Chapter 1: Assets,
liabilities and the accounting equation
A business may be defined in
various ways. Its purpose is to make a profit for its owner(s).
Profit is the excess of
income over expenditure.
A business owns assets and
owes liabilities.
Assets are items belonging to
a business and used in the running of the business. They may be non-current
(such as machinery or office premises) or current (such as inventory,
receivables and cash).
Liabilities are sums of money
owed by a business to outsiders such as a bank or a supplier.
For accounting purposes it is
important to keep business assets and liabilities separate from the personal
assets and liabilities of the proprietor(s).
Assets = Capital +
Liabilities (the accounting equation)
P = I + D – C (the business
equation)
Where P = Profit earned in current period
I = Increase/decrease in net asset in current period
D = Drawing in current period
C = Capital introduced in current period
Double entry book-keeping
requires that every transaction has two accounting entries, a debit and a
credit.
Chapter 2: Statement of
financial position and income statement
A statement of financial
position shows the financial position of a business at a given moment in time.
A distinction is made between non-current liabilities and current liabilities,
and between non-current assets and current assets.
Non-current assets are those
acquired for long-term use within the business.
Current assets are expected
to be converted into cash within one year. Current liabilities are debts which
are payable within one year.
An income statement shows in
detail how the profit or loss of a period has been made.
An important distinction is
made between capital and revenue items. If these are not identified correctly,
then the resulting profit figure will be wrong and misleading.
Chapter 3: Recording and
summarizing transactions
It is very important that
businesses keep financial records for both internal and external use.
Business transactions are
initially recorded on source documents. The most important are invoices and
credit notes. Records of the details on these documents are made in books of
prime entry.
Most accounts are contained
in the general ledger (or nominal ledger).
The rules of double entry
state that every financial transaction gives rise to two accounting entries,
one a debit, the other a credit.
There are two kinds of
discount:
- Trade discount: a
reduction in the cost of goods
- Cash (or
settlement) discount: a reduction in the amount payable to the supplier
Chapter 4: Posting
transactions, balancing accounts and the trial balance
The rules of double entry
state that every financial transaction gives rise to two accounting entries,
one a debit, the other a credit. It is vital that you understand this
principle.
A debit in one of the
following:
- An increase in an
asset
- An increase in an
expense
- A decrease in a
liability
A credit in one of the
following:
- An increase in a
liability
- An increase in
income
- A decrease in an
asset
The accounts in the general
ledger are impersonal accounts. There are also personal accounts for customers
and suppliers and these are contained in the receivables ledger and payables
ledger.
A control account is an
account in the general ledger in which a record is kept of the total value of a
number of similar but individual items.
- A receivables
control account (or receivable account) records all transactions involving all
customers in total.
- A payables
control account (or payables account) is an account in which records are kept
of transactions involving all suppliers in total.
Sales tax rules can be quite
complex but main points to remember are:
- Output tax is
charged on sales
- Input tax is
incurred on purchases
- Sales invoices
must show sales tax
A journal keeps a record of
unusual movements between accounts. The format of journal is:
DEBIT Account
to be debited
CREDIT Account
to be credited
Narrative to explain the transaction
Balances on ledger accounts
can be collected in a trial balance. The debit and credit balances should be
equal.
Computerized accounting
systems perform the same tasks as manual accounting systems, but they can cope
with greater volumes of transactions and process them at a faster rate.
Chapter 5: Accounting
concepts and principles
In preparing financial
statements, certain fundamental principles and concepts are adopted as a
framework.
Going concern: the business
is expected to stay in business
Accruals: revenues and costs
should be matched in the same time period
Prudence: a cautious approach
is advised
Consistency: like items
should be treated in a like way
Materiality: in some cases,
attention to detail can obscure the big picture
Qualitative characteristics
of financial statements are those characteristics that make them more
meaningful to anyone using them. The four most important of these are:
- Relevance
- Reliability
- Comparability
- Understandability
Accounting policies are used
by the entity to help achieve relevance, reliability, comparability and
understandability.
Chapter 6: Control
accounts and the correction of errors
The two most important
control accounts are those for receivables and payables. They are part of the
double entry system.
Day books (cash day books,
sales day book and purchases day book) are totaled periodically (say a month)
and the appropriate totals are posted to the control accounts. The individual
entries in day books will have been entered one by one in the appropriate
personal accounts contained in the receivables ledger and payables ledger. The
personal accounts are not part of the double entry system.
At suitable intervals the
balances on personal accounts are extracted from the ledgers, listed and
totaled. The total of the outstanding balances can then be reconciled to the
balance on the appropriate control account and any errors located and
corrected.
There are five types of
errors:
-
Errors of
transposition
-
Errors of
omission
-
Errors of
principle
-
Errors of
commission
-
Compensating
errors
Errors which leave total
debits and total credits on the ledger accounts in balance can be corrected by
using journal entries. Otherwise, a suspense account has to be opened.
Suspense accounts, as well as
being used to correct some errors, are also opened when it is not known
immediately where to post an amount. When the mystery is solved, the suspense
account is closed and the amount correctly posted using a journal entry.
Bank reconciliations identify
and explain differences between the bank statement and the bank ledger account.
