Course notes ICAEW Certificate Level Accounting For exams in 2025

Course notes ICAEW Certificate Level Accounting For exams in 2025

Tutor details

ii Intro ductio n

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Accounting

Accounting

Intro ductio n

Contents Page 1 The ACA qualification and Accounting (AC) 2 Accessing the First Intuition online content

vi vii

1: Introduction to accounting

1

1 The purpose of financial statements 2 The main financial statements 3 The regulation of accounting and ethical considerations 4 Qualitative characteristics of financial information 5 Accounting concepts and conventions 6 Capital and revenue items 7 Terminology

2 3 3 5 5 7 7

2: The accounting equation

9

1 Assets, liabilities and the business entity concept 2 The accounting equation 3 Credit transactions 4 The statement of financial position 5 Preparing the statement of financial position 6 The statement of profit or loss

10 11 13 15 16 18

3: Recording financial transactions

21

1 Computerised accounting systems 2 Source documents for recording financial transactions 3 Recording bank transactions 4 The petty cash book 5 The payroll

22 23 24 24 25

4: Ledger accounting and double entry

27

1 Ledgers 2 The nominal ledger 3 Double entry bookkeeping 4 Journal entries 5 Double entry for petty cash 6 The receivables and payables ledgers 7 Accounting for VAT

28 28 28 36 36 37 37

5: Preparing basic financial statements

41

1 Balancing ledger accounts 2 The Trial Balance 3 Making adjustments after the trial balance has been extracted 4 Preparing the financial statements from the trial balance 5 More practice of accounts preparation

42 44 45 46 47

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iv Intro ductio n

Accounting

6: Errors and corrections to accounting records and financial statements

51

1 Reconciling to external documents 2 Adjustments to trade receivables and trade payables 3 Bank reconciliations 4 Types of error in accounting 5 Correcting errors

52 54 57 61 61

7: Cost of sales and inventories

65

1 IAS 2, Inventories 2 Cost of sales 3 Accounting for opening and closing inventories 4 Inventories on the trial balance 5 Counting inventories 6 Valuing inventories 7 Using margins and mark ups to establish cost 8 Writing off inventories and inventory drawings

66 66 70 71 72 73 77 78

8: Irrecoverable debts and allowances

81

1 Irrecoverable debts 2 Allowance for receivables 3 Summary of key journals

82 83 86

9: Accruals and prepayments

87

1 The principle behind accruals and prepayments 2 Prepayments 3 Accounting for accruals and prepayments 4 The accruals principle and income

88 90 90 93

10: Non-current assets and depreciation

97

1 Non-current assets 2 Calculating depreciation 3 Fall in value (impairment loss) 4 Accounting for depreciation 5 Non-current assets disposals 6 The asset register 7 Intangible assets 8 The non-current asset note to the statement of financial position

98 99 105 105 106 110 110 112

11: Company financial statements

115

1 The nature of a limited company 2 Equity: share capital and dividends 3 Equity: retained earnings and other reserves 4 Rights issues and bonus issues of shares 5 Non-current liabilities (debt capital) 6 Provisions (IAS 37) 7 Tax 8 IFRS 15 Revenue recognition 9 IAS 8 Accounting policies, changes in accounting estimates and errors 10 The regulatory framework for company financial statements

116 116 117 117 120 121 122 123 123 124

Accounting

Intro ductio n

12: Company financial statements under IFRS Accounting Standards

125

1 The statement of profit or loss (IAS 1 revised) 2 The statement of financial position 3 The statement of changes in equity 4 Preparing single entity accounts from a trial balance

126 127 128 129

13: Statement of cash flows

133

1 Statement of cash flows 2 Format of the statement of cash flows 3 Preparing a statement of cash flows

134 134 140

14: Company financial statements under UK GAAP

145

1 What is UK GAAP? 2 Published accounts 3 UK GAAP terminology and formats

146 146 146

15: Sole trader financial statements under UK GAAP

149

1 Sole trader financial statements

150

16: Solutions to interactive questions

155

17: Appendix: Summary of debits and credits

183

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Accounting

1 The ACA qualification and Accounting (AC) There are 15 modules that can be taken in any order with the exception of the Case Study which you must be attempt last. You must pass every exam (or receive credit) – there are no options. Once qualified, all ICAEW Chartered Accountants have a consistent level of knowledge, skills and experience.

Certificate Level The six certificate level modules introduce the fundamentals of accountancy, finance and business.

Each has a 1.5-hour computer-based assessment which can be sat at any time. You may be eligible for credit for some modules if you studied accounting, finance, law or business at degree level or through another professional qualification.

The six certificate modules are also available as a stand-alone certificate, the ICAEW Certificate in Finance, Accounting and Business (ICAEW CFAB). On successful completion, you can use CFAB as a stepping stone to study to the ACA.

Specification and grid weighting for Accounting Accounting aims to develop a sound understanding of the techniques of double entry accounting and apply its principles in recording transactions, adjusting financial records and preparing non-complex financial statements.

The grid below shows the weightings of subjects within Accounting and should guide your relative study time. In each assessment, the marks available equate to the weightings.

Maintaining financial records Adjustment to accounting records and financial statements Preparing financial statements

Weighting (%) 30 25 45 100

Accounting

Intro ductio n

Method of assessment Your exam will consist of 25 questions – one long question worth 40 marks and 24 objective test questions worth 2.5 marks each, together adding up to 100 marks. You should complete them all.

The objective test questions are of two types: 🞂 🞂

Multiple choice – select 1 from 4 options A, B, C or D Multiple response – select 2 or 3 responses from 4 or more options

In your exam you will not have to complete any linked objective test questions which share the same data, nor will the objective test questions require numerical entry.

The long question will be an accounts preparation question requiring the preparation of either 🞂 🞂

a Statement of Profit or Loss and Statement of Financial Position or a Statement of Cash Flows.

The pass mark is 55%.

2 Accessing the First Intuition online content You have access to FI’s online course which includes recorded lectures, question debriefs, your mock exams and step by step guidance to help you succeed in the exam.

A link to FI Learn should have been sent to you by your centre, giving full access to the online content.

When you access the link for the first time you will be prompted to create a password. Please contact your centre if you have not received the link to access the course.

If you are an online learner, it is important that you log in and listen to the introductory videos in the getting started pod of the course. These videos explain the Accounting exam and the resources you have to help you pass.

Good Luck with your studies!

The FI Team

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Accounting

1

1 Introduction to accounting

Topic List 1

The purpose of accounting information

2

The main financial statements

3

The regulation of accounting and ethical considerations

4

Qualitative characteristics of financial information

5

Accounting concepts and conventions

6

Capital and revenue items

Learning Objectives 🞂

Specify why an entity maintains financial records and prepares financial statements

🞂

Specify the ethical considerations for preparers of financial statements

🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate bases of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Specify the key aspects of the accrual basis of accounting and the cash basis of accounting

2

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1 The purpose of financial statements 1.1 What is accounting?

Accounting is a way of recording, analysing and summarising transactions of an entity.

1.2 Types of business entity There are three main types of profit-making business entity. 🞂

Sole traders

🞂

Partnerships (general or Limited Liability Partnerships (LLPs))

🞂

Limited liability companies (Ltd or Plc) 🞂

Owned by shareholders

🞂

Managed by directors

🞂

Shareholders have limited liability, i.e. the extent of their liability is limited to the amounts outstanding on their shares.

1.3 The objectives of financial statements The IFRS Foundation’s Conceptual Framework for Financial Reporting states that the objective of financial statements is to “provide information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity”.

Existing and potential investors, lenders and other creditors are the primary users of the financial statements.

When making decisions, these primary users need to assess the economic resources of an entity, changes in those resources and claims and how efficiently and effectively the entity’s management have discharged their responsibilities.

1.4 Users of financial statements and their information needs As well as investors and lenders, a number of other groups of users may be interested in the financial statements of larger entities.

User group

Information need

Investors (current and potential owners) the primary users:

assess performance of management, profitability of entity, likely dividend payments, whether to buy or sell shareholdings.

Employees:

assess job security or career opportunities.

Lenders:

assess ability to pay interest and principal amount, assets that may be used as security, levels of debt already held by the entity.

Suppliers and other creditors:

assess whether to supply to entity and what credit terms should be offered.

Customers:

assess whether to buy from the company, future warranties will be upheld and supply will be continuous.

Government:

obtain economic data, tax revenues.

Public:

review the entities ethical and social disclosures.

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Managers (directors) are appointed by the owners and are responsible for the preparation and presentation of the financial statements. They also need information about the company’s financial situation that will enable them to manage the business efficiently and to make decisions.

2 The main financial statements 2.1 The statement of financial position This is a list of all the assets controlled and all the liabilities owed by a business as at a particular date.

It is a snapshot of the financial position of the business at a particular moment. Monetary amounts are attributed to assets and liabilities.

It also quantifies the amount of the owners' interest in the company, equity.

The sum of the assets will always be equal to the sum of the liabilities plus equity (capital).

Assets = Liabilities + Equity Assets – liabilities = Equity Net assets = Equity Under UK generally accepted accounting principles, the Statement of Financial Position is often called a Balance Sheet.

2.2 The statement of profit or loss This is a statement displaying items of income and expense in a reporting period. The statement shows whether the business has had more income than expense (a profit for the period) or vice versa (a loss for the period), and thus it’s performance for the period.

Statements of profit or loss are prepared for a reporting period, usually for a year commencing from the date of the previous year’s financial statements.

Under UK generally accepted accounting principles, the statement of profit or loss is often called a Profit and Loss Account.

3 The regulation of accounting and ethical considerations 3.1 Generally accepted accounting practice (GAAP) GAAP signifies all the rules, from whatever source, which govern accounting.

UK GAAP rules derive from: 🞂 🞂 🞂 🞂

The Companies Act 2006 UK and international accounting and financial reporting standards Statutory requirements in other countries (particularly the US) Stock exchange listing requirements

3.1.1 Legislation Limited liability companies are required by the Companies Act 2006 to prepare and publish financial statements annually. Their form and content are regulated by legislation. Financial statements are required to give true and fair view, or present fairly in all material respects, the financial results of the entity. These terms are not defined and tend to be decided on a case by case basis in courts of law.

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Accounting

3.1.2 Accounting standards Legislation also requires compliance with financial reporting standards. For listed groups this means compliance with International Financial Reporting Standards (IFRS Standards). IFRS Standards include both International Financial Reporting Standards (IFRSs) and older International Accounting Standards (IASs). Non listed companies may follow UK standards which are gradually converging with International ones.

3.2 IESBA Code of Ethics for Professional accountants – fundamental principles The exercise of judgement in accounting matters is underpinned by ethical principles. The International Ethics Standards Board for Accountants (IESBA) have produced codes of ethics which all professional accountants should adhere to, whether they are in public practice, in business, education or the public sector.

Integrity

A professional accountant should be straightforward and honest in all professional and business relationships.

Objectivity

A professional accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgements.

Professional competence or due care

A professional accountant has a continuing duty to maintain professional knowledge and skills to provide a competent service. They should act diligently and in accordance with technical and professional standards.

Confidentiality

A professional account should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose and such information to third parties without proper and specific authority.

Professional behaviour

A professional accountant should comply with the relevant laws and regulations and should avoid any action that discredits the profession.

3.2.1 ICAEW Code of Ethics “Chartered accountants are expected to demonstrate the highest standards of professional conduct and take into consideration the public interest and to maintain the reputation of the accounting profession.”

Of particular relevance is the principle of professional competence and due care. Professional accountants have a duty to achieve a level of professional knowledge and skill and must ensure they do not operate beyond their current level of competence, and that any staff working under their authority are competent, adequately trained and supervised.

3.3 Sustainability standards Users of the financial statements are increasingly interested in the impact of an entity’s activities on the natural environment and on the communities within which they operate. UK companies are not legally required to disclose sustainability information, although many choose to do so.

Various organisations have provided guidance on the disclosure of sustainability information, but there is inconsistency as to the kind of information provided and how it is disclosed.

In 2021 the IFRS Foundation formed the International Sustainability Standards Board (ISSB), which will develop and issue IFRS Sustainability Disclosure Standards.

Sustainability Disclosure Standards will enable entities to disclose high-quality and transparent information about the sustainability of their operations that can be compared with that of other entities. This will provide users with the information that they need in order to understand the environmental and social risks that an entity faces and how it responds to them. Sustainability

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Disclosure Standards will not replace IFRS Standards, but will operate alongside them. The ISSB will build on the work already done by other organisations, such as the Task Force on Climate Related Financial Disclosures.

No Sustainability Disclosure Standards have yet been issued. The first standards will focus on climaterelated disclosures.

4 Qualitative characteristics of financial information Fundamental qualitative characteristics (per the Conceptual Framework) Faithful

Relevance

Faithful representation

Information is relevant if it makes a difference to a user’s decisions, ie if it has:

ie : it faithfully represents the transactions and other events it purports to represent.

A faithful representation will be:

Predictive Confirmatory Relevance is affected by nature and materiality.

Neutral/unbiased (supported by Free from error

Enhancing qualitative characteristics next and between firms in the same line

5 Accounting concepts and conventions 5.1 Fair presentation Financial statements are required to give a true and fair view or present fairly in all material respects the financial results of the entity. These terms are not defined and tend to be decided in courts of law on the facts Applying IFRS Standards is presumed to result in fair presentation. Compliance should be explicitly stated in a note and all relevant IASs and IFRSs must be followed.

5

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Departure from IFRS Standards may rarely be required to achieve fair presentation, in which case full disclosure should be made of the departure from the IFRS, why the IFRS would be misleading and the treatment adopted (including its financial effect). A statement will be required that all IASs/IFRSs have been complied with except for the relevant departure.

In recent years there has been a drive towards increased international harmonisation of accounting standards.

5.2 Going concern The entity is viewed as continuing in operation for the foreseeable future. It is assumed that the entity has neither the intention nor the necessity of liquidation or ceasing to trade. When an entity is not a going concern it accounts are prepared on a “break up” basis.

5.3 Accruals basis of accounting Entities should prepare their financial statements on the basis that transactions are recorded in them, not as the cash is paid or received (cash accounting), but as the income or expenses are earned or incurred in the reporting period to which they relate.

According to the accrual basis, when computing profit income earned must be matched against the expenses incurred in earning it.

5.4 Consistency of presentation To aid comparability over a period of time and between companies, the presentation and classification of items in the financial statements should stay the same from one period to the next, unless: 🞂 🞂

There is a significant change in the nature of the operations or A change in presentation is required by an IFRS Standard.

5.5 Materiality and aggregation Omissions or misstatements of items are material if they could influence the economic decisions of users of the financial statements. Materiality depends on the size and nature of the omission or misstatement.

Each material class of similar items should be aggregated and presented separately in the financial statements, eg “Revenue”, “Purchases”, “Trade Receivables”, “Trade Payables”.

5.6 The business entity concept Accountants regard a business as a separate entity, distinct from its owners or managers. This concept applies to companies, partnerships and sole-traders.

5.7 The historical cost convention Items are normally measured in financial statements at historical cost, ie at the amount which the business paid to acquire them. An important advantage of this concept is that there is usually a source document to prove the amount paid to purchase an asset or pay an expense.

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6 Capital and revenue items 6.1 Capital and revenue expenditure 🞂

Capital expenditure: Expenditure which results in the acquisition of long term assets, or an improvement or enhancement of their earning capacity.

Creates a non-current asset in the Statement of Financial Position (see Chapter 10)

🞂

Revenue expenditure: expenditure incurred either for trade purposes (purchase of raw materials, wages and salaries, administrative expenses) or to maintain the existing earning capacity of long term assets (repairs and maintenance).

Creates an expense in the statement of profit or loss.

6.2 Capital and revenue income 🞂

Capital income: proceeds from the sale of non-current assets. The profit or loss on sale of the assets is included in the statement of profit or loss in the period that the sale takes place.

🞂

Revenue income: Income derived from the sale of trading assets or provision of service (“Revenue”) and interest or dividends received.

7 Terminology For most of these notes (in common with the Workbook) we shall be employing the terminology used in International standards. Financial statements prepared under UK GAAP (for most sole traders and partnerships, and for many smaller companies) may use different terminology as follows: International GAAP

UK GAAP

Non-current asset

Fixed asset

Inventory

Stock

Receivables

Debtors

Payables

Creditors

Statement of financial position

Balance sheet

Statement of profit or loss

Profit and loss account

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Accounting

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you state the objective of financial statements?

Can you state the two main examinable components of a set of financial statements?

Can you list and describe the IESBA’s Code of Ethics?

Can you state the six qualitative characteristics of financial information, including which are fundamental and which are enhancing?

Can you distinguish between capital and revenue items?

Yes/No

9

2 The accounting equation

Topic List 1

Assets, liabilities and the business entity concept

2

The accounting equation

3

Credit transactions

4

The statement of financial position

5

Preparing the statement of financial position

6

The statement of profit or loss

Learning Objectives 🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and capital in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Identify the main components of a set of financial statements and specify their purpose and interrelationship

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Accounting

1 Assets, liabilities and the business entity concept 1.1 Assets The Conceptual Framework states that an asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow.

INTERACTIVE QUESTION: ASSETS Give four examples of assets of a business SOLUTION

Some assets are held and used in operations for a long time. For example, an office building or a machine. These are long-term or non-current assets.

Other assets are held for only a short time. A newsagent, for example, has to sell his newspapers on the same day that he gets them. Short-term assets are called current assets.

1.2 Liabilities The Conceptual Framework states that a liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources from the business embodying economic benefits.

Liabilities are also categorised as either non-current (payable in more than 12 months) or current (payable in less than 12 months).

INTERACTIVE QUESTION: LIABILITIES Give four examples of liabilities for a business and state whether they are likely to be current or noncurrent liabilities.

SOLUTION

Accounting

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1.3 Capital The Conceptual Framework states that capital (which it calls equity in the context of a company, as we shall see in Chapter 11) is the residual interest in the assets of the entity after deducting all its liabilities. It is effectively what the business owes the owner.

2 The accounting equation 2.1 What is the accounting equation?

FORMULA TO LEARN Assets = Capital + Liabilities

WORKED EXAMPLE: THE ACCOUNTING EQUATION Liza opens a flower stall and invests £2,500 into it. The business is a separate entity in accounting terms and so it owes the money to Liza as capital.

Assets

=

Capital

+

Liabilities

£2,500 (cash)

=

£2,500

+

£0

Liza then purchases a market stall for £1,800 and some flowers for £650.

Assets

=

Capital

+

Liabilities

£1,800 (stall)

=

£2,500

+

£0

£650 (goods) £50 (cash) £2,500

Liza sells all her flowers for £900 cash, creating a profit on the flowers of £250 (£900 less £650).

Assets

=

Capital

+

Liabilities

£1,800 (stall)

=

£2,500 (introduced)

+

£0

£0 (goods)

£250 (profit)

£950 (cash) £2,750

Note that: 🞂 🞂

profits are added to owner’s capital losses are deducted from owner’s capital

£2,750

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2.2 Appropriation of profits: sole trader drawings A sole trader does not get paid a wage; they 'draw out' or appropriate some of their capital as drawings (money and goods taken out of the business by its owner).

WORKED EXAMPLE: THE ACCOUNTING EQUATION (CONTINUED) Liza decides to pay herself £180 in “wages” at the end of the week.

Assets

=

Capital

+

Liabilities

£1,800 (stall)

=

introduced

£2,500

+

£0

£0 (goods)

plus profit

£250

£770 (cash)

Less drawings

(£180)

£2,570

Closing capital

£2,570

Capital

+

Liabilities

£2,570

+

£0

In the following week, Liza purchases flowers for £740 cash.

Assets

=

£1,800 (stall)

=

Opening capital

£740 (goods) £30 (cash) £2,570

She employs Ethel for the day and pays her £40. They sold all the flowers for £1,100 cash. Liza drew out £200 for herself.

The profit calculation will be: £ Sales Less cost of goods sold Less Ethel’s wage

£ 1,100

740 40 (780) 320

Profit

Assets

=

Capital

+

Liabilities

£1,800 (stall)

=

Opening capital

£2,570

+

£0

£0 (goods)

Plus profit

£320

£890 (cash)

Less drawings

(£200)

£2,690

Closing capital

£2,690

Cash being: £30 brought forward + £1,100 cash sales - £40 Ethel’s wages – £200 drawings = £890

Accounting

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3 Credit transactions 3.1 Trade payables (creditors) A trade creditor is a person to whom a business owes money for trading debts. The amounts outstanding to these suppliers are called the trade payables (a current liability of a business).

3.2 Trade receivables (debtors) A debtor is an amount outstanding from a customer. The amounts due are known as trade receivables (a current asset of a business).

WORKED EXAMPLE: THE ACCOUNTING EQUATION (CONTINUED) Liza invests another £250 and borrows £500 from her Uncle Henry.

Assets

=

£1,800 (stall)

=

£0 (goods)

Capital

+

Liabilities

Opening capital

£2,690

+

£500 (loan)

Capital introduced

£250

Capital

+

Liabilities

Opening capital

£2,690

+

£500 (loan)

Capital introduced

£250

£700 (payable)

£2,940

£1,200

£1,640 (cash) £3,440

£2,940

Liza buys a van for £700 on c redit.

Assets

=

£1,800 (stall)

=

£700 (van) £0 (goods) £1,640 (cash) £4,140

Liza buys £800 flowers, paying £750 in cash and £50 on credit.

Assets

=

£1,800 (stall)

=

£700 (van)

Capital

+

Liabilities

Opening capital

£2,690

+

£500 (loan)

Capital introduced

£250

£800 (goods)

£700 (payable - van) £50 (trade payable)

£890 (cash) £4,190

£2,940

£1,250

The goods are sold for £1,250 in cash. Ethel’s wages were £40 (paid), Uncle Henry’s interest charge is £5 (not paid yet) and Liza took £240 in “wages” (paid).

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The profit calculation will be: £ Sales Less cost of goods sold Less Ethel’s wage Less interest expense

£ 1,250

800 40 5 (845) 405

Profit

Assets

=

Capital

+

Liabilities

£1,800 (stall)

=

Opening capital

£2,690

+

£500 (loan)

£700 (van)

Capital introduced

£250

£700 (payable - van)

£0 (goods)

Plus profit

£405

£50 (trade payable)

£1,860 (cash)

Less drawings

(£240)

£5 (interest due)

£3,105

£1,255

£4,360

INTERACTIVE QUESTION: THE ACCOUNTING EQUATION How would each of these transactions affect the accounting equation in terms of an increase or decrease in an asset, capital or a liability? (a)

Purchasing £800 worth of goods on credit

(b)

Paying the telephone bill £25

(c)

Selling £450 worth of goods for £650

(d)

Paying £800 to a credit supplier

SOLUTION

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4 The statement of financial position The statement of financial position of a business shows its financial position at snapshot in time, highlighting its liabilities, capital and assets. As such it is an extension of the accounting equation.

4.1 Proforma statement of financial position NAME OF BUSINESS STATEMENT OF FINANCIAL POSITION AS AT (DATE) Non-current assets

£ X

Current assets

X

Total assets Capital and liabilities Capital brought forward + capital introduced + profit for period - drawings

£

x

X X X X

Closing capital

x

Non-current liabilities

x

Current liabilities

x

Total capital and liabilities

x

INTERACTIVE QUESTION: ASSET CLASSIFICATION Identify which of the following assets falls into the non-current category and which should be treated as current. Could any be treated as either? (a)

Van (Delivery firm)

(b)

Machine (Manufacturing company)

(c)

Car (Car trader)

(d)

Investment (any business)

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Accounting

5 Preparing the statement of financial position EXAM SMART The first question in your exam is worth 40 marks and will require the preparation of either a statement of financial position and a statement of profit or loss or a statement of cash flows.

It is therefore vital that you are familiar with these statements.

INTERACTIVE QUESTION: PREPARING A STATEMENT OF FINANCIAL POSITION Prepare a statement of financial position for Sunken Arches as at 31 December 20X6, given the information below.

Capital as at 1 January 20X6 Profit for the year to 31 December 20X6 Premises, carrying amount at 31 December 20X6 Motor vehicles, carrying amount at 31 December 20X6 Fixtures and fittings, carrying amount at 31 December 20X6 Non-current loan Bank overdraft * Inventories Trade receivables Cash in hand * Trade payables Drawings Accrued costs of rent Prepayment of insurance premium * A shop might have cash in its cash registers, but an overdraft at the bank

£ 51,100 8,000 50,000 9,000 8,000 25,000 2,000 16,000 500 100 1,200 4,000 600 300

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SOLUTION Sunken Arches, Statement of financial position as at 31 December 20X6 £ Assets Non-current assets

Current assets

Total assets Capital and liabilities Opening capital Profit for the period Less drawings Capital at 31 December 20X6

Non-current liabilities Current liabilities

Total capital and liabilities

£

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6 The statement of profit or loss The statement of profit or loss is a performance statement in which two key elements of financial statements – income and expenses – are matched to arrive at profit or loss.

Statement or profit or loss for the year ended 31 December 2014 Revenue

£ X

Cost of sales

(x)

Gross profit

x

Distribution costs

(x)

Administrative expenses

(x)

Income from other sources

X

Finance costs

(x)

Net profit

X

Income from other sources will include: 🞂 🞂 🞂

Profit on disposals of non-current assets Dividends or interest received from investments Rental income from property owned but not otherwise used by the business

Distribution costs: Expenses associated with selling and delivering goods to customers.

Administrative costs: Expenses of providing management and administration for the business.

Finance costs: These include interest expenses (on loans or overdraft)

EXAM SMART Be careful with inventory as its treatment depends on the question and we will see later that it does not form part of the day-to-day double entry system.

Questions relating to the accounting equation

Questions relating to double entry (see Chapter 7)

Purchase of goods for resale (inventories)

Increase inventory Decrease cash/Increase trade payable

Dr Purchase expenses Cr Cash/trade payables

Sales of goods

Increase cash/increase trade receivables Decrease inventories

Dr Cash/trade receivables Cr Sales income

The difference between the purchase price and sales value creates a profit (or loss) which increases (or reduces) the owner’s capital

Inventory is counted at the year end and adjusted for with the following journal: Dr Inventories (asset) Cr Cost of sales (expense)

Accounting

2 : T he acco unting equatio n

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you state the accounting equation?

