly stated.
A term loan is a type of loan offered by banks and other financial institutions, and is usually
tailored to the needs of the client business.
The amount of the loan, the time period, the repayment terms and the interest payable are all
open to negotiation and agreement.
The major risk facing those who invest in loan capital is that the business will default on
interest payments and capital repayments. To protect themselves against this risk, lenders
often seek some form of security from the business, so, in the event of default, they have the
right to seize the assets pledged and sell these in order to obtain the amount owing.
Debentures
This is simply a loan that is evidenced by a trust deed. The debenture loan is frequently
divided into units and investors are invited to purchase the number of units they require. The
debenture loan may be redeemable or irredeemable.
A convertible loan (or debenture) gives an investor the right to convert a loan into ordinary
shares at a given future date and at a specified price. The investor remains a lender to the
business and will receive interest on the amount of the loan until such time as the conversion
takes place. The investor is not obliged to convert the loan or debenture to ordinary shares.
This will be done if the market price of the shares at the conversion date exceeds the agreed
conversion price.
188
Mortgages
A mortgage is a form of loan that is secured on an asset, typically freehold property.
Financial institutions such as banks, insurance businesses and pension funds are often
prepared to lend to businesses on this basis. The mortgage may be over a long period (20
years or more).
189
13.2.2 Short-term sources of external finance

Bank overdrafts
A bank overdraft enables a business to maintain a negative balance on its bank account. It
represents a very flexible form of borrowing as the size of an overdraft can (subject to bank
approval) be increased or decreased according to the financing requirements of the business.
The rate of interest charged on an overdraft will vary according to how creditworthy the
customer is perceived to be by the bank. The banks may ask for forecast cash flow statements
from the business to see when the overdraft will be repaid and how much finance is required.
One potential drawback with this form of finance is that it is repayable on demand. This may
pose problems for a business that is illiquid.
This form of borrowing, though in theory regarded as short term, can often become a longterm source of finance.
Debt factoring
Debt factoring is a service offered by a financial institution known as a factor. It involves the
factor taking overt the debt collection for a business.
The factor is usually prepared to make an advance to the business of up to around 80 per cent
of approved trade debtors, or as high as 90 per cent. This advance is paid immediately after
the goods have been supplied to the customer. The balance of the debt, less any deductions
for fees and interest, will be paid after an agreed period or when the debt is collected. The
charge made for the factoring service is based on total turnover and is often around 2-3 per
cent of turnover. Any advances made to the business by the factor will attract a rate of
interest similar to the rate charged on bank overdrafts.
Although many businesses find a factoring arrangement very convenient, as it can result in
savings in credit management and can create more certain cash flows, however, not all
businesses will find factoring arrangements the answer to their financing problems.
Factoring agreements may not be possible to arrange for very small businesses because the
high set-up costs. In addition, businesses engaged in certain sectors such as retailers or
building contractors, where trade disputes are part of the business culture, may find that
factoring arrangements are simply not available.
When considering a factoring agreement, the costs and likely benefits arising must be
identified and carefully weighed.
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Invoice discounting
Invoice discounting involves a business approaching a factor or other financial institution for
a loan based on a proportion of the face value of credit sales outstanding. If the institution
agrees, the amount advanced is usually 75-80 per cent of the value of the approved sales
invoices outstanding. The business must agree to repay the advance within a relatively short
period perhaps 60 or 90 days. The responsibility for collecting the trade debts outstanding
remains with the business and repayments of the advance is not dependent on the trade debts
being collected.
It may be a one-off arrangement whereas debt factoring usually involves a longer-term
arrangement between the client and the financial institution.
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13.3 Internal sources

Internal sources of finance usually have the advantage that they are flexible. They may also
be obtained quickly particularly working capital sources and do not require the
permission of other parties.
The major sources of internal finance are:
Retained profits
Reduced stock levels
Retained profits
Retained profits are the major source of finance (internal or external) for most businesses. By
retaining profits within the business rather than distributing them to shareholders in the form
of dividends, the funds of the business are increased.
The reinvestment of profit rather than the issue of new shares can be a useful way of raising
finance from ordinary shares investors. There are no issue costs associated with retaining
profits and the amount raised is certain once the profit has been made. When issuing new
shares, the issue costs may be substantial and there may be uncertainty over the success of the
issue.
Retaining profits will have no effect on the control of the business by existing shareholders.
However, where new shares are issued to outside investors there will be some dilution of
control suffered by existing shareholders.
The retention of profit is something that is determined by the directors of the business. They
may find easier to retain profits rather than to ask investors to subscribe to a new share issue.
A problem with the use of profits as a source of finance, however, is that the timing and level
of future profits cannot always be reliably determined.
Reduced stock levels

Holding stocks imposes an opportunity cost on a business as the funds tied up cannot be used
for other opportunities. By holding less stock, funds become available for those opportunities.
However, sufficient stocks must be available to meet future sales demand otherwise the
business will suffer a loss of sales revenue and customer goodwill.
A balance needs to be found for each business, as the form of finance may not be suitable for
all type of businesses. Sometimes overstock is the result of poor buying decisions.
192
Diploma in
Accounting
Accounting
Module 7: Accounting Standards, Published Accounts
and Partnership Accounts
193
LESSON 14. ACCOUNTING STANDARDS

14.1 Introduction
International Accounting Standards (IAS) are now renamed International Financial Reporting
Standards (IFRS). However, we are going to use the terms International Accounting
Standards (IAS) in this course.
An accounting standard is a statement on how certain transactions or items are to be treated in
financial statements in order that the statements give a true and fair view.
Accounting standards are used in the preparation of financial statements. They are the rules
for the treatment of certain items that appear in financial statements.
The objective of financial statements is to provide information about the financial position,
performance, and changes in financial position of an entity that is useful to a wide range of
users in making economic decisions. Users include present and potential investors,
employees, lenders, suppliers and other trade creditors, customers and government and their
agencies, and the public.
There are two assumptions underlying the preparation and presentation of financial
statements:
1. The accrual basis. The effects of transactions and other events are recognized when
they occur (not a cash or its equivalent is received or paid), and they are recorded in
the accounting records and reported in the financial statements of the periods to which
they relate.
2. The going concern. It is assumed that the entity has neither the intention nor the need
to liquidate materially the scale of its operations, but will continue in operation for the
foreseeable future.
The standards, together with the various Companies Acts, set the parameters that company
directors have to adhere to when choosing the accounting practices to be used in the
preparation of the financial statements.
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14.2 Presentation of financial statements. IAS 1

Financial statements provide stakeholders with information about the entitys financial
position, financial performance, and cash flows by providing information about its assets,
liabilities, equity, income and expenses, other changes in equity, and cash flows.
This standard sets out how financial statements are to be presented. This ensures that
financial statements can be compared with accounting statements prepared by the company in
previous accounting periods and that accounting statements can be compared with other
companies.
The standard states that a company must prepare a complete set of financial statements
comprising:
An income statement
A balance sheet
A cash flow statement
A statement showing changes in equity
A statement of accounting policies and explanatory notes
This standard addresses certain accounting concepts which must be applied in the preparation
of the financial statements:
The going concern concept. Financial statements should be prepared on the basis
that the company will continue to operate into the foreseeable future unless
management intends to liquidate the entity or cease trading or has no realistic option
but to do so. When upon assessment it becomes evident that there are material
uncertainties regarding the ability of the business to continue as a going concern,
those uncertainties should be disclosed.
The accruals concept. Excluding the cash flow statement, all other financial
statements must be prepared on an accrual basis, whereby assets and liabilities are
recognised when they are receivable or payable rather than when actually received
and paid.
Consistency. Entities are required to retain their presentation and classification of
items in successive periods unless an alternative would be more appropriate or if so
required by a standard.
Materiality. Each material class of similar items shall be presented separately in the
financial statements. Material items that are dissimilar in nature or function should be
separately disclosed. However, some items of expenditure are so low in value that to
record them separately would be inappropriate. This allows aggregation of similar
items rather than showing them separately in the financial statements, e.g.
classification of assets as non-current or current.
In addition, there are other considerations that ought to be taken into account in the
preparation of financial statements:
195
Offsetting. Assets and liabilities, income and expenses cannot be offset against each
other unless required or permitted by a Standard.
Comparative information. Comparative information (including narrative
disclosures) relating to the previous period should be reported alongside current
period disclosure, unless otherwise required. In case there is a change in the
presentation or classification of items in the financial statements, the comparative
information needs to be appropriately reclassified, unless it is impracticable to do so.
We can not forget the other concepts used in the preparation of financial statements:
Prudence. Financial statements should take a conservative approach where there is
any doubt in the reporting of profits or the valuation of assets.
Business entity. Financial statement should not include the personal expenses or
incomes or record personal assets or liabilities for any of the personnel involved in the
ownership or running of the company.
Money measurement. Only transactions that can be measured in monetary terms
should be included in financial records or in financial statements.
Historical cost. All financial transactions are to be recorded using the actual cost of
purchase.
Duality. There are always two ways of looking at every accounting transaction. One
considers the assets of the company, and the other considers any claims against the
assets.
Structure and Content

IAS 1 requires that:
1. Financial statements should be clearly identified from other information in the same
published document (such as an annual report).
2. The name of the company is displayed.
3. The period covered by the financial statements is shown.
4. The currency used and its magnitude is shown (i.e. or 000, etc).
Financial statements should be presented at least annually. In all other cases, that is, when a
shorter or a longer period than one year is used, the reason for using a different period and
lack of total comparability with previous period information must be disclosed.
Income Statement
All items that qualify as income or expense should be included in the profit or loss
calculation for the period, unless stated otherwise.
Material income and expense should be disclosed separately with their nature and amount.
Analysis of expenses can be classified on the basis of their nature or function.
The minimum line items to be included in the income statement are:
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Revenue
Finance costs
Share of the profit or loss of associates and joint ventures accounted for using the
equity method
The total of the post-tax profit or loss of discontinued operations, post-tax gain or loss
recognized on the disposal of the assets or disposal group(s) constituting the
discontinued operation.
Profit and loss
Tax expense
The amount of total and per-share dividends distributable to equity holders should be
disclosed in the income statement, the statement of changes of equity, or the notes.
Additionally, the income statement should disclose the share of profit attributable to
minority interest and equity shareholders of the parent.
The layout that you will encounter in future examination questions and you should be
familiar with, is shown below:
ABC plc
Income statement for the year ended 31 July 2008
000
Revenue
Cost of sales
Inventories 1 August 2007
Purchases
Inventories 31 March 2008
Gross profit
Distribution expenses
Sales and marketing expenses
Administrative expenses
Profit/(loss) from operations
Finance costs
Profit/(loss) before tax
Tax
Profit/(loss) for the year attributable to equity holders
Statement showing changes in equity
Balance 1 August 2007
Profit for the year
Dividends paid
Balance at 31 July 2008
4,900
17,100
22,000
5,600
(840)
(560)
(630)
000
35,000
(16,400)
18,600
2,030
16,570
(70)
16,500
(4,250)
12,250
32.650
12,250
44,900
5,400
39,500
Also included under this heading would be any new issues of shares and any unrealised
profits, for example, an upward revaluation of property.
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Statement of Changes in Equity

The company is required to present a statement of changes in equity consisting of:
Profit or loss for the period

Each item of income and expense for the period that is recognized directly in equity,
and the total of those items.
Total income and expense for the period, showing separately the total amounts
attributable to equity holders of the parent and to minority interest.
For each component of equity, the effects of changes in accounting policies and
corrections of errors.
These amounts may also be presented either in the preceding statement of in the notes:
Capital transactions with owners

The balance of accumulated profits at the beginning and at the end of the period, and
the movements for the period.
A reconciliation between the carrying amount of each class of equity capital and each
reserve at the beginning and end of the period, disclosing each movement.
Balance Sheet
IAS 1 requires a certain amount of information to be shown on the Balance Sheet:
Property, plant and equipment

Investment property
Intangible assets
Financial assets
Investments accounted for using the equity method
Biological assets
Inventories
Trade and other receivables
Cash and cash equivalents
Trade and other payables
Provisions
Financial liabilities
Liabilities and assets for current tax
Deferred tax liabilities and deferred tax assets
Minority interest, presented within equity
Issued capital and reserves attributable to equity holders of the parent
Current and non-current assets and liabilities should be separately classified.
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Other disclosures include:
Number of shares authorized, issued and fully paid, and issued but not fully paid
Reconciliation of shares outstanding at the beginning and the end of the period
Description of rights, preferences, and restrictions
Treasury shares, including shared held by subsidiaries and associates
Shares reserved for issuance under options and contracts
A description of the nature or purpose of each reserve within owners equity
Nature and purpose of each reserve
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An example is shown below:
ABC plc
Balance Sheet at 31 July 2008
Non-current assets
Intangible
Goodwill
Freehold land and buildings
Machinery
000
Valuation
000
Cost
000
Aggregate
Depreciation
1,500
500
1,000
24,000
7,500
33,000
6,240
8,400
3,000
18,140
52,760
15,600
4,500
73,860
59,000
59,000
Current assets
Inventories
Trade receivables
Total assets
Current liabilities
Trade payables
Tax liabilities
5,600
2,970
820
9,390
83,250
(2,000)
(4,250)
(6,250)
Net current assets
3,140
77,000
Net current liabilities

7% debentures (2058)
Total liabilities
Net assets
Equity
Authorised share capital
200,000,000 Ordinary shares of 50 pence each
Issued share capital
60,000,000 Ordinary shares of 50 pence each fully paid
Capital reserves
Revaluation reserve
Revenue reserve
Retained earnings
Total equity
000
Net
(1,000)
7,250
76,000
000
000
10,000
30,000
5,000
1,500
6,500
39,500
76,000
200
Other Disclosures
A company shall disclose in the notes:
Amount of dividends proposed or declared before the financial statements were

authorized for issue but not recognized as a distribution to equity holders during the
period, and the related amount per share.
The amount of cumulative preference dividends not recognized.
Interim dividends are paid part way through the financial year. They are based on half-yearly
profits reported by the company.
Final dividends are paid on the profits based on the results of the whole year being
considered. They will be paid in the early part of the next financial year.
Only dividends that have actually been paid are to be recorded in the financial statements.
This means that last years proposed final dividend (provided it has been approved by the
shareholders and has been paid) and this years interim dividend paid will be included in the
current years financial statements.
For example:
Notes to the Financial Statements
Dividends
Equity dividends on ordinary shares
Amounts recognised as distributions to equity holders during the year:
Final dividend for the year ended 31 March 2007 of 6p per share
Interim dividend for the year ended 31 March 2008 of 2p per share
000
3.6
1.2
4.8
Proposed final dividend for the year ended 31 March 2008 of 3p per share
1.8
The proposed final dividend is subject to approval by shareholders at the annual general
meeting and accordingly has not been included as a liability in the financial statements.
The summary of significant accounting policies in the notes should include the measurement
bases used in the financial statements and all other accounting policies required for further
understanding. Furthermore, it should include significant judgement made by management
while applying the accounting policies.
Once accounting policies are adopted, managers of a company must apply the policies
consistently.
The notes to the financial statements should disclose the basis of preparation of financial
statements, significant accounting policies, information required by IAS but not disclosed in
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the statements, and additional information not present in the statements but required for
further comprehension. Notes should be systematically presented, and each item in the
statements should be cross-referenced to the relevant note.
Directors report
As part of the published accounts, the directors must report to the shareholders.
The directors report contains details of:
The principal activities of the company

A review of the activities of the company over the past year
Likely developments that will affect the company in the future including research and
development
The names of directors and their shareholdings in the company
Proposed dividends
Any significant differences between the market value and the book value of land and
buildings
Political and charitable contributions
Actions taken on employee involvement and consultation
The companys policies on:
o Employment of disabled people
o Health and safety at work
o Payment of suppliers
Auditors report
Larger companies must have their published accounts audited. The auditors are appointed by
the shareholders and their report is printed in the published accounts.
The auditors report has three main sections:
The respective responsibilities of directors and auditors

The basis of audit opinion
The opinion
The opinion may be unqualified if the auditors are of the opinion that:
-
The financial statements have been properly prepared

They give a true and fair view of the companys affairs in accordance with the IFRS
as adopted by the European Union and
The information given in the directors report is consistent with the financial
statements
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The auditors report may be qualified if the auditors feel that certain parts of the financial
statements have not been dealt with correctly and that this is important enough to be brought
to the attention of any of the users of the accounts.
14.3 Inventories. IAS 2

The Standard prescribes the accounting treatment for inventories. The main issue is the
amount of cost to be recognised as an asset.
In general, inventories are valued at the lower of cost and net realisable value.
The cost of inventories comprises all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition.
The costs of purchase constitute all of:
The purchase price

Import duties
Transportation costs
Handling costs directly pertaining to the acquisition of the goods
(Trade discounts and rebates are deducted when arriving at the cost of purchase of inventory)
The cost of inventories should be measured using either:
The FIFO method; or

The weighted-average cost method.
The net realisable value is the estimated selling price less estimated costs incurred to get the
product into a condition necessary to complete the sale.
203
14.4 Cash flow statements. IAS 7

This part is fully examinable. And you will learn more in Lesson 15.
IAS 1 makes it incumbent upon companies preparing financial statements under IFRS to
present a cash flow statement as an integral part of the financial statements.
IAS 7 lays down rules regarding cash flow statement preparation and reporting. The cash
flow statement provides information about a companys cash receipts and cash payments for
the period for which the financial statements are presented.
IAS 7 requires that a cash flow statement should be classified into four components:
1.
2.
3.
4.
Operating activities
Investing activities
Financing activities
IAS 7 requires that companies prepare a cash flow statement in the format described in the
Standard.
204
An example of a cash flow statement is shown below:
ABC Limited
Cash flow statement for the year ended 31 July 2008
000
Net cash from operating activities
Cash flows from investing activities
Purchase of non-current assets
Proceeds of sales from non-current assets
Interest received
Dividends received
Net cash from investing activities
Cash flows from financing activities
Proceeds of issue of equity share capital
Repayment of share capital
Proceeds from long term borrowings
Repayment of long term borrowings
Dividends paid
Net cash from financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of the year
Cash and cash equivalents at end of year
000
88
(170)
20
13
2
(135)
370
(30)
100
(60)
(25)
355
308
668
976
Reconciliation of profit from operations to net cash flow from operating activities.
Profit from operations

Adjustments for:
Depreciation for the year
Increase in inventories
Decrease in trade receivables
Decrease in trade payables
Cash from operations
Interest paid
Income taxes paid
000
100
14
(3)
7
(10)
108
(12)
(8)
88
(The information will be provided from the Balance Sheets prepared at the end of two
consecutive years)
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14.5 Net profit or loss for the period fundamental errors and changes in
accounting procedures. IAS 8
IAS 8 prescribes criteria for selecting and changing accounting policies and the disclosures
thereof and also sets out the requirements and disclosures for changes in accounting estimates
and corrections of errors. It purports to achieve these objectives:
To enhance the relevance and reliability of an entitys financial statements; and

