F3 BPP Notes

Financial Accounting
Paper F3 (International) Course Notes ACF3CN07 (INT)
F3 Financial Accounting (INT) (Paper Based Exam) Study Programme

1 2 3 4 5
Page Introduction to the paper and the course............................................................................................................... (ii) Introduction to accounting ........................................................................................................................... 1.1 Home study chapter - The regulatory framework ........................................................................................ 2.1 Accounting conventions............................................................................................................................... 3.1 Sources, records and books of prime entry................................................................................................. 4.1 Ledger accounts and double entry .............................................................................................................. 5.1 Home Study
End of Day 1 refer to Course Companion for 6 7 8 9 10 11
From trial balance to financial statements ................................................................................................... 6.1 Sales tax...................................................................................................................................................... 7.1 Inventory...................................................................................................................................................... 8.1 Tangible non-current assets........................................................................................................................ 9.1 Intangible non-current assets .................................................................................................................... 10.1 Accruals and prepayments........................................................................................................................ 11.1 Home Study
End of Day 2 refer to Course Companion for 12 13 14 15
Irrecoverable debts and allowances .......................................................................................................... 12.1 Provisions and contingencies.................................................................................................................... 13.1 Control accounts ....................................................................................................................................... 14.1 Bank reconciliations................................................................................................................................... 15.1 Home Study
End of Day 3 refer to Course Companion for 16 17 18 19 20 21 22 23 24 25 26
Correction of errors.................................................................................................................................... 16.1 Preparation of financial statements for sole traders .................................................................................. 17.1 Incomplete records.................................................................................................................................... 18.1 Partnerships .............................................................................................................................................. 19.1 Home Study Introduction to company accounting.......................................................................................................... 20.1 Preparation of financial statements for companies.................................................................................... 21.1 Events after the balance sheet date .......................................................................................................... 22.1 Cash flow statements ................................................................................................................................ 23.1 Home study chapter - Information technology........................................................................................... 24.1 Home Study Answers to Lecture Examples .................................................................................................................. 25.1 Pilot paper (Questions only) ...................................................................................................................... 26.1 Dont forget to plan your revision phase!
End of Day 4 refer to Course Companion for
End of Day 5 refer to Course Companion for
Revision of syllabus Testing of knowledge Question practice Exam technique practice
BPP provides revision courses, question days, mock days and specific material to assist you in this important phase of your studies.
(i)
INTRODUCTION
Introduction to Paper F3 Financial Accounting (INT)

Overall aim of the syllabus
To develop knowledge and understanding of the underlying principles and concepts relating to financial accounting and technical proficiency in the use of double-entry accounting techniques including the preparation of basic financial statements.
The syllabus
The broad syllabus headings are: A B C D E F The context and purpose of financial reporting The qualitative characteristics of financial information and the fundamental bases of accounting The use of double entry and accounting systems Recording transactions and events Preparing a trial balance Preparing basic financial statements
Main capabilities
On successful completion of this paper, candidates should be able to: Explain the context and purpose of financial reporting Define the qualitative characteristics of financial information and the fundamental bases of accounting Demonstrate the use of double entry and accounting systems Record transactions and events Prepare a trial balance (including identifying and correcting errors) Prepare basic financial statements for incorporated and unincorporated entities
Links with other papers

Corporate Reporting (P2)
Financial Reporting (P7)
Accountant in Business (F1)
Financial Accounting (F3)
This diagram shows where direct (solid line arrows) and indirect (dashed line arrows) links exist between this paper and other papers that may precede or follow it. Paper F7 Financial Reporting, assumes knowledge acquired in paper F3 Financial Accounting, and develops and applies this further and in greater depth. Paper P2 Corporate Reporting, assumes knowledge acquired at the Fundamentals level including core technical capabilities to prepare and analyse financial reports for single and combined entities.
(ii)
INTRODUCTION
Assessment methods and format of the exam

Examiner: Nicola Ventress The examination is a two hour paper and all questions are compulsory. Questions will assess all parts of the syllabus and will contain both computational and non-computational elements. Format of the Exam 40 two mark questions 10 one mark questions Marks 80 10 90
(iii)
INTRODUCTION
Course Aims
Achieving ACCA's Study Guide Outcomes
A The context and purpose of financial reporting
Chapter 1 Chapter 1 Chapter 1 Chapter 2
A1 The reasons for and objectives of financial reporting A2 Users and stakeholders needs A3 The main elements of financial reports A4 The regulatory framework
The qualitative characteristics of financial information and the fundamental bases of accounting
Chapter 3 Chapter 3
B1 The qualitative characteristics of financial reporting B2 Alternative bases used in the preparation of financial information
The use of double entry and accounting systems

Chapters 4 & 5 Chapters 4 & 5 Chapter 24
C1 Double entry bookkeeping principles including the maintenance of accounting records and sources of information C2 Ledger accounts, books of prime entry and journals C3 Accounting systems and the impact of information technology on financial reporting
Recording transactions and events

Chapters 4, 5, 7 & 14 Chapters 4 & 5 Chapter 8 Chapter 9 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapters 20 & 21
D1 Sales and purchases D2 Cash D3 Inventory D4 Tangible non-current assets D5 Depreciation D6 Intangible non-current assets and amortisation D7 Accruals and prepayments D8 Receivables and payables D9 Provisions and contingencies D10 Capital structure and finance costs
(iv)
INTRODUCTION
E
E1 E2 E3 E4 E5
Preparing a trial balance

Trial balance Correction of errors Control accounts and reconciliations Bank reconciliations Suspense accounts Chapter 6 Chapter 16 Chapter 14 Chapter 15 Chapter 16
F
F1 F2 F3 F4 F5 F6
Preparing basic financial statements

Balance sheets Income statements Events after the balance sheet date Accounting for partnerships Cash flow statements (excluding partnerships) Incomplete records Chapter 17 Chapter 17 Chapter 22 Chapter 19 Chapter 23 Chapter 18
(v)
INTRODUCTION
Classroom tuition and Home study

Your studies for BPP consist of two elements, classroom tuition and home study.
Classroom tuition
In class we aim to cover the key areas of the syllabus. To ensure examination success you will to spend private study time reinforcing your classroom course with question practice and reviewing areas of the Course Notes and Study Text.
Home study
To support you with your private study BPP provides you with a Course Companion which helps you to work at home and aims to ensure your private study time is effectively used. The Course Companion includes a Home Study section which breaks down your home study by days, one to be covered at the end of each day of the course. You will find clear guidance as to the time to spend on various activities and their importance. You are also provided with progress tests and two course exams which should be submitted for marking as they become due. These may include questions on topics covered in class and home study.
BPP Learn Online

Come and visit the BPP Learn Online free at www.bpp.com/acca/learnonline for exam tips, FAQs and syllabus health check.
ACCA Forum
We have thriving ACCA bulletin boards at www.bpp.com/accaforum. Register and discuss your studies with tutors and students.
Helpline
If you have any queries during your private study simply contact your class tutor on the telephone number or e-mail address that they will supply. Alternatively, call +44 (0)20 8740 2222 (or your local training centre if outside the London area) and ask for a tutor for this paper to speak to you or to call you back within 24 hours.
Feedback
The success of BPPs courses has been built on what you, the students tell us. At the end of the course for each subject, you will be given a feedback form to complete and return. If you have any issues or ideas before you are given the form to complete, please raise them with the course tutor or relevant head of centre. If this is not possible, please email ACCAcoursesfeedback@bpp.com.
(vi)
INTRODUCTION
Key to icons
Question practice from the Study Text

This is a question we recommend you attempt for home study.
Section reference in the Study Text

Further reading is needed on this area to consolidate your knowledge.
(vii)
INTRODUCTION
(viii)
Introduction to accounting
Syllabus Guide Detailed Outcomes

Having studied this chapter you will be able to:

Define and understand the principles of financial reporting. Identify and define the different business entities of: sole trader, partnership and limited liability company and recognise the legal differences between them. Identify the advantages and disadvantages of operating as each of the three types of business entity. Identify the users of financial statements and state and differentiate between their information needs. Understand and identify the purpose of each of the main financial statements. Define and identify assets, liabilities, equity, revenue and expenses.
Exam Context
This chapter introduces the subject of accounting. Questions on this area will most likely focus on the different characteristics of the three types of business entity: sole trader, partnership and limited liability company.
Qualification Context
Sole trader and partnership accounts are only examined in Financial Accounting. The Fundamentals and Professional level papers of Financial Reporting (F7) and Corporate Reporting (P2) are set in the context of a limited liability company. These papers will test your understanding of the content of financial statements and the detailed accounting rules which companies must apply.
1.1
1: INTRODUCTION TO ACCOUNTING
Overview
Income statement Balance sheet
Financial statements
Users of financial information
Introduction to accounting
Types of business entities
Sole trader
Partnership
Limited liability company
Concept of separate entity
1.2
1
1.1
Accounting
Accounting is a way of recording, analysing and summarising transactions of a business.
Definition
2
2.1
Proforma financial statements

Income statement for the year ended 31 December 20X7: $ Sales Less: Cost of sales Opening inventories Purchases Carriage inwards Closing inventories Gross profit Sundry income Discounts receivable Less: Expenses Rent Carriage outwards Telephone Electricity Wages and salaries Depreciation Bad and doubtful debts Motor expenses Discounts allowable 11,000 4,000 1,000 2,000 9,000 7,000 3,000 5,000 1,000 (43,000) 45,000 40,000 110,000 20,000 170,000 (50,000) (120,000) 80,000 5,000 3,000 88,000 $ 200,000
Income statement
Profit for the period
1.3
Balance sheet
2.2 Balance sheet as at 31 December 20X7: $ ASSETS Non-current assets Land and buildings Office equipment Motor vehicles Furniture and fixtures Current assets Inventories Trade receivables Less: allowance for receivables Prepayments Cash in hand and at bank Total assets CAPITAL AND LIABILITIES Capital Capital Profit Less: drawings Non-current liabilities Bank loans Current liabilities Bank overdraft Trade payables Accruals Total capital and liabilities $ 100,000 50,000 30,000 20,000 200,000 50,000 30,000 (2,000) 28,000 5,000 7,000 90,000 290,000
170,000 45,000 (25,000) 190,000 40,000 16,000 40,000 4,000 60,000 290,000
1.4
Users of financial information

Idea generation
Lecture example 1
Required What information would these users of financial information be interested in?
Solution
(a) Investors
(b)
Employees
(c)
Lenders
(d)
Suppliers
(e)
Customers
(f)
Governments and their agencies
(g)
Public
1.5
4
4.1 4.2 4.3 4.4
Accounting records
In order to be able to produce an income statement and a balance sheet a business needs to keep a record of all its transactions. This process is called bookkeeping. Accounting records should be complete, accurate and valid if the information produced is to be useful for the users of financial information. The mechanics of bookkeeping and the accounting records a business should keep will be covered in Chapters 4, 5 and 6.
5
Quick Quiz Q2
Types of business entities

Businesses fall into three main types: (a) Sole trader
5.1
(b)
Partnership
(c)
Sections 2.3, 2.4
Limited liability company
The sole trader is the simplest of these forms.
6
6.1 6.2 6.3
The concept of business entity (separate entity)

A business is considered to be a separate entity from its owner and so the personal transactions of the owner should never be mixed with the business transactions. When considering a limited liability company this distinction is laid down in law the company has a separate legal identity. In preparing accounts, any type of business is treated as being a separate entity from its owner(s).
1.6
7
7.1
Summary of Chapter 1
Financial statements are used by a wide variety of users, each with different information needs. Satisfying the investors needs will mean that the majority of other users needs are also met. There are three main types of businesses. For sole traders and partnerships the owners have unlimited liability and bear all the risks and reap all the rewards of being in business. For a limited liability company the shareholders' liability is limited to the extent of their investment. The business entity concept states that a business is a separate entity from its owners
7.2
7.3
1.7
1.8
Chapter 1: Questions
1.9
1: QUESTIONS
1.1
In a sole trader and a partnership the owners are personally liable if the business cannot meet its debts. Is this statement true or false? A B True False (1 mark)
1.2
If a limited liability company goes into liquidation will the shareholders have to make a financial contribution to help the company pay its creditors? A B Yes No The business must be treated as being separate from its owners. A business must be set up as a separate legal entity. (1 mark) (1 mark)
1.3
Which of the following statements most accurately defines the business entity concept? A B
1.10
Chapter 1: Answers
1.11
1: ANSWERS
1.1 1.2 1.3
A B A
END OF CHAPTER
1.12
Home study chapter The regulatory framework

Having studied this chapter you will be able to: Understand the role of the regulatory system including the roles of the International Accounting Standards Committee Foundation (IASCF) International Accounting Standards Board (IASB) Standards Advisory Council (SAC) International Financial Reporting Interpretations Committee (IFRIC)
Understand the role of International Financial Reporting Standards (IFRS)
Exam Context
Questions on this chapter will be knowledge based and so it is important that you are familiar with the role of each body. The role of IFRIC was tested in the Pilot Paper.
Financial Accounting introduces the International Accounting Standards Board's role in issuing IFRSs and paper F3 examines some key standards. All of these standards are built upon in the Fundamentals level paper Financial Reporting (F7) and the Professional level paper Corporate Reporting (P2).
2.1
2: HOME STUDY CHAPTER - THE REGULATORY FRAMEWORK
Overview
Regulatory framework
IASCF
SAC
IASB
IFRIC
Issue IFRS
2.2
1
1.1 1.2
Introduction
Financial statements are produced by an entity's managers in order to show its owners how the entity has performed over a period of time. Company financial statements particularly need to show a true and fair view. This means a system of regulation is necessary to ensure that financial statements are produced to a high standard and are comparable across different companies.
2
2.1
Regulatory system
International Accounting Standards Committee Foundation (IASCF) (22 Trustees)
Standards Advisory Council (SAC)
International Accounting Standards Board (IASB) (14 Board members)
International Financial Reporting Interpretations Committee (IFRIC)
Key: Appoints Reports to Advises
International Accounting Standards Committee Foundation (IASCF)

2.2 The IASCF is a not-for-profit organisation based in the United States which heads up the regulatory system. Its Trustees appoint members to the IASB, IFRIC and SAC. They also oversee the regulatory system and raise the finance necessary to support it. It has no involvement in the standard setting process.
International Accounting Standards Board (IASB)

2.3
Section 1.4.1
The IASB's principal aim is to develop a single set of high quality accounting standards: International Financial Reporting Standards (IFRS). It also liaises with national accounting standard setters (for example the UK's ASB) to achieve convergence in accounting standards around the world.
2.3
International Financial Reporting Interpretations Committee (IFRIC)

2.4 The IFRIC issues guidance on both how to apply existing IFRSs in company financial statements and how to account for new financial reporting issues where no IFRS exists. It reports to the IASB.
Standards Advisory Council (SAC)

2.5 The SAC's principal role is to advise the IASB on a range of issues which include:

The IASB's agenda and timetable for developing IFRSs Advising the IASB of areas that may need to be considered by IFRIC.
3
3.1
The role of International Financial Reporting Standards (IFRS)

IFRSs provide guidance as to how items should be shown in a set of financial statements both in terms of their monetary amount and any other disclosure. For example: IAS 2: Inventory states at what amount a company should value its inventory and also requires that the financial statements breakdown the inventory figure between its components such as raw materials, work in progress and finished goods.
3.2
If a company follows the relevant accounting standards its financial statements should show a true and fair view.
Exam standard question for 1 mark
Lecture example 1
A B To appoint members of the IASB
What is the role of the International Accounting Standards Committee Foundation? To advise the IASB on new accounting standards they should consider issuing.
Solution
2.4
Lecture example 2
Exam standard question for 1 mark
Which of the following bodies is involved is trying to achieve convergence of global accounting standards? A B IASB IFRIC
Solution
4
4.1 4.2 4.3 4.4
The IASCF appoints members to the IASB, IFRIC and SAC. The IASB issues International Financial Reporting Standards. The IFRIC issues guidance on how to apply accounting standards. The SAC advises the IASB on its agenda.
2.5
2.6
2.7
2: QUESTIONS
2.1
Accounting standards are prepared by A B C the IASB the IASC Foundation the IAASB (1 mark)
2.2
Which of the following best describes the role of The International Financial Reporting Interpretations Committee? A B C Issues International Financial Reporting Standards. Provides advice on the development of standards. Interprets International Financial Reporting Standards. (1 mark)
2.8
Chapter 2: Answers
2.9
2: ANSWERS
2.1 2.2
A C
END OF CHAPTER
2.10
Accounting conventions


Define, understand and apply accounting concepts and qualitative characteristics. Understand the balance between qualitative characteristics. Identify and explain the main characteristics of alternative valuation bases (for example net realisable value). Understand the advantages and disadvantages of historical cost accounting. Understand the provision of International Financial Reporting Standards governing financial statements regarding changes in accounting policies. Identify the appropriate accounting treatment if a company changes a material accounting policy.
Exam Context
Questions on this chapter are likely to test your understanding of the qualitative characteristics of information. For example, the Pilot Paper required you to identify the factors that make information reliable. Questions may also ask you to define accounting conventions.
Your understanding of the remaining chapters of IASB Framework will be developed in the Fundamentals level paper Financial Reporting (F7). You should also expect to see more detailed calculations on IAS 8 tested in Paper F7.
3.1
3: ACCOUNTING CONVENTIONS
Overview
The objective of financial statements Underlying assumptions
IASB Framework
Qualitative characteristics of financial information
Elements of financial statements
Accounting conventions
Other issues
Concepts and conventions
Alternative valuation bases
IAS 8: Accounting policies, changes in accounting estimates and errors
3.2
1
1.1 1.2
Introduction
As noted in Chapter 2 financial statements should show a true and fair view of, or present fairly, the entity's activities. They are produced to provide information to the entity's owners. In order for this information to be useful it must possess certain characteristics.
The IASB's Framework for the Preparation and Presentation of Financial Statements
The IASB's Framework is not an accounting standard. It is a set of principles which underpin the foundations of financial accounting. Whenever a new accounting standard is issued it will be based on the principles of the IASB Framework. Furthermore its principles should be applied to account for any item where no accounting standard exists. The Framework is divided into seven sections.
1) The objective of financial statements 2) Underlying assumptions 3) Qualitative characteristics of financial information 7) Concepts of capital and capital maintenance 6) Measurement of the elements of financial statements
Conceptual framework
2.1 2.2 2.3
2.4
4) The elements of financial statements
Framework
5) Recognition of the elements of financial statements
Only sections 1 4 are examinable at Paper F3.
The objective of financial statements

2.5 To provide information about the financial position, financial performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.
3.3
Underlying assumptions
2.6 Accruals basis The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the period to which they relate. Going concern
Quick Quiz Q3
The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. If this is not appropriate, then additional disclosure about the basis of preparation must be made in the financial statements.
Qualitative characteristics of financial information

2.7
Quick Quiz Q4, Q10
Understandability
Comparability
Information should be readily understandable by users who are assumed to have reasonable knowledge
For same entity over different periods: consistency Between different entities: disclosure of accounting policies
Relevance
Reliability
Assist users in evaluating past and predicting future events Materiality
Faithful representation Substance over form Neutrality Prudence Completeness
3.4
3: ACCOUNTING CONVENTIONS 2.8 The elements of financial statements The five elements of financial statements and their definitions are listed below. Asset A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. Liability A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of economic benefits. Equity The residual interest in the assets of an entity after deducting all its liabilities, so EQUITY = NET ASSETS = SHARE CAPITAL + RESERVES Income Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expenses Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or increases of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
3
3.1
Alternative valuation bases

Financial statements are generally produced using the historical cost convention where items are recorded at their historic cost. For example, if an entity purchased a building in 20X6 for $1 million then the building would be recorded as an asset at $1 million. The $1 million asset would then be depreciated to reflect the wearing out of the building. However, in reality, the value of the building may appreciate over time depending on market values.
Historic cost
3.5
Lecture example 1
Idea generation
What are the advantages and disadvantages of recording the building at its historic cost of $1 million? (consider the Framework's qualitative characteristics).
Solution
Advantages of historic cost (1) (2) (3) Disadvantages of historic cost (1) (2)
3.2 3.3
Note that in times of rising prices using the historical cost convention will lead to asset values being too low and profits too high in a set of financial statements. Due to the limitations of historic cost, alternative valuation bases exist. They are:

replacement cost net realisable value economic value
Replacement cost
3.4 Assets are carried at the amount it would cost to acquire an equivalent asset today. Liabilities are shown at the amount that would be required to settle the obligation today. Replacement cost is also known as 'current cost'.
Net realisable value

3.5 This values items at their expected selling price less any costs that need to be incurred before the item can be sold. Inventory should always be shown in the financial statements at the lower of cost (historic cost) and net realisable value.
3.6
Lecture example 2
Preparation question
A Ltd has 100 items in inventory at the year end. The following information is available: Total cost of items to date Expected selling price per item Costs which still need to be incurred per item before item can be sold Required (a) What is the historic cost of the inventory? (b) What is the net realisable value of the inventory? (c) What value for inventory should be shown in the financial statements? Workings $ $ $ $ 1,000 11 2
Economic value
3.6
Quick Quiz Q6
This is the value of an item derived from its ability to generate net cash flows. It can also be known as 'present value'. For example, the economic value of a machine would be calculated by determining the value in today's prices, of the future cash inflows from selling items produced by the machine less the related cash outflows.
3.7
4
4.1 4.2 4.3
The IASB Framework provides a set of principles on which financial accounting is based. Financial statements should provide information on an entitys financial position, financial performance and changes in financial position. In order for this information to be useful to users the financial statements should contain the qualitative characteristics of understandability, relevance, reliability and comparability.
3.8
Additional Notes
3.9
5
5.1
Other examinable concepts and conventions

In addition to the concepts and conventions set out in the Framework, the following are also relevant in the preparation of financial statements.
The business entity concept

5.2 This recognises the distinction between the business and its activities and the owners or managers themselves. This is particularly important when considering sole trader or partnership accounts as these businesses are not separately identified by law.
The money measurement concept

5.3 Only items which are capable of being measured in monetary terms should be recognised in the financial statements. For example, even though a loyal workforce may be of benefit to a business this value cannot be measured in monetary terms and is therefore not included on the balance sheet.
The duality concept

5.4 Every transaction has two effects. This is the underlying principle of the double entry accounting system.
The historical cost convention

5.5 Assets and liabilities are recorded at their historical cost. This is the amount recorded when the transaction took place.
IAS 8: Accounting policies, changes in accounting estimates and errors

Accounting policies are the significant principles, bases, conventions, rules and practices applied by an entity in preparing and presenting the financial statements. It is the way the entity has decided to treat an item in its financial statements, for example whether non-current assets are carried at historic cost or a revalued amount.
Accounting policies definition

6.1
Changes in accounting policy

6.2 Changes in accounting policy will only arise if: (a) (b) There is a new accounting standard or statutory requirement. Using the new policy makes the financial statements more relevant and reliable.
3.10
Accounting treatment
6.3 Financial statements contain two years worth of figures. For example a company whose year end is 31 December 20X7 will show information for 20X7 and 20X6. The current year figures (20X7) will be produced using the new accounting policy. In order for the financial statements to be comparable over time the comparative figures (20X6) will be restated. This means they will be reproduced and drawn up using the 20X7 accounting policies. 6.4 Disclosure The following disclosure should be made: (a) (b) (c) The nature of the change in accounting policy The reasons for the change The amount of the adjustment in the current period and the comparative period.
Errors
6.5 These are material omissions from, or misstatements in, the financial statements that ought to have been identified before the financial statements were finalised. An error is accounted for in exactly the same way as a change in accounting policy. For example, an entity may discover a material error in the 20X6 figures whilst producing the 20X7 financial statements. When the 20X7 financial statements are produced the 20X6 comparatives should be restated and the error corrected.
3.11
3.12
3.13
3: QUESTIONS
3.1
The Framework for the Preparation and Presentation of Financial Statements identifies two assumptions which are the bedrock of accounting. What are they? A B C Consistency and prudence Accruals and going concern Materiality and separate entity If the directors want to improve the balance sheet value If required by an accounting standard If it results in reliable and more relevant information (ii) only (i) and (ii) (ii) and (iii) (i), (ii) and (iii) (2 marks) (1 mark)
3.2
In which of the following circumstances can a change of accounting policy be made? (i) (ii) (iii) A B C D
3.14
Chapter 3: Answers
3.15
3: ANSWERS
3.1 3.2
B C
END OF CHAPTER
3.16
Sources, records and books of prime entry

Having studied Chapters 4 and 5 you will be able to:

Identify and explain the function of the main data sources in an accounting system and how the accounting system provides useful information. Outline the contents and purpose of different types of business documentation such as an invoice. Identify the main types of business transactions, for example, sales, purchases, payments and receipts. Understand and apply the concept of double entry accounting, the duality concept and the accounting equation. Identify the main types of ledger account and illustrate how to balance and close a ledger account. Understand and illustrate the uses of journals and the posting of journal entries into ledger accounts. Identify correct journals from given narrative. Record credit sale, credit purchase and cash transactions in ledger accounts and day books. Understand and record sales and purchase returns. Understand the need for a record of petty cash transactions and security over the petty cash system. Describe the features and operation of a petty cash imprest system. Account for petty cash using imprest and non-imprest methods.
Exam Context
Questions are unlikely to feature solely on this chapter, however, you should have a good understanding of what constitutes an asset, liability, capital, income and expense. You should also be aware of the principal contents of each book of prime entry and the purpose of the memorandum ledgers.
These topics are only examined in Financial Accounting.
4.1
4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY
Overview
Balance sheet
Income statement
Sources, records and books of prime entry
Books of prime entry
Memorandum ledgers
Cash book
Sales day book
Purchase day book
Petty cash book
Journal book
4.2
1
1.1
The balance sheet

An individual could prepare a list of everything they own and everything by owe.
Idea generation
Lecture example 1
Required List out everything you own and owe.
Solution
(a) Own
(b)
Owe
1.2
For a business, this list is formalised as a balance sheet and show the entity's assets and liabilities. (a) (b) Asset: is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Liability: is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of economic benefits.
4.3
Proforma balance sheet sole trader

1.3 Balance sheet as at 31 December 20X7: $ ASSETS Non-current assets Land and buildings Office equipment Motor vehicles Furniture and fixtures Current assets Inventories Trade receivables Less: allowance for receivables Prepayments Cash in hand and at bank Total assets CAPITAL AND LIABILITIES Capital Capital Profit Less: drawings Non-current liabilities Bank loans Current liabilities Bank overdraft Trade payables Accruals Total capital and liabilities $ 100,000 50,000 30,000 20,000 200,000 50,000 30,000 (2,000) 28,000 5,000 7,000 90,000 290,000
170,000 45,000 (25,000) 190,000 40,000 16,000 40,000 4,000 60,000 290,000
Key features
1.4 (a) (b) (c) (d) Always headed as at, for the date of the balance sheet. Non-current assets - assets held and used in the business over the long-term (i.e. more than one year). Current assets - not non-current assets! Conventionally listed in increasing order of liquidity (i.e. closeness of assets to cash). Capital - what the business owes the proprietor/owner. In this case the sole trader owns all of the business, i.e. its total net worth. CAPITAL = = ASSETS - LIABILITIES NET ASSETS
4.4
4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY (e) Don't include a caption (item heading) if there isnt a value for it. The balance sheet is a snapshot of the business at one point in time.
2
2.1
The income statement

Suppose a business buys three books for $10 each. Then it sells them for $15 each: Sales Cost of sales Gross profit Profit is the excess of total income over total expenditure. NOTE: The business may have other expenses such as rent, telephone bills, etc. to take off before the true profit is shown. $ 45 Income (30) Expenditure 15
Profit example
Proforma income statement - sole trader

2.2 Income statement for the year ended 31 December 20X7: $ Sales Less: Cost of sales Opening inventories Purchases Carriage inwards Closing inventories Gross profit Sundry income Discounts receivable Less: Expenses Rent Carriage outwards Telephone Electricity Wages and salaries Depreciation Bad and doubtful debts Motor expenses Discounts allowable 11,000 4,000 1,000 2,000 9,000 7,000 3,000 5,000 1,000 (43,000) 45,000 40,000 110,000 20,000 170,000 (50,000) (120,000) 80,000 5,000 3,000 88,000 $ 200,000
Profit for the period
4.5
Key features
2.3 (a) (b) Headed up with the period for which the income and expenses are being included. The top part Sales Cost of sales Gross profit X (X) X
is called the trading account as it records just the trading activities (buying and selling) of the business. (c) (d) Sundry income includes items like bank account interest. Do not include nil value captions.
The income statement is a summary of the business' performance over a period of time think of it as a DVD!
3
3.1
Relationship between the balance sheet and the income statement

Balance sheet shows the worth of business at a point in time (financial position). Income statement shows the trading activities over a period of time (financial performance).
3.2 3.3
The accounting period is the period for which the income statement was prepared. This is usually a year. Therefore, there will be a balance sheet at the beginning of the year (prior year end) and at the end of the accounting period. The income statement is for the intervening period. Income statement for the year ended 31.12.X7
Balance sheet as at 31.12.X6
Balance sheet as at 31.12.X7
4.6
4
4.1
From business transactions to financial statements

A business will enter into a number and variety of transactions during an accounting period: CASH TRANSACTIONS
Sales
Purchases
Wages
Stationery
Acquisition of non-current assets
CREDIT TRANSACTIONS
Sales
Purchases
Ultimately all of these transactions must be summarised in the business' financial statements (ie the balance sheet and income statement). 4.2 This is achieved by having accounting records to record each stage of the process: Assorted transactions (eg invoices)
Categorised (in Books of Prime Entry)
Summarised (eg nominal ledger, trial balance)
FINANCIAL STATEMENTS (eg Balance Sheet and Income Statement)
4.7
5
5.1 5.2

The business' transactions are categorised with other similar transactions in the books of prime entry.
Cash book
Sales day book
Purchase day book
Petty cash book
Journal book
Receipts
Payments
Cash transactions
Credit sales
Credit purchases
Small cash transactions
Adjustments and errors
Cash book
5.3 (a) (b) Records receipts and payments into and out of the bank. For exam purposes often assumed to be two books, one for receipts, one for payments.
Cash book (receipts)

5.4 Example: Date 2.1.X7 5.1.X7 6.1.X7 Narrative F. Bloggs J. Spalding J. Smith Total $ 4,000 200 500 4,700 total cash received 4,000 500 500 200 Capital $ 4,000 200 Sales $ Receivables $
reason why cash was received
4.8
Cash book (payments)

5.5
Date
Example:
Narrative Total $ Purchases $ Van $ Rent $ Payables $ Petty cash
Drawings $
6.1.X7 6.1.X7 8.1.X7
Manley & Co. Petty Cash Digby Co
350 50 1,000 1,400
350 50 1,000 1,000 350 50
total cash payment
reason why payment was made
Sales day book

5.6 5.7 Lists all sales made on credit, i.e. each individual invoice raised. Example: Date 3.1.X7 5.1.X7 8.1.X7 14.1.X7 Customer J. Spalding G. McGregor J. Spalding G. McGregor TOTAL $ 200 400 400 300 1,300
Purchase day book

5.8 5.9 Lists all purchases made on credit, i.e. each individual invoice received. Example: Date 1.1.X7 4.1.X7
16.1.X7
Supplier Tewson Co. Manley & Co. Manley & Co.