Can you explain “Capital”?

Can you recognise the main assets, liabilities, income and expenses of an entity?

Can you state the dual impact of key business transactions on the accounting equation?

Do you know how profits, losses and drawings affect the accounting equation?

Yes/No

19

20

2 : T he acco unting equatio n

Accounting

21

3 Recording financial transactions

Topic List 1

Computerised accounting systems

2

Source documents for recording financial transactions

3

Recording bank transactions

4

The petty cash book

5

The payroll

Learning Objectives 🞂

Identify the sources of information for the preparation of accounting records and financial statements

🞂

Record transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

22 3 : Recording f i nancial transactions

Accounting

1 Computerised accounting systems An accounting system is the system which allows a business to record, process and store financial information.

Most accounting systems are now computerised, rather than the historic manual accounting system.

The principles of accounting remain the same whether you are producing accounts manually or using a computerised accounting system, but computerised systems have a number of obvious advantages: 🞂 🞂 🞂 🞂

Speed of processing large volumes of transactions In-built controls to reduce input errors Storage and sharing vast quantities of data in easily accessible formats Freeing up accountants’ time to focus on higher level skills, such as analysis and advice

These systems can range in complexity from simple “off-the shelf” programmes (such as Sage or Xero) to bespoke, integrated systems that include HR and inventory management functions, but all have the same underlying elements:

INPUTS

PROCESSES

source documents standing data

ledgers journals calculations record keeping

OUTPUTS reports trial balance financial statements

Elements within a computerised accounting system Standing data

Reference data that does not regularly change, for example customer addresses for delivery of goods, payment details for suppliers.

Account codes

Unique codes allow a business to accurately record the various transactions correctly. The codes can be sub-divided into the required level of detail.

Processing

The recording of transactions in a computerised system often referred to as processing and can be performed “real-time” (each transaction is updated at the point it takes place) or “batch processing” where are group of similar transactions are recorded in bulk at the end of a period (eg the day or week).

Controls

Computerised accounting systems will require adequate controls embedded within them to ensure the accuracy of the information, such as authorisation and mathematical controls.

1.1 Cloud accounting Cloud computing

Cloud accounting

Resources such as software and information are provided to computers via the internet. Users can then log into their accounts remotely, with the software and processing being performed in the cloud rather than on their computer.

An example of cloud computing where the accountancy software is provided in the cloud, allowing the software to be constantly updated, access to up-to-date data from a range of users and off-site back-up of the data. However, cloud accounting does increase the risk of loss through hacking and relies on the security and back-ups provided by the service provider.

Accounting

3 : Recording f i nancial transactions

2 Source documents for recording financial transactions Whenever a sale or purchase takes place, or the receipt of payment of money, it is usual for the transaction to be recorded on a source document.

2.1 Credit sales system

Customer order

Dispatch goods

Raise invoice

Receive payment

Customer sends a request for goods or services at an agreed price

Goods or services are delivered to the customer, along with a delivery note (agreed to the sales order) which the customer should sign.

The seller should then create the sales invoice to request payment for the goods or services delivered. This is the source document that must be recorded in the accounting system.

Customer then pays the outstanding amount.

2.2 Credit purchases system

Purchase order

Receive goods

Receive invoice

Make payment

A business will identify goods and services required and raise an approved purchase order to send to a supplier.

A goods received note (GRN) records the receipt.

An invoice will be received from the supplier requesting payment.

This purchase invoice is the source document for recording the purchase in the accounting system.

The business then pays the outstanding amount.

23

24 3 : Recording f i nancial transactions

Accounting

2.3 Invoices and credit notes Sales and purchases invoices are the key source documents for credit transactions.

Credit notes are documents issued to customers relating to returned goods, or refunds when a customer has been overcharged. It is like a negative invoice and thus is another source document for credit transactions.

3 Recording bank transactions Traditionally a bookkeeper would have kept a record of all cash payments and receipts in a “cash book” which was then reconciled to the businesses bank statements, usually monthly.

Electronic banking has changed the way a business records its cash transactions by providing constant access to bank accounts, and often the ability to use the information recorded by the bank to update their own accounting records.

Sophisticated systems can download a transaction report from the bank detailing the receipts and payments for a period which is then uploaded into the computerised accounting system. The transaction report thus acts as the source document for these cash transactions.

Unexpected or “unmatched” cash transactions can be highlighted in an exception report for further investigation.

Examples of transactions that the 🞂 accounting system should usually 🞂 recognise and match: 🞂

Receipts from and payments to ongoing customers and suppliers Regular monthly transactions such as payroll or rental charges (often paid by direct debit or BACs transfer) Payments to recognised bodies such as HMRC

Examples of transactions that the 🞂 accounting system may not recognise and would therefore be 🞂 highlighted in an exception report:

Unusual/one off transactions such as the proceeds on disposal of non-current assets or additional capital invested into the business Amounts that do not agree to the original transactions (for example where settlement discounts have been unexpectedly taken)

The accounting system will include a “cash at bank” account which records all payments and receipts of cash through the bank including card transactions, standing orders, direct debits, BACS transfers or cheque payments.

Some businesses may also handle physical cash which is periodically deposited with the bank as well as maintaining a “petty cash” balance for small items of day to day expenditure.

4 The petty cash book The petty cash book records all payments out of and receipts into petty cash. It is one area of accounting that is often still manual.

The petty cash book will analyse the different types of petty cash expenditure plus any VAT on the purchases.

Under the imprest system, the amount of money in petty cash is kept at an agreed sum or “float” (say £250). Any money taken from petty cash is replaced with an expense voucher (detailing the amount and purpose of the expense) so that at any time cash + vouchers = £250.

The vouchers can then be used to complete the petty cash book.

Accounting

3 : Recording f i nancial transactions

WORKED EXAMPLE: PETTY CASH BOOK Assuming a business maintains a cash float of £250 and starts with a payment from the bank of this amount into petty cash, the following payments are then made from petty cash.

Receipts

Date

Narrative

Payments

£250

1.3.X7

Bank

2.3.X7

Stamps

£12.00

£12.00

8.3.X7

Stamps

£10.00

£10.00

19.3.X7

Taxi fare

£16.00

23.3.X7

Flowers

£5.00

28.3.X7

Stamps

£11.50

£250

VAT

Postage

Travel

Other

£16.00 £1.00

£4.00 £11.50

£54.50

£1.00

£33.50

£16.00

£4.00

What amount should remain in petty cash (notes and coins) and how much cash is required to restore the imprest amount?

SOLUTION Cash remaining in petty cash £250 - £54.50 = £195.50. Any discrepancies would need to be investigated. £54.50 must be transferred from the business’ cash at bank to restore petty cash to the imprest amount of £250.

5 The payroll The payroll is the record of wages and salaries costs. It records all the key information from the employee’s payslip and any additional costs to the employer.

WORKED EXAMPLE: THE PAYROLL Sunny Climes Ltd employs three people: Anja earns £36,000 a year, Mark earns £33,000 a year and Dipak earns £30,000 a year. The gross pay in September for each employee is as follows: Anja Mark Dipak

£3,000 £2,750 £2,500

These amounts can be analysed as follows (NB: Deductions + Net Pay = Gross pay) deductions PAYE

NI

Pension

Net pay

Gross pay

£

£

£

£

£

Anja

550

250

150

2,050

3,000

Mark

500

230

135

1,885

2,750

Dipak

460

210

125

1,705

2,500

1,510

690

410

5,640

8,250

25

26 3 : Recording f i nancial transactions

Accounting

However, Sunny Climes must also pay employers national insurance (NI) and the companies contribution to the pension scheme, so the final payroll might look like this: PAYE

Employees NI

Employees Pension

Net pay Gross pay

Employer NI

Employer Pension

Total payroll cost

£

£

£

£

£

£

£

£

Anja

550

250

150

2,050

3,000

310

200

3,510

Mark

500

230

135

1,885

2,750

265

180

3,195

Dipak

460

210

125

1,705

2,500

230

165

2,895

1,510

690

410

5,640

8,250

805

545

9,600

The total payroll cost for Sunny Climes Ltd is £9,600. This is paid out as follows: Employees (net pay) HMRC: Income tax PAYE HMRC: Employee and employer NI (690 + 805) Pension trustees: Employee and employer pension (410 + 545) Total payroll cost

£ 5,640 1,510 1,495 955 9,600

INTERACTIVE QUESTION: THE PAYROLL Fantab Ltd has 10 employees who had gross pay of £190,000 per annum between them in 20X4. In that year, Fantab Ltd made net pay payments to employees of £129,200, and paid £20,900 to the pension trustees. Its total payroll cost was £220,400.

How much did Fantab Ltd pay to HMRC in respect of NI and PAYE? SOLUTION

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you state the key source document for recording a credit purchase or credit sale?

Can you identify which transactions a bank transaction report is likely to recognise?

Can you explain the IMPREST system for petty cash?

Can you explain the difference between net pay, gross pay and total payroll cost of a business?

Yes/No

27

4 Ledger accounting and double entry

Topic List 1

Ledgers

2

The nominal ledger

3

Double entry bookkeeping

4

Journal entries

5

Double entry for petty cash

6

The receivables and payables ledgers

7

Accounting for VAT

Learning Objectives 🞂

Identify the sources of information for the preparation of accounting records and financial statements

🞂

Record transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Prepare journals for nominal ledger entry and to correct errors in the draft financial statements

28 4 : L edger accounti ng and double entry

Accounting

1 Ledgers Ledger accounts record and analyse all the individual transactions of a business. Each transaction will be dated and recorded in chronological order using double entry. The ledgers can then build up the totals for each day, week, month and year.

Each item within the statement of financial position and the statement of profit or loss will have its own ledger account.

Ledger accounts often take the form of T accounts.

DEBIT

Date

Narrative

Name of account (eg Cash) £ ref

000

Date

Narrative

CREDIT £ ref

000

2 The nominal ledger The nominal ledger groups together all the individual ledger (T) accounts.

Examples of ledger accounts in the nominal ledger include: 🞂 🞂 🞂 🞂 🞂 🞂 🞂

Plant and machinery at cost (non-current asset) Owner's capital (capital) Inventories – finished goods (current asset) Trade receivables (current asset) Trade payables (current liability) Wages and salaries (expense) Sales (income)

3 Double entry bookkeeping Each transaction has an equal but opposite effect (the duality concept). Double entry bookkeeping is the method used record each transaction into the correct nominal ledger accounts.

Every accounting event must be entered in ledger/T accounts both as a debit and a credit.

DEBITS INCREASE

CREDITS INCREASE

Expenses

Liabilities

Assets

Income

Drawings

Capital

This can be easily remembered as DEAD CLIC.

Accounting

4 : L edger accou nti ng and double entry

Conversely a DEBIT will REDUCE liabilities, income and capital and a CREDIT will REDUCE expenses, assets and drawings.

Debit

Assets (SOFP) Expenses (SPL)

Credit

Debit

Liabilities (SOFP) Income (SPL)

Credit

INTERACTIVE QUESTION: DEBITS AND CREDITS Complete the following table relating to the transactions of a bookshop.

Transaction

Debit (Dr)

Credit (Cr)

Purchase of books on credit

Purchase of cash register by cheque

Payment received from a credit customer

Sell books for cash

It is often helpful to start with the cash at bank ledger account, that is the cash T account that records the cash receipts (debits) and cash payments (credits), remembering to take the corresponding credit or debit to the relevant account.

29

30 4 : L edger accounti ng and double entry

Accounting

INTERACTIVE QUESTION: DOUBLE ENTRY FOR CASH TRANSACTIONS A business has the following cash transactions to be recorded in their accounting system (ignore VAT). (i) (ii) (iii) (iv)

A cash sale of £250 Payment of a rent bill totalling £150 Buy some goods for cash £100 Buy some shelves for cash for £200

Post the transactions to the correct ledger accounts below.

SOLUTION Dr

Cash

Cr £

Sales (income) £

Cr

Rent expense £

Cr

Dr

Purchases expense £

Cr £

Dr

Non-current asset (shelves) £

Cr

£

Dr

Dr

£

£

£

Accounting

4 : L edger accou nti ng and double entry

Not all transactions involve cash immediately, a business can purchase or sell goods on credit.

Suppliers are trade payables (a liability) until they have been paid. Customers are trade receivables (an asset) until they have paid the business.

INTERACTIVE QUESTION: DOUBLE ENTRY FOR CREDIT TRANSACTIONS A business has the following transactions: (a) (b) (c) (d)

The business sells goods on credit to Mr A for £2,000 The business buys goods on credit from B Ltd for £100 One month later B Ltd is paid £100.

On the same date Mr A settles his debt of £2,000

Show how these transactions would be recorded in the ledger accounts.

SOLUTION Dr

Dr

Dr

Dr

Trade receivable £

Cr

Sales (income) £

Cr

Trade payables £

Cr

Purchase expenses £

Cr

Cash

Cr

Dr £

£

£

£

£

£

31

32 4 : L edger accounti ng and double entry

Accounting

INTERACTIVE QUESTION: DEBITS AND CREDITS Identify the debit and credit entries in the following transactions (ignore VAT) Transaction

Debit (Dr)

Credit (Cr)

Bought a machine on credit from A, cost £8,000 Bought goods on credit from B, cost £500 Sold goods on credit to C, value £1,200 Paid D (a credit supplier) £300 Collected £180 from E, a credit customer Paid net pay £4,000 Received rent bill of £700 from landlord Paid rent of £700 to landlord G Paid insurance premium £90

3.1 Accounting for discounts Discounts

Trade discounts

Early settlement (or cash) discounts

Definition: a reduction in the cost of goods usually from bulk buying.

Definition: a reduction in the amount payable in return for immediate or early payment in cash.

It is deducted from the list price in arriving at the sales/purchases figure for double entry purposes.

Initial sales/purchase is recorded NET of early settlement discount if it is expected to be taken. Otherwise the sale/purchase is recorded ignoring the early settlement discounts.

If behaviour is then not as expected, the accounts are adjusted accordingly at the point of cash receipt or payment.

Accounting

4 : L edger accou nti ng and double entry

3.1.1 Illustrative example of early settlement discounts on a credit sale Credit sale £1,000. 5% discount offered for payment within 7 days.

At point of sale, the customer is expected to take advantage of the early settlement discount.

At point of sale, the customer is NOT expected to take advantage of the early settlement discount.

Dr Receivables £950 Cr Sales income £950

Dr Receivables £1,000 Cr Sales income £1,000

Customer pays early as expected:

Customer pays AFTER 7 days:

Customer after 7 days as expected:

Customer pays BEFORE 7 days:

Dr Cash £950 Cr Receivables £950

Dr Cash £1,000 Cr Receivables £950 Cr Sales income £50

Dr Cash £1,000 Cr Receivables £1,000

Dr Cash £950 Dr Sales income £50 Cr Receivables £1,00

INTERACTIVE QUESTION: LEDGER ACCOUNTS Ron Knuckle set up a business selling fitness equipment. He put £7,000 of his own money into a business bank account (transaction a) and in his first period of trading, the following transactions occurred. It is expected that all early payment discounts will be taken. (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)

Paid rent of shop for the period Purchase equipment (inventories) on credit – offered £50 early settlement discount Loan from bank Purchase of shop fittings for cash Sale of equipment for cash Sale of equipment on credit – offered £20 early settlement discount.

Payment for trade payables (as expected) Receipt from trade receivable (as expected) Interest on loan (paid) Other expenses (all paid in cash) Drawings

£3,500 £5,000 £1,000 £2,000 £10,000 £2,500 £4,950 £2,480 £100 £1,900 £1,500

Prepare the ledger accounts for Ron Knuckle by opening up the required T accounts and completing them (ignore VAT).

33

34 4 : L edger accounti ng and double entry

Accounting

SOLUTION Dr

Cash £

Dr

Dr

£

Capital

Cr

£

£

Rent expense

Cr

£

£

Dr

Dr

Cr

Purchases

Cr

£

£

Trade payables

Cr

£

£

Dr

Loan £

Cr £

Accounting

Dr

Dr

Dr

Dr

Dr

4 : L edger accou nti ng and double entry

Non-current asset

Cr

£

£

Sales income

Cr

£

£

Trade receivables

Cr

£

£

Interest expense

Cr

£

£

Other expenses

Cr

£

£

Dr

Drawings £

Cr £

35

36 4 : L edger accounti ng and double entry

Accounting

4 Journal entries Journal entries can be used to record any business transactions but are usually used to record unusual or one off transactions, often part of the final adjustments to prepare the accounts.

Journal entries have a particular form: Date Dr

Ledger account to be debited Cr Ledger account to be credited

£’000 £’000

“Being the……” followed by a short explanation of the journal, for example, “being the year end insurance prepayment”.

5 Double entry for petty cash WORKED EXAMPLE: PETTY CASH JOURNALS Assuming a business maintains a cash float of £250 and starts with a payment from the bank of this amount into petty cash, the following payments are then made from petty cash (ignore VAT) Receipts

Date

Narrative

Payments

Postage

£250

1.3.X7

Bank

2.3.X7

Stamps

£12.00

£12.00

8.3.X7

Stamps

£10.00

£10.00

19.3.X7

Travel

£16.00

£16.00

23.3.X7

Travel

£5.00

£5.00

28.3.X7

Stamps

£11.50

£11.50

£54.50

£33.50

£250

Travel

£21.00

Complete the double entries to transfer the petty cash book to the ledger accounts.

SOLUTION Dr

£ Cr

£

Being the receipt of cash from the bank.

Dr Dr

£ £ Cr

£

Being the expenses from petty cash in March.

Following the above journal, petty cash should then be topped up with £54.50 from the bank account to maintain the float.

Dr

Petty cash Cr Cash at bank

£54.50 £54.50

Accounting

4 : L edger accou nti ng and double entry

6 The receivables and payables ledgers The trade receivables and trade payables accounts in the nominal ledger will record the total amounts outstanding from credit customers, and owing to credit suppliers.

However, a business will also need a record of amounts owed by each individual customer and amounts owed to each individual supplier. This detail is contained in the receivables ledger or payables ledger.

Although these are memorandum accounts and not part of the double entry system, in a computerised accounting system source documents recorded in the personal accounts (the receivables or payables ledgers) are then automatically updated in the trade receivables and trade payables accounts in the nominal ledger. They should therefore always agree.

7 Accounting for VAT VAT in an indirect tax on the supply of goods and services. Tax is collected by businesses in the supply chain on behalf of HMRC. VAT registered businesses recover any VAT paid and hence only the final consumer bears the full cost.

Manufacturer sells for £10 + VAT = £12

Retailer sells on for £15 + VAT = £18

Consumer buys for £18 (£15 + £3 VAT)

£2 paid to HMRC (output VAT)

£2 due from HMRC (input VAT) £3 due to HMRC (output VAT) Net payment to HMRC £1

HMRC have collected £3 of VAT (in total) from each of the registered traders.

Non Registered Businesses

Registered Businesses

Do not charge and cannot recover VAT

Taxable Activities

Exempt Activities

Can recover VAT

Do not charge and cannot recover VAT

Standard Rated

Reduced rate

Zero rated

Currently 20% (eg CDs, furniture, biscuits)

(5% of domestic fuel)

(eg books, eggs, cakes)

37

38 4 : L edger accounti ng and double entry

Accounting

7.1 Accounting for VAT For registered businesses with taxable activities, income and expenses should EXCLUDE VAT, but trade receivables and trade payables should INCLUDE VAT. From the above example, the following double entries would be required: Manufacturer Dr Trade receivables Cr Sales income (revenue) Cr VAT account

£12 £10 £2

Retailer Dr Trade receivables Cr Sales income (revenue) Cr VAT account

£18

Dr Purchase expenses Dr VAT account Cr Trade payables

£10 £2

£15 £3

£12

In the VAT account, credits represent amounts owed TO HMRC (a current liability), debits represent amounts owed FROM HMRC (a current asset). 🞂

If the VAT cannot be recovered (non-registered businesses or exempt activities) then the income and expenses will include VAT as this becomes a real cost to the business.

🞂

VAT on certain purchases is never recoverable, for example cars and business entertaining.

EXAM SMART Remember: 🞂 🞂

Gross includes VAT (trade receivables, trade payables) Net excludes VAT (sales, purchases, most expenses)

GROSS = NET × 1.2 NET = GROSS/1.2

INTERACTIVE QUESTION: VAT Mussel is preparing financial statements for the year ended 31 May 20X9. Included in its statement of financial position as at 31 May 20X8 was a balance for VAT due from HMRC of £15,000.

Mussel's summary statement of profit or loss for the year to 31 May 20X9 is as follows.

Revenue (net) Purchases (net) Gross profit Expenses:

Net profit

all standard rated all standard rated Wages & salaries (exempt VAT) Entertaining (£40k + irrecoverable VAT £7k) Other (net) all standard rated

£’000 500 (120) 380 (163) (47) (70) 100

In respect of VAT payments of £5,000, £15,000 and £20,000 have been made in the year to HMRC and a repayment of £12,000 was received.

Accounting

4 : L edger accou nti ng and double entry

Complete the VAT ledger account to deduce what is the balance for VAT in the statement of financial position as at 31 May 20X9?

Assume a 20% standard rate of VAT. SOLUTION Remember VAT will be calculated at 20% of the net amount or 20/120 of the gross amount.

VAT Control account £

£

Balance brought forward Input VAT

Output VAT

Cash paid

Cash received

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Have you memorised the rules of DEAD CLIC? Can you complete the relevant T accounts for simple business transactions?

Can you distinguish a trade discount from an early settlement discount?

Can you explain the double-entries required when a settlement discount is or isn’t expected to be taken and what happens when payment is made or received?

Can you state if net of VAT means it includes or excludes VAT? Can you switch between gross and net easily?

Can you state the correct double entry for a sale or purchase including VAT? Can you identify whether the VAT account represents a current asset or a current liability?

Do you know the rule for recovering VAT on cars or business entertaining?

Yes/No

39

40 4 : L edger accounti ng and double entry

Accounting

41

5 Preparing basic financial statements

Topic List 1

Balancing ledger accounts

2

The trial balance

3

Preparing the statement of profit or loss

4

Preparing the statement of financial position

5

Preparing basic financial statements

Learning Objectives 🞂

Prepare a trial balance from accounting records and identify the uses of a trial balance

🞂

Prepare and present a statement of financial position, statement of profit or loss and statement of cash flows (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity

42 5 : Prepari ng basic f i n ancial statements

Accounting

1 Balancing ledger accounts At the end of a reporting period, each ledger (T) account must be balanced to find the final figures for the financial statements.

Example: cash ledger Cash ledger Opening balance Capital introduced Trade receivables Cash sales

£ 1,500 5,500 4,000 500

Trade payables Cash purchases Cash expenses Carried forward

£ 3,000 1,000 2,000

The above process if used for any ledgers relating to the statement of financial position.

However, when balancing all the ledger accounts in the nominal ledger, the first step is to identify the ledgers that relate to income and expenses.

These balances are then transferred (through double entry journals) to the profit and loss ledger account.

The balance on the P&L ledger account then represents the net profit or loss for the period.

INTERACTIVE QUESTION: PREPARING THE STATEMENT OF PROFIT OR LOSS Continuing the previous example for Ron Knuckle, follow the above steps to prepare his statement of profit or loss.

SOLUTION Dr Cash

Dr Trade payables

Dr

Dr Cash

Rent expense £ 3,500

Cr

Purchases

Cr

£

£ 4,950

Sales income £ Cash Trade receivables

Interest expense £ 100

£

Cr £ 10,000 2,480

Cr £

Accounting

5 : Prepar ing basic f i nancial statemen ts

Dr

Other expenses £ 1,900

Cash

Dr

(EXPENSES)

Profit & loss Ledger £

Cr £

(INCOME)

Cr £

The ledgers accounts relating to the Statement of Financial Position (assets, liabilities, capital) will be balanced at the year-end in the same way, but this time usually creating a carried down figure which will represent the opening balance in the following year.

However the drawings ledger and profit and loss ledgers are transferred to the capital account, which will therefore represent the amount the business currently owes its owners (the capital invested, plus any profit due to them less any drawings from the business).

INTERACTIVE QUESTION: PREPARING THE STATEMENT OF FINANCIAL POSITION Using the Ron Knuckles ledger accounts for assets, liabilities, capital and drawings calculate the carried forward figure.

SOLUTION Dr Capital Loan Sales Trade receivables

Cash £ 7,000 1,000 10,000 2,480

Dr

Rent expense Shop fittings (non-current asset) Trade payables Interest expense Other expenses Drawings

Capital £ Cash

Cr £ 3,500 2,000 4,950 100 1,900 1,500

Cr £ 7,000

43

44 5 : Prepari ng basic f i n ancial statements

Accounting

Dr

Drawings

Cr

£ Cash

£

1,500

Dr Cash

Trade payables £ 4,950 Purchases

Cr

Loan

Cr

Dr £

Cash

Dr

Non-current asset

£ 4,950

£ 1,000

Cr

£ Cash

£

2,000

Dr Sales

Trade receivables £ 2,480 Cash

Cr £ 2,480

2 The Trial Balance The trial balance is a list of the nominal ledger balances shown in debit and credit columns. It provides a check on the accuracy of the double entry bookkeeping system (total debits should equal total credits) and is the next step towards producing the financial statements.

Accounting

5 : Prepar ing basic f i nancial statemen ts

Ron Knuckle: Trial Balance as at 31 December 2010

Debit £ 6,530

Cash at bank Capital Bank loan Purchases Trade payables Rent Shop fittings Sales Trade receivables Bank loan interest Other expenses Drawings

Credit £ 7,000 1,000

4,950 0 3,500 2,000 12,480 0 100 1,900 1,500 20,480

20,480

3 Making adjustments after the trial balance has been extracted In a computerised accounting system, the initial trial balance will always balance, but this does not mean that they are complete and error-free. If errors or omissions are discovered after the initial trial balance has been extracted, correcting journals will need to be made.

These adjustments will need to be made in the relevant nominal ledger accounts, but rather than extracting another trial balance, we adjust the first trial balance to produce a final trial balance.