To ensure the comparability of the financial statements of an entity over time as well
as with financial statement of other companies.
Accounting policies are essential for a proper understanding of the information contained in
the financial statements prepared by the management of a company. A company should
clearly outline all significant accounting policies it has used in preparing the financial
statements
For example, under IAS 2 a company has the choice of the weighted-average method or the
FIFO method in valuing its inventory. If the company does not disclose the method of
inventory valuation used in the preparation of its financial statements, user of the financial
statements would not be able to use the financial statements to make relative comparisons
with other entities.
Once selected, an accounting policy must be applied consistently for similar transactions;
however, an accounting policy may be changed only if the change is required by a Standard
or results in financial statements providing reliable and more relevant information.
A change in accounting policy required by a Standard shall be applied in accordance with the
transitional provisions therein. If a Standard contains no transitional provisions or if an
accounting policy is changed voluntarily, the change shall be applied retrospectively.
The practical impact is that corresponding amounts presented in financial statements must be
restated as if the new policy had always been applied. The impact of the new policy on the
retained earnings prior to the earliest period presented should be adjusted against the opening
balance of retained earnings.
Accounting estimates may change as circumstances change. Thus a change in estimate does
not warrant restating the financial statements of a prior period because it is not a correction of
an error. Common examples of accounting estimates are bad debts, inventory obsolescence,
useful lives of property, plant and equipment.
Discovery of material errors relating to prior periods shall be corrected by restating
comparative figures in the financial statements for the year in which the error is discovered,
unless it is impracticable to do so.
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14.6 Events after balance sheet date. IAS 10

Events that occur up to the balance sheet date are critical in arriving at a companys financial
results and the financial position. However, sometimes events occurring after the balance
sheet date may provide additional information about events that occurred before and up to the
balance sheet date. This information may have an impact on the financial results and the
financial position of the company. Therefore, it is imperative that those post-balance sheet
events up to the authorization date be taken into account in preparing the financial statements
for the year ended and as at the balance sheet.
The authorization date is the date which the financial statements could be considered legally
authorised for issuance. Once the financial statements are authorised for issue no alterations
can be made.
IAS 10 provides guidance on accounting and disclosure of post-balance sheet events, which
are categorised into adjusting and non-adjusting events.
Adjusting events.
Adjusting events are those post-balance sheet events that provide evidence of conditions that
actually existed at the balance sheet date, albeit they were not known at the time. Financial
statements should be adjusted to reflect adjusting events after the balance sheet date.
Typical examples of adjusting events are:
The bankruptcy of a customer after the balance sheet date usually suggests a loss of
trade receivable at the balance sheet date.
A liability that existed at the year-end, the value of which became clear after the
balance sheet date.
Non-adjusting events.
Non-adjusting events are conditions that arose after the balance sheet date. No adjustment is
necessary in the financial statements. If such events are material then they are disclosed by
way of notes to the accounts. These notes would explain the nature of the event and if
possible the likely financial consequences of the event.
Examples might include:
A major restructuring of the business;

Significant business commitments entered into after the balance sheet date.
Dividends on equity shares proposed or declared after the balance sheet date should not be
recognised as a liability at the balance sheet date. Such declaration is a non-adjusting
subsequent event and footnote disclosure is required, unless immaterial.
IAS 10 requires these three disclosures:
1) The date when the financial statements were authorised for issue and who gave that
authorisation.
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2) If information is received after the balance sheet about conditions that existed at the
balance sheet date, disclosures that relate to those conditions should be updated in the
light of the new information.
3) Where non-adjusting events after the balance sheet date are of such significance that
non-disclosure would affect the ability of the users of financial statements to make
proper evaluations and decisions, disclosure should be made for each such significant
category of non-adjusting event regarding the nature of the event and an estimate of
its financial effect or a statement that such an estimate cannot be made.
208
14.7 Property, plant and equipment. IAS 16

IAS 16 prescribes rules regarding the recognition, measurement and disclosures relating to
property, plant and equipment (fixed assets) that would enable users of financial statements to
understand the extent of an entitys investment in such assets and the movements therein.
The principal issues involved relate to the recognition of items of property, plant and
equipment, determining their costs, and assessing the depreciation and impairment losses that
need to be recognised.
An item of property, plant and equipment should be recognised initially at its cost. The cost
comprises:
Purchase price, including import duties, non-refundable purchase taxes, less trade
discounts and rebates.
Costs directly attributable to bringing the asset to the location and condition necessary
for it to be used.
Estimated costs of dismantling and removing the asset at the end of its life.
After the initial acquisition, the asset should be measured using either the cost model or the
revaluation model. Once selected, the policy shall apply to an entire class of property, plant
and equipment.
The cost model requires an asset to be carried at cost less accumulated depreciation and
impairment losses.
The revaluation model requires an asset to be measured at a revalued amount, which is its
fair value less subsequent depreciation and impairment losses. When an asset is revalued, any
increase in carrying amount should be credited to a revaluation reserve in equity.
Depreciation is to be charged on all non-current assets with the exception of freehold land.
Such depreciation charge shall be charged to the income statement.
The depreciable amount takes account of the expected residual value of the assets. They
should be reviewed annually
The method used (straight-line method or reducing balance method) should be reviewed at
least annually in order to consider whether the method used is still the most appropriate
method.
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14.8 Revenue. IAS 18

IAS 18 prescribes the requirements for the recognition of revenue in a companys financial
statements. Revenue can take various forms, such as sales of goods, provision of services,
royalty fees, franchise fees, management fees, dividends, interest, subscriptions, and so on.
The principal issue in the recognition of revenue is its timing. It is critical that the point of
recognition of revenue is properly determined. The decision as to when and how revenue
should be recognised has a significant impact on the determination of net income for the
year.
Revenue includes sales of goods, rendering of services and the receipts of interest, royalties
and dividends.
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14.9 Impairment of assets. IAS 36

IAS 36 ensures that assets are carried at no more than their recoverable amount. If an assets
carrying value exceeds the amount that could be received through use or through selling the
asset, then the asset is impaired and IAS 36 requires a company to make provision for the
impairment loss.
The Standard applies to non-current assets:
Subsidiaries, associates and joint ventures

Investment property carried at cost
Intangible assets and goodwill
Assets need to be reviewed at each Balance Sheet date to judge whether there is evidence of
any impairment. Some of the events that might indicate that an asset is impaired are:
-
External sources, such as a decline in market value, increases in market interest rates,
economic, legal or technological changes that have an adverse affect on the company.
Internal sources of information, such as physical damage to an asset, or its
obsolescence, or an asset becoming idle.
If there is an indication that an asset is impaired, the assets useful life, depreciation, or
residual value may need adjusting.
The recoverable amount of an asset is the higher of the assets fair value less costs to sell and
its value in use.
If there is an impairment loss, the asset should be shown on the Balance Sheet at its
recoverable amount and the impairment loss should be shown on the income statement as an
expense.
211
14.10 Provisions, contingent liabilities and contingent assets. IAS 37

IAS 37 seeks to ensure consistency of treatment of provisions, contingent liabilities and
contingent assets. The bases of treatment are disclosed in the notes to the financial
statements.
Provisions should be recognised if, and only if, all of these conditions are met:
a) A company has a present obligation resulting from a past event;
b) It is probable that an outflow of resources embodying economic benefits would be
required to settle the obligations; and
c) A reliable estimate can be made of the amount of the obligation.
Only present obligations resulting for a past obligating event give rise to a provision. An
obligation could either be a legal obligation or a constructive obligation.
Provisions differ from other liabilities in that the amounts are set aside out of profits for a
known expense, the amount of which is uncertain.
When one of the prescribed conditions is not satisfied, then a provision cannot be recognised.
It is then a contingent liability and needs to be disclosed in footnotes, unless the probability
of the outflow embodying economic benefits is remote (in which case it does not even have
to be disclosed).
A contingent liability is a possible obligation arising from past events, the outcome of which
will be confirmed only on the occurrence or non-occurrence of one or more uncertain future
events. If the probability of the outflow of the future economic benefits changes to more
likely than not, then the contingent liability may develop into an actual liability and would
need to be recognised as a provision.
For each class of contingent liability a company should disclose at the balance sheet date a
brief description of the nature of the contingent liability.
Contingent assets are possible assets that arise from a past event and whose existence is
confirmed only by the occurrence or non-occurrence of one or more uncertain future events
not wholly within the control of the entity.
212
14.11 Intangible assets. IAS 38

IAS 38 prescribes the recognition and measurement criteria for intangible assets that are not
covered by other Standards
The principal issues involved relate to the nature and recognition of intangible assets,
determining their costs, and assessing the amortization and impairment losses that need to be
recognised.
In order to meet the definition of an intangible asset, expenditure on an item must be
separately identifiable in order to distinguish it from goodwill.
An asset must be capable of being separated from the company and sold, transferred, licensed
or renter either individually or in combination with a related contract, asset or liability.
Intangible assets are either:
Purchased; or
Internally generated.
Only purchased intangible assets can be recognised in the financial statements, so internally
generated goodwill or brand names cannot be recognised.
The Standards states that, after recognition, intangible assets may be measured using either a
cost model or a revaluation model. If the cost model is selected, then after initial recognition,
an intangible asset shall be carried at cost less accumulated amortization and impairment
losses. If the revaluation model is selected, the intangible asset shall be carried at its fair
value less subsequent accumulated amortization and impairment losses.
Like tangible assets, intangible assets are amortised (depreciated) using the straight-line
method.
213
LESSON 15. PUBLISHED ACCOUNTS
15.1 Introduction
When a company draws up its own financial statements for internal use it can draft them in
any way it wishes.
When it comes to publication, i.e. when the financial statements are sent to the shareholders
or to the Registrar of Companies, the Companies Acts lay down the information which must
be shown.
Remember that your tutor is there to help if something is not clear or you need more
questions for practice.
15.2 Published reports

An annual report is a document produced annually by companies. It intends to give a true a
fair view of the companys annual performance, with audited financial statements prepared in
accordance with company law and other regulatory requirements, and also containing other
non-financial information.
The Companies Act 1985/89 requires companies to publish their annual report and accounts.
That includes:
-
A Profit and Loss Account

A Balance Sheet
A Cash Flow Statement
Notes to the accounts
Accounting policies
A Directors Report
Auditors Report
Operating and financial review. This is a statement in the annual report which
provides a formalised, structures explanation of financial performance. The operating
review covers items such as operating results, profit and dividend. The financial
review discusses items such as capital structure and treasury policy.
The Stakeholders in the annual report are:
Shareholders, who are the owners of the business

Potential shareholders
Managers and employees
Creditors and potential creditors
Suppliers (credit suppliers)
214
Employees and their trade unions

The government for tax purposes
The directors are responsible for the preparation of the accounts which must give a true and
fair view. A true and fair view is one where accounts reflect what has happened and do not
mislead the readers. The accounts must be prepared in accordance with relevant accounting
standards.
The functions of the annual report are to provide information about the performance and
changes in the financial position of the company and to provide shareholders with financial
information so that they can make decisions such as buying or selling shares.
215
15.3 Cash Flow Statements

The presentation of cash flow statements by companies is guided by IAS 7, Cash Flow
Statements.
The benefits of cash flow information are explained in IAS 7. A cash flow statement, when
used in conjunction with the rest of the financial statements, provides users with information
on solvency and liquidity. It shows how cash is generated in the business and helps users to
understand how much flexibility is available to adapt to changing circumstances and
opportunities.
The cash flow statement presents three classifications of cash flows:
Operating activities
Investing activities
Financing activities
Operating activities. They are the principal revenue-producing activities of the entity and
other activities that are not investing or financing activities.
The net cash inflow from operating activities is calculated by using figures from the profit
and loss account and balance sheet as follows:
Operating profit (i.e. net profit, before deduction of interest)

Add depreciation for the year
Add decrease in debtors, or deduct increase in debtors
Add increase in creditors, or deduct decrease in creditors
Add decrease in stock, or deduct increase in stock
Depreciation is added to profit because depreciation is a non-cash expense, that is, no money
is paid out by the business in respect of depreciation charged to profit and loss account.
Investing activities. They are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
Financing activities. They are activities that result in changes in the size and composition of
the contributed equity and borrowings of the entity.
The cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible to
known amounts of cash and which are subject to an insignificant risk of changes in value.
There are two approaches to presenting the cash flows arising from operations:
1. The direct method. It presents cash inflows from customers and cash outflows to
suppliers and employees, taken from the entitys accounting records of cash receipts
and payments.
2. The indirect method. It starts with the operating profit and makes a series of
adjustments to convert profit to cash.
216
You will learn the indirect method following the format given in IAS7.
Layout of a Cash Flow Statement:
CASH FLOW STATEMENT

Cash flows from operating activities
Operating profit (i.e. net profit before deduction of interest)

Depreciation charge for the year
Profit or loss on sale of fixed assets
Changes in debtors, creditors and stock
Outflows: interest paid,
Outflow: corporation tax paid by limited companies during the year

Inflows: sale proceeds from non-current assets

Outflows: purchase of non-current assets
Interest received
Net cash from investing activities

Inflows: receipts from increase in capital/share capital, raising/increase of loans

Outflows: repayment of capital/share capital/loans
Proceeds from long term borrowings
Repayment of long term borrowings
Dividends paid
Net cash from financing activities

Net increase/(decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of the year
Cash and cash equivalents at end of year
217
The following information is used to illustrate the indirect method:

Income Statement Year 2
000
246
(110)
136
4
5
(30)
(10)
105
(15)
90
(30)
60
Revenue
Cost of sales
Gross profit
Investment income interest received
Gain on disposal of equipment
Depreciation
Administrative and selling expenses
Operating profit before interest
Interest expense
Profit after deducting interest
Taxation
Profit after tax
Balance Sheets at 31 December
Non-current assets
Year 2
000 000
Property, plant and equipment at cost

Accumulated depreciation 40 + 30 10
150
(60)
90
100
Investments
Current assets
Inventory (stock)
Trade receivables (debtors)
Current liabilities
Trade payables (creditors)
Interest payable
Taxes payable

Share capital
Share premium
Retained earnings
100
(40)
60
100
20
18
32
70
15
16
5
36
(14)
(6)
(8)
(28)
(13)
(7)
(7)
(27)
42
Non-current liabilities
Long-term loans
Net assets
Year 1
000 000
(20)
212
(15)
154
140
20
52
212
130
18
6
154
218
Further information:
1. The dividend paid during Year 2 was 14m. The retained earnings increased by 60m
profit of the period and decreased by the amount of the dividend 14m.
2. During Year 2 the company acquired property, plant and equipment costing 80m.
3. During Year 2 the company sold property, plant and equipment that had an original
cost of 30m and accumulated depreciation of 10m. The proceeds of sale were
25m.
Required:
Prepare a cash flow statement using the indirect method.
Answer:
Cash flow statement for the year ended 31 December
000
Net cash inflows from operating activities (Note 1)
Purchase of non-current assets
Proceeds from sale of non-current assets
Interest received
Net cash used in investing activities
Proceeds from issue of share capital
Proceeds from long-term borrowing
Dividends paid
Net cash used in financing activities
Increase/(decrease) in cash and cash equivalents
Cash and cash equivalents at the start of the year
Cash and cash equivalents at the end of the year
000
75
(80)
25
4
(51)
12
5
(14)
3
27
5
32
Note 1:
Reconciliation of operating profit to net cash inflow(outflow) from operating activities:
Operating profit
Depreciation charges
Gain on disposal of equipment
(Increase) in inventories (stocks)
(Increase) in trade receivables
Increase in trade payables
Interest paid
Taxes paid
000
101
30
(5)
(5)
(2)
1
(16)
(29)
75
219
Explanatory notes:
Operating profit (before taxes)
Is there any interest expense included in this figure?
If so add it back to arrive at:
Operating profit before deducting interest payable and taxes
Is there any interest received/receivable or any dividends received in
this figure? If so deduct it to arrive at:
Operating profit before deducting interest payable and taxes and before
including interest receivable and dividends received
90
15
105
(4)
101
The depreciation is seen in the income statement (profit and loss account). It is added back to
exclude the effect of a non-cash item.
The gain on disposal is seen in the income statement (profit and loss account). It is added
back to exclude the effect of a non-cash item.
There is an increase in inventory (stock) seen by comparing the balance sheets at the end of
year 1 and year 2. This decreases the cash flow.
There is an increase in trade receivables (debtors) seen by comparing the balance sheets at the
end of year 1 and year 2. This decreases the cash flow.
There is an increase in trade payables (creditors) seen by comparing the balance sheets at the
end of year 1 and year 2. This has a positive effect on the cash flow by increasing the amount
unpaid.
Interest paid is calculated from the profit and loss account expense 15m plus the unpaid
interest at the start of the year 7m minus the unpaid interest at the end of the year, 6m.
Taxes paid are calculated from the profit and loss account charge 30m plus the unpaid
liability at the start of the year 7m minus the unpaid liability at the end of the year 8m.
The purchase cost of non-current assets is given in the further information. It can be checked
by taking the cost at the start of the year 100m, adding 80m and deducting the 30m cost
of the disposal to leave 150m as shown in the balance sheet at the end of the year.
The proceeds of sale 25m are given in the further information. This can be checked by
taking the net book value of the asset sold (30m - 10m = 20m) and adding the gain on
disposal 5m shown in the income statement.
The interest received is taken from the income statement. There is no interest receivable
shown in the balance sheet so the profit and loss account figure must be the same as the cash
figure.
The proceeds from the share issue are the total of the increase in share capital 10m plus the
increase in share premium 2m.
220
The proceeds from long-term borrowings are the increase in long-term loans calculated by
comparing the opening and closing balance sheets.
The dividend paid is given in the further information. It can be checked by taking the retained
earnings at the start of the period 6m, add the profit of the period 60m and deduct dividend
14m to arrive at the retained earnings at the end of the period, 52m.
The cash and cash equivalents at the start and end of the year are taken from the balance
sheet.
Comment on cash flow statement:
The cash flow from operating activities amounted to 75m. The purchase of non-current
(fixed) assets cost 80m but this was offset by 25m proceeds of sale of non-current assets no
longer required and was also helped by the 4m interest received from investments. The net
outflow from investments was 51m. This left 24m of cash flow available to increase cash
resources but 14m was required for dividend payments. The remaining 10m was added to
the proceeds of a share issue, 12m and an increase in long-term loans, 5m, giving an
overall cash inflow of 27m.
221
15.4 Duties of Directors

Under the Companies Act the directors of a company have a series of duties which are owed
to the company:
A director must act in accordance with the companys constitution, and only exercise
powers for the purposes for which they are conferred.
A director must act in the way he considers, in good faith, would be most likely to
promote the success of the company for the benefit of its members as a whole.
A director must exercise independent judgment.
He must exercise reasonable care, skill and diligence.
He must avoid conflict of interest
He must not accept a benefit from a third party conferred by reason of being a director
or his doing (or not doing) anything as director
222
15.5 Duties of Auditors

Under the Companies Act the auditors have a series of duties owed to the company:
A companys auditor, in preparing his report, must carry out such investigation as will
enable him to form an opinion as to:
o Whether adequate accounting records have been kept by the company and
returns adequate for their audit have been received
o Whether the companys individual accounts are in agreement with the
accounting records and returns, and
o In the case of a quoted company, whether the auditable part of the companys
directors remuneration report is in agreement with the accounting records and
returns.
If the auditor is of the opinion that the company has not complied with the above the
auditor shall state that fact in his report.
If the auditor fails to obtain all the information and explanations which, to the best of
his knowledge and belief, are necessary for the purposes of his audit, he shall state
that fact in his report.
If the directors of the company have prepared accounts and reports in accordance with
the small companies regime and in the auditors opinion they were not entitled so to
do, the auditor shall state that fact in his report.
223
15.6 Non-current Assets