TOTAL
$ 400 350
200 950
4.9
Petty cash book

5.10 (a) (b) Records the movement of physical cash (kept on the premises) in and out of the petty cash tin. Used for small incidental expenses.
5.11 Example: Receipts

Date Narrative Total $
Payments
Date Narrative Total $ Stationery $ Travel $
6.1.X7
Cheque cashed
50
7.1.X7 8.1.X7
City Stationers F. Bloggs Metro fare
10 2 12
10 2 10 2
Controlling petty cash the imprest system

An imprest system acts as an accounting control by having a set amount of petty cash. 5.12 (a) (b) (c) (d) (e) Pre-set limit, say $50. Voucher filled in when money is taken out to pay expenses. At any time, vouchers + cash = pre-set limit. At the end of the week/month, the petty cash book is filled in from the vouchers. The amount needed to bring the balance back up to the pre-set limit = money spent.
Quick Quiz Q5, Q6
Journal book
5.13 Certain transactions do not fit in the main books, for example: (a) (b) period end adjustments correction of errors
The journal book lists these sundry transactions.
6
6.1
Memorandum ledgers
To know how much is owed by a particular customer or to a certain supplier at a point in time. For example, the sales day book shows the sales made on credit to all customers and the cash book receipts shows the cash received from all sources. J. Spalding owes the business $400 but this cannot be seen from the books of prime entry without trawling back through the detailed information. A separate memorandum ledger is kept to show this information.
4.10
Purpose
4: SOURCES, RECORDS AND BOOKS OF PRIME ENTRY 6.2 There are two types of memorandum ledgers kept by the business: (a) (b) 6.3 Receivables ledger showing how much is owed by each individual customer. Payables ledger showing how much is owed to each individual supplier.
The entries in these ledgers are made by rearranging the information in the day books into individual customer and supplier accounts.
Receivables ledger
6.4 Example: J. Spalding (Customer) Date 3.1.X7 5.1.X7 8.1.X7 Narrative Invoice 1032 Cash received Invoice 1101 400 Sales $ 200 200 Cash $ Total $ 200 400
G. McGregor (Customer) Date 5.1.X7 14.1.X7 Narrative Invoice 1033 Invoice 1129 Sales $ 400 300 Cash $ Total $ 400 700
Payables ledger
6.5 Example: Tewson Co. (Supplier) Date 1.1.X7 Invoice A112 Manley & Co. (Supplier) Date 4.1.X7 6.1.X7 16.1.X7 Invoice 063 Cash book Invoice 097 350 200 Cash $ Purchases $ 350 Total $ 350 200 Cash $ Purchases $ 400 Total $ 400
4.11
7
7.1 7.2
The balance sheet shows the assets and liabilities of a business at a particular point in time whilst the income statement shows its performance over a period. In order to produce a set of financial statements the business transactions must first be categorised into the books of prime entry. The totals on these books are then summarised in the nominal ledger.
4.12
Chapter 4: Question
4.13
4: QUESTION
4.1
Which of the following is not a book of prime entry? A B C Wages day book Cash book Sales ledger (1 mark)
4.14
Chapter 4: Answer
4.15
4: ANSWER
4.1
END OF CHAPTER
4.16
Ledger accounts and double entry

Having studied Chapters 4 and 5 you will be able to:

Identify and explain the function of the main data sources in an accounting system and how the accounting system provides useful information. Outline the contents and purpose of different types of business documentation such as an invoice. Identify the main types of business transactions, for example, sales, purchases, payments and receipts. Understand and apply the concept of double entry accounting, the duality concept and the accounting equation. Identify the main types of ledger account and illustrate how to balance and close a ledger account. Understand and illustrate the uses of journals and the posting of journal entries into ledger accounts. Identify correct journals from given narrative. Record credit sale; credit purchase and cash transactions in ledger accounts and day books. Understand and record sales and purchase returns. Understand the need for a record of petty cash transactions and security over the petty cash system. Describe the features and operation of a petty cash imprest system. Account for petty cash using imprest and non-imprest methods.
Exam Context
Your understanding of double entry will be crucial to passing Financial Accounting. Whilst an individual question may not ask you to produce a double entry it will be instrumental in answering the question. For example, a question may ask you to derive the income statement expense for electricity where amounts need to be accrued at the year end. You will only get this right if you understand the double entry for recording expenses and accruals. A question could also describe a transaction and ask you to identify the correct double entry to record this.
Being confident at double entry will help you account for many of the more complex accounting standards you will meet in the Fundamentals level paper, Financial Reporting (F7) and the Professional level paper, Corporate Reporting (P2).
5.1
5: LEDGER ACCOUNTS AND DOUBLE ENTRY
Overview
Ledger accounts and double entry
Ledger accounts
Double entry
Debit
Credit
Balancing off
5.2
1
1.1 1.2
Introduction
This chapter is designed to enable you to explain the principles of double entry and apply these principles to the preparation of accounting records within the nominal/general ledger. In Chapter 4 we saw how transactions were categorised in books of prime entry, the next step is to summarise the information in a format nearer to that of the final financial statements.
The nominal ledger

1.3 (a) (b) (c) Each item in the balance sheet or income statement will have an "account" (which might be a page in a book or a record on a computer). All the accounts are collected together in the nominal ledger. The books of prime entry are totalled up and two entries will be made in these accounts with each of these totals this is called double entry.
The dual effect

1.4 The method used stems from the fact that every transaction affects two things, for example: (a) A sole trader pays $6,000 in the business bank account: Cash increases by $6,000 Capital increases by $6,000 (b) A sole trader purchases goods on credit for $400: Purchases increase by $400 Trade payables increase by $400
2
2.1
Ledger accounts (T-accounts)

Debit $ Decrease Capital Increase Capital CAPITAL Credit $
We make two entries from each total extracted from the books of prime entry, and call one a Debit (Dr), and the other one a Credit (Cr). TOTAL DEBITS = TOTAL CREDITS
5.3
Principles of double entry bookkeeping

2.2 The cash account is a good starting point: Dr $ CASH IN = DEBIT CASH OUT = CREDIT CASH $ Cr
General rules
2.3 (a) DEBIT entry represents: (i) (ii) (iii) (b) (i) (ii) (iii) an increase in an asset; a decrease in a liability; an item of expense. an increase in a liability; a decrease in an asset; an item of income.
CREDIT entry represents:
This can be remembered as follows Debits (increase)

Quick Quiz Q1 - 4
Credits (increase) Liabilities Income Capital
Expenses Assets Drawings
5.4
Lecture example 1
Required What is the double entry for each of the following? Explain each entry in terms of the general rules above.
Solution
Transaction (a) Sales for cash. Debit Credit
(b)
Sales on credit.
(c)
Purchase for cash.
(d)
Purchase on credit.
(e)
Pay electricity bill.
(f)
Receive cash from a credit customer.
(g)
Pay cash to a credit supplier.
5.5
5: LEDGER ACCOUNTS AND DOUBLE ENTRY Transaction (h) Borrow money from the bank. Debit Credit
Lecture example 2
Douglas Douglas had the following transactions during January: (1) (2) (3) (4) (5) (6) (7) (8) Introduced $5,000 cash as capital; Purchased goods on credit from Richard, worth $2,000; Paid rent for one month, $500; Paid electricity for one month, $200; Purchased car for cash, $1,000; Sold half of the goods on credit to Tish for $1,750; Drew $300 for his own expenses; Sold goods for cash, $2,100.
Technique demonstration
Required Post transactions (1) to (8) to the relevant ledger accounts.
Solution
5.6
5.7
3
3.1
Flow of information
In Lecture example 2 the original transactions were posted to the ledger accounts. A business would firstly categorise this information in the books of prime entry. The totals from the books of prime entry are then posted to the nominal ledger using double entry.
3.2
4
4.1
Balancing off the ledger accounts

The totals from the books of prime entry may be posted to the nominal ledger each month. A business will want to know the balance on each account. This is done by 'balancing off' each account.
Lecture example 3
The following information has been posted to the cash account below. Required Balance off the cash account to determine the amount of cash held at the end of January.
Solution
Dr 2/1 Sales 10/1 Sales $ 500 500 Cash 1/1 Purchases 25/1 Telephone Cr $ 300 50
5.8
Steps
4.2 (1) (2) (3) (4) Add the debit and credit sides separately. Fill in the higher of the two totals on both sides. Literally 'balance' the account (what number do we need and on which side to make the two sides equal?) balance c/d Complete the 'double entry' balance b/d on opposite side.
Lecture example 4
Douglas Refer to Lecture example 2 on page 5.6. Required Balance off the ledger accounts for Douglas
Solution
Complete in the solution space for Lecture example 2.
5
5.1 5.2 5.3 5.4
The totals on the books of prime entry are posted to the nominal ledger using double entry. The principles of double entry work on the basis that for each debit entry there must be a credit entry. A debit entry increases assets, expenses and drawings and a credit entry increases liabilities, income and capital this can be remembered as DEAD CLIC. At the end of each period the nominal ledger accounts (T accounts) are 'balanced off' to determine the closing balance on each account.
5.9
5.10
5.11
5: QUESTIONS
5.1
A credit balance of $3,000 brought down on X Cos account in Y Cos books means that A B C X Co is owed $3,000 by Y Co Y Co is owed $3,000 by X Co Y Co has sold $3,000 of goods to X Co A list of all assets and liabilities at a point in time A collection of accounts to record the transactions of the business A record of amounts owed to/from individual suppliers and customers An initial record of internally generated transactions (2 marks) (1 mark)
5.2
Which of the statements below best describes the nominal ledger? A B C D
5.12
Chapter 5: Answers
5.13
5: ANSWERS
5.1 5.2
A B
The balance represents the outstanding amount i.e. purchases less cash paid.
END OF CHAPTER
5.14
From trial balance to financial statements

Having studied this chapter you will be able to: Identify the purpose of a trial balance. Extract ledger balances into a trial balance. Prepare extracts of an opening trial balance. Identify and understand the limitations of a trial balance.
Exam Context
Questions on this chapter may require you to derive missing figures (for example, profit for the period) using the accounting equation and identify the correct double entry to record transactions such as closing inventory or drawings.
Financial Accounting is the only paper where you are required to produce financial statements for a sole trader. Financial statements for limited liability companies are tested in detail in the Fundamentals level paper, Financial Reporting (F7) and the Professional level paper, Corporate Reporting (P2).
6.1
6: FROM TRIAL BALANCE TO FINANCIAL STATEMENTS
Overview
Trial balance
Closing inventory adjustment
From trial balance to financial statements
Income statement
Balance sheet
Accounting equation
6.2
1
1.1
Introduction
We saw in Chapters 4 and 5 that:

transactions are categorised in the books of prime entry; the totals are then posted to the ledger accounts in the nominal ledger using double entry; the ledger accounts are then balanced off and the balances brought down.
2
2.1
The trial balance

The trial balance consists of a list of the balances brought down on each ledger account, separated in to debits and credits as below.
Example
2.2 Miss Smith Trial Balance at as 31 December 20X7: Account Cash Capital Sales Purchases Furniture Electricity Telephone Drawings Total 2.3 The trial balance should balance, i.e. Total debits = Total credits If the trial balance doesn't balance then an error must have occurred. The correction of errors is covered in Chapter 16. 1,100 500 120 60 200 2,700 2,700 Debit $ 720 500 2,200 Credit $
6.3
Lecture example 1
Douglas
Refer to Lecture example 2 in Chapter 5 on page 5.6 where the ledger accounts were balanced off. Using the ledger accounts for Douglas, prepare the trial balance as at the end of January.
Solution
6.4
3
3.1
The closing inventory adjustment

Whilst a business will purchase items to sell during the year it is unlikely that all of them will have been sold by the year end. The items still held at the year end are known as inventories. These are an asset of the business and so should be included in inventories in the balance sheet. Also when a business determines its profit for the year it should match the sales revenue earned to the cost of goods it sold, ie, cost of sales.
Objective
Lecture example 2
Colin opens a business selling cordless telephones. In the first month he buys 50 phones for $20 each, and sells 20 for $30 each. Complete the trading account below.
Solution
$ Sales Cost of sales Purchases Less: closing inventories Gross profit $
3.2 The closing inventory adjustment is accounted for via a journal entry. The double entry is: Dr Inventories (B/S) Cr Closing inventories (COS I/S) 3.3 3.4 This adjustment is usually made after the preliminary trial balance has been prepared. Last period's closing inventories will become this period's opening inventories. These items will be sold in the year and so will form part of cost of sales. As the items are sold they will no longer be an asset of the business and should be removed from the balance sheet. The double entry is: Dr Opening inventories (COS I/S) Cr Inventories (B/S This can be done as soon as the new period begins.
6.5
4
4.1
The income statement

The income statement is part of the double entry system and can be shown as a T-account.
Completing the income statement

4.2 4.3 The balances on all the income and expenditure T-accounts are transferred to the income statement and the closing inventory adjustment is made. The income and expenditure accounts have now been closed out and a new account will be created for each income and expenditure item next year.
Lecture example 3
Douglas Refer to Lecture example 1 on page 6.4 The cost of goods remaining unsold at year end was $250. Required Prepare an income statement in ledger account form.
Solution
Income Statement a/c
6.6
5
5.1
The balance sheet

Balance sheet: (a) (b) (c) lists all ledger accounts with balances remaining; i.e. all assets and liabilities; is not part of double entry system so these balances are not transferred out.
Completing the balance sheet
5.2
At end of period, clear balances on income statement and drawings to capital account.
Lecture example 4
Douglas Refer to Lecture example 3 on page 6.6. Required
Draw up an income statement for the period and a balance sheet at the end of January.
Solution
DOUGLAS INCOME STATEMENT FOR THE MONTH OF JANUARY $ Sales Less cost of sales: Purchases Less: closing inventories $
Gross profit Less expenses: Rent Electricity
Net profit
6.7
6: FROM TRIAL BALANCE TO FINANCIAL STATEMENTS DOUGLAS BALANCE SHEET AS AT 31 JANUARY NON-CURRENT ASSET Motor vehicle CURRENT ASSETS Inventories Trade receivables Cash $ $
PROPRIETORS INTEREST Capital introduced on 1 January Profit for the year Less: drawings Balance 31 January CURRENT LIABILITIES Trade payables
6.8
Lecture example 5
Douglas Refer to Lecture example 4 on page 6.7. Required Transfer the profit and drawings to the capital account.
Solution
Drawings
5.3 Drawings are amounts being taken out of a business by its owner. Drawings are generally in the form of cash, but an owner may also take inventory out of the business. Drawings of inventories are recorded at the cost of the inventories not the sales price.
6.9
6
6.1 6.2
The accounting equation

The accounting equation expresses the balance sheet as an equation. At its most simple:
ASSETS (debits) LIABILITIES (credits)
Different types of liabilities (credits)
CAPITAL
PROFIT (less drawings)
PAYABLES
Proprietors interest
Lecture example 6
Douglas Refer to Lecture example 5. Required Prepare the accounting equation for Douglas.
Solution
6.10
7
7.1 7.2
The trial balance consists of a list of the balances brought down on each ledger account. At the end of the year an adjustment must be made for closing inventory to match sales revenue to the cost of making those sales and also to reflect the fact that the inventories are an asset of the business. The opening inventory balance should also be transferred to cost of sales. The income statement and balance sheet are then produced from the trial balance (incorporating any adjustments such as closing inventory). The accounting equation expresses the balance sheet as an equation.
7.3 7.4 7.5
8
8.1
Double Entry Summary for Chapter 6

Closing inventory adjustment: Dr Inventories (B/S) Cr Closing inventories (I/S)
8.2
Opening inventory adjustment: Dr Opening inventories (I/S) Cr Inventories (B/S)
8.3
The accounting equation: Assets = Liabilities Assets = Capital + Profit + Payables
6.11
6.12
6.13
6: QUESTIONS
6.1
At the end of the accounting period and after the balance sheet and income statement have been prepared for a sole trader: A B C D All journals are reversed The balances on asset and liability accounts are transferred to the capital account The balances on the income statement and drawings account are transferred to the capital account Balances are carried forward on all the accounts in the nominal ledger (2 marks)
6.2
A business has cash of $1,100, trade payables of $2,500, a mortgage liability of $8,000 and land of $16,000. What is the proprietor's interest? $ (2 marks)
6.3
Joe, a sole trader, set up business on 1 October 20X6 with $40,000 of his own money. During the year to 30 September 20X7 he won $50,000 on the lottery and paid $30,000 of this into his business. He took cash drawings of $5,000 during the year and at 30 September 20X7 the net assets of the business totalled $59,000. What was the profit or loss of the business for the year ended 30 September 20X7? A B C D $4,000 profit $6,000 profit $16,000 loss $6,000 loss (2 marks)
6.4
Joan Joan, a second hand bookseller, has been in business for two months. In this time she: (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (a) (b) (c) paid in cash $5,000 as capital; took the lease of a stall and paid two months rent. The annual rental was $1,200; purchased, on credit from J Fox, books at cost of $825; spent $420 cash on the purchase of other books from W Smith; paid an odd-job man $75 to paint the exterior of the stall and repair a broken lock; put an advertisement in the local paper at a cost of $10; sold three volumes containing "The Complete Works of Shakespeare" to an American for $60 cash; sold six similar sets on credit to a local school for $300; paid J Fox $525 on account for the amount due to him; received $200 from the school; purchased cleaning materials at a cost of $10 and paid a char lady $30; took $100 from the business to pay for her own personal expenses; made other cash sales during the two months of $1,500; all books had been sold by the end of two months. Write up the relevant ledger accounts for these transactions. Balance off all of the ledger accounts. Prepare a trial balance, an income statement and a balance sheet.
Required
6.14
6: QUESTIONS
6.5
Brian Brian set himself up in business on 1 January selling ice creams. During his first two months in business he: (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (a) (b) (c) (d) (e) (f) Introduced $20,000 of cash as capital into the business; Purchased a second hand ice cream van from John. He paid John $10,500 cash; Paid Terry $200 to repair the ice cream machine in the van; Purchased on credit, inventories totalling $750; Spent $400 on petrol; Sold goods for $750 in cash; Paid $600 in tax and insurance; Made additional cash purchases of $80 for strawberry sauce and chocolate flakes; Withdrew $300 for his own expenses; The cost of goods remaining unsold was $500. Post transactions (1) (9) to the relevant ledger accounts. Balance off the ledger accounts. Prepare a trial balance. Prepare an income statement in ledger account form (remembering to deal with item 10). Draw up an income statement for the period and a balance sheet at the end of the period. Transfer the loss and drawings to the capital account.
Required
6.6
Dealers On 1 January the proprietors interest in a business, Dealers, was $18,500. At 31 January the assets and liabilities of the business were as follows. $ Plant and equipment 10,000 Motor vehicles 5,000 Trade payables 3,000 Trade receivables 2,000 Inventories 4,500 Accrued expenses 250 Balance in the bank 3,500 Cash in the till 250 On 7 January the proprietor had paid in additional capital of $2,000. On 14 January he had taken goods at a cost of $350 for his own consumption and on 30 January had drawn cash of $1,250 from the business, for his own personal expenditure. Required (a) (b) (c) (d) Calculate the net asset value at 1 January. Calculate the net asset value of the business at 31 January. Calculate the profit of the business for the month of January. Show the accounting equation at 31 January.
6.15
6: QUESTIONS
6.16
Chapter 6: Answers
6.17
6: ANSWERS
6.1 6.2
C $6,600 Cash Trade payables Mortgage liability Land Proprietor's interest (balancing figure) Dr $ 1,100 16,000 17,100 Cr $ 2,500 8,000 6,600 17,100
6.3
D Net assets at 1.10.X6 Capital introduced Drawings loss for year (balancing figure) Net assets at 30.9.X7
$ 40,000 30,000 (5,000) (6,000) 59,000
6.4
Joan Bank (B/S) (1) (7) (10) (13) Capital Sales Trade receivables Sales $ 5,000 60 200 1,500 (2) (4) (5) (6) (9) (11) (11) (12) Rent Purchases Repairs Advertising Trade payables Cleaning materials Cleaning Drawings Balance c/d $ 200 420 75 10 525 10 30 100 5,390 6,760
Balance b/d
6,760 5,390
Capital (B/S) Balance c/d $ 5,000 5,000 (1) Bank Balance b/d Rent (I/S) (2) Bank Balance b/d $ 200 200 200 Balance c/d $ 200 200 $ 5,000 5,000 5,000
6.18
6: ANSWERS
Trade payables (B/S) (9) Bank Balance c/d $ 525 300 825 (3) Purchases Balance b/d $ 825 825 300
Purchases (I/S) (3) (4) Trade payables Bank Balance b/d $ 825 420 1,245 1,245 Balance c/d $ 1,245 1,245
Repairs (I/S) (5) Bank Balance b/d $ 75 75 75 Balance c/d $ 75 75
Advertising (I/S) (6) Bank Balance b/d $ 10 10 10 Sales (I/S) Balance c/d $ 1,860 1,860 (7) (8) (13) Bank Trade receivables Bank Balance b/d Trade receivables (B/S) (8) Sales Balance b/d $ 300 300 100 Cleaning materials (I/S) (11) Bank Balance b/d $ 10 10 10 Balance c/d $ 10 10 (10) Bank Balance c/d $ 200 100 300 $ 60 300 1,500 1,860 1,860 Balance c/d $ 10 10
6.19
6: ANSWERS
Cleaning (I/S) (11) Bank Balance b/d $ 30 30 30 Balance c/d $ 30 30
Drawings (B/S) (12) Bank Balance b/d $ 100 100 100 Balance c/d $ 100 100
Trial Balance Bank Capital Rent Trade payables Purchases Repairs Advertising Sales Trade receivables Cleaning materials Cleaning Drawings Joan Income statement for the two months ended Sales Purchases Gross profit Rent Repairs Advertising Cleaning (10 + 30) Profit for the period
Debit $ 5,390 200 1,245 75 10 100 10 30 100 7,160
Credit $ 5,000 300
1,860
7,160
200 75 10 40
$ 1,860 (1,245) 615
(325) 290
6.20
6: ANSWERS
Joan Balance sheet as at. Current Assets Trade receivables Bank Proprietor's Interest Capital Profit Less: drawings Current Liabilities Trade payables 6.5 Brian (a) (1) (6) Capital Sales Bank (B/S) $ 20,000 (2) 750 (3) (5) (7) (8) (9) Capital (B/S) $ (1) Bank $ 20,000 $ 10,500 200 400 600 80 300 $ 100 5,390 5,490 $ 5,000 290 (100) 5,190 300 5,490
Van Repairs & Maintenance Petrol Tax & Insurance Purchases Drawings
(2)
Bank
Van (B/S) $ 10,500 Repairs & Maintenance (I/S) $ 200 Purchases (I/S) $ 750 80 Trade payables (B/S) $ (4) Purchases
(3)
Bank
(4) (8)
Trade payables Bank
$ 750
6.21
6: ANSWERS
(5)
Bank
Petrol (I/S) $ 400 Sales (I/S) $ (6) Bank
$ 750
(7)
Bank
Tax & Insurance (I/S) $ 600 Drawings (B/S) $ 300 Bank (B/S) $ 20,000 (2) 750 (3) (5) (7) (8) (9) 20,750
(9) (b) (1) (6)
Bank
Capital Sales
Van Repairs & Maintenance Petrol Tax & Insurance Purchases Drawings Bal c/d
$ 10,500 200 400 600 80 300 8,670 20,750
Bal b/d
8,670 Capital (B/S) $ 20,000 (1) Bank 20,000 Bal b/d Van (B/S)
Bal c/d
$ 20,000 20,000 20,000
(2)
Bank Bal b/d
$ 10,500 10,500 10,500
Bal c/d
$ 10,500 10,500
(3)
Bank Bal b/d
Repairs & Maintenance (I/S) $ 200 Bal c/d 200 200
$ 200 200
6.22
6: ANSWERS
(4) (8)
Trade payables Bank Bal b/d
Purchases (I/S) $ 750 80 Bal c/d 830 830 Trade payables (B/S) $ 750 (4) Purchases 750 Bal b/d Petrol (I/S)
$ 830 830
Bal c/d
$ 750 750 750
(5)
Bank Bal b/d
$ 400 400 400
Bal c/d
$ 400 400
Bal c/d
Sales (I/S) $ 750 (6) Bank 750 Bal b/d Tax & Insurance (I/S) $ 600 Bal c/d 600 600 Drawings (B/S) $ 300 300 300 Trial balance Debit $ 8,670 10,500 200 830 400 600 300 21,500
$ 750 750 750 $ 600 600
(7)
Bank Bal b/d
(9)
Bank Bal b/d
$ Bal c/d 300 300
(c) Bank Capital Van Repairs and Maintenance Purchases Trade payables Petrol Sales Tax & Insurance Drawings
Credit $ 20,000
750 750 21,500
6.23
6: ANSWERS
(d) Purchases Gross profit c/d Petrol Repairs & Maintenance Tax & Insurance
Income Statement $ 830 Sales 420 Closing inventories 1,250 400 200 600 1,200 Gross profit b/d Net loss c/d
$ 750 500 1,250 420 780 1,200
Net loss b/d
780 Purchases (I/S) $ 750 80 Balance c/d 830 830 Petrol (I/S) Income statement $ 830 830 830
(4) (8)
Trade payables Bank Balance b/d
(5)
Bank Balance b/d
$ 400 400 400
Balance c/d Income statement
$ 400 400 400
(3)
Bank Balance b/d
Repairs & Maintenance (I/S) $ 200 Balance c/d 200 200 Income statement
$ 200 200 200
(7)
Bank Balance b/d
Tax & Insurance (I/S) $ 600 Balance c/d 600 600 Income statement
$ 600 600 600
Balance c/d Income statement
Sales (I/S) $ 750 (6) Bank 750 750 Balance b/d
$ 750 750 750
6.24
6: ANSWERS
Closing inventories (I/S)
Inventories (B/S) $ 500
(e)
Brian Income statement for the two months ended 28 February Sales Less cost of sales: Purchases Less: closing inventories Gross profit Less expenses: Petrol Repairs & Maintenance Tax & Insurance Net loss for the period Brian Balance sheet as at 28 February Non current assets Motor vehicles Current assets Inventories Bank Total assets Proprietors interest Capital introduced on 1 January Loss for the period Less: drawings Balance at 28 February Current liabilities Trade payables Total capital and liabilities
$ 830 (500)
$ 750
330 420 400 200 600
((1,200) (780)
$ 10,500 500 500 8,670 19,670 $ (780) (300) $ 20,000 (1,080) 18,920 750 19,670 Drawings (B/S) $ 300 Bal c/d 300
(f) (9) Bank $ 300 300 300
Bal b/d
300
Capital a/c
6.25
6: ANSWERS
Purchases Gross profit c/d Petrol Repairs & Maintenance Tax & Insurance
Income statement $ 830 Sales 420 Closing inventories 1,250 400 Gross profit b/d 200 600 Net loss c/d 1,200 780 Capital a/c Capital account (B/S) $ 20,000 (1) Bank 20,000 300 780 18,920 20,000 Bal b/d
$ 750 500 1,250 420 780 1,200 780 $ 20,000 20,000 20,000 20,000 18,920
Net loss b/d
Bal c/d Drawings Net loss Bal c/d
Bal b/d 6.6 Dealers (a) (b) Net assets = proprietors interest Net assets at 1 January are $18,500 Net assets = assets liabilities At 31 January the assets total: Plant and equipment Motor vehicles Trade receivables Inventories Balance in the bank Cash in the till At 31 January the liabilities total: Trade payables Accrued expenses Net assets at 31 January (c) Profit = Increase in net assets between two points in time Drawings between the same two points in time $ 10,000 5,000 2,000 4,500 3,500 250 3,000 250
25,250 3,250 22,000
Additional capital paid in between the same two points in time
Profit for the month of January = (22,000 18,500) + (350 + 1,250) 2,000 = $3,100
6.26
6: ANSWERS
(d)
Accounting equation at 31 January ASSETS = CAPITAL + PROFIT DRAWINGS 25,250 = 20,500 + 3,100 1,600 Plant & equipment Motor vehicles Inventories Trade receivables Balance in bank Cash in the till $ 10,000 5,000 4,500 2,000 3,500 250 25,250 + + PAYABLES 3,250 $ 18,500 2,000 3,100 23,600 1,600 22,000 3,000 250 25,250
Capital at 1 January Additional capital Profit Less: drawings Trade payables Accrued expenses
6.27
6: ANSWERS
END OF CHAPTER
6.28
Sales tax

Having studied this chapter you will be able to: Understand the general principles of the operation of a sales tax. Calculate sales tax on transactions and record the consequent accounting entries.
Exam Context
This topic is likely to be tested in two main ways. You may be asked to identify the correct journal entry to post sales and purchases transactions including sales tax. You may also be required to consider how sales tax affects the calculation of amounts to be capitalised for non-current assets and the amount for trade receivables where discounts are offered.
Financial Accounting introduces accounting for sales tax. More detailed rules and calculations relating to this area are covered in the Fundamentals level paper, Taxation (F6).
7.1
7: SALES TAX
Overview
Output tax Input tax
Sales tax
Irrecoverable sales tax
Discounts
7.2
7: SALES TAX
1
1.1
Introduction
This chapter is designed to enable you to prepare basic accounting entries for sales tax, known in many countries as Value Added Tax (VAT).
Sales tax
1.2 A business' sales and purchases are often subject to sales tax. This is an indirect tax, as it is not levied directly on the individual like personal income tax. Sales tax is collected by traders who charge it on the goods they sell to the customer. A business charges sales tax on its sales (output tax) and suffers sales tax on its purchases (input tax). Typically, a business which is registered for sales tax only needs to make a payment to the tax authorities of the net amount of sales tax (i.e. sales tax owed on outputs less sales tax suffered on inputs).
Purchases Goods into factory (input tax)
Sales Goods out of factory (output tax)
1.3
A registered business shows: (a) (b) items of income and expenditure net of sales tax; trade receivables and trade payables gross of sales tax.
1.4
Illustration (all figures include sales tax at 15%). Purchase raw materials Sell finished product Required Calculate the amounts due to or from the sales tax authority. $ Input tax Output tax $115.00 $287.50
The rate of sales tax will always be provided in an exam question.
7.3
7: SALES TAX
Lecture example 1
A business buys goods for $1,000 plus 15% sales tax. They then sell those goods for $1,500 + 15% sales tax. The purchases will cost ($1,000 1.15) = $1,150 The sales will raise ($1,500 1.15) = $1,725 The sales tax payable to tax authorities will be: Payable on outputs (sales) Reclaimable on inputs (purchases) Net sales tax to tax authorities (15% $1,500) (15% $1,000) $ 225.00 (150.00) 75.00
As the business is purely collecting the sales tax for the tax authorities, and is able to set off its sales tax suffered it does not include sales tax as either an expense or income in the income statement. The sales tax is accounted for when the transaction occurs. Required (a) Post the double entry to the ledger account below. Dr Purchases Dr Sales tax control account Cr Trade payables $ 1,000 150 $ 1,150
Solution
(a) Purchases (I/S) Trade payables (B/S)
Sales tax control account (B/S)
7.4
7: SALES TAX Points to note Purchases Trade payables (b) NET GROSS $ 1,725 $ 1,500 225
Post the double entry to the ledger account below. Dr Trade receivables Cr Sales Cr Sales tax control account
Solution
Sales (I/S) Trade receivables (B/S)
Sales tax control account (B/S) $ Balance b/d 175
Points to note Sales Trade receivables NET GROSS
3
3.1
Irrecoverable sales tax

In some tax regimes, sales tax on certain inputs is never recoverable. For example, sales tax on business entertaining or on cars may not be recoverable. In this case the tax is a genuine expense of the business and is charged to the income statement or included in the cost of an asset to be depreciated. For example, the double entry for buying a car where the sales tax is irrecoverable would be: Dr Cr Motor vehicles account Cash account
7.5
Cost + sales tax Cost + sales tax
7: SALES TAX
4
4.1
Sales tax and discounts

Many businesses offer discounts to their customers. There are two types:

trade discounts settlement discounts
4.2 4.3
Sales tax is calculated on the amount after all discounts. The calculation and accounting treatment of discounts is covered in Chapter 14.
5
Quick Quiz
A business acts as a collecting agent for the tax authorities and charges sales tax (output tax) on its sales and reclaims sales tax (input tax) on its purchases. Sales and purchases are recorded at the net amount. Sales tax may be charged at various rates, however the rate of sales tax will always be provided in an exam question. The effect of discounts on sales tax is covered in Chapter 14.
5.1 5.2 5.3 5.4
6
6.1

Recording a credit purchase with sales tax: Dr Dr Cr Purchases net Sales tax control account tax Trade payables
gross
6.2
Recording a credit sale with sales tax: Dr Cr Cr Trade receivables gross Sales net Sales tax control account tax
7.6
7.7
7: QUESTIONS
7.1
Elmo is a trader registered for sales tax. All his sales and purchases carry sales tax at a rate of 15%. A customer has just returned goods sold for $230 plus sales tax, the double entry for this transaction is A B C D Debit payables $264.50, Credit sales tax $34.50, Credit sales $230 Debit sales $264.50, Credit trade receivables $264.50 Debit sales $230, Debit sales tax $34.50, Credit trade receivables $264.50 Debit sales $230, Debit irrecoverable sales tax $34.50, Credit trade receivables $264.50 (2 marks)
During 20X1 Fergus buys two vans and a car each costing $10,000 plus sales tax at 15%. The car will be used 70% for business use and 30% personal use. He depreciates vehicles on a straight line basis, vans over five years and cars over six years. What is his depreciation expense to the nearest $ for the year? In the tax regime in which Fergus operates sales tax is only recoverable on items used wholly for business purposes. A B C D $5,917 $6,517 $6,100 $5,666 (2 marks)
7.8
Chapter 7: Answers
7.9
7: ANSWERS
7.1 7.2
C A Sales tax on the car is not recoverable as it is not wholly used for business purposes. Sales tax is however recoverable on the vans. $ Vans (2 $10,000) 5 = 4,000 Car ($10,000 115%) 6 = 1,917 5,917
END OF CHAPTER
7.10
Inventory