ILLUSTRATIVE EXAMPLE: ADJUSTING A TRIAL BALANCE Ron Knuckle needed to make one year end adjustment, for the prepayment of his insurance, as follows: Dr

Prepayment (asset) Cr Other expenses

£30 £30

His initial and final trial balance would look like this: Initial trial balance Ledger Cash at bank Capital Bank loan Purchases Trade payables Rent Shop fittings Sales Trade receivables Bank loan interest Other expenses Drawings Prepayment

Dr 6,530

Cr

Adjustments

Final trial balance

Dr

Dr 6,530

Cr

7,000 1,000

7,000 1,000

4,950

4,950 0

0

3,500 2,000

3,500 2,000 12,480

12,480

0 100 1,900 1,500

30

0 100 1,870 1,500 30

30

20,480

30 20,480

Cr

20,480

30

20,480

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46 5 : Prepari ng basic f i n ancial statements

Accounting

EXAM SMART In question one of your exam you may be given a trial balance, along with a number of adjustments, from which to prepare the statement of profit or loss and statement of financial position. You will not be required to prepare an adjusted/final trial balance but you will be expected to handle the information and ensure the financial statements include the necessary adjustments.

4 Preparing the financial statements from the trial balance The final step is to prepare the financial statements from the trial balance. Continuing with the figures from the trial balance above, we will prepare the financial statements for Ron Knuckle.

Statement of profit or loss for the year ended 31 December 2010 £ Sales Cost of sales (purchases) Gross profit Rent expense Other expenses Interest expense Net profit

Statement of financial position as at 31 December 2010 Assets

£

Non-current assets Current assets

Total assets Capital and liabilities Owners capital brought forward Profit for the year Drawings

Non-current liabilities (Loan) Current liabilities Total capital and liabilities

–

Accounting

5 : Prepar ing basic f i nancial statemen ts

5 More practice of accounts preparation INTERACTIVE QUESTION: PREPARATION OF ACCOUNTS - POLLY Polly had the following transactions in her first year of trading as a beauty therapist visiting clients at home. 🞂

Opened a bank account with £400. Took out bank loan for £5,000, and agreed an overdraft limit of the same amount

🞂

Bought car for £2,500 cash. Insured it for £300 cash. Bought other equipment for £1,500, and consumable items for £500, both on credit

🞂

During the year charged customers £15,945, all on credit.

🞂

During the year purchased further consumables for £3,690 on credit, and diesel for car for £650 in cash.

🞂

During the year took £1,250 in cash from ATMs for herself

🞂

By end of year had received £12,935 from customers and paid £3,250 to suppliers

Prepare Polly’s ledger accounts including a profit and loss ledger account and draw up a statement of profit or loss and statement of financial position in respect of her first year of trading.

SOLUTION Cash at bank £

£

Capital £

£

Loan £

£

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48 5 : Prepari ng basic f i n ancial statements

Accounting

Non-current assets £

£

Trade payables £

£

Insurance expense £

£

Car ex penses £

£

Purchase expenses £

£

Sales in come £

£

Trade receivables £

£

Accounting

5 : Prepar ing basic f i nancial statemen ts

Drawings £

£

Profit and loss ledger £

Statement of profit or loss for the year ended 31 December 20XX £ Sales Cost of sales (purchases) Gross profit Insurance expenses Car expenses Net profit

Statement of financial position as at 31 December 20XX Assets Non current assets Current assets Trade receivables Cash Total assets Capital and liabilities Owners capital brought forward Profit for the year Drawings Non-current liabilities Current liabilities Total capital and liabilities

£

£

£

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50 5 : Prepari ng basic f i n ancial statements

Accounting

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you correctly calculate the balancing figure in a ledger account?

Do you know the different way to balance a ledger account relating to the statement of financial statement compared to the statement of profit or loss?

Can you explain the balancing figure in the Profit or Loss ledger?

Can you identify the elements of the financial statements from their description in the trial balance (eg asset, liability, income or expense?)

Do you know where in the trial balance (debit or credit column) you would expect to see the main elements of the financial statements?

Can you explain how the profit or loss for the year affects the statement of financial position?

Yes/No

51

6 Errors and corrections to accounting records and financial statements

Topic List 1

Reconciling to external documents

2

Adjustments to trade receivables and trade payables

3

Bank reconciliations

4

Types of error in accounting

5

Correcting errors

Learning Objectives 🞂

Prepare a trial balance from accounting records and identify the uses of a trial balance

🞂

Identify omissions and errors in accounting records and financial statements and demonstrate how the required adjustments will affect profits or losses

🞂

Correct omissions and errors in accounting records and financial statements

🞂

Prepare journals for nominal ledger entry and to correct errors in draft financial statements

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Accounting

1 Reconciling to external documents As we saw in Chapter 3, in a computerised accounting system, at any point in time, the total of the personal accounts of each credit customer and each credit supplier will be equal to the total trade receivables and total trade payables balances (in the nominal ledger) respectively.

Reconciliation of the personal accounts to external records (such as supplier statements) allows a business to verify the accuracy of their accounting records.

The most common external documents used for this purpose are: 🞂 🞂 🞂

Supplier statements Customer statements Bank statements

1.1 Reconciling trade payables

SUPPLIER STATEMENT RECEIVED

Reconciled to individual supplier account

PAYABLES LEDGER/ MEMORANDUM LEDGER

NOMINAL LEDGER trade payables

In a manual bookkeeping system, it is possible that the total on the personal accounts (payables ledger) will not agree to the trade payables in the nominal ledger and therefore this additional reconciliation would be an important check on the accuracy of the nominal ledger.

In a computerised system, transactions will automatically be updated in the personal account of the credit supplier and trade payables account in the nominal ledger so this reconciliation is not required.

However, it is common practice for a business to send statements (monthly or quarterly) detailing transactions since the last statement. When these are received from credit suppliers (supplier statements) they should be reconciled to the personal account of the supplier (the payables ledger or memorandum ledger) and any discrepancies investigated.

Errors or omissions identified must be corrected in the accounting system.

1.2 Reconciling trade receivables

CUSTOMER STATEMENT SENT

Reconciled to individual customer account

RECEIVABLES LEDGER/ MEMORANDUM LEDGER

NOMINAL LEDGER trade receivables

A business will produce its own statements to send to customers based on their personal account balances. Discrepancies highlighted by the customers can then investigated and corrected if needed, but the process depends upon the customer replying to the statement.

Accounting

6 : Erro rs and correctio ns to accounting r ecords and financia l s tatem ent s

WORKED EXAMPLE: SUPPLIER STATEMENT RECONCILIATION Violet has received the following statement from Jade (a credit supplier) for March 2018: Supplier statement for Violet: March 2018 Date

Details

Debit £

Credit £

Balance £

1 March

Balance b/f

5 March

Invoice 13287

129.40

621.62

7 March

Invoice 13299

22.72

644.34

10 March

Payment received

18 March

Invoice 14101

31 March

Balance c/f

492.22

615.17 394.95

29.17 424.12

424.12

Violet has extracted a report from the computerised accounting system which shows Jade’s personal account in the payables ledger as follows: Payables ledger extract: ACCOUNT NAME: Jade DATE 5.3.18 7.3.18 10.3.18 10.3.18 18.3.18 29.3.18

TRANSACTION Opening balance Invoice 13287 Invoice 13299 Payment Early settlement discount re invoice 13287 Invoice 14101 Returns Closing balance

(Debit)/Credit £ 492.22 129.40 22.72 (615.17) (6.45) 394.95 (64.40) 353.27

The difference between the supplier statement (£424.12) and the payables ledger extract (£353.27) is explained by: 🞂 🞂

The early settlement discount of £6.45 – not recorded by Jade The returns of £64.40 – not recorded by Jade

On further investigation Violet confirmed that although there were not initially expecting to take the early payment discount, and hence recorded the purchase invoice amount in full, it had paid within the appropriate period to qualify and hence the discount is valid.

On contacting Jade, they have confirmed that the discount will be applied.

The returns of £64.40 had not been received by Jade until 4 April 2018 and hence not noted on their supplier statement. Jade has confirmed it will be reflected in the next supplier statement.

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2 Adjustments to trade receivables and trade payables For trade receivables and trade payables, there are a number of adjustments that may need to be reflected in the personal accounts and nominal ledger.

It is important to be comfortable with the double entry for these.

Adjustments

Required journal entry

Sales returns

Dr Sales Returns (or Sales) Cr Trade receivables

Purchase returns

Dr Trade payables Cr Purchase returns (or Purchases)

Contra

Dr Trade payables Cr Trade receivables

Irrecoverable debts

Dr Irrecoverable debt expense Cr Trade receivables

Refund to customers

Dr Trade receivables Cr Cash

Refund from suppliers

Dr Cash Cr Trade payables

Dishonoured cheque

Dr Trade receivables Cr Cash

2.1.1 Sales and purchase returns If a customer returns goods to us this is effectively a “negative sale”. An entity may use a “sales returns” ledger to record the return transaction. It is then normal to issue the customer with a credit note confirming the amount is no longer owed.

Similarly, if we return goods to a supplier it is effectively a negative purchase which may be recorded in a “purchase returns” ledger.

The total returns for a period must be deducted from the revenue and purchases figure in the final financial statements, for example: Extract from a trial balance Sales Purchases Returns

Dr £ 20,000 5,000

Cr £ 30,000 2,000

This would be recorded in the final statement of profit or loss as follows Statement of profit or loss Sales (30,000 – 5,000) Purchases (20,000 – 2,000) Gross profit

£ 25,000 (18,000) 7,000

2.1.2 Contras Occasionally a business may have a customer who is also a supplier and hence the business owes money to, and is owed money from, the same entity. This receivable and payable should then be offset against each other (a “contra”) and the difference settled as usual.

Accounting

6 : Erro rs and correctio ns to accounting r ecords and financia l s tatem ent s

For example, if A owes B £100 but B owes A £70, we can see that this would be settled by a net payment from A to B of £30. Before the contra, A would record: Trade receivables Trade payables

£70 £100

The double entry for a contra (for both A and B): Dr

Trade payables Cr Trade receivables

£70 £70

A would now have the following: Trade receivables Trade payables

nil £30

EXAM SMART 🞂

Remember a contra will always reduce trade receivables (Cr) and reduce trade payables (Dr) of both parties.

2.1.3 Refunds Refunds to customers and refunds from suppliers can be notoriously tricky in the exam. It is important to remember the entry to cash, that is, a refund to a customer involves a cash payment (Cr Cash) and a refund from a supplier is the receipt of cash (Dr Cash).

Remember we would only be refunding a customer if we owed them money, so the trade receivable (usually a debit balance) has become a credit. Hence the effect of the refund is to cancel the credit balance that you would not expect to see within trade receivables. Consider the following: As credit sale is made to a customer for £100 Dr

Trade receivables Cr Sales

£100 £100

The customer then pays for the goods Dr

Cash Cr Trade receivables

£100 £100

The customer then returns the goods (having already paid for them) Dr

Sales returns Cr Trade receivables

£100 £100

Leaving a net “credit” in trade receivables of £100.

We then refund the £100 to the customer Dr

Trade receivables (to cancel to credit above) Cr Cash

£100

EXAM SMART If you feel confused by the double entry for a refund, remember to “follow the cash”, ie a refund from a supplier will be cash in to the business (Dr Cash) but a refund to a customer will be cash out of the business (Cr Cash).

£100

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Accounting

Questions can include any number of above adjustments to the trade receivables or trade payables T account, the following may help you remember how to treat these adjustments:

Opening balance b/f Credit sales (incl VAT) Dishonoured cheques Refunds to customers

Cash paid Contra Purchase returns Closing balance (c/f)

Trade receivables £ X Cash received X Contra X Irrecoverable debts X Sales returns Closing balance c/f

£ X X X X

Trade payables £ X Opening balance (b/f) X Credit purchases (incl VAT) X Refunds from suppliers X

£ X X X

INTERACTIVE QUESTION: TRADE PAYABLES A trade payables account contains the following entries: (a) (b) (c) (d)

Bank: £79,500 Credit purchases: £83,200 Contra with receivables account: £4,000 Balance c/d at 31 December 20X8: £12,920

There are no other entries in the account. What was the opening balance brought down at 1 January 20X8?

SOLUTION Trade payables £

£

Accounting

6 : Erro rs and correctio ns to accounting r ecords and financia l s tatem ent s

INTERACTIVE QUESTION: TRADE RECEIVABLES AND TRADE PAYABLES For Exports Co on 1 October 20X8 the receivables ledger balances were £7,967 debit, and the payables ledger balances on the same date were £6,235 credit and £105 debit. These balances agree with the nominal ledger.

For the year ended 30 September 20X9 the following particulars are available: Sales Purchases Cash from credit customers Cash paid to credit suppliers Irrecoverable debts Refunds from suppliers Settlement by contra

£62,514 £39,439 £55,212 £37,307 £326 £105 £434

What are the nominal ledger balances as at 30 September 20X9 for: (i) (ii)

Trade receivables Trade payables

SOLUTION Trade receivables £

£

Trade payables £

£

3 Bank reconciliations 3.1 The cash at bank account and the bank statement The “cash at bank” account needs to be regularly reconciled to the bank statement. Information relating to deposits and withdrawals shown on the bank statement will be used to update transactions in the cash at bank account.

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6 : Erro rs and correctio ns to accounti ng r ecords and f i nancial statements

As described in Chapter 3, in a computerised accounting system, a regular extract from the electronic banking system detailing all deposits and withdrawals can then be uploaded into the businesses accounting system. This “bank transaction report” will then automatically record the cash transaction in the correct nominal ledger accounts (using transaction codes and unique reference numbers).

Any transactions which cannot be matched are posted to a temporary account known as the suspense account and highlighted in an exception report.

Once investigated, correcting journals are required to record the transaction properly and clear the suspense account.

EXAM SMART BEWARE! The bank statement is a mirror image of the cash at bank account. 🞂

Money received is “credited” by the bank (debited by the business) as the bank now owes this money back to the business.

🞂

Money paid is “debited” by the bank (and credited by the business). Thus a bank overdraft is recorded by the bank as a “debit balance” representing the receivable to the bank from the business.

3.2 The bank reconciliation A regular reconciliation between the cash at bank account and the bank balance per the bank statement must be performed. Common explanations for differences are: Correction required to cash T account

Item included in bank reconciliation statement

Error

?

?

Unrecorded bank interest or charges

🗸

🗴

Automated payments and receipts

🗸

🗴

Dishonoured cheques

🗸

🗴

Timing differences (unpresented cheques and uncleared lodgements or electronic transfers that have not yet cleared)

🗴

🗸

Explanation

EXAM SMART In the exam, most questions relating to bank reconciliations will require you to calculate the correct cash figure for the financial statements by either: 🞂

Correcting the bank statement figure for timing differences or bank errors.

🞂

Correcting the cash at bank account for errors and omissions in the recording of cash transactions.

Accounting

6 : Erro rs and correctio ns to accounting r ecords and financia l s tatem ent s

INTERACTIVE QUESTION: BANK RECONCILIATION At his year end of 30 June 20X0, Cook's cash at bank account showed that he had an overdraft of £310 on his current account at the bank. A bank statement as at 30 June 20X0 showed that Cook has an overdraft of £70.

On checking the cash at bank account and the bank statement you find the following. (a)

Cheques sent to suppliers, amounting to £500, had been entered in the cash at bank account but had not yet been presented.

(b)

Electronic transfers received, amounting to £400, had been entered in the cash at bank account, but had not yet been credited by the bank.

(c)

Bank charges of £35 shown in the bank statement had not been entered in the cash at bank account

(d)

Dividends received of £225 had been paid directly into the bank and not entered in the cash at bank account.

(e)

An electronic payment for £50 from Sunil was recorded and banked on 24 June. This was returned unpaid on 30 June and then shown as a debit on the bank statement. No entry has been made in the cash at bank account for the dishonoured payment.

We need to make the appropriate adjustments in the cash at bank account, then prepare a statement reconciling the amended balance with that shown in the bank statement SOLUTION Cash at bank account £

£

Bank reconciliation as at 30 June 20X0 £ Balance per bank statement ADD

outstanding lodgement

LESS

unpresented cheques

Balance per corrected cash at bank account

£

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INTERACTIVE QUESTION: BANK RECONCILIATION A bank reconciliation statement is being prepared. Using the table select the effect of each of the following on the closing balance shown by the bank statement of £388 in hand. (The closing balance shown by the cash at bank account is £106 debit) Tick one box for each finding: SOLUTION Increase A

The bank has made a mistake in crediting the account with £110 belonging to another customer – an error not yet rectified.

B

£120 received by the bank under a standing order arrangement has not been entered into the cash at bank account

C

An electronic payment totalling £5,629 has been made to a supplier and entered in the cash at bank account but is not yet been presented on the bank transaction report.

D

Cash receipts from customers totalling £5,577 have been entered in the cash at bank account but not yet credited in the bank statements.

Decrease

No effect

INTERACTIVE QUESTION: BANK RECONCILIATION Tilfer's bank statement shows £715 direct debits and £353 investment income which were not automatically matched in the computerised accounting system and therefore not updated into the cash at bank account. The bank statement does not show a receipt from a customer for £875 entered in the cash at bank account on the last day of the reporting period. The cash at bank account has a credit balance of £610.

What balance appears on the bank statement?

SOLUTION Cash at bank account £

£

Accounting

6 : Erro rs and correctio ns to accounting r ecords and financia l s tatem ent s

Bank reconciliation £

£

Balance per bank statement ADD

outstanding lodgement

LESS

unpresented cheques

Balance per corrected cash at bank account

4 Types of error in accounting In a computerised accounting system, the total debit entries will always equal total credit entries as the system will not allow an imbalanced journal. This does not mean that the accounts are free from error and complete.

There are broadly five types of errors: Transposition errors

when two digits are accidentally recorded the wrong way around

Omission errors

failing to record a transaction at all

Errors of principle

an accounting entry that breaks the “rules” of an accounting principle or concept, eg incorrectly classifying capital vs revenue expenditure

Errors of commission

an accounting entry into the wrong account but of the correct nature, eg recording a telephone expense as an electricity expense

Compensating errors

errors which are, coincidentally, equal and opposite to each other

Once identified, all errors must be corrected. After the trial balance has been produced we often need to make a number of further adjustments (to correct for these errors and other “year-end” procedures).

This is done by way of adjustment journals before extracting a final trial balance.

5 Correcting errors To determine the required correcting journal, it is sometimes useful to use the following approach: Did

Should have

Correcting journal

Dr Cr

Dr Cr

Dr Cr

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Accounting

INTERACTIVE QUESTION: JOURNAL ENTRIES Write out the journal entries which would correct these errors. (a)

A business receives an invoice for £250 from a supplier which was omitted from its accounting records entirely.

(b)

Repairs worth £150 were incorrectly debited to the non-current asset (machinery) account instead of the repairs account.

(c)

The bookkeeper of a business reduces cash sales by £280 because he was not sure what the £280 represented. In fact, it was drawings.

(d)

Telephone expenses of £540 are incorrectly debited to the electricity account

SOLUTION Did

Should have

Correcting journal

(a)

(b)

(c)

(d)

5.1 Suspense accounts A suspense account is a temporary account used when the computerised accounting system or the bookkeeper is unsure how to record one side of a transaction.

Once the issue has been resolved and the correct account identified, the suspense account should be cleared using a correcting journal.

A suspense account may contain several unmatched transactions, all of which should be investigated and correcting entries made.

Suspense accounts should never appear in the final accounts.

EXAM SMART An exam question might give you a suspense account with a number of issues that require correction to clear the suspense account.

You may also be asked to recalculate the business’ profit once the corrections have been made.

Accounting

6 : Erro rs and correctio ns to accounting r ecords and financia l s tatem ent s

WORKED EXAMPLE: SUSPENSE ACCOUNTS An amount of £1,000 was credited to the bank statement in the year and automatically entered into the cash at bank account by the computerised accounting system, but it could not match the amount to a known transaction and a credit entry was made to the suspense account. On investigation it was discovered that the amount was a part payment from a credit customer.

A non-current asset was purchased on credit just before the year end for £5,400. The was correctly entered in the non-current asset account but the bookkeeper was unsure about the credit entry and hence posted it, temporarily, to the suspense account.

Requirements Prepare journal entries to correct each of the above errors. Narratives are not required.

SOLUTION Did

Should have

Correcting journal

Dr Cash at bank £1,000 Cr Suspense account £1,000

Dr Cash at bank £1,000 Cr Trade receivables £1,000

Dr Suspense account £1,000 Cr Trade receivables £1,000

Dr Non-current asset £5,400 Cr Suspense account £5,400

Dr Non-current asset £5,400 Cr Trade payables £5,400

Dr Suspense account £5,400 Cr Trade payables £5,400

INTERACTIVE QUESTION: ERRORS At T Down & Co year end, the initial trial balance was extracted before discovering it contained the following errors. (a)

A sale of goods on credit for £1,000 has not been recorded.

(b)

Delivery and installation costs of £240 (which are allowed to be included as part of the cost of a non-current asset – see chapter 10) on a new item of plant had been recorded as distribution costs.

(c)

On recording a purchase invoice from JW of £1,500, T Down & Co did not expect to take the early settlement discount of £150 and thus recorded the full amount of £1,500 as a payable. As expected, T Down paid after the early settlement period had expired but incorrectly assumed the discount was valid, and recorded the payment of £1,350 as such. JW is correctly insisting that £150 is still payable.

(d)

A raw materials purchase of £350 had been recorded as £850.

Requirements (i)

Prepare journal entries to correct each of the above errors. Narratives are not required.

(ii)

Before the errors were corrected, T Down & Co's gross profit was calculated at £35,750 and the net profit for the year at £18,500. Calculate the revised gross and net profit figures after correction of the errors.

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SOLUTION

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you correctly calculate the balancing figure for trade receivables or trade payables including more complex issues such as discounts, returns, contras or refunds?

In a bank reconciliation, can you identify which items affect the bank statement and which are adjusted in the cash at bank account?

Can you distinguish and name different types of errors?

Can you correctly identify the correcting journal for a given error?

Do you understand the purpose of a suspense account and understand where it appears in the financial statements?

Can you calculate an adjusted profit figure after the correction of errors?

Yes/No

65

7 Cost of sales and inventories

Topic List 1

IAS 2 Inventories

2

Cost of sales

3

Accounting for opening and closing inventories

4

Inventories on the trial balance

5

Counting inventories

6

Valuing inventories

7

Using margins and mark ups to establish cost

8

Writing off inventories and inventory drawings

Learning Objectives 🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Identify the main components of a set of financial statements and specify their purpose and interrelationship

🞂

Prepare and present a statement of financial position, statement of profit or loss and statement of cash flows (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity

66 7 : Co st of sales and inventories

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1 IAS 2, Inventories Inventories are current assets that are held for sale in the ordinary course of business. They can include: 🞂 🞂 🞂 🞂

Goods purchased and held for resale Finished goods Work in progress Raw materials

IAS 2 prescribes the accounting treatment for inventories, in particular the valuation at the reporting date.

2 Cost of sales Cost of sales is a key figure in the profit or loss, and you must know how it is calculated.

Extract from statement of profit or loss Revenue Cost of sales

£ 20,000 (17,000)

Gross profit

3,000

Cost of sales Opening inventories

£ 3,000

+ purchases + carriage inwards (delivery) Less closing inventories

20,000 2,000 (8,000)

Cost of sales

17,000

This calculation demonstrates the fundamental accounting concept of accruals (or matching) as the revenue for a period is matched to only the cost of the goods sold.

WORKED EXAMPLE: CLOSING INVENTORIES The Umbrella Shop's year end is 30 September. On 1 October 20X4 it had no opening inventory. During the year it purchased 30,000 umbrellas costing £60,000. It resold the umbrellas for £5 each, and sales for the year amounted to £100,000 (20,000 umbrellas). At 30 September 20X5 there were 10,000 umbrellas left in inventory, valued at cost of £2 each.

What was The Umbrella Shop's gross profit for the year?

SOLUTION If we were to simply use the sales and purchases figures we would calculate profit as: Statement of profit or loss Revenue

20,000 units

£ 100,000

Purchases

30,000 units

(60,000)

Gross profit

40,000

🗴

Clearly we have not matched the revenue from 20,000 umbrellas with the cost of those 20,000 umbrellas.

Accounting

7 : Co st of sales and i nve nt ories

Statement of profit or loss Revenue

20,000 units

£ 100,000

Cost of sales

20,000 units

(40,000)

Gross profit

Cost of sales Opening inventories + purchases Less closing inventories Cost of sales

60,000

🗸

Revenue and cost of sales now both relate to the 20,000 umbrellas.

£ 0 units 30,000 units 10,000 units

0 60,000 (20,000) 40,000

WORKED EXAMPLE: OPENING AND CLOSING INVENTORIES In its next reporting period, 1 October 20X5 to 30 September 20X6, The Umbrella Shop purchased 40,000 umbrellas at a total cost of £95,000, and sold 45,000 umbrellas for £230,000. At 30 September 20X6 it had (10,000 + 40,000 – 45,000) = 5,000 umbrellas left in inventory, which together had cost £12,000.

What was The Umbrella Shop's gross profit for the second period?

SOLUTION Umbrellas profit or loss (year 2) Revenue (45,000 units) Cost of sales (45,000 units)

£ 230,000 (103,000)

Gross profit

127,000

Cost of sales Opening inventories + purchases Less closing inventories Cost of sales

10,000 units 40,000 units 5,000 units 45,000 units

£ 20,000 95,000 (12,000) 103,000

INTERACTIVE QUESTION: GROSS PROFIT On 1 January 20X6, Grand Union Food Stores had goods in inventory valued at £6,000. During 20X6 its owner purchased supplies costing £50,000. Sales for the year to 31 December 20X6 amounted to £80,000. The cost of goods in inventory at 31 December 20X6 was £12,500.

Calculate the business’s gross profit for the year

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SOLUTION

2.1 Carriage inwards and carriage outwards Delivery costs to receive goods from suppliers (carriage inwards) is added to the cost of purchases (and therefore cost of sales) in the statement of profit or loss.

Delivery costs to distribute goods to customers (carriage outwards) is treated as an “expense” (usually distribution costs) below the gross profit line.