Chapter 7: Accruals and
prepayments, receivable and irrecoverable debts
Accrued expenses are expenses
which relate to (i.e. have been incurred during) an accounting period but have
not yet been paid. They are a charge against the profit for the period and they
are shown in the statement of financial position as at the end of the period as
a current liability.
Prepayments are expenses
which have already been paid but relate to a future accounting period. They are
not charged against the profit of the current period, and they are shown in the
statement of financial position at the end of the period as a current asset.
Receivables can be broken
down into trade receivables and non-trade receivables.
Some trade receivables may
need to be written off as irrecoverable debts. Additionally, an allowance for
receivables may be created. Rather than affecting individual customer balances,
an allowance for receivables recognizes the fact that ordinarily a certain
proportion of all debts may not be collected.
Chapter 8: Cost of goods sold
and the treatment of inventories
The cost of goods sold is
calculated by applying the formula:
Opening inventory value
x
Add cost of purchases
x
Less closing inventory value (x)
Equals cost of goods sold
x
The value of closing
inventory is accounted for in the general ledger by debiting the inventory
account and crediting the income statement. The inventory account will
therefore always have a debit balance at the end of a period, and this balance
will be shown in the statement of financial position as a current asset for
inventories.
Opening inventories brought
forward in the inventory account are transferred to the income statement, so
the closing balance on the inventory account is the closing inventory value
carried forward.
An inventory ledger account
is kept which is only ever used at the end of an accounting period, when the
business counts up and values inventory in hand. The quantity of inventory held
at the year end is established by means of a physical count of items in an
annual exercise, or by a ‘continuous’ inventory count.
The value of inventories is
calculated by taking the lower of cost and NRV (net realizable value) for each
item or group of items:
-
NRV is selling
price less all costs to completion and less selling costs
-
Cost comprises
purchase costs
In order to value the
inventory, some pricing method must be adopted. This can be FIFO or average
cost.
Chapter 9: Non-current
assets and depreciation
Capital expenditure results
in the acquisition of non-current assets or an improvement in their earning
capacity. Revenue expenditure is expenditure which is incurred for the purpose
of the trade of the business or to maintain the existing earning capacity of
non-current assets.
Only material items should be
capitalized.
Since a non-current asset has
a cost and a limited useful life and its value eventually declines, it follows
that a charge should be made in the income statement to reflect the use that is
made of the asset by the business. This charge is called depreciation.
The most common method of
depreciation are:
-
The straight line
method
-
The reducing
balance method
The accounting entries to
record depreciation are:
DEBIT Depreciation
expense (in the income statement)
CREDIT Accumulated
depreciation (in the statement of financial position)
The book of prime entry from
which postings are made relating to purchases, sales and depreciation of
non-current assets is the journal.
The profit or loss on
disposal of non-current assets is the difference between the sale price of the
asset and the net book value of the asset at the time of sale.
Discrepancies between the
register and the actual assets, and between the register and the general ledger
must be investigated and resolved.
Additions and disposals over
a certain amount must be authorized on a capital expenditure authorization form
and a disposal authorization form respectively.
Chapter 10: The accounts
of sole traders
At suitable intervals, the
entries in each ledger account are totaled and a balance is struck. Balances
are usually collected in a trial balance which is then used as a basis for
preparing an income statement and a statement of financial position. A trial
balance checks the accuracy of the accounting records. Debits and credits
should be equal.
An income and expense ledger
account is opened up to gather all items relating to income and expenses. When
rearranged, the items make up the income statement.
The balances on all remaining
ledger accounts (including the income and expense account) can be listed and
rearranged to form the statement of financial position.
Chapter 11: Extended trial
balance
An extended trial balance is
used to adjust trial balance figures for:
-
Errors
-
Accruals and
prepayments
-
Depreciation
-
Irrecoverable debts
written off
-
Adjustments to
the allowance for receivables
-
Closing inventory
figures
The extended trial balance is
basically a worksheet showing all the ledger account balances and adjustments
to them. It produces balances which can be taken directly to the statement of
financial position and income statement.
Chapter 12: Incomplete
records
Incomplete records questions
may test your ability to prepare accounts in the following situations.
-
A trader does not
maintain a ledger and therefore has no continuous double entry record of
transactions.
-
Accounting records
are destroyed by accident, such as fire.
- Some essential
figure is unknown and must be calculated as a balancing figure.
The approach to incomplete
records questions is to build up the information given in order to complete the
necessary double entry. This may involve reconstructing control accounts for:
-
Cash and bank
-
Trade accounts
receivable and payable
Where inventory, sales or
purchases is the unknown figure it will be necessary to use information on
gross profit percentages to construct a trading account in which the unknown
figure can be inserted as a balance.
Chapter 13: Partnerships
In the partnership statement
of financial position, net assets are financed by partners’ capital and current
accounts. Current accounts must be credited with the profits appropriated to
each partner for the year, and debited with partners’ drawings. Drawings,
salaries and interest on capital are not expenses. They appear in the
appropriation account.
An income statement may be
prepared for a partnership in exactly the same way as for a sole trader. In the
appropriation account the net profit is then apportioned between the partners
according to the partnership agreement.
When a new partner is
admitted to the partnership they will introduce funds to share in the ownership
of the firm’s assets and to purchase a share of the partnership’s goodwill.