Recognise the need for adjustments for inventory in preparing financial statements. Record opening and closing inventory. Identify the alternative methods of valuing inventory. Understand and apply the IASB requirements for valuing inventories. Recognise which costs should be included in valuing inventories. Calculate the value of closing inventory using 'first in, first out' and 'average cost'. Understand the use of continuous and period end inventory records. Understand the impact of accounting concepts on the valuation of inventory. Identify the impact of inventory valuation methods on profit and on assets.
Exam Context
Accounting for inventories and inventory valuation is a basic principle that affects any business. Examination questions are likely to test your understanding of the terms cost and net realisable value. You should also expect calculations on this area and be able to make adjustments for both opening and closing inventory.
The Fundamentals level paper Management Accounting (F2) explores inventories in more detail. There you will look at the classification of costs (for example, production versus non production and fixed versus variable) and you will also cover detailed calculations on overhead absorption.
8.1
8: INVENTORY
Overview
Accounting adjustments
Inventory
Valuation
Effects on profit
Cost
Net realisable value
Methods of estimating cost
FIFO
AVCO
8.2
8:
INVENTORY
1
1.1 1.2
Introduction
For some businesses, for example manufacturing entities, inventory can be a significant figure. It impacts the financial statement in two ways: (a) (b) Balance sheet: Income statement: a potentially large balance within Current Assets opening and closing inventory have a direct impact on cost of sales and therefore profits
1.3
Businesses must therefore ensure that their financial statements account for inventory accurately in terms of: (a) (b) the accounting adjustment its valuation
2
2.1 2.2
Accounting adjustment
Inventory is generally accounted for as a year end adjustment via a journal entry. Opening inventory The trial balance produced by the entity at the end of the year will show an inventory figure. This amount generally relates to the opening inventory i.e. the goods held by the business at the beginning of the year. Such goods will have been sold during the year. They are no longer an asset of the entity but will form part of the costs that should be matched against sales revenue when determining profit. The accounting entry is: Dr Cr Cost of sales (I/S) Inventories (B/S)
2.3
Closing inventory The goods held by the business at the end of the year must be included as an asset in the balance sheet and within cost of sales in the income statement. The accounting entry is: Dr Cr Inventories (B/S) Cost of sales (I/S)
8.3
8: INVENTORY 2.4 The inventories figure comprises two elements: QUANTITY VALUATION Quantity: Valuation: 2.5 normally ascertained by inventory count at end of accounting period or by continuous inventory records. much more subjective, so guidance is provided in IAS 2.
Inventory overview Inventory = Quantity Inventory count x Valuation Lower of and NRV
Continuous Inventory records
Cost
All costs to get item to current location in current condition
Selling price Less: completion costs Less: selling costs
$ X (X) (X) X
Actual cost
Deemed cost
FIFO
Average Cost
3
3.1
Valuation
The basic rule per IAS 2: Inventories is: 'Inventories should be measured at the lower of cost and net realisable value.'
3.2
This is another example of prudence in presenting financial information. (a) If inventory is expected to be sold at a profit: (i) (ii) (b) (i) (ii) value at cost do not anticipate profit. value at net realisable value do provide for the future loss.
If inventory is expected to be sold at a loss:
8.4
8:
INVENTORY
4
4.1
Cost
The cost of an item of inventory includes:

For example: purchase price import duties But not: sales tax trade discounts
Cost of purchase

Costs of conversion
Section 5.4
Relating to productions: direct labour direct/variable overheads an allocation of fixed overheads (based on normal level of activity) For example: carriage inwards
Other costs incurred in bringing the inventories to their present location and condition
Lecture example 1
Exam standard question worth 2 marks
According to IAS 2: Inventories, which of the following should not be included in valuing the inventories of an entity? (1) (2) (3) (4) A B C D Labour costs Transport costs to deliver goods to customers Administrative overheads Depreciation on factory machine All four items 1 only 2 and 3 only 2, 3, and 4 only
Solution
8.5
8: INVENTORY
5
5.1 5.2
Net realisable value (NRV)

The net realisable value of an item is essentially its net selling proceeds after all costs have been deducted. It is calculated as: Estimated selling price Less: estimated costs of completion Less: estimated selling and distribution costs $ X (X) (X) X
Lecture example 2
Jessie is trying to value her inventory. She has the following information available: Selling price Costs incurred to date Cost of work to complete item Selling costs per item Required What is the net realisable value of Jessie's inventory? Workings $ $ 35 20 12 1
No netting off
5.3 The IAS 2 rule 'lower of cost and net realisable value' should be applied as far as possible on an item by item (or line by line) basis.
8.6
8:
INVENTORY
Illustration
5.4 Suppose an entity has four items of inventories on hand at the year end. Their costs and NRVs are as follows: Inventory item 1 2 3 4 Cost $ 27 14 43 29 113 NRV $ 32 8 55 40 135 Lower of cost and NRV $ 27 8 43 29 107
It would be incorrect to compare total cost of $113 with total NRV of $135 and state inventories as $113. A loss on item 2 of $6 can be foreseen and should therefore be recognised. The comparison should be made for each item of inventory and thus a value of $107 would be attributed to inventories. This would be accounted for by the journal entry: Dr Cr Inventories (B/S) Cost of sales (I/S) $ 107 $ 107
6
6.1
Section 4.3
Theoretical methods of estimating cost

If various batches of inventories have been purchased at different times during the year and at different prices, it may be impossible to determine precisely which items are still held at the year end and therefore what the actual purchase cost of the goods was. IAS 2 therefore allows an entity to approximate the cost of its inventories. There are two methods examinable at Paper F3:

Issue
First in, first out (FIFO) Average cost FIFO Under FIFO it is assumed that: (i) (ii) first goods purchased/produced will be the first to be sold remaining inventories are the most recent purchases/production.
6.2
(a)
(b)
Average Cost (AVCO) There are two average costs available: (i) Simple average cost The cost of all purchases/production during the year is divided by the total number of units purchased
8.7
8: INVENTORY (ii) Weighted average cost The weighted average of the cost of similar items is recalculated each time a new item is purchased/produced during the period (IAS 2 requires the weighted average to be used)
Lecture example 3
On 1 January 20X7 a company held 200 units of finished goods valued at $10 each. During January the following transactions took place. Date 10 January 20 January 25 January Units purchased 300 350 250 Cost per unit $10.85 $11.50 $13.00
Sales during January were as follows: Date 14 January 21 January 28 January Required Determine the valuation of closing inventories and cost of sales using: (a) (b) FIFO Weighted average cost Units sold 280 400 80 Sales price per unit $18.00 $18.00 $18.00
Solution
(a) Closing inventories (FIFO) 1.1.X7 Sales Purchases 10.1.X7 20.1.X7 25.1.X7
Cost of sales (FIFO)
8.8
8: (b) Closing inventories and cost of sales (AVCO) Units 1.1.X7 10.1.X7 14.1.X7 20.1.X7 21.1.X7 25.1.X7 28.1.X7 Workings b/f Purchase Sale Purchase Sale Purchase Sale Cost $ Average Unit Cost $
INVENTORY
Total Cost $
Cost of Sales $
Advantages and disadvantages

6.3 FIFO: more realistic value on balance sheet. Average cost: can be complex as weighted average is required by IAS 2.
8.9
8: INVENTORY
7
7.1
Valuation effects on profit

All of the inventory valuation methods affect profits. Using the FIFO, and average cost examples above, this can be illustrated in an income statement. FIFO $ Sales (760 $18) Cost of sales Opening inventories Purchases Closing inventories Gross profit 2,000 10,530 (4,285) 8,245 5,435 $ 13,680 Weighted average $ $ 13,680 2,000 10,530 (4,160) 8,370 5,310
7.2
The only figure that varies is the closing inventories, the result being quite different profit figures. This re-emphasises the significance of inventory valuation in the preparation of financial statements.
Effects in times of changing prices

7.3 In the above example, the purchase price of inventories was rising during the period. Notice that when prices are rising: FIFO will tend to give higher inventory values and higher profits.
8
8.1 8.2 8.3 8.4 8.5
Inventories should be valued at the lower of cost and net realisable value. The cost of inventory includes the cost of purchase, costs of conversion and any other costs necessary to bring the inventory to its present location and condition. Methods available to estimate the cost of inventories are first in, first out (FIFO) and average cost. In times of rising prices, using FIFO will mean the financial statements show higher inventory values and higher profits. Net realisable value is the estimated selling price less the costs to completion and any selling and distribution costs.
8.10
8.11
8: QUESTIONS
8.1
An item of inventory could be sold for $100 after it has been modified at a cost of $21. The company incurs selling and distribution costs of 5% of selling price on each article sold. The cost is $45 per unit excluding carriage inwards of $2 and production overheads of $17 per unit. Following the rules in IAS 2 at what valuation should this item be included in the inventories of the company? $ (2 marks)
8.2
Harrow Co sells one line of inventory. At the year end it has 200 units in inventory which originally cost $10 per unit and had incurred delivery costs of $120 in total. They expect these goods to sell for $13 per unit. Harrow Co incurs selling costs amounting to 10% of the selling price on all its sales. In the balance sheet these items should be valued at: A B C D $2,000 $2,080 $2,120 $2,600 (2 marks)
8.3
Lamp makes the following purchases in the year. (i) (ii) (iii) (iv) (v) 21.01.X9 30.04.X9 31.07.X9 01.09.X9 11.11.X9 Units 100 300 40 60 80 $/unit 12.00 12.50 12.80 13.00 13.50 Total ($) 1,200 3,750 512 780 1,080
At the year end 200 units are in inventory but eight are damaged and are only worth $10 per unit. These are identified as having been part of the 11.11.X9 delivery. Lamp operates a FIFO system for valuing inventories. The figure for inventories at 31 December 20X9 is: A B C D 8.4 $2,524 $2,594 $2,622 $2,700 (2 marks)
Inventories At the year end, Biggs Co holds the following inventories: (1) (2) (3) (4) 10 units of L in a completed state; each unit cost $160 to make and has a selling price of $200. 45 units of M in a partly completed state. Costs to date have amounted to $240 per unit and completion costs will amount to $90 per unit. Selling price per unit is $360. 60 units of N purchased for $40 each. These sell at $56 each and would now cost $48 each if additional units were bought. 50 units of O costing $10 each. These cannot be sold unless they are modified at a cost of $2 per unit. After that, the selling price will be $8.
The companys selling costs are 25% of the selling price. Required Calculate the value of inventories that would be shown on the balance sheet at the end of the year.
8.12
8: QUESTIONS
8.5
T Bag T Bag commenced business as a tea importer on 1 January 20X5. His purchases and sales during his first six months of trading are set out below: Tonnes 1 January 15 February 27 February 31 March 16 April 30 April 30 May 8 June 28 June 30 20 40 25 35 10 Purchases Price per tonne $ 700 750 820 880 900 1,050 Total price $ 21,000 15,000 32,800 22,000 31,500 10,500 132,800 Required Calculate the value of closing inventories and produce a trading account for the 6 months ended 30 June 20X5 assuming: (a) (b) Inventories are valued on a FIFO basis Inventories are valued on a weighted average basis Tonnes Sales Proceeds $ 36,000 35,000 77,000 148,000
40 35 70
8.13
8: QUESTIONS
8.14
Chapter 8: Answers
8.15
8: ANSWERS
8.1
$64
NRV = 100 21 (5% 100) = $74 Cost = 45 + 2 + 17 = $64 Lower of cost and NRV = $64 200 @ $10 = Delivery costs Cost/ unit = $10.60 Net realisable value per unit = $13 90% = $11.70 valued at cost $ 2,000 120 2,120
8.2
8.3
B Inventories = 8 72 60 40 20 200 @ $10 @ $13.50 @ $13 @ $12.80 @ $12.50 = = = = =
$ 80 972 780 512 250 2,594
8.4
Inventories The inventories total on the balance sheet would be: $12,200 ($1,500 + $8,100 + $2,400 + $200). Workings (1) 1 unit of L would be valued at: Selling price Less selling costs (25%) NRV Cost NRV is lower and so 10 units of L are valued at $1,500 (2) 1 unit of M would be valued at: Selling price Less: Selling costs (25%) Costs to completion NRV Cost NRV is lower and so 45 units of M are valued at $8,100 (3) 1 unit of N would be valued at: Selling price Less selling costs (25%) NRV Cost Cost is lower and 60 units of N are valued at $2,400 Replacement cost is irrelevant. $ 56 14 42 40 $ 90 90 $ 360 180 180 240 $ 200 50 150 160
8.16
8: ANSWERS
(4)
1 unit of O would be valued at: $ Selling price Less: Selling costs (25%) Costs of modification NRV Cost NRV is lower and so 50 units of O are valued at $200 2 2 $ 8 4 4 10
8.5
T Bag Trading account for the 6 months ended 30 June 20X5 FIFO Sales Cost of sales Purchases Closing inventories (W) Gross profit Workings (W1) FIFO method Purchases in tonnes Sales in tonnes: 27 Feb 30 Apr 28 June Inventories at 30 June 20X5 Cost per tonne Valuation Total valuation $4,500 + $10,500 = $15,000 (W2) Weighted average method Tonnes 1 Jan 15 Feb 27 Feb 31 March 16 April 30 April 30 May 8 June 28 June 30 20 50 (40) 10 40 25 75 (35) 40 35 10 85 (70) 15 Cost $ 700 750 Average Unit Cost $ 720 Total Cost $ 21,000 15,000 36,000 (28,800) 7,200 32,800 22,000 62,000 (28,945) 33,055 31,500 10,500 75,055 (61,810) 13,245 Cost of Sales $ 1 Jan 30 (30) 15 Feb 20 (10) (10) 31 Mar 40 (25) (15) 16 Apr 25 30 May 35 8 June 10 132,800 (15,000) (117,800) 30,200 $ 148,000 132,800 (13,245) (119,555) 28,445 Weighted average $ 148,000
(25)
(30) 5 $900 $4,500
10 $1,050 $10,500
28,800
820 880
827
28,945
900 1,050
883
61,810 119,555
8.17
8: ANSWERS
END OF CHAPTER
8.18
Tangible non-current assets


Define non-current assets and recognise the difference between current and non-current assets. Explain the difference between capital and revenue items and classify expenditure accordingly. Prepare ledger entries to record the acquisition, disposal, depreciation and accumulated depreciation of noncurrent assets. Calculate and record profits or losses on disposal of non-current assets in the income statement. Record the revaluation of a non-current asset and calculate its subsequent depreciation and profit or loss on disposal. Illustrate how non-current asset balances and movements are disclosed in company financial statements. Explain the purpose and function of an asset register. Understand and explain the purpose of depreciation. Calculate the charge for depreciation using the straight line and reducing methods, identifying when each is appropriate. Calculate the adjustments to depreciation necessary if changes are made in the estimated useful life and/or residual value of a non-current asset. Record depreciation in the income statement and balance sheet.
Exam Context
Tangible non-current assets and depreciation are an important part of the F3 syllabus and you should expect several questions on this area. Questions are likely to focus on areas such as calculating depreciation and asset values (both on assets held at historic cost and revalued amounts), profits or losses on disposal of assets and the components that can be included in the cost of a non-current asset.
The knowledge covered in this chapter is developed in the Fundamentals level paper Financial Reporting (F7) where you will deal with more complex issues such as impairments of non-current assets and leasing.
9.1
9: TANGIBLE NON-CURRENT ASSETS
Overview
Capital versus revenue expenditure
Cost
Tangible non-current assets
Revaluations
Depreciation
Disposals
Straight line method
Reducing balance depreciation
9.2
1
1.1 1.2
Introduction
The purchase of a non-current asset is often a significant cost to a business which will have a large impact on its financial statements. It is important therefore that this expenditure is accounted for appropriately.
2
2.1
Non-current assets
Non-current assets are assets which are intended to be used by the business on a continuing basis and include both tangible and intangible assets. Intangible non-current assets are covered in Chapter 10.
Definition
2.2
The accounting treatment of tangible non-current assets is covered by IAS 16: Property, Plant and equipment. Tangible non-current assets are defined as those which: (a) (b) are held for use in the production or supply of goods or services or for administrative purposes; and are expected to be used during more than one period.
Idea generation
Lecture example 1
Required What examples of tangible non-current assets can you identify?
Solution
(a) (b) (c) (d)
9.3
Capital versus revenue expenditure

2.3
Section 1.3
(a) (b)
Capital expenditure: Revenue expenditure:
results in the acquisition, replacement or improvement of non-current assets. for the trade of the business, or to repair, maintain and service non-current assets.
2.4
Capital expenditure results in the appearance of a non-current asset in the balance sheet of the business. Revenue expenditure results in an expense in the income statement.
Cost
2.5 Tangible non-current assets should initially be recorded at cost. Cost includes:

Purchase price:
excluding sales tax and trade discounts but including import duties
Directly attributable costs to bring the asset to its intended location and ready to use. These include: (a) (b) (c) (d) (a) (b) (c) Initial delivery and handling costs Installation and assembly costs Costs of testing whether the asset is working properly Professional fees The cost of maintenance contracts Administration and general overhead costs Staff training costs
The following costs may not be included:
2.6
The asset can then be kept at cost and depreciated or the entity may choose to revalue its tangible non-current assets.
Exam standard worth 2 marks
Lecture example 2
On 10 December 20X7 an entity bought a machine. The breakdown on the invoice showed: Cost of machine Delivery costs One-year maintenance contract Further installation costs of $500 were also incurred.
$ 20,000 200 900 21,100
9.4
9: TANGIBLE NON-CURRENT ASSETS Required At what amount should the machine be capitalised in the entity's records? A B C D $20,000 $20,700 $20,200 $21,600
Solution
3
3.1
Depreciation
Tangible non-current assets are used in the business to generate the income shown in the income statement. Assets will eventually be worn out (used up) and so there is a cost of generating income. This cost should be shown in the income statement to 'match' against the income. This is called depreciation.
3.2
Depreciation results in the non-current asset being systematically charged to the income statement over several accounting periods in recognition of the fact that the asset will contribute to the income-generating activities of each of these periods. A formal definition is given by the accounting standard, IAS 16: "the systematic allocation of the depreciable amount of an asset over its useful life." 'Depreciable amount' 'Residual value' = = cost/revalued amount residual value the amount the asset is expected to be sold for at the end of its useful life (scrap value).
3.3
Land normally has an unlimited useful life and is therefore not depreciated. Buildings have a limited life and, therefore, are depreciable assets.
9.5
4
4.1
Methods of depreciation
There are two main methods for calculating depreciation: (a) (b) Straight line method Reducing balance method
5
5.1
Straight line method

The depreciation charge is the same every year. cost residual value useful life (years)
Formula
5.2 Depreciation = where:
or (Cost Residual value) %
Residual value = expected proceeds/scrap value at the end of the asset's useful life. Useful life 5.3 = the number of years the business expects to make use of the asset.
This method is suitable for assets which are used up evenly over their useful life.
Lecture example 3
A business buys a machine for $2,500. It is expected to have a useful life of three years after which time it will have a scrap value of $250. Required (a) (b) Calculate the annual depreciation charge. Calculate the cost, accumulated depreciation and net book value (NBV) for each year of the asset's life. Note: NBV = cost accumulated depreciation to date.
Solution
(a)
(b) Year 1 2 3 Cost $ Accumulated depreciation $ NBV $
9.6
6
6.1
Reducing balance depreciation

This method is suitable for those assets which generate more revenue in earlier years than in later years; for example a machine which may become progressively less efficient as it gets older. Under this method the depreciation charge will be higher in the earlier years and reduce over time.
Formula
6.2 Depreciation where: Note: = Depreciation rate (%) Net Book Value (NBV) net book value (NBV) = cost accumulated depreciation to date This method does not take account of any residual value, since the NBV under this method will never reach zero. The depreciation rate percentage will be provided in the question.
Lecture example 4
A business buys a machine costing $6,000. The depreciation rate is 40% on a reducing balance basis. Required Calculate depreciation expense, accumulated depreciation and net book value of the asset for the first three years.
Solution
Year 1 2 3 NBV b/d $ Depreciation rate Depreciation expense $ Accumulated depreciation $ NBV c/d $
9.7
7
7.1
Accounting for depreciation

Depreciation has a dual effect which needs to be accounted for: (a) (b) It reduces the value of the asset on the face of the balance sheet. It is an expense in the income statement.
Dual effect
7.2
The asset remains at its original cost in the asset account. Two accounts are set up to record depreciation: Dr Cr Depreciation expense Accumulated depreciation
Accumulated depreciation account

7.3 (a) (b) (c) Used to provide for the reduction in value of the asset. Reduces original cost of the asset on the balance sheet. (The balance on the account is offset against the cost account for the corresponding asset.) Separate account kept for each class of asset (eg motor vehicles, buildings, plant and machinery).
Lecture example 5
Required Using the information in Lecture example 3, show: (a) (b) (c)
The journal entry which would have been written at the end of the first year. The treatment of depreciation for all years in the relevant ledger accounts. The relevant income statement and balance sheet extracts for each year.
Solution
(a) Journal entry Debit $ Credit $
9.8
9: TANGIBLE NON-CURRENT ASSETS (b) Machine (B/S)
Depreciation expense (I/S)
Accumulated depreciation (B/S)
(c)
Income statement (extracts) Year 1 $ Expenses Year 2 $ Year 3 $
9.9
9: TANGIBLE NON-CURRENT ASSETS Balance sheet (extracts) Cost $ (Year 1) (Year 2) (Year 3) Accumulated depreciation $ Net book value $
8
8.1
Disposal of non-current assets

When a non-current asset is disposed, of its net book value needs to be removed from the balance sheet. The sales proceeds received are unlikely to be exactly the same as the asset's net book value and so a profit or loss on disposal will arise. If: Sales proceeds > NBV profit on disposal Sales proceeds < NBV loss on disposal This is not a 'true' profit or loss, but rather a book adjustment to reflect the fact that the depreciation charged over the asset's life wasn't completely accurate.
Profit or loss on disposal
8.2 Everything to do with the disposal is transferred to a Disposal Account. Steps: (1) Remove the cost of the asset: Dr Cr (2) Dr Cr Disposal account Non-current asset Accumulated depreciation Disposal account
Remove the accumulated depreciation charged to date:
Note: Steps (1) and (2) have effectively transferred the NBV of the asset to the disposal account.
9.10
9: TANGIBLE NON-CURRENT ASSETS (3) Account for the sales proceeds: Dr Cr (4) Cash Disposal account
Balance off disposal account to find the profit or loss on disposal.
A gain on disposal is shown in the income statement as sundry income, a loss as an expense.
Lecture example 6
The machine costing $6,000 in Lecture example 4 is sold in year 3 for $3,000. No depreciation is charged in the year of disposal. Required (a) (b) Calculate the profit or loss on disposal of the machine. Complete the ledger accounts to show how the disposal would be accounted for.
Solution
(a)
(b) Machine (B/S) Bal b/d $ 6,000 $
9.11
9: TANGIBLE NON-CURRENT ASSETS Accumulated depreciation (B/S) $ Bal b/d
$ 3,840
Disposal account $ $
Part exchange allowance

8.3 Instead of receiving sales proceeds as cash, a part exchange allowance could be offered against the cost of a replacement asset: Dr Cr New asset cost Disposal account
The part exchange allowance takes the place of proceeds in the disposals account.
Lecture example 7
Assume in Lecture example 6 that instead of cash proceeds of $3,000, there is a part exchange allowance of $3,000 on a replacement machine costing $10,000. Required (a) (b) (c) Calculate the profit or loss on disposal of the machine. Calculate the amount of cash paid for the new machine. Complete the ledger accounts to show both the disposal and the acquisition.
9.12
Solution
(a)
(b)
(c) Old machine (B/S) Bal b/d $ 6,000 $
Accumulated depreciation (B/S) $ Bal b/d
$ 3,840
New machine (B/S) $ $
Disposal account $ $
9.13
9
9.1 9.2
Revaluations
If an entity owns a property it may notice that its value increases over time. IAS 16 requires tangible non-current assets to initially be recorded at cost. The entity can then either keep the asset at cost (and depreciate it) or choose to revalue it (depreciation is still required). This is a choice of accounting policy.
9.3
If an entity chooses a policy of revaluation then all items in the same class of assets must be revalued. Examples of classes of assets are:

land and buildings plant and machinery motor vehicles
9.4
Revaluations must be carried out sufficiently often so that the assets carrying value is not materially different from its market value.
Steps and accounting treatment

9.5 (1) (2) (3) Adjust cost account to revalued amount. Remove accumulated depreciation charged on the asset to date. Put the balance to the revaluation reserve.
Note: The balance posted to the revaluation reserve will equal the new revalued amount less the previous net book value. 9.6 The required journal is: Dr Dr Cr 9.7 Non-current asset cost Accumulated depreciation Revaluation reserve
Depreciation should now be based on the revalued amount.
9.14
Lecture example 8
A building costing $100,000 on which depreciation of $20,000 has been charged is to be revalued to $150,000. Required (a) (b) Show the double entry to record the revaluation and make the postings to the ledger accounts. What would be the depreciation charge for the year if the building has a remaining useful life of 40 years?
Solution
(a)
Building (B/S) $
Accumulated depreciation (B/S) $
9.15
9: TANGIBLE NON-CURRENT ASSETS Revaluation reserve (B/S) $
(b)
10 Summary of Chapter 9
10.1 Capital expenditure results in a non-current asset being shown on the balance sheet. Revenue expenditure, such as repairs and maintenance, is shown as an expense in the income statement. 10.2 Tangible non-current assets should initially be recorded at cost. This includes the purchase price of the item plus any directly attributable costs to bring the item to its intended location and ready to use. 10.3 Depreciation is an expense charged on the asset each year to reflect the using up of the asset. Depreciation is usually calculated on a straight line or reducing balance basis. 10.4 On disposal of a non-current asset the sales proceeds are compared to the net book value of the asset in order to calculate the profit or loss on disposal. Where an asset is given in part exchange for another asset, the part exchange allowance takes the place of the sales proceeds. 10.5 An entity may choose to revalue its assets rather than hold them at cost this is a choice of accounting policy. Where an entity revalues, it must revalue all assets in the same class and the depreciation charge will now be based on the revalued amount.
9.16
11 Double Entry Summary for Chapter 9

11.1 Depreciation adjustment: Dr Cr Depreciation expense (I/S) Accumulated depreciation (B/S)
11.2 Disposal of a non-current asset (four steps): (1) Remove the cost of the asset: Dr Cr (2) Disposal account (I/S) Non-current assets (B/S)
Remove the accumulated depreciation charged to date: Dr Cr Accumulated depreciation (B/S) Disposal account (I/S)
(3)
Account for the sales proceeds: Dr Cr Cash (B/S) Disposal account (I/S)
(4)
Balance off the disposal account to determine the profit or loss on disposal.
11.3 Revaluation of a non-current asset: Dr Dr Cr Non-current asset cost (B/S) Accumulated depreciation (B/S) Revaluation reserve (B/S)
9.17
9.18
Additional Notes
9.19
12 Depreciation revisited
12.1 Depreciation is charged to allocate the wearing out of an asset (depreciable amount) to the income statement over its useful life. There are two main depreciation methods available:

straight line reducing balance
Section 3.12
12.2 The useful life of an item of property, plant and equipment should be reviewed at least every financial year-end and, if expectations are significantly different from previous estimates, the depreciation charge for current and future periods should be revised. This is achieved by writing the net book value off over the asset's revised remaining useful life.
Lecture example 9
1.1.X1 Asset cost $40,000 Estimated useful life five years No residual value Total useful life revised to four years.
1.1.X3 Required
Calculate the depreciation charge, accumulated depreciation and NBV for each year of the asset's life (year end 31 December).
Solution
Depreciation Accumulated charge depreciation $ $ 20X1 20X2 20X3 20X4 NBV $
9.20
Review of depreciation method

Section 3.7-3.9
12.3 The depreciation method should be reviewed at least every financial year-end and, if there has been a significant change in the expected pattern of the asset's use, the method should be changed. This is achieved by writing the net book amount off over the remaining useful life, using the revised method.
Lecture example 10
1.1.X1 Asset cost $40,000 Residual value $1,500 Useful life five years Depreciation: 25% reducing balance Change depreciation method to straight line
1.1.X3 Required
Calculate the depreciation charge, accumulated depreciation and NBV for each year of the assets life (year ended 31 December).
Solution
Depreciation Accumulated charge depreciation $ $ 20X1 20X2 20X3 20X4 20X5
NBV $
9.21
9.22
9.23
9: QUESTIONS
Data for Questions 9.1 and 9.2

Bungo Co purchases a car for its managing director, which would cost $17,000, by paying $1,000 cash, and trading in an old vehicle. The old vehicle had a net book value of $15,500 immediately before the trade in took place. 9.1 What is the effect of the above transaction on the profit for the year in respect of the disposal of the old vehicle? A B C D 9.2 Reduce profit by $1,500 Increase profit by $1,500 Reduce profit by $500 Increase profit by $500 (2 marks)
Bungo Co charges depreciation at 10% per annum, with a full years charge in the year of acquisition. What will the annual depreciation charge on the new vehicle be? $ (2 marks)
9.3
A company held property, plant and equipment at 31 December 20X5 with a net book value of $22,700. During 20X6 items with a net book value of $2,100 were sold, realising a profit of $700. The depreciation charge in the 20X6 income statement was $4,300. Items with a book value of $15,200 were revalued to $21,250. At 31 December 20X6 the companys balance sheet showed the net book value of property, plant and equipment as $44,100. What was the cost of new property, plant and equipment acquired during 20X6? A B C D $13,150 $17,550 $22,050 $21,750 (2 marks)
9.4
Nick Nick started trading on 1 January 20X8 and bought equipment for his business as follows: 1 January 20X8 2 January 20X8 1 March 20X8 1 May 20X8 Purchased a cutting machine for $4,960. The estimated useful life of the machine is eight years, after which it will have no resale value. Purchased a car for $6,800. Purchased a van for $3,800. This has an estimated useful life of four years, after which Nick believes he could sell it for $200. Purchased office furniture costing $5,400. This has an estimated useful life of 10 years with no resale value.
Depreciation for all assets, except the car, is to be calculated on the straight line basis, time apportioned where the asset is owned for part of a year. The car is to be depreciated at 40% per annum on the reducing balance basis. Required For the years ending 31 December 20X8 and 31 December 20X9, prepare relevant extracts from the financial statements, together with the appropriate ledger accounts.
9.24
9: QUESTIONS
9.5
Eggo On 1 January 20X4 Eggo Co, a manufacturer, acquired two identical grinding machines at a cost of $10,000 each, and a duplicating machine at a cost of $3,000. The grinding machines are depreciated at the rate of 30% per annum on a reducing balance basis, and the duplicating machine, which has an estimated life of 10 years and a residual value of $500, is depreciated on a straight line basis. On 1 January 20X5 one of the grinding machines was sold for $5,000 and replaced by a new one costing $12,000. Required Prepare the relevant ledger accounts dealing with the non-current assets, depreciation and the disposal for the years to 31 December 20X4 and 31 December 20X5, respectively.
9.6
Hopkins During 20X4 Hopkins gave his old van in part-exchange for a new van. The old van had cost $4,000 and had accumulated depreciation of $2,400 at the date of exchange. Hopkins received a part-exchange allowance of $1,800 and made a cash payment of $6,200 for the new van. Depreciation is over four years on a straight line basis. Required (a) (b) Calculate the profit or loss on disposal of the old van. Calculate the depreciation expense for the year ended 20X4.
9.25
9: QUESTIONS
9.26
Chapter 9: Answers
9.27
9: ANSWERS
9.1 9.2
D $1,700
Profit on disposal = (17,000 1,000) 15,500 = $500
10% $17,000 = $1,700 9.3 D Property, plant and equipment (NBV) $ 22,700 Disposals 6,050 Depreciation ? 50,500 C/d $ 2,100 4,300 44,100 50,500
B/d Revaluation (21,250-15,200) Additions
additions = $21,750 9.4 Nick Income statement for the year ended 31 December .... (extract) Depreciation Expense Machine Car Van Furniture Balance sheet as at 31 December 20X8 (extract) Non-current assets Machine Car Van Furniture Balance sheet as at 31 December 20X9 (extract) Non-current assets Machine Car Van Furniture Machine (B/S) 1.1.X8 Bank $ 4,960 Cost $ 4,960 6,800 3,800 5,400 20,960 Accumulated depreciation $ 1,240 4,352 1,650 900 8,142 Net Book Value $ 3,720 2,448 2,150 4,500 12,818 Cost $ 4,960 6,800 3,800 5,400 20,960 Accumulated depreciation $ 620 2,720 750 360 4,450 Net Book Value $ 4,340 4,080 3,050 5,040 16,510 20X8 $ 620 2,720 750 360 4,450 20X9 $ 620 1,632 900 540 3,692
9.28
9: ANSWERS
Machine Accumulated Depreciation (B/S) 31.12.X8 bal c/d $ 620 620 31.12.X9 bal c/d 1,240 1,240 1.1.X9 31.12.X9 1.1.Y0 31.12.X8 Depn expense: machine bal b/d Depn expense : machine bal b/d $ 620 620 620 620 1,240 1,240
Car (B/S) 2.1.X8 Bank $ 6,800 Car Accumulated Depreciation (B/S) 31.12.X8 bal c/d 31.12.X9 bal c/d $ 2,720 2,720 4,352 4,352 31.12.X8 1.1.X9 31.12.X9 1.1.Y0 Van (B/S) 1.3.X8 Bank $ 3,800 Van Accumulated Depreciation (B/S) 31.12.X8 bal c/d 31.12.X9 bal c/d $ 750 750 1,650 1,650 31.12.X8 1.1.X9 31.12.X9 1.1.Y0 Furniture (B/S) 1.5.X8 Bank $ 5,400 Depn expense: van bal b/d Depn expense: van bal b/d $ 750 750 750 900 1,650 1,650 Depn expense: car bal b/d Dep'n expense: car bal b/d $ 2,720 2,720 2,720 1,632 4,352 4,352
9.29
9: ANSWERS
Furniture Accumulated Depreciation (B/S) 31.12.X8 bal c/d $ 360 360 31.12.X9 bal c/d 900 900 1.1.X9 31.12.X9 1.1.Y0 31.12.X8 Depn expense: furniture furniture bal b/d Depn expense: furniture bal b/d $ 360 360 360 540 900 900
Depreciation Expense : Machine (I/S) 31.12.X8 31.12.X9 Accd depn: machine Accd depn: machine $ 620 620 31.12.X8 31.12.X9 I/S I/S $ 620 620
Depreciation Expense : Car (I/S) 31.12.X8 31.12.X9 Accd depn: car Accd depn: car $ 2,720 1,632 31.12.X8 31.12.X9 I/S I/S $ 2,720 1,632
Depreciation Expense : Van (I/S) 31.12.X8 31.12.X9 Accd depn: van Accd depn: van $ 750 900 31.12.X8 31.12.X9 I/S I/S $ 750 900
Depreciation Expense : Furniture (I/S) 31.12.X8 31.12.X9 Accd depn: furniture Accd depn: furniture $ 360 540 20X8 $ 620 2,720 (6,800 2,720) 40% (note: reducing balance method) 31.12.X8 31.12.X9 I/S I/S $ 360 540 20X9 $ 620 1,632
Workings: Depreciation charge Machine Car Van 4,960 8 6,800 40% (3,800 200) 4 = 900 900
10 = 750 12
(10 months) Furniture (5,400)

8 (8 months) 12
750 360
(full year) (full year)
900 540
9.30
9: ANSWERS
9.5
Eggo Grinding machines (B/S) 1.1.X4 1.1.X5 1.1.X5 1.1.X6 Bank Balance b/d Bank Balance c/d $ 20,000 20,000 12,000 32,000 22,000 31.12.X4 Balance c/d 1.1.X5 Disposals 31.12.X5 Balance c/d $ 20,000 10,000 22,000 32,000
Grinding machines Accumulated Depreciation (B/S) 31.12.X4 Balance c/d 1.1.X5 Disposals 31.12.X5 Balance c/d $ 6,000 3,000 8,700 11,700 31.12.X4 Dep'n expense (W) 1.1.X5 Balance b/d 31.12.X5 Dep'n expense (W) 1.1.X6 Balance b/d $ 6,000 6,000 5,700 11,700 8,700
Duplicating machine (B/S) 1.1.X4 1.1.X5 1.1.X5 Bank Balance b/d Balance b/d $ 3,000 3,000 3,000 31.12.X4 Balance c/d 31.12.X5 Balance c/d $ 3,000 3,000
Duplicating machine Accumulated Deprecation 31.12.X4 Balance c/d $ 250 250 500 500 31.12.X4 1.1.X5 31.12.X5 1.1.X6 Depreciation expense Balance b/d Depreciation expense Balance b/d $ 250 250 250 250 500 500
31.12.X5
Balance c/d
Depreciation expense (I/S) 31.12.X4 Acc dep'n grinding machines 31.12.X4 Acc dep'n duplicating machine 31.12.X5 Acc dep'n grinding machines 31.12.X5 Acc dep'n duplicating machine $ 6,000 250 6,250 5,700 250 5,950 $ 31.12.X4 I/S 6,250 6,250 5,950 5,950
31.12.X5 I/S
9.31
9: ANSWERS
Disposal account (I/S) 1.1.X5 Grinding machines $ 10,000 10,000 Working Depreciation charge Year ended 31 December Grinding machines ($20,000 30%) Duplicating machine ($3,000 $500) 10 Grinding machines Machine 1 ($10,000 $3,000) 30% Machine 2 ($12,000 30%) Duplicating machine 6,250 9.6 Hopkins (a) $200 profit Working Disposal account (I/S) Cost Profit on disposal $ 4,000 200 4,200 Or alternatively: "Proceeds" part-exchange allowance Net book value ($4,000 $2,400) Profit on disposal (b) $2,000 Cost of new van to be depreciated ($6,200 + $1,800) Depreciate over four years $ 8,000 2,000 $ 1,800 (1,600) 200 Accumulated depreciation Part exchange allowance $ 2,400 1,800 4,200 20X4 $ 6,000 250 20X5 $ 1.1.X5 Bank 1.1.X5 Acc Dep'n grinding machine 31.12.X5 I/S loss on disposal $ 5,000 3,000 2,000 10,000
2,100 3,600 250 5,950
END OF CHAPTER
9.32
Intangible non-current assets

Recognise the difference between tangible and intangible non-current assets. Identify types of intangible assets. Identify the definition and treatment of research and development costs in accordance with IFRS. Calculate amounts to be capitalised as development expenditure or to be expensed from given information. Calculate and account for the charge for amortisation and explain its purpose.
Exam Context
Intangible non-current assets are a smaller part of the syllabus than tangible non-current assets, however you should still expect this area to be tested. Questions are likely to focus on the difference between tangible and intangible assets, the accounting treatment for research and the capitalisation criteria for development expenditure. You should also be confident in calculating amortisation.
The knowledge covered in this chapter forms a platform which will be built on in the Fundamentals level paper Financial Reporting (F7). There you will cover internally generated intangible assets and goodwill.
10.1
10: INTANGIBLE NON-CURRENT ASSETS
Overview
Intangible non-current assets
Research
Development expenditure
Amortisation
10.2
1
1.1 1.2
Definition
An intangible non-current asset is an identifiable non-monetary asset without physical substance. The following are examples of intangible assets: Development expenditure Goodwill Concessions, patents, licences, trade marks.
The Paper F3 syllabus only requires knowledge of the accounting treatment of research and development expenditure.
2
2.1 2.2
Research and development expenditure

Many companies, such as pharmaceutical companies, spend huge amounts on research and development every year in order to maintain or enhance their competitive position. Companies need to account for these costs and whilst the credit entry will be recorded as a current liability, the question remains as to where the debit entry should be shown. The choices are: (a) (b) to debit the income statement with an expense, or to debit the balance sheet with an intangible non-current asset.
An intangible non-current asset should only be recorded when the entity is confident that the expenditure will generate future profit.
3
3.1
IAS 38: Intangible assets

(a) (b) Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.
Definitions
10.3
4
4.1
Research
Development
No certainty that the expenditure will generate future profit Show as an expense in income statement Dr Research expense (I/S) Cr Bank/payables
Future profits are expected MUST capitalise as an intangible noncurrent asset if all of the relevant criteria are satisfied Dr Intangible non-current assets (B/S) Cr Bank/payables
P robable future economic benefits I ntention to complete and use/sell asset R esources adequate and available to complete and use/sell asset A bility to use/sell the asset T echnical feasibility of completing asset for use/sale E xpenditure can be measured reliably
Amortise asset over its useful life once asset is ready for use
Lecture example 1
Z Co incurred the following costs during the year ended 31 August 20X8. (1) (2) (3)
$20,000 on salaries for market research staff sent out to canvass drivers' opinions on a potential new car. $100,000 to purchase a machine to manufacture components for the new car. It has an estimated useful life of 10 years. $25,000 on materials to manufacture a prototype and $50,000 on salaries relating to its design and manufacture. The new car is expected to go on sale in 20X9.
Required How should each of the above items be shown in the financial statements for the year ended 31 August 20X8?
10.4
Solution
5
5.1 5.2
Amortisation of capitalised development expenditure

A tangible non-current asset, such as a machine, is capitalised and then depreciated over its useful life. This is to allocate its costs over the accounting periods which benefit from its use. In the same way development expenditure which is incurred now will generate revenue and profits in the future. The cost of the development expenditure should be matched against the revenue it produces. This is called amortisation.
5.3 5.4
The 'depreciable amount' (cost less residual value) should be amortised over the useful life in the same way that revenues are expected to be generated. Amortisation should begin when the asset is ready for use.
10.5
10: INTANGIBLE NON-CURRENT ASSETS 5.5 It is an expense in the income statement and is accounted for using the following entry: Dr Cr Amortisation expense (I/S) Accumulated amortisation (B/S)
Lecture example 2
Development Co incurs the following expenditure in years 20X1 20X5.
20X1 20X2 20X3 20X4 20X5
Research $ 35,000 38,000
Development $ 55,000 65,000
The development expenditure meets the IAS 38 criteria that require capitalisation ('PIRATE'). The item developed in 20X1 and 20X2 goes on sale on 1.1.X3 and it will be three years from then until any competitor is expected to have a similar product on the market. Required Show income statement and balance sheet extracts for the years 20X1 20X5 inclusive.
Solution
X1 $ Expenses Research expenditure Amortisation of development expenditure X1 $ Non-current assets Development expenditure Amortisation Net book value Balance sheet extracts X2 X3 X4 $ $ $ X5 $ Income statement extracts X2 X3 X4 $ $ $ X5 $
10.6
6
6.1
Quick Quiz
Research relates to costs incurred to obtain knowledge or understanding. There is no certainty of future profit from this expenditure and so it should be shown as an expense in the income statement. Development expenditure should be capitalised as an intangible non-current asset provided all of the PIRATE criteria are met. This asset will then be amortised over the period during which it is expected to generate income.
6.2
10.7
10.8
Chapter 10: Question
10.9
10: QUESTION
10.1
Which of the following statements about research and development are true? (1) (2) (3) A B C D Development expenditure shown on the balance sheet should be amortised over the periods expected to benefit from the product or service. Development expenditure must be capitalised if it meets various criteria. Research expenditure is always written off. All of the above (1) and (2) (2) and (3) (1) and (3) (2 marks)
10.10
Chapter 10: Answer
10.11
10: ANSWER
10.1
END OF CHAPTER
10.12
Accruals and prepayments


Understand how the matching concept applies to accruals and prepayments. Identify and calculate the adjustments needed for accruals and prepayments in preparing financial statements. Prepare the journal entries and ledger entries for the creation of an accrual or prepayment. Understand and identify the impact on profit and net assets of accruals and prepayments.
Exam Context
Accruals and prepayments are key accounting adjustments and you should expect to see them tested in Paper F3. You may be asked to calculate the balance sheet amount for accruals and prepayments and/or the relevant expense that would be shown in the income statement. Alternatively, you may be asked to determine the appropriate journal entries to record accruals and prepayments. The Pilot Paper included questions on the calculation of a year-end prepayment of an expense and the income to be shown in the income statement where rent is received both in advance and in arrears.
This area is a basic skill which is not tested in detail in any other paper. The matching concept however is fundamental to the preparation of financial statements and this is relevant to Paper F7, Financial Reporting.
11.1
11: ACCRUALS AND PREPAYMENTS
Overview
Accruals and prepayments
Year-end adjustments
Reversing out accruals and prepayments
Balance sheet presentation
Accrued income and deferred income
11.2
1
1.1 1.2
Introduction
This chapter is designed to enable you to apply accounting concepts and principles in relation to the calculation of and adjustments for accruals and prepayments. IAS 1 requires financial statements to be prepared on an accruals basis. This is so that transactions and events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the period to which they relate. The accruals basis is also an underlying assumption in the IASB's Framework for the Preparation and Presentation of Financial Statements.
Accruals
1.3 Accruals are expenses incurred by the business during the accounting period but not yet paid for, ie. expenses in arrears.
Example
1.4 Fred prepares accounts to 31 December each year. On 1 January 20X8, he pays a telephone bill of $60 which relates to the period October-December 20X7. Although the payment does not go through the cash book until 20X8, this expense must be included in the accounts for the year ended 31 December 20X7, as it was incurred during this period.
Prepayments
1.5 Prepayments arise when expenses are paid for before they have been used. ie. expenses in advance.
Example
1.6 On 20 December 20X7 Fred pays for insurance on his business premises for the 12 months commencing 1 January 20X8. Although the payment was made in 20X7, the expense should not appear in the accounts for 20X7. The accounts for 20X7 will show a prepayment for the full amount of the insurance cost and the expense will be recorded in 20X8.
11.3
2
2.1
Adjustments for accruals and prepayments tend to occur at the end of the year and are made by way of a journal entry. The required entries are: Accruals Dr Expense (I/S) Cr Accruals (B/S) Prepayments Dr Prepayments (B/S) Cr Expense (I/S)
Year-end adjustments
Balance sheet presentation

2.2 Accruals: Sub-heading under 'current liabilities' Prepayments: Sub-heading under 'current asset'.
Lecture example 1
Fiona set up a business on 1 January 20X7. Her cash payments for the year to 31 December 20X7 included: Date paid Electricity 10.3.X7 12.6.X7 14.9.X7 10.12.X7 Rent 1.2.X7 6.4.X7 375 1,584 3 months to 31 March 20X7 12 months to 31 March 20X8 96 120 104 145 2 months to 28 February 20X7 quarter to 31 May 20X7 quarter to 31 August 20X7 quarter to 30 November 20X7 Amount $ Period
Note: On 6 March 20X8 Fiona received an electricity bill for $168 for the quarter to 28 February 20X8.
11.4
11: ACCRUALS AND PREPAYMENTS Required (a) (b) (c) Calculate the expense incurred by Fiona for electricity and rent for the year ended 31 December 20X7. Calculate the amount of any accruals/prepayments at the end of the year. State the journal entry required for the year-end adjustments.
Solution
11.5
Lecture example 2
Required Using the figures from Lecture example 1:
Complete the necessary entries in Fionas ledger accounts as at 31 December 20X7, then balance off the accounts.
Solution
Electricity expense (I/S) $ 96 120 104 145 $
10.3.X7 12.6.X7 14.9.X7 10.12.X7
Cash Cash Cash Cash
1.2.X7 6.4.X7
Cash Cash
Rent expense (I/S) $ 375 1,584
Accruals (B/S) $
Prepayments (B/S) $
Section 1.9
11.6
3
3.1
Reversing out accruals and prepayments

Using the figures from Lecture example 1, what is Fionas rent expense for the year to 31 December 20X8 assuming that on 10 April 20X8 she paid rent of $1,740 for the 12 months commencing 1 April 20X8? 1.1.X8 1.4.X8 31.12.X8
Problem
3.2
Expense = ( 3 12 $1,584) + ( 9 12 $1,740) = $1,701
Double entry
3.3 10.4.X8 Cash Rent expense $ 1,740 31.12.X8 $ Prepayments ( 3 12 1,740 ) 435
1.1.X8 Balance b/d 31.12.X8 Rent
Prepayments $ 396 435
This does not produce a sensible answer! The rent expense in the ledger account would result in a charge to the income statement of $1,305 (not $1,701) and the balance on the prepayment account would be overstated by $396.
11.7
Solution
3.4 The opening prepayment must therefore be reversed, ie: Debit Credit Rent expense (I/S) Prepayments (B/S) $396 $396
Post this to the ledger accounts in 3.3 and balance off the expense should now be correct!
Summary
3.5 Accruals and prepayments brought forward at the start of the year must be reversed. Reversal of accrual Dr Accruals (B/S) Cr Expense (I/S) Prepayments Dr Expense (I/S) Cr Prepayments (B/S)
Approach to questions
3.6 There are four steps to follow: (1) (2) (3) (4) Reverse opening accrual/prepayment. Post cash paid during the year. Post closing accrual/prepayment. Balance off the accounts.
Lecture example 3
In 20X8 Fiona paid the following electricity bills: Date paid 12.3.X8 9.6.X8 12.9.X8 12.12.X8 Required Amount $ 168 134 118 158 Period quarter to 28 February 20X8 quarter to 31 May 20X8 quarter to 31 August 20X8 quarter to 30 November 20X8
During March 20X9 Fiona received an electricity bill for $189 for the quarter to 28 February 20X9. Calculate the electricity expense and accrual for the year ended 31 December 20X8 and complete the ledger accounts.
11.8
Solution
Electricity expense (I/S) $ $
Accruals (B/S) $
Lecture example 4
Exam standard question for 2 marks
Jimmy Co prepares its financial statements for the year to 30 June each year. The company pays for its insurance quarterly in advance on 1 March, 1 June, 1 September and 1 December each year. The annual insurance premium was $24,000 until 31 August 20X6, after that date it increased to $30,000 per year. Required What insurance expense and end of year prepayment should be included in the financial statements for the year ended 30 June 20X7? A B C D Expense $29,000 $29,000 $28,500 $28,500 Prepayment $2,500 $5,000 $2,500 $5,000
11.9
Solution
4
Quick Quiz Q2-5
Accruals and prepayments are an example of the accruals basis which is an underlying assumption from the IASB Framework. Accruals are made when expenses are paid in arrears, whereas prepayments arise when expenses are paid for in advance. Reverse accruals and prepayments at the beginning of the next accounting period so that the current year expense is correct.
4.1 4.2 4.3
5
5.1

Accruals adjustment: Dr Cr Expense (I/S) Accruals (B/S)
5.2
Prepayments adjustment: Dr Cr Prepayments (B/S) Expense (I/S)
11.10
11: ACCRUALS AND PREPAYMENTS 5.3 Approach to questions (four steps): (1) Reverse opening accrual/ prepayment: Accruals: Dr Accruals (B/S) Cr Expense (I/S) Prepayments: Dr Expense (I/S) Cr Prepayments (B/S) (2) (3) (4) Post cash paid during the year. Post closing accrual/ prepayment. Balance off the ledger accounts.
11.11
11.12
Additional Notes
11.13
6
6.1
Accrued income and deferred income

Accruals and prepayments relate to when expenses are paid in arrears or advance. Income may also be received in arrears or advance.
Accrued income
6.2 This relates to when income has been earned during the accounting period but not invoiced or received.
Illustration
6.3 Jenny owns a property which she rents out for $3,000 per quarter. The property was occupied all year; however Jenny only received $9,000 in rent because she forgot to send out the final invoice of the year. As the property was let for 12 months, Jenny's income statement should show income of $12,000 (4 $3,000) as this is what she has earned. She will therefore need to accrue the 'missing' income of $3,000 as a year end journal and also show a receivable for "rent in arrears". The adjustment is: Dr Cr Rent in arrears (B/S) Rental income (I/S) $ 3,000 $ 3,000
The rent in arrears is shown in the balance sheet within current assets.
Deferred income
6.4 This relates to when income is received in advance of it being earned.
Illustration
6.5 Ben has a year end of December and rents out his property for $1,000 per month. His tenant pays on time each month and during December 20X7 paid Ben $2,000 as he would be away when the January 20X8 payment was due. Ben has received income of $13,000 but only $12,000 of this relates to the current year. He must therefore remove $1,000 of income from this years accounts because it relates to next year. A liability will also be shown for "rent in advance". The adjustment is: Dr Cr Rental income (I/S) Rent in advance (B/S) $ 1,000 $ 1,000
The rent in advance is shown in the balance sheet within current liabilities.
11.14
Approach to questions
6.6 The approach for accrued income and deferred income is exactly the same as for accruals and prepayments. There are four steps to follow: (1) (2) (3) (4) Reverse opening rent in arrears/advance. Post cash received during the year. Post closing rent in arrears/advance. Balance off the accounts.
11.15
11.16
11.17
11: QUESTIONS
Data for Questions 11.1 11.3

A company made the following payments in 20X5 in respect of rent and telephone expenses: Rent Quarter ended 31 January 20X5 Quarter ended 30 April 20X5 Quarter ended 31 July 20X5 Quarter ended 31 October 20X5 Quarter ended 31 January 20X6 Telephone Quarter ended 31 January 20X5 Quarter ended 30 April 20X5 Quarter ended 31 July 20X5 Quarter ended 31 October 20X5 Date paid 02.01.20X5 02.01.20X5 31.04.20X5 30.07.20X5 01.11.20X5 02.03.20X5 05.06.20X5 02.09.20X5 10.12.20X5 Amount $ 300 300 450 450 450 270 310 320 330
A telephone bill for $345 in respect of the quarter ended 31 January 20X6 was received by the company in February 20X6. The company's year end is December. 11.1 What balance should have been brought forward on the accruals account in relation to rent payable at 1 January 20X5? A B C D 11.2 $100 credit $200 credit $100 debit $200 debit (2 marks)
What will be the income statement charge for telephone expenses for the year ended 31 December 20X5? A B C D $1,165 $1,180 $1,255 $1,280 (2 marks)
11.3
At 31 December 20X5 what balance will be included as a prepayment or accrual in respect of rent? A B C D $300 prepayment $200 accrual $150 prepayment $150 accrual (2 marks)
11.4
At 31 December 20X8 Blue Anchor Co has an insurance prepayment of $250. During the year they pay $800 in respect of various insurance contracts. The closing accrual for insurance is $90. What is the income statement charge for insurance for year ended 31 December 20X9? $ (2 marks)
11.18
11: QUESTIONS
11.5
Max has paid his rent for the period 1 April 20X0 to 30 June 20X1 of $4,800. His first set of accounts is drawn up for the period from 1 April 20X0 to 28 February 20X1. His accounts should reflect A B C D Rent expense of $4,800 only Rent expense of $3,520, a prepayment of $1,280 Rent expense of $3,600, a prepayment of $1,200 Rent expense of $3,840, a prepayment of $960 (2 marks)
11.6
Constains Co has an insurance prepayment of $320 at 31 March 20X2. During the year ended 31 March 20X2 Constains paid two insurance bills, one for $1,300 and one for $520. The charge for the year in the accounts for insurance was $1,760. What was the prepayment at 31 March 20X1? $ (2 marks)
11.7
An electricity prepayment for $300 was treated as an accrual in a sole traders income statement. As a result the profit was A B C Overstated by $600 Understated by $300 Understated by $600 (1 mark)
11.8
A. Cruel A. Cruel prepares his financial statements for the year to 31 December each year. He pays rent on his premises quarterly in advance on 1 February, 1 May, 1 August and 1 November. The annual rent was $12,000 until 30 September 20X7 and $15,000 per year thereafter. (i) What rent expense and prepayment should be included in the financial statements for the year ended 31 December 20X7? Expense A B C D (ii) $12,750 $12,750 $15,000 $15,000 Prepayment $1,250 $2,500 $2,250 $1,250
The following year the reversal of the prepayment will result in which of the following in the rent expense account? A B C D Credit balance of $1,250 Debit balance of $1,250 Credit balance of $2,500 Debit balance of $2,250
(iii)
A. Cruel has just looked at the accounts you have prepared and is confused as he knows he has paid more rent than is showing in the income statement. Which accounting concept means that the income statement may not just show the cash paid? A B C Going concern Accruals Business entity
11.19
11: QUESTIONS
11.9
Fairlop The accounts of Fairlop are made up to 31 December every year. When preparing the accounts for 20X7 you extract the following information from the payments side of the cash book: $ 20X6 1 October Rent (to 31.3.X7) 500 20X7 10 January 1 April 10 April 10 July 1 October 10 October 20X8 10 January Electricity Rent Electricity Electricity Rent Electricity Electricity 300 550 300 250 550 250 350
You ascertain that rent is paid half-yearly in advance and that electricity bills relate to the quarter ended in the month before payment. Required Calculate the following amounts: (i) (ii) (iii) (iv) The rent expense for the year ended 31 December 20X7 The electricity expense for the year ended 31 December 20X7 The balance on the prepayment account at 31 December 20X7 The balance on the accruals account at 31 December 20X7
11.20
Chapter 11: Answers
11.21
11: ANSWERS
11.1 11.2
B D
300 = 200
Reverse accrual at 1.1.X5 Paid (270 + 310 + 320 + 330) Accrual at 31.12.X5 ( 2 3 x 345) I/S charge 11.3 11.4 C $1,140 $250 + $800 + $90 = $1,140 11.5 B Rent for the 15-month period Prepayment 4 15 $4,800 $4,800 $1,280
1 3
$ (180) 1,230 230 1,280
450 = 150
11.6
$260 Insurance Expense Prepayment reversal () Cash Cash $ 260 1,300 520 2,080 $ I/S Prepayment 1,760 320 2,080
11.7
The prepayment would have decreased the electricity expense by $300 and increased profits. Treating the prepayment as an accrual would have increased the electricity expense and decreased profit. Profit is therefore understated by 2 $300 = $600. A Rent expense: January September 20X7 ($12,000 9/12) October December 20X7 ($15,000 3/12) Prepayment: 1 November payment of $3,750 ($15,000 ) relates to November, December and January. prepay January 20X8 expense: $3,750 1/3 = $1,250. $ 9,000 3,750 12,750
11.8
A. Cruel (i)
(ii) (iii)
B B
11.22
11: ANSWERS
11.9
Fairlop (i) (ii) (iii) (iv) Rent expense: Electricity expense: Prepayments: Accruals: $1,075 $1,150 $275 $350 Prepayments (B/S) 1.1.X7 31.12.X7 1.1.X8 Balance b/d (500 3/6) Rent (550 3/6) Balance b/d $ 250 275 525 275 Accruals (B/S) 1.1.X7 31.12.X7 Electricity Balance c/d $ 300 350 650 1.1.X7 31.12.X7 1.1.X8 Rent (I/S) 1.1.X7 1.4.X7 1.10.X7 Prepayments Bank Bank $ 250 550 550 1,350 Electricity (I/S) $ 10.1.X7 10.4.X7 10.7.X7 10.10.X7 31.12.X7 Bank Bank Bank Bank Accruals 300 300 250 250 350 1,450 1.1.X7 Accruals $ 300 $ 31.12.X7 31.12.X7 Income statement Prepayments 1,075 275 1,350 Balance b/d Electricity Balance b/d $ 300 350 650 350 1.1.X7 31.12.X7 Rent Balance c/d $ 250 275 525
Workings
31.12.X7
Income statement
1,150 1,450
11.23
11: ANSWERS
END OF CHAPTER
11.24
Irrecoverable debts and allowances


Explain and identify examples of receivables and payables. Identify the benefits and costs of offering credit facilities to customers. Understand the purpose of credit limits and an aged receivables analysis. Prepare the bookkeeping entries to write off a bad debt, record a bad debt recovered and create and adjust an allowance for receivables. Identify the impact of bad debts on the income statement and on the balance sheet. Illustrate how to include movements in the allowance for receivables in the income statement and how the closing balance of the allowance should appear in the balance sheet. Account for contras between trade receivables and payables. Prepare, reconcile and understand the purpose of supplier statements. Classify items as current or non-current liabilities in the balance sheet.
Exam Context
Questions on this topic are likely to require you to perform basic calculations dealing with writing off debts, adjusting for cash subsequently received and adjusting the allowance for receivables. You will also need to be able to determine the balances to be shown in the income statement and balance sheet.
This area is a basic skill and detailed calculations are not tested in any other paper.
12.1
12: IRRECOVERABLE DEBTS AND ALLOWANCES
Overview
Amounts recovered
Bad debts
Irrecoverable debts and allowances
Doubtful debts
Allowances
Specific
General
12.2
1
1.1 1.2
Introduction
This chapter is designed to enable you to calculate and make adjustment for bad debts, and allowances for receivables. A trade receivable should only be classed as an asset if it is probable that it is recoverable (ie that the customer will pay the amounts due).
2
2.1
Bad debts
If a debt is definitely irrecoverable it should be written off to the income statement as a bad debt. This is an example of prudence.
2.2 Dr Cr Bad debt expense (I/S) Trade receivables (B/S)
You may see the debit entry being made to an 'irrecoverable debts expense' account. This is effectively the same thing.
Lecture example 1
Fight & Co has trade receivables at 31 December 20X7 of $65,000. A review of customer files indicates that two customers, Ali and Tyson, which owe $7,000 and $8,000 respectively, have gone bankrupt and their debts are considered irrecoverable. Required (a) (b) Calculate the balance c/d on the trade receivables account at the end of the year. Calculate the bad debt expense shown in the income statement.
Solution
Trade receivables (B/S) $ 65,000 $
31.12.X7 Bal b/d
Bad debt expense (I/S) $
12.3
3
3.1
Doubtful debts
If a debt is possibly irrecoverable an allowance for the potential irrecoverability of that debt should be made. A new account is created, Allowance for receivables, this account is offset against the trade receivables balance on the balance sheet and the expense taken to the income statement.
3.2 Dr Cr Doubtful debts expense (I/S) Allowance for receivables (B/S)
Again, an 'irrecoverable debts expense' account can also be used.
Lecture example 2
A further review of Fight & Co's customer files indicates there is some uncertainty as to whether a debt of $3,500 owed by Bugner is recoverable. (a) (b) (c) Calculate the allowance for receivables shown on the balance sheet. Calculate the doubtful debts expense shown in the income statement. Show how the information from Lecture examples 1 and 2 would be shown in extracts from the income statement and balance sheet.
Solution
Allowance for receivables (B/S)
Doubtful debts expense (I/S)
12.4
Types of allowance
3.3 (a) (b) Specific: General: (i) (ii) provided against a particular/named individual customer. percentage applied to total trade receivables after:
writing off bad debts; deducting full balance of any customers for which specific allowance has been created.
Order of calculation
3.4 (a) (b) Write up trade receivables account for credit sales and cash received in period. Write off bad debts Dr Cr (c) Dr Cr (d) (e) Total trade receivables Less: specific allowances General allowance @ 5% = total allowance: Specific General Bad debt expense (I/S) Trade receivables (B/S) Doubtful debts expense (I/S) Allowance for receivables (B/S)
Make any entries for specific allowances:
In workings, calculate the general allowance on trade receivables (after bad debts written off and excluding full amounts for which specific allowance has been made). $ 100 (20) 80 4 20 4 24
12.5
Lecture example 3
A businesss trade receivables account showed a year end balance of $47,440. It was decided that amounts totalling $340 should be written off as irrecoverable, a specific allowance was to be made against an amount of $400 due from Dodgy Co, a customer, and a general allowance of 2% was to be made against remaining debts. Required (a) (b) Calculate the allowance for receivables shown in the balance sheet. Calculate the bad and doubtful debts expense shown in the income statement.
Solution
Trade receivables (B/S) $ 47,440 $
Balance b/d
Allowances for receivables (B/S) $
Bad and doubtful debts expense (I/S) $
General allowance $ Trade receivables (net of bad debts written off) Less: specific allowance General allowance @ 2%
12.6
4
4.1
Effect in subsequent periods

If a bad debt is recovered having previously been written off, it is credited to the bad debt expense account, i.e. the accounting treatment from the original write-off is reversed. Accounting treatment (1) Cash received Dr Cr Cash Trade receivables
Bad debts written off last year, customer pays this year
Reverse original write off Dr Cr OR (2) Short method Dr Cr Cash Bad debt expense
Trade receivables Bad debt expense
Lecture example 4
Required Show the treatment of this recovery in the relevant T accounts.
Fight & Co (see Lecture example 1) subsequently receive a cheque of $7,000 from Ali.
Solution
Trade receivables (B/S) 1.1.X8 Bal b/d $ 50,000 $
12.7
12: IRRECOVERABLE DEBTS AND ALLOWANCES Bad debt expense (I/S) $ $
Cash (B/S) $ $
Doubtful debts specific allowance last year, customer pays outstanding amounts this year
4.2 A credit entry for the cash is made to the trade receivables account because the debt is still included in the total trade receivables figure. The allowance is then reversed as it is no longer needed. Accounting treatment (a) Record the cash received Dr Cr then: (b) Remove allowance Dr Cr Allowance for receivables (B/S) Doubtful debts expense (I/S) Cash (B/S) Trade receivables (B/S)
12.8
Lecture example 5
Required
Show the accounting treatment for Fight & Co if, having made a specific allowance (see Lecture example 2), during the next year Bugner repays his debt of $3,500 to Fight & Co in cash?
Solution
Trade receivables (B/S) 1.1.X8 Bal b/d $ 50,000 $
Allowance for receivables (B/S) $ 1.1.X8 Bal b/d
$ 3,500
Bad and doubtful debt expense (I/S) $
Doubtful debts specific allowance last year, goes bad this year
4.3 The debt is no longer doubtful, but definitely bad. It should therefore be removed from the trade receivables and the allowance for receivables accounts. Dr Cr Allowance for receivables (B/S) Trade receivables (B/S)
12.9
Lecture example 6
Required
Following on from the information used in Lecture example 2, suppose that in the next accounting period, the debt from Bugner is considered to have gone bad. What double entry would be required to record this?
Solution
Doubtful debts - general allowance

4.4 Allowance is usually changed at the end of each period to reflect the change in value of total trade receivables.
4.5 (1) Dr Cr Remove opening allowance Allowance for receivables Doubtful debts expense Replace with closing allowance Dr Cr Doubtful debts expense Allowance for receivables
12.10
12: IRRECOVERABLE DEBTS AND ALLOWANCES OR (2) Short method: Increase/decrease opening allowance to arrive at required closing allowance Increase: Dr Cr Doubtful debts expense Allowance for receivables
Decrease: Dr Cr Allowance for receivables Doubtful debts expense

Lecture example 7
The following information is available for A Co. Year ended 31 December 20X7: Trade receivables $20,000 Year ended 31 December 20X8: Trade receivables $30,000 A Co requires a general allowance of 5% of trade receivables in each year. Required
Show the required adjustment to the allowance for receivables account in the year ended 31 December 20X8 using both methods described in section 4.5
Solution
Long method: 4.5 (1) Allowance for receivables $ $
Doubtful debts expense $ $
12.11
12: IRRECOVERABLE DEBTS AND ALLOWANCES Short method: 4.5 (2) Allowance for receivables $ $
Doubtful debts expense $ $
Lecture example 8
At 30 September 20X7 G Co had an allowance for receivables of $24,000.
Exam standard for 2 marks
During the year ended 30 September 20X8 G Co recovered $2,000 from a customer whose balance was written off in 20X7 and wrote off further debts totalling $18,000. The closing allowance for receivables is required to be $21,000. No adjustments have been made for this information. Required What amount should appear in the income statement for the year ended 30 September 20X8 for the above items? A B C D $13,000 $15,000 $17,000 $23,000
12.12
Solution
5
Quick Quiz
A trade receivable is an asset of the business which should only be shown in the financial statements if it is believed to be recoverable. Bad or irrecoverable debts must therefore be written off as an expense in the income statement. An allowance should be made against trade receivables where there is concern as to whether or not a balance will be recoverable. There are two types of allowance: specific and general. Specific allowances relate to particular customer balances whereas a general allowance is usually a percentage of remaining debts.
5.1 5.2 5.3
5.4
12.13
6
6.1

Bad (irrecoverable) debt adjustment: Dr Cr Bad debt expense (I/S) Trade receivables (B/S)
6.2
Doubtful debt adjustment: Dr Cr Doubtful debts expense (I/S) Allowance for receivables (B/S)
6.3
Recording of cash received from a customer whose balance was previously written off: Dr Cr Cash (B/S) Bad debt expense (I/S)
6.4
Recording of cash received from a customer against which a specific allowance was previously made: Record cash received: Dr Cash (B/S) Cr Trade receivables (B/S) Remove the allowance: Dr Allowance for receivables (B/S) Cr Doubtful debts expense (I/S)
6.5
Writing a balance off as irrecoverable where a specific allowance was previously made: Dr Cr Allowance for receivables (B/S) Trade receivables (B/S)
12.14
12.15
12: QUESTIONS
12.1
A company receives news that a major customer has been declared bankrupt. The entries now required are: A B Debit bad debt expense, Credit trade receivables Debit sales, Credit trade receivables (1 mark)
12.2
At 1 January 20X9 Farriers has an allowance for receivables of $2,000 consisting of a specific allowance for $700 in respect of Black Lion Co and a $1,300 general allowance. During the year Black Lion goes into liquidation and the debt is written off. No other debts go bad and at 31 January 20X9 the balance on the trade receivables is $50,950. Farriers wishes to provide for a debt of $950 from Verulam and to have a general allowance of 2% of good trade receivables. The bad and doubtful debts charged to the income statement for 20X9 is: A B C D $900 $924 $1,600 $2,200 (2 marks)
12.3
The preliminary trial balance of Jessie and Co as at 30 September 20X7 included: Debit $ 90,350 1,985 Credit $ 2,490
Trade receivables Allowance for receivables (brought forward as at 1 October 20X6) Bad and doubtful debt expense Further adjustments are to be made as follows: (i) (ii)
No entries have been made in respect of cash of $1,320 received from Dome Co whose balance had been written off last year, and At 30 September 20X7 an allowance is required against a balance of $1,950 due from Jed Co as well as a general allowance of 1.5% of remaining debts. $ (2 marks)
What is the bad and doubtful debt expense in the income statement? 12.4 Gillian
On 31 December 20X4, Gillians nominal ledger included a trade receivables balance of $47,900 along with an allowance for receivables (brought forward as at 1 January 20X4) of $2,551. Of this $537 relates to a specific customer, the remainder being a general allowance. After a review of trade receivables at the year end, the following adjustments are to be made: (1) (2) (3) (4) Debts totalling $1,615 are to be written off as irrecoverable. No entry has yet been made in the books for $418 cash received on 31 December 20X4 from David, a customer whose debt was written off during 20X3. Cash posted to the trade receivables account during the year include $537 from Jim. The amount due from Jim had been specifically provided against at 31 December 20X3.
Specific allowance is to be made against debts totalling $835 together with a general allowance of 2%. Required (a) (b) Write up the relevant ledger accounts for the year ended 31 December 20X4. Show the relevant extracts from the financial statements.
12.16
12: QUESTIONS
12.5
Johnson & Co (1) Johnson & Co had total receivables owing to them at 31 December 20X7 of $9,650. They included $700 owed by T Black, who had fled the country six months earlier, and various debts due from K White, totalling $335 and dating back to the years 20X1-20X5. It was decided that the above debts should be written off. During 20X8 Johnson & Co made sales on credit of $40,385 and received cash from trade receivables of $32,050. There were no irrecoverable debts. However, there was some doubt as to whether a debt of $450 owed by J Green would be met and it was decided to make an allowance against this specific debt and against 2% of the remaining debts. During 20X9 credit sales totalled $50,235 and cash of $37,140 was received from trade receivables. A review of trade receivables at the year end revealed the following: (i) (ii) (iii) (iv) Required Produce ledger accounts to record the above transactions for the years ended 31 December 20X7, 20X8 and 20X9. The amount owed by J Green was now considered irrecoverable and should be written off; Other irrecoverable debts totalling $545 were to be written off; Allowance was to be made against an amount of $250 owed by P Brown; The general allowance was to be maintained at 2% of good debts.
(2)
(3)
12.17
12: QUESTIONS
12.18
Chapter 12: Answers
12.19
12: ANSWERS
12.1 12.2
A A Trade receivables balance Less specific allowance General allowance = 2% $50,000 = Movement in general allowance is a reduction of $50 ($1,300 $1,250) Charge to I/S Specific allowance Verulam Less: decrease in general allowance $ 950 (50) 900 $ 50,950 (950) 50,000 $1,250
12.3
$1,451 Bad and doubtful debts expense per trial balance Less: bad debt recovered Add: increase in allowance (W) $ 1,985 (1,320) 786 1,451 $ 1,950 1,326 3,276 2,490 786
Allowance c/d
specific general 1.5% (90,350 1,950)
Less allowance b/d increase 12.4 Gillian (a)
31.12.X4
Balance b/d
Trade receivables (B/S) $ 47,900 31.12.X4 Bad debts 31.12.X4 Balance c/d 47,900
$ 1,615 46,285 47,900
Allowance for receivables (B/S) $ 807 1.1.X4 Balance b/d Irrecoverable & doubtful debts () 31.12.X4 Balance c/d (W1) 1,744 2,551 Irrecoverable and doubtful debts expense (I/S) $ 1,615 Bank (bad debt recovered) Allowance for receivables Income statement 1,615
$ 2,551 2,551
Trade receivables
$ 418 807 390 1,615
12.20
12: ANSWERS
Working Trade receivables Less: specific allowance General allowance ($45,450 2%) (b) Gillian Balance sheet as at 31 December 20X4 (extract) CURRENT ASSETS Trade receivables Less: allowance for receivables
Receivables $ 46,285 (835) 45,450
Allowance $ 835 909 1,744
$ 46,285 (1,744)
$ 44,541 $
Income statement for the year ended 31 December 20X4 (extract) Less expenses: Irrecoverable and doubtful debts expense 12.5 Johnson & Co Trade receivables (B/S) $ 9,650 31.12.X7 Irrecoverable debts expense (700 + 335) 31.12.X7 Balance c/d 9,650 8,615 40,385 49,000 16,950 50,235 Bank 31.12.X8 Balance c/d Bank 31.12.X9 Irrecoverable debts expense (450 + 545) 31.12.X9 Balance c/d $ 1,035 8,615 9,650 32,050 16,950 49,000 37,140 995 29,050 67,185 390
31.12.X7 Balance b/d
1.1.X8
Balance b/d Sales Balance b/d Sales
1.1.X9
67,185 1.1.YO Balance b/d 29,050
Irrecoverable (bad) & doubtful debts expense (I/S) $ 31.12.X7 Trade receivables 1,035 31.12.X7 Income statement 31.12.X8 Allowance for receivables (W1) 31.12.X9 Trade receivables 31.12.X9 Allowances for receivables 780 995 31.12.X9 Income statement 46 1,041 31.12.X8 Income statement
$ 1,035 780
1,041 1,041
12.21
12: ANSWERS
31.12.X8 Balance b/d
31.12.X9 Balance c/d (W2)
Allowance for receivables (B/S) $ 780 31.12.X8 Irrecoverable and doubtful debts expense 1.1.X9 Balance b/d 31.12.X9 Irrecoverable and doubtful debts expense () 826 826
$ 780 780 46
826
Workings (W1) Allowance for receivables as at 31 December 20X8. Trade receivables Less: specific allowance (J Green) General allowance ($16,500 2%) (W2) Allowance for receivables as at 31 December 20X9. Receivables $ 29,050 (250) 28,800 Allowance $ 250 576 826 Receivables $ 16,950 (450) 16,500 Allowance $ 450 330 780
Trade receivables Less: specific allowance (P Brown) General allowance required ($28,800 2%)
END OF CHAPTER
12.22
Provisions and contingencies


Understand the definition of 'provision', 'contingent liability' and 'contingent asset', distinguish between them and classify items accordingly. Identify and illustrate the different methods of accounting for provisions, contingent liabilities and contingent assets. Calculate provisions and changes in provisions and account for the movement in provisions. Report provisions in the final accounts.
Exam Context
Questions on this area are likely to focus on identifying when a provision or contingent liability should be made/disclosed in the financial statements. You may also be required to calculate a provision. The Pilot Paper included a question on how a remote contingent liability should be accounted for.
Your understanding of IAS 37 will be developed at the Fundamentals level paper Financial Reporting (F7) where you are likely to have to consider whether the provision criteria are satisfied based on more subjective scenarios.
13.1
13: PROVISIONS AND CONTINGENCIES
Overview
Accounting treatment Recognition criteria
Provisions
Provisions and contingencies
Contingent liabilities
Contingent assets
13.2
1
1.1
IAS 37: Provisions, contingent liabilities and contingent assets

Introduction Before the introduction of IAS 37, there was little guidance on when a provision must and must not be made. This caused problems as entities tended to choose to make and then release provisions in order to smooth out profits, rather than making a provision where they had an obligation to incur expenditure. IAS 37 aims to prevent this happening in the future.
2
2.1
Provisions
Definition A provision is a liability of uncertain timing or amount.
2.2
Recognition A provision should only be recognised (ie. included in the financial statements) when: (a) (b) (c) An entity has a present obligation (legal or constructive) as a result of a past event; It is probable that an outflow of economic resources will be required to settle the obligation; and A reliable estimate can be made of the amount of the obligation.
Unless all three conditions are met, no provision can be recognised. 2.3 Legal obligation A legal obligation usually arises out of a contract. Illustration Grass Co sells lawnmowers and offers a one-year warranty on all models. Once Grass Co sells a lawnmower (the past event) it has a legal obligation to repair any defects according to the warranty agreement. It should therefore make an estimate of the probable costs of repair and make a provision for this amount in its financial statements. 2.4 Constructive obligation A constructive obligation arises through past behaviour and actions where the entity has raised a valid expectation that it will carry out a particular action. Illustration Seed Co also sells lawnmowers. It does not offer a warranty on its products, however it has a reputation for making free reasonable repairs to lawnmowers bought from the business. Customers buying from Seed Co all expect to receive this benefit.
13.3
13: PROVISIONS AND CONTINGENCIES Here no warranty is offered and so Seed Co does not have a legal obligation. Its past actions however have created a constructive obligation. It should also therefore make a provision for the probable costs of repairs. 2.5 Accounting treatment The provision represents both a cost to the business and a potential liability: Dr Cr Expense (I/S) Provision (B/S)
The required provision will be reviewed at each year end and increased or decreased as necessary. To increase a provision: Dr Cr Dr Cr Expense (I/S) Provision (B/S) Provision (B/S) Expense (I/S)
To decrease a provision:
Lecture example 1
Grass Co is reviewing its warranty obligations. Based on sales during 20X7 it has established that if all lawnmowers sold required minor repairs this would cost $1m whereas if major repairs were required this would cost $6m. Grass Co expects that 75% of lawnmowers will have no faults, 20% will need minor repairs and 5% major repairs. Required (a) (b) (c) What provision should be made in 20X7 and what accounting entry is needed to record it? What entry should be made in 20X8 assuming the provision required then is $0.75m? What entry should be made in 20X9 assuming the provision required then is $0.3m?
Solution
13.4
3
3.1
Contingent liabilities
A contingent liability is an uncertain liability that does not meet the three criteria for recognising a provision. IAS 37 defines a contingent liability as the following: (a) A possible obligation that arises from past events and whose existence will be confirmed only the occurrence or non-occurrence of one or more uncertain future event not wholly within the control of the entity; or A present obligation that arises from past events but is not recognised because: (i) (ii) it is not probable that an outflow of economic resources will be required to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability.
(b)
Contingent liabilities should be disclosed in the notes unless probability of an outflow of resources embodying economic benefits is remote.
Illustrative example
3.2 Company A has entered into an agreement to act as guarantor on a bank loan taken out by Mr Smith. Mr Smith is a financially secure individual, and the directors are of the opinion that the chances of him defaulting on the loan are slim. How should company A account for this guarantee?
Solution
3.3 Company A has a present obligation (it is legally obliged to honour the guarantee). However, as the likelihood of Company A having to pay out under the guarantee is not probable then no provision for the liability should be made. Instead, the guarantee should be disclosed in the notes as a contingent liability (unless considered remote, in which case it should be ignored altogether).
13.5
13: PROVISIONS AND CONTINGENCIES 3.4 Decision Tree
4
4.1
Contingent assets
A possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. Contingent assets should be disclosed in the notes where an inflow of economic benefits is probable, otherwise they should be ignored. If the probability of an inflow of economic benefits is virtually certain then the asset is not a contingent asset and should be recognised in the financial statements.
13.6
5
Quick Quiz
A provision should only be made in the financial statements when an entity has a present obligation to incur expenditure. It must also be more likely than not that the expenditure will be incurred and a reliable estimate of the amount is known. A contingent liability should be disclosed where the criteria for making a provision are not met, but where there is either a possible obligation or a present obligation but it is only possible that the expenditure will be incurred. Contingent assets should only be included in the financial statements if it is certain to be received and should be disclosed if probable.
5.1
5.2
5.3
6
6.1

Adjustment to create or increase a provision: Dr Cr Expense (I/S) Provision (B/S)
6.2
Adjustment to decrease a provision: Dr Cr Provision (B/S) Expense (I/S)
13.7
13.8
13.9
13: QUESTIONS
13.1
H Co is currently in the middle of a protracted lawsuit which it is vigorously defending. The directors are reasonably confident that the action will not be successful but are aware that the opposite outcome is a possibility. It is difficult to quantify any potential damages, but the directors feel they are unlikely to exceed $50,000. How should the above item be treated in the financial statements? A B C Provision Contingent liability Contingent asset Probable contingent assets and contingent liabilities should be disclosed in the financial statements. Probable contingent assets must always be accrued and contingent liabilities must always be disclosed in the financial statements. Contingent liabilities must always be either accrued or disclosed and probable contingent assets must always be disclosed in the financial statements. Contingent liabilities must always be provided for and probable contingent assets must be disclosed in the financial statements. (2 marks) (1 mark)
13.2
How should a contingent liability and a probable contingent asset be accounted for? A B C D
13.10
Chapter 13: Answers
13.11
13: ANSWERS
13.1 13.2
B A
END OF CHAPTER
13.12
Control accounts


Understand the purpose of control accounts for accounts receivable and accounts payable. Understand how control accounts relate to the double entry system. Prepare ledger control accounts from given information. Perform basic control account reconciliations for accounts receivable and accounts payable and identify errors which would be highlighted by performing them. Identify and correct errors in control accounts and ledger accounts. Account for discounts allowed and discounts received. Account for contras between trade receivables and trade payables.
Exam Context
Questions on this topic are likely to require you to correct the closing balance on a receivables or payables control account including items such as contras and discounts. You may also be required to calculate receivables/payables balances where goods are sold/bought with trade and/or settlement discounts.
This chapter covers topics which are only examined in Financial Accounting.
14.1
14: CONTROL ACCOUNTS
Overview
Reconciliations
Receivables ledger control account Payables ledger control account
Receivables ledger Payables ledger
Control accounts
Contra entries
Returns, credit notes, refunds and over payments
Discounts allowed and received
Trade discounts
Settlement discounts
Sales tax considerations
14.2
1
1.1
Recap
In Chapters 4 and 5 we saw how a business' transactions were categorised in the books of prime entry. The totals of these were then posted using double entry to the nominal ledger to give a summary of the information. For example, credit sales:
1.2
1.3 The nominal ledger contains three ledger accounts which are affected when a business sells on credit: (a) (b) (c) Sales Bank Trade receivables this shows the total amount owed by all customers at a particular point in time. it is also called the receivables ledger control account (RLCA) 1.4 In order to chase overdue debts however a business must know how much each customer owes at a particular time. This balance could be determined by going back into the detail of the books of prime entry and extracting the information for each customer. This is a very time consuming process and so instead a memorandum ledger is maintained for each individual customer showing invoices raised, cash received and therefore the amount owed to the business. This memorandum ledger is called a receivables ledger. 1.5 The reverse is true when a business buys on credit.
14.3
Terminology
1.6 In the nominal ledger:

Receivables ledger control account (trade receivables/RLCA): total owed by all credit customers. Payables ledger control account (trade payables/PLCA): total owed to all credit suppliers.
Memorandum ledgers:

Receivables ledger: balance owed by each individual credit customer Payables ledger: balance owed to each individual credit supplier
2
2.1
The flow of information

Sales Invoice Receipt from customers Payment to suppliers Purchase Invoice
Memo Receivables Ledger Customer A Customer B Customer C
SDB
Cash book
PDB
Memo Payables Ledger Supplier X
Nominal Ledger
PLCA Trade payables
Supplier Y Supplier Z
Bank (B/S) Sales (I/S) Purchases (I/S)
Trial Balance Financial Statements
14.4
14: CONTROL ACCOUNTS 2.2 The information in the receivables ledger control account (RLCA) and receivables ledger (RL) is posted from the same source documents. Therefore the balance on the RLCA should equal the sum of all balances from the RL Similarly the balance on the PLCA should equal the sum of all balances from the PL 2.3 If the balances do not agree then an error has been made. This will be identified through a control account reconciliation (Section 5).
Lecture example 1
A Co has the following information: 10 January 20X6 Sells $150 of goods to customer A Sells $200 of goods to customer B 15 January 20X6 A Co purchases $100 of goods from supplier Y A Co purchases $1,300 of goods from supplier Z 21 January 20X6
A Co receives full payment from customer B and this money is used to pay supplier Y. Required (1) (2) (3) (4) Record the above transactions in the books of prime entry and the memorandum ledgers. Post the totals from the BOPE to the nominal ledger. Balance off nominal ledger accounts. Reconcile the memorandum ledgers to the control accounts.
Solution
(1) Books of prime entry Sales day book Date Customer Amount
14.5
14: CONTROL ACCOUNTS Purchase day book Date Supplier Amount
Cash rceipts book Date Narrative Total Sales Receivables
Cash payments book Date Narrative Total Purchases Payables
Memorandum ledgers Receivables ledger Customer A Customer B
Payables ledger Supplier Y Supplier Z
14.6
14: CONTROL ACCOUNTS (2) & (3) Nominal ledger RLCA (B/S) PLCA (B/S)
Bank (B/S)
Sales (I/S)
Purchases (I/S)
(4)
Reconciliation Balance per list of balances $ Receivables ledger Customer A Customer B Balance per RLCA Balance per list of balances $ Payables ledger Supplier Y Supplier Z Balance per PLCA
14.7
Other entries
A business must ensure that any transaction recorded in the receivables ledger control account or the payables ledger control account is also reflected in the memorandum ledgers.
Contra entries
3.1 Sometimes a business may have a customer which also supplies the business with goods. Illustration: P Co is a printing business which sells stationery to F Co, a florist. F Co supplies P Co with flowers and plants for its offices. During October, P Co sells stationery worth $200 to F Co and F Co delivers flowers and plants to P Co worth $70. P Co has the following amounts in its books: Receivables: Payables: $200 $70
The two businesses agree to offset the balances receivable and payable via a contra. The contra will be for the lower of the two amounts: $70. This will decrease both receivables and payables by $70 and the remaining $130 can then be paid in cash. 3.2 A contra entry is always recorded as: Dr Cr PLCA RLCA
This will reduce both receivables and payables. 3.3 Note that the memorandum ledgers will also need to be updated for the contra entry.
Returns, credit notes and refunds

3.4 3.5 Sometimes when a business has made a sale, the customer will return the goods. Steps: (1) Goods are sold to the customer for $250: Dr Cr (2) Dr Cr RLCA Sales Bank RLCA $250 $250 $250 $250
Customer pays for goods:
At this point the balance on the receivables ledger control account is nil.
14.8
14: CONTROL ACCOUNTS (3) Customer returns the goods and is issued with a credit note: Dr Cr Sales (returns) RLCA $250 $250
This entry reverses the original sale. The receivables ledger control account will show a credit balance reflecting that the business owes money to the customer. This could be offset against future purchases or the customer may request a refund. (4) The business refunds the customer: Dr Cr RLCA Bank $250 $250
Once again the balance on the receivables ledger control account is nil. 3.6 Again, the memorandum ledgers must also be updated.
Over payment
3.7 If a customer pays too much to settle an invoice or pays an invoice twice the business will owe the excess to the customer. This may be held and treated like a credit note or the monies refunded to the customer.
4
4.1
Discounts
There are two types of discounts: (a) Trade discounts (i) (ii) (b) (a) (b) given at the time of the sale/purchase, they reduce the selling price as an inducement to purchase; usually for regular customers or bulk buyers. offered, but not necessarily taken, as an inducement to settle a debt early; eg. 5% discount if settled within 14 days.
Settlement discounts
Terminology
4.2 Discounts allowed: offered by a seller to their customer. Discounts received: received by a business from their supplier.
Discounts allowed
4.3 Accounting treatment Sales are recorded net of (i.e. after) trade discounts but inclusive of (i.e. before) settlement discounts. Therefore trade discounts never appear in the financial statements.
14.9
14: CONTROL ACCOUNTS Settlement discounts allowed are recorded as discounts allowed and are shown as an expense in the income statement: Dr Cr Discounts allowed (I/S) RLCA
Lecture example 2
(a)
On 1 January 20X7 a business made a sale on credit for $12,000. A trade discount of $2,000 was available with a further 10% settlement discount if payment were made within 10 days. Required Record the initial sale.
Solution
The initial sale would be recorded as: Sales (I/S) RLCA (B/S)
(b)
On 4.1.X7, the customer pays for the goods taking advantage of the settlement discount. The discount will be 10% of sales value. Required Record the full settlement of the amount owed.
Solution
Bank (B/S) Discounts allowed (I/S)
14.10
14: CONTROL ACCOUNTS (c) Required What would your answer be to part (b) if the settlement discount were not taken?
Solution
Bank (B/S) RLCA (B/S)
Discounts received
4.4 Accounting treatment Purchases are recorded net of trade discounts but inclusive of settlement discounts. Again trade discounts never appear in the financial statements. Settlement discounts received are recorded as discounts received and are shown as sundry income in the income statement. Dr Cr PLCA (B/S) Discounts received (I/S)
Lecture example 3
Ryan Co purchases goods worth $5,000 from Austin Co. Ryan Co will receive a 5% settlement discount if the goods are paid for within seven days. Ryan Co has every intention of taking advantage of the settlement discount. Required (a) (b) (c) Show the initial recording of the purchase. Record the payment for the goods assuming Ryan pays within seven days. Record the payment for the goods if payment is made after seven days.
14.11
Solution
Sales tax and discounts

4.5 Sales tax is calculated on the amount after all discounts, regardless of whether the discount is taken or not.
Lecture example 4
Brick buys goods with a list price of $50,000 from Cement. Brick receives a trade discount of 12% from Cement and a further discount of 4% if payment is made within 10 days. Sales tax is at 15%. Required What amount should Brick show in Cement's payables ledger to record this purchase? A B C D $48,576 $50,336 $50,600 $57,500
14.12
Solution
5
5.1
Control account reconciliations

As mentioned in Section 2 if we add up the balances in the receivables and payables ledgers, they should agree to the balances per the RLCA and PLCA. If not, an error must have occurred at some point in the system. The easiest way to identify the error is to perform a reconciliation between the two amounts.
5.2
Proforma control account reconciliation RLCA $ X Transposition error in posting X X Balance c/d X Balance b/d X $ $ X $ X X X
Balance b/d Sales day book undercast Sales omitted from SDB
Reconciliation Statement $ + Total per listing of receivables ledger balances Adjustments Balance omitted Credit balance listed as debit Balance as per adjusted control account X X
(2X) X
X X
14.13
Lecture example 5
(a) Required
Technique demosntration
Post the following transactions to and balance off the receivables ledger control account. (1) (2) (3) (4) (5) (6) (b) Opening balance $614,000 Credit sales made during the month $302,600 Receipts from customers $311,000 Bad debts were written off $32,000 Discounts allowed for prompt payment $3,400 Contras against amounts due to suppliers in payables ledger $8,650
The receivables ledger list of balances totals to $563,900. You have found the following errors: (i) (ii) (iii) The total of the sales day book was undercast by $3,600. A credit balance of $450 was included in the list of balances as a debit. A customer balance of $2,150 was left out when the receivables ledger list of balances was totalled.
Required Reconcile the receivables ledger control account to the receivables ledger list of balances.
Solution
14.14
6
6.1
At any point in time the balance on the receivables ledger control account should equal the total of all the balances in the receivables ledger. Also the balance on the payables ledger control account should equal the total of all the balances in the payables ledger. Where the two balances are not the same an error must have arisen and a reconciliation should be performed to identify the errors. If a customer is also a supplier the two parties may choose to settle their accounts by making a contra entry. The contra is always for the lower of the two balances. Sometimes a business may offer discounts to attract custom. There are two types of discounts: trade discounts and settlement discounts. Sales and purchases are recorded after trade discounts but before settlement discounts. Sales tax is calculated on the amount after all discounts, regardless of whether the discount is taken or not.
6.2 6.3 6.4 6.5
7
7.1

Contra entry adjustment: Dr Cr Payables ledger control account (B/S) Receivables ledger control account (B/S)
7.2
Adjustment to record settlement discounts allowed to customers: Dr Cr Discounts allowed (I/S) Receivables ledger control account (B/S)
7.3
Adjustment to record settlement discounts received from suppliers: Dr Cr Payables ledger control account (B/S) Discounts received (I/S)
14.15
14.16
14.17
14: QUESTIONS

Womble & Sons have an accounting year ended 31 July 20X8. At that date the balance on the receivables ledger control account was $130,000, but the total of the individual accounts in the receivables ledger came to $127,240. Upon investigation the following facts were discovered: (i) (ii) (iii) The sales day book total for week 22 had been overcast by $600. A credit balance of $420 on Orinocos account had been incorrectly treated as a debit entry when listing the receivables ledger. A contra of $3,000 has been entered in Bungos account in the receivables ledger but no other entry had been made. The adjusted balance on the receivables ledger control account is: A B C D 14.2 $125,560 $126,400 $127,240 $129,400 (2 marks)
14.1
The adjusted balance on the receivables ledger is: A B C D $125,560 $126,400 $127,240 $129,400 (2 marks)
14.3
A page of the sales day book is undercast by $250. The journal necessary to correct the error is: A B C D Debit trade receivables $500, Credit sales $500 Debit sales $500, Credit trade receivables $500 Debit trade receivables $250, Credit sales $250 Debit sales $250, Credit trade receivables $250 (2 marks)
14.4
Winn Co has opening trade payables of $24,183 and closing trade payables of $34,665. Purchases for the period totalled $254,192 ($31,590 relating to cash purchases). What were total payments recorded in the payables ledger for the period? $ (2 marks)
14.5
The double entry to record a discount granted by a supplier is: A B C D Debit trade payables, Credit discounts allowed Debit trade payables, Credit discounts received Debit discounts received, Credit trade payables Debit trade payables, Credit purchases (2 marks)
14.18
14: QUESTIONS
14.6
The following receivables ledger reconciliation has been prepared by the bookkeeper of Julian Co as at 31 October 20X7: Total per listing of receivables ledger balances Debit balance omitted Credit listed as debit Unexplained difference Balance per control account Which of the following errors could have produced the unexplained difference? A B C D A refund of $300 was omitted from the receivables ledger. The sales day book for October was undercast by $300. The trade receivables column of the cash receipts book was overcast by $300. A payables ledger contra of $300 was not entered in the memorandum records. (2 marks) $ 26,170 1,740 (1,220) 300 26,990
14.7
Justin has attempted to write up his own nominal ledger but is very confused about debits and credits. He realises he has made some mistakes and has asked you to correct the following receivables ledger control account: Receivables ledger control account Balance b/d Sales on credit Purchase ledger contra $ 12,460 15,520 1,600 29,580 Cash sales Cheques from credit customers Discounts allowed Balance c/d $ 4,430 11,650 890 12,610 29,580
The opening balance is correct. What should the closing balance be? A B C D 14.8 $9,410 $13,840 $15,620 $17,040 (2 marks)
Which of the following is not a valid reason for a credit balance on a customer's account in the receivables ledger? A B C Over payment Cheque dishonoured by bank Returned goods credited to account (1 mark)
14.19
14: QUESTIONS
14.9
During April a company receives an invoice for $12,000 relating to goods bought on credit. These purchases qualify for a 5% trade discount which has not yet been taken into account. The company also sells goods with a list price of $20,000. A 6% trade discount is to be offered on these goods. Sales tax is applicable to all items and is at 15%. Sales tax is not included in the above amounts. If there is no opening balance on the sales tax account at the beginning of April, what is the closing balance at the end of April? A B C D $1,110 Cr $1,110 Dr $1,200 Cr $1,200 Dr (2 marks)
14.10 The following transactions were recorded in a companys books during one week of its trading year: $ Trade purchases (at list price) 4,500 Sales on credit (at list price) 6,000 Purchase of a van 10,460 A trade discount of $300 was given on the sales. All figures are given exclusive of sales tax at 15%. If the balance on the sales tax account was $2,165 credit at the beginning of the week, what is the balance at the end of the week? $ (2 marks) 14.11 Thomas Thomas is a sole trader. He has been reading a book on basic bookkeeping but his grasp of the subject is weak. He has produced the following receivables ledger control account but is not sure whether his closing balance is correct. Receivables ledger control account $ 12,240 Cheques received from customers 2,165 Cheques dishonoured by customers Irrecoverable debts 180 Allowance for receivables 71,250 Cash received from customers 2,250 230 Balance c/d 31.12.X6 88,315 10,350 $ 74,730 425 470 1,470 870 10,350 88,315
Balance b/d 1.1.X6 Discounts allowed Cash paid to customers with credit balances Sales Returns inwards Purchase ledger contras Balance b/d 1.1.X7 Required
Produce a corrected receivables ledger control account.
14.20
14: QUESTIONS
14.12 Duff On 31 December 20X7 the balance on Duffs receivables ledger control account was $1,070, but the receivables ledger balances totalled only $890. You ascertain the following: (1) (2) (3) (4) (5) (6) The sales day book was overcast by $100 on 1 December 20X7. Receivables ledger balances totalling $70 had been omitted from the list. A contra entry of $20 had been made between the payables ledger and receivables ledger accounts of Jones & Co, but no other entry had been made. The only posting made in respect of sales on 15 December 20X7, $50 in total, had been to individual ledger accounts. $60 worth of goods had been returned by Smith Co in November; this had been recorded only in the control account. The ledger account balance of Davis & Co had been listed as $90, but was in fact $190.
Required Prepare a reconciliation between the receivables ledger control account and the receivables ledger.
14.21
14: QUESTIONS
14.22
Chapter 14: Answers
14.23
14: ANSWERS
14.1 B Balance b/d
Receivables ledger control account $ 130,000 130,000 SDB overcast Contra balance c/d $ 600 3,000 126,400 130,000 $ 127,240 (840) 126,400
14.2 B
Receivables Ledger Balance per list of balances Credit balance treated as a debit (2 $420)
14.3 C 14.4 $212,120 Trade payables $ Bal b/d Payments Bal c/d 212,120 34,665 246,785 Bal b/d 14.5 B 14.6 A B C D Day book total has no effect on the receivables ledger, where individual invoice amounts will be entered. Cash book total has no effect on receivables ledger. If a contra had been omitted, the receivables ledger total would have to be reduced by $300. Receivables ledger control account Balance b/d Sales on credit $ 12,460 15,520 27,980 Note: Cash sales are not recorded in the control account 14.8 B This would leave a debit balance as the original debt would be reinstated. Purchase ledger contra Cheques from credit customers Discounts allowed Balance c/d $ 1,600 11,650 890 13,840 27,980 Purchases ($254,192 $31,590) $ 24,183 222,602 246,785 34,665
14.7 B
14.24
14: ANSWERS
14.9
A Input sales tax $12,000 95% 15% Output sales tax $20,000 94% 15% Closing balance on sales tax account at end of April
$ 1,710 (2,820) (1,110) Cr
14.10 $776 Cr $2,165 + [15% ($6,000 $3,000)] [15% $4,500] [15% $10,460] = $776 14.11 Thomas Receivables ledger control account Balance b/d Cash cheque dishonoured Cash credit balances Sales $ 12,240 425 180 71,250 $ Cheques Irrecoverable debts Cash received Discounts allowed Returns inwards Purchase ledger contras Balance c/d 74,730 470 870 2,165 2,250 230 3,380 84,095
84,095 14.12 Duff Receivables ledger control account Balance b/d Sales 15.12.X7 (4) $ 1,070 50 1,120 Balance b/d 1,000 SDB Overcast (1) Purchase ledger contra (3) Amended balance c/d
$ 100 20 1,000 1,120
Receivables ledger reconciliation statement Total balance per receivables ledger Adjustments: Balances omitted (2) Goods returned (5) Balance understated (6) Amended total $ + 70 100 170 $ 60 60 110 1,000 $ 890
14.25
14: ANSWERS
END OF CHAPTER
14.26
Bank reconciliations


Understand the purpose of bank reconciliations. Identify the main reasons for differences between the cash book and the bank statement. Correct cash book errors and/or omissions. Prepare bank reconciliation statements and identify the bank balance to be reported in the final accounts. Derive bank statement and cash book balances from given information.
Exam Context
Exam questions are likely to ask you to perform calculations to correct a bank reconciliation. Alternatively they may ask you to state whether differences between the cash book and the bank statement should be adjusted in the cash book or in the reconciliation statement.
This chapter covers a topic which is only examined in Paper F3.
15.1
15: BANK RECONCILIATIONS
Overview
Bank reconciliations
Cash book balance
Bank statement balance
Differences
Timing differences
Errors by the business
Errors by the bank
15.2
1
1.1 1.2
Introduction
This chapter is designed to enable you to explain and apply the approach to identifying and correcting errors through the use of bank reconciliations. The cash book is used to record the detailed transactions of receipts and payments into and out of the bank account. These are then posted to the nominal ledger periodically using double entry. At the end of each accounting period, the balance on the cash book should equal the balance in the nominal ledger cash account. Bank statements provide an independent record of the balance on the bank account but this balance is unlikely to agree exactly to the cash book balance therefore a reconciliation is required.
1.3
Differences between the cash book balance and the bank statement
1.4 Differences essentially occur for three reasons: (a) Timing differences: (i) (ii) (b) unrecorded lodgements (money paid into the bank by the business but not yet appearing as a receipt on bank statement) outstanding/unpresented cheques (cheques paid out by business which have not yet appeared on bank statement). omissions, such as: standing orders direct debits bank charges interest (ii) (iii) (c) transposition errors casting errors
Errors by the business (i.e. in the cash book): (i)
Errors by the bank.
A word of warning
1.5 In the books of the business: POSITIVE BANK BALANCE = ASSET = DEBIT NEGATIVE BANK BALANCE (OVERDRAFT) = LIABILITY = CREDIT But from the banks point of view: POSITIVE BALANCE = LIABILITY = CREDIT (the bank owes you your money) NEGATIVE BALANCE (OVERDRAFT) = ASSET = DEBIT (you owe the bank this is an asset for the bank)
15.3
2
2.1
Preparing a bank reconciliation

(a) (b) Compare the bank statement to the cash account and tick off all items which agree. Remaining items must represent timing differences or errors decide which!
Procedures
Example of how to set out a bank reconciliation

2.2 Cash account $ X Dishonoured cheque Bank charges Standing orders X Direct debits Balance c/d X $ X X X X X X $ X X (X) X/(X) X
Balance b/d Under cast error in balance b/d
Balance per bank statement plus unrecorded lodgements less outstanding cheques plus/less bank errors Balance per adjusted cash account
Practical tips
2.3 (a) (b) On reconciliation, put overdrafts and payments in brackets. It is the corrected cash account balance which is shown on the balance sheet. This figure will be the recalculated 'Balance c/d' on the cash account (or the total at the end of the reconciliation statement which should be identical!).
15.4
Lecture example 1
The cash account of Graham showed a debit balance of $204 on 31 March 20X8. A comparison with the bank statements revealed the following. $ (1) Cheques drawn but not presented 3,168 (2) (3) Amounts paid into the bank but not credited Entries in the bank statements not recorded in the cash account (i) Standing order payments (ii) Interest on bank deposit account (iii) Bank charges Balance on the bank statement at 31 March 20X8 723 35 18 14 2,618
(4)
Required Make any necessary adjustments to the cash book balance and complete the bank reconciliation statement as at 31 March 20X8.
Solution
Adjustment of cash book balance Cash account $ $
Bank reconciliation statement $ Balance per bank statement 31 March 20X8 Unrecorded lodgements Outstanding cheques Balance per cash account at 31 March 20X8
15.5
Lecture example 2
Whilst preparing a bank reconciliation statement at 31 December. The following items caused a difference between the bank statement balance and the cash book balance. (1) (2) (3) (4) (5) Bank interest charged to the account in error Direct debit for $500 for insurance Bank charges of $70 Cheque paid to a supplier on 29 December Receipt from a trade receivable by electronic transfer
Required Which of these items will be shown in the bank reconciliation? A B C D 2, 3, and 5 1 and 4 1, 4, and 5 1, 3 and 5
Solution
3
Quick Quiz
A business maintains a cash book to tell it how much cash it has at a particular point in time. It should reconcile this balance to the bank statement in order to ensure the cash book information is accurate. Differences between the cash book balance and the bank statement balance will arise for three reasons: timing differences, errors by the business and errors by the bank.
3.1
3.2
15.6
15.7
15: QUESTIONS

In the books of Ted Co the bank account shows a balance overdrawn of $6,530 as at 31 December 20X8. On comparing the bank statements with the cash book the following items are discovered: (i) (ii) (iii) (iv) (v) 15.1 Bank charges of $100 and overdraft interest of $50 have been omitted. Cheques received from customers totalling $1,900 have not yet been cleared by the bank. Cheques drawn in favour of suppliers amounting to $2,300 are outstanding at the year end. A credit transfer from a customer of $2,000 was not recorded. A direct debit to a supplier of $1,000 was omitted. What figure will be shown in the balance sheet as at 31 December 20X8 for bank overdraft? A B C D 15.2 $5,480 $5,680 $6,130 $7,380 (2 marks)
Assuming that the above items are all that is required to reconcile the cash book balance to the balance per the bank statement, what balance did the bank statement show as at 31 December 20X8? A B C D $5,280 overdrawn $6,080 overdrawn $7,780 overdrawn $8,580 overdrawn (2 marks)
15.3
Rectify A summary of the cash book of Rectify Co for the year to 31 May 20X5 is as follows: $ 805 145,720 146,525 Cash Book Payments Closing balance c/d $ 146,203 322 146,525
Opening balance b/d Receipts
After some investigation of the cash book and vouchers you discover that: (1) (2) (3) (4) (5) (6) (7) (8) bank charges of $143 shown on the bank statement have not yet been entered in the cash book; a cheque drawn for $98 has been entered in the cash book as $89, and another drawn at $230 has been entered as a receipt; a cheque received from a customer for $180 has been returned by the bank marked refer to drawer, but it has not yet been written back in the cash book; an error of transposition has occurred in that the opening balance of the cash book should have been brought down at $850; cheques paid to suppliers totalling $630 have not yet been presented at the bank, whilst payments in to the bank of $580 on 31 May 20X5 have not yet been credited to the companys account; a cheque for $82 has been debited to the companys account in error by the bank; the company owes $430 to the electricity board; standing orders appearing on the bank statement have not yet been entered in the cash book: (i) (ii) (iii) interest for the half year to 31 March on a loan of $20,000 at 11% pa; hire purchase repayments on the managing directors car 12 months at $55 per month; dividend received on a trade investment $1,147;
15.8
15: QUESTIONS
(9) (10)
a page of the receipts side of the cash book has been undercast by $200; the bank statement shows a balance overdrawn of $870.
Required Prepare a bank reconciliation as at 31 May 20X5.
15.9
15: QUESTIONS
15.10
Chapter 15: Answers
15.11
15: ANSWERS
15.1 B Unadjusted cash book balance Corrections to cash book (i) interest (100 + 50) (iv) unrecorded cash received (v) payment to supplier omitted Adjusted cash book balance 15.2 A Adjusted cash book balance Less: unrecorded lodgements Add: outstanding cheques Balance per bank statement 15.3 Rectify Bank $ Balance b/d Error in opening balance (4) (850 805) Dividend received (8iii) Undercast (9) Balance c/d 322 45 1,147 200 838 Bank charges (1) Cheque drawn entered as $89 (2) (98 89) Cheque drawn entered as receipt (2) (2 $230) Cheque returned written back (3) Loan interest (8i) HP repayments (8ii) 2,552 Bank reconciliation statement as at 31 May 20X5 Balance per bank statement Add: lodgements not yet credited Less: outstanding cheques Add: cheque wrongly debited by bank Balance per cash book $ (870) 580 (630) 82 (838)
$ (6,530) (150) 2,000 (1,000) (5,680) $ (5,680) (1,900) 2,300 (5,280)
$ 143 9 460 180 1,100 660 2,552
O/D
O/D
END OF CHAPTER
15.12
Correction of errors


Identify the types of error which may occur in bookkeeping systems. Identify errors which would be highlighted by the extraction of a trial balance. Prepare journal entries to correct errors. Calculate and understand the impact of errors on the income statement and balance sheet. Understand the purpose of a suspense account. Identify errors leading to the creation of a suspense account. Record entries in a suspense account and make journal entries to clear it.
Exam Context
Questions on this area are likely to focus on three main areas. You may be asked to identify which explanations could have led to a particular difference or be asked to identify the journal entry to correct an error. You may also need to determine the effect errors may have on the profit figure.
This topic is only tested in Financial Accounting.
16.1
16: CORRECTION OF ERRORS
Overview
Types of error
Correction of errors
Suspense account
Adjustments to profit
16.2
1
1.1 1.2
Introduction
Chapter 6 showed us how the trial balance was extracted from the ledger accounts and that it should balance, i.e. total debits should equal total credits. If the trial balance doesn't balance then an error has definitely been made and must be corrected.
2
2.1
Section 1
Types of error
The following errors will still allow the trial balance to balance. Type of error Error of omission Example
Error of commission
Error of principle
Compensating error
2.2
The trial balance will not balance if total debits do not equal total credits. This could be due to the following: (1) Transposition error
(2)
An entry has been posted where (a) debits credits
(b)
a debit entry has been posted and no corresponding credit made (or vice versa)
16.3
16: CORRECTION OF ERRORS (c) two debit entries or two credit entries have been posted.
These errors will be corrected by creating a suspense account and making a journal entry to correct the error.
3
3.1 3.2
Suspense accounts
A suspense account is a temporary account. They never appear in the final accounts. It is used for two main reasons: (1) (2) To account for a debit or credit entry when the accountant is unsure as to where it should go To make a preliminary trial balance balance when an error has been detected.
3.3
Steps to clear a suspense account. (1) (2) (3) Determine the original accounting entry which was made. Decide what entry should have been made. Make the required adjustment.
3.4
Illustration W Co sold goods with a value of $2,500 to James, a credit customer. When recording the sale W Co posted the transaction to the correct accounts but made two debit entries. Steps (1) Entry made was: Dr Dr (2) Dr Cr (3) Trade receivables Sales Trade receivables Sales $2,500 $2,500 $2,500 $2,500
Entry should have been:
Correction: The trade receivables entry is correct but sales have been debited by $2,500 when they should have been credited by that amount. The correction is therefore twice the original error: Dr Cr Suspense account Sales (2 $2,500) $5,000 $5,000
Being: correction of sales posting.
16.4
Lecture example 1
Dan, the bookkeeper of Tiffany's, has made his usual mess of things and produced the following attempt at a trial balance for the year ended 30 April 20X7. $ Property, plant and equipment At cost Provision for depreciation Capital at 1 May 20X6 Profit for the year Inventory, at cost Receivables ledger control account Payables ledger control account Balance at bank As chief accountant you discover the following: (1) (2) (3) A rent payment of $350 in March 20X7 had been debited in the receivables ledger control account. Discounts allowed of $500 during the year ended 30 April 20X7 had not been recorded in the books. No entry had been made for the refund of $2,620 made by cheque to V Woolf in March 20X7, in respect of defective goods returned to Tiffany. V Woolf, who had already paid for the goods, returned them on 28 February 20X7. The total column of the cash receipts book had been overcast by $1,900 in March 20X7. The purchase of stationery for $1,460 cash in June 20X6 has not been posted to the appropriate expense account. Capital of $35,000 was recorded incorrectly as $53,000. 60,000 31,000 53,000 12,300 14,000 9,600 6,500 1,640 85,240 102,800 $
(4) (5) (6)
Required Prepare (a) (b) Journal entries to correct the above errors; A suspense account showing how it is cleared.
16.5
Solution
16.6
4
4.1 4.2
Adjustments to profit
When errors are corrected they may affect the business' profit for the year figure. For example in Lecture example 1, item 5 tells us that a stationery expense of $1,460 has not been recorded in the expense account. The profit for the year figure in the trial balance of $12,300 is therefore too high and needs to be corrected.
4.3
This is done by using a statement of adjustments to profit.
Proforma
4.4 Original profit Adjustment: (a) over depreciation (b) unrecorded expense (c) unrecorded sale Adjusted profit $ + X X X X (X) X X $ $ X
Lecture example 2
Required Prepare a statement of adjustments to profit for Lecture example 1.
Solution
Statement of adjustments to profit for the year ended 30 April 20X7. Increases $ Draft profit Adjustments Decreases $
Revised profit
16.7
Lecture example 3
Z Co's income statement showed a profit of $112,400 for the year ended 30 September 20X7. The following errors were later discovered: (1) (2) Sales returns of $2,700 had been recorded as a new sale. A machine which had been held for two years and had originally cost $15,000 was 1 depreciated this year using a 33 3 % reducing balance basis. Z Co's policy is to depreciate machines over four years.
Required What would be the net profit after adjusting for these errors? A B C D $103,250 $105,750 $105,950 $108,450
Solution
5
Quick Quiz
Some errors, such as errors of omission and errors of principle, will still allow the trial balance to balance. Where the trial balance does not balance a suspense account will be inserted and the errors, once identified, will be corrected via a journal entry. Some of these corrections may impact the business profit; in this case a statement of adjustments to profit can be prepared to determine the revised profit figure.
5.1 5.2 5.3
16.8
16.9
16: QUESTIONS
16.1
Which of the following errors could result in a suspense account being required to balance the trial balance? A B C Cash received from receivables treated as a cash sale Payments to suppliers of $513 recorded as $531 in the payables ledger A suppliers invoice for $19 recorded as $91 in the purchases account (1 mark)
16.2
Duncan corrected the following errors before producing his final balance sheet. What was the balance on the suspense account before he did this? (i) (ii) (iii) A B C D Sales day book for March overcast by $63. Cash receipts from receivables of $713 posted to the receivables ledger control account as $731. Cash received from the issue of $1,000 debentures at par had been posted to a suspense account. $982 $982 Dr Cr (2 marks)
$1,018 Dr $1,018 Cr
16.3
Russells bookkeeper transposed some figures when the weeks cash payments were being posted to the nominal ledger. Payments for staff wages of $125 were posted to the wages account as $152 and payments of $31 for stationery were posted to the stationery expense account as $13. The entry required to correct this is A B C D Dr stationery $18 Dr wages $27 Dr wages $27 Dr suspense $45 Dr suspense $9 Dr stationery $18 Cr stationery $18 Cr wages $27 Cr wages $27 Cr suspense $45 Cr suspense $9 Cr stationery $18 (2 marks)
16.4
Which of the following errors would cause a trial balance imbalance? (i) (ii) (iii) A B C D The discounts received column of the cash payments book was overcast. Cash paid for the purchase of office furniture was debited to the general expenses account. Returns inwards were included on the credit side of the trial balance. (i) only (i) and (ii) (iii) only all of the errors (2 marks)
16.5
If sales of $150 has been wrongly entered on the debit side of the purchases account, but correctly entered in the trade receivables account, the totals on the trial balance would show: A B C D The debit side to be $150 more than the credit side The debit side to be $300 more than the credit side The debit side to be $150 less than the credit side The debit and credit sides to be equal in value (2 marks)
16.10
16: QUESTIONS
16.6
Platinum Co Platinum Co, a manufacturer of electrical goods, has just produced its draft accounts for the year ended 30 September 20X7. These show a draft profit of $28,960. Unfortunately, the accountant has since discovered the following matters which require consideration before the final accounts can be prepared: (1) (2) (3) Returns outwards to Metals Co in June 20X7 of $490 have been treated as returns inwards in error in the nominal ledger. R. Silverman, a customer owing $1,850 has gone bankrupt. Full allowance had been made against this amount in Platinum's accounts for the year ended 30 September 20X6. An item of equipment with a net book value of $6,000 (cost $10,000) was sold for $5,000 in September 20X7. The proceeds were included in cash and credited to the motor expenses account. No other entries were made. An amount owing from Aluminium Co of $780 was written off in January 20X7. The amount was removed from trade receivables and debited to the sales account.
(4)
Required Calculate the corrected profit for the year ended 30 September 20X7.
16.11
16: QUESTIONS
16.12
Chapter 16: Answers
16.13
16: ANSWERS
16.1
C Suspense account Transposition error (731 713) Bal c/d 18 Cash from debentures 982 1,000 Bal b/d 1,000 1,000 982
16.2 B
16.3 16.4 16.5 16.6
A C B Platinum Co (a) Statement of corrected profit for the year ended 30 September 20X7. Draft profit (1) (2) (3) (4) Returns outwards ($490 x 2) No effect Disposal of machine ($5,000 + $1,000) No effect + $ $ $ 28,960
980 6,000
980 Revised profit
(6,000)
(5,020) 23,940
END OF CHAPTER
16.14
Preparation of financial statements for sole traders


Prepare extracts of an opening trial balance. Prepare journal entries to correct errors. Record entries in a suspense account Make journal entries to clear a suspense account Prepare extracts of a balance sheet and income statement from given information.
Exam Context
This chapter recaps some of the key skills you have learnt in the chapters covered to date. Whilst you will not be asked to produce a balance sheet or an income statement in the real exam any of the adjustments in this chapter could be tested as an individual question. This chapter will also help you to see how financial accounting fits together.
The skills to produce a balance sheet and an income statement are tested in detail in the Fundamentals level paper, Financial Reporting (F7).
17.1
17: PREPARATION OF FINANCIAL STATEMENTS FOR SOLE TRADERS
Overview
Preparation of financial statements for sole traders
Trial balance
Adjustments
Suspense account
Income Statement and Balance Sheet
17.2
1
1.1 1.2
Introduction
The purpose of this chapter is to recap some of the skills covered in Chapters 116. You will not be required to answer a question in the format of Lecture example 1 in the exam. However completing this exercise will revise your understanding of topics covered so far and enable you to see the end product a business' transactions ordered into a set of financial statements.
Technique demonstation
Lecture example 1
You have been given the information below and asked to prepare the accounts of Mugg for the year ended 31 December 20X7. Trial balance as at 31 December 20X7. Dr $ Capital account at 1 January 20X7 Rent Inventories 1 January 20X7 Electricity Insurance Wages Trade receivables Sales Repairs Purchases Discounts received Drawings Petty cash Bank Motor vehicles at cost Furniture and fixtures at cost Accumulated depreciation at 1 January 20X7 Motor vehicles Furniture and fixtures Travel and entertaining Trade payables Suspense account 500 510 240 120 1,634 672 15,542 635 9,876 129 1,200 5 762 1,740 830 435 166 192 700 433 19,349 The following information is also available: (1) (2) (3) (4) Closing inventories, valued at cost, amounts to $647; Mugg has drawn $10 a month and these drawings have been charged to wages; Depreciation is to be provided at 25% on cost on motor vehicles, and 20% on cost on furniture and fixtures; Bad debts totalling $37 are to be written off;
17.3
Cr $ 2,377
19,349
17: PREPARATION OF FINANCIAL STATEMENTS FOR SOLE TRADERS (5) (6) (7) (8) (a) (b) (c) $180 received from a credit customer was correctly entered in the trade receivables account and credited to the bank account; Mugg has taken goods from inventories for his own use. When purchased by his business these goods cost $63 and they would have been sold for $91; The annual rental of the business premises is $600, and $180 paid for electricity in August 20X7 covers the 12 months to 30 June 20X8; Discounts allowed of $73 have only been recorded in the trade payables account. Prepare journal entries to record items (1) (8). Clear the suspense account. Produce an income statement for the year ended 31 December 20X7 and a balance sheet as at that date.
Required
Solution
(a) Journals (1)
(2)
(3)
(4)
17.4
17: PREPARATION OF FINANCIAL STATEMENTS FOR SOLE TRADERS (5)
(6)
(7)
(8)
(b) Suspense account $ $
17.5
17: PREPARATION OF FINANCIAL STATEMENTS FOR SOLE TRADERS (c) Mugg Income statement for the year ended 31 December 20X7 $ Sales Less: cost of sales Opening inventories Purchases Less: closing inventories Gross profit Discounts received Less: expenses: Rent Electricity Insurance Wages Repairs Depreciation Travel and entertaining Bad debts Discounts allowed Profit for the period Mugg Balance sheet as at 31 December 20X7 Cost $ Non-current assets Motor vehicles Furniture and fixtures Current assets Inventories Trade receivables Prepayments Cash and bank balances Capital Capital as at 1 January 20X7 Profit for the period Less: drawings Current liabilities Trade payables Accruals Accumulated depreciation $ NBV $ $
17.6
2
Quick Quiz
The balance sheet and income statement are the end product produced by a business. All the business transactions need to be categorised into the books of prime entry and posted to the nominal ledger. The trial balance is then extracted and some adjustments may need to be made before the financial statements are drawn up. You will not have to produce a balance sheet or income statement however this chapter should reinforce your understanding of Chapters 1 16.
2.1
2.2
17.7
17.8
Chapter 17: Question
17.9
17: QUESTION
17.1
Drawings are an expense of the business. Is this statement true or false? A B True False (1 mark)
17.10
Chapter 17: Answer
17.11
17: ANSWER
17.1
END OF CHAPTER
17.12
Incomplete records

Having studied this chapter you will be able to: Understand and apply techniques used in incomplete record situations: (i) (ii) (iii) (iv) use of accounting equation use of ledger accounts to calculate missing figures use of cash and/or bank summaries use of profit percentages to calculate missing figures
Exam Context
Questions on this chapter will require you to identify missing figures, for example sales, closing inventories and drawings. The Pilot Paper included two questions asking you to derive the value of closing inventories using information about the gross profit margin earned by the business.
This topic is only tested in Financial Accounting.
Business Context
Some sole traders do not keep very detailed accounting records. They still however need to produce accounts so they know how their business is performing and also how much tax to pay to the tax authorities. The preparation of accounts from incomplete records can generate a lot of income for smaller accountancy practices.
18.1
18: INCOMPLETE RECORDS
Overview
Margin
Cost structures
Mark-up
Incomplete records
Techniques for solving incomplete records
Derive missing figures from given information
Sales
Purchases
Drawings
Inventory
18.2
1
1.1
Issue
Individuals running small businesses such as a newsagent or greengrocer may not keep all of the accounting records we have studied or have a detailed understanding of double entry bookkeeping. They still need to know how the business is performing and so will produce financial statements. If some necessary information isn't maintained by the business, it will need to be derived from other available information.
1.2
2
2.1
Cost structures
Cost structure information is usually expressed in one of two ways, either as a margin or a mark-up. (a) Margin: here gross profit is expressed as a percentage of sales, for example a margin of 25% gives: Sales Cost of sales Gross profit (b) Mark-up: 100% 75% 25%
here gross profit is expressed as a percentage of cost of sales, for example a mark-up of 35% gives: Sales Cost of sales Gross profit 135% 100% 35%
2.2
Remember that: Cost of sales = opening inventories + purchases closing inventories
Lecture example 1
W Co has on average a profit margin of 40%. In 20X7 sales total $476,000. Required What is cost of sales? Workings $
18.3
Lecture example 2
Y Co operates with a standard mark-up of 30% and has the following information available for 20X7. $ Sales 221,000 Opening inventories 43,000 Closing inventories 47,500 Required What is the value for purchases in 20X7? Workings $
Lecture example 3
On 1 January 20X7 J Co had inventory of $620,000. Sales for the month amounted to $985,000 and purchases were $700,000. At the end of January a fire in the warehouse destroyed some inventory items. The owners salvaged inventory valued at $180,000. J Co operates with a mark up of 25%. What is the cost of inventory destroyed in the fire? A B C D $335,000 $352,000 $401,250 $532,000
Solution
18.4
Other techniques for solving incomplete records

Lecture example 4
A Co has recorded the following details relating to trade payables: Balance at Cash paid from till Payments from bank Required 1.1.X7 31.12.X7
$ 38,450 43,825 430 167,224
Based on the information above what was the value of purchases made during the year? $ Workings Trade payables $ $
18.5
Lecture example 5
B Co maintains a cash float of $50. In 20X7, all receipts from credit customers were banked, after the following payments from the till had been made: General expenses Drawings $ 4,500 6,250
Total bankings in the year amounted to $28,454, and opening and closing trade receivables were $1,447 and $1,928 respectively. Required Based on the information above what was the value of sales made during the year? $ Workings Cash
Trade receivables
18.6
Lecture example 6
Bob owns and manages B Co although he does not keep detailed accounting records. All of Bob's sales are for cash. He pays certain expenses from his till and then banks the remaining funds. Bob maintains a $1,000 float and operates with a margin of 20%. He has provided you with the following information. Purchases of goods Wages for clerical assistant (per week) Stationery Electricity Bankings Opening inventories Closing inventories $ 20,000 100 500 1,200 12,800 2,000 3,000
Bob is unsure of the level of drawings taken during the year but estimates they were between $60 and $90 per week. Required What were Bob's drawings during the year? Workings $
18.7
4
4.1
Goods drawn by proprietor

The owners of the business may at times take goods or cash from the business for their own use. We have seen these before as drawings. In incomplete records questions these drawings need to be included. Cash drawings Dr Cr Dr Cr Drawings Cash Drawings Purchases
Goods taken for own use
These are recorded at the cost to the business not at sale price. They are taken out of purchases and not recorded against inventories. Note: If you are using a trade payables T account to calculate purchases remember to adjust purchases for any goods taken by proprietor.
Example
4.2 During the year ended 31 December 20X7, Peter Albert, a sole trader, carried out the following transactions: Sales (40 units @ $100) Purchases (45 units @ $60) His inventories (at cost) were: 1 January 20X7 31 December 20X7 (5 units @ $60) (8 units @ $60) $ 4,000 2,700 $ 300 480
During the year he had withdrawn two units for his own use. Firstly, ignoring the drawings, an outline trading account would appear as follows: $ $ Sales 4,000 Cost of sales Opening inventories 300 Purchases 2,700 3,000 Less: closing inventories (480) 2,520 Gross profit 1,480 How should the drawings of goods be treated?
18.8
18: INCOMPLETE RECORDS It should be fairly obvious that the debit entry will be to drawings on the balance sheet, but what about the credit entry? It will not, as you might initially think, go to inventories (because these goods were not in hand at the year end so they are not included in the value of $480) but rather to purchases (as this is where they will have been previously recorded). In the trading account, this credit entry is often shown as a separate deduction from cost of sales, i.e.: $ $ Sales 4,000 Cost of sales Opening inventories 300 Purchases 2,700 Less: goods drawn by proprietor 2 units @ $60 (120) 2,880 Less: closing inventories (480) 2,400 Gross profit 1,600
Points to note
4.3 (a) (b) Drawings of goods are recorded at cost. Gross profit figure now makes sense, i.e. profit of $40 per unit 40 units sold.
5
Quick Quiz
Not all businesses keep proper accounting records, however all businesses need to know how much profit they have made in a particular year so that they can pay the relevant amount of tax over to the tax authorities. Where a business does not have sufficient records to produce financial statements they need to piece together the missing information. A margin is where a business expresses gross profit as a percentage of sales. A mark-up is where gross profit is expressed as a percentage of cost of sales. A business is a separate entity from its owner which means that any monies or goods taken out of the business for personal use must be classified as drawings. Drawings of goods are recorded at cost.
5.1
5.2 5.3 5.4 5.5
18.9
6
6.1

Adjustment to record cash drawings: Dr Cr Drawings (B/S) Cash (B/S)
6.2
Adjustment to record drawings of goods: Dr Cr Drawings (B/S) Purchases (I/S)
18.10
18.11
18: QUESTIONS
18.1
If a business has sales of $6,000 and a margin of 20%, what is the gross profit? $ (1 mark)
18.2
A trader has budgeted sales for the coming year of $300,000. He achieves a constant mark-up of 25% on cost. He plans to reduce his inventory level by $14,000 over the year. How much will his purchases for the year be? A B C D $211,000 $239,000 $226,000 $254,000 (2 marks)
18.3
A business has opening inventories of $273 and makes purchases during the year of $2,781. The proprietor removes goods costing $87 for his own use. The business achieves a constant mark-up of 20% on cost and records sales for the year of $3,360. What is the cost of closing inventories? $ (2 marks)
18.4
Jethro sold goods for $157,470 during the year ended 31 October 20X7. Inventories at that date were valued at $8,920 more than at the previous year end. Jethro prices his goods to give a mark-up of 45%. What was the total value of purchases in the year ended 31 October 20X7? A B C D $77,689 $95,529 $99,680 $117,520 (2 marks)
18.12
Chapter 18: Answers
18.13
18: ANSWERS
18.1 $1,200 $6,000 0.2 = $1,200 18.2 C

100 Cost of sales = $300,000 125
$ 240,000 (14,000) 226,000
Less: decrease in inventories 18.3 $167 Cost of sales 100 $3,360 120
$ 2,800 (273) (2,694) 167
Less: opening inventories purchases (2,781 87) closing inventories 18.4 D Cost of sales purchases = $157,470 x 100/145 = $108,600 = $108,600 + $8,920 = $117,520
END OF CHAPTER
18.14
Partnerships


Understand and identify the typical content of a partnership agreement, including profit sharing terms. Understand the nature of capital accounts, current accounts and division of profits. Calculate and record the partners' shares of profits/losses. Account for guaranteed minimum profit shares. Calculate and record (i) (ii) (iii) (iv) partners' drawings interest on drawings interest on capital partner salaries
Prepare an extract of a capital account and a current account. Prepare extracts of the income statement, including division of profit, and balance sheet of a partnership. Define goodwill in relation to partnership accounts and identify the factors leading to the creation of goodwill. Calculate the value of goodwill from given information.
Exam Context
Questions on this topic are likely to require you to calculate a partner's profit share. This may include dealing with partners' salaries, interest on capital and drawings and loan interest. You may also need to allocate goodwill to partners when a new partner is admitted.
Partnerships are only examined in this paper.
Business Context
Many individuals set up business as a sole trader as they expand they need new finance. One way of obtaining this is to go into partnership with someone else. That other person could provide some of the finance needed. They may also bring new ideas to the table. Becoming a partnership will mean that the sole trader will share some of their risk but they will also need to share their profits too! It is always recommended that a partnership agreement is drawn up to retain a legal record of how the partnership will operate.
19.1
19: PARTNERSHIPS
Overview
Partnership agreements Appropriation account
Partnerships
Capital accounts
Current accounts
Other issues
Guaranteed minimum profit share
Loans
Goodwill
19.2
19: PARTNERSHIPS
1
1.1 1.2
Definition
Partnership: The relationship which exists between two or more persons carrying on a business with a view to profit.
Partnerships are similar to sole traders. With a sole trader the owner will run the business and any profits belong to him. The sole trader also bears the risk that the business may not be successful. In a partnership, the owners (partners) run the business together and share profits and risk.
1.3
Most partnerships have unlimited liability which means the partners are personally liable for the debts of the business. Liability is also joint and several so if one partner cannot meet the partnership's obligations the other partners must make up any shortfall.
1.4
Limited liability partnerships (LLPs) exist nowadays to limit partner liability. These are outside the scope of the F3 syllabus.
Partnership agreements
The partners will need to agree the terms under which the partnership will operate, and decide, for example how much capital each partner will contribute and what share of profits they will be entitled to. This is done by way of a partnership agreement which usually covers the following areas:
2.1 Area Capital Profit sharing ratio (PSR) Consideration

how much each partner pays in whether a "Fixed Capital" level is specified allocation of profit more to senior partners? equal shares? guaranteed minimum profit share? whether or not partners are entitled to salaries it is an appropriation of profit it is not an income statement expense whether or not allowed paid on capital injected interest rate may set a limit may set an interest charge
Salaries
Interest on capital
Drawings
19.3
19: PARTNERSHIPS
3
3.1 3.2
Accounting for partnerships

There are two key differences between accounting for a sole trader and a partnership. These are illustrated below. Income statement Sole trader Sales Cost of sales Gross profit Less: expenses Profit for period All belongs to sole trader $ X (X) X (X) X Partnership Sales Cost of sales Gross profit Less: expenses Profit for period Shared between partners according to the partnership agreement $ X (X) X (X) X
Appropriating the profit for the period

3.3 The profit for the period is appropriated (shared out) between the partners according to their partnership agreement. Steps (1) (2) (3) (4) Allocate the partner salaries Allocate any interest on capital Charge any interest on drawings Allocate remaining profit balance in profit sharing ratio Appropriation account Profit before appropriation Interest on drawings X Partner A X Partner B X X X X X * PSR is always the last entry, splitting the residual profit after all other allocations X
This is done using an appropriation account. Salaries Partner A Partner B Interest on capital Partner A Partner B * PSR Partner A Partner B X X X
19.4
19: PARTNERSHIPS 3.4 Balance sheet Sole trader $ Capital Capital Profit Less: drawings X X (X) X Capital accounts Partner A Partner B Current accounts Partner A Partner B Amount owed back to the partners by the business Partnership $ X X X X X X
Amount owed back to the owner by the business 3.5 Capital accounts
These represent the capital invested in the business by each individual partner. The balances in these accounts will remain relatively static. The capital account can be shown as one T account subdivided into columns. For example, if Partner A contributed $5,000 and Partner B $8,000, the capital account would show. Capital account Ptnr A $ Ptnr B $ Bal b/d Ptnr A $ 5,000 Ptnr B $ 8,000
3.6
Current accounts These record each partner's day to day transactions with the business. The main entries in the current account will be the partners appropriation of profits (salary, interest on capital and profit share) less drawings they have taken from the business and any interest charged on those drawings. Current account Ptnr A $ 2,900 100 4,000 7,000 Ptnr B $ 970 30 5,000 6,000 Ptnr A $ 1,000 1,500 500 4,000 7,000 Ptnr B $ 1,500 800 3,700 6,000
Drawings Interest on drawings Bal c/d
Bal b/d Salaries Interest on capital Profit share
19.5
19: PARTNERSHIPS
Lecture example 1
(a)
On 1 January 20X4 Tick, Cast and Balance entered into partnership together as chartered certified accountants. They agreed that Balance would receive a salary of $15,000 p.a., they would all be allowed interest on capital of 12% p.a. and they would share profits in the ratio: Tick five tenths, Cast three tenths, Balance two tenths. They paid in the following capital amounts: Tick Cast Balance $50,000 $30,000 $20,000
In the year to 31 December 20X4 their profit for the period was $50,000. During the year they had made drawings in cash as follows: 30.6.20X4 Tick 30.9.20X4 Cast 31.12.20X4 Balance Required (i) (ii) (iii) (iv) Write up their capital accounts in columnar form. Write up the appropriation account. Write up their current accounts in columnar form. Show the partners' balances on the balance sheet. $6,000 $4,000 $8,800
Solution
(i) Tick $ Cast $ Capital Accounts Balance $ Tick $ Cast $ Balance $
19.6
19: PARTNERSHIPS (ii) Appropriation account for the year ended 31 December 20X4 $ $
(iii) Current accounts Tick Cast Balance $ $ $ Tick $ Cast $ Balance $
19.7
19: PARTNERSHIPS (iv) Tick, Cast and Balance Balance sheet as at 31 December 20X4 (extract) $ Capital accounts Tick Cast Balance Current accounts Tick Cast Balance $
(b)
What would your answer be to (ii) and (iii) if the agreement had also provided for interest to be charged on drawings at the rate of 10% p.a.? (ii) Appropriation account for the year ended 31 December 20X4 $ $
19.8
19: PARTNERSHIPS (iii) Tick $ Current accounts Cast Balance $ $ Tick $ Cast $ Balance $
19.9
19: PARTNERSHIPS
4
4.1 4.2 4.3 4.4
Guaranteed minimum profit share

It may be that the partnership agreement specifies that one or more partners must receive a minimum share of profits. If when the appropriation of profits is made this level is exceeded, there is nothing further to do. If, however, there is a shortfall then this will be made up by the remaining partners in their profit sharing ratio. Illustration A, B and C are in partnership and share profits in the ratio 2:2:1. The partnership made a profit for the year of $50,000. A and B each receive a salary of $12,000. Interest due on the partners' capital is $2,000, $1,700 and $1,500 respectively. No interest is charged on drawings. C has a guaranteed minimum profit share of $7,000. A $ 12,000 2,000 8,320 22,320 (670) 21,650 B $ 12,000 1,700 8,320 22,020 (670) 21,350 C $ 1,500 4,160 5,660 1,340 7,000 Total $ 24,000 5,200 20,800 50,000 50,000
Salaries Interest on capital Profit share (2:2:1) Subtotal Guaranteed minimum profit share shortfall (2:2)
5
5.1
Loans
Unlike sole traders, a partner can make a loan to the partnership.
Reasons for making a loan

5.2 (a) (b) (c) (d) Partnership may be short of funds. Partner is unwilling to tie cash up for long period. Partner wants to earn interest. Partner retires but partnership does not have enough cash to buy out his share.
5.3 5.4 The loan is shown as a non-current liability on the balance sheet and not in the partner's capital account. The interest incurred on the loan is shown as an expense in the income statement (just like bank interest). It will need to be deducted from the profit figure before any appropriation is made if it has not already been accounted for.
19.10
19: PARTNERSHIPS 5.5 If the loan interest has not been paid by the end of the year, the liability will be shown in the relevant partners current account. The double entry would be: Dr Cr Loan interest expense (I/S) Current account (B/S)
Lecture example 2
X, Y and Z are in partnership sharing profits in the ratio 6:3:1.
Y made a loan of $10,000 to the partnership on 1 July 20X7. The loan carries interest at 12% but this has not yet been accounted for. X and Z receive salaries of $15,000 and $8,000 respectively and interest due on capital to each partner is $400. The profit for the year to 31 December 20X7 was $67,000. Required What is the amount of profit appropriated to each partner for the year ended 31 December 20X7? $ Workings
19.11
19: PARTNERSHIPS
6
6.1 6.2 6.3
Changes to the partnership agreement

Profits are always appropriated according to the partnership agreement. Therefore if the terms of the agreement change during the period this will affect the profit appropriation. Always use the old partnership agreement to appropriate the profits for the first part of the year and the new partnership agreement for the latter part of the year. Assume profits accrue evenly unless the question specifies otherwise.
Lecture example 3
Melanie, Sarah and Angela are in partnership, compiling their accounts for the year to 31 December each year. The partnership agreement states the following: Until 30 June 20X3 Annual salaries Sarah Angela $40,000 $20,000
Profit sharing ratio Melanie: Sarah: Angela is 60:20:20: From 1 July 20X3 Salaries to be discontinued, profit sharing ratio to be: 50:30:20 The profit for the year ended 31 December 20X3 was $400,000 before charging partners' salaries, accruing evenly through the year and after charging an expense of $40,000, which it was agreed related wholly to the first six months of the year. Required How should the profit for the year be divided among the partners? Use a separate page for your workings. Melanie $ A B C D 182,000 200,000 198,000 180,000 Sarah $ 130,000 116,000 118,000 132,000 Angela $ 88,000 84,000 88,000 88,000
19.12
19: PARTNERSHIPS
7
7.1 7.2
Changes to the partnership goodwill

When a partner retires from the partnership or a new partner is admitted to the partnership it is usual for the partners to value the business. It is likely that over time the value of items such as property, plant and equipment will increase over their net book value. However, hopefully the business will also have built up a good reputation and a loyal customer base and the business itself will be worth more than its individual assets.
7.3
Section 2.8-2.10
The worth of a business over and above its individual assets is called goodwill. When a partner retires it is important that he is paid a sum that represents not just the money he invested but also his share of the extra value created in the business, i.e. his share of goodwill. Goodwill is therefore added to the partners' accounts according to the existing or old profit sharing ratio.
7.4
7.5
Similarly, when a new partner joins, he will pay in a sum of money (capital). It is important that the original partners value the partnership so they know its worth and can determine how much the partner should contribute. Goodwill is an extremely subjective figure and so it is not left in the partnership's balance sheet, but is removed. This is done using the new profit sharing ratio.
7.6
Lecture example 4
Katie, Chantel and Heather are in partnership sharing profits in the ratio 4:3:2.
On 1 September Heather decides to retire and leaves the partnership. At that point the partnership has goodwill valued at $180,000. Katie and Chantel continue to share profits 4:3. On 1 December Stacy joins the partnership contributing $200,000. At that time goodwill is valued at $210,000. The new profit sharing ratio for Katie, Chantel and Stacy is 3:2:2. Required Show how the goodwill would be accounted for at each change of the partnership.
19.13
19: PARTNERSHIPS
Solution
Goodwill $ $
Capital account $
8
Quick Quiz
The purpose of a partnership agreement is to specify how the partnership operates in terms of the how much capital the partners pay in and whether they are paid interest on capital; whether they are entitled to a salary; whether interest is charged on drawings and the profit sharing ratio. Partners salaries are not an expense of the business but an appropriation of profit. Capital accounts represent the capital paid in by each partner and are generally static. Current accounts record the partners day to day transactions with the business. Whenever a new partner is admitted or an existing partner retires the partnership will be valued. The worth of the partnership over and above the balance sheet valued is called goodwill. This is allocated to the partners according to their profit sharing ratio.
8.1
8.2 8.3 8.4 8.5
19.14
19.15
19: QUESTIONS

John, Paul and David have been in a partnership for one year providing advice on landscape gardening. The partnership agreement provides for the following: a salary to John of $5,000 per annum. interest on capital balances @ 10% per annum. interest on drawings @ 5% per annum. profit sharing ratio of 2:2:1 respectively.
The capital accounts as at 31 March 20X3 showed the following balances: John $30,000 Paul $25,000 David $20,000 The partners made the following drawings during the year: John $6,000 on 30 June 20X2 Paul $2,000 on 31 December 20X2 David $1,500 on 31 March 20X3 On 30 September 20X2 Paul lent the partnership $100,000. Interest (which has not been included in the accounts) is to be charged at 4% per annum. Loan interest is to be included in the current account. The profit for the year ended 31 March 20X3 was $40,000.
19.1 19.2 19.3
What is Johns share of the residual profits? $ What will be the balance on Pauls current account at 31 March 20X3? $ Which of the following is not true? A B C Partners are jointly and severally liable Partner salaries are an appropriation of profits Interest on drawings is an appropriation of profits
(2 marks) (2 marks)
(1 mark)
19.16
19: QUESTIONS
19.4
A, B and C A, B and C are in partnership, agreeing to share profits in the ratio of 4:2:1. They have also agreed to allow interest on capital at 8% per annum, a salary to C of $5,000 per annum, and to charge interest on drawings made in advance of the year end at a rate of 10% per annum. The balance sheet as at 30 June 20X8 disclosed the following: Capital accounts A B C A B C A $ 50,000 30,000 10,000 2,630 521 (418) $
Current accounts
90,000
Loan account (5% interest)
2,733 15,000 107,733
Drawings were: A $6,400, B $3,100, C $2,000, with all sums being withdrawn on 1 July 20X8. Profit for the year to 30 June 20X9 was $24,750, before charging interest on A's loan. The partnership made a payment to A for loan interest on 29 June 20X9 but has not recorded this in its books. Required Prepare the current accounts and the appropriation account for the partners as at 30 June 20X9.
19.17
19: QUESTIONS
19.18
Chapter 19: Answers
19.19
19: ANSWERS
19.1 $10,300 Profit per accounts Less loan interest 4% $100,000

6 12
$ 40,000 (2,000) 38,000 John $ 5,000 3,000 (225) 10,300 18,075 Paul $ 2,500 (25) 10,300 12,775 David $ 2,000 5,150 7,150 Total $ 5,000 7,500 (250) 25,750 () 38,000
Salary Interest on capital Interest on drawings PSR (2:2:1) Total profit
19.2 $12,775 Current account Paul Drawings Interest on drawings c/d 2,000 25 12,775 14,800 Interest on capital Loan interest PSR b/d 2,500 2,000 10,300 14,800 12,775
19.3
Interest on drawings increases available profits to share and is therefore not an appropriation of profit. Partner salaries are an appropriation of profit, not an expense.
19.4
A, B and C A $ Balance b/d Drawings 6,400 Interest on drawings 640 Balance c/d 6,990 14,030 B $ 3,100 310 3,211 6,621 Current accounts C $ 418 2,000 200 5,032 7,650 Balance b/d Salary Interest on capital Share of profit Balance b/d A $ 2,630 4,000 7,400 14,030 6,990 B $ 521 2,400 3,700 6,621 3,211 C $ 5,000 800 1,850 7,650 5,032
19.20
19: ANSWERS
Appropriation account Salary Interest on capital C A B C $ 5,000 Profit (W1) Interest on drawings $ 24,000
4,000 2,400 800
7,200
A B C
640 310 200
1,150
Share of profits in PSR A(4/7) B(2/7) C(1/7)
7,400 3,700 1,850
12,950 25,150 24,750 (750) 24,000
25,150
(W1)
Profit Interest on loan
19.21
19: ANSWERS
END OF CHAPTER
19.22
Introduction to company accounting


Understand the capital structure of a limited liability company including ordinary shares, preference shares and loan notes. Record movements in the share capital and share premium accounts. Define a bonus issue and a rights issue, their advantages and disadvantages and show how they are recorded in the balance sheet. Identify and record the other reserves which may appear in the company balance sheet. Record dividends in ledger accounts and the financial statements. Calculate and record finance costs in ledger accounts and the financial statements.
Exam Context
Questions on this chapter are likely to focus on the calculation of share capital movements (new issues, bonus issues and rights issues), dividends and finance costs and their associated journal entries. You may also see a question comparing a sole trader and a limited company as was included in the Pilot Paper.
The knowledge covered in this chapter is developed further in the Fundamentals level paper Financial Reporting (F7). This paper looks in more detail at whether shares and borrowings should be classified as debt or equity and also at how they should be valued. The area of income taxes is also extended to include adjustments for deferred tax as well as current tax.
Business Context
When a company is seeking to raise finance it will evaluate its current financing structure and gearing levels before deciding how to secure additional funds. It will also consider the degree of risk attached to each method of financing and will weigh up the cost in terms of interest payments versus future dividends. A company will also receive tax relief on its interest payments (but not on dividends) and so the tax implications will form part of the final decision.
20.1
20: INTRODUCTION TO COMPANY ACCOUNTING
Overview
Finance costs
Reserves
Long term borrowings
Income taxes
Introduction to company accounting
Shares
Issue at a premium
Bonus issue
Rights issue
Dividends
20.2
1
1.1
Introduction
We have seen how financial statements are produced for sole traders and partnerships. These accounts are not subject to any specific regulation and so there is some flexibility as to how they are presented. Companies use exactly the same bookkeeping process as sole traders and partnerships; however, the financial statements they produce are subject to regulation and must follow a prescribed format. Many of the differences are due to the terminology used by company financial statements.
1.2
2
2.1

Income statement for the year ended 31 March 20X7 Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Investment income Profit before tax Income tax expense Profit for the period $'000 X (X) X X (X) (X) (X) X (X) X X (X) X
20.3
20: INTRODUCTION TO COMPANY ACCOUNTING 2.2 Balance sheet as at 31 March 20X7 ASSETS Non-current assets Property, plant and equipment Other intangible assets Current assets Inventories Trade receivables Other current assets Cash and cash equivalents Total assets EQUITY AND LIABILITIES Equity Share capital Share premium account Revaluation reserve Retained earnings Non-current liabilities Long term borrowings Long term provisions Current liabilities Trade payables Short term borrowings Current tax payable Short term provisions Total equity and liabilities 2.3 These proformas will be covered in more detail in Chapter 21.
$'000 X X X X X X X X X
X X X X X X X X X X X X X
3
3.1
Section 2.3
Share capital
It is necessary to be able to distinguish between the following types of share capital: (a) (b) (c) (d) Authorised share capital Issued share capital Called up share capital Paid up share capital maximum number of shares the company may issue. number of shares actually issued to shareholders. the amount of issued share capital the company has asked shareholders to pay for to date. amount of called up share capital which has been paid for.
Share capital
20.4
Types of shares
3.2 Ordinary share

Preference share

Equity share Ordinary shareholders own business Usually have voting rights No right to a dividend, receive what directors decide to pay
Fixed rate of dividends (eg 7% preference share) Receive dividend in priority to ordinary shareholders On winding up, receive capital in priority
4
4.1
Share capital: accounting treatment

Rab Co started business on 1 January 20X6 issuing 100,000 ordinary shares of 50c each for 50c per share. The initial balance sheet would be: Cash Share capital 50c ordinary shares $ 50,000 50,000
Issue of new shares
Issue of new shares at a premium

4.2 Where shares are issued for more than their nominal value, the excess must be credited to a share premium account.
Lecture example 1
Required
On 1 June 20X6 Rab Co issued a further 200,000 ordinary shares of 50c each for 80c per share. Show how this issue of shares would be accounted for and what the balance sheet would look like immediately after the issue.
20.5
Solution
Dr $ Dr Cash Cr Share capital Cr Share premium account Rab Co balance sheet (extract) as at 1 June 20X6 Equity $ Share capital 50c ordinary shares Share premium account Cr $
Bonus issue (capitalisation issue)

4.3 This is used when a company wishes to increase its share capital without needing to raise additional finance by issuing new shares. Any reserve may be used including the share premium account. Advantages
4.4 Disadvantage
Bonus issue can be made from the share premium account which has few other uses Will allow the share price to fall (without disadvantaging shareholder wealth) to make the company's shares more affordable to new investors Shareholders will now own more shares and could sell part of their holding
The rationale for a bonus issue is not always understood by shareholders
4.5
A bonus issue is always done at nominal value.
20.6
Lecture example 2
Rab Co Balance sheet (extract) Share capital 50c ordinary shares Share premium account Retained earnings Several years later Rab Co is to make a bonus issue on a 1 for 4 basis. Required
$ 150,000 60,000 200,000 410,000
Show how this issue of shares would be accounted for and prepare the balance sheet of Rab Co immediately after the issue.
Solution
Dr $ Dr Share premium account Cr Share capital Rab Co Balance Sheet (extract) $ Share capital 50c ordinary shares Share premium account Retained earnings Cr $
Rights issue
4.6 (a) (b) A rights issue is an issue of shares for cash (unlike a bonus issue) to existing shareholders. Rights are offered to the existing shareholders who can sell them if they wish.
20.7
20: INTRODUCTION TO COMPANY ACCOUNTING 4.7 Advantages
Disadvantages
More cost effective way for the company to raise finance than a fresh issue to the public A more time efficient way to issue shares If all rights are taken up shareholders will maintain their existing percentage shareholding
Lack of shareholder interest may reflect badly on the company Unwelcome predators may try to acquire shares where not all rights are taken up Effect on future dividend policy as company will have issued more shares under the rights issue than it would have under a fresh issue to the public
Lecture example 3
One year later, Rab Co is to make a rights issue on a 1 for 5 basis. The rights price is $1.50. All shareholders take up their rights. The following balance sheet extract shows the position before the issue Rab Co Balance sheet (extract) Share capital 50c ordinary shares Share premium account Retained earnings Required Show how this issue of shares would be accounted for and prepare the balance sheet of Rab Co immediately following the issue. $ 187,500 22,500 230,000 440,000
Solution
Dr $ Dr Cash Cr Share capital Cr Share premium account Rab Co Balance sheet (extract) Share capital 50c ordinary shares Share premium account Retained earnings Cr $
20.8
5
5.1
Reserves
The following reserves are commonly found in limited liability company accounts. (a) The share premium account: (i) Typical permitted uses: (1) (2) (b) (c) (d) to issue bonus shares; to write off share issue expenses.
The revaluation reserve (see Chapter 9): Other reserves: as designated by the individual company, for example a 'general reserve'. Retained earnings: cumulative undistributed profits less any losses.
6
6.1
Dividends
Dividends a sharing out/appropriation of retained earnings to owners/shareholders.
Definition
Illustration
6.2 Suppose a company with 1,000 ordinary $1 shares in issue made a profit of $500 in its first year. The company has two choices as to what can be done with this profit: (a) (b) distribute it as a dividend to the shareholders; retain it in the business.
If this company decides to pay a dividend of 10c per share and retain the remaining profits, the financial statements would appear as follows: Income statement for the year ended 31 December 20X7 Profit for the period Balance Sheet as at 31 December 20X7 (extract) Share capital $1 shares Retained earnings (500 100) 6.3 6.4 $ 1,000 400 1,400 $ 500
Dividends are charged directly to retained earnings as they are an appropriation of profits earned to date. They are not an expense of the income statement. The double entry is: Dr Cr Retained earnings Dividends payable (B/S)
20.9
20: INTRODUCTION TO COMPANY ACCOUNTING 6.5 A company may pay dividends in two stages: (a) (b) Interim Final (mid year) (end year)
In reality the directors will wait until they know the company's full year profit before declaring the final dividend. The final dividend will only be accounted for in the current year if it is declared before the year end. Otherwise it will be disclosed in a note to the financial statements (see Chapter 22).
Lecture example 4
ABC Co has the following share capital: 100,000 200,000 6% $1 preference shares 50c ordinary shares
Retained earnings at the beginning of the year were $125,000. During the year ended 31 December 20X7 it made the following profit: Profit before tax Income tax expense Profit for the period Dividends paid and declared during the year were as follows: Interim dividend paid 5c per share Final dividend declared on 20 January 20X8 10c per share Required Show the movement in retained earnings for ABC Co for the year ended 31 December 20X7. $ 60,000 10,000 50,000
Solution
$ Retained earnings at beginning of year Profit for the period Dividends Preference Ordinary Retained earnings at end of year $
20.10
7
7.1
Long term borrowings

A company may choose to raise finance by issuing shares (equity). Alternatively it can raise funds by issuing debt.
7.2
One way of raising long term finance is for a company to issue loan notes (also called loan stock or debentures). These loans usually carry a fixed rate of interest and have a pre-determined redemption date, for example, $50,000 10% debentures 2012. This means the company will pay interest at 10% on the $50,000 borrowed each year. The capital amount of $50,000 will be repaid in 2012.
8
8.1 8.2
Finance costs
The interest expense incurred on long term borrowings will be shown as an expense called 'finance costs' in the income statement. It will be accounted for as follows: Dr Cr Finance costs (I/S) Bank
9
9.1
Income taxes
Companies must pay income tax on their profits. This tax is payable after the end of the financial year and so the financial statements will include an accrual for the directors' best estimate of the tax due on the profit for the period. The tax is shown as an expense in the income statement and a current liability in the balance sheet and will be accounted for as follows: Dr Cr Income tax expense (I/S) Current tax payable (B/S)
9.2
9.3
Often the actual amount of tax paid will be different from the amount that was recorded in the financial statements. This over or under provision is simply adjusted in the next financial statements.
20.11
Lecture example 5
Lauren Ltd has a year end of December.
When preparing its financial statements for the year ended 31 December 20X5, Lauren Ltd estimated that its income tax payable would be $62,000. Lauren Ltd settled this tax liability on 30 September 20X6, paying $65,000. The tax estimate for the year ended 31 December 20X6 is $43,000. Required (1) (2) Record the tax entries for the years ended 31 December 20X5 and 20X6 in the ledger accounts. Prepare the tax note which relates to the income statement for the year ended 31 December 20X6.
Solution
(1) Income tax expense (I/S) $ $
Current tax payable (B/S) $ $
(2)
Tax note for the year ended 31 December 20X6
20.12
10 Comparison
The following table shows a comparison between a sole trader and a limited liability company. Sole trader Ownership The proprietor owns the business. Company There are often a large number of owners, who are called shareholders or members. Members/shareholders have limited liability. This means that they are only liable to the extent of their investment in the business. A company is a separate legal entity.
Liability
The proprietor has unlimited legal liability regarding the business.
Legal status
The business and the proprietor share legal identity (although the business is a separate business entity for reporting purposes). The proprietor usually owns and manages the business.
Management
Members/shareholders do not usually manage the business, but appoint a Board of Directors to run the company on their behalf. Members/shareholders receive profits in the form of dividends. The remainder of the profits are retained in the company. The directors receive a salary from the company and this is an expense in the income statement. Income tax is paid on the company profits. The middle of the balance sheet is split into 'share capital' and 'reserves'. There are extensive legal requirements governing limited companies. Investors can invest in a company.
Profits
The proprietor takes 'drawings' out of the business. Any cash amounts taken as a salary are not an expense of the business but drawings.
Taxation
Business profits are taxed in the hands of the proprietor, using individual's tax rates. The middle of the balance sheet is split into 'opening capital', 'profits' and 'drawings'. There are no legal requirements specific to a sole trader. The business is closed to outside investors.
Balance sheet
Legal requirements Other
20.13
11 Summary of Chapter 20
Quick Quiz
11.1 In a limited liability company the shareholders own the business. A company may raise finance by issuing new share capital. Where shares are issued at a premium to their nominal value, the premium is recorded in the share premium account. 11.2 A bonus issue is where the company issues shares for no cash consideration. With a rights issue, shares are issued for cash but the price charged is slightly lower than the current market price. 11.3 Shareholders may receive a dividend as a return on their investment; these are accounted for as a deduction to retained earnings. 11.4 A company may also raise finance by issuing debt such as loan notes or debentures. It will have to pay interest on these and this will be shown as 'finance costs' in the income statement. 11.5 Companies pay income tax on their profits.
12 Double Entry Summary for Chapter 20

12.1 Adjustment to record dividends: Dr Cr Retained earnings (B/S) Dividends payable (B/S)
12.2 Adjustment to record finance costs: Dr Cr Finance costs (I/S) Bank (B/S)
12.3 Adjustment to record the income tax expense: Dr Cr Income tax expense (I/S) Current tax payable (B/S)
20.14
20.15
20: QUESTIONS
20.1
A company has an authorised share capital of 1,000,000 50c ordinary shares and an issued share capital of 800,000 50c ordinary shares. If an ordinary dividend of 5% is declared what is the amount payable to shareholders? $ (1 mark)
20.2
If a shareholder in a limited liability company sells his shares to another private investor, for less than he paid for them, the share capital of the company will A B C D Remain unchanged Increase by the nominal value of the shares Increase by the amount received for the shares Decrease by the nominal value of the shares (2 marks)
20.3
A companys issued share capital consists of $100,000 in 6% $1 preference shares and $50,000 in 50c ordinary shares. The directors wish to pay an ordinary dividend for the year of 5 cents per share. What is the companys total dividend for the year? A B C D $8,500 $11,000 $5,000 $17,000 (2 marks)
20.16
Chapter 20: Answers
20.17
20: ANSWERS
20.1
$20,000 5% (800,000 0.50)
20.2 20.3
A B ($100,000 6%) + ($50,000 2 5c)
END OF CHAPTER
20.18
Preparation of financial statements for companies


Recognise how the balance sheet equation and business entity convention underlie the balance sheet. Understand the nature of reserves and report them in a company balance sheet. Prepare extracts of a balance sheet from given information. Understand why the heading 'retained earnings' appears in a company balance sheet. Prepare extracts of an income statement from given information. Understand how accounting concepts apply to revenue and expenses. Calculate revenue, cost of sales, gross profit and net profit from given information and disclose items of income and expenditure in the income statement. Record income taxes in the income statement of a company. Understand the inter-relationship between the balance sheet and income statement. Identify items requiring separate disclosure on the face of the income statement. Identify the components of the statement of changes in equity.
Exam Context
Whilst you will not be required to produce an entire income statement, balance sheet or statement of changes in equity you may be asked to calculate individual elements of each statement. A question on the Pilot Paper required you to demonstrate understanding of what was included in the statement of changes in equity.
The topics covered in this chapter are developed further in the Fundamentals level paper Financial Reporting (F7). Here you will need to produce financial statements using the format specified by IAS 1. You will also learn how accounting standards such as IFRS 5 affect the presentation of the financial statements if, for example, a company discontinues part of its operations.
Business Context
Financial statements are used by a wide range of user groups to make decisions, for example whether or not to buy shares in a company. Financial statements need to be prepared in a consistent way in order for users to be able to compare different companies. The notes to the accounts will also provide a lot more detail on the headline figures shown in the income statement and balance sheet.
21.1
21: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES
Overview
Income statement Balance sheet
Preparation of financial statements for companies
Statement of changes in equity
Notes to the accounts
21.2
1
1.1 1.2
Introduction
As stated in Chapter 20 the financial statements of a limited liability company are subject to regulation and must follow a prescribed format. Much of the prescribed format is determined by IAS 1. This accounting standard states what should be included in a set of financial statements and how they should be presented. A complete set of financial statements in accordance with IAS 1 comprises: (a) (b) (c) a balance sheet an income statement a statement showing either: (i) (ii) (d) (e) all changes in equity; or changes in equity other than those arising from transactions with equity holders acting in their capacity as equity holders;
a cash flow statement; and notes, comprising a summary of significant accounting policies and other explanatory notes.
2
2.1

Income statement for the year ended 31 March 20X7 Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Investment income Profit before tax Income tax expense Profit for the period $'000 X (X) X X (X) (X) (X) X (X) X X (X) X
21.3
21: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES 2.2 Balance sheet as at 31 March 20X7 $'000 ASSETS Non-current assets Property, plant and equipment Other intangible assets Current assets Inventories Trade receivables Other current assets Cash and cash equivalents Total assets EQUITY AND LIABILITIES Equity Share capital Share premium account Revaluation reserve Retained earnings Non-current liabilities Long term borrowings Long term provisions Current liabilities Trade payables Short term borrowings Current tax payable Short term provisions Total equity and liabilities X X X X X X X X X
X X X X X X X X X X X X
21.4
Lecture example 1
The following balances have been extracted from the trial balance of Arrow, a limited liability company, at 30 September 20X6. Sales Share capital 50c ordinary shares Share premium account Trade receivables Bad debts written off Bank balance Purchases Revaluation reserve Office expenses Property, plant and equipment 6% loan notes 20X9 Short term warranty provisions Vehicle distribution costs Inventories at 1 October 20X5 Trade payables Administrative staff salaries Retained earnings The following information still needs to be accounted for: (1) (2) (3) (4) (5) (6) (7) During the year the company made a rights issue on a 1 for 6 basis. The issue was fully subscribed and the rights price was $1.27. No account has been taken of the interest on the loan notes. The estimate for tax payable on this year's profit is $270,000. Inventories held at the year end amounted to $610,000. The warranty provision needs to be increased to $80,000. The property, plant and equipment was valued at $5m and this amount needs to be incorporated in the financial statements. A dividend of $300,000 was paid in the year but this has not been accounted for. $'000 12,740 1,500 200 1,000 45 835 7,200 800 1,800 4,400 1,200 50 2,060 450 550 500 1,250
Required Prepare the income statement of Arrow for the year ended 30 September 20X6 and a balance sheet as at that date.
21.5
Solution
Arrow Income statement for the year ended 30 September 20X6 $'000 Revenue Cost of sales Gross profit Distribution costs Administrative expenses Finance costs Profit before tax Income tax expense Profit for the period Arrow Balance sheet as at 30 September 20X6 $'000 ASSETS Non-current assets Property, plant and equipment Current assets Inventories Trade receivables Cash and cash equivalents Total assets EQUITY AND LIABILITIES EQUITY Share capital Share premium account Revaluation reserve Retained earnings Non-current liabilities Long term borrowings Current liabilities Trade payables Other payables Current tax payable Short term provisions Total equity and liabilities
21.6
21.7
21: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES 2.3 Statement of changes in equity for the year ended 31 March 20X7 Share Share Revalcapital premium uation account reserve $'000 $'000 $'000 Balance at 31 March 20X6 Changes in accounting policies Restated balance Gain on revaluation of properties Tax on items taken directly to equity Net income recognised directly in equity Profit for the period Total recognised income and expense for the period Dividends Issue of share capital Balance at 31 March 20X7 2.4 X X X X X X X (X) X X X X X X X X X X (X) X X
Retained Total earnings equity $'000 X (X) X $'000 X (X) X X (X) X X X (X) X X
As an alternative the statement of changes in equity may be presented as a note to the financial statements. In this case it is replaced by the statement of recognised gains and losses as a primary statement. Statement of recognised gains and losses for the year ended 31 March 20X7 Gain on revaluation of properties Tax on items taken directly to equity Net income recognised directly in equity Profit for the period Total recognised income and expense for the period $'000 X (X) X X X
21.8
Lecture example 2
From the trial balance in Lecture example 1, Arrow had the following equity balances at 1 October 20X5: Share capital 50c ordinary shares Share premium account Revaluation reserve Retained earnings Required Using the information from Lecture example 1, produce a statement of changes in equity for Arrow for the year ended 30 September 20X6. $'000 1,500 200 800 1,250 3,750
Solution
Share capital $'000 Balance at 30 September 20X5 Gain on revaluation of property, plant and equipment Net income recognised directly in equity Profit for the period Total recognised income and expense for the period Dividends Issue of share capital Balance at 30 September 20X6 Share premium account $'000 Revaluation reserve $'000 Retained earnings $'000 Total equity $'000
21.9
Notes to the accounts

Notes are included in a set of financial statements to give users extra information. You should be aware of the following notes:
3.1
Property, plant and equipment (Chapter 9) Land and buildings $ X X X (X) (X) X X (X) X X (X) X Machinery $ X X (X) (X) X X (X) X X (X) X Office equipment $ X X (X) (X) X X (X) X X (X) X Total $ X X X (X) (X) X X (X) X X (X) X
Net book value at 1 April 20X6 Additions Revaluation surplus Depreciation charge Disposals Net book value at 31 March 20X7 At 31 March 20X7 Cost or valuation Accumulated depreciation Net book value At 31 March 20X6 Cost or valuation Accumulated depreciation Net book value 3.2
Intangible non-current assets (Chapter 10) Development expenditure $ X X (X) (X) X X (X) X X (X) X
Net book value at 1 April 20X6 Additions Amortisation charge Disposals Net book value at 31 March 20X7 At 31 March 20X7 Cost Accumulated amortisation Net book value At 31 March 20X6 Cost Accumulated amortisation Net book value
21.10
21: PREPARATION OF FINANCIAL STATEMENTS FOR COMPANIES 3.3 Provisions (Chapter 13) At 1 April 20X6 Increase in period Released in period At 31 March 20X7 3.4 Contingent liabilities (Chapter 13) Unless remote, disclose for each contingent liability: (a) (b) (c) (d) 3.5 a brief description of its nature; and where practicable an estimate of the financial effect an indication of the uncertainties relating to the amount or timing of any outflow; and the possibility of any reimbursement $ X X (X) X
Contingent assets (Chapter 13) Where an inflow of economic benefits is probable, an entity should disclose (a) (b) a brief description of its nature; and where practicable an estimate of the financial effect
3.6
Events after the balance sheet date (Chapter 22) In respect of non-adjusting events after the balance sheet date disclose (a) (b) the nature of the event an estimate of its financial effect (or a statement that an estimate cannot be made).
4
4.1 4.2
The financial statements produced by a company need to follow the format prescribed by IAS 1. The statement of changes in equity shows the movements on each of the accounts in the equity section of the balance sheet in a separate statement.
21.11
21.12
21.13
21: QUESTIONS
21.1
Which of the following items impact on the Statement of Changes in Equity? (i) (ii) (iii) (iv) A B C D Issue of ordinary shares Revaluation of a building Profit for the period Revaluation of a non-current asset investment (i) (i), (iii) (ii), (iii) All of the above (2 marks)
21.2
Spend Co The following balances remain in the books of Spend Co at 30 June 20X8 after the preparation of the trading account. $ Share capital 80,000 $1 ordinary shares 80,000 40,000 8% $1 preference shares 40,000 Share premium account 10,000 Revaluation reserve 30,000 Inventories at 30 June 20X8 83,852 Trade receivables and prepayments 27,200 Trade payables and accruals 13,722 Bank balance 7,796 10% debentures 16,000 General reserve 28,000 Irrecoverable debts 340 Gross profit for the period 81,508 Wages and salaries 28,200 Insurance 1,410 Postage and telephone 620 Light and heat 1,216 Debenture interest ( year to 31 December 20X7) 800 Directors fees 2,500 General expenses 3,108 Vehicles (cost $19,400) 6,800 Office furniture and equipment (cost $44,640) 27,440 Land and buildings at valuation 132,200 Retained earnings at 1 July 20X7 24,252 The following information is also available: (1) (2) (3) (4) The land and buildings are to be revalued at $150,000; Office furniture and equipment is to be depreciated at 15% on cost, and vehicles at 20% on cost; A bill for $348 in respect of electricity consumed up to 30 June 20X8 has not been entered in the ledger; The amount for insurance includes a premium of $300 paid in December 20X7 to cover the company against fire loss for the year 1 January 20X8 to 31 December 20X8;
21.14
21: QUESTIONS
(5)
Provisions are to be made for: Directors fees Audit fee The outstanding debenture interest. $ 5,000 1,200
(6)
The directors made the following recommendations prior to the year end which have not yet been adjusted for: (i) (ii) $12,000 should be transferred to a general reserve; the preference dividend be should accrued for payment;
Required Prepare the income statement from the gross profit line downwards for the period ended 30 June 20X8 and a balance sheet as at that date (ignore income tax).
21.15
21: QUESTIONS
21.16
Chapter 21: Answers
21.17
21: ANSWERS
21.1 21.2
D Spend Co Spend Co Income statement for the period ended 30 June 20X8 $ Gross profit for the period Less expenses: Irrecoverable debts Wages and salaries Insurance (1,410 (300 x 6/12)) Postage and telephone Light and heat (1,216 + 384) Debenture interest (800 + 800) Directors fees (2,500 + 5,000) Audit fee General expenses Depreciation: Office furniture and equipment Vehicles Profit for the period Spend Co Balance sheet as at 30 June 20X8 340 28,200 1,260 620 1,564 1,600 7,500 1,200 3,108 6,696 3,880 55,968 25,540 $ 81,508
NON-CURRENT ASSETS Land and buildings Furniture and equipment Motor vehicles
Cost or Valuation $ 150,000 44,640 19,400 214,040
Acc. Dep'n $ 23,896 16,480 40,376
NBV $ 150,000 20,744 2,920 173,664 83,852 27,350 7,796 118,998 292,662
CURRENT ASSETS Inventories Trade receivables and prepayments (27,200 + (300 6/12)) Cash and cash equivalents
EQUITY Share capital 80,000 $1 ordinary shares 40,000 8% $1 preference shares Share premium account Revaluation reserve (30,000 + 17,800) General reserve (28,000 + 12,000) Retained earnings (Working) NON-CURRENT LIABILITIES 10% debentures CURRENT LIABILITIES Trade payables and accruals (13,722 + 5,000 + 1,200 + 800 + 348) Dividends payable
80,000 40,000 10,000 47,800 40,000 34,592 252,392 16,000 21,070 3,200 24,270 292,662
21.18
21: ANSWERS
Working Retained earnings Retained earnings at 1 July 20X7 Profit for the period Dividends declared 8% preference dividend Transfer to general reserve Retained earnings at 30 June 20X8 $ 24,252 25,540 (3,200) (12,000) 34,592
21.19
21: ANSWERS
END OF CHAPTER
21.20
Events after the balance sheet date

Define an event after the balance sheet date in accordance with International Financial Reporting Standards. Classify events as adjusting or non-adjusting. Distinguish between how adjusting and non-adjusting events are reported in the financial statements.
Exam Context
Questions on this topic are likely to require you to identify adjusting and non-adjusting events from a list of options and the appropriate accounting treatment of each event. Both these types of questions were tested in the Pilot Paper.
The knowledge in this chapter is tested again at the Professional level paper, Corporate Reporting (P2) where you will be expected to consider how events after the balance sheet date may impact the way in which transactions are reported.
22.1
22: EVENTS AFTER THE BALANCE SHEET DATE
Overview
Definition
Events after the balance sheet date
Adjusting events
Non-adjusting events
22.2
1
1.1
Definition
Events after the balance sheet date: events, both favourable and unfavourable, that occur between the balance sheet date and the date when the financial statements are authorised for issue. There are two types of event after the balance sheet date.
1.2
2
2.1
Adjusting and non-adjusting events

Adjusting events Non-adjusting events
Events which provide evidence of conditions which existed at the balance sheet date.
Events that relate to conditions which arose after the balance sheet date
(1) (2) (3) (4)
Examples: resolution of a court case bankruptcy of a major customer evidence of NRV of inventories discovery of fraud or errors that show the financial statements were incorrect
Examples: (1) destruction of major asset, eg by flood or fire (2) major share transactions (3) announcement of a plan to close part of a business
Accounting treatment:
Accounting treatment:
Change the amounts in the financial statements 2.2 (a) (b)
Disclose non-adjusting event in a note to the financial statements
Dividends proposed or declared after the balance sheet date but before the financial statements are approved should be disclosed in a note to the financial statements. A non-adjusting event that affects going concern becomes an adjusting event.
22.3
Lecture example 1
Which of the following events after the balance sheet date would normally qualify as a nonadjusting event? 1 2 3 4 A B C D A fall in the market price of shares held by the entity as investments. Insolvency of a trade receivable with a balance of $200,000 outstanding at the balance sheet date. Declaration of the year-end dividend by the directors. Confirmation of the amount of damages awarded to an employee who sued for unfair dismissal after being sacked two months before the year end. 2 only 1 and 3 1, 3 and 4 2 and 4
Solution
3
Quick Quiz
Events after the balance sheet date are events which occur between the balance sheet date and the date the financial statements are approved for issue. There are two types: adjusting and non-adjusting. Adjusting events provide evidence of conditions that existed at the balance sheet date. The financial statements should be changed to include this information. Non-adjusting events relate to conditions which arose after the balance sheet date. These should be disclosed as a note to the financial statements.
3.1 3.2 3.3 3.4
22.4
22.5
22: QUESTIONS
22.1
The following are examples of events which might occur between the balance sheet date and the date on which the financial statements are authorised for issue: (1) (2) (3) A B C D Losses on inventories as a result of a catastrophe such as a fire or flood after the year end The discovery of fraud which shows that the financial statements were incorrect Revaluations of property which provide evidence of an impairment in value (1), (2) and (3) (1) and (2) (1) and (3) (2) and (3) (2 marks)
Which of the examples given should normally be classified as an adjusting event?
22.2
Robin Co has a year end of 31 December 20X8, the directors were informed on 27 February 20X9 that a serious fire at one of the company's factories would stop production there for at least six months to come. On 3 March 20X9 the directors of Robin Co were informed that a major customer had gone into liquidation. The liquidator was pessimistic about the prospect of recovering anything for unsecured creditors. The financial statements for the year ended 31 December 20X8 were approved on 20 March 20X9. In accordance with IAS 10, Events after the balance sheet date, how should the two events be treated in the financial statements? Fire A B C D Accounts adjusted Disclosed in notes Accounts adjusted Disclosed in notes Liquidation Disclosed in notes Disclosed in notes Accounts adjusted Accounts adjusted (2 marks)
22.3
A Co has a year end of 31 December 20X7. During the preparation of the financial statements in March 20X8 the following issues arose: (1) Sales of a particular inventory line were poor during the second half of 20X7. The directors had hoped that sales would pick up in 20X8 but it is now apparent that the inventory will need to be marked down below their original cost in order to sell them. On 12 February 20X8 one of the company's production plants was struck by lightening. The company will suffer a net loss of $55,000 as a result of this. Sporran Co is a valued customer which owed A Co $34,000 at the balance sheet date, although they were behind with their payments. Since the year end sales to Sporran Co were $12,000. The directors have just received notification that Sporran Co has gone into liquidation. Adjusting event A B C D 2,3 1, 2 1,3 1, 2, 3 Non-adjusting event 1 3 2 (2 marks)
(2) (3)
How should the above events be classified according to IAS 10 Events after the balance sheet date?
22.6
Chapter 22: Answers
22.7
22: ANSWERS
22.1 D
(1) (2) (3)
After the balance sheet date and therefore non-adjusting. The financial statements are incorrect, therefore clearly we must adjust. The impairment is assumed to have taken place by the balance sheet date. We simply did not find out until later.
22.2
The fire is a non-adjusting event as it does not affect the value of the building at 31 December 20X8. It is therefore only disclosed in a note to the financial statements unless it threatens the company's going concern in which case it would become an adjusting event. The customer is assumed to be insolvent at 31 December 20X8. We simply did not know this and therefore it is an adjusting event and it should be adjusted for.
22.3
END OF CHAPTER
22.8
Cash flow statements


Differentiate between profit and cash flows and understand the need for management to control cash flow. Recognise the benefits and drawbacks to users of the financial statements of a cash flow statement. Classify the effect of transactions on cash flows and how they should be treated in a company's cash flow statement. Calculate the figures needed for the cash flow statement including cash flows from operating, investing and financing activities. Calculate the cash flow from operating activities using the direct and indirect method. Prepare extracts from cash flow statements from given information.
Exam Context
Questions on this chapter are likely to focus on whether you can identify which items should and should not go into the cash flow statement and also on performing basic calculations. For example, you may be asked to calculate figures such as the cash generated from operations from given information or the cash paid to acquire property, plant and equipment.
The knowledge covered in this chapter is developed in the Fundamentals level paper Financial Reporting (F7) where you will have to produce a cash flow statement in full. This is likely to involve more complex areas such as cash flows related to non-current assets held on finance leases. You will also need to be able to interpret a cash flow. Group cash flows are examined in the Professional level paper Corporate Reporting (P2).
Business Context
The ability to generate cash is key to the survival of an entity. Whilst directors may use cash budgets to estimate future cash flows, the cash flow statement shows an historic record of how cash has been generated and where it was spent. Cash is not subject to manipulation through an entity's choice of accounting policies. It is therefore a reliable measure of performance that is relevant to users of the financial statements.
23.1
23: CASH FLOW STATEMENTS
Overview
Cash
Cash equivalents
Cash flows
Cash flow statements
IAS 7
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
Indirect method
Direct method
23.2
1
1.1
Purpose
To show the effect of a companys commercial transactions on its cash balance. It is thought that users of accounts can readily understand cash flows, as opposed to income statements and balance sheets which are subject to manipulation by the use of different accounting policies. Cash flows are used as an investment appraisal method such as net present value and hence a cash flow statement gives potential investors a method with which to evaluate a business.
2
2.1
IAS 7: Cash flow statements

IAS 7 splits cash flows into the following headings: Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities
Definitions
2.2 (a) Cash (b) Cash equivalents
cash on hand demand deposits
short term, highly liquid investments readily convertible to known amounts of cash insignificant risk of changes in value
eg current asset investments (shares) (c) Cash flows
inflows and outflows of cash and cash equivalents
23.3
23: CASH FLOW STATEMENTS 2.3 XYZ CO Cash flow statement for the year ended 31 December 20X7 (indirect method) $000 Cash flows from operating activities Profit before taxation Adjustment for: Depreciation 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 Proceeds from sale of equipment Interest received Dividends received Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings Dividends paid* Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period * This could also be shown as an operating cash flow. 250 250 (1,290) (790) 110 120 230 (900) 20 200 200 (480) 3,390 450 (500) 400 3,740 (500) 1,050 (1,740) 2,550 (270) (900) 1,380 $000
23.4
3
3.1
Section 1.7.1
Cash flows from operating activities

These represent cash flows derived from operating or trading activities. An entity should report cash flows from operating activities using either: (a) (b) The direct method, whereby major classes of gross cash receipts and payments are disclosed (preferred method per IAS 7 see Section 6.1), or The indirect method (as above), whereby reported profit or loss is adjusted for the effects of transactions of a non cash nature, any accruals or prepayments of operating expenses, and items relating to investing or financing cash flows.
Income taxes paid

3.2 Income taxes paid may need to be calculated from other data given to you. This is best achieved by putting the relevant figures into a 'T' account working.
Lecture example 1
In the balance sheets of Tacks Co as at 31 December 20X9 and 31 December 20X8 were the following amounts for income tax payable. 31 December 20X9 20X8 $ $ 156,000 168,000
Income tax payable The income statement tax charge for 20X9 amounted to $104,000. Required What is the amount of income taxes paid during the year? Workings Income tax payable $'000 $
$'000
23.5
4
4.1
Section 1.7.2
Cash flows from investing activities

The cash flows included in this section are those related to the acquisition or disposal of any non-current assets or investments together with returns received in cash from investments, i.e. dividends and interest. This section shows the extent to which expenditures have been made for resources intended to generate future income and cash flows.
Lecture example 2
On 31 December 20X8 the value of plant and equipment in the books of Erosion Co was as follows: Plant and equipment at cost Accumulated depreciation Plant and equipment at net book value
$ 200,000 80,000 120,000
On 1 January 20X9 an item of plant was sold for $8,000 which had originally cost $20,000 when new, but had a net book value of $11,000 at the time of sale. (The balance sheet values shown above do not show that this sale has taken place.) On 31 December 20X9 the value of plant and equipment in the balance sheet was: Plant and equipment at cost Accumulated depreciation Plant and equipment at net book value Required Show the relevant entries for property, plant and equipment which would appear in a cash flow statement for Erosion Co in 20X9. $ 280,000 111,000 169,000
Solution
Workings Plant & equipment cost $'000 $'000
Accumulated depreciation $'000
$'000
23.6
5
5.1
Section 1.7.3
Cash flows from financing activities

Financing cash flows comprise receipts from or repayments to external providers of finance in respect of principal amounts of finance. Examples of financing cash flows are:

Cash proceeds from issuing shares Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long term borrowings Cash repayments of amounts borrowed Dividends paid to shareholders
In order to calculate such figures the closing balance sheet figure for debt or share capital and share premium is compared with the opening position for the same items.
Dividends paid
5.2 The cash outflows included in dividends paid are dividends paid on the reporting company's equity shares.
Lecture example 3
20X9 $'000 45
Distribution Co balance sheet extract for the year ended 31 December 20X9 20X8 $'000 35
Dividends payable Dividends charged to retained earnings were $60,000. Required
What are the dividends paid during the year ended 31 December 20X9? Workings Dividends payable $'000
$'000
23.7
Lecture example 4
Balance sheets as at 31 December 20X8 $'000 Non-current assets Property, plant and equipment Current assets: Inventories Trade receivables Cash 628 214 168 7 389 1,017 250 70 110 314 744 80 136 39 18 193 1,017
Technique question
The summarised accounts of the Emma Co for the year ended 31 December 20X8 are as follows: 20X7 $'000 514 210 147 357 871 200 60 100 282 642 50 121 28 16 14 179 871 $'000 600 319 281 186 8 87 31 56
Equity Share capital ($1 ordinary shares) Share premium account Revaluation reserve Retained earnings Non-current liabilities 10% debentures Current liabilities Trade payables Income tax payable Dividends payable Overdraft
Income statement for the year ended 31 December 20X8 Revenue Cost of sales Gross profit Other expenses (including depreciation of $42,000) Finance costs (interest paid) Profit before tax Income tax expense Profit for the period
23.8
23: CASH FLOW STATEMENTS Statement of changes in equity (extract) Balance at 31 December 20X7 Profit for the period Dividends Balance at 31 December 20X8 Retained earnings $000 282 56 (24) 314
You are additionally informed that there have been no disposals of property, plant and equipment during the year. The new debentures were issued on 1 January 20X8. Required Produce a cash flow statement for Emma Co for the year ended 31 December 20X8.
Solution
EMMA CO
Cash flow statement for the year ended 31 December 20X8
$000 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation Interest expense Increase in trade receivables Increase in inventories Increase 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 Net cash used in investing activities Cash flows from financing activities Proceeds from issue of shares Proceeds from issue of debentures Dividends paid Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year
$000
23.9
23: CASH FLOW STATEMENTS Workings
23.10
6
6.1
Cash flows from operating activities using the direct method

As noted in Section 3.1, IAS 7 has two methods available under which the cash flow statement can be prepared:

indirect method (seen previously) direct method
6.2
The only difference is the direct method derives the 'cash generated from operations' figure in a different way. The operating element of the cash flow statement should be shown as follows: $000 Cash flows from operating activities Cash receipts from customers Cash payments to suppliers and employees Cash generated from operations Interest paid Income taxes paid Net cash from operating activities 30,150 (27,600) 2,550 (270) (900) 1,380 $000
Cash received from customers

6.3 This represents cash flows received during the accounting period in respect of sales.
Cash payments to suppliers and employees

6.4 This represents cash flows made during the accounting period in respect of goods and services and amounts paid to employees.
23.11
Lecture example 5
Required
Technique question
Using the information in Lecture example 4 produce the 'cash flows from operating activities' section of the cash flow statement using the direct method.
Solution
EMMA CO Cash flow statement for year ended 31 December 20X8 (extract) $ Cash flows from operating activities Cash receipts from customers Cash payments to suppliers and employees Cash generated from operations Interest paid Income taxes paid Net cash used in operating activities $
23.12
7
7.1
Quick Quiz
The cash flow statement shows the movement between a companys cash and cash equivalents at the beginning and the end of the year. Cash comprises cash on hand and on demand deposits. Cash equivalents are short term, highly liquid investments such as shares held as a current asset investment. The cash flow categorises cash flows under one of three headings: cash flows from operating activities; cash flows from investing activities and cash flows from financing activities.
7.2 7.3
23.13
23.14
23.15
23: QUESTIONS
23.1
In a cash flow statement which of the items below would not appear as an outflow of cash? A B C The nominal value of debenture redeemed at par during the year The dividends paid to preference shareholders during the year The income statement charge for tax for the year (1 mark)

Extracts from a companys balance sheets show the following items of property, plant and equipment at net book value: 30 June 20X7 $ Property, plant and equipment Freehold property Plant and equipment Furniture and fixtures 1,230,000 465,000 90,000 20X6 $ 750,000 380,000 105,000
The building element of the freehold property was depreciated by $6,000 and then revalued on 30 June 20X7 by $95,000. Plant and equipment, which had cost $49,000 when purchased in January 20X2 on which $35,000 of depreciation had been charged, was disposed of in November 20X6 for $8,000. Depreciation on the plant and equipment for the year amounted to $37,000. Depreciation of $55,000 has been charged on furniture and fixtures. 23.2 23.3 23.4 What is the total figure to be adjusted for in cash flows from operating activities in respect of property, plant and equipment? $ (2 marks) What is the total expenditure on property, plant and equipment included under cash flows from investing activities? $ (2 marks) In a cash flow statement, a decrease in loan stock would be shown as a cash inflow under 'cash flows from financing activities'. A B 23.5 True False (1 mark)
These extracts have been taken from the accounts of Jeanne Co. Balance sheet (extracts) Current liabilities Dividends payable Dividends charged to retained earnings during the year were $15,500. What will appear as dividends paid in the cash flow statement for the year ended 31 October 20X7? A B C D $5,750 $11,500 $15,500 $21,250 (2 marks) 31 October 20X7 9,750 31 October 20X6 5,750
23.16
23: QUESTIONS
23.6
Jane Co Income statement for the year ended 31 December 20X2 Revenue Cost of sales Gross profit Distribution costs Administrative expenses Investment income Finance costs Profit before tax Income tax expense Profit for the period Balance sheet as at 31 December Non-current assets Property, plant and equipment Development expenditure Investments Current assets Inventories Trade receivables Short-term investments Cash in hand Total assets Equity Share capital ($1 ordinary shares) Share premium account Revaluation reserve Retained earnings Non-current liabilities Long term loan Current liabilities Trade payables Bank overdraft Income tax payable Dividends payable Total equity and liabilities 20X7 $000 380 250 630 150 390 50 2 592 1,222 200 160 100 160 620 100 127 85 190 100 502 1,222 $000 2,553 1,814 739 125 264 25 75 300 140 160 20X6 $000 305 200 25 530 102 315 1 418 948 150 150 91 100 491 119 98 160 80 457 948
23.17
23: QUESTIONS
The following information is available: (a) (b) (c) (d) The proceeds of the sale of non-current asset investments amounted to $30,000; Furniture and fixtures, with an original cost of $85,000 and a net book value of $45,000, were sold for $32,000 during the year; The current asset investments fall within the definition of cash equivalents under IAS 7; The following information relates to property, plant and equipment: 20X7 $000 720 340 380 20X6 $000 595 290 305
Cost Accumulated depreciation Net book value (e) (f) (g)
50,000 $1 ordinary shares were issued during the year at a premium of 20c per share; Dividends charged to retained earnings were $100,000 in 20X7; Development expenditure has not yet started being amortised.
Required Prepare a cash flow statement for the year to 31 December 20X7.
23.18
Chapter 23: Answers
23.19
23: ANSWERS
23.1
Income tax paid is a cash flow not the income statement tax charge.
23.2 $104,000 Property, plant and equipment Bal b/d Freehold property Plant & Equipment Furniture & Fixtures $000 750 380 105 $000 Disposal Plant & Equipment (49 35) Depreciation Freehold property 6 Plant & Equipment 37 Furniture & Fixtures 55 Bal c/d Freehold property Plant & Equipment Furniture & Fixtures 14
Revaluation Freehold property Acquisitions
95 567 1,897
98 1,230 465 90 1,897 $000 98 6 104
Total adjustments in the reconciliation: Depreciation Loss on disposal of plant and equipment (8 14) 23.3 $567,000 See previous calculation 23.4 B Dividends payable $ Balance b/d Paid Balance c/d 11,500 Retained earnings 9,750 21,250
23.5 B
$ 5,750 15,500 21,250
23.20
23: ANSWERS
23.6
Jane Co Cash flow statement for the year ended 31 December 20X7 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation (W2) Loss on sale of property, plant and equipment (45 32) Profit on sale of non-current asset investments (30 25) Investment income Finance costs Increase in trade receivables (390 315) Increase in inventories (150 102) Increase in trade payables (127 119) Cash generated from operations Interest received Interest paid Income taxes paid (W4) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W1) Proceeds from sale of property, plant and equipment Proceeds from sale of non-current asset investments Payments for development expenditure (W3) Net cash used in investing activities Cash flows from financing activities Proceeds from issue of ordinary share capital Proceeds from long term loan Dividends paid (W5) Net cash from financing activities Increase in cash and cash equivalents Cash and cash equivalents at beginning of period (1 98) Cash and cash equivalents at end of period (50 + 2 85) Workings (W1) Property, plant and equipment cost Balance b/d Revaluation (100 91) Additions (bal fig) $000 595 9 201 805 Disposals Balance c/d $000 85 720 805 60 100 (80) 80 64 (97) (33) (201) 32 30 (50) (189) $000 300 90 13 (5) (25) 75 448 (75) (48) 8 333 25 (75) (110) 173 $000
(W2) Property, plant and equipment - Accumulated depreciation Disposals (85 45) Balance c/d $000 40 340 380 Balance b/d Depreciation charge $000 290 90 380
23.21
23: ANSWERS
(W3) Development expenditure Balance b/d additions $000 200 50 250 $000 Balance c/d 250 250
(W4) Income tax payable Income tax paid Balance c/d $000 110 190 300 Balance b/d Income statement $000 160 140 300
(W5) Dividends payable Dividends paid Balance c/d $000 80 100 180 Balance b/d Retained earnings $000 80 100 180
END OF CHAPTER
23.22
Home study chapter Information technology


Understanding the basic function and form of accounting records in manual and computerised systems. Compare manual and computerised systems and identify advantages and disadvantages of computerised accounting systems. Understand the uses of integrated accounting software packages. Understand business use of computers and the nature and purpose of spreadsheets and database systems.
Exam Context
Questions on this topic are likely to focus on the advantages and disadvantages of using a computerised system and the differences between a manual and a computerised system.
The importance of accounting systems and internal controls is tested in the Fundamentals level paper, Accountant in Business (F1).
24.1
24: HOME STUDY CHAPTER INFORMATION TECHNOLOGY
Overview
Integrated software
Computerised accounting packages
Accounting modules
Information technology
Databases
Spreadsheets
24.2
1
1.1 1.2
Introduction
In today's world most businesses use accounting systems which are computerised, although some smaller businesses may keep manual records. The same principles of double entry are used regardless of whether an accounting system is manual or computerised.
2
2.1
Accounting packages
There are two main types of computerised accounting packages: (a) (b) Dedicated accounting packages, for example SAGE. General software, for example spreadsheets which can be used to keep accounting records.
2.2
Advantages and disadvantages of computerised accounting packages. Advantages (1) Large amounts of data can be processed very quickly (2) Computerised systems are more accurate (3) Large volumes of data can be processed (4) Little training is required (5) Computer can analyse data into tailored reports Disadvantages (1) Time and cost in setting up the system and staff training (2) Need for internal controls and security checks to ensure the accuracy of data (3) Lack of 'audit trail' (4) Staff may resist the introduction of a computerised system
3
3.1 3.2
Accounting modules
Accounting module a program which deals with one part of a business' accounting system Examples of modules include: (a) (b) (c) (d) (e) (f) Invoicing Receivables ledger Nominal ledger Payroll Cash book Non-current asset register
Definition
24.3
Integrated software
3.3
Section 1.5
Each module may be integrated with other modules so that when information is recorded in one module it is automatically updated in another module. Examples: (a) The payroll module may be integrated with the nominal ledger module so that once the payroll information is determined the associated wages expense is updated in the nominal ledger. The invoicing module may be integrated with the inventory, receivables ledger and nominal ledger modules so that once an invoice is sent the inventory levels are updated as is the customer's account in the receivables ledger.
(b)
3.4
Advantages and disadvantages of integrated software. Advantages (1) An entry in one module automatically updates all the others Reports generated by the system can draw information from all relevant modules Reduction in clerical time used to input information and errors Disadvantages (1) These systems require more memory than a stand-alone system so there is less space to store actual data Each module may be limited to fewer functions than a specialised module (because one program is doing everything) An error in one part of the system will flow through to all areas
(2)
(2)
(3)
(3)
4
4.1 4.2
Databases
A database is a 'pool of data' which can be used by any number of applications. Examples: (a) (b) (c) Non-current asset register List of customers/suppliers Price lists
Definition
24.4
Lecture example 1
Idea generation
What sort of information might be contained in a database file for a non-current asset register?
Solution
4.3
A database should have four major objectives. (a) (b) (c) different individuals should be able to access the same information Its integrity must be preserved only valid alterations to information should be made It should meet the needs of different users. For example, the accounts department may be interested predominantly in the net book value of the non-current assets but the production manager will need to know their whereabouts in order to schedule jobs efficiently (d) The database must be able to grow and develop according to the needs of the business It should be shared
5
5.1 5.2
Spreadsheets
Spreadsheets are essentially an electronic piece of paper. They are used in all parts of a business, predominantly to perform numerical calculations. Uses of spreadsheets by the accounting function: (a) (b) (c) (d) To maintain accounting records, for example a cash book To produce financial statements To produce budgets/forecasts To conduct variance analysis
24.5
6
Quick Quiz
There are two main types of accounting packages: dedicated packages and general software. An accounting module is a program which deals with one part of a business accounting system. These modules may or may not be integrated with other modules. Databases and spreadsheets are electronic ways of holding and manipulating information.
6.1 6.2 6.3
24.6
24.7
24: QUESTIONS
24.1
All businesses will apply the same principles of double entry bookkeeping regardless of whether they operate a manual or a computerised system. Is this statement true or false? A B True False (1 mark)
24.2
If a database is to contain accurate and valid information it should only be amended by authorised personnel. Is this statement true or false? A B True False (1 mark)
24.8
Chapter 24: Answers
24.9
24: ANSWERS
24.1 24.2
A A
END OF CHAPTER
24.10
Answers to Lecture Examples
25.1
25: ANSWERS TO LECTURE EXAMPLES
Chapter 1
Answer to Lecture Example 1
Users of financial information (a) Investors (b) (c) (d) (e) (f) (g) Profitability Future prospects Likely risk and return Chance of capital growth Ability to pay dividends Profitability Long-term growth Security of their job Likelihood of bonus Number of employees Ability to pay retirement benefits Whether return on finance will continue to be met Other providers and security of their debt Likelihood of repayment of capital amount Likelihood of payment on time Likelihood of payment at all Whether they should continue to supply Ability of entity to continue supplying Profitability as a measure of value for money of goods bought Statistics Size of company Growth rates Average payment