Summary for all chapters

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.