A schedule of non-current assets need to be prepared as a note to the accounts.
The format will be:
Net book value at beginning of the year
Additions at cost
Disposals (it will be with a minus (-))
Depreciation for the year (-)
At the end of the year (total)
1,000
1,000
(500)
(300)
2,200
224
LESSON 16. PARTNERSHIP ACCOUNTS
16.1 Introduction
The term Partnership is defined in the Partnership Act 1890 as:
The relation which subsists between persons carrying on business in common with a view of
profit.
In a Partnership a number of individuals will contribute to the capital of the business and
share the responsibility of running the business. As the share of capital contributed by each
partner, and the involvement of each individual partner in the management of the business
may vary partners are advised to draw up a legally binding Partnership Agreement.
This agreement sets out the legal entitlements of each partner in respect of all aspects of the
business relationship and will cover such items as:
Interest on capital
Partners salaries
Interest on drawings
Profit sharing ratio
Interest on loans
Partners joining or leaving
The accounting requirements of a partnership are:

Either to follow the rules set out in the Partnership Act 1980
Or for the partners to agree amongst themselves, by means of the partnership
agreement to follow different accounting rules.
Unless the partners agree otherwise, the Partnership Act 1980 states the following accounting
rules:
Profits and losses are to be shared equally between the partners
No partner is entitled to a salary
Partners are not entitled to receive interest on their capital
Interest is not to be charged on partners drawings
When a partner contributes more capital than agreed, he or she is entitled to receive
interest at 5% per annum on the excess
225
16.2 Financial Statements for partnership

A partnership prepares the same type of year end accounts as a sole trader business:
Trading and Profit and Loss Account
Balance Sheet
In addition to the Trading and Profit and Loss Account an Appropriation Account also
prepared. The Appropriation Account is an extension to the Profit and Loss Account and is
used to apply the terms of the Partnership Agreement and therefore deal with the distribution
between partners of the net profit and loss.
It is common to keep separate fixed Capital Accounts for each partner. The balance on the
partners Capital Account normally remains fixed unless the partner specially increases or
decreases his capital investment in the business. A Current Account is also kept for each
partner through which we process non Capital Account transactions but which will effect a
partners claim on the business. These include:
Drawings taken by a partner

Interest charged on drawings
Interest given on capital invested
Partnership salaries
Interest payable on a loan from a partner
Share of profit or loss
An example of sharing profits will be as follows:

Brent, Jakes and Ranns are partners sharing profits and losses equally; their profit and loss
account for the current year shows a net profit of 60,000. The appropriation of profits
appears as:
Brent, Jakes and Ranns
Profit and Loss Appropriation Account
For the year ended.
Net profit
Share of profits:
Brent
Jakes
Ranns
60,000
20,000
20,000
20,000
60,000
This is a simple appropriation of profits. Throughout this lesson you will learn how to prepare
a full Profit and Loss Account along with the Appropriation Account of a partnership.
226
16.2.1 Capital Accounts and Current Accounts

Unlike a sole trader, in a partnership each partner usually has a capital account and a current
account. The capital account is usually fixed unless there is a permanent increase or decrease
in capital contributed by the partner.
However, the current account is fluctuating and it is to this account that:
Share of profits is credited

Share of loss is debited
Salary (if any), or commissions, are credited
Drawings are debited
Interest charged on partners drawings is debited
Partner A: Current Account
Dr
Cr
Drawings
Interest charged on drawings
Balance c/d
Balance b/d
Share of net profit
Salary (or commissions)
Interest allowed on capital
The normal balance on a partners account is credit, however when the partner has drawn out
more than his or her share of the profits, then the balance will be debit.
The initial entries in the capital account for each partner will be:
Debit: Bank Account
Credit: Partners Capital Account
However, it is possible to have a fluctuating capital account where the distribution of
profits would be credited and the drawings and interest on drawings debited. Therefore the
balance on the capital account will change each year, i.e. it will fluctuate.
The keeping of fixed capital accounts plus current accounts is considered preferable to
fluctuating capital accounts. When partners are taking out greater amounts that the share of
the profits that they are entitled to, this is shown up by a debit balance on the current account
and so acts as a warning.
227
16.2.2 Appropriation of profits

The appropriation account follows the Profit and Loss Account and shows how net profits has
been divided amongst the partners.
The example which follows shows the additional account, the Appropriation Account. You
will learn how to process the transactions through the Appropriation Account and the partners
current account.
Brent, Jakes and Ranns have been in partnership for several years. The following information
is available, the Trading and Profit and Loss Account for the year ended 30 April 2001
having already been prepared:
1
Capital Account Balance
Current Account Balance
Loan Account Balance
Drawings Account Balance
2
1 May 2000
1 May 2000
1 May 2000
30 April 2001
Brent
60,000
2,150 CR
Jakes
50,000
1,550 CR
12,000
16,000
Ranns
40,000
750 CR
20,000
14,000
Net Profit in the year to 30 April 2001: 52,000
3
Interest is charged on partners drawings for the year ended 30 April 2001. Charges are to be
Brent 1,000, Jakes 1,200 and Ranns 1,100.
Interest is given on partners Capital Account balances at the rate of 8% per annum.
Brent receives a partnership salary of 5,000 per annum.
Robins receives interest on his loan at the rate of 10% per annum.
Profits/(Losses) are to be shared in the ratio of Brent, Jakes and Ranns 3:3:2 respectively.
The following is the Appropriation Account for the year ended 30 April 2001 and the Current
Accounts for the partners:
228
Brent, Jakes and Ranns

Appropriation Account for the Year Ended 30 April 2001
Net Profit
Add Interest on Drawings:
Brent
Jakes
Ranns
52,000
1,000
1,200
1,100
3,300
55,300
Less Interest on Capital:
Brent (60,000 x 8%)

Jakes (50,000 x 8%)
Ranns (40,000 x 8%)
4,800
4,000
3,200
(12,000)
43,300
(5,000)
38,300
Less Salary:
Brent
Less Share of Profit:
Brent (38,300 x 3/8)

Jakes (38,300 x 3/8)
Ranns (38,300 x 2/8)
14,363
14,362
9,575
38,300
The interest on loan does not appear in the Appropriation Account. The loan interest of
2,000 for the year ended 30 April 2001 will have been debited as an expense to the Profit
and Loss Account. The net profit of 52,000 will already have been adjusted therefore to
account for loan interest. The loan interest however will be credited to Ranns Current
Account.
Note that all of the available profit, after allowing for any salary, and interest charged and
allowed, is shared amongst the partners, in the ratio in which they share profit and losses.
The partners current accounts for the year appears as:
Dr
Partners Current Accounts
Date
Details
01/05/2000
Balance b/f
30/04/2001
Interest on Drawings
30/04/2001
30/04/2001
Brent
Jakes
Brent
Jakes
01/05/2000
Balance b/f
2,150.00
1,550.00
30/04/2001
Interest on Capital
4,800.00
4,000.00
2,712.00
30/04/2001
Salary
5,000.00
2,712.00
30/04/2001
Interest on Loan
30/04/2001
Share of Profit
30/01/2001
Balance c/d
Drawings
13,313.00
Balance c/d
13,313.00
Details
750.00
1,200.00
30/04/2001
Date
1,100.00
1,000.00
26,313.00
Ranns
Cr
19,912.00
Ranns
3,200.00
2,000.00
14,363.00
14,362.00
9,575.00
1,075.00
15,850.00
26,313.00
19,912.00
1,075.00
13,313.00
2,712.00
15,850.00
229
16.2.3 Balance Sheet

Within the Balance Sheet of a partnership must be shown the year end balances on each
partners capital and current account. The other sections of the Balance Sheet (fixed assets,
current assets and current liabilities) are presented in the same way as for a sole trader.
If we continue with our previous examples we will extract the Financed by section of the
Balance Sheet (the other sections are not shown):
Balance Sheet (Extract) as at 30 April 2001
Financed by:
Capital Accounts
Brent
Jakes
Ranns
60,000
50,000
40,000
150,000
Current Accounts
Brent
Jakes
Ranns
13,313
2,712
(1,075)
14,950
164,950
Under the long term liability section of the Balance Sheet we will show the loan to Ranns:
Long Term Liability:
Ranns -
Loan
20,000
Note that an examination question will call either for the preparation of the partners current
accounts or for a detailed Balance Sheet extract, in which case you will need to show the
current account opening balance and add salary, interest on capital and share of profit and
deduct drawings and interest on drawings, to reach the same answer as if we had prepared
the partners current accounts and transfer their balances to the Financed by section of the
Balance Sheet as shown on our example above.
230
16.3 Changes in partnerships

16.3.1 Goodwill
Any changes made in respect of a partnership, such as the introduction of a new partner or a
change in the profit sharing ratio, mean an end to the old partnership on the commencement
of a new partnership.
When changes are made to a partnership such as the introduction of a new partner, it is usual
for the assets to be revalued, and also for a valuation to be made for goodwill if it is
considered to be appropriate.
Goodwill can be defined in accounting terms as:
The difference between the value of a business as a whole, and the aggregate (total) of the
value of its separate assets, less liabilities.
It is the value of that part of the business that is not tangible, for example, the reputation of
the business, the skill of the workforce, the trade that has built up and the success at
developing new products.
Any partners coming into the existing business will be charged for a share in this goodwill.
Valuation of goodwill
The actual value of the goodwill can be arrived at in a number of ways, usually based on
some aspects of the business. It is always subject to negotiation between the people
concerned if, for example, a partnership is to be sold.
Two commonly used methods of valuing goodwill are:
Average profits. Goodwill is valued at the average net profit over the last, say, five
years multiplied by, say, four, to give a goodwill figure being 4 years purchase of net
profits.
Net profit: 10,000 (2001), 12,000 (2002), 14,000 (2003), 12,000 (2004), 14,000
(2005).
Goodwill is to be valued at five times the average profit of the last four years:
12,400 x 4 = 49,600
Super profits. It takes the annual profit less any remuneration that the partners might
have earned elsewhere and less any interest that would have been earned if the capital
had been invested elsewhere, then it is multiplied by an agree factor.
231
For example:
The capital of a partnership is 100,000; the profits after payment of a salary to each
partner are 15,000 per year; the general level of interest for savers is 10%, gross of
tax; and goodwill is to be valued at five times the super profits.
Thus, 100,000 x 10% interest = 10,000 (interest that would have been earned if
invested). The profit of the partnership is 15,000. Therefore, 15,000 - 10,000 =
5,000, which is the amount of super profits.
Goodwill, therefore, is valued at 5,000 x 5 = 25,000.
Once a figure has been agreed for any goodwill the partners Capital Accounts will be
adjusted accordingly as a credit entry in their profit-sharing ratio and that amount is
temporally debited to goodwill account. The old partners who created the goodwill being
given credit for this, and any new partners being charged for a share in this. After the
change in the partnership the partners capital accounts are debited and goodwill account is
credited.
In a Balance Sheet, goodwill is shown as an intangible fixed asset. It is only recorded on the
Balance Sheet when it has been purchased, e.g. a sole trader or a partnership purchasing
goodwill when taking over another business.
The goodwill should then either be depreciated (or amortised) to Profit and Loss Account
over its estimated economic life (generally up to a maximum of twenty years), or, if the
estimated economic life is deemed to be indefinite, the goodwill need not be amortised.
232
16.3.2 Admission of a new partner

A new partner can only be admitted with the consent of all existing partners and is charged a
premium for goodwill.
The reason for the charge for goodwill is because the new partner will start to share in the
profits of the business immediately and will benefit from the goodwill established by the
existing partners.
We use a goodwill account which is opened by the old partners with the agreed valuation of
goodwill and, immediately after the admission of the new partner, is closed by transfer to the
partners capital accounts, including that of the new partner.
The calculation is done in four stages:
1. Show value of goodwill divided between old partners in old profit and loss sharing
ratios.
2. Show value of goodwill divided between partners (including new partner) in new
profit and loss sharing ratio.
3. Goodwill gain shown: charge these partners for the gain
4. Goodwill loss shown: give these partners an allowance for their losses.
Lets see this with an example:
Al and Ben are in partnership sharing profits and losses equally. Col is admitted as a new
partner, with a new profit-sharing ratio of 2:2:1. Goodwill has been agreed at a valuation of
25,000. Col will bring 20,000 of cash into the business as his capital and premium of
goodwill. The capital balances before Col was admitted were 45,000 Al, and 35.000 Ben.
Partners Old profit

Shares
Al
1/2
Ben
1/2
Col
Share of
goodwill
12,500
12,500
New profit
shares
2/5
2/5
2/5
25,000
Share of
goodwill
10,000 2,500 loss Cr Al capital
10,000 2,500 loss Cr Ben capital
5,000
5,000 gain Dr Col capital
25,000
The capital accounts of the partners, after the above transactions have been recorded, appear
as:
Dr
Al
Goodwill
Written off
Balances c/d
Ben
Partners Capital Accounts

Col
10,000 10,000 5,000

47,500 37,500 15,000
Balances b/d
Goodwill
Bank
57,500 47,500 20,000

Balances b/d
Al
Ben
Cr
Col
45,000 35,000
12,500 12,500
20,000
47,500 37,500 20,000
47,500 37,500 15,000
233
The Balance Sheet, following the admission of Col, appears as;

Balance Sheet of Al, Ben and Col (Extract)
100,000
Net assets
Capital accounts:
Al
Ben
Col
(45,000 + 12,500 - 10,000)

(35,000 + 12,500 - 10,000)
(20,000 + 5,000)
47,500
37,500
15,000
100,000
In this way, the new partner has paid the existing partners a premium of 5,000 for a one-fifth
share of the profits of a business with a goodwill value of 25,000. Note that, although a
goodwill account has been used, it has been fully utilised and, therefore, does not appear on
the Balance Sheet.
234
16.3.3 Retirement of a partner

When a partner retires it is necessary to calculate how much is due to the partner in respect of
capital and profits. It is similar to the admission of a new partner.
Old partners:
-
Debit goodwill with the amount of goodwill

Credit partners capital accounts (in their old profit-sharing ratio) with the amount of
goodwill
Credit goodwill with the amount of goodwill
For the remaining partners:

-
Debit partners capital accounts (in their new profit-sharing ratio) with the amount of
goodwill
Credit goodwill with the amount of goodwill.
The effect of this is to credit the retiring partner with the amount of the goodwill built up
whilst he or she was a partner.
Example
The following example will show you the procedure:
Jan, Kay and Lil are in partnership sharing profit and losses in the ratio of 2:2:1 respectively.
Jan decides to retire. At that point the partnership Balance Sheet is as follows:
Balance Sheet of Jan, Kay and Lil
Net assets
Capital accounts:
Jan
Kay
Lil
100,000
35,000
45,000
20,000
100,000
Goodwill is agreed at a valuation of 30,000. Kay and Lil are to continue in partnership and
will share profits and losses in the ratio of 2:1 respectively. Jan agrees to leave 20,000 of the
amount due to her as a loan to the new partnership.
235
Answer
Old partners:
- Debit goodwill:
30,000
- Credit capital accounts (in the old profit-sharing ratio of 2:2:1)
o Jan
12,000
o Kay
12,000
o Lil
6,000
Remaining partners:
- Debit capital accounts (in their new profit-sharing ratios of 2:1)
o Kay
20,000
o Lil
10,000
- Credit goodwill
30,000
Jans capital balance is 47,000 (35,000 + 12,000 goodwill). Jan will receive 27,000 from
the partnership bank account, as 20,000 will be retained in the business as a loan.
The Balance Sheet will now be:
Balance Sheet of Kay and Lil

Net assets (100,000 - 27,000 paid to Jan)
Less Loan account of Jan
Capital accounts:
Kay (45,000 + 12,000 + 20,000)
Lil (20,000 + 6,000 - 10,000)
73,000
20,000
53,000
37,000
16,000
53,000
The effect of this is that the remaining partners have bought out Jans 12,000 share of
goodwill of the business, i.e. it has cost Kay 8,000 (45,000 - 37,000) and Lil 4,000
(20,000 - 16,000).
236
16.3.4 Changes in profit-sharing ratios

The profit-sharing ratios of partners may change, from time to time, if necessary. That
requires the agreement of all partners.
The change in profit-sharing ratios involves establishing a figure for goodwill in order to
know how much goodwill was built up while they shared profits in their old ratios. Each
partner will receive a value for the goodwill based on the old profit-sharing ratio.
Example
Partners Exe, Why and Zed have been sharing profits equally but have now agreed to change
the profit sharing ratio to 2:2:1 (Exe 2/5, Why 2/5, and Zed 1/5). The balances on their
Capital Accounts at the date of the change were as follows:
Exe
Why
Zed
5,000 CR
6,000 CR
3,000 CR
Goodwill was agreed to be valued at 4,500.
Answer
We open a Goodwill account:
DR Goodwill Account (with value of goodwill)
CR Individual partners Capital Accounts in old profit sharing ratio
Dr
Details
Capital
Goodwill
1,500
1,500
1,500
4,500
4,500
Exe
Why
Zed
Balance b/d
Dr
Details
Balance c/d
Cr
4,500
Details
Balance c/d
4,500
Capital
Exe
6,500
Why
7,500
Zed
4,500
6,500
7,500
4,500
Cr
Details
Balance b/f
Goodwill
Balance b/d
Exe
5,000
1,500
6,500
6,500
Why
6,000
1,500
7,500
7,500
Zed
3,000
1,500
4,500
4,500
237
If it is then decided to close the Goodwill Account, the goodwill will be written off to the
new partners in the new profit sharing ratio.
DR Individual partners Capital Accounts in new profit sharing ratio
CR Goodwill Account (sharing goodwill in new profit sharing ratio)
Dr
Details
Balance b/d
Goodwill
4,500
Details
Capital -
4,500
Dr
Details
Goodwill
Balance c/d
Capital
Exe
1,800
4,700
6,500
Why
1,800
5,700
7,500
Zed
900
3,600
4,500
Exe
Why
Zed
Cr
1,800
1,800
900
4,500
Cr
Details
Balance b/d
Exe Why Zed
6,500 7,500 4,500
Balance b/d
6,500 7,500 4,500

4,700 5,700 3,600
238
16.3.5 Revaluation of assets

On the introduction of a new partner or any other change in the partnership it is usual to
revalue the assets of the business. This is done by opening a Revaluation Account and
adjusting any change in asset values through this account.
An increase in an asset value will be adjusted as:

o Debit asset account with the amount of the increase
o Credit revaluation account with the amount of the increase
A decrease in value of an asset will be adjusted as:

o Debit revaluation account with the amount of the decrease
o Credit asset account with the amount of the decrease
The overall increase/decrease (that is, the balance on the revaluation account) is then
transferred to the partners capital accounts in their profit-sharing ratio, the old profit-sharing
ratio.
Example
Tee and Ewe are in partnership sharing profits and losses equally. The Balance Sheet of the
partnership on 31 December 2000 is:

Stock
Debtors
Bank
Capital:
Tee
Ewe
30,000
12,000
10,000
5,000
57,000
25,000
32,000
57,000
On 1 January 2001 Vee is to join the partnership and the assets are to be revalued as below:

Stock
40,000
10,000
Debtors and Bank are to remain at previous values

Goodwill is valued at 42,000
No goodwill account is to be kept
239
Vee is to introduce 30,000 as capital and profits are to be shared equally by the 3
new partners.
Answer
What do you need to do? Follow the steps below:
1- Open a Revaluation Account and make necessary adjustments for the change in value
of relevant assets.
2- Share any balance, following revaluation, on the Revaluation Account between old
partners in the old profit sharing ratio.
3- Create goodwill and share it between the old partners in the old profit-sharing ratio.
Delete goodwill by sharing it between new partners in the new profit-sharing ratio.
Dr
Date
Details
31/12/2000 Balance b/f
01/01/2001 Revaluation
01/01/2001 Balance b/d
Date
Details
30,000.00 01/01/2001 Balance c/d
10,000.00
40,000.00
Stock
Date
Details
Date
Details
12,000.00 01/01/2001 Revaluation
01/01/2001 Balance c/d
12,000.00
10,000.00
Dr
Bank
Date
Details
5,000.00 01/01/2001 Balance c/d
30,000.00
35,000.00
Details
01/01/2001 Stock
01/01/2001 Capital - Vee
Ewe
Cr
2,000.00
10,000.00
12,000.00
Cr
35,000.00
35,000.00
35,000.00
Dr
Date
40,000.00
40,000.00
Dr
Date
Details
01/01/2001 Capital - Vee
Cr
40,000.00
Revaluation
Date
Details
Fixtures and
2,000.00 01/01/2001 Fittings
*4,000.00
*4,000.00
10,000.00
Cr
10,000.00
10,000.00
*Profit on revaluation shared between old partners in old profit-sharing
240
Dr
Capital
Date
Details
01/01/2001
Goodwill Adjm't
Tee
01/01/2001
Balance c/d
Ewe
36,000.00
36,000.00
43,000.00
43,000.00
Vee
Cr
Date
Details
Tee
Vee
31/12/2000
Balance b/f
16,000.00
01/01/2001
Bank
01/01/2001
Revaluation
4,000.00
4,000.00
01/01/2001
Goodwill Adjm't
7,000.00
7,000.00
36,000.00
43,000.00
30,000.00
36,000.00
43,000.00
16,000.00
30,000.00
01/01/2001
Balance c/d
25,000.00
Ewe
14,000.00
32,000.00
30,000.00
Workings
Creation and Deletion of Goodwill
Creation
21,000 CR
21,000 CR
Tee
Ewe
Vee
42,000 CR
Deletion
14,000 DR
14,000 DR
14,000 DR
42,000 DR
Net Adjustment
7,000 CR
7,000 CR
14,000 DR
NIL
A revised Balance Sheet could now be prepared for the new partnership as follows:
Balance Sheet as at 1 January 2001
40,000
10,000
10,000
35,000
95,000

Stock
Debtors
Bank
Capital
Tee
Ewe
Vee
36,000
43,000
16,000
95,000
In the event of some assets may have fallen in value and provisions for depreciation and/or
bad debts may have been too much or too little and adjustments have not been made on the
accounts, the procedure is:
Increase in provision for depreciation/bad debts will be adjusted as:

o Debit revaluation account with he amount of the increase
o Credit provision account with the amount of the increase
241
Reduction in provision for depreciation/bad debts:

o Debit provision account with the amount of the reduction
o Credit revaluation account the amount of the reduction
Example
The Balance Sheet of Matt, Nia and Olly on 31 December 2008 is as follows:
Balance Sheet of Matt, Nia and Olly as at 31 December 2008
Cost Depn to date

100,000
50,000
10,000
150,000
10,000
Fixed Assets
Premises
Machinery
Current Assets
Stock
Debtors
Bank
Net
100,000
40,000
140,000
30,000
20,000
5,000
55,000

Creditors
Working Capital
NET ASSETS
25,000
30,000
170,000
FINANCED BY:
Capital accounts
Matt
Nia
Olly
60,000
60,000
50,000
170,000
They share profits and losses equally. Olly decides to retire at 31 December 2008; Matt and
Nia are to continue the partnership and will share profits and losses equally. The following
valuations are agreed;
Goodwill
Premises
Machinery
Stock
30,000
150,000
30,000
21,000
A provision for bad debts equal to 5% of debtors is to be made.

Olly agrees that the money owing on retirement are to be retained in the business as a longterm loan.
242
Required:
Show the revaluation account, and adjust the Balance Sheet at 1 January 2009.
Answer:
Dr
Date
Details
31/12/2008 Provision for depn:
Machinery
Stock
Provision for bad
debts
Capital accounts:
Matt (1/3)
Nia (1/3)
Olly (1/3)
Revaluation
Date
Details
31/12/2008 Goodwill
10,000.00
Premises
9,000.00
Cr
30,000.00
50,000.00
1,000.00
20,000.00
20,000.00
20,000.00
80,000.00
80,000.00
The amount of goodwill has been credited to revaluation account (and thus to the capital
accounts); it will, later, be debited to the capital accounts of the two remaining partners; in
this way it will not feature on the Balance Sheet.
Balance Sheet of Matt and Nia as at 1 January 2009
Fixed Assets
Premises
Machinery
Current Assets
Stock
Debtors
Les provision for bad debts
Cost Depn to date

150,000
50,000
20,000
200,000
20,000
Net
150,000
30,000
180,000
21,000
20,000
(1,000)
Bank
19,000
5,000
45,000

Creditors
Working Capital
(25,000)
20,000
200,000
Les Long-term Liabilities

Loan accounts of Olly (50,000 + 20,000)
(70,000)
Net Assets
130,000
243
FINANCED BY:
Capital accounts
Matt (60,000 + 20,000 - 15,000 goodwill debited)
Nia (60,000 + 20,000 - 15,000 goodwill debited)
65,000
65,000
130,000
244
16.3.6 Dissolution of a partnership

A partnership may come to an end for a number of reasons. It may be, for example, that the
business for which the partnership was formed has come to the end of its natural life, or that
the partnership is unable to meet its financial obligations.
Reasons why a partnership may come to an end:
A partnership may be formed for a fixed term or for a specific purpose and, at the end
of that term or when that purpose has been achieved, it is dissolved.
A partnership might be dissolved as a result of bankruptcy, or because a partner
retires or dies and no new partners can be found to keep the firm going.
Sales may fall due to changes in technology and product obsolescence, with the
partners not feeling it is worthwhile to seek out and develop new products.
At the other end of the scale, the business might expand to such an extent that, in
order to acquire extra capital needed for growth, the partnership may be dissolved and
a limited company formed to take over its assets and liablities.
Whatever the reason the assets will be sold off, the liabilities settled, and the accounts will be
closed off.
It is possible that partners may agree to any number of arrangements regarding the disposal
of the assets and the settling of the liabilities. For example, it might be agreed that a partner
takes one or more of the business assets as part settlement of the amount due to him/her.
Whatever the arrangement, the amount of cash remaining after all debts have been settled
should be sufficient to cover the amount due to each partner.
The necessary steps to account for the dissolution are:
1- Open a Realisation Account.
2- Transfer all asset balances except Bank/Cash to Realisation Account:
DR
CR
Realisation Account
Asset Accounts
3- For Disposal of Assets:

If taken by partners:
DR
CR
Partners Capital Account

Realisation Account
DR
CR
Bank/Cash
Realisation Account
If sold:
245
4- Settlement of Liabilities:
If taken over by partners:
DR
CR
Liability Account
If paid off:
DR
CR
Liability Account
Cash/Bank
Any gains (e.g. discounts) on settlement:

DR
CR
Liability Account
Realisation Account
5- As expenses of realisation are incurred, they are paid from cash/bank account and
entered in realisation account:
DR
CR
Realisation Account
Cash/Bank Account
The balance of realisation account, after all assets have been sold and all creditors
have been paid, represents the profit and loss on realisation, and is transferred to the
partners capital accounts in the proportion in which profits and losses are shared. If a
profit has been made, the transactions are:
DR
CR
Realisation Account
Where a loss has been made, the entries are reversed
Partners loan (if any) are paid:

DR
CR
Partners Loan Accounts

Cash/Bank Account
Partners current accounts are transferred to capital accounts:

DR
CR
Partners Current Accounts

If a partner has a debit balance on current account, the entries will be reversed.
If any partner now has a debit balance on capital account, he or she must introduce
cash to clear the balance:
DR
Cash/Bank Account
246
CR
The remaining cash and bank balances are used to repay the credit balances on
partners capital accounts;
DR
CR

Cash/Bank Account
Example
Dan, Eve and Fay are in partnership, sharing-profits and losses equally. As a result of falling
sales they decide to dissolve the partnership as from 31 December 2008. The Balance Sheet
at that date is shown below:
Balance Sheet of Dan, Eve and Fay as at 31 December 2008
Fixed Assets
Machinery
Delivery van
Cost
25,000
10,000
35,000
Accum. Depn
10,000
5,000
15,000
Current Assets
Stock
Debtors
Bank
NVB
15,000
5,000
20,000
12,000
10,000
3,000
25,000

Creditors
Working Capital
NET ASSETS
8,000
17,000
37,000
FINANCED BY:
Capital Accounts
Dan
Eve
Fay
The sale proceeds of the assets are:

o Machinery
o Stock
o Debtors
13,000
12,000
12,000
37,000
12,000
8,000
9,000
Dan is to take over the delivery van at an agreed valuation of 30,000. The expenses of
realisation amount to 2,000.
247
Required:
Show the realisation account, partners capital accounts and bank account to record the
dissolution of the partnership.
Answer
Realisation Account
Dr
Cr
25,000.00
10,000.00
12,000.00
10,000.00
2,000.00
Machinery
Delivery van
Stock
Debtors
Bank: realisation expenses
Provisions for depreciation:

machinery
delivery van
Bank: machinery
Bank: stock
Bank: debtors
Dan's captial account: van
Loss on
realisation;
Dan (1/3)
Eve (1/3)
Fay (1/3)
59,000.00
Dr
Details
4,000.00
4,000.00
4,000.00
59,000.00
Partners' Capital Accounts

Dan
Eve
Fay
Details
Realisation account:
delivery van
10,000.00
5,000.00
12,000.00
8,000.00
9,000.00
3,000.00
Balances b/d
Cr
Dan
Eve
Jay
13,000.00
12,000.00
12,000.00
13,000.00
12,000.00
12,000.00
3,000.00
Realisation account:
loss
4,000.00
4,000.00
4,000.00
Bank
6,000.00
8,000.00
8,000.00
13,000.00
12,000.00
12,000.00
Now you can see that the assets have been realised, the liabilities paid, and the balances due
to the partners have been settled; the partnership has been dissolved.
248
Dr
Balance b/d
Machinery
Stock
Debtors
Bank Account
3,000.00 Realisation account: expenses

12,000.00 Creditors
8,000.00 Capital accounts:
9,000.00
Dan
Eve
Fay
32,000.00
Cr
2,000.00
8,000.00
6,000.00
8,000.00
8,000.00
32,000.00
The ruling in Garner v. Murray

As we have mentioned earlier, the partner with a debit balance in their capital account will
pay in the amount to clear their indebtedness to the firm. However, sometimes he or she will
be unable to pay all, or part, of such a balance.
In the case of Garner v. Murray in 1904 (a case in England) the court ruled that, subject to
any agreement to the contrary, such a deficiency was to be shared by the other partners not in
their profit and loss sharing ratios but in the ratio of their last agreed capitals. By their last
agreed capitals is meant the credit balances on their capital accounts in the normal Balance
Sheet drawn up at the end of their last accounting period.
Where a partnership deed is drawn up it is commonly found that agreement is made to use
normal profit and loss sharing ratios instead, thus rendering the Garner v. Murray rule
inoperative.
Example
The Balance Sheet, before making the final payments to the partners, but after completing the
realisation of all the assets, in respect of which a loss of 4,200 was incurred, appears as
follows:
Balance Sheet
Cash at bank
Capitals: R
S
T
Less Q (debit balance)
6,400
6,400
5,800
1,400
400
7,600
(1,200)
6,400
6,400
249
The partners capital account credit balances before the dissolution were:
Q: 600
R: 7,000
S: 2,000
T: 1,000
The profit and losses were shared:
Q: 3
R: 2
S: 1
T: 1
Q is unable to meet any part of his deficiency. Now we are going to calculate how each of the
other partners suffers the deficiency. It is calculated as follows:
Own capital per Balance Sheet before dissolution
x Deficiency
Total of all solvent partners capital per same Balance Sheet
Therefore,
R
7,000
7,000 + 2,000 + 1,000
x 1,200 = 840
2,000
7,000 + 2,000 + 1,000
x 1,200 = 240
1,000
7,000 + 2,000 + 1,000
x 1,200 = 120
1,200
When these amounts have been charged to the capital accounts, then the balances remaining
on them will equal the amount of the bank balance:
Credit balance b/d
R
5,800
S
1,400
T
400
Equals the bank balance
Share of deficiency
840
240
120
Final credit balances
=
4,960
=
1,160
=
280
6,400
250

Question 1
You have received the following Balance Sheet extracts from Bell plc:
At 31 December 2006 At 31 December 2007
000
000
Assets
Non current assets
4,217
4,301
(1) During the year ended 31 December 2007, property, plant and equipment which had
originally cost 1,634,000, was sold. The depreciation charge on these non-current assets
up to 31 December 2007 was 920,000. The loss on disposal amounted to 294,000.
(2) During the year ended 31 December 2007, additions to property, land and equipment cost
930,000.
Required:
Prepare a detailed note to the accounts showing movements in property, land and equipment during the
year ended 31 December 2007.
(7 marks)
(for quality of presentation: plus 1 marks)
Total for this questions: 8 marks
251
Question 2
The directors of Troop plc have prepared the following draft Balance Sheet:
Troop plc
Balance Sheet at 31 December 2007
000
Assets
Non-current assets
2,000
Current assets
Inventories
Trade receivables
Suspense
Liabilities
Current liabilities
Trade payables
Net assets
Shareholders equity
Called up share capital
Retained earnings and other reserves
120
16
28
200
364
2,364
(84)
2,280
1,500
780
2,280
After the preparation of the draft financial statements for the year ended 31 December 2007, the following
items were discovered. They all need consideration when redrafting the Balance Sheet at 31 December
2007.
(1) On 1 January 2007, Troop plc purchased the business Tomkins Ltd. As part of the assets
taken over, Troop plc paid 200,000 for the goodwill of Tomkins Ltd. It had been entered
in a suspense account. The directors of Troop plc estimate that the economic life of the
goodwill will be 5 years.
(2) Troop plcs sales have doubled over the past few years and the directors believe that they
are now market leaders in their business sector. As a result, they propose to introduce a
further 560,000 as additional goodwill. It is estimated that the economic life of the
goodwill will be 8 years.
(3) On 1 January 2007, property, plant and equipment were revalued from a net book value
of 2,000,000 to 2,500,000. The revaluation had not been included in the companys
books of account. Non-current assets are generally depreciated at 2% per annum, but no
depreciation had been charged for the year ended 31 December 2007.
252
(4) No provision has been made for doubtful debts. The directors feel that 3% of trade
receivables would be appropriate.
(5) The directors of Troop plc have valued all closing stock at cost. Included in the value of
closing stock were 10 microwave cookers that had been damaged. The microwave
cookers cost 20 each and would normally sell for 50 each. The damaged microwave
cookers could be sold for 30 each after the necessary repairs are carried out. The total
costs of repairing the damaged microwave cookers will be 125.
Required:
a) Identify the appropriate International Accounting Standard (IAS) for each of the
additional information items 1 5.
(5 marks)
b) Calculate the corrected retained earnings and other reserves balance at 31 December
2007, showing clearly the effect of each of the additional information items 1 5.
(8 marks)
c) Prepare a Balance Sheet at 31 December 2007 taking into account the additional
information items 1 5.
(12 marks)
d) Discuss the reasons why limited companies are required to comply with International
Accounting Standards (IAS).
(12 marks)
253
Question 3
Amanda sells one model of luxury mobile home. She provides the following information for March 2007.
At 1 March 2007 she had four in stock; they had been valued at their cost price of 26,000 each.
Date
Purchases
7 March
15 March
22 March
26 March
30 March
31 March
3 at 27,000
1 at 28,000
Sales
5 at 52,000
1 at 52,500
2 at 30,000
2 at 53,000
Total purchases
For the month = 169,000
Total sales
for the month = 418,500
Amanda has prepared a trading account using the AVCO (weighted average cost) method of valuing her
stock. She has calculated her gross profit for the month at 202,125.
A friend has suggested that it might be better if Amanda changed her method of valuing stock to the FIFO
method (first in first out).
Required:
a) Prepare a trading account for the month ended 31 March 2007 using the FIFO method of
valuing stock.
(6 marks)
b) Advise Amanda whether or not she should change her current method of valuing stock.
Give reasons for your advice.
(12 marks)
254
Question 4
Dough, Ray and Mee were in partnership sharing profits and losses in the ratio 3:2:1 respectively.
Business profits have been falling consistently over the past few years and the partners have decided to
dissolve the partnership with effect from 31 December 2007.
The Balance Sheet of the partnership at 31 December 2007 was as follows:
Fixed assets
Premises at cost
Machinery at cost
Vehicles at cost
100,000
40,000
20,000
160,000
Current assets
Stock
Trade debtors
Bank
Current liabilities
Trade creditors
7,000
11,000
5,000
23,000
2,000
21,000
181,000
Capital accounts
Dough
Ray
Mee
120,000
60,000
1,000
181,000
Additional information at 31 December 2007
1) The debtors settled their outstanding debts for 10,000.

2) Trade creditors were settled. They allowed 500 cash discount.
3) Premises were sold to Loneta plc at an agreed purchase consideration of 140,000,
consisting of 50,000 ordinary shares of 1 each, 18,000 7% debentures and 14,000
cash. The shares were divided in the profit sharing ratio and the debentures were shared
equally between the partners.
4) The machinery, which was extremely old, was sold for 1,100 cash.
5) One vehicle was taken over by Dough at an agreed value of 3,000. A second vehicle
was taken over by Ray at an agreed value of 2,000. The third vehicle was sold for
4,000 cash.
6) Ray took overt the stock at an agreed value of 6,000.
7) Dissolution expenses amounted to 5,400
8) All cash transactions were processed through the business bank account.
Required:
255
Prepare the following to show the closing entries in the partnership books of account:
a) A realisation account to dissolve the partnership
(10 marks)
b) The partners capital accounts.

(12 marks)
Question 5
Healthy Living Ltd has prepared the following financial statements:
Healthy Living Ltd
Profit and Loss Account for the year ending
December 31, 2003
000
12,368
(3,209)
9,159
(3,306)
(2,192)
Sales
Cost of sales
Gross profit
Distribution costs
Administrative expenses
Loss on disposal of fixed assets
Profit on ordinary activities
Interest payable
Profit on ordinary activities before taxation
Taxation
Profit after tax
Dividends payable
(924)
2,737
(941)
1,796
(420)
1,376
(500)
876
Healthy Living Ltd

2003
000
Fixed assets
Cost
Depreciation
Net book value
Current assets
Stock
Debtors
Bank
2002
000
25,676
24,176
(16,288)
(14,060)
9,388
10,116
249
2,120
273
2,013
1,932
4,301
1,320
3,606
Current liabilities
256
Creditors
Taxation
Dividends
Long term liabilities
1,105
235
500
1,840
(3,500)
1,009
280
460
1,749
(4,500)
Net assets
8.349
7,473
4,000
4,000
Share Capital
Ordinary shares of 1
Reserves
Share Premium Account
1,300
3,049
1,300
2,173
8,349
7,473
During 2003 the company acquired a new fixed asset at a cost of 5,100,000. It sold a similar asset whose
original cost was 3,600,000 and whose net book value was 2,160,000.
Required
Calculate the net cash flow from operating activities and prepare a cash flow statement, using the indirect
method.
(15 marks)
257
Diploma in
Accounting
Unit 4: Further Aspects of
Management Accounting
Module 8: Manufacturing Accounts
Module 9: Costing
Module 10: Capital Investment Appraisal, Budgeting,
Further Considerations and Social Accounting
258
Diploma in
Accounting
Module 8: Manufacturing Accounts
259
LESSON 17: MANUFACTURING ACCOUNTS
17.1 Introduction
The manufacturing account is a statement of all costs incurred in the manufacture of goods
within a given period of time. It is prepared in addition to the Trading and Profit and Loss
Accounts. It is produced for internal use only.
The Trading Account will contain the cost of manufacturing the goods manufactured during
the period, instead of a figure for purchases (of finished goods. The manufacturing account is
used to calculate and show the cost of manufacturing those goods. The figure it produces that
is used in the trading account is known as the production cost.
The costs are divided into different types:
Prime cost
Production cost
Total cost
17.2 Prime costs

These are costs which can be associated directly with a unit of production. Prime costs are the
sum total of:
Direct Materials
Direct Wages
Direct Expenses
Direct materials
Direct materials are those materials from which the product is made. A combination of costs
are used to calculate the cost of direct materials consumed in the manufacture of finished
goods. For example:
Opening stock of raw materials

Add purchases of raw materials
Add carriage inwards on raw materials
Less raw materials returned to suppliers
Less closing stock of raw materials
Direct materials consumed
x
x
x
x
x
x
x
260
Direct wages
Direct wages are paid to those employees who operate production machinery, work on a
production line, or assemble the product.
Direct expenses
Direct expenses are more difficult to determine than direct materials and wages. They are
likely to include:
Royalties paid to the designer of a product.

The cost of hiring special tools or equipment to be used in the manufacture of a
product.
17.3 Production overheads

Production overheads or indirect manufacturing costs are all those costs which occur in
the factory or other place where production is being done, but which cannot easily be traced
to the items being manufactured. Such costs include:
Factory rents, rates and insurances.

Maintenance of factory buildings, fixtures, fittings, plant and machinery, etc.
Salaries and wages paid to the factory manager, production foremen/supervisors, and
factory administration staff.
Consumable materials such as gases, welding rods, lubricants, cleaning materials, etc.
Factory power, heat and light.
Depreciation on those fixed asset used in the place of manufacture, e.g., factory
buildings, factory plant equipment and machinery, factory fixtures and fittings, and
any equipment within the factory administration office.
Production overheads are added to prime costs within the Manufacturing Account to give
Total Factory cost or Production (Manufacturing) Cost.
17.4 Cost of finished goods

The manufacturing account includes all purchases of raw materials, including the stock
adjustments for raw materials. It also includes stock adjustments for work in progress
(goods that are part-completed at the end of a period).
There are a series of steps you need to follow:
1. Add opening stock of raw materials to purchases and subtract the closing stock of raw
materials.
2. Add in all the direct costs to get the prime cost.
3. Add in all the indirect manufacturing costs.
261
4. Add the opening stock of work in progress and subtract the closing stock of work in
progress to get the production cost of all goods completed in the period.
When completed, the manufacturing account shows the total of production cost that relates to
those manufactured goods that have been available for sale during the period. This figure will
then be transferred down to the Profit and Loss Account where it will replace the entry for
purchases.
Format of the manufacturing account and the trading account:
Manufacturing Account
Production costs for the period

Direct materials
Direct labour
Direct expenses
Prime cost
Add Production (factory) overheads:
Indirect materials
Indirect labour
Rent of factory
Depreciation
Factory light and heat
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Add Opening stock of work-in-progress

Less Closing stock of work-in-progress
Production cost of goods completed
Trading Account
Sales
Less Production cost of goods sold:
Opening stock of finished goods
(1)
Add Production costs of goods completed
Less Closing stock of finished goods (2)
Cost of goods sold
Gross profit
xxx
xxx
xxx
xxx
(xxx)
(xxx)
xxx
Notes:
(1) Is production costs of goods unsold in previous period.
(2) Is production costs of goods unsold at end of the current period.
262
Manufacturing businesses hold stocks of goods in three different forms:

Raw materials: commodities and components purchased from suppliers required in
manufacturing the finished product.
Work-in-progress: products in course of manufacture at a particular moment in time.
Finished goods: products on which the manufacturing process has been completed
and which are ready for sale.
The first two stocks appear in the manufacturing account, while finished goods stock is in the
trading account.
The Balance Sheet includes the closing stock valuation of all three forms of stock.
Example:
You have received the following information:
1 January 2007, stock of raw materials
31 December 2007, stock of raw materials
1 January 2007, work in progress
31 December 2007, work in progress
1 January 2007, stock of finished goods
31 December 2007, stock of finished goods
800
1,050
350
420
3,500
4,400
Year to 31 December 2007:

Sales of finished goods
25,000
Wages: Direct
Indirect
Purchase of raw materials
Fuel and power
Direct expenses
Lubricants
Carriage inwards on raw materials
Rent of factory
Depreciation of factory plant and machinery
Internal transport expenses
Insurance of factory buildings and plant
General factory expenses
3,960
2,550
8,700
990
140
300
200
720
420
180
150
330
Required:
Prepare the manufacturing account and the trading account for the year ended 31 December
2007.
263
Answer:
Manufacturing Account for the year ended 31 December 2007
Stock of raw materials 1.1.2007

Add Purchases
Add Carriage inwards
Less Stock of raw materials 31.12.2007
Cost of raw materials consumed
Direct wages
Direct expenses
Prime cost
Indirect manufacturing costs:
Fuel and power
Indirect wages
Lubricants
Rent
Depreciation of plant
Internal transport expenses
Insurance
General factory expenses
5.640
18,390
350
18,740
( 420)
18,320
Less Work in progress 31.12.2007

Production cost of goods completed c/d
Trading Account for the year ended 31 December 2007
Less stock of finished goods 31.12.2007

Gross profit
800
8,700
200
9,700
(1,050)
8,650
3,960
140
12,750
990
2,550
300
720
420
180
150
330
Add Work in progress 1.1.2007
Sales
Less cost of goods sold:
Stock of finished goods 1.1.2007
Add production cost of goods completed b/d
25,000
3,500
18,320
21,820
(4,400)
(17,420)
7,580
The Profit and Loss Account is then constructed in the normal way. You do not need to
present the accounts separated in different parts, everything is part of one Account. In the
264
example above has been done in that way so that you can understand how the figures are
calculated.
You will learn how to prepare the full set of financial statements at the end of this lesson.
17.5 Unrealised profit

Some manufacturing businesses transfer completed goods from the factory to the warehouse
at factory cost plus a percentage (the transfer price). The objective in doing this is for the
factory to make a notional profit which is added into net profit at a later stage.
By showing a factory profit, the profit (or loss) from trading activities (as distinct from
manufacturing) can be identified separately.
The final net profit is unchanged, but the manufacturing cost is higher, and gross profit is
lower. The factory profit is added back in the Profit and Loss Account, after showing
separately the profit and loss from trading.
For example:
Production cost
Factory profit of 10%
Production cost of goods completed (including profit)
Sales
Less Closing stock of finished goods
Cost of goods sold
Gross profit
Less non-production overheads:
Selling and distribution expenses
Administration expenses
Finance expenses
Loss from trading
Add Factory profit
Net profit
115,500
11,550
127,050
195,500
6,500
127,050
133,550
7,500
126,050
69,450
38,500
32,000
3,500
74,000
( 4,550)
11,550
7,000
Statement of Standard Accounting Practice No 9 (Stocks and long-term contracts) requires

that stocks should be shown in the Balance Sheet at cost price if purchased, or cost of
production if manufactured.
In order to comply with SSAP 9, it is necessary to account for the element of unrealised profit
included in the finished goods stock valuation. This is done through an account called
provision for unrealised profit.
265
If you look at the example above, the opening stock of finished goods is 6,500 and the
closing stock of finished goods is 7,500. Now the manufacturing profit is 10% of
manufacturing cost, therefore:
Opening stock: 6,500 x 10% (manufacturing profit) = 650
Closing stock: 7,500 x 10% (manufacturing profit) = 750
The provision for unrealised profit is 750. Thus, there has been an increase on the provision
for unrealised profit of 100: 750 - 650 = 100
Therefore:
Factory profit
Less increase in provision for unrealised profit
11,550
100
11,450
Note that the increase in provision for unrealised profit of 100 is shown as an expense in
Profit and Loss Account. It is recorded as a deduction form factory profit shown in the Profit
and Loss Account.
If there is a fall in the value of finished goods stock during the year, then there will be a
decrease in the provision for unrealised profit, and this will be added to the factory profit
shown in the Profit and Loss Account.
The Balance Sheet for finished goods stocks shows the net value:
Finished goods stock
Less Provision for unrealised profit
Net value
8,250
750
7,500
As can be seen this reduces the closing stock value of finished goods to cost price, and
enables the Balance Sheet valuation to comply with SSAP 9.
Question
A manufacturer values the closing stock of finished goods at factory cost plus 20%. For 2008
the opening and closing stock (including profit of 20%) were 12,000 and 18,000
respectively.
Required:
Calculate the amount to be entered in the Profit and Loss Account for the provision for
unrealised profit for the year ended 31 December 2008.
266
17.6 Accounts preparation

Production cost is the final figure of the manufacturing account.
A manufacturing account forms one part of the year-end accounts for a manufacturing
business, and precedes the trading account. The latter is prepared in the usual way except that
production cost takes the place of purchases. However, some businesses both manufacture
goods and buy in finished goods, in which case the figures will be shown for both production
cost and purchases of goods for resale.
In the trading account, the opening and closing stocks are the finished goods held by a
business.
The layout of a manufacturing, trading and profit and loss account is shown below:
Manufacturing, Trading and Profit and Loss Account
Opening stock of raw materials

Add purchases of raw materials
Less closing stock of raw materials
Cost of raw materials used
Direct labour
Direct expenses
Prime cost
Add Production (factory) overheads:
Indirect materials
Indirect labour
Rent of factory
Depreciation
Factory light and heat
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Add Opening stock of work-in-progress

Less Closing stock of work-in-progress
Sales
Less Production cost of goods sold:
Add Production costs of goods completed
Less Closing stock of finished goods
Cost of goods sold
Gross profit
xxx
xxx
xxx
xxx
(xxx)
(xxx)
xxx
267
Less non-production overheads:

Selling and distribution expenses
Administration expenses
Finance expenses
Net profit
xxx
xxx
xxx
xxx
xxx
The Balance Sheet follows on and includes the closing stock valuation of all three forms of
stock: raw materials, work-in-progress and finished goods.
268
Diploma in
Accounting
Module 9: Costing
269
LESSON 18: COSTING
18.1 Introduction
So far you have learnt about bookkeeping and the preparation of financial statements. The
information that is produced by financial accounting is usually historic, backward-looking
and for the use of decision-makers external to the organisation to which the data relates.
However, there is a second side to accounting: management accounting. This one is generally
forward-looking or capable of being used to aid managerial control, forecasting and planning.
It also consists of two components: one where costs are recorded and one where the data is
processed and converted into reports for managers and other decision-makers. The cost
recording component is called costs accounting and the processing and reporting component
is called management accounting
Management accounting produces the financial forecasts that guide planning. It embeds
controls into the flow of operating data and uses them to control activities within the context
of the plans. It evaluates performance and uses the information that is produced in order to
underpin the forecasts that guide planning.
This is the area that will be covered in this lesson. You will learn and understand the different
cost terms, how to calculate the break-even point and profit, evaluate variances and cost a
simple project.
18.2 Cost terms and concepts

A cost object is any activity for which a separate measurement of costs is desired. In other
words, if the users of accounting information want to know the cost of something, this
something is called the cost object. Examples of costs objects: cost of a product, the cost of
rendering a service to a bank customer or hospital patient, or anything for which one wants to
measure the cost of resources used.
Now we are going to explain the following cots terms and concepts:
Direct and indirect costs;

Period and product costs;
Cost behaviour in relation to volume of activity;
Relevant and irrelevant costs;
Avoidable and unavoidable costs;
Sunk costs;
Opportunity costs;
Incremental and marginal costs.
270
Direct and indirect costs

Costs that can be assigned to costs objects can be divided into two categories:
-
Direct costs
Indirect costs
Direct costs are those costs that can be specifically and exclusively identified with a
particular costs object.
Indirect costs cannot be identified specifically and exclusively with a given cost object.
Direct costs can be accurately traced because they can be physically identified with a
particular object whereas indirect costs cannot. And estimate must be made of resources
consumed by cost objects for indirect costs.
Sometimes, however, direct costs are treated as indirect because tracing costs directly to the
cost object is not cost-effective. For example, the nails used to manufacture a particular desk
can be identified specifically with the desk, but, because the cost is likely to be insignificant,
the expense of tracing such items does not justify the possible benefits from calculating more
accurate product costs.
Think of a desk that is manufactured by an organisation. In this case the wood used to
manufacture the desk can be specifically identified. Also the wages of operatives whose time
can be traced to the specific desk are a direct cost. However, the salaries of factory
supervisors or the rent of the factory cannot be specifically and exclusively traced to a
particular desk, therefore, those costs are indirect.
Remember what you learnt in the previous lesson about the manufacturing accounts and how
we classified the costs into direct and indirect costs for materials and labour to arrive to the
prime costs and the manufacturing overheads.
Period and product costs

Product costs are those costs that are identified with goods purchased or produced for resale.
In a manufacturing organisation the are costs that are attached to the product and that are
included in the inventory valuation for finished goods, or for partly completed goods (work in
progress), until they are sold.
Period costs are those costs that are not included in the inventory valuation and as a result
are treated as expenses in the period in which they are incurred.
In a manufacturing organisation all manufacturing costs are regarded as product costs and
non-manufacturing costs are regarded as period costs.
271
Cost behaviour in relation to volume of activity

A knowledge of how costs and revenues will vary with different levels of activity (or
volume) is essential for decision-making. Activity or volume may be measured in terms of
units of production or sales, hours worked, miles travelled, patients seen.
The terms variable, fixed, semi-variable and semi-fixed have been used to describe
how a cost reacts to changes in activity.
Variable costs vary in direct proportion to the volume of activity: doubling the level of
activity will double the total variable cost.
Fixed costs remain constant over wide ranges of activity for a specific time period. Examples
of fixed costs include depreciation of the factory building, supervisors salaries. Total fixed
costs are constant for all levels of activities whereas unit fixed costs decrease proportionally
with the level of activity. If you divide the total fixed cost by the number of units you will
have the unit fixed costs. For example, the total fixed costs are 5,000 and the units produced
are 1, 10, 100 and 1,000, what are the fixed costs per unit? The answer is 5,000, 500, 50
and 5.
However, if production capacity expands to some critical level, additional workers might be
employed. Thus within a short-term period, such as one year, labour costs can change in
response to changes in demand. Costs that behave in this manner are described as semi-fixed
or step fixed costs. The distinguishing feature of step fixed costs is that within a given time
period they are fixed within specified activity levels, but they eventually are subject to step
increases or decreases by a constant amount at various critical activity levels.
Semi-variable costs (also known as mixed costs) include both a fixed and a variable
component. The cost of maintenance is semi-variable cost consisting of planned maintenance
that is undertaken whatever the level of activity, and a variable element that is directly related
to the level of activity. A typical example of semi-variable costs would be electricity charges
containing a fixed element, the standing charge, and a variable element, the cost per unit
consumed.
Relevant and irrelevant costs

For decision-making, costs can be classified according to whether they are relevant to a
particular decision.
Relevant costs are those future costs that will be charged by a decision, whereas irrelevant
costs are those that will not be affected by the decision. For example, if you are faced with a
choice of making a journey using your own car or by public transport, the car tax and
insurance costs are irrelevant, since they will remain the same whatever alternative is chosen.
However, petrol costs for the car will differ depending on which alternative is chosen, and
this cost will be relevant for decision-making.
272
Avoidable and unavoidable costs

Avoidable costs are those costs that may be saved by not adopting a given alternative,
whereas unavoidable costs cannot be saved. Therefore, only avoidable costs are relevant for
decision-making purposes.
Sometimes the terms avoidable and unavoidable costs are used instead of relevant and
irrelevant cost.
Sunk costs
Sunk costs are the cost of resources already acquired where the total will be unaffected by
the choice between various alternatives. They are costs that have been created by a decision
made in the past and that cannot be changed by any decision that will be made in the future,
i.e. they are costs which have already been incurred.
Sunk costs are irrelevant for decision-making, but they are distinguished from irrelevant costs
because not all irrelevant costs are sunk costs.
Opportunity costs
An opportunity cost is that measures the opportunity that is lost or sacrificed when the
choice of one course of action requires that an alternative course of action be given up.
It is important to note that opportunity costs only apply to the use of scarce resources. Where
resources are not scarce, no sacrifice exists from using these resources. Opportunity costs are
of vital importance for decision-making. If no alternative use of resources exist then the
opportunity cost is zero, but if resources have an alternative use, and are scarce, then an
opportunity cost does exist.
Incremental and marginal costs

Incremental costs are the difference between costs and revenues for the corresponding items
under each alternative being considered. For example, the incremental costs of increasing
output from 1000 to 1100 units per week are the additional costs of producing an extra 100
units per week.
Marginal costs represent the additional cost of one extra unit of output. Incremental cost
represents the additional cost resulting from a group of additional units of output.
273
18.3 Absorption and marginal costing

Marginal costing distinguishes between fixed costs and variable costs. The marginal cost of
a product is its variable cost.
Marginal cost = variable cost = direct labour + direct material + direct expense + variable
overheads
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the
total marginal costs of a department or batch or operation.
There are two main uses for marginal costing:
a) As a basis for providing information to management for planning and decision
making. It is appropriate for short run decisions involving changes in volume or
activity and the resulting cost changes.
b) It can also be used in the routine cost accounting system for the calculation of costs
and the valuation of stocks.
An important concept in connection with variable costs is contribution. It is the difference
between the variable cost of sales and the sales revenue generated. It can be calculated at the
unit cost level or in aggregate for all production.
Contribution = sales variable costs
With absorption costing, a share of the fixed production overheads is allocated to individual
products and is included in the products production cost.
Look at the information below:
The cost of making a door is:
Material: 20Kg @ 4/Kg
Labour: 4 hours @ 6/hour
Machine: 4 hours @ 2/hour
Marginal cost
80
24
8
112
This marginal cost is the sum of the variable costs. However, there are other costs which you
will incur such as renting the factory, heating and cooling the factory, cleaning and
maintenance, production and administration. These are fixed costs which are not included in
the marginal costs. They are known as fixed production overheads, and unless some
account is taken of them, the cost of items produced may be understated.
However, it is more difficult to account for fixed costs than it is for variable costs, where the
extra cost of making an extra unit could be directly measured. Fixed costs do not increase as
more units are made so a fixed cost per unit cannot simply be measured.
One solution is to work out the overhead absorption rate, which is the fixed cost in period
divided by units produced in period.
274
Overhead absorption rate =
Fixed cost in period

Units produced in period
Say that the fixed overhead production costs for a period were 500, and that in that period
10 doors were produced. What would it be the overhead absorption rate?
Here, the absorption rate is 50/unit, and this would be added to the marginal cost per unit to
give the total absorption cost per unit.
Thus, following the example above, the total absorption cost is 162 (112 + 50).
Changes in the level of activity
When changes occur in the level of activity, the absorption costing approach may cause some
confusion.
For example, in a period, 20,000 units of Z were produced and sold. Costs and revenues
were:
Sales
Production costs:
Variable
Fixed
Administrative + Selling overheads:
Fixed
100,000
35,000
15,000
25,000
Using the absorption approach, the profit per unit and cost per unit can be calculated as
follows:
Selling Price per unit

(100,000 / 20,000)
Less Total cost per unit = 75,000
20,000
Profit per unit
5
3.75
1.25
If these figures were used as guides to results at any activity level other than 20,000, they
would be incorrect and may mislead. For example, if the level of activity changed to 25,000
units, it might be assumed that the total profits would be 25,000 x 1.25 = 31,250
However, the results are likely to be as follows:
275
Operating Statement (Absorption approach)
Sales (25,000 x 5)
Less Production Cost (35,000 x 125% + 15,000)
= Gross Profit
Less Admin + Selling overheads
= Net Profit
125,000
58,750
66,250
25,000
41,250
As you can see the difference is caused by the incorrect treatment of the fixed costs. In such
circumstances the use of the marginal approach presents a clearer picture. Based on the data
above the marginal cost per unit and the contribution per unit is calculated as follows:
Marginal cost/unit = Marginal cost = 35,000 = 1.75
Quantity
20,000
Contribution/unit = Sale price Marginal cost/unit = 5 - 1.75 = 3.25
If the activity is increased to 25,000 units, the expected profit would be:
(25,000 units x Contribution / unit) Fixed costs = (25,000 x 3.25) - 40,000 = 41,250
And the operating statement on marginal costing lines would be:
Sales
Less Marginal cost (25,000 x 1.75)
= Contribution
Less Fixed costs
Net profit
125,000
43,750
81,250
40,000
41,250
Acceptance of a special order

This is the case when a lower than normal price is quoted and there is spare capacity. In this
scenario we must consider whether to accept or reject the order which utilises spare capacity.
The following example will illustrate the procedure:
Wall Ltd manufacture and market a slimming drink which they sell for 20p per can. Current
output is 400,000 cans per month which represents 80% of capacity. They have the
opportunity to utilise their surplus capacity by selling their product at 13p per can to a
supermarket chain who will sell it as an own label product.
Total costs for the last month were 56,000 of which 16,000 were fixed costs. This
represented a total cost of 14p per can.
276
Based on the above data should Wall accept the supermarket order? What other factors
should be considered?
Solution
The present position is as follows:
Sales (400,000 x 20p)
Less Marginal cost (= 10p/can)
= Contribution
Less Fixed costs
= Net profit
80,000
40,000
40,000
16,000
24,000
If we assume that fixed costs will not change, the special order will produce the following
contribution:
Sales (100,000 x 13p)

Less Marginal costs (100,000 x 10p)
= Contribution
13,000
10,000
3,000
(100,000 is the 20% of spare capacity)

As you can see the special order looks worthwhile. It makes a contribution of 3,000, as the
fixed costs are already covered if they remain unchanged.
Another way to calculate the contribution would be by multiplying the quantity by the
contribution per can: 100,000 x 3p = 3,000.
Dropping a product
If a company has a range of products one of which is deemed to be unprofitable, it may
consider dropping the item from its range.
Example
A company produces three products. The operating statements are as follows:
Sales
Total costs
Net Profit (Loss)
Product X
32,000
36,000
(4,000)
Product Y
50,000
38,000
12,000
Product Z
45,000
34,000
11,000
Total
127,000
108,000
19,000
The total costs comprise: 2/3 variable and 1/3 fixed.

The directors consider that as Product X shows a loss it would be discontinued.
Based on the above cost data should Product X be dropped? What other factors should be
considered?
277
Solution
First calculate the fixed costs:
1/3 (36,000) + 1/3 (38,000) + 1/3 (34,000) = 36,000 in total.
Now we will use the marginal costs to prepare the operating statement:
Sales
Less Marginal cost
= Contribution
Less fixed costs
= Net Profit
Product X
32,000
24,000
8,000
Product Y
50,000
25,333
24,667
Product Z
45,000
22,667
22,333
Total
127,000
72,000
55,000
36,000
19,000
Product X produces a contribution of 8,000. Should Product X be dropped the position

would be:
Contribution Product Y
Contribution Product Z
Total Contribution
Less Fixed Costs
= Net profit
24,667
22,333
47,000
36,000
11,000
As you can see it seems that dropping product X with an apparent loss of 4,000 reduces total
profits by 8,000 which is the amount of contribution loss from Product X.
We still need to consider other factors:
a) The assumption above was that the fixed costs were general fixed costs which would
remain even if X was dropped. If dropping X resulted in the reduction of fixed costs
by more than 8,000 then the elimination would be worthwhile.
b) More profitable products should be considered, as Product X provide some
contribution at a low rate.
Make or buy
In some cases businesses are faced with the decision whether to make a particular product or
component or whether to buy it in.
The decision is usually based on an analysis of the cost implications. The relevant cost
comparison is between the marginal cost of manufacture and the buying in price.
However, when manufacturing the component displaces existing production, the lost
contribution must be added to the marginal cost of production of the component before
comparison with the buying in price.
278
Example A
A firm manufactures component AB and the costs for the current production level of 50,000
units are:
Costs/unit
Materials
Labour
Variable overheads
Fixed overheads
Total Cost
2.50
1.25
1.75
3.50
9.00
Component AB could be bought in for 7.75 and, if so, the production capacity utilised at
present would be unused. Assuming that there are no overriding technical considerations,
should AB be bought in or manufactured?
Solution
If we compare the buying in price of 7.75 and the full cost of 9.00, we could conclude that
the component should be bought in.
Remember that the correct comparison is between the marginal cost of manufacture, 5.50
(2.50 + 1.25 + 1.75) and the buying in price of 7.75. This indicates that the component
should be manufactured, not bought in.
Marginal cost:
Materials
Labour
Variable overheads
Total marginal cost
2.50
1.25
1.75
5.50
Now consider what will happen to the fixed costs of 175,000 (50,000 units at 3.50). The
fixed costs would probably continue and the fixed overheads would not be absorbed into
production, because the capacity would not be used.
Therefore, if AB was bought in, overall profits would fall by 112,500:
Buying in price
Less marginal cost
7.75
5.50
2.25
50,000 units x 2.25 = 112,500

Being that the difference between buying in price and the marginal cost of manufacture.
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Example B
A firm is considering whether to manufacture or purchase a particular component XY. The
marginal cost of manufacturing component XY is 4.75 per unit and the component would
have to be made on a machine which was currently working at full capacity. The manufacture
of component XY would be in batches of 10,000 and the buying in price would be 6.50.
If the component was manufactured, it is estimated that the sales of finished product FP
would be reduced by 1,000 units. FP has a marginal cost of 60/unit and sells for 80/unit.
Should the firm manufacture or purchase component XY?
Solution
If we simply compare the marginal cost of manufacturing and buying in price, we would
conclude that the component should be manufactured. However, such an approach is
insufficient in this situation, which is a more realistic situation. It is important to consider the
loss of contribution from the displaced product:
Cost analysis of Component XY
Marginal Cost of manufacture = 4.75/unit x 10,000
+ loss contribution for FP = 20/unit x 1,000
47,500
20,000
67,500
Buying in price = 6.50/ unit x 10,000
65,000
As you can see there is a saving of 2,500 per 10,000 batch by buying in rather than
manufacture.
Important note
The lost contribution of 20,000 is an example of an opportunity costs. This is defined as
the value of a benefit sacrificed in favour of an alternative course of action. Whenever there
are scarce resources, there are alternative uses which must be forgone and the benefit
sacrificed is the opportunity cost. Where there are no alternative uses for the resources, the
opportunity cost is zero and it can thus be ignored.
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18.4 Cost-volume-profit analysis

Cost-volume-profit analysis (CVP) is the term given to the study of the interrelationships
between costs, volume and profit at various levels of activity. There is an alternative term
commonly used break-even analysis.
The break-even analysis uses many of the principles of marginal costing and is an important
tool in short-term planning. It explores the relationship which exists between costs, revenue,
output levels and resulting profit and is more relevant where the proposed changes in the
levels of activity are relatively small. For greater changes of activity and in the longer term
existing cost structures are likely to change, the break-even analysis or CVP analysis
becomes less appropriate.
Typical short run decisions where break-even analysis or CVP analysis can be useful include:
choice of sales mix, pricing policies, multi-shift working and special order acceptance.
One important concept to remember is contribution, which is defined as:
Sales value less variable costs of sale. It may be expressed as total contribution,
contribution per unit or as a percentage of sales.
CIMA, 1996
Contribution per unit = sales price per unit variable costs per unit
You should remember that the contribution approach is often only used for decision making
and breakeven analysis or cost-volume-profit analysis (CVP).
Breakeven occur when there is neither a profit nor a loss. Once the breakeven point has
been reached and all costs, including fixed costs, have been covered, any extra contribution
generated is additional profit.
You do not need to produce different operating statements to calculate net profit or loss for
any level of sales. All you need to do is calculate how much the sales volume is above
(profit) or below (loss) the breakeven point and multiply the answer by the contribution per
unit.
When using breakeven analysis is important to recognise the assumptions implicit:
The relationship between the variables remain constant

Profits are calculated on a marginal costing basis
Linearity variable costs and sales revenues change in direct proportion and in the
same direction as changes in activity levels
Constant sales mix or single product or service
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The breakeven point

The breakeven point is determined by simply dividing the total fixed costs by the contribution
per unit:
Total fixed costs = number of units sold to break even
Contribution per unit
It is possible to calculate the breakeven point in volume of sales:

Breakeven point ( sales) =
Fixed costs
x Sales price/unit
Contribution/unit
Level of sales to result in target profit (in units) = Fixed costs + Target profit
Contribution/unit
Level of sales to result in target profit ( sales) = (fixed cost + target profit) x sales price/unit
Contribution/unit
Question
A company makes a single product with a sales price of 10 and a marginal cost of
6. Fixed costs are 60,000 p.a.
Required:
Calculate
a)
b)
c)
d)
Number of units to breakeven

Sales at breakeven point
What number of units will need to be sold to achieve a profit of 20,000 p.a.
What level of sales will achieve a profit of 20,000 p.a.
Solution
Contribution = 10 - 6 = 4
a) Breakeven point (units) = 60,000 = 15,000
4
b) Breakeven point ( sales) = 60,000 x 10 = 150,000
4
c) Number of units for target profit = 60,000 + 20,000 = 20,000
4
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d) Sales for target profit = (60,000 + 20,000) x 10 = 200,000

4
Break-even chart
The chart is drawn in the following way:
a. Draw the axes
o Horizontal showing levels of activity expressed as units of output or as
percentages of total capacity
o Vertical showing values in s or 000s as appropriate, for costs and revenues
b. Draw the cost lines
o Fixed cost.
This will be a straight line parallel to the horizontal axis at the level of the
fixed costs.
o Total cost. This will start where the fixed cost line intersects the vertical axis
and will be a straight line sloping upward at an angle depending on the
proportion of variable cost in total costs.
c. Draw the revenue line
This will be a straight line from the point of origin sloping upwards at an angle
determined by the selling price.
Break-even chart
450
400
350
300
250
200
200
150
100
50
0
0
50000
100000
150000
200000
250000
300000
350000
400000
450000
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In the chart below you will see what each line means:
In the chart above, the line OA represents the variation of income at varying levels of
production activity (output). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase.
At low levels of output, Costs are greater than income. At the point of intersection, P, costs
are exactly equal to income, and hence neither profit nor loss is made.
When the volume is zero, there is a loss equal to the fixed costs.
Breakeven chart. Example:

A firm manufactures compact discs and has the following costs:
Fixed costs: 10,000

Variable costs: 2.00 per unit
Required:
Calculate the breakeven point by drawing a breakeven chart.
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Solution
You first construct a chart with output (units) on the horizontal (x) axis, and costs and
revenue on the vertical (y) axis. On to this, you plot a horizontal fixed costs line (it is
horizontal because fixed costs don't change with output).
Then you plot a variable cost line from this point, which will, in effect, be the total costs line.
This is because the fixed cost added to the variable cost gives the total cost. To do this, you
multiply:
variable cost per unit number of units
In this example of the CD manufacturing firm, you can assume that the variable cost per unit
is 2 and there are 2 000 units = 4,000
Once you have done this, you are ready to plot the total revenue line. To do this, you
multiply:
sales price number of units (output)
If the sales price is 6.00 and 2.000 items were to be manufactured, the calculation is:
6.00 2,000 = 12,000 total revenue
Where the total revenue line crosses the total costs line is the breakeven point (ie costs and
revenue are the same). Everything below this point is produced at a loss, and everything
above it is produced at a profit.
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Fixed costs: 10,000, Variable costs: 2 per unit, Sales price: 6 per unit
If you read downwards, it tells you how many units you need to produce and sell at this price
to breakeven: 2,500 CDs
If you read across, it tells you how much money you must spend before you recover your
outlay: 15,000.
Limitations of breakeven and profit charts

1. As fixed costs are likely to change at different activity levels, a stepped fixed cost line
is probably the most accurate representation.
2. Variable costs and sales are unlikely to be linear. Extra discounts, overtime payments,
special delivery charges, etc, make it likely that variable cost and revenue lines are
some form of a curve rather than a straight line.
3. The charts depict relationships which are essentially short term. This makes them
inappropriate for planning purposes where the time scale stretches over several years.
4. The charts and breakeven analysis make the assumption that all variable costs vary
accordingly to the same activity indicator, usually sales or production. This is a gross
over-simplification and reduces the accuracy of the charts and breakeven analysis.
5. It does not take into account the stock levels. It is assumed that everything produced is
sold.
18.5 Activity-based costing

Activity-based costing (ABC) is an approach to absorption costing based on the notion that it
is activities that incur costs and, therefore, activities should be the basis for allocating such
costs.
A single measure of volume is used for each product or service cost centre in traditional
indirect cost absorption, for example:
Machine hours
Direct labour hours
Direct materials cost
Direct labour cost
These bases are often unjustifiable when the nature of the activity at the cost centre and the
nature of the item that is absorbing the cost is considered. The amount of cost incurred may
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depend on any one of a range of factors. And appropriate basis for cost absorption ought to
truly, as possible, reflect the changes in costs arising from the activities.
Cost drivers are the factors that cause costs to be incurred.
A cost driver is an activity that generates cost. It may be related to:
A short-term variable expense, for example, machine running costs, where the cost is
driven by production volume and the cost driver is volume-based, for example,
machine hours.
A long-term variable expense, for example, quality inspection costs, where the cost is
driven by the number of times the relevant activity occurs and the cost driver is
transaction-based, for example, number of inspections.
Activity-based costing is the process of using cost drivers as the basis for indirect cost
absorption. It involves attributing cost to units on the basis of benefit received from indirect
activities, e.g. ordering, setting up a machine, assuring quality.
Organisations that use ABC have to develop a new information system to provide that
information. ABC creates cost pools for each activity area where costs held are attributed to
the units that pass through the cost centre on the basis of an appropriate cost driver.
A cost pool is a collection of individual costs within a single heading and in traditional
overhead absorption, cost pools are production cost centres. Under ABC, a cost pool is
created for each activity area.
The terms cost centres or cost pools are used to describe a location to which overhead costs
are initially assigned. Normally costs centres consist of departments, but in some cases they
consist of smaller segments such as groups of machines.
18.6 Standard costing and variance analysis

18.6.1 Standard costing
A standard cost is a carefully predetermined, and realistic, target cost that should be incurred
during normal efficient operating conditions. Therefore, if the normal operating conditions
change overt time, the standard costs applied to products and services have to be changed
accordingly.
Standard costs are used as the basis for a comparison with actual incurred costs. Instead of
tracing the actual costs to production, the standard costs are used.
Using standard costs has the following advantages:
Record keeping during the period is greatly simplified. As units pass from one
department to another, they are recorded on job cards, etc. at their standard costs. The
business normally needs to calculate actual costs only for control purposes, not for
individual job or batch pricing purposes.
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By comparing standard costs to the actual costs, the business has a way of judging
performance. Differences between actual and standard costs are known as variances.
it is also possible to extend the application of standard costing to overheads,
particularly indirect manufacturing costs. Standard costs may be used on marginal
costs, in which case they would not include an element of fixed overhead absorption.
The principal purposes of standard costing are to:
Provide management with performance benchmarks.

Call attention to areas of the firms activities which do not fulfil the original plans.
Provide cost information for use in future planning.
Standards consist of two parts:

-
A physical measure, such as the weight of material per unit or the hours of labour
required to make one unit; and
A financial measurement, such as the cost per kilo of material or the cost per hour
of labour.
Types of standard
There are three important types of standard:
1. Basic standards. These are standards that could remain unchanged over a long
period, perhaps even years. Their sole use is to show trends over time for such items
as material prices, labour rates and efficiency and the effect of changing methods.
2. Ideal standards. These standards take no account of wastage, breakdowns, natural
breaks or idle time. They are based on optimal operating conditions and are therefore
highly unlikely to ever be achieved in practice. This makes them unsuitable for use in
control systems.
3. Attainable standards. These standards are usually used within standard costing
systems. They should be attainable in that they are realistic, but they should also be
challenging and stimulating. They assume efficient levels of operation and include
allowance for normal loss, waste and machine downtime.
18.6.2 Variance analysis

Variances represent differences between actual and planned performance. They are
calculated by comparing actual costs (or revenue) with the standard costs (or revenue) there
would have been if everything had gone according to plan. When something goes better than
planned there will be a favourable variance. When something goes worse than planned there
will be an adverse variance.
Variance analysis is not concerned only with comparison of actual results with budgeted
results; its principal aim is to determine the reasons why the differences have occurred. This
provides management with the opportunity to look behind the numbers to establish what
factors have caused the changes in performance, and to see to what extent it has changed.
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It is important to try to ascertain the causes of specific variances, as each one may require a
specific cure. The major causes of variances are as follows:
1) Inefficiency in operation, through inability or lack of motivation
2) Originally incorrect plans and standards, or originally correct plans and standards that
have been invalidated by environmental changes.
3) Poor communication of standards and budgetary goals.
4) If, in budgeting, the interdependence of departments has not been taken into account,
then action taken by one department may cause variances elsewhere within the firm.
These points illustrate the close link between budgeting and standard costing. They
emphasise that standard costing and variance analysis are, in reality, an extension to
budgeting. Variance analysis provides a practical system for mangers to exercise control over
all corporate activities.
Without the use of variance analysis, management may arrive at the wrong conclusions about
the cause of discrepancies. By analysing and interpreting the variances, management has the
opportunity to determine the underlying causes.
For example, a companys actual profit is lower than was forecast, despite the turnover being
higher. This could be due to:
1. The sale price per unit being reduced
2. The cost per unit increasing.
Both of these changes would result in a lower profit margin and potentially, therefore, a
lower actual profit.
The overall objective of variance analysis is to subdivide the total difference between
budgeted profit and actual profit for the period into the detailed differences (relating to
material, labour, overheads or sales) which go to make up to total difference.
Calculating variances
Variance calculations fall into two groups:
Material, labour and variable overheads

These are all variable costs. As production increases or decreases you would expect
these costs to vary.
Fixed overheads and sales

Fixed costs are independent of the level of production. Therefore, actual fixed costs
and be compared with the original budget. Sales are also compared to the original
budget.
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Material variances
Look at the following information:
Standard for materials
Cost = 5/Kg
Usage = 10 Kg/unit
Standard material cost per unit = 50
Actual materials
Cost = 72,000
Units made = 1,000
You can see that more has been spent then would have been if the business had kept to the
standard: 1,000 units should have cost 50,000 (1,000 x 50), so there has been an overspend
of 22,000. This would be known as adverse variance.
The two potential causes of the adverse variance would be:
1. A rise in the price per kilogram
2. A rise in the kilograms used per unit
What we are going to do now is to see how the total variance of 22,000 could be split up so
as to estimate how much has been caused by a raise in prices (price variance) and how much
by the raise in material per unit (usage variance).
1. Price variance
We need to know how much material was used. Lets assume that it was 12,000 Kg. Now we
can work out the actual cost per kilogram: 6/Kg (72,000/12,000).
You can see that the business has bought and used 12,000 Kg at 6/Kg. If it had bought the
material at the standard cost, it should have cost only 5 per kilogram, so an extra 1 has
been spent on each kilogram. Therefore, the business has spent an extra 12,000 on the
12,000 kilograms because of the change in price.
Thus, the price variance is defined as:
Actual usage x (standard price per Kg Actual price per Kg)
If we apply it to our example, we have:
12,000 x (5 - 6) = - 12,000
Here, a negative sign indicates an adverse variance as the actual price is higher than the
standard price.
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Remember that the total adverse variance was 22,000 and12,000 of it has been accounted
for by the price variance, therefore, the usage variance must be 10,000.
2. Usage variance
The usage variance is calculated as:
Standard cost per Kg x (Standard usage for output achieved Actual usage)
Thus, in our example that will be:
5 x (1,000 x 10 - 12,000) = - 10,000
Note that usage variance is worked out using the standard cost of material. The actual usage
must be compared to the standard usage for the output achieved (the quantity that should
have been used for the output had the standard been kept to.
Do not forget that variance can be favourable as well as adverse.
Now you have the following information:
Standard for materials
Cost = 5/Kg
Usage = 10 Kg/unit
Standard material cost per unit = 50
Actual materials
Cost =
Units made =
Material =
Cost =
48,000
1,000
12,000 Kg
4/Kg
In this case the total variance is 2,000 favourable: actual cost 48,000 compared to the
standard cost of 50,000 for the actual production.
Price variance =
12,000 x (5 - 4) =
Usage variance = 5 x (1,000 x 10 12,000) =
Net variance =
12,000 (favourable)
(10,000) (adverse)
2,000 (favourable)
Possible reasons for the favourable variance:
The price of the materials fell

Errors in estimating the price of materials when the budgets were set
A reduced price was charged by the supplier because the amount purchased increased
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A different supplier was found who charged a lower price for the same or better
quality of material
The supplier charged a lower price for a poorer quality of material
A different supplier was found who charged a lower price for a poorer quality of
material.
Possible reasons for the adverse variance:
A change in manufacturing process resulted in higher material wastage than expected

Poorer quality workers caused a higher than expected level of wastage of materials
during production
Higher than expected pilferage of raw material stocks
Errors in calculating the usage rate when the budgets were set
Poorer quality materials than anticipated from the supplier
Poorer quality materials as a result of buying cheaper materials than anticipated.
Labour variances
You are given the following standard cost information for labour:
Standard for labour
Cost = 5/h
Time = 10h/unit
Standard labour cost per unit = 50
Actual labour
Cost = 84,000
Units made = 1,000
When the resources used for a month are measured, you can see that more has been spent
than would have been if the business had kept to the standard: 1,000 units should have cost
50,000 so there has been an overspend of 34,000: an adverse variance.
There are three potential causes of the adverse variance:
1. A rise in the labour rate per hour
2. A rise in the hours needed per unit
3. Idle time
Now we need to see how the total variance of 34,000 could be split up so as to estimate how
much has been caused by the rise in wage rates (rate variance), how much by the rise in time
taken per unit efficiency variance), and how much by idle time (idle time variance).
To make the split, we have to know how much time was paid for and how much of that was
worked: assume that it was 12,000 hours was paid for and that of that 11,000 were worked.
292
Then we can work out that the actual rate per hour must have been 7/h (84,000/12,000).
Therefore, the business has paid for 12,000 h at 7/h. If it had paid the labour at the standard
rate, it should have cost only 5 per hour, so an extra 2 has been spent on each hour. This
will mean that the business has spent an extra 24,000 on the 12,000 hours because of the
change in price.
The labour rate variance is defined as:
Hours paid for x (standard rate per hour actual rate per hour)
Thus,
12,000 x (5 - 7) = - 24,000
The negative sign indicates an adverse variance as the actual rate is higher than the standard
rate.
The total adverse variance was 34,000 and 24,000 of it has been accounted for by the rate
variance. Idle time and efficiency variance must be 10,000. These can be worked out as:
Idle time variance:
Standard rate per hour x (hours worked hours paid for)
Thus,
5 x (11,000 12,000) = - 5,000
If the workforce is hanging around idle for 1,000 hours, yet being paid, there must be an
adverse variance. This is evaluated at the standard rate per hour.
The labour efficiency variance looks at how well people work whilst they are working; idle
time is excluded as work is not being done then. The labour efficiency variance is defined
as:
Standard rate per hour x (standard hour for output achieved actual hours worked)
Thus,
5 x (1,000 x 10 11,000) = - 5,000
When working, the workforce has spent 11,000 hours on production that should have taken
them only 10,000 hours. So they have been inefficient by 1,000 hours in addition to being
completely idle for another 1,000 hours.
293
Sales variances
You have the following budgeted sales information for a month and the actual results:
Sales budget
Selling price = 30/unit
Contribution = 10/unit
Budgeted volume = 1,000 units
Actual sales
Selling price = 32/unit
Budgeted volume = 1,100 units
You can see that more units have been sold and at a higher price; both of these effects will
give rise to favourable sales variances.
There are two potential causes of favourable sales variances:
A rise in the selling price per unit

A rise in the number of units sold
Note that sales variances consider sales prices and volumes only; any cost differences (from
material, labour and overheads will be ignored in the calculation of sales variances.
The sales price variance is defined as:
Actual sales x (actual price per unit standard price per unit)
Thus,
1,100 x (32 - 30) = 2,200
There is a favourable variance as the actual selling price is higher than the standard selling
price.
The sales volume variance is defined as:
Standard contribution per unit x (actual sales budgeted sales)
In our example, this will give: 10 x (1,100 1,000) = 1,000
Here the volume variance is worked out using the standard contribution per unit. This is
correct if marginal costing is being used. If total absorption costing is being used, the volume
variance would be calculated in terms of standard profit per unit.
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Variable overheads variances

You receive the following cost information for variable overheads:
Standard for variable overheads:
Cost =
3/h
Time =
10hs/unit
Standard variable overhead cost per unit = 30
However, when the resources used for a month are measured, the following is discovered:
Actual variable overheads:
Cost
Units made
=
=
44,000
1,000
Now you can see that more has been spent than would have been if the business had kept to
the standard: 1,000 units should have cost 30,000 so there has been an overspend of
14,000: an adverse variance.
There are two potential causes of the variable overhead adverse variance:
A rise in the overhead rate per hour

A rise in the hours needed per unit
Note that idle time does not play a part, as the machines can be switched off and no costs
incurred.
The next step is to find out how the total variance of 14,000 could be split up so as to
estimate how much has been caused by the rise in overhead rates (rate or expenditure
variance) and how much by the rise in time taken per unit (efficiency variance).
To make the split, we have to know how much time was worked: assume that 11,000 hours
were worked.
Once you know that, you can then work out that the actual rate per hour must have been 4/h
(44,000/11,000).
You can see that the business has paid for 11,000 h at 4/h. if it had paid variable overheads
at the standard rate, it should have cost only 3 per hour, so an extra 1 has been spent on
each hour. This will mean that the business has spent an extra 11,000 on the 11,000 hours
because of the change in price.
The rate (or expenditure) variance is defined as:
Hours worked
(standard rate per hour - actual rate per hour)
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11,000 x (3 - 4) = -11,000
Here, a negative sign indicates an adverse variance as the actual rate is higher than the
standard rate.
The total adverse variance was 14,000, and 11,000 of it has been accounted for by the rate
variance. The efficiency variance must be 3,000. This can be worked out as:
Efficiency variance:
Standard rate per hour x (standard hours for output achieved - actual hours worked)
Therefore, the efficiency variance is:
3 x (1,000 x 10 11,000) = -3,000
The workforce has spent 11,000 hours on production that should have taken them only
10,000 hours. So they have been inefficient by 1,000 hours when running the machines at a
standard rate of 3/hour.
Note that once the rate variance accounts for the difference between standard and actual rates,
the remaining variance is evaluated at the standard rate per hour.
Example
The standard variable overhead rate is 9, and a unit should take 12 hours.
3,000 units were made for a cost of 363,600. Hours worked 36,000.
a) What is the total variable overhead variance?
b) What is the variable overhead rate variance?
c) What is the variable overhead efficiency variance?
Answer
a) 3,000 should have cost 324,000 (3,000 x 9 x12).
They did cost 363,600, so the total variance is 39,600 unfavourable.
b) 36,000 x (9 10.1) = -39,600 unfavourable.
c) 9 x (36,000 36,000) = 0
Therefore:
Rate variance:
Efficiency variance:
Total variance
36,000 x (9 10.1)
9 x (36,000 36,000)
324,000 363,600
= -39,600
=
0
= -39,600
unfavourable
unfavourable
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Fixed overheads variance

Under marginal costing we assume that fixed production overheads should not vary with
volume, so the only fixed overhead variance is an expenditure variance reflecting the
difference between budgeted and actual cost.
The fixed overhead expenditure variance is not very meaningful on its own. Any meaningful
analysis requires a comparison of actual expenditure for each individual item of fixed
overhead expenditure against the budget to find out which expenses cost more or less than
anticipated.
Reconciling budgeted profit and actual profit

Management will be interested in reasons why actual profit is different from the budgeted
profit. Variances can be used to explain this difference. We can prepare a summary statement
that adds the favourable cost and sales variances to the budgeted profit, and deducts the
adverse variances, to show how the actual profit is arrived at.
Operating statements use variances to reconcile budgeted results and actual results.
An example of a reconciliation of budget to actual profit is shown below:
Reconciliation of budgeted and actual profit
Original budgeted contribution

Sales volume variance (adverse)
Flexed budgeted contribution
20,832
( 832)
20,000
Less: budgeted fixed overheads

Flexed profit
(6,250)
13,750
Variances
Selling price
Direct material price
Direct material usage
Direct labour rate
Direct labour efficiency
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Favourable
2,400
1,890
Total variances
Actual profit
6,290
Adverse
(2,000)
(1,800)
1,200
(2,400)
800
( 250)
(6,450)
( 160)
13,590
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Diploma in
Accounting
Module 10: Capital Investment Appraisal, Budgeting,
Further Considerations and Social Accounting
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LESSON 19: CAPITAL INVESTMENT APPRAISAL
19.1 Introduction
Capital investment appraisal is not simply an arithmetical calculation of financial
information, but a decision-making process that should also involve qualitative issues. It
should show how the proposed investment will further the aims of the enterprise and help to
meet its strategic objectives.
The financial appraisal is used to:
Show which investments from a range of alternative proposals are the most profitable
Show which investment opportunities will yield the greatest increase in present value
to the business
Compare the expected return on an investment proposal with a minimum or standard
rate of return requirement specified by the business
Assist in decisions on whether and how to finance a new investment proposal
Compare alternatives, for example: asset replacements or a major renovation,
purchase or hire, and retention or divestment of a product facility
Capital investment appraisal compares expected future revenues arising from an investment
with the costs of that investment.
One technique of capital investment appraisal, accounting rate of return (ARR) takes an
entirely different approach from the others.
The other capital investment appraisal techniques are based on the marginal or incremental
cash flows that are forecast for the project under review. You only analyse the cash flows that
can be directly attributable to the project, which includes both inflows and outflows.
As depreciation does not form part of the cash flow profile, it must not be included in any
project-related cash flows. Depreciation is simply a non-cash expense that is reported in the
Profit and Loss Account and the Balance Sheet as the reduction of an assets value.
For ease of calculation, the convention is that all cash flows after the initial investment are
deemed to occur at the end of the year in which they arise. It is also normal to define the
initial investment as occurring at Year 0. Year 1 is one year later, Year 2 two years later,
and so on.
19.2 Payback
The payback period is the time that must elapse before the net cash flows from a project
result in the initial outlay being repaid in full in cash terms. It is argued that the shorter
payback period, the more attractive the project. It is a valid indicator for capital investment
appraisal, although it ignores inflation. It also gives no indication of the overall cash flow
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benefits because it ignores all cash flows after payback has been achieved. It is for this reason
that it should never be used in isolation.
Payback can be defined as: The time required for the cash inflows from a capital investment
project to equal the cash outflows.
The usual decision rule is to accept the project with the shortest payback period.
Example
A project costing 10,000 is expected to have a projected cash flow over a 4-year period,
shown as follows. As normal in capital investment project appraisal, Year 0 represents the
time the investment is made at the start of the project.
The net cash flows for each year are shown below:
Year 0
(10,000)
Year 1
2,000
Year 2
3,000
Year 3
4,000
Year 4
5,000
Required:
Calculate the payback period
Solution
Year 0
Amount
outstanding b/f
Net cash flow
Amount
Outstanding b/f
(10,000)
(10,000)
Year 1
Year 2
Year 3
Year 4
(10,000)
(8,000)
(5,000)
(1,000)
2,000
(8,000)
3,000
(5,000)
4,000
(1,000)
5,000
4,000
At the end of Year 4 the cumulative cash flow becomes positive. At this point, you need to
estimate when during Year 4 payback occurred. You do so by dividing the amount required at
the end of Year 3 to achieve payback by the net cash flow during Year 4 and then multiplying
the answer by 12 (representing 12 months):
Payback = payback year + payback month
3 years + (1,000 x 12) = 3 years + 2.4 months
5,000
The advantages of the payback are:
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Simple to understand and calculate

Is more objectively based because it uses project cash flows rather than accounting
profits
Favours quick return projects which may produce faster growth for the firm and
enhance liquidity
Choosing projects which payback quickest will tend to minimise time related risks.
However, not all risks are related merely to time elapsed.
Disadvantages:
It ignores all cash flows after the payback period

It does not fully take into account the riskiness of the project, only that risk which is
time-related
It ignores the time value of money (money received in the future is not worth the
same as money received today).
19.3 Net present value

The purpose of investment is to generate more cash in real terms than was consumed in
making it, therefore, it is necessary to consider cash flows relating to the investment. Noncash costs (such as depreciation) and costs that had already been incurred prior to the
investment decision should be ignored in the calculations.
Future cash flows must be discounted to arrive at their present value using an appropriate
discount factor:
1
1+
Where r is the rate at which monetary value is to be discounted over a number of n years.
r = discount rate
n = number of years
The present value of any amount received after n years is obtained by multiplying the
amount by the discount factor.
For example, calculate the present value of 1 receivable in three years time if the discount
rate is 15%.
Using the formula:
1
1 + 0.15
= 0.6575
Thus it will be worth about 2/3 of the value of 1 receivable now: 1 x 0.6575 = 0.6575
The rate applied to adjust (discount) future cash flows in order to arrive at their present value
is called the discount rate. It reflects the risk that future cash will be worth less by way of
inflation than current cash, the risk that the borrower or investment project may, for some
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reason, fail to meet the repayment expectations, and the general cost of borrowing funds to
invest.
As you can see capital investment appraisal techniques require forecasts of future cash flows,
which do not include non-cash items, such as depreciation. Discounted cash flow takes
timing differences into account by adjusting all cash flows to their present values before
comparing amounts.
Outflows of cash are given a negative or minus sign; inflows are positive. The sum of the
present value of the outflows and inflows is known as the net present value (NPV).
If the net present value is positive, the present value of inflows exceeds the present value of
the outflows and you would become richer by taking on the project. Therefore, you should
accept it.
If the net present value is negative, the present value of outflows exceeds the present value of
the inflows and you would become poorer if you took on the project.
Example
Consider the following project:
A machine costs 20,000 and will yield net cash inflows of 8,000, 9,000 and 7,000 at the
end of each of the next three years. Is this a worthwhile investment if the discount rate is
10%?
Solution
If no account were paid to the timing differences, the project is worthwhile: it costs 20,000
and yields net cash inflows totalling 24,000. However, we know that it is not valid to
compare the cash flows without adjusting for the different timings.
Time
Cash flow
Discount factor
Present value
0
1
2
3
(20,000)
8,000
9,000
7,000
1
1/1.1
1/1.12
1/1.13
Net present value
(20,000)
7,273
7,438
5,259
(30)
Time 0 means now, which is normally assumed to be when the project starts. Brackets are
used to show negative cash flows (outflows). A discount factor of 1 means that the cash flow
is not discounted at all which is appropriate if the cash flow is happening in the present.
At the end of the year, there is a net cash inflow of 8,000. This must be discounted by one
year to find its present value.
Two years after the start of the project, there is a cash inflow of 9,000; this has to be
discounted two years to find its present value.
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Finally, in three years time, there is a cash inflow of 7,000, worth only 5,259 when
discounted for three years.
The present values are then added up to give a net present value of (30). This means that the
present value of the outflows exceeds the present value of the inflows so this project should
not be undertaken as it would leave you poorer than would merely investing the 20,000 at
10% for three years.
30 is a small amount when compared to the other figures in the calculation. However, a
small change in an estimate could make the net present value positive, implying that the
project should be accepted.
The advantage of the NPV method is that the final answer is expressed in financial terms,
which makes the comparison with other mutually exclusive project proposals easier to
achieve. The objective is to maximise the net present value of a firms future revenues. If
there is a choice between mutually exclusive proposals, then the proposal with the highest
NPV would be chosen.
The disadvantages are that the results are very sensitive to the rate of discount chosen, and it
is by no means easy to select an appropriate rate of discount.
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LESSON 20: BUDGETING: FUTHER CONSIDERATIONS
20.1 Introduction
As you have learnt in this course, management control is needed to try to ensure that
organisations achieve their objectives. Once the objectives have been agreed, plans should be
drawn up so that the progress of the organisations can be directed towards the ends specified
in the objectives.
When a plan is expressed quantitatively it is known as a budget and the process of converting
plans into budgets is known as budgeting.
Budgets are prepared in order to try to guide the firm towards its objectives and are drawn up
for control purposes, that is, as an attempt to control the direction that the firm is taking.
20.2 Budgetary Control

When the budgets are being drawn up two main objectives must be uppermost in the mind of
top management:
Planning. This means a properly co-ordinated and comprehensive plan for the whole
business. Each part must interlock with the other parts.
Control. Control is exercised via the budgets, thus the name budgetary control. To
do this means that the responsibility of managers and budgets must be so linked that
the responsible manager is given to help him to produce certain desired results, and
the actual achieved results can be compared against the expected, i.e. actual compared
with budget.
Therefore, the budgetary control is an integral part of both planning and control. Budgeting is
about making plans for the future, implementing those plans and monitoring activities to see
whether they conform to the plan. To do this successfully requires full top management
support, cooperative and motivated middle managers and staff, and well organised reporting
systems.
The following benefits of budgeting are those that can be derived from the full budgetary
process. They have to be worked for, as they do not accrue automatically:
Planning and coordination

Clarification of authority and responsibility
Communication
Control
Motivation
Planning and coordination. The formal process of budgeting works within the framework
of long term, overall objectives to produce operational plans for different sectors and facets
of the organisation. Planning is the key to success in business and budgeting forces planning
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to take place. The budgeting process provides for the coordination of the activities and
departments of the organisation so that each facet of the operation contributes towards the
overall plan.
This is express in the form of a Master Budget which summarises all the supporting budgets.
The budget process forces managers to think of the relationship of their function or
department with others and how they contribute to the achievement of organisational
objectives.
Clarification of authority and responsibility. The process of budgeting makes it necessary
to clarify the responsibilities of each manager who has a budget. The authority and
responsibilities of each individual manager must be clearly defined and managers at every
level must be aware of their responsibilities for the performance of their departments within
the framework of the organisations objectives. Budgeting is integrally related to the
delegation of authority and responsibility.
Communication. As the budgetary process includes all levels of management, it is important
that communication exists between top and middle management regarding the organisations
objectives and the practical problems of implementing these objectives and, when the budget
is finalised, it communicates the agreed plans to all the staff involved. There must be also
communication between the sales and production functions to ensure that coordinated
budgets are developed.
Control. Actual results will be compared with planned results and the variation will be
reported. Then, deviations are noted so that corrective action can be taken.
Motivation. It is due to the involvement of lower and middle management with the
preparation of budgets and the establishment of clear targets against which performance can
be judged.
Therefore, budgetary control involves logging actual revenue and expenditure against the
appropriate budget headings and reporting regularly to budget holders about how the totals
for these compare with the levels of revenue and expenditure that had been expected. Such
reports allow budget holders to monitor their own progress and to identify areas where
significant differences have arisen between planned and actual revenue and expenditure.
Such differences are called variances.
A natural reaction when a variance is found is to seek an explanation, particularly where it is
large or unexpected. Where the variance is significant some form of action is called for and
this is in turn needs to be determined, and the response needs to be implemented.
Another important point to bear in mind is the limiting factor. It is that factor which, at any
given time, effectively limits the activities of an organisation. It may be customer demand,
production capacity, shortage of labour, materials, space or finance. Because such as a
constraint will have a pervasive effect on all plans and budgets, the limiting factor must be
identified and its effect on each of the budgets carefully considered during the budget
preparation process.
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20.3 The interrelationship of budgets

The various budgets have to be linked together to draw up a master budget, which is really a
budgeted set of financial statements. The sales budget and the various budgets which make
up the cost of sales, e.g. material usage, wages, salaries, overheads and so on are used to
produce the budgeted operating statement and the budgets which deal with assets and
liabilities, e.g. capital expenditure, cash, stock, debtors and creditors and so on make up the
budgeted balance sheet.
The various budgets are called functional budgets. A functional budget is a budget for a
specific function within a business that summaries the policies and levels of performance
expected to be achieved by that function over the budget period.
Functional budgets are:
Sales budget planned sales and revenues over the budget period
Production budget planned production to achieve target sales
Production cost budget planned spending on production incurred to achieve the
production targets. This subsumes budgets for direct labour, direct materials and
production overheads.
Administration budget planned spending on administration and other overheads,
e.g. spending on the HR function.
Marketing budget planned spending on marketing.
Distribution budget planned spending on distribution.
The sales forecast is the starting point for budgeting, although it is not a plan or a budget. It is
necessary to take into account the productive capacity of the business, as there is no point in
budgeting for a level of sales that is beyond the capacity of the business. Once the sales
forecast is in place, plans can be devised to achieve the level of output and sales.
Example of sales budget:
Product
A
B
C
Total sales
Jan (000)
45
27
25
97
Feb (000)
46
28
25
99
March (000)
50
30
26
106
April (000)
55
35
30
120
Example of production costs budget:
Direct materials
Direct labour
Production overheads
Production costs
Jan
000
20
12
4
36
Feb
000
20
12
4
36
March
000
21
13
4
38
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The Master Budget

This is the final co-ordinated budget for the organisation as a whole which brings together the
functional budgets into forecast final accounts for the year. It incorporates:
Cash flow budget (cash flow forecast) the forecast flow of cash into and out of the
organisation
Budget profit and loss account based on forecasts and plans this is what the Profit
and Loss Account is expected to be at the end of the budget period.
Forecast balance sheet a forecast of the Balance Sheet at the end of the period.
These three budgets are identical in format to the equivalent statements in the financial
report but budget statements refer to expectations and plans for the future.
Capital budget covers the capital expenditure the organisation expects to make
within a given period.
20.4 The profit and loss budget

As you have learnt earlier, preparation of the sales budget comes first, because expenditure
cannot be planned until the source and amounts of resource available have been estimated.
The first part of the sales budget, based on the forecast sales volume, reflects the owners
estimate of several factors, including:
The forecast growth of these markets

The selling prices of the products
Competition from other firms
The size of the markets for the companys products
Lets use a example to illustrate how the functional budgets interrelate:

Prestige Ltd is a small business making just one product. Each unit will sell for 65 and the
owner has estimated the orders for the first 15 months of trading:
Year 1
1st quarter
2nd quarter
3rd quarter
4th quarter
Sales volume
1,000
1,100
1,200
1,500
Year 2
1st quarter
1,600
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Therefore, the sales revenue budget for Year 1 will be as follows:
Sales volume
Sales revenue
Q1
1,000
65,000
Q2
1,100
71,500
Q3
1,200
78,000
Q4
1,500
97,500
Total
4,800
312,000
Once the sales budget has been drafted, the production plan can be prepared. The budgeted
level of production is calculated by adjusting the required sales volume for any opening and
closing stocks.
Prestige Ltd does not have any opening stock, as it is a new business. The owner has decided
to keep a stock at the end of each quarter equal to 10% of the anticipated sales for the next
quarter. This buffer stock represents the closing stock at the end of a quarter and the opening
stock for the quarter that follows.
Therefore, the production budget for Year 1 will be as follows:
Sales volume
Less: opening stock
Add: closing stock
Production required
Q1
1,000
( 0)
1,000
110
1,110
Q2
1,100
( 110)
990
120
1,110
Q3
1,200
( 120)
1,080
150
1,230
Q4
1,500
( 150)
1,350
160
1,510
Year
4,800
(
0)
4,800
160
4,960
Once the budgeted level of production has been established, the detailed labour budget,
materials (or purchases) budget and production overheads budget can be calculated. These
three components together make up the cost of production budget.
The direct cost of making each unit is as follows:
Direct materials
Direct labour
16
20
Production overhead costs will be 20,000 for the first year, including depreciation of 2,000
for the year on fixed assets. There will be no other expenditure incurred during the year.
First we must multiply the direct materials and labour costs per unit by the number of units
required by the production plan, we then add the fixed cost for the period. The production
overhead cost is found by dividing the annual production overhead cost into quarters.
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Production costs budget for Year 1:
Production
Required
Direct materials
Cost
Direct labour
Cost
Production
Overheads
Total production
Cost
Q1
Q2
Q3
Q4
Year
1,110
1,110
1,230
1,510
4,960
17,760
17,760
19,680
24,160
79,360
22,200
22,200
24,600
30,200
99,200
5,000
5,000
5,000
5,000
5,000
44,960
44,960
49,280
59,360
198,560
Profit and Loss Budget for Prestige Ltd
Sales (4,800 x 65)

Less: cost of sales
Direct materials
Direct labour
Production overheads
Less closing stock
(198,560 / 4,960 = 40 x 160)
Budgeted gross profit
312,000
79,360
99,200
20,000
198,560
(6,400)
192,160
119,840
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LESSON 21: SOCIAL ACCOUNTING

One of the problems associated with social actions, that is actions which do not have purely
financial implications, is the difficulty of identifying costs and measuring the effects of
factors (often intangible) that contribute to the value of an organisation.
Providing social information required under the Companies Act 1985 is not particularly
difficult; it requires information regarding employees to be presented in the financial
statements, including numbers of employees, wages and salaries data, and details regarding
the companys policy on disabled persons. Also, even where social actions are required by
legislation, they can often be cost reasonably accurately. For example, there are a large
number of European Union directives which have been implemented in the UK relating to
social and environmental policies, including the monitoring and control of air and water
pollution.
The costs of complying with these disclosure requirements and operational control measures
can be high and, as the number of regulations increase, these costs will become a basic and
essential part of financial statements. It will become increasingly important that not only the
costs are reported, but also the benefits, and this is where the difficulties arise: how can the
benefits of controlling pollution from a factory be evaluated? Indeed, should an attempt be
made to evaluate them at all? Would they be better reported in qualitative or non-financial
quantitative terms?
As soon as a company seeks to incorporate social criteria alongside other, more traditional
performance measures, problems of objectivity, comparability and usefulness arise. For
example, social criteria for a paper manufacturer may include environmental issues
concerning reforestation; and an oil extraction company would include the environmentally
safe disposal of oil rigs at the end of their useful economic lives among its social criteria.
Social accounting is concerned with how to report upon the application of the social policies
adopted by an organisation, and upon how they have impacted upon the organisation and its
environment. An organisation that does so effectively will not only be providing user groups
with rich information from which to form a view concerning its social ethos, it will also be
enhancing its ability to take decisions appropriate for its own longer-term survival and
prosperity.
The reporting of non-financial information usually takes the form of narrative disclosure,
sometimes supported by a statistical summary. Sometimes the issue is what to report, due to
the lack of standards governing what to include and how to present social reports.
Oil companies, for example, produce a notable amount of additional information in their
annual reports. This environmental information usually includes details about the companys
waste disposal practices, attitudes towards pollution and natural resource depletion, as well as
the overall corporate environmental policy. However, many continue to avoid any nonmandatory social reporting, and many instances have been reported of organisations claiming
to be socially responsible, when they were, in fact, anything but.
If we now look at the Gross National Product (GNP), which is the measure of the nations
productivity recorded in the accounts, we may think that an increase in GNP would seem to
310
indicate a betterment or progress in the state of affairs existing in the country. However, this
is not necessarily so.
Lets think of a new chemical factory that is built in a town. Fumes are emitted during
production, what causes houses in the surrounding areas to suffer destruction of paintwork
and rotting woodwork, and it also causes extensive corrosion of bodywork on motor vehicles
in the neighbourhood. In addition it also affects the health of the people living nearby. An
increase in GNP results because the profit elements in the above add to GNP.
What do you think the profit elements will be?
They may include:
To construction companies and suppliers of building materials: profit made on

construction of plant
To house paint dealers and paint manufacturers, painters and decorators, joiners and
carpenters: profit made on all work effected in extra painting, woodwork, etc.
To garages and car paint manufacturers: profit made on all extra work needed on
motor vehicles
To chemists and medical requirement manufacturers: profit made on dealing with
effects on residents health, because of extra medical purchases, etc.
As you can see the quality of life has been seriously undermined for many people; therefore,
in real terms one can hardly say that there has been progress.
As national income accounts do not record the social well-being of a country, other national
measures have been proposed. The one most often mentioned is a system of social
indicators. These measure social progress in such ways as:
National life expectancies

Living conditions
Levels of disease
Nutritional levels
Amount of crime
Road deaths.
The main difficulty with this approach is that it cannot be measured in monetary terms.
Because of this, the national social income accounts cannot be adjusted to take account of
social indicators
While national social accounting would measure national social progress, many individuals
and organisations are interested in their own social progress. This form of social progress is
called social responsibility.
To identify activities to be measured, a social audit is required, investigating: which of their
activities contribute to, or detract from, being socially responsible; measurement of those
activities; a report on the results disclosed by the investigation.
Social audits may be carried out b an organisations own staff or by external auditors. The
reports may be for internal use only or for general publication.
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The matters that can be use for a social audit are:
Employment of women
Employment of disabled people
Occupational safety
Occupational health
Benefits at pensionable age
Air pollution
Water pollution
Charitable activities
Help to developing countries
The idea is to discover how the organisation had performed in respect of those matters.
It is very important that an organisation comes to a compromise about how far it should look
after the interests of its shareholders and how far it should bother about social considerations.
For example, there may be instances that, no matter what the effects on profits, the expenses
just have to be incurred. That would be the case of a chemical plant which could easily
explode, causing widespread destruction and danger to people; then there cannot be any
justification for not spending the money either to keep the plant safe or to demolish it.
The organisation will need to bring all the facts of the particular case into account.
In other cases, the company may already have environmental policies in place. For example,
a company may have decided to have the following principles of environmental policy:
To comply with both governmental and community standards of environmental

excellence.
To minimise waste
To get to as low a level as possible the discharge of pollutants
To research fully the ecological effect of the companys products and packaging
To carry on business operations in an open, honest and co-operative manner
To ensure that the those principles are fully observed
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Question 1
Tom Hill runs a manufacturing business and the following information is provided for the year ended 31
December 2007:
Stocks of raw materials at:

1 January 2007 (at cost)
31 December 2007 (at cost)
14,700
15,900
Stocks of work in progress (work in progress has decreased by 900 over the year)
Stock of finished goods at:
1 January 2007 (at cost plus 30%)
31 December 2007 (at cost plus 30%)
Sales
Purchases of raw materials
Carriage inwards
Carriage outwards
Wages
Manufacturing royalties
Factory rent, rates and insurances
General factory overheads
Manufacturing machinery at cost
Provision for depreciation of manufacturing machinery at 1 January 2007
Provision for unrealised profit at 1 January 2007
22,100
24,700
1,200,000
317,600
1,450
2,375
361,665
22,000
16,200
33,045
300,000
180,000
5,100
Additional information at 31 December 2007
1)
2)
3)
4)
5)
Manufacturing royalties paid in advance amounted to 500

Wages are apportioned 2/3 to direct labour and 1/3 to indirect labour
Insurances paid in advance amounted to 900
Rates owed amounted to 850
Depreciation is to be charged at 10% per annum on a straight-line basis
Required:
a) Prepare a manufacturing account for the year ended 31 December 2007
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(22 marks)
b) Tom has prepared a trading account using the information given. He has calculated his
gross profit on trading to be 214,600. Calculate the amount to be entered in the profit
and loss account for the provision for unrealised profit for the year ended 31 December
2007.
(5 marks)
(for quality of presentation: plus 1 marks)
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Question 2
The trading, profit and loss account for Eat Ltd for the year ended 31 March 2007 was as follows:
Sales (12,000 units)

Opening stock (2,000 units)
Purchases (14,000 units)
Closing stock (4,000 units)
Cost of sales
Gross profit
Production costs
Non-production fixed costs
Net profit
36,000
40,000
210,000
(60,000)
(190,000)
170,000
95,000
70,000
(165,000)
5,000
The business expects the following changes to occur during the year ending 31 March 2008.
1) Sales should increase by 25% following an aggressive advertising campaign and a

decrease in price of 5% per unit.
2) The advertising campaign should cost 8,000.
3) Unfortunately, the supplier has increased his costs by 10% but the purchasing manager of
Eat Ltd has been able to arrange a discount of 2% by buying in bulk.
4) Closing stock is to be 20% of the total annual sales units.
5) Production costs are expected to rise to 110,000.
Required:
a) Prepare a budgeted trading, profit and loss account for Eat Ltd for the year ending 31
March 2008.
(15 marks)
b) Calculate the following for the year ending 31 March 2008 and the year ended 31 March
2007:
1. Gross profit margin
(4 marks)
2. Net profit margin (in relation to turnover)
(4 marks)
3. Rate of stock turnover

(4 marks)
c) Write a report to the directors of Eat Ltd explaining the reasons for the expected changes
315
in b).
To
From
Date
Subject.
(7 marks)
316
Question 3
Hill Ltd needs to replace one of the assembly machines which will cost 200,000 payable on purchase.
The replacement machine is expected to last 4 years, but will need a complete maintenance check in year3
at a cost of 50,000.
The existing machine assembles 4,000 units a year. The number of units assembled by the replacement
machine is expected to be 25% lower in year 1 than the existing machine due to the time lost during
installation and testing. In year 2 it is expected that 4,500 units will be assembled and this will increase by
20% each year compared to the previous year.
The existing machine produces units at a cost of 26 each, whereas the replacement machine will produce
units at a cost of 24 each. The selling price is currently 42 per unit but with the improved quality
provided by the replacement machine this will increase to 45 per unit. From year 3, it is expected that
the cost of manufacture will increase by 25% each year and the selling price will increase by 30% each
year compared to the previous year.
The cost of capital is 14%.
The following is an extract from the present value table for 1.
14%
0.877
0.769
0.675
0.592
Year 1
Year 2
Year 3
Year 4
It is assumed that all units produced are sold.

Required:
a) Calculate the expected net cash flows for each year, using the replacement machine.
(12 marks)
b) Calculate the payback period for the replacement machine
(2 marks)
c) Calculate the net present value for the replacement machine using the expected net cash
flows. Assume that revenues are received and costs are paid at the end of each year.
(6 marks)
d) Compare the two methods of capital investment appraisal.

(4 marks)
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Question 4
The following information relates to the month of May 2008 of Smith Ltd:
Budgeted
Production
Direct material
Direct labour
Actual
2,400 units
2,200 units
5 kilos at 5.50 per kilo per unit 66,000 (13,200 kilos)
6 hours at 4.50 per hour per unit
70,400 (17,600 hours)
The budgeted profit for May 2008 was 26,000.

Required:
a) Calculate the material price and material usage variances.

(2 marks)
b) Calculate the labour rate and labour efficiency variances.

(2 marks)
c) Calculate the actual profit for Smith Ltd for the month ended May 2008.
(3 marks)
d) Explain two possible ways in which the variances will affect the current workforce.
(2 marks)
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Question 5
Sue sells greeting cards. On average each card costs 50p to buy and is sold for 1.20. The annual business
fixed costs are 110,000. Sue has set a target profit for the year of 30,000.
Required:
a) Calculate the contribution per greeting card.

(2 marks)
b) Calculate the number of greeting cards which Sue needs to sell to achieve the target profit
of 30,000. State the formula used.
(3 marks)
319

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Diploma in Accounting

Oxford Learning 2007

Oxford Learning 2007

Oxford College Press

Oxford College Press

Oxford College Press

2008 Oxford Learning. All rights reserved.

Oxford Learning 2007

Oxford Learning 2007

Oxford Learning 2007

INTRODUCTION TO FINANCIAL ACCOUNTING

Oxford Learning 2007

Oxford Learning 2007

LESSON 1. PURPOSES OF ACCOUNTING

1.2 . Why we need to keep records.

To provide a permanent record of financial transactions.

To provide information from which financial statements can be prepared.

To provide information from which management report can be prepared.

To provide a means of controlling assets.

To provide information for decision making.

To comply with statutory regulations.

Oxford Learning 2007

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

1.3 . Who is interested in the accounting records?

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Oxford Learning 2007

LESSON 2. ACCOUNTING RECORDS

2.1.Primary Accounting Records and the Ledgers.

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The date of the transaction

Sales Day Book

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Purchases Day Book

Returns Day Books:

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Total for the month

Purchases Returns Day Book

Total for the month

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B) The different types of Ledgers are:

Purchases made on credit from suppliers of the business

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Cheque book counterfoils

Sales account (cash and credit sales), sales returns

2.2.Documents used in business transactions.

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To make sure that the goods have been received

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

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

Oxford Learning 2007

Oxford Learning 2007

Oxford Learning 2007

2.3. Initial entries. Double entry system.

Left Hand this is name the Debit (DR) side

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Oxford Learning 2007

Account which gains value

Account which gives value

To increase an asset we make a DEBIT entry

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

Entry in the account

Cheque book counterfoils