INTERACTIVE QUESTION: CARRIAGE INWARDS AND OUTWARDS Gwyn Tring imports and resells clocks. He pays for the costs of delivering the clocks from his supplier.

He resells clocks to other traders paying carriage costs for deliveries from his business premises to his customers.

On 1 July 20X5, he had clocks in inventory valued at £17,000. During the year to 30 June 20X6 he purchased more clocks for £75,000. Carriage inwards amounted to £2,000. Sales for the year were £162,100. Other business expenses amounted to £56,000, excluding carriage outwards which cost £2,500. The value of clocks in inventory at the year end was £15,400.

Prepare the statement of profit or loss for Gwyn Tring for the year ended 30 June 20X6 SOLUTION Statement of profit or loss for year ended 30 June 20X6 Revenue Cost of sales Gross profit Carriage outwards Other expenses Net profit (w) Cost of sales Opening inventories Purchases Carriage inwards Less closing inventories Cost of sales

£

Accounting

7 : Co st of sales and i nve nt ories

2.2 Service organisations Many businesses (for example, accountants) sell services to customers, rather than products.

Cost of sales for this type of business may include: 🞂 🞂 🞂

Direct labour costs: the cost of any labour directly related to the service provided.

Sales commission: where a business pays its employees a commission for securing work Materials used: e.g. printing costs (for a design company)

WORKED EXAMPLE: SERVICE RELATED COST OF SALES Skills Ltd provides workplace training for the employees of businesses operating in the hospitality sector. Skills Ltd operates from a single office location on which monthly rental payments are made.

Training is always carried out remotely and the office is not used to deliver training. Skills Ltd has a receptionist and a number of sales agents who are each paid an annual salary. The sales agents are paid commission for every new contract they secure. Skills Ltd uses freelance experts who are paid a flat rate per day to design and run the training courses required by its clients. Some clients request that a hard copy of learning materials is printed by Skills Ltd and delivered to them in advance of the course.

Explain whether the costs incurred by Skills Ltd can be included in its cost of sales.

SOLUTION Cost

Included?

Explanation

Office rental

No

The office rental costs are not direct costs incurred in providing the service as the office is not used to provide training.

Receptionist staff salary

No

The receptionist’s salary is not a direct labour cost incurred in providing the service as the salary is paid regardless of whether the service is undertaken.

Sales agent salaries

No

The sales agent salaries are not direct labour costs incurred in providing the service.

Sales agent commission

Yes

The commission is only paid when a new contract is secured and is therefore incremental to the contract.

Freelance expert fees

Yes

Freelance experts are appointed to design and deliver courses as required by clients and are therefore incremental to the contract.

Printing and delivery of hard copy learning materials

Yes

The costs of printing and delivering the hard copy materials are direct materials costs and should be included in cost of sales.

Note: Costs which cannot be presented in cost of sales are included in other expense categories in the statement of profit or loss. Administrative expenses are often used.

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INTERACTIVE QUESTION: DIRECT LABOUR COSTS ABC Accountants offers accounting and tax services to its clients. ABC Accountants is preparing its financial statements for the year end 31 August 20X5 and provides services to its clients which span its year-end. The following information is relevant to the preparation of the financial statements and tax return for a client engagement which spans ABC Accountants’ year end. ABC Accountants bills its clients on completion of the contract.

Staff member Partner Manager Student Accountant Tax Manager

Hourly cost £200 £140 £80 £160

Budgeted hours 4 8 20 4

Hours incurred 1 2 14 0

Calculate the amount that should be included in ABC Accountants’ work in progress at 31 August 20X5.

SOLUTION Staff member Partner Manager Student Accountant Total

Hourly cost £ 200 140 80

Hours incurred

Labour cost £

3 Accounting for opening and closing inventories In the statement of profit or loss, cost of sales is matched to revenue to calculate gross profit.

Cost of sales

£

Opening inventories + purchases Less closing inventories

X X (X)

Cost of sales

X

This figure will also appear as the current asset ‘Inventories’ in the statement of financial position.

Quick reminder: When a business purchases goods (inventories) during the year the double entry is: Dr

Purchase expenses Cr Trade payables / cash

Inventory does not form part of the double entries during day to day business. In fact, there are only ever two journals that you will ever need for inventories as follows:

KEY JOURNALS 🞂

Account for year end closing inventories as follows

Dr

Inventories (current asset) account Cr Cost of sales expense

🞂

Reverse out opening inventories as follows

Dr

Cost of sales expense £ opening inventories Cr Inventories (current asset) account £ opening inventories

£ closing inventories £ closing inventories

These two journals will result in the correct calculation for cost of sales as seen above.

Accounting

7 : Co st of sales and i nve nt ories

4 Inventories on the trial balance The inventory journals can be dealt with very simply through the trial balance. Assuming that no double entries have been posted to inventory since the prior year “closing inventories” journal, then any figure for ‘Inventories’ in the initial trial balance should represent opening inventories for the year.

Opening inventories and purchases should be transferred to a “Cost of Sales” expenses line.

Dr

Cost of sales Cr Purchases/Opening inventories from initial trial balance

We then need only to post the above journal for closing inventories.

WORKED EXAMPLE: INVENTORIES ON THE TRIAL BALANCE Sam’s Music Shop trial balance as at 31.12.X5 is as follows.

Dr £

Cash at bank Opening capital Loan Non-current assets Trade payables Expenses Purchases Sales Trade receivables Inventories at 1.1.X5 Drawings

Cr £ 5,123 10,000 12,000

20,000 6,800 12,785 18,425 38,745 3,546 8,754 9,158 72,668

72,668

Closing inventories at 31 December 20X5 cost £13,855.

Complete Sam’s final trial balance and calculate his net profit for the year.

SOLUTION Initial trial Balance Dr £ Cash Opening capital

Cr £

Adjustments Dr £

Cr £

Final trial balance Dr £

5,123 10,000

5,123 10,000

Loan Non current assets Trade payables

20,000

12,000

12,000

Expenses

12,785

Purchases Sales

18,425

Trade receivables Inventories

3,546 8,754

3,546

Drawings

9,158

9,158

20,000 6,800

6,800 12,785

38,745

Cost of sales 72,668

Cr £

72,668

38,745

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Accounting

Sam’s Music Shop: Statement of profit or loss for the year ended 31 December 20X5 £ Revenue Cost of sales Opening inventories Purchases Closing inventories Cost of sales Gross profit Expenses Net profit

£ 38,745

8,754 18,425 (13,855) (13,324) 25,421 (12,785) 12,636

Sam’s Music Shop: Statement of financial position as at 31 December 20X5 £ Non-current assets Current assets Inventories Trade receivables

13,855 3,546 17,401 37,401

Total assets CAPITAL AND LIABILITIES Opening capital Profit for year Drawings Closing capital

10,000 12,636 (9,158) 13,478

Non-current liabilities Bank loan Current liabilities Trade payables Bank overdraft

£ 20,000

12,000

6,800 5,123 11,923

Total capital and liabilities

37,401

5 Counting inventories For most business’, the quantity of inventories held at year end is simply determined by an inventory count (or “stock-take”) on the last day of the reporting period. For practical reasons businesses should ensure there are no deliveries of goods inwards or outwards on this day.

For companies with large inventory levels, it may not be possible to count the entire stock on one day (or even a week), so instead a process of continuous inventory records can be used, whereby a record is kept of all receipts and issues of each type of goods, with running totals of current inventory levels.

Throughout the year these records are continuously checked against actual stock levels to ensure they up accurate so that each product line has been checked against actual stock at least once during the year.

Accounting

7 : Co st of sales and i nve nt ories

6 Valuing inventories A more examinable issue is how to value the inventories once they have been counted. The golden rule here is that inventories should be valued as follows:

KEY TERMS Inventories must be valued at the lower of cost and net realisable value (NRV).

Cost Cost is the historic cost of purchasing the goods or the costs to date of manufacturing them. It includes purchase price, delivery, import taxes and duties, and any conversion costs to bring it to its present location and condition.

Net realisable value Net realisable value is the expected selling price, less any further direct costs before sale (cost to complete, modification costs, selling and distribution expenses).

WORKED EXAMPLE: LOWER OF COST AND NET REALISABLE VALUE A trader buys two items of inventory, each costing £100. He can sell them for £140 each. He has only sold one of them. The other is closing inventory. £ Revenue Opening inventories Purchases Less closing inventories

£ 140

0 200 (100) (100) 40

Gross profit

Being the £40 profit on the one items sold.

Suppose that it costs £5 to get the item ready for sale and selling it. The market slumps and the expected selling price is £90. The item's NRV is then £(90 – 5) = £85 and the business will make a loss of £15 (£100 – £85) on the item. The loss will be recognised by valuing the item in the statement of financial position at its NRV of £85. £ Revenue Opening inventories Purchases Less closing inventories

£ 140

0 200 (85) (115)

Gross profit

25

Being the £40 profit on the one items sold, and £15 loss on the unsold item

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6.1 Applying the lower of cost and NRV rule The comparison of cost and NRV should be carried out for each line item separately. It is not sufficient to compare the total cost of all inventory items with their total NRV. Consider a company has four inventory items with the following cost and NRVs: Item 1 2 3 4

Cost £ 27 14 43 29 113

It would be incorrect to just compare the totals and show closing inventories as £113

NRV £ 32 8 55 40 135

Lower of cost / NRV 27 8 43 29 107

The lower of cost and NRV rule must be applied to each line to get the correct closing inventories of £107.

INTERACTIVE QUESTION: INVENTORY VALUATION The following figures relate to inventory held at the end of the reporting period.

Cost Selling price Modification cost to enable sale Marketing costs

Item A £20 £30 – £7

Item B £9 £12 £2 £2

Item C £14 £22 £8 £2

Units held

200

150

300

Calculate the value of inventory for inclusion in the financial statements.

SOLUTION

Accounting

7 : Co st of sales and i nve nt ories

6.2 Determining cost of inventories Inventories can be Raw materials

Cost = purchase price including import duties, transport, handling and non-recoverable VAT.

Part completed items (work in progress)

Cost = cost of purchase plus conversion costs (eg labour, production overheads) and other costs to bring it to its present location and condition.

Finished goods

6.3 Costing methods If a company has a large volume of identical items purchased at different prices (eg nuts and bolts) a method needs to be used to assign a cost to the units sold. 🞂

FIFO: first in first out. Older items are sold first so closing inventories are the newer items

🞂

LIFO: last in first out. Sales are made from the most recent deliveries, leaving older items remaining in closing inventories. This assumption is disallowed under IFRS Standards.

🞂

AVCO: average cost. As each delivery is received a new “average” cost is calculated for the total inventories held. The average is used to value items sold and any remaining inventories.

EXAM SMART In the exam you can expect to use FIFO or AVCO for the valuation of inventory.

WORKED EXAMPLE: FIFO AND AVERAGE COST Consider the following transactions during May 20X7:

Opening balance: 1 May Purchases: 3 May Sales: 4 May Purchases: 9 May Sales: 11 May Purchases: 18 May Sales: 20 May Closing balance

Quantity (units) 100 400 (200) 300 (400) 100 (100) 200

Unit cost £ 2.00 2.10

Total cost £ 200 840

2.12

636

2.40

240

total purchases £1,716

What is the value of cost of sales for May and the closing inventories under FIFO and AVCO.

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Accounting

SOLUTION First in first out (FIFO) Date

Units

Unit cost £ £2.00 £2.10

Opening inventories 3 May Purchases 4 May Sales

100 400 (200)

9 May Purchases 11 May Sales

300 (400)

£2.12

18 May Purchases 20 May Sales Closing inventory

100 (100) 200

£2.40

Being 100@

£2.12

100@

£2.40

Cost of sales £

100 @ 100@

£2.00 £2.10

200 210

300@ 100@

£2.10 £2.12

630 212

100@

£2.12

212 £1,464

£452

Check: Cost of sales Opening inventories + purchases Less closing inventories Cost of sales

£ 200 1,716 (452) 1,464

Weighted average cost (AVCO) Date Opening inventories 3 May Purchases 4 May Sales 9 May Purchases 11 May Sales 18 May Purchases 20 May Sales Closing inventory

Units 100 400 500 (200) 300 600 (400) 100 300 (100) 200

Check: Cost of sales Opening inventories + purchases Less closing inventories Cost of sales

£ 200 1,716 (440) 1,476

Total inventory value £200 £840 £1,040 (£416) £636 £1,260 (£840) 240 £660 (£220) £440

Unit cost £2.00

Cost of sales

£2.08 £2.08

£416

£2.10 £2.10

£840

£2.20 £2.20

£220 £1,476

Accounting

7 : Co st of sales and i nve nt ories

6.4 Inventory valuations and profit In the above example, where supplier prices were rising, we can see that FIFO produced a higher closing inventory and lower cost of sales (and therefore higher profit) than AVCO. 🞂

Prices rising: FIFO Profit > AVCO Profit FIFO Closing inventories > AVCO closing inventories

🞂

Prices falling: FIFO Profit < AVCO Profit FIFO Closing inventories < AVCO closing inventories

7 Using margins and mark ups to establish cost It is common to establish standard gross profit percentages in relation to cost to set the selling price.

Remember: 🞂 🞂

Mark-up is calculated on cost Margin is calculated on sales

WORKED EXAMPLE: MARGINS AND MARK UPS For example, if a unit cost £120, what would be the selling price and profit per unit assuming: (a) (b)

a margin of 40% a mark up of 40%.

SOLUTION Margin of 40%

Mark-up of 40%

%

£

%

£

Sales

100

200

140

168

Cost of sales

(60)

(120)

(100)

(120)

Gross profit

40

80

40

48

🞂 🞂

If using a “margin on sales” the sales figure should be 100% If using a “mark-up on cost” the cost of sales figure should be 100%

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Accounting

INTERACTIVE QUESTION: MARK UP A business has valued its inventory at £1,000, being the selling price of the items.

What is the cost of closing inventory at cost assuming the business operates: (a) (b)

on a margin of 25%? on a mark-up of 25%?

SOLUTION

8 Writing off inventories and inventory drawings If inventory is correctly valued at the lower of cost and NRV, no further inventory “write-down” journal entries are needed.

In the rare situation where a material amount of inventory has been stolen or destroyed then then the usual treatment of inventories would unfairly distorted view of the entities gross profitability.

To overcome this, the cost of the goods stolen or destroyed is removed from purchases and shown in other expenses below the gross profit line.

Dr

Other expenses Cr Purchases

£x £x

Any insurance the entity has against the loss is recorded as: Dr

Cash/Receivables Cr Other income

£x £x

8.1 Inventory drawings If an owner takes items of inventory from the business as drawings, we do not need to adjust opening or closing inventory at all. Instead we reduce the purchases figure in cost of sales with the cost of items withdrawn.

Dr

Drawings Cr Purchases

£ cost of items £ cost of items (don’t be tempted to credit inventories)

Accounting

7 : Co st of sales and i nve nt ories

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you state the calculation for cost of sales, including the correct treatment of carriage inwards and outwards?

Can you state the year end journal for closing inventory?

Can you quote the rule for valuation of inventories?

Can you correctly calculate the cost and net realisable value for a line of inventory?

Can you correctly calculate the cost of closing inventory assuming either a FIFO or weighted average approach?

Do you feel confident applying a margin or a mark up to calculate the profit, cost or sales value of an item of inventory?

Yes/No

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81

8 Irrecoverable debts and allowances

Topic List 1

Irrecoverable debts

2

Allowances for receivables

3

Summary of key journals

Learning Objectives 🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Identify the main components of a set of financial statements and specify their purpose and interrelationship

🞂

Prepare and present a statement of financial position, statement of profit or loss and statement of cash flows (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity

82 8 : I rrecoverable debts and al lowances

Accounting

1 Irrecoverable debts Irrecoverable debts are receivables that are not expected to be paid. They are therefore “written off”, that is, cancelled in the trade receivables ledger and charged against the profit or loss for the period.

KEY JOURNAL Dr Irrecoverable debt expense (often included as part of administrative expenses) Cr Trade receivables The trade receivable must also be removed from the personal/memorandum ledgers since the business does not want to bother to chase the amount.

INTERACTIVE QUESTION: IRRECOVERABLE DEBTS WRITTEN OFF At 1 October 20X5 a business had total outstanding debts due from customers of £8,600. During the 12 month reporting period to 30 September 20X6 the following transactions took place. 🞂

Credit sales £44,000.

🞂

Receipts from customers £49,000.

🞂

Two debts, for £180 and £420, were declared irrecoverable and the customers are no longer purchasing goods from the company. These are to be written off.

Prepare the trade receivables and irrecoverable debts expense account for the reporting period SOLUTION

In the rare situation that an irrecoverable debt subsequently paid, the double entry is:

KEY JOURNAL Dr Cash Cr Irrecoverable debt expense

Accounting

8 : I rrecovera bl e debts and al lowances

2 Allowance for receivables If there is some doubt over a customer’s ability to pay, but the business still wishes to chase the debt, then a separate allowance can be made for these “doubtful receivables”.

In practice, a business will often use past experience regarding levels of irrecoverable debts to estimate the probability of non-payment from the receivables as a whole. This allowance for receivables represents the total potential amounts that may not be recovered from customers.

EXAM SMART In the exam you will be required to calculate the required allowance for receivables based on a probability of non-payment which is applied to trade receivables AFTER any irrecoverable debts have been written off.

KEY JOURNAL Dr Irrecoverable debt expense Cr Allowance for receivables Note that we have not credited trade receivables directly, but this allowance will be offset against receivables in our final financial statements.

This allowance may subsequently need to be adjusted for changes in our estimate of the level of doubtful debts.

INCREASE in allowance

Dr

Irrecoverable debt expense Cr Allowance for receivables

£ the required increase £ the required increase

DECREASE in allowance

Dr

Allowance for receivables £ the required decrease Cr Irrecoverable debt expense £ the required decrease

WORKED EXAMPLE: ALLOWANCE FOR RECEIVABLES A business commences operations on 1 July 20X4, and in the twelve months to 30 June 20X5 makes credit sales of £300,000 and writes off irrecoverable debts of £6,000. Cash received from customers during the reporting period is £244,000.

Brought forward Credit sales

Trade receivables £ nil Irrecoverable debts 300,000 Cash received c/f (balancing figure) 300,000

£ 6,000 244,000 50,000 300,000

Of these outstanding debts it is estimated that an allowance of 10% is required to reflect the risk of non-payment of debts.

Dr

Irrecoverable debts expense Cr Allowance for receivables

£5,000 £5,000

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84 8 : I rrecoverable debts and al lowances

Accounting

In the statement of financial position, the value of trade receivables (after the debt write-off, ie £50,000) must be shown with the allowance for receivables netted off £

Trade receivables at 30 June 20X5 Less allowance for receivables Amount to be shown in the statement of financial position (net)

50,000 (5,000) 45,000

INTERACTIVE QUESTION: ACCOUNTING ENTRIES FOR ALLOWANCE FOR RECEIVABLES Alex Gullible has total receivables outstanding at 31 December 20X2 of £28,000. He believes there is a chance that 1% of these balances may not be collected and wishes to make an appropriate allowance.

Before now, he has not made any allowance for receivables at all.

Next year, on 31 December 20X3, his trade receivables are £40,000. He believes an allowance of 5% needs to be made against the receivables ledger.

What accounting entries should Alex make on 31 December 20X2 and 31 December 20X3, and what figures for trade receivables will appear in his statements of financial position as at those dates?

SOLUTION

EXAM SMART Many exam questions will be looking for the irrecoverable debt expense in the statement of profit or loss.

This can be quickly found with the following: (1)

Irrecoverable debts written off in period

£ x

Dr

(2)

Increase/(decrease) in allowance

x/(x)

Dr/(Cr)

(3)

Old irrecoverable debts that pay in the period

(x)

Cr

Overall expense (Dr) or other income (Cr)

x/(x)

Accounting

8 : I rrecovera bl e debts and al lowances

INTERACTIVE QUESTION: CALCULATING THE IRRECOVERABLE DEBT EXPENSE During 2015 Helena plc received £50 from a customer in respect of a balance that had previously been written off in 2013. At the 31 December 2015, Helena has calculated the required allowance for receivables to be £400. The allowance as at 1 January 2015 was £600.

At the year end the bank notified Helena of the dishonour of a cheque received for £350. Helena has not yet accounted for this but has decided that the debt related to it should be written off.

What is the irrecoverable debts debit or credit in the statement of profit or loss for the year ended 31 December 2015?

A

£500 debit

B

£700 debit

C

£100 credit

D

£100 debit

INTERACTIVE QUESTION: CALCULATING THE IRRECOVERABLE DEBT EXPENSE AND TRADE RECEIVABLES At 31 March 2015 Jane's receivables totalled £30,000. In April 2015 Jane received notification of the liquidation of a customer and it was decided to write off amounts totalling £1,800 at the year end.

Jane wishes to adjust the allowance to 2% of the remaining receivables. An allowance for receivables of £500 had been brought forward from the year ended 31 March 2014.

What is the irrecoverable debts expense and the amount that should appear in the statement of financial position as trade receivables in Jane’s financial statements?

SOLUTION Expense

Trade receivables

A

£1,736

£28,200

B

£1,736

£27,636

C

£1,864

£27,636

D

£1,864

£28,136

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Accounting

3 Summary of key journals Event

Journal

Irrecoverable debt written off

Dr

Cash received from amount previously written off as irrecoverable Increase in allowance

Decrease in allowance

Dr

Dr

Dr

Irrecoverable debt expense Cr Trade receivables

£x

Cash Cr Irrecoverable debt expense

£x

Irrecoverable debt expense Cr Allowance

£x

Allowance Cr Irrecoverable debt expense

£x

£x

£x

£x

£x

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you correctly calculate the irrecoverable debt expense in the statement of profit or loss?

Can you correctly calculate the year end net receivables asset in the statement of financial position?

Are you confident with the key journals, being the write off of an irrecoverable debt, the movement in the allowance for receivables and the receipt of cash from a customer previously written off as irrecoverable?

Yes/No

87

9 Accruals and prepayments

Topic List 1

The principle behind accruals and prepayments

2

Accruals

3

Prepayments

4

Accounting for accruals and prepayments

5

The accrual principle and income

Learning Objectives 🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Identify the main components of a set of financial statements and specify their purpose and interrelationship

🞂

Prepare and present a statement of financial position, statement of profit or loss and statement of cash flows (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity

88

Accounting

9: Accruals and prepayments

1 The principle behind accruals and prepayments We have seen that revenue must be matched to cost of sales. The accruals principle also requires that expenses are matched to the period to which they relate, not when they were paid.

WORKED EXAMPLE: ACCRUALS PRINCIPLE A business rents a shop for £20,000 per annum and pays the full annual rent on 1 April each year.

If we calculate the profit of the business for six months to 30 June 20X7, the correct charge for rent in the profit or loss is £10,000, even though the rent paid is £20,000 in that period. Similarly, the rent charge in the profit or loss for the second six months of 20X7 is £10,000, even though no rent is actually paid in that period.

We use the accrual principle to match the expense to the relevant time period. This creates accruals and prepayments in the statement of financial position.

ACCRUALS

PREPAYMENTS

A liability for expenses to be charged against a particular period even though they have not been paid for. eg outstanding phone bill as at 31.12.X1

As asset relating to expenses that have been paid in one period but are not charged to the profit or loss until a later period to which they relate.

Dr Expense (profit or loss) Cr Accruals (a liability in SOFP)

eg rent paid for in advance (as in example above) Dr Prepayments (an asset in the SOFP) Cr Expense (profit or loss)

WORKED EXAMPLE: ACCRUALS Goodrunning started in business on the 1 March 20X6 and his reporting period ends on 28 February each year. His telephone was installed immediately on 1 March and the first telephone bill was for the four months to 30 June 20X6. Thereafter, he pays quarterly at the end of each quarter. Calculate the telephone expense to be charged to the statement of profit or loss for the year ended 28 February 20X7.

Telephone bills received: 4 months ended 30.6.20X6 Quarter ended 30.9.20X6 Quarter ended 31.12.20X6 Quarter ended 31.3.20X7

£ 23.50 27.20 33.40 36.00

All the bills were paid on the final day of period.

SOLUTION Mar

Apr

£23.50

May

Jun

Jul

Aug

£27.20

Sep

Oct

Nov

£33.40

Dec

Jan

Feb

£36. 00

Accounting

9: Accruals and prepayments

Telephone expenses for the year ended 28 February 20X7 are as follows: 1 March – 30 June 20X6 1 July – 30 September 20X6 1 October – 31 December 20X6 1 January – 28 February 20X7 (two months: £36 × 2/3)* Total telephone expense

£ 23.50 27.20 33.40 24.00 108.10

* The charge for the period 1 January – 28 February 20X7 is two thirds of the bill received on 31 March. As this is an expense incurred by the year end, for which no bill has been received, it will need to be accrued.

The accrual will also appear in the statement of financial position of the business as at 28 February 20X7, as a current liability. The journal to set this up is as follows: Dr

Telephone expense Cr Accrual (current liability)

£24 £24

INTERACTIVE QUESTION: ACCRUALS Cleverley started in business on 1 January 20X2, preparing financial statements to 31 December 20X2.

He is not registered for VAT. Electricity bills received were as follows.

20X2 £ 31 January 30 April 31 July 31 October

20X3 £ 491.53

279.47 663.80 117.28 1,060.55

What should the electricity charge be for the year ended 31 December 20X2? Prepare a journal to record the accrual or prepayment as at 31 December 20X2.

SOLUTION

89

90

Accounting

9: Accruals and prepayments

2 Prepayments WORKED EXAMPLE: PREPAYMENT A business opens on 1 January 20X4 in a shop where the rent is £20,000 per year, but an initial payment for 18 months (£30,000) is required to be paid in advance.

What will the rental charge be for the year ended 31 December 20X4?

SOLUTION The total amount paid in the year is £30,000. The yearly rental, however, is only £20,000. The £10,000 is a payment in advance for the first six months of 20X5 (i.e. the next financial year). The charge for 20X4 is therefore: Paid in year Prepayment Rent expense

£30,000 (£10,000) 20,000

The double entry for this prepayment is: Dr

Prepayments (current asset) Cr Rent expense

£10,000 £10,000

3 Accounting for accruals and prepayments We have seen the required double entries for accounting for accrued and prepaid expenses at the year end.

These must then be reversed by an opening journal in the new period to ensure the expenses are correctly matched to the appropriate reporting period.

As such the 3 step approach is as follows:

STEPS Step 1: Reverse opening accruals and prepayments Step 2: Post cash payments to the relevant expense ledger Step 3: Calculate and post closing accruals and prepayments ACCRUALS

PREPAYMENTS

Reverse opening accrual

Reverse opening prepayment

Dr Accruals (SOFP) Cr Expense (profit or loss)

Dr Expense (profit or loss) Cr Prepayment (SOFP)

Post closing accrual

Post closing prepayment

Dr Expense (profit or loss) Cr Accruals (SOFP)

Dr Prepayments (SOFP) Cr Expense (profit or loss)

Accounting

9: Accruals and prepayments

INTERACTIVE QUESTION: REVERSING ACCRUALS Continuing with Cleverly, prepare the ledger accounts for 20X3 20X2 £ 31 January 30 April 31 July 31 October Total invoices received during year

279.47 663.80 117.28

20X3 £ 491.53 400.93 700.94 620.00

20X4 £ 753.24 192.82 706.20 156.40

1,060.55

2,213.40

1808.66

What should the electricity charge be for the year ended 31 December 20X3? Prepare a journal to record the accrual or prepayment as at 31 December 20X3. (Remember that the accrual for the year ended 31.12.X2 worked out previously was £327.69).

SOLUTION Accruals (SOFP) £ b/f opening accrual

Electricity ex pense – 20X3 £

£ 327.69

£

WORKED EXAMPLE: REVERSING PREPAYMENTS Continuing with the previous rent example and assuming a cash payments are £22,000 is made on 1 July 20X5 for the year ended 30 June 20X6.

What should the rent charge be for the year ended 31 December 20X5? Prepare a journal to record the accrual or prepayment as at 31 December 20X5.

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SOLUTION Prepayment (SOFP) £ 10,000

b/f opening prepayment

Rent expense – 20X5 £

£

£

WORKED EXAMPLE: PREPAYMENTS The Square Wheels Garage pays fire insurance annually in advance on 1 June each year. The firm's reporting period is the year ended 28 February. From the following record of insurance payments you are required to calculate the insurance charge to the profit or loss for the 12 month reporting period ended 28 February 20X8.

Insurance paid 1.6.20X6 1.6.20X7

£600 £700

SOLUTION 3 months, 1 March – 31 May 20X7 (3/12 × £600) (opening prepayment) 9 months, 1 June 20X7 – 28 February 20X8 (9/12 × £700) Insurance cost for the year to 28 February 20X8, to the profit or loss At the year end there will be a prepayment (current asset) of £175 (3/12 × £700)

EXAM SMART Questions that give information regarding opening or closing accruals or prepayments are usually best tackled using ledger (T) accounts and the 3 step approach.

If there is no information on opening or closing balances, a simple timeline and logic is often quicker.

£ 150 525 675

Accounting

9: Accruals and prepayments

INTERACTIVE QUESTION: ADMINISTRATIVE EXPENSES The computerised accounting system of Xbat has recorded various administrative expenses purchased on credit totalling £10,500 during 20X2. The transaction report from the bank has also highlighted £250 of administrative costs paid directly from its bank account. At 31 December 20X2 the business estimates that the year-end accrual should be £100 less than the accrual brought forward, and the prepayment should be £150 less.

What is the total cost of administrative expenses in the year ended 31 December 20X2?

SOLUTION

4 The accruals principle and income The accruals principle also applies to the recognition of income.

Accrued Income

Deferred Income

Receipt of income is in arrears at the year and (income is outstanding)

Income has been received in advance of delivering the goods or services

Dr Accrued income (an asset in the SoFP) Cr Revenue/other income

Dr Revenue/other income Cr Deferred income (a liability in the SoFP)

The steps as the same as for expenses, namely:

STEPS Step 1: Reverse opening accrued or deferred income Step 2: Post cash received in the normal way Step 3: Calculate and post the closing accrued or deferred income This idea commonly examined in relation to rental incomes and subscription income, for which it is useful to use a “Subscriptions/Rent receivables” account (similar to a trade receivables account)

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The terminology can be confusing as rents/subscriptions paid in advance are a liability to the business (deferred income). Rents/subscriptions in arrears are an asset to the company (accrued income).

Opening arrears (accrued income) Annual income Closing advances (deferred income)

Rent receivable account £ Opening advances (deferred income) X Cash received in year X Closing arrears (accrued income) X

£ X X X

INTERACTIVE QUESTION: ACCRUED INCOME Simon Ltd owns a number of properties which are rented to tenants. The following information is available for the year ended 30 June 2015:

30 June 2014 30 June 2015

Deferred income £ 730 650

Accrued income £ 2,450 3,200

Cash received from tenants in the year ended 30 June 2015 was £55,220.

What figure should appear in Simon’s statement of profit or loss for rent receivable in the year ended 30 June 2015?

A

£54,390

B

£56,450

C

£55,250

D

£56,050

SOLUTION

Accounting

9: Accruals and prepayments

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you explain the accounting principle behind accruals and prepayments?

Can you correctly calculate the year end figures for accruals or prepayments that would appear in the statement of financial position?

Can you explain the impact of an accrual or prepayment on the related expense in the statement of profit or loss?

Can you correctly calculate the expense for the accounting period using either ledgers or logic?

Can you identify correcting journals where errors have been made, for example treating an accrual as a prepayment?

Can you explain accrued and deferred income?

Can you correctly calculate income for the year involving both opening and closing accrued and deferred income?

Yes/No

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10 Non-current assets and depreciation

Topic List 1

Non-current assets and depreciation (IAS 16) (FRS 102 s17)

2

Calculating depreciation

3

Fall in value (impairment)

4

Accounting for depreciation

5

Non-current asset disposals

6

The asset register

7

Intangible non-current assets

8

The non-current asset note to the statement of financial position

Learning Objectives 🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Identify the main components of a set of financial statements and specify their purpose and interrelationship

🞂

Prepare and present a statement of financial position, statement of profit or loss and statement of cash flows (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity

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1 Non-current assets When an asset is acquired that is expected to be held for more than one accounting period, we account for this capital expenditure as

KEY JOURNAL Dr Non-current asset £ cost Cr Cash / Trade payables £ cost

1.1 Cost of non-current assets The cost of an asset includes all directly attributable amounts to bring it to its present location and condition. It can include: 🞂

Purchase price

🞂

Delivery costs

🞂

Stamp duty and import duties (and irrecoverable VAT on cars)

🞂

Site preparation

🞂

Installation and assembly costs

🞂

Professional fees

🞂

Testing costs

🗸

It can also include subsequent costs that enhance the asset, such as major improvements or a major overhaul.

It does NOT include: 🞂

General overheads

🞂

Staff training costs

🞂

Fuel for cars

🞂

License fees for operating the asset

🞂

Repairs and maintenance

🗴

1.2 Useful life Non-current assets are held and used for a number of years, but they wear out and lose their usefulness in the course of time. Every tangible non-current asset has a limited life, with the exception of land, known as its useful life.

The “writing off” of the asset’s cost to the profit or loss over it’s useful life is known as depreciation.

1.3 Depreciation Depreciation is an application of the accruals principle. It matches the cost of the asset to the period that the business expects to gain the benefits from using it. It is defined as the “systematic allocation of the cost of an asset, less its residual value, over its estimated useful life”.

All tangible non-current assets must be depreciated, except land which is deemed to have an indefinite useful life. 🞂 🞂

Depreciation does not reflect the fall in the assets value over its life.

Depreciation is not “setting aside money” to replace the asset at the end of its life.

Accounting

10 : No n- current assets and depr eciatio n

To calculate an asset’s depreciation, the following factors are relevant: 🞂 🞂 🞂

Asset cost Useful life Asset residual value

The residual value is the estimated scrap value for an asset at the end of its useful life for the business.

EXAM SMART For exam purposes, always assume the residual value is zero unless told otherwise.

INTERACTIVE QUESTION: DEPRECIABLE AMOUNT Arundel Enterprises purchased a new car for a sales representative. The invoice received contained the following information: List price of car Deposit paid

£18,720 £6,200

Amount due

£12,520

It is estimated that the new car will have a useful life of three years and will have a residual value of £6,360.

Calculate the total amount to be depreciated in respect of the new car.

SOLUTION

The cost of the asset less its depreciation charge to date is known as the assets carrying amount, that is: Cost – Accumulated depreciation = Carrying Amount (CA).

2 Calculating depreciation There are two key methods to calculate the depreciation charge for a period. 🞂 🞂

Straight line basis Reducing balance basis

2.1 Straight line depreciation As its name suggests, this method spread the depreciable amount (cost less residual value) evenly over the asset’s useful life.

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FORMULA TO LEARN Depreciation charge = It can be expressed as a % of cost (assuming no residual value) or number of years.

For example: 🞂

10% straight line = 10 years (120 months)

🞂

25% straight line = 4 years (48 months)

🞂

20% straight line = 5 years (60 months)

🞂

5% straight line = 20 years (240 months)

EXAM SMART In your exam, straight line depreciation will normally be calculated on a monthly basis.

WORKED EXAMPLE: STRAIGHT LINE DEPRECIATION A non-current asset costing £60,000 has a useful life of 5 years and a residual value of £6,000. The monthly depreciation charge using the straight line method is: £60,000 − £6,000 60 𝑚𝑜𝑛𝑡ℎ𝑠

= £900 per month or £10,800 per annum.

The carrying amount (cost less accumulated depreciation) of the non-current asset would be as follows:

Cost of the asset Accumulated depreciation

After 1 year £ 60,000 (10,800)

After 2 years £ 60,000 (21,600)

After 3 years £ 60,000 (32,400)

After 4 years £ 60,000 (43,200)

After 5 years £ 60,000 (54,000)

Carrying amount

49,200

38,400

27,600

16,800

6,000 *

* the estimated residual value.

Accounting

10 : No n- current assets and depr eciatio n

INTERACTIVE QUESTION: STRAIGHT LINE DEPRECIATION A business has a reporting period from 1 January to 31 December and purchases a non-current asset on 1 April 20X1, at a cost of £24,000. The expected life of the asset is four years, and its residual value is nil.

What is the depreciation charge for the reporting period to 31 December 20X1?

SOLUTION

WORKED EXAMPLE: MORE STRAIGHT LINE DEPRECIATION

1 January 2012 b/f 1 April 2012 Additions

Motor Vehicles - Cost £ 10,000 31 August 2012 Disposals 2,000 31 December 2012 c/f 12,000

£ 3,000 9,000 12,000

Motor vehicles are depreciated on a straight line basis at 20% on cost per annum.

What is the depreciation to be charged to the profit or loss for the year ended 31 December 2012?

SOLUTION From the ledger account, it is possible to distinguish assets held all year (the opening figure less the disposals during the year) on which a full years depreciation should be charged.

The depreciation on the additions and disposals should then be calculated on a pro-rata basis based on the number of months the assets were held.

Assets held all year (£10,000 - £3,000) × 20% Additions £2,000 × 20% × 9/12 Disposals £3,000 × 20% × 8/12 Total depreciation charge for the year

£ 1,400 300 400 2,100

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2.2 Reducing balance depreciation The annual depreciation charge is a fixed percentage of the brought forward carrying amount (carrying value or net book value) of the asset. It allocates a greater proportion of the cost to the asset’s earlier years, and a lower proportion in its later years and the asset becomes less useful to the business.

EXAM SMART In the exam, you will usually need to calculate this depreciation on an annual basis and will be given the relevant % of carrying value. You do not need to know the assets useful life or residual value.

WORKED EXAMPLE: REDUCING BALANCE DEPRECIATION A business purchases a non-current asset at a cost of £10,000 on 1 January 20X1, which it plans to keep for three years to 31 December 20X3. The business wishes to use the reducing balance method to depreciate the asset, and calculates that the rate of depreciation should be 40% of the reducing balance (carrying amount) of the asset.

The depreciation charge per annum and the carrying amount of the asset as at the end of each reporting period will be as follows.

SOLUTION

Asset at cost Depreciation in 20X1 (40%) Carrying amount at end of 20X1 Depreciation in 20X2 (40% of £6,000) Carrying amount at end of 20X2 Depreciation in 20X3 (40% × 3,600) Carrying amount at end of 20X3

Carrying value £ 10,000 (4,000) 6,000 (2,400) 3,600 (1,440) 2,160

Accumulated depreciation £ 4,000 6,400 7,840

EXAM SMART When asked to use reducing balance depreciation in the exam, a useful shortcut to arrive at the carrying value after a number of years, is as follows: Carrying Value after n years = Cost × (1 – deprecation rate as a decimal)n So in the above example, the carrying value of the van after 3 years could have been quickly arrived at as follows £10,000 × (1 – 0.4)3 = £2,160

Accounting

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INTERACTIVE QUESTION: A lorry bought by a business cost £17,000 plus VAT of 20%. It is expected to last for five years and then be sold for £2,000 plus VAT. Work out the depreciation to be charged each 12 month reporting period under: (a) (b)

The straight line method The reducing balance method using a rate of 35%

SOLUTION

2.3 Depreciating enhancement expenditure Where expenditure is incurred to enhance an asset after its initial purchase, this is added to the asset’s cost and depreciated over the asset’s remaining useful life. This type of expenditure is sometimes called subsequent expenditure.

WORKED EXAMPLE: DEPRECIATING ENHANCEMENT EXPENDITURE Malcolm buys a building on 1.1.X0 for £200,000. On 1.1.X2 he adds an extension that cost £50,000.

Calculate the annual depreciation charge before and after the extension is built, on the basis of straight line depreciation over 10 years, with no residual value.

SOLUTION Before extension: £200,000/10 years = £20,000 per annum After extension: £200,000/10years + £50,000/8 years = £26,250 per annum

2.4 Reviewing and changing the depreciation method The depreciation method should be reviewed annually for appropriateness. If there are any changes in the expected useful life, pattern of usage or residual value then the method should be changed. The remaining carrying value less the residual value should be written off over its remaining useful life.

Only current and future periods will be affected.

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WORKED EXAMPLE: CHANGE IN DEPRECIATION METHOD Jakob Co purchased an asset for £100,000 on 1.1.X1. It had an estimated useful life of 5 years and it was depreciated using the reducing balance method at a rate of 40%. On 1.1.X3 it was decided to change the depreciation method to straight line. There was no change to the useful life, and no residual value is anticipated.

Show the depreciation charge for each year (to 31 December) of the asset's life.

SOLUTION Year 20X1 20X2 20X3 20X4 20X5

£100,000 × 40% £60,000 × 40% £100,000 – £64,000 3 remaining years

Depreciation charge £ 40,000 24,000 12,000 12,000 12,000

Accumulated depreciation £ 40,000 64,000 76,000 88,000 100,000

INTERACTIVE QUESTION: CHANGE IN DEPRECIATION METHOD Ford plc prepares its financial statements for the 12 month reporting period to 31 December each year. On 1 January 20X0 it bought a machine for £100,000 and depreciated it at 10% per annum on the reducing balance basis. On 31 December 20X3, the machine will be included in Ford plc's financial statements at: Cost Accumulated depreciation (10,000 + 9,000 + 8,100 + 7,290)

£ 100,000 (34,390)

Carrying amount

65,610

or £100,000 × (1 – 0.1)4 = £65,610 On 1 January 20X4, the company decided to change the basis of depreciation to straight line over a total life of nine years, ie five years remaining from 1 January 20X4. There is no residual value.

Calculate the revised annual depreciation charge.

SOLUTION

Accounting

10 : No n- current assets and depr eciatio n

3 Fall in value (impairment loss) Sometimes an asset might suffer a permanent fall in its value (perhaps due to damage) called an impairment loss. The asset should be written down to its new carrying value, called the “recoverable amount” with the difference being expensed to the profit or loss.

The recoverable amount is the higher of the “fair value less cost to sell” of the asset and its “value in use”.

Carrying amount before impairment Recoverable amount (after impairment)

£ x x

Impairment expense in profit or loss

x

4 Accounting for depreciation For each period’s calculated depreciation charge: Dr

Depreciation expense (profit or loss) Cr Accumulated depreciation (statement of financial position)

£x £x

There is no impact on the non-current asset cost accounts, but in the final statement of financial position the balance on the accumulated depreciation account (Cr) is offset against the cost account (Dr) to derive the carrying amount (carrying value or net book value) of the non-current assets.

An extract from a trial balance might look like this: Trial Balance as at year end

Debit £

Freehold building – cost

2,000,000

Freehold building – accumulated depreciation

500,000

Motor vehicles – cost

70,000

Motor vehicles – accumulated depreciation

40,000

Office equipment – cost

25,000

Office equip – accumulated depreciation

15,000

Depreciation expense

38,000

The statement of financial position would then include the following: Non current assets Freehold building Motor vehicles Office equipment

Credit £

£ 1,500,000 30,000 10,000

£

1,540,000

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INTERACTIVE QUESTION: ACCOUNTING FOR DEPRECIATION Brian Box purchased a computer system on credit from a manufacturer for £16,000. The system has an expected life of three years and a residual value of £2,500.

Using the straight line method of depreciation, calculate extracts for the statement or profit or loss and statement of financial position for each of the next three reporting periods ending 28 February 20X7, 20X8 and 20X9: SOLUTION Statement of profit or loss extract: Year ended 28 Feb 20X7: Depreciation expense Year ended 28 Feb 20X8: Depreciation expense Year ended 28 Feb 20X9: Depreciation expense

Statement of financial position extract Cost £

Accumulated depreciation £

Carrying value £

Year ended 28 Feb 20X7 Year ended 28 Feb 20X8 Year ended 28 Feb 20X9

5 Non-current assets disposals When a business decides to sell off a non-current asset it will make an accounting profit or loss on disposal.

Net disposals proceeds Less carrying value Profit / loss on disposal

£ x (x) x/(x)

A profit on disposal would be reported in other income. A loss on disposal will be recorded in expenses.

The above calculation is highly examinable, both for calculating the profit or loss on disposal or to deduce the carrying value of an asset that has been disposed of.

Accounting

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WORKED EXAMPLE: DISPOSAL OF A NON-CURRENT ASSET A business purchased a non-current asset on 1 January 20X1 for £25,000. It had an estimated life of six years and an estimated residual value of £7,000 and is depreciated on the straight line basis. The asset was sold after three years on 1 January 20X4 to another trader who paid £17,500 for it.

What was the profit or loss on disposal?

SOLUTION Annual depreciation = £25,000 – 7000/ 6 years = £3,000 per annum Net disposals proceeds Less carrying value: £25,000 – (3x £3000) Profit on disposal

£ 17,500 (16,000) 1,500

WORKED EXAMPLE: MORE DISPOSALS OF NON-CURRENT ASSETS A business purchased a machine on 1 July 20X1 for £39,000. The machine had an estimated residual value of £3,000 and a life of eight years. The machine was sold for £18,600 on 31 December 20X4. To make the sale, the business had to incur dismantling costs and costs of transporting the machine to the buyer's premises of £1,200. The business uses the straight line method of depreciation.

What was the profit or loss on disposal of the machine?

SOLUTION Depreciation expense = £39,000 –£3,000/ 8 years = £4,500 per annum £ 17,400 (23,250) (5,850)

Net disposal proceeds (£18,600 - £1,200) Less carrying value: £39,000 – (3.5x £4,500) Loss on disposal

5.1 Accounting for non-current asset disposals When an asset is disposed of we create a disposals account and have the following 3 steps:

STEPS Step 1: Remove cost of disposed asset from cost ledger Dr

Disposals account Cr Non-current cost account

£ cost £ cost

Step 2: Remove accumulated depreciation from the accumulated depreciation ledger Dr

Accumulated depreciation account Cr Disposals account

£ accumulated depreciation £ accumulated depreciation

Step 3: Account for the disposal proceeds Dr

Cash Cr Disposals account

£ proceeds £ proceeds

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The balance on the disposals account then represents the profit (balancing Dr) or loss (balancing Cr) on disposal and should be transferred to the profit and loss ledger account.

INTERACTIVE QUESTION: ACCOUNTING FOR DISPOSALS OF NON-CURRENT ASSETS A business has £110,000 worth of machinery at cost. Its policy is to depreciate at 20% per annum straight line. The total accumulated depreciation now stands at £70,000. The business sells for £19,000 a machine which it purchased exactly two years ago for £30,000.

Show the relevant ledger entries.

SOLUTION

b/f

Machinery – Cost £ 110,000

£

Machinery – Accumulated depreciation £ b/f

£ 70,000

Disposal £

Check: Proceeds Carrying value (cost less accumulated depreciation) Profit on disposal

£

£

5.2 Accounting for disposals given in a part exchange Sometimes an asset does not receive cash for an asset but instead receives a “part exchange” allowance against the cost of a new asset.

In this case, the three steps are the same but the cash proceeds in step 3 (Dr Cash) is replaced with part exchange value assigned to the old asset and debited to the new asset cost account.

Accounting

10 : No n- current assets and depr eciatio n

STEPS Step 1: Remove cost of disposed asset from cost ledger (as before) Dr

Disposals account Cr Non-current cost account

£ cost £ cost

Step 2: Remove accumulated depreciation from the accumulated depreciation ledger (as before) Dr

Accumulated depreciation account Cr Disposals account

£ accumulated depreciation £ accumulated depreciation

Step 3: Account for the disposal proceeds (replace cash with trade in value) Dr

New asset cost account Cr Disposals account

£ part exchange allowance £ part exchange allowance

The remaining cash paid (after the part exchange allowance) for the new asset is then accounted for in the usual way: Dr

New asset cost account Cr Cash

£ cash paid £ cash paid

WORKED EXAMPLE: ACCOUNTING FOR PART EXCHANGE DISPOSALS Asset A, costing £20,000 is acquired by a business for £12,000 cash, plus its old Asset B. The partexchange value attributed to Asset B is £20,000 – £12,000 = £8,000. This amount must be compared with Asset B's carrying amount in order to establish the profit or loss on Asset B's disposal.

Asset B cost £15,000 and has had £4,000 depreciation charged in respect of it, so its carrying amount at the date of the part-exchange disposal is £11,000. The business has made a loss of £11,000 – £8,000 = £3,000 on Asset B's disposal.

The £8,000 part-exchange value must be included in the cost of Asset A, along with the £12,000 cash handed over.

SOLUTION Three steps for disposal: (1)

Remove cost of asset B Dr

(2)

£15,000 £15,000

Remove accumulated depreciation of asset B Dr

(3)

Disposal account Cr NCA cost account

NCA accumulated depreciation Cr Disposal account

£4,000 £4,000

Account for trade in value on part exchange Dr

NCA cost account Cr Disposal account

£8,000 £8,000

Account for additional cash paid for asset A Dr

NCA cost account Cr Cash

£12,000 £12,000

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Accounting

6 The asset register The asset register is a detailed listing of all non-current assets held by an organisation. It can be used to record information such as: 🞂 🞂 🞂 🞂 🞂 🞂

Reference number (internal and/or manufacturers serial number) Location Purchase date Depreciation method Estimated useful life Residual value

As the asset register is not part of the double entry system, it can be reconciled to the ledgers as check on the completeness and accuracy of the ledgers. This reconciliation can help detect stolen, damaged or scrapped assets as well as new assets which may not have been accounted for in the ledgers.

7 Intangible assets Some non-current assets do not have physical substance, these are called intangible assets.

INTERACTIVE QUESTION: EXAMPLES OF INTANGIBLES Can you think of four examples of intangible assets?

SOLUTION (1)

Goodwill (see below)

(2)

(3)

(4)

7.1 Purchased intangible assets These may include: 🞂

Licences: purchased to allow a business to operate in a particular area (e.g. a bus company may be granted a licence to operate in certain areas of the country)

🞂

Patents: on ideas or designs that a business has developed

🞂

Brands: these help to distinguish a business’ products or services from those of other businesses

Purchased intangible assets are treated in the same way as tangible non-current assets. They are initially valued at their directly attributable cost. This should then be amortised over the asset’s useful life, usually on a straight line basis and assuming a nil residual value.

Accounting

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Most intangible assets have finite useful lives (e.g. a licence is granted for a set period). A purchased brand may have an indefinite useful life (where it is expected to generate economic benefits over a period that cannot be readily determined). Brands are not amortised but instead are tested annually for impairment.

7.2 Goodwill The value of a business as a whole will often exceed the value of its individual net assets. This is due to factors such as a good reputation with customers, having skilled and friendly staff, a prime location for attracting business and strong relationships with suppliers.

Although this goodwill can be an extremely valuable asset to a company, it is rarely recognised within the financial statements.

Internally generated goodwill cannot be recognised as an asset, because it is not separately identifiable from the business, it does not arise from legal rights and is not controlled by the entity.

Purchased goodwill arises when an entity purchases an existing business. Goodwill arising on an acquisition is the excess of the purchase consideration paid over the fair value of the individual assets and liabilities acquired.

Purchased goodwill can be recognised in the acquirer’s accounts.

WORKED EXAMPLE: GOODWILL Tony purchases Clive's business for £30,000. Clive's business has total assets less liabilities of £25,000, all of which are taken over by Tony. Tony will be paying (£30,000 – £25,000) £5,000 more for the business than its net assets are worth, because he is purchasing the goodwill of the business too.

The statement of financial position of Tony's business when it begins operations will be as follows Tony: Statement of Financial Position as at the start of business.

Intangible non-current asset: goodwill Other net assets acquired

£ 5,000 25,000

Net assets

30,000

Capital

30,000

Purchased goodwill is shown in this statement of financial position because it has been directly paid for. It has no tangible substance, and so it is an intangible non-current asset. It will be annually reviewed for impairment (it is not depreciated).

7.3 Internally generated intangible assets (development costs) Many businesses spend considerable amounts of money developing new or improved products that they hope will generate future income streams. The key is to identify whether this should be treated as revenue expenditure (expensed in the profit or loss) or capital expenditure (recognised as an intangible asset in the statement of financial position).

Dr

Expense or intangible asset Cr Cash

🞂

All research must be expensed to profit or loss

🞂

Development which meets certain criteria must be capitalised as an intangible asset in the statement of financial position. It is then amortised over the commercial production period.

Internally generated brands cannot be capitalised as an intangible asset.

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10 : No n- current assets and de precia tio n

EXAM SMART Intangible assets, such as licenses or patents, will often feature in the long form question.

Subject to the ideas above, they can be treated in much the same way as property, plant and equipment. However in the final statement of financial position, the carrying amount (cost less accumulated amortisation) of the intangible assets must be shown separately from property, plant and equipment.

8 The non-current asset note to the statement of financial position To keep the detail away from the face of the statement of financial position, a note is required that summarises changes in the cost and accumulated depreciation over the period for each class of assets.

Cost At 1.1.X0 Additions Disposals At 31.12.X0 Accumulated depreciation At 1.1.X0 Charge for the reporting period Disposals At 31.12.X0 Carrying amount At 31.12.X0 At 1.1.X0

Freehold land and buildings £ 100,000

Plant and equipment £ 45,000

100,000

(10,000) 35,000

Motor vehicles £ 25,000 13,300 (8,000) 30,300

Total £ 170,000 13,300 (18,000) 165,300

20,000

18,750 5,290 (1,250) 22,790

14,650 6,900 (4,500) 17,050

48,400 17,190 (5,750) 59,840

80,000 85,000

12,210 26,250

13,250 10,350

105,460 121,600

15,000 5,000

This figure will then be shown on the statement of financial position for Non-current assets: Property, plant & equipment.

Accounting

10 : No n- current assets and depr eciatio n

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you identify what elements should and shouldn’t be treated as capital expenditure?

Can you explain the purpose of depreciation of non-current assets?

Can you distinguish straight line deprecation from reducing balance depreciation?

Can you calculate the carrying amount of an asset on the basis of straight line or reducing balance depreciation?

Can you state the double entry for the annual depreciation charge?

Can you calculate the profit or loss on the disposal of an asset?

Can you state the three journals required to reflect the disposal of an asset?

Can you calculate the cost of an asset acquired during a part-exchange?

Can you define an intangible non–current asset?

Can you explain the accounting treatment of research and development?

Yes/No

113

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Accounting

115

11 Company financial statements

Topic List 1

The nature of a limited company

2

Equity: share capital and dividends

3

Equity: retained earnings and other reserves

4

Rights issues and bonus issues of shares

5

Non-current liabilities (debt capital)

6

Provisions

7

Tax

8

Revenue

9

The regulatory framework for company financial statements

Learning Objectives 🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Record and account for changes in the ownership structure and ownership interests in an entity

🞂

Identify the main components of a set of financial statements and specify their purpose and interrelationship

🞂

Prepare and present a statement of financial position and statement of profit or loss (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity

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1 The nature of a limited company A company has a separate legal existence to its owners (shareholders). It can enter contracts in its own name, sue or be sued and is liable to tax.

Companies can either be public (plc) or private (Ltd). Public companies have shares available for sale to the public but suffer stricter regulations. Not all public companies are “quoted” (traded on a stock market).

1.1 Share capital and shareholders A company’s initial capital is divided into shares which have a ‘par’, ‘nominal’ or ‘face’ value. This can be any amount (1p, 50p, £1). This will not change.

The issue price of a share is the amount that the shareholders actually paid for the share, and this often exceeds the par value.

2 Equity: share capital and dividends Preference shares

Equity (ordinary) shares

Set entitlement to dividend, usually expressed as % of nominal value

No entitlement to a dividend Carry voting rights Treated as “Capital” in the equity section of the statement of financial position 🞂

Issued share capital

🞂

Called up share capital

🞂

Paid share capital

🞂

Dividends charged to retained earnings

🞂

Dividends expressed as p per share or % of nominal value

Usually no voting rights

Redeemable

Irredeemable

Treated as a non current liability on the SOFP

Treated as “Capital” in the equity section of the SOFP

Dividend treated as an interest expense (finance charge)

Dividend charged to retained earnings

2.1 Accounting for dividends Dividend paid during the period

Dividend declared before the period end

Equity or irredeemable preference shares

Dr

Retained earnings Cr Cash

Dr

Retained earnings Cr Accruals

Redeemable preference shares

Dr

Finance charge Cr Cash

Dr

Finance charge Cr Accruals

2.2 Accounting for share issues Shares are often issued in excess of their par value. The difference is taken to a share premium account (a credit balance in the equity section of the statement of financial position).

Accounting

11 : Company f i nancial s tatemen ts

KEY JOURNAL Dr

Cash £ issue proceeds Cr

Share capital £ nominal value of shares issued

Cr

Share premium £ the balance

WORKED EXAMPLE: SHARE PREMIUM A company issues 1 million 50p equity shares at a price of £4.20 per share for cash.

The shares are issued at a premium of £3.70 (£4.20 – £0.50) above their nominal value, and the share issue should be recorded in the ledger accounts as follows: Dr

Cash £4,200,000 Cr Share capital £500,000 Cr Share premium £3,700,000

3 Equity: retained earnings and other reserves 3.1 Retained earnings Unlike sole traders, or partnerships, the profit for each reporting period is not added to the shareholders capital, instead it is transferred to a retained earnings ledger account which represents accumulated profits and losses over time.

Losses Dividends Transfer to general reserve c/f (closing SoFP)

Retained earnings £ x b/f (opening SoFP) x Net profit for the period x

profits £ x x

3.2 Share premium account It is illegal to issue shares below their nominal value but when they are issued in excess of the nominal value, this excess is credited to a share premium account. There are tight restrictions on the use of the share premium account, although it can be used in a bonus issue.

3.3 General reserve A company can choose to move some of its retained earnings into a general reserve.

4 Rights issues and bonus issues of shares 4.1 Rights issues A rights issue of shares is made to existing shareholders in proportion to their shareholdings. It is a means for a company to raise new cash.

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For example, a company with 20 million shares in issue makes a “1 for 4” rights issue, which would mean issuing another 5 million shares.

INTERACTIVE QUESTION: RIGHTS ISSUE The statement of financial position of Omnibus plc contains the following information.

ASSETS Non-current assets Current assets Total assets

£'000 18,600 2,900 21,500

EQUITY AND LIABILITIES Equity Share capital: equity shares of 20p each Share premium Retained earnings Total equity Total liabilities

6,000 5,700 7,000 18,700 2,800

Total equity and liabilities

21,500

The company decides to make a 1 for 3 rights issue for cash, fully paid, at a £1.80 per share.

What are the balances for a) current assets, b) share capital and c) share premium after the rights issue?

SOLUTION

4.2 Bonus issues Bonus issues of shares (or capitalisation issue or scrip issue) is an issue of shares to existing shareholders, free of charge, in proportion to their existing shareholding. No cash is generated.

The double entry is:

KEY JOURNAL Dr Share premium OR retained earnings £ nominal value of shares Cr Share capital

£ nominal value of shares

In the exam you should always utilise the share premium account fully before using the retained earnings account unless told otherwise.

Accounting

11 : Company f i nancial s tatemen ts

WORKED EXAMPLE: BONUS ISSUE A company has the following statement of financial position: Total assets

£'000 30,000

EQUITY AND LIABILITIES Equity Share capital: equity shares of £1 each Share premium Retained earnings Total equity Total liabilities Total equity and liabilities

5,000 1,300 9,700 16,000 14,000 30,000

The company decides to make a 2 for 5 bonus issue of shares. The company is issuing 2 million new shares (5m/5 × 2) for £1 each.

Dr Dr

Share premium Retained earnings Cr Share capital

£1,300,000 (to reduce to nil) £700,000 £2,000,000

Assets and liabilities will be unchanged but equity has changed as follows.

Statement of financial position (after bonus issue) Total assets

£'000 30,000

EQUITY AND LIABILITIES Equity Share capital: equity shares of £1 each Share premium Retained earnings Total equity Total liabilities Total equity and liabilities

7,000 – 9,000 16,000 14,000 30,000

INTERACTIVE QUESTION: BONUS ISSUE The statement of financial position of Canvat plc at 31 December 20X1 is as follows: Total assets

£'000 2,000

EQUITY AND LIABILITIES Equity Share capital: equity shares of 50p each Share premium Retained earnings Total equity Total liabilities Total equity and liabilities

400 500 300 1,200 800 2,000

The directors decide to make a 1 for 5 bonus issue, followed by a 1 for 3 rights issue at £1.60 per share.

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Show the revised statement of financial position of Canvat plc after both share issues have taken place.

SOLUTION

5 Non-current liabilities (debt capital) Companies can also raise cash finance by borrowing, either from a bank (bank loans) or other parties (debenture loans or bonds). This is usually called debt finance and includes redeemable preference shares.

Any loans due for repayment within twelve months would be treated as current liabilities, otherwise as non-current liabilities.

Interest is usually payable on non-current liabilities and must be accrued for if it remains unpaid at the year end.

5.1 Accounting for non-current liabilities On issue of debt

Dr Cash Cr Non-current liabilities

On repayment of debt

Dr Non-current liabilities Cr Cash

Interest paid

Dr Interest expense (finance cost) Cr Cash

Outstanding interest owed

Dr Interest expense (finance cost) Cr Accruals

Accounting

11 : Company f i nancial s tatemen ts

5.2 Repayment of a loan with shares In the exam you may be told that a loan is repaid through the issue of shares. In this case the outstanding loan at redemption is effectively the proceeds from the issue of shares

WORKED EXAMPLE: REPAYMENT OF LOAN BY SHARE ISSUE Lizzie Ltd has an outstanding loan of £20,000 with Bank & Co. The bank has agreed to accept 5,000 £1 shares in Lizzie Ltd in full and final settlement of this amount.

What is the correct journal to account for the redemption of the loan.

SOLUTION Dr

Loan £20,000 (to clear) Cr Share Capital £5,000 (the nominal value of the additional shares issued) Cr Share Premium £15,000 (a balancing figure)

6 Provisions (IAS 37) Provisions are liabilities of uncertain timing or amount. For example, a provision for claims under warranty. Whilst the company can expect to incur some costs under warranty claims it needs to estimate the value and timing of the claims.

Where there is a present obligation to incur the expenditure and it is considered more likely than not that the amount will be payable, then the full amount should be provided for: Create provision based on best estimate of amounts payable

Dr Expense (SPL) Cr Provision (SoFP)

Incur expenditure.

Note that if the expenditure is greater than the amount provided the excess will be charged to the profit or loss.

Dr Provision (SoFP) Dr Expense (SPL) Cr Cash

Remove excess provision.

Dr Provision (SoFP) – to clear If the expenditure is less than the amount provided then Cr Expense (SPL) the unused provision is released to the profit or loss.

In the accounting exam you may be asked to increase or decrease a provision, often a warranty provision, from an existing balance in the trial balance.

INCREASE in provision

Dr Expense £ the required increase Cr Provision £ the required increase

DECREASE in provision

Dr Provision £ the required decrease Cr Expense £ the required decrease

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WORKED EXAMPLE: CALCULATION OF PROVISION ‘Toasters To Go’ sells toasters with a one year warranty. Based on past experience the company expects approximately 5% of toasters sold to be returned within the warranty period for a minor repair at a cost of £10 per minor repair. Approximately 3% of toasters will be returned for a major repair at a cost of £25 per major repair. 92% of toasters sold will not need any repair.

During the year ended 30 September 2019, total revenue was £500,000 based on sales of 10,000 toasters. Calculate the required warranty provision as at 30 September 2019.

10,000 × 5% × £10 10,000 × 3% × £25 Total provision

£5,000 £7,500 £12,500

7 Tax As a separate legal entity, a company is liable to pay tax on its profits, creating an expense in the profit or loss and a current liability in the statement of financial position.

When the tax charge is estimated for a period: Dr

Tax expense Cr Tax payable (current liability)

£’000 £’000

When a payment is made for tax: Dr

Tax payable (current liability) Cr Cash

£’000 £’000

As this payment made will inevitably be slightly different to the actual amount paid, the difference is “mopped” up through the following year’s tax expense as follows: Paid less than expected (leaving a Cr on tax payable)

Over provision in prior year

Reduces tax expense in the following year

Paid more than expected (leaving a Dr on tax payable)

Under provision in prior year

Increases tax expense in the following year

WORKED EXAMPLE: TAX Hardwork plc has estimated that £90,000 is payable in tax on the profits earned in the year ended 31 December 20X1. Because the company’s profit or loss will need to be prepared before the final tax charge is known accurately, the journal will be prepared using estimated figures.

Dr

Tax expense (20X1) Cr Tax payable

£90,000 £90,000

In the year to 31 December 20X2, Hardwork plc has a credit balance brought down on its tax payable account of £90,000. It agrees with HMRC that the tax due on 20X1's profits is £87,000, which it pays in February 20X2. Its over-provision for 20X1 is therefore £3,000. It estimates that its tax due on 20X2's profits should be £100,000.

Hardwork plc's net tax expense in the profit or loss for the year to 31 December 20X2 will be £97,000 (£100,000 less the over-provision of £3,000 in the previous reporting period). The statement of financial position current liability as at 31 December 20X2 is £100,000.

Accounting

11 : Company f i nancial s tatemen ts

Cash c/f tax liability

Tax payable £ 87,000 b/f opening tax liability 100,000 Tax expense for 20X2

£ 90,000 97,000

187,000

187,000

EXAM SMART The following working may be useful in the long form question.

Directors estimated tax for the year (given in a note to the trial balance) Under/over provision from prior year (tax figure found in the trial balance)

£ x

= current tax payable in SOFP

x/(x) x

= tax expense in the P or L

8 IFRS 15 Revenue recognition Revenue is income arising in the ordinary course of an entity’s activities and includes the sale of goods or services.

It includes credit and cash sales, net of discounts, refunds and VAT. Generally, revenue should be recognised when the entity has transferred the goods or services is to the customer.

Revenue received in advance is treated as deferred income liability until control has transferred.

Revenue does not include: 🞂

Profit on disposal of tangible non-current assets (this does not arise in the course of the entity’s ordinary activities)

🞂

Interest received and dividends received from investments. These are presented as ‘finance income’ or ‘investment income’ in the statement of profit or loss

EXAM SMART The long form question will tell you where to include profits and losses on disposal of assets and interest and dividends received in the statement of profit or loss.

9 IAS 8 Accounting policies, changes in accounting estimates and errors IAS 8 aims to enhance the usefulness of financial statements by ensuring that: 🞂

Entities clearly disclose the accounting policies they have adopted

🞂

There are constraints to limit changes in accounting policies

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Changes in accounting policies, accounting estimates and errors are all dealt with in the same way by different entities, including making appropriate disclosures.

10 The regulatory framework for company financial statements Company financial statements are made available for external publication and are therefore extensively regulated to protect investors who will be using them to make economic decisions. All published financial statements are prepared on the same basis so that investors can make meaningful comparisons.

Rules and regulations are applied to: 🞂 🞂 🞂

Content: what information the financial statements must contain Accounting concepts: how figures should be prepared (Chapter 2) Presentation: the layout of the final accounts

The main sources of the regulations are Companies Act 2006, and the accounting standards (IFRS Standards), notably IAS 1 (revised) for the presentation of accounts.

The regulatory structure must be underpinned by strong ethical values to maintain public confidence.

The process must be: 🞂 🞂 🞂 🞂

Honest and truthful Transparent and adaptable Legally compliant Consistent

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Can you explain the correct accounting treatment of redeemable and irredeemable preference shares?

Can you confidently calculate the number of ordinary shares held by a company from the nominal value of one share and the total value of share capital?

Can you distinguish the correct accounting treatment for dividends on equity shares, redeemable preference shares and irredeemable preference shares?

Can you account for the issue of new shares, both as a rights issue or a bonus issue?

Can you explain and calculate a company’s retained earnings?

Can you calculate the interest (finance charge) due on outstanding debt capital?

Can you calculate and account for a change in a provision during the year?

125

12 Company financial statements under IFRS Accounting Standards

Topic List Prepare single entity accounts from a trial balance

Learning Objectives 🞂

Prepare and present the following statements for a single entity accounts from a trial balance: – – –

statement of profit or loss statement of financial position statement of changes in equity

126 12 : Company f i nancial s tatement s under IFRS Accounti ng Standards

Accounting

1 The statement of profit or loss (IAS 1 revised) Name of company and date of the profit or loss must be disclosed DUCAT PLC

STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X3 Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Finance costs Profit before tax Tax expense Profit for the period

£ 623,000 (414,000) 209,000 26,000 (73,000) (32,000) (15,000) 115,000 (35,000) 80,000

The above layout is known as the functional format, splitting costs between costs of sales, administrative expenses and distribution costs. Professional judgement is required to allocate expenses between these headings.

Accounting

12 : Company f i nancial s tatemen ts under IFRS Accoun ting Sta ndar ds

2 The statement of financial position Name of company and date of the SoFP must be disclosed

DUCAT PLC STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X3 ASSETS Non-current assets Property, plant and equipment Goodwill Other intangible assets

£

427,000 15,000 110,000 552,000

Trade receivables less any allowance for receivables.

Current assets Inventories Trade and other receivables Other current assets (eg prepayments) Cash and cash equivalents

£

51,000 102,000 20,000 33,000

Total assets

206,000 758,000

EQUITY AND LIABILITIES Equity Share capital: £1 equity shares Reserves: share premium Reserves: retained earnings Reserves: general Total equity

150,000 125,000 161,000 65,000 501,000

Non-current liabilities Long-term borrowings 10% £1 redeemable preference shares Current liabilities Trade and other payables (including accruals) Deferred income Short-term borrowings (eg bank overdraft) Provisions Current tax payable Total equity and liabilities

158,000 20,000 36,000 2,000 20,000 10,000 11,000 79,000 758,000

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3 The statement of changes in equity The statement of changes in equity explains how the equity section of the statement of financial position has changed in the reporting period.

INTERACTIVE QUESTION: THE STATEMENT OF CHANGES IN EQUITY Bunbury Ltd is preparing its statement of changes in equity for the year ended 31 December 20X9. Use the following information to complete the statement. 🞂

In February, Bunbury issued 5,000 50p equity shares for £0.80 per share.

🞂

On 1 July 20X9, Bunbury issued 20,000 £1 5% redeemable preference shares at par. Prior to this, Bunbury had never issued any preference shares.

🞂

An ordinary dividend of 2p per share was declared and paid in November 20X9.

🞂

Bunbury made a profit for the year of £15,800 before accounting for any dividends on the ordinary or redeemable preference shares above.

Statement of changes in equity for the year ended 31 December 20X9

Balance at 1 January 20X9

Balance at 31 December 20X9

Share capital

Share premium

£ 100,000

£ 20,000

Retained earnings

Other reserves

Total

45,500

£ 10,000

£ 175,500

10,000

Accounting

12 : Company f i nancial s tatemen ts under IFRS Accoun ting Sta ndar ds

4 Preparing single entity accounts from a trial balance EXAM TECHNIQUE FOR PREPARING SINGLE ENTITY ACCOUNTS FROM A TRIAL BALANCE Step 1: Review trial balance (given) and additional information to see which figures from the trial balance are likely to change Step 2: Set up key workings (eg expenses, non-current assets, retained earnings) Step 3: Transfer figures from the trial balance to the proformas or your workings Step 4: Work through additional information, dealing with the easiest adjustments first Step 5: Complete your workings and transfer figures to your proformas.

Step 6: Calculate the profit for the year and transfer to the retained earnings working.

INTERACTIVE QUESTION: ACCOUNTS PREPARATION FOR A LIMITED COMPANY (EXAM TECHNIQUE) Digby Ltd The following trial balance relates to Digby Ltd as at 31 December 20X6: Dr £ Revenue Purchases Inventories 1 January 20X6 Administrative expenses Distribution costs Labour costs Factory Warehouse of finished goods Delivery drivers Office staff Interest income Interest expense Property, plant and equipment Land and buildings: cost (Land element: £171,500) Land and buildings: depreciation Motor vehicles: cost Motor vehicles: depreciation Furniture and fixtures: cost Furniture and fixtures: depreciation Trade receivables and trade payables Ordinary share capital (£1 shares) Redeemable preference shares (6% 20X9) Share premium Retained earnings 1 January 20X6 Taxation Ordinary dividend paid Bank and cash balances

Cr £ 487,280

258,411 64,060 31,046 6,011 2,046 1,097 3,400 9,682 3,411 680 496,500 150,200 186,000 89,000 525,000 193,545

460 2,500 75 1,780,513

275,000 201,600 250,000 150,000 50,000 123,382

640 1,780,513

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Additional information: (a)

(b)

Depreciation is to be charged and presented as follows: 🞂

Buildings 2% per annum on cost – administrative expenses

🞂

Motor vehicles 40% reducing balance – distribution costs

🞂

Furniture and fixtures 25% per annum on cost less residual value, with residual value estimated at 10% of purchase cost – administrative expenses

Inventories at 31 December 20X6 are unknown, however a count undertaken on 17 January 20X7 valued it at a sales price of £114,600.

The company charges a flat 30% mark-up on cost. Sales during the period from 1 to 17 January were £23,600 and goods were purchased costing £9,000.

(c)

No dividends have been accounted for on the 6% preference shares as yet, but the directors publicly announced that they would pay them before the year end.

(d)

Taxation for the year has been estimated at £14,200. This does not take into account the under provision for the previous year of £460 shown in the trial balance above.

Complete the statement of profit or loss for the year ended 31 December 20X6 and a statement of financial position at that date for Digby Ltd in a form suitable for publication. You should classify expenses by function.

EXAM SMART Each figure in the trial balance will go into the answer once (either into the proforma directly or a working).

The figures in the additional information will have two impacts in your answer (think of the double entry!).

SOLUTION Digby Ltd: Statement of profit or loss for the year ended 31 December 20X6 £ Revenue Cost of sales Gross profit Distribution costs Administrative expenses Profit from operations Investment income Finance cost Profit before tax Income tax expense Profit for the year

Accounting

12 : Company f i nancial s tatemen ts under IFRS Accoun ting Sta ndar ds

Digby Ltd: Statement of financial position as at 31 December 20X6 £ ASSETS Non-current assets Property, plant and equipment Current assets Inventories Trade and other receivables Cash and cash equivalents Total assets EQUITY AND LIABILITIES Equity Ordinary share capital Share premium Retained earnings

Non-current liabilities Borrowings Current liabilities Borrowings Trade payables Accruals Taxation

Total equity and liabilities

EXAM SMART Remember you must show expenses as negative in the statement of profit or loss (brackets or a minus sign) or will lose the mark.

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Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you calculate and distinguish a company’s tax liability (in the statement of financial position) from its tax expense (in the statement of profit or loss)?

Are you familiar with the format of the statement of financial position and the statement of profit or loss?

Do you feel comfortable with the exam technique to preparing single entity accounts from a trial balance with a series of adjustments?

Yes/No

133

13 Statement of cash flows

Topic List 1

The statement of cash flows (IAS 7)

2

Format of the statement of cash flows

3

Preparing a statement of cashflows

Learning Objectives 🞂

Prepare and present a statement of financial position and statement of profit or loss and statement of cash flows (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity

134

Accounting

13: Statement of cash flows

1 Statement of cash flows The objective of IAS 7 is to provide information to the users about the “entity’s ability to generate cash and cash equivalents and the needs of the entity to utilise those cash flows”.

Statements of cash flow are not affected by accounting policies and hence can be more comparable between entities and less vulnerable to manipulation.

Cash flows are in and out flows of cash and cash equivalents. 🞂

Cash comprises cash on hand and demand deposits.

🞂

Cash equivalents are short term, highly liquid investments that are readily convertible into known amounts.

2 Format of the statement of cash flows Under IAS 7 cash inflows and outflows are classified under three headings: Operating activities

primarily derived from the principal revenue-producing activities of the entity and other activities that are not investing or financing activities. IAS7 allows two possible layouts for cash generated from operating activities 🞂 the indirect method (use in the exam unless told otherwise) or 🞂 the direct method (preferred by the standard).

Investing activities

cash flows derived from acquisition and disposal of non-current assets and other investments not included in cash equivalents.

Financing activities

cash flows derived from activities that result in changes to the equity capital and borrowings of the entity.

Example of statement of cash flows – indirect method £'000

£'000

Cash flows from operating activities Profit before taxation Depreciation Loss on disposal Investment income Interest expense Increase in trade and other receivables Decrease in inventories Decrease in trade payables Cash generated from operations Interest paid Income taxes paid Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment/intangibles Proceeds from sale of equipment/intangibles Interest received Net cash used in investing activities

3,350 350 7 (500) 400 3,607 (500) 1,090 (1,740) 2,457 (270) (1,085) 1,102

(2,550) 53 200 (2,297)

Accounting

13: Statement of cash flows

£'000 Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings Dividends paid

£'000

8,400 250 (1,290)

Net cash used in financing activities

7,360

Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period

6,165 10,240 16,405

Example of statement of cash flows – direct method Cash flows from operating activities

£'000

Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Interest paid Income taxes paid

30,150 (27,693) 2,457 (270) (1,085)

Net cash from operating activities

£'000

1,102

Cash flows from investing activities Purchase of property, plant and equipment/intangibles Proceeds from sale of equipment/intangibles Interest received

(2,550) 53 200

Net cash used in investing activities

(2,297)

Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings

8,400 250

Dividends paid

(1,290)

Net cash used in financing activities

7,360

Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period

6,165 10,240 16,405

2.1 Cash flows from operating activities WORKED EXAMPLE: CASH FLOWS FROM OPERATING ACTIVITIES Quest Ltd has profit before tax for the year to 31 December 20X6 of £850,000, after charging £650,000 for depreciation and making a profit on sale of a car of £120,000.

The statement of financial position for the year shows the following entries:

Inventories Trade and other receivables Trade and other payables

20X6 £’000 586 1,021 443

20X5 £’000 763 589 1,431

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13: Statement of cash flows

Calculate the cash generated from operations (before interest and tax paid).

SOLUTION Cash flow from operating activities: Profit before tax Depreciation (add) Gain on sale of property, plant and equipment (deduct) Movement in inventories (add a decrease) Movement in trade receivables (deduct an increase) Movement in trade payables (deduct a decrease) Cash generated from operations

£’000 850 650 (120) 177 (432) (988) 137

‘Interest paid’ and ‘tax paid’ are both calculated from the balances in the statement of financial position and expense in the profit or loss, using a ledger account to deduce the missing “cash paid” figure.

WORKED EXAMPLE: TAX PAID A company had a liability for income tax at 31 December 20X6 of £940,000 and a liability for income tax at 31 December 20X7 of £1,125,000. The income tax charge for the year to 31 December 20X7 was £1,270,000.

What amount of income tax was paid during the year?

SOLUTION

Tax paid (balancing figure) c/f

Tax payable $ 1,085,000 b/f 1,125,000 Tax expense

£ 940,000 1,270,000

2,210,000

2,210,000

ALTERNATIVE LAYOUT TO SOLUTION b/f liability Tax expense Tax paid (balancing figure) c/f liability

£ 940,000 1,270,000 (1,085,000) 1,125,000

Note that you may not be given the tax expense in the profit or loss. You will then have to assume that the tax paid in the year is last year's year-end liability (that is, the opening tax payable) and calculate the expense as the balancing figure.

2.2 Cash flows from investing activities Cash in or outflows relating to the purchase and disposal of non-current assets are dealt with under investing activities.

Remember the non-cash figures of “depreciation” and “profit or loss on disposal” should be reversed out under operating activities.

Accounting

13: Statement of cash flows

This means non-current assets will impact the statement of cash flows in four ways: 1 2 3 4

Non cash Non cash Cash Cash

Depreciation Profit or loss on disposal Payment to acquire new non-current assets Proceeds on disposal of non-current assets

+ -/+ +

Operating activities Operating activities Investing activities Investing activities

WORKED EXAMPLE: CASH RECEIPTS FROM SALE OF PROPERTY, PLANT AND EQUIPMENT A company's statement of financial position as at the beginning and the end of the year showed the following.

Property, plant and equipment Cost At 1 January 20X7 Disposals At 31 December 20X7

£ 760,000 (240,000) 520,000

Accumulated depreciation At 1 January 20X7 Disposals Charge for year At 31 December 20X7

270,000 (180,000) 50,000 140,000

Carrying amount At 31 December 20X7

380,000

At 31 December 20X6

490,000

The property, plant and equipment was disposed of at a loss of £7,000. What was the cash flow from the disposal?

SOLUTION Proceeds on disposal Carrying value (£240,000 - £180,000) Loss on disposal

£ 53,000 (60,000) (7,000)

INTERACTIVE QUESTION: CASH PAYMENTS FOR PROPERTY, PLANT AND EQUIPMENT A company's accounts show that at 31 December 20X7, it had property, plant and equipment at cost of £6,800,000. During the year, it disposed of assets that had a cost of £850,000. At 31 December 20X6, the company's property, plant and equipment at cost had been £5,100,000.

What were purchases of property, plant and equipment during the year?

SOLUTION Property, plant an d equipment – cost £

£

137

138

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13: Statement of cash flows

ALTERNATIVE LAYOUT TO SOLUTION £ b/f PPE – cost Disposal – cost Additions (balancing figure) c/f PPE – cost

EXAM SMART If the question allows you to prepare separate ledger accounts for the cost and accumulated depreciation of non-current assets, these should both be created. However some questions will only provide you with the carrying value of the non-current assets at the beginning and end of the period, in which case only one ledger account is required highlighting the movements on the carrying value.

2.2.1 Example workings: If you are able to separate cost and accumulated depreciation:

b/f Additions Disposals Charge for the year c/f

Cost £ x x (x)

Accumulated depreciation £ x

x

(x) x x

If you are only given carrying values:

b/f Additions Disposals (at carrying value) Charge for the year c/f

CV £ x x (x) (x) x

For any disposal of non-current assets: Proceeds on disposal Carrying value of disposed asset

£ x (x)

Profit or loss on disposal

x/(x)

2.3 Cash flows from financing activities Proceeds from share issues can normally be derived from the increase in the Equity Share Capital and Share Premium during the period.

However in the case of a bonus issue of shares which has not been charged to the share premium, the amount charged to another reserve should be deducted.

Accounting

13: Statement of cash flows

INTERACTIVE QUESTION: BONUS ISSUE Groat plc's accounts for the year to 31 December 20X7 show the following figures: 31.12.X7 £ 22,500,000 900,000

Share capital: Ordinary shares of 10p Share premium

31.12.X6 £ 10,000,000 4,800,000

The company made a ‘one for two’ bonus issue of shares at the start of the year. It used the share premium account and £200,000 from retained earnings to do this.

What amount of cash was raised from share issues during the year?

SOLUTION

WORKED EXAMPLE: CASH FLOW FROM FINANCING ACTIVITIES Spear Ltd issued 87,500 £1 shares at par during the year to 31 December 20X6. Loans taken out increased from £18,000 at the beginning of the year to £30,000 at the end of the year. The company declared a dividend of 10p per share.

Calculate the cash flows from financing activities.

SOLUTION Cash flow from financing activities Proceeds from issue of shares Movements in borrowings Net cash from financing activities

£ 87,500 12,000 99,500

Note that only dividends paid (as opposed to declared) in the period represent cash flows.

Interest paid on the loans will be shown under cash flows from operating activities.

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13: Statement of cash flows

3 Preparing a statement of cash flows INTERACTIVE QUESTION: PREPARING A STATEMENT OF CASH FLOWS Kane Ltd's statement of profit or loss for the year ended 31 December 20X2 and statement of financial position at 31 December 20X1 and 31 December 20X2 were as follows.

Kane Ltd: Statement of profit or loss for the year ended 31 December 20X2 Sales Cost of sales Gross profit Other operating expenses Operating profit Finance charge Profit before tax Taxation Profit for the year

£'000 720 (200) 520 (100) 420 (28) 392 (124) 268

Accounting

13: Statement of cash flows

Kane Ltd: Statement of financial position as at 31 December 20X2

Non-current assets Cost Depreciation Current assets Inventory Trade receivables Recoverable corporation tax Bank Total assets Equity Share capital Share premium Retained earnings Non current liabilities Long-term loans Current liabilities Trade and other payables Taxation Total equity and liabilities

20X2 £'000

20X1 £'000

1,596 318 1,278

1,560 224 1,336

24 66 10 48 148 1,426

20 50 8 56 134 1,470

360 36 716 1,112

340 24 514 878

200

500

12 102 114 1,426

6 86 92 1,470

Additional information 🞂

Dividends were paid during the year.

🞂

During the year, the company paid £90,000 for a new piece of machinery and disposed of plantat a loss of £18,000. Depreciation charged during the year totalled £118,000 and is included in cost of sales.

🞂 Trade and other payables includes accrued interest of £2,000 at 31 December 20X2 (£1,000 as at 31 December 20X1) Prepare a statement of cash flows for Kane Ltd for the year ended 31 December 20X2 in accordance with the requirements of IAS 7.

SOLUTION Step 1

Prepare standard T account or column workings

Step 2

Review additional information to get a feel for what calculations will be needed

Step 3

Work down the Statement of Financial Position taking the information to the T account /column workings or straight to the face of your answer

Step 4

Work through the key figures in the statement of profit or loss

Step 5

Deal with the additional information

Step 6

Complete the T account or column workings and the statement of cash flows

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Accounting

13: Statement of cash flows

Kane Ltd: Statement of cash flows for the year ended 31 December 20X2 (indirect method) £'000 Cash flows from operating activities Profit before taxation Loss on sale of property, plant and equipment Depreciation Interest expense Increase in trade and other receivables Increase in inventories Increase in trade payables Cash generated from operations Interest paid (W1) Income taxes paid (W2) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of equipment (W3) Net cash from investing activities Cash flows from financing activities Proceeds from issue of share capital Movement in long-term borrowings Dividend paid (W4) Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at the beginning of the period Cash and cash equivalents at the end of the period

Workings (W1) Interest paid £’000 b/f accrued interest Finance charge Interest paid (balancing figure) c/f accrued interest

(W2) Tax paid £ b/f tax liability

Accounting

13: Statement of cash flows

Tax expense Tax paid (balancing figure) c/f tax liability

(W3) Property, plant and equipment COST £’000 b/f Purchases Depreciation charge for year Disposal (balancing figure) c/f £’000 Proceeds on disposal Carrying value Loss on disposal

(W4) Dividends paid £’000 b/f retained earnings Profit after tax Dividends paid (balancing figure) c/f retained earnings

ACC. DEPN £’000

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13: Statement of cash flows

Accounting

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you define cash and cash equivalents?

Can you identify the correct heading in the statement of cash flows (operating, investing or financing) for key cash changes during the year?

Can you explain the difference between the indirect and direct method of presenting the statement of cash flows?

Can you identify the four figures relating to non-current assets that are relevant to a statement of cash flows?

Can you accurately calculate the cash received from a share issue?

Do you feel confident with the technique for preparing a statement of cash flows?

Yes/No

145

14 Company financial statements under UK GAAP

Topic List 1

What is UK GAAP?

2

Published accounts

3

UK GAAP terminology and formats

Learning Objectives 🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Identify the main components of a set of financial statements and specify their purpose and interrelationship

🞂

Prepare and present a statement of financial position and statement of profit or loss and statement of cash flows (or extracts) from the accounting records and trial balance in a format which satisfies the information requirements of the entity.

146

Accounting

14: Company financial statements under UK GAAP

1 What is UK GAAP? So far we have focussed on the terminology and format required by the international financial reporting standards. In the UK only listed companies are required to produce their accounts under IFRSs, the remainder can still prepare their accounts under UK generally accepted accounting practice, UK GAAP. This is the rules, from whatever source, which govern accounting and financial reporting in the UK. At present it is primarily a combination of: 🞂 🞂

Company law UK accounting standards

2 Published accounts UK companies are required by law to publish financial statements annually and file them with the Registrar of Companies. The accounts are required to show a true and fair view and must include 🞂

A balance sheet (directors have a duty to prepare and must be signed as approved by at least one director)

🞂

A profit and loss account

🞂

A director’s report

🞂

An auditor’s report

3 UK GAAP terminology and formats 3.1 Terminology International terminology

UK GAAP terminology

Statement of profit or loss

Profit and loss account

Statement of financial position

Balance sheet

Non-current asset

Fixed asset

Carrying amount

Net book value

Inventories

Stock

Receivables

Debtors

Irrecoverable debt

Bad debt

Irrecoverable debt expense

Bad and doubtful debt expense

Allowance for irrecoverable debts

Allowance for doubtful debts

Retained earnings

Retained profits

Payables

Creditors

Non-current liabilities

Creditors: amounts falling due after more than one year

Current liabilities

Creditors: amounts falling due within one year

Revenue

Turnover

Finance costs

Interest payable

Accounting

14: Company financial statements under UK GAAP

3.2 Formats Typical Company Ltd: Balance sheet as at 31 December 20XX £’000 Fixed assets Intangible assets Development costs Goodwill Tangible fixed assets Land and buildings Plant and machinery Motor vehicles

£’000

X X X X X 6

Current assets Stocks Debtors and prepayments Cash at bank and in hand Creditors: amounts falling due within one year Bank overdraft Trade creditors Provisions Tax Accruals

X X X 5 X X X X X 3

Net current assets Total assets less current liabilities Creditors: amounts falling due in more than one year Debentures

2 8

X 1

Net assets Capital and reserves Ordinary share capital Preference share capital Share premium account Other reserves Retained profits

7

X X X X X 7

147

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14: Company financial statements under UK GAAP

Typical Company Limited: Profit and loss account for the year ended 31 December 20XX Turnover Cost of sales Gross profit Distribution costs Administrative expenses Other operating income

£’000 X (X) X (X) (X) X

Operating profit Interest payable and similar charges Profit before taxation Taxation Profit after taxation

X (X) X (X) X

Note: 🞂

Operating profit is the profit before interest and tax for the company.

🞂

Under UK GAAP in financial statements for publication there is less detail on the face of the balance sheet; the detail that we saw earlier in the Companies Act 2006 format is normally shown in notes to the financial statements.

EXAM SMART 🞂

Remember, in your exam the accounts preparation question will only require the international format and terminology as seen in Chapter 11.

Knowledge diagnostic Before you move on to the next chapter, complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you list the elements of financial statements published under UK GAAP? Can you explain the differences in the format of the financial statements?

Do you feel familiar with UK GAAP terminology?

Yes/No

149

15 Sole trader financial statements under UK GAAP

Topic List 1

Sole trader financial statements

Learning Objectives 🞂

Record and account for transactions and events resulting in income, expenses, assets, liabilities and equity in accordance with the appropriate basis of accounting and the laws, regulations and accounting standards applicable to the financial statements

🞂

Record and account for changes in the ownership structure and ownership interests in an entity

🞂

Identify the main components of a set of financial statements and specify their purpose and interrelationship

🞂

Prepare and present balance sheet, profit and loss account and statement of cash flows (or extracts) from the accounting records and trial balance in a format that satisfies the information requirements of the entity

150

Accounting

15 : So le trader financial s tat eme nts under UK GAAP

1 Sole trader financial statements Under UK GAAP the terminology and format of the accounts for a sole trader is very similar to that of a company. However: 🞂

There is no tax in a sole trader’s accounts

🞂

The “capital and reserves” section will be replaced with “ownership’s interest”, being: Ownership interest Opening capital Capital introduced Profit / (loss) for the period Drawings Closing capital

£ X X X/(X) (X) X

The accounting equation from Chapter 2 can be used to deduce the profits made by a sole trader, remembering that:

FORMULA TO LEARN Net assets (assets – liabilities) = Closing Capital therefore: Change in net assets = capital introduced + profit – drawings

INTERACTIVE QUESTION: SOLE TRADER FINANCIAL STATEMENTS A Lone had the following trial balance as at 31 December 20X5 Initial TB Debit £’000 Owner’s capital at 1.1.X5 Bank loan Freehold land and buildings Freehold land and buildings – accumulated depreciation Plant and machinery – cost Plant and machinery – accumulated depreciation Stock Sales Purchases Loan interest Wages and salaries Drawings Sundry expenses Suspense account Debtors Creditors Cash at bank

Credit £’000 650 813

630 40 1,360 102 390 1,935 1,052 30 354 51 123 860 464 215 161 4,615

4,615

The following matters have now been discovered: (1)

On 1 January 20X5 A Lone injected a further £530,000 into the business. The entry made was to debit cash at bank and credit the suspense account.

Accounting

15 : So le t rader f inancial s tateme nts under UK GAAP

(2)

On 1 January 20X5 an item of high emissions plant that had cost £550,000 and on which depreciation of £94,000 had been charged was disposed of for £330,000. The only entry made was to debit cash at bank and credit the suspense account.

(3)

Depreciation of £56,000 needs to be charged on the remaining plant and machinery, and £15,000 on the land and buildings.

(4)

Loan interest of £60,000 should be accrued at 31 December 20X5.

(5)

Stock on hand at 31 December 20X5 cost £440,000.

Requirement Prepare A Lone’s profit and loss (P&L) account for the year ended 31 December 20X5 and the balance sheet at that date.

SOLUTION A Lone’s final trial balance can be calculated as follows

Owner’s capital at 1.1.X5 Bank loan Freehold land and buildings Freehold land and buildings – accumulated depreciation Plant and machinery – cost Plant and machinery – accumulated depreciation Stock Sales Purchases Loan interest Wages and salaries Drawings Sundry expenses Suspense account Debtors Creditors Cash at bank Capital introduced Disposals Depreciation expense Accruals Cost of sales

Initial TB Debit Credit £’000 £’000 650 813 630 40 1,360 102 390 1,935 1,052 30 354 51 123 860 464 215 161

4,615

4,615

Adjustments Debit Credit £’000 £’000

Final TB Debit Credit £’000 £’000

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15 : So le trader financial s tat eme nts under UK GAAP

A Lone: Profit and loss account for year ended 31 December 20X5 £’000

£’000

Sales Cost of sales Gross profit Expenses Loan interest Wages and salaries Sundry expenses Loss on disposal Depreciation expense Net profit

A Lone: Balance sheet as at 31 December 20X5 Cost £’000

Acc. depn. £’000

Fixed assets Freehold land and buildings Plant and machinery Current assets Stock Debtors Cash

Current liabilities Accruals Creditors Net current assets Non-current liabilities Bank loan Ownership interest Opening capital Capital introduced Profit for year Drawings Closing capital

£'000's

£'000's

£’000

Accounting

15 : So le t rader f inancial s tateme nts under UK GAAP

Knowledge diagnostic Complete the following knowledge diagnostic and check you are able to confirm you possess the following essential learning from this chapter. If not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Can you record and account transactions and events in accordance with the appropriate basis of accounting and laws, regulations and accounting standards?

Can you record and account for changes in ownership structure and interests in an entity?

Are you able to identify the main components of a set of financial statements and their purpose and interrelationship?

Are you confident in preparing and presenting balance sheet, profit and loss account?

Can you prepare statement of cash flows or extracts from accounting records and trial balance in a format that satisfies the information requirements of the entity?

Yes/No

153

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15 : So le trader financial s tat eme nts under UK GAAP

Accounting

155

16 Solutions to interactive questions

Chapter 1 Introduction to accounting No interactive questions.

Chapter 2 The accounting equation Examples of assets Examples of assets could be any of: cash, trade receivables, inventories, prepayments, non-current assets (vans, buildings, land, equipment, computers) intangible assets (goodwill, brand names)

Examples of liabilities Examples of current liabilities could be any of: overdraft, bank loans repayable within a year, trade payables, accruals, tax payable.

Examples of non-current liabilities could be loans repayable in more than a year, provisions.

Interactive question: the accounting equation (a)

Increase assets by £800, increase liabilities by £800

(b)

Decrease assets/cash by £25, decrease capital (profits) by £25

(c)

Increase assets by £200 overall, increase capital (profits) by £200.

(d)

Decrease assets by £800, decrease liabilities by £800

156

Accounting

16 : So lutio ns to inte ractive questions

Interactive question: asset classification (a)

Non-current asset

(b)

Non-current asset

(c)

Current asset (inventories for a car trader)

(d)

Non-current or current asset depending on how long the investment is to be held for.

Interactive question: Preparing a statement of financial position Sunken arches: Statement of financial position as at 31 December 20X6 £ Assets Non-current assets Premises Motor vehicles Fixtures & fittings

£

50,000 9,000 8,000 67,000

Current assets Inventories Trade receivables Prepayment Cash

16,000 500 300 100 16,900 83,900

Total assets Capital and liabilities Opening capital Profit for the period Less drawings Capital at 31 December 20X6 Non-current liabilities: loan Current liabilities Overdraft Trade payables Accrual

51,100 8,000 (4,000) 55,100 25,000 2,000 1,200 600

Total capital and liabilities

3,800 83,900

Chapter 3 Recording financial transactions Interactive question: Payroll Net pay to employees HMRC (PAYE and NI) – balance Pension trustees Total payroll costs

£ 129,200 70,300 20,900 220,400

Accounting

16 : So lutio ns to int eractiv e qu est ions

Chapter 4 Ledger accounting and double entry Interactive question: debits and credits Transaction

Debit (Dr)

Credit (Cr)

Purchase of books on credit

Purchases

Trade payables

Purchase of cash register by cheque

Non-current asset

Cash

Payment received from a credit customer

Cash

Trade receivables

Sell books for cash

Cash

Sales

Interactive question: Double entry for cash transactions Dr

Cash £ 250

Sales

Dr

Dr Cash Dr Cash Dr Cash

Cr £ 150 100 200

Rent expense Purchases Non-current asset (shelves)

Sales (income) £ Cash

Cr

Rent expense £ 150

Cr

Purchases expense £ 100

Cr

Non-current asset (shelves) £ 200

Cr

£ 250

£

£

£

Interactive question: Double entry for credit transactions Dr Sales

Dr

Trade receivable £ 2,000 Cash

Sales (income) £ Trade receivables

Cr £ 2,000

Cr £ 2,000

157

158

Accounting

16 : So lutio ns to inte ractive questions

Dr Cash

Dr Trade payables

Trade payables £ 100 Purchases

£ 100

Purchase expenses £ 100

Cr

Cash

Cr

Dr Trade receivables

Cr

£ 2,000

£

£ 100

Trade payables

Interactive question: Debits and credits Transaction

Debit (Dr)

Credit (Cr)

Bought a machine on credit from A, cost £8,000

Non-current asset £8,000

Trade payables £8,000

Bought goods on credit from B, cost £500

Purchases £500

Trade payables £500

Sold goods on credit to C, value £1,200

Trade receivables £1,200

Sales £1,200

Paid D (a credit supplier) £300

Trade payables £300

Cash £300

Collected £180 from E, a credit customer

Cash £1,800

Trade receivables £1,800

Paid net pay £4,000

Wages expense £4,000

Cash £4,000

Received rent bill of £700 from landlord

Rent expense £700

Trade payables £700

Paid rent of £700 to landlord G

Trade payables £700

Cash £700

Paid insurance premium £90

Insurance expense £90

Cash £90

Interactive question: Ledger accounts (Ron Knuckle) Dr Capital Loan Sales Trade receivables

Cash £ 7,000 1,000 10,000 2,480

Dr

Rent expense Non-current asset (shop fitting) Trade payables Interest expense Other expenses Drawings

Capital £ Cash

Dr Cash

Rent expense £ 3,500

Cr £ 3,500 2,000 4,950 100 1,900 1,500 Cr £ 7,000

Cr £

Accounting

16 : So lutio ns to int eractiv e qu est ions

Dr Trade payables Dr Cash

Purchases £ 4,950

Cr £

Trade payable £ 4,950 Purchases

Cr £ 4.950

Dr

Loan

Cr

£ Cash Dr Cash Dr

Dr Sales

Dr Cash Dr Cash Dr Cash

Non-current asset £ 2,000 Sales income £ Cash Trade receivables

£ 1,000 Cr £

Cr £ 10,000 2,480

Trade receivables £ 2,480 Cash

Cr £ 2,480

Interest expense £ 100

Cr £

Other expenses £ 1,900

Cr £

Drawings £ 1,500

Cr £

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Accounting

16 : So lutio ns to inte ractive questions

Worked example: Petty cash journals Dr

Petty cash Cr Cash at bank

£250 £250

Being the receipt of cash from the bank Dr Dr

Postage expense Travel expense Cr Petty cash

£33.50 £21.00 £54.50

Being the expenses from petty cash

Interactive question: VAT Balance brought forward Input VAT Purchases (£120k × 20%) Other expenses (£70k × 20%) Cash paid Balance c/f DUE TO HMRC

VAT Control account £ 15,000 Output VAT Sales (£500k × 20%) 24,000 14,000 40,000 Cash received 19,000 112,000

£ 100,000

12,000 112,000

Chapter 5 Preparing basic financial statements Balancing ledger accounts Cash ledger Opening balance Capital introduced Trade receivables Cash sales Brought forward

£ 1,500 5,500 4,000 500 11,500 5,500

Trade payables Cash purchases Cash expenses Carried forward

£ 3,000 1,000 2,000 5,500 11,500

Interactive question: Preparing the statement of profit or loss Dr Cash

Dr Trade payables

Rent expense £ 3,500 Profit & loss ledger (balancing figure) 3,500

Cr £ 3,500 3,500

Purchases £ 4,950 Profit & loss ledger (balancing figure) 4,950

Cr £ 4,950 4,950

Accounting

16 : So lutio ns to int eractiv e qu est ions

Dr Profit & loss ledger (balancing figure)

Dr Cash

Dr Cash

Sales income £ 12,480 Cash Trade receivables

Cr £ 10,000 2,480

12,480

12,480

Interest expense £

Cr £

100

100

Profit & loss ledger (balancing figure)

100

100

Other expenses £

Cr £

1,900

1,900

Profit & loss ledger (balancing figure)

1,900 Dr

(EXPENSES)

Purchases Rent Loan interest Other expenses Net profit (balancing figure)

1,900

Profit & loss Ledger £ 4,950 Sales 3,500 100 1,900 2,030

(INCOME)

12,480

Cr £ 12,480

12,480

Interactive question: Preparing the statement of financial position Dr Capital Loan Sales Trade receivables

Cash £ 7,000 1,000 10,000 2,480

Rent expense Shop fittings (non current asset) Trade payables Interest expense Other expenses Drawings carried forward (balancing figure)

20,480 Dr carried forward (balancing figure) Dr Cash

Capital £ 7,000 7,000

Cash

Drawings £ 1,500 carried forward (balancing figure) 1,500

Cr £ 3,500 2,000 4,950 100 1,900 1,500 6,530 20,480 Cr £ 7,000 7,000 Cr £ 1,500 1,500

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16 : So lutio ns to inte ractive questions

Dr Cash carried forward (balancing figure)

Trade payable £ 4,950 Purchases 0 5,000

Cr £ 4,950

Loan

Cr £ 1,000 1,000

Dr carried forward (balancing figure) Dr Cash Dr Sales

£ 1,000 1,000

Cash

Non-current asset £ 2,000 carried forward (balancing figure) 2,000

Cr £ 2,000 2,000

Trade receivables £ 2,480 Cash carried forward (balancing figure) 2,480

Cr £ 2,480 0 2,480

Preparing the financial statements Statement of profit or loss for the year ended 31 December 2010 £ 12,480 (4,950) 7,530 (3,500) (1,870) (100) 2,060

Sales Cost of sales (purchases) Gross profit Rent expense Other expenses (1900 – 30 prepayment) Interest expense Net profit

Statement of financial position as at 31 December 2010 Assets Non-current assets Current assets Prepayment Cash Total assets Capital and liabilities Owners capital brought forward Profit for the year Drawings

£ 2,000

£

30 6,530 8,560

7,000 2,060 (1,500) 7,560

Non-current liabilities Total capital and liabilities

5,000

1,000 8,560

Accounting

16 : So lutio ns to int eractiv e qu est ions

Homestudy – Preparation of accounts – Polly SOLUTION Transaction

Required journal

Capital invested

Dr Cash £400 Cr Capital £400

Bank loan

Dr Cash £5,000 Cr Loan £5,000

Overdraft limit

No double entry required

Purchased car for cash (capital expenditure)

Dr Non-current assets £2,500 Cr Cash £2,500

Paid for car insurance

Dr Insurance expense £300 Cr Cash £300

Purchased other equipment on credit (capital expenditure)

Dr Non-current assets £1,500 Cr Payables £1,500

Purchased consumables on credit

Dr Purchase expenses £500 Cr Trade payables £500

Credit sales

Dr Trade receivables £15,945 Cr Sales income £15,945

Purchased consumables on credit

Dr Purchase expenses £3,690 Cr Trade payables £3,690

Purchased diesel for cash

Dr Car expenses £650 Cr Cash £650

Cash drawings

Dr Drawings £1,250 Cr Cash £1,250

Cash received from credit customers

Dr Cash £12,935 Cr Trade receivables £12,395

Cash paid to suppliers

Dr Trade payables £3,250 Cr Cash £3,250

Capital Loan Trade receivables

Cash at bank £ 400 Non current assets 5,000 Insurance expense 12,935 Car expenses Drawings Trade payables Carried forward 18,335

£ 2,500 300 650 1,250 3,250 10,385 18,335

Capital Carried forward

£ 400 400

Cash

£ 400 400

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16 : So lutio ns to inte ractive questions

Loan Carried forward

Cash Trade payables

Cash Carried forward

Cash

Cash

Trade payables Trade payables

Profit & loss (balancing figure)

Sales

£ 5,000 5,000

Cash

£ 5,000 5,000

Non Current assets £ 2,500 1,500 Carried forward 4,000

4,000 4,000

Trade payables £ 3,250 Non current assets Purchases 2,440 Purchases 5,690

£ 1,500 500 3,690 5,690

£

Insurance expense £ 300 Profit & loss (balancing figure) 300

£ 300 300

Car expenses £ 650 Profit & loss (balancing figure) 650

£ 650 650

Purchase expenses £ 500 3,690 Profit & loss (balancing figure) 4,190

4,190 4,190

Sales income £ 15,945 Trade receivables 15,945

£ 15,945 15,945

Trade receivables £ 15,945 cash Carried forward 15,945

£ 12,935 3,010 15,945

£

Drawings Cash

£ 1,250 1,250

Carried forward

£ 1,250 1,250

Accounting

Purchases Car expenses Insurance expenses Net profit (balancing figure)

16 : So lutio ns to int eractiv e qu est ions

Profit and loss ledger £ 4,190 Sales 650 300 10,805 15,945

£ 15,945

15,945

Statement of profit or loss for the year ended 31 December 20XX £ 15,945 (4,190) 11,755 (300) (650) 10,805

Sales Cost of sales (purchases) Gross profit Insurance expenses Car expenses Net profit

Statement of financial position as at 31 December 20XX Assets Non current assets Current assets Trade receivables Cash

£

3,010 10,385 13,395 17,395

Total assets Capital and liabilities Owners capital brought forward Profit for the year Drawings

£ 4,000

400 10,805 (1,250)

Non-current liabilities (loan) Current liabilities (trade payables)

9,955 5,000 2,440

Total capital and liabilities

17,395

Chapter 6 Errors and corrections to accounting records and financial statements Interactive question: Trade payables

Cash Contra Carried forward

Trade payables £ 79,500 b/f– balancing figure 4,000 Purchases 12,920 96,420

£ 13,220 83,200 96,420

165

166

Accounting

16 : So lutio ns to inte ractive questions

Interactive question: Trade receivables and trade payables (Exports Company)

b/f Sales

Trade receivables £ 7,967 62,514 Cash Irrecoverable debt Contra c/f balancing figure 70,481

£ 55,212 326 434 14,509 70,481

Trade payables b/f Cash Contra c/f balancing figure

£ 105 37,307 434 7,933 45,779

£ 6,235 39,439 105

b/f Purchases Refund from supplier

45,779

Interactive question: Bank reconciliation Cash at bank £ brought forward 225 Bank charges 170 Dishonoured cheque 395

Dividends received carried forward

£ 310 35 50 395

Note that the brought forward balance would be a credit balance, i.e. an overdraft Bank reconciliation as at 30 June 20X0 £ Balance per bank statement

£ (70)

ADD

outstanding lodgement

400

LESS

unpresented cheques

(500)

Balance per corrected cash at bank account

Interactive question: Bank reconciliation A: decrease B: no effect C: decrease D: increase

(170)

Accounting

16 : So lutio ns to int eractiv e qu est ions

Interactive question: Bank reconciliation (Tilfner) Cash at bank £ 353 972

Investment income c/f balancing figure

£ 610 715

b/f Direct debits

1,325

1,325

Bank reconciliation £ Balance per bank statement

(1,847)

ADD

outstanding lodgement

875

LESS

unpresented cheques

nil

Balance per corrected cash at bank account

(972)

Interactive question: Journal entries Did

Should have

Correcting journal

nothing

Dr Purchases £250 Cr Trade payables £250

Dr Purchases £250 Cr Trade payables £250

Dr Non current asset £150 Cr Cash £150

Dr Repairs expense £150 Cr Cash £150

Dr Repairs expense £150 Cr Non current asset £150

Dr Sales £280 Cr Cash £280

Dr Drawings £280 Cr Cash £280

Dr Drawings £280 Cr Sales £280

Dr Electricity expense £540 Cr Cash £540

Dr Telephone expense £540 Cr Cash £540

Dr Telephone expense £540 Cr Electricity expense £540

Interactive question: Errors (T Down) Did

Should have

Correcting journal

nothing

Dr Receivables £1,000 Cr Sales £1,000

Dr Receivables £1,000 Cr Sales £1,000

Dr Distribution expenses £240 Cr Cash £240

Dr Non current asset £240 Cr Cash £240

Dr Non current assets £240 Cr Distribution expenses £240

Dr Payables £1500 Cr Purchases £150 Cr Cash £1,350

Dr Payables £1,350 Cr Cash £1,350

Dr Purchases £150 Cr Payables £150

Dr Purchases £850 Cr Trade payables £850

Dr Purchases £350 Cr Payables £350

Dr Payables £500 Cr Purchases

£500

Adjustments to profit Sales adj £ + 1,000

Expenses adj £

Gross profit

uncorrected £ 35,750

Discounts adj £ -150

Purchases adj £ + 500

corrected figures £ = £37,100

Net profit

18,500

+ 1,000

+ 240

- 150

+ 500

= £20,090

167

168

Accounting

16 : So lutio ns to inte ractive questions

Chapter 7 Cost of sales and inventories Interactive question: gross profit Statement of profit or loss Revenue/Sales

£ 80,000

Cost of sales (w1)

(43,500)

Gross profit

36,500

Cost of sales Opening inventories + purchases Less closing inventories

£ 6,000 50,000 (12,500)

Cost of sales

43,500

Interactive question: carriage inwards and outwards Statement of profit or loss for year ended 30 June 20X6 Revenue Cost of sales Gross profit Carriage outwards Other expenses

£ 162,100 (78,600) 83,500 (2,500) (56,000)

Net profit

25,000

(w) Cost of sales Opening inventories Purchases Carriage inwards Less closing inventories Cost of sales

17,000 75,000 2,000 (15,400) 78,600

Interactive question: Direct labour costs Staff member Partner Manager Student Accountant Total

Hourly charge out rate £ 200 140 80

Hours incurred 1 2 14

Labour cost £ 200 280 1,120 1,600

Accounting

16 : So lutio ns to int eractiv e qu est ions

Worked example: Inventories on the trial balance Initial trial Balance Dr £ Cash Opening capital Loan Non current assets Trade payables Expenses Purchases Sales Trade receivables Inventories Drawings Cost of sales

Cr £ 5,123 10,000 12,000

Adjustments Dr £

Final trial balance

Cr £

Dr £

20,000

Cr £ 5,123 10,000 12,000

20,000 6,800

6,800

12,785 18,425

12,785 18,425 38,745

3,546 8,754 9,158

72,668

38,745 13,855

8,754

8,754 18,425 41,034

13,855

3,546 13,855 9,158 13,324

41,034

72,668

72,668

Trade receivables £ 8,600 Irrecoverable debts (£180 + £420) 44,000 Cash received c/f (balancing figure) 52,600

£ 600 49,000 3,000 52,600

72,668

Interactive question: inventory valuation Item A Item B Item C Total inventory valuation

200 units at £20 each (cost) 150 units at £8 each (NRV) 300 units at £12 each (NRV)

£ 4,000 1,200 3,600 8,800

Interactive question: mark up and margins Margin of 25%

Mark-up of 25%

%

£

%

£

Sales

100

1,000

125

1,000

Cost of sales

(75)

(750)

100

800

Gross profit

25

250

25

200

Chapter 8 Irrecoverable debts and allowances Irrecoverable debts written off Brought forward Credit sales

169

170

Accounting

16 : So lutio ns to inte ractive questions

Trade receivables

Irrecoverable debt expense £ 600 To profit & loss ledger

£ 600

600

600

Interactive question: accounting entries for allowances for receivables 31 December 20X2 Dr

Irrecoverable debt expense Cr Allowance for receivables (1% × £28,000)

£280 £280

31 December 20X3: Closing allowance (5% × £40,000) = £2,000 therefore need to increase the allowance by £1,720 (£2,000 – £280) Dr

Irrecoverable debt expense Cr Allowance for receivables

£1,720 £1,720

Extract from Statement of Financial Position as at 31 December 20X3 Trade receivables Allowance for receivables Net trade receivable

£ 40,000 (2,000) 38,000

Interactive question: calculating the irrecoverable debt expense Irrecoverable debt expense (working) (1) Irrecoverable debts written off in period (2) Decrease in allowance (3) Old irrecoverable debts that pay in the period

£ 350 (200) (50)

Dr Dr/(Cr) Cr

Overall expense (Dr)

100

Dr

Answer: D

Interactive question: calculating the irrecoverable debt expense and trade receivables Statement of financial position (working) Trade receivables per question Irrecoverable debts written off Trade receivables (corrected)

£ 30,000 (1,800) 28,200

Year-end allowance at 2% of £28,200 Trade receivables disclosed in SOFP: £28,200 – £564 Irrecoverable debt expense (working) (1) Irrecoverable debts written off in period (2) Increase in allowance (3) Old irrecoverable debts that pay in the period Overall expense (Dr)

Answer: C

564 £27,636 £ 1,800 64 – 1,864

Dr Dr/(Cr) Cr Dr

Accounting

16 : So lutio ns to int eractiv e qu est ions

Chapter 9 Accruals and prepayments Interactive question: accruals For year ended 31.12.X2: 279.47 + 663.80 + 117.28 + (2/3 × 491.53) = £1,388.24 During the year as payments are made: Dr

Electricity expense Cr Cash

£1,060.55 £1,060.55

At year end, a journal adjustment (2/3 × 491.53) Dr

Electricity expense Cr Accruals

£327.69 £327.69

Worked examples: reversing accruals Accruals (SOFP) £ 327.69 b/f opening accrual 502.16 Electricity expense 829.85

Reverse opening accrual C/f (balancing figure)

Cash Closing accrual

Electricity expense – 20X3 £ 2,213.41 Reverse opening accrual 502.16 Profit and loss ledger 2,715.57

£ 327.69 502.16 829.85

£ 327.69 2,387.88 2,715.57

Closing accrual: £753.24 × 2/3 = £502.16

Worked example: reversing prepayment

b/f opening prepayment Closing prepayment

Reverse opening prepayment Cash

Prepayment (SOFP) £ 10,000 Reverse opening prepayment 11,000 C/f (balancing figure)

£ 10,000 11,000

21,000

21,000

Rent expense £ 10,000 Profit and loss ledger 22,000 Closing prepayment 32,000

£ 21,000 11,000 32,000

Logic check: First 6 months 1 Jan – 30 June (£20,000pa × 6/12) = £10,000 Next 6 months 1 July – 31 Dec (£22,000pa × 6/12) = £11,000 Total expense for the year ended 31 Dec

= £21,000

171

172

Accounting

16 : So lutio ns to inte ractive questions

Interactive question: Administrative expenses account In questions that are worded like this, where you are told that “closing accruals are higher/lower than brought forward accruals”, it easier to put some (invented) figures into the T account. For example, an opening accrual of £100 would create a c/f = nil and an opening prepayment of £150 would mean a c/f nil.

Reverse opening prepayment Trade payables Cash at bank

Administrative expense £ 150 Reverse opening accrual 10,500 Profit and loss ledger 250

£ 100 10,800

10,900

10,900

Interactive question: Accrued income (Simon Ltd) Reverse opening accrued income Income to P&L (balancing figure) Closing deferred income

Rent receivable £ 2,450 Reverse opening deferred income 56,050 Cash received 650 Closing accrued income 59,150

£ 730 55,220 3,200 59,150

Answer: D

Chapter 10 Non current assets and depreciation Interactive question: Depreciable amount £18,720 – £6,360 = £12,360

Interactive question: straight line depreciation Depreciation= (£24,000 – £0)/ 48 months = £500 per month Depreciation expense for the year ended 31 December 20X1, asset has been held for 9 months: 9 × £500 = £4,500

Interactive question: straight line vs reducing balance (a)

Straight line depreciation: (£17,000 – £2,000)/5 years = £3,000 per annum for each of the 5 years

(b)

Reducing balance: Cost Depreciation @ 35% Net book value Depreciation @ 35% Net book value Depreciation @ 35% Net book value Depreciation @ 35% Net book value Depreciation @ 35% Net book value

£ 17,000 (5,950) 11,050 (3,868) 7,182 (2,514) 4,668 (1,634) 3,034 (1,062) 1,972

Depreciation charge for year 1 Depreciation charge for year 2 Depreciation charge for year 3 Depreciation charge for year 4 Depreciation charge for year 5

Accounting

16 : So lutio ns to int eractiv e qu est ions

Interactive question: change in depreciation method Revised annual depreciation charge (£65,610 – £0)/5 years = £13,122 per annum

Interactive question: accounting for depreciation Statement of profit or loss extract: Year ended 28 Feb 20X7: Depreciation expense £4,500 Year ended 28 Feb 20X8: Depreciation expense £4,500 Year ended 28 Feb 20X9: Depreciation expense £4,500 Statement of financial position:

Year ended 28 Feb 20X7 Year ended 28 Feb 20X8 Year ended 28 Feb 20X9

Cost £ 16,000 16,000 16,000

Accumulated depreciation £ 4,500 9,000 13,500

Carrying value £ 11,500 7,000 2,500

Interactive question: accounting for disposals of non-current assets Machinery – Cost £ 110,000 Disposal

£ 30,000

Machinery – Accumulated depreciation £ 12,000 b/f

£ 70,000

b/f

Disposal (£30k × 20% × 2 years)

Cost P&L ledger – PROFIT on disposal

Disposal ledger £ 30,000 Accumulated depreciation 1,000 Cash 31,000

Check: Proceeds Carrying value (cost less accumulated depreciation) Profit on disposal

£ 12,000 19,000 31,000 £ 19,000 18,000 1,000

Example of intangible assets Some examples of intangible assets might be: goodwill, brand name, license rights, patents, customer lists, development costs.

173

174

Accounting

16 : So lutio ns to inte ractive questions

Chapter 11 Company financial statements Interactive question: rights issue Before the rights issue: £6,000,000/0.2 = 30 million shares in issue 1 for 3 rights issue: 30m × 1/3 = 10 million shares at £1.80 each Dr

Cash (10 million × £1.80) Cr Share capital (10 million × 20p) Cr Share premium (balancing figure)

Current assets Share Capital Share premium

£2,900k + £18,000k = £6,000k + £2,000k = £5,700k + £16,000k =

£18,000k £2,000k £16,000k £20,900k £8,000k £21,700k

Interactive question: bonus issue Shares before bonus issue: £400,000 / 50p = 800,000 shares 800,000 × 1/5 = 160,000 shares issues for free with nominal value of 50p = £80,000 Dr

Share premium Cr Share capital

£80,000 £80,000

There are now 960,000 shares prior to the rights issue 960,000 × 1/3 = 320,000 shares issued for £1.60 per share Dr

Cash (320,000 × £1.60) Cr Share capital (320,000 × 50p) Cr Share premium (balancing figure)

£512,000 £160,000 £352,000

Revised statement of financial position Total assets (£2,000k + £512k)

£'000 2,512

EQUITY AND LIABILITIES Equity Share capital: equity shares of 50p each (£400k + £80k + £160k) Share premium (£500k – £80k + £352k) Retained earnings Total equity

640 772 300 1,712

Total liabilities Total equity and liabilities

800 2,512

Accounting

16 : So lutio ns to int eractiv e qu est ions

Chapter 12 Company financial statements under UK GAAP Interactive question: The statement of changes in equity Statement of changes in equity for the year ended 31 December 20X9

Balance at 1 January 20X9 Issue of shares Profit for the year (W1) Dividends (W2) Balance at 31 December 20X9

Share capital £ 100,000 2,500

102,500

Share premium £ 20,000 1,500

21,500

Retained earnings 45,500

Other reserves £ 10,000

15,300 (4,100) 56,700

10,000

Total £ 175,500 4,000 15,300 (4,100) 190,700

(W1) Profit for the year (after deducting 6 months of accrued dividend on the redeemable preference shares): £15,800 – (£20,000 × 5% × 6/12) = £15,300 (W2) Dividends based on the number of ordinary/equity shares in November being the brought forward 200,000 shares (£100,000/0.5p per share) and the additional 5,000 shares issued in February.

205,000 shares at 2p per share is a total dividend of £4,100.

Remember redeemable preference shares are treated as a liability and should not appear in the SOCIE. The dividend on redeemable preference shares is treated as a finance cost in the statement of profit or loss.

Interactive question: Accounts preparation for a limited company (exam technique – Digby Ltd) Statement of profit or loss for the year ended 31 December 20X6 Revenue Cost of sales (W1) Gross profit Distribution costs (W1) Administrative expenses (W1) Profit from operations Investment income Finance cost (680 + 9,000 (W4)) Profit before tax Income tax expense (460 + 14,200) Profit for the year

£ 487,280 (227,209) 260,071 (49,308) (165,353) 45,410 3,411 (9,680) 39,141 (14,660) 24,481

175

176

Accounting

16 : So lutio ns to inte ractive questions

Statement of financial position as at 31 December 20X6 £ ASSETS Non-current assets Property, plant and equipment (W2) Current assets Inventories (W3) Trade and other receivables Cash and cash equivalents Total assets

529,875 97,308 193,545 75 820,803

EQUITY AND LIABILITIES Equity Ordinary share capital Share premium Retained earnings (123,382 + 24,481 – 2,500)

250,000 50,000 145,363 445,363

Non-current liabilities Borrowings Current liabilities Borrowings Trade and other payables Accruals (W4) Taxation Total equity and liabilities

150,000 640 201,600 9,000 14,200 820,803

WORKINGS (1)

Expenses COS £ 258,411 64,060 2,046

Per TB Opening inventories 1 Jan 20X6 Labour Closing inventories at 31 Dec 20X6 (W3) Depreciation Buildings (W5) Motor Vehicles (W5) Fix + Fittings (W5)

(2)

Dist’n £ 6,011

Admin £ 31,046

1,097 3,400

9,682

(97,308) 6,500 38,800 227,209

49,308

118,125 165,353

Cost b/f Depreciation b/f

Land and buildings £ 496,500 (150,200)

Motor vehicles £ 186,000 (89,000)

Furniture & fixtures £ 525,000 (275,000)

Total £ 1,207,500 (514,200)

Carrying amount b/f Charge for year (W5)

346,300 (6,500)

97,000 (38,800)

250,000 (118,125)

693,300 (163,425)

Carrying amount

339,800

58,200

131,875

529,875

Property, plant and equipment

Accounting

(3)

16 : So lutio ns to int eractiv e qu est ions

Inventories Sales price 17 January Sales 1-17 January Sales price Cost price Purchases 1-17 January Inventories at cost on 31 December

(4)

£ 114,600 23,600 138,200 106,308 (9,000) 97,308

130% 100%

Finance cost 'Dividend' on redeemable preference shares (6% × £150,000) = £9,000

(5)

Depreciation expense Buildings: (£496,500 – £171,500) × 2% = £6,500 Motor vehicles: £97,000 × 40% = £38,800 Fixtures and fittings: (£525,000 – £52,500) × 25% = £118,125

Chapter 13 Statement of cash flows Interactive question: Cash payment for property, plant and equipment

Brought forward Additions – balancing figure

Property, plant and equip -cost £ 5,100,000 Disposal 2,550,000 Carried forward 7,650,000

£ 850,000 6,800,000 7,650,000

The company started the year with PPE at cost of £5,100,000. It bought a further £2,550,000 of PPE, giving a total of £7,650,000 at cost. However, there were disposals of PPE with a cost of £850,000, bringing the year-end figure down to £6,800,000.

Interactive question: Bonus issue

Carried forward

Share Capital + Share Premium £ Brought forward Retained earnings 23,400,000 Cash received (balancing figure) 23,400,000

£ 14,800,000 200,000 8,400,000 23,400,000

177

178

Accounting

16 : So lutio ns to inte ractive questions

Interactive question: Preparing a statement of cash flows (Kane Ltd) Statement of cash flows for the year ended 31 December 20X2 (indirect method) £'000 Cash flows from operating activities Profit before taxation

392

Loss on sale of property, plant and equipment

18

Depreciation

118

Interest expense

28

Increase in trade and other receivables

(16)

Increase in inventories

(4)

Increase in trade payables (12 – 2) – (6-1)

5

Cash generated from operations

541

Interest paid (W1)

(27)

Income taxes paid (W2)

(110)

Net cash from operating activities

404

Cash flows from investing activities Purchase of property, plant and equipment

(90)

Proceeds from sale of equipment (W2)

12

Net cash from investing activities

(78)

Cash flows from financing activities Proceeds from issue of share capital 360 + 36 – 340 – 24

32

Movement on borrowings 500 – 200

(300)

Dividend paid

(66)

Net cash from financing activities

(334)

Net increase in cash and cash equivalents

(8)

Cash and cash equivalents at the beginning of the period

56

Cash and cash equivalents at the end of the period

48

Accounting

16 : So lutio ns to int eractiv e qu est ions

Workings (W1) Interest paid b/f accrued interest Finance charge Interest paid (balancing figure) c/f accrued interest

£’000 1,000 28,000 (27,000) £2,000

(W2) Tax paid £’000 b/f tax liability (86,000 – 8,000)

78,000

Tax expense

124,000

Tax paid (balancing figure)

(110,000)

c/f tax liability (102,000 – 10,000)

92,000

(W3) Property, plant and equipment

b/f Purchases Depreciation charge for year Disposal (balancing figure) c/f

COST £’000 1,560,000 90,000 – (54,000) 1,596,000

Proceeds on disposal

£’000 12,000

Carrying value (£54k – £24k)

30,000

Loss on disposal

(18,000)

ACC. DEPN £’000 224,000 – 118,000 (24,000) 318,000

(W4) Dividends paid b/f retained earnings Profit after tax Dividends paid (balancing figure) c/f retained earnings

£’000 514,000 268,000 (66,000) 716,000

Chapter 14: Company financial statements under UK GAAP No interactive questions.

179

180

Accounting

16 : So lutio ns to inte ractive questions

Chapter 15: Sole trader financial statements Worked example: Sole trader financial statements: A Lone SOLUTION A Lone’s final trial balance can be calculated as follows

Owner’s capital at 1.1.X5 Bank loan Freehold land and buildings Freehold land and buildings – accumulated depreciation Plant and machinery – cost Plant and machinery – accumulated depreciation Stock Sales Purchases Loan interest Wages and salaries Drawings Sundry expenses Suspense account Debtors Creditors Cash at bank Capital introduced Disposals Depreciation expense Accruals Cost of sales

Initial TB Debit Credit £’000 £’000 650 813 630

Adjustments Debit Credit £’000 £’000

40

15 550

810

56 390

440

1,360 102 390

94 440

64 1,935

1,052 30

860

60 354 51 123

860

464

464 215

215

161

161 456 71

4,615

1,442 3,393

A Lone: Profit and loss account for year ended 31 December 20X5 £’000

Net profit

55

1,935 1,052 30 354 51 123

4,615

Sales Cost of sales Gross profit Expenses Loan interest Wages and salaries Sundry expenses Loss on disposal Depreciation expense

Final TB Debit Credit £’000 £’000 650 813 630

£’000 1,935 (1,002) 933

60 354 123 126 71 (734) 199

530 330 30 440 3,393

530 126 71 30 1,002 4,292

4,292

Accounting

16 : So lutio ns to int eractiv e qu est ions

A Lone: Balance sheet as at 31 December 20X5

Fixed assets Freehold land and buildings Plant and machinery

Cost £’000

Acc. depn. £’000

£’000

630 810 1,440

55 64 119

575 746 1,321

Current assets Stock Debtors Cash

Current liabilities Accruals Creditors Net current assets Non-current liabilities Bank loan Ownership interest Opening capital Capital introduced Profit for year Drawings Closing capital

440 464 161 1,065 £'000's 30 215 245

£'000's

2,141 813 1,328 650 530 199 51 1,328

181

182

16:Solutions to interactive questions

Accounting

183

17 Summary of debits and credits

The table on the next page gives you a useful summary of debits and credits.

184

17 : Appendix : Summary of debits and c redits

DEBITS INCREASE

Examples

Accounting

CREDITS INCREASE

Expenses

🞂 🞂 🞂 🞂 🞂 🞂 🞂 🞂 🞂 🞂 🞂 🞂 🞂

Purchases Telephone expense Wages and salaries Heat and light Irrecoverable debt expense Depreciation expense Rent and rates Interest expense Office expenses Repairs and maintenance Carriage inwards Carriage outwards Loss on disposal

Assets

🞂 🞂 🞂 🞂 🞂 🞂

Cash at bank Income Petty cash Trade receivables * Prepayments Inventory (closing) Non-current assets ** (eg land and buildings, motor vehicles, plant and equipment, fixtures and fittings, intangibles) VAT due from HMRC Accrued income

🞂 🞂

Liabilities

Examples 🞂 🞂 🞂 🞂 🞂 🞂 🞂

Trade payables Loans Accruals VAT due to HMRC Bank overdraft Tax payable Deferred income

🞂 🞂 🞂 🞂 🞂 🞂

Sales/revenue Profit on disposal Rental income Subscription income Dividend income Interest income

🞂 🞂 🞂

Share capital Share premium Retained earnings

* disclosed net of allowance for receivables ** disclosed net of accumulated depreciation Drawings

🞂

Dividends for a limited company

Capital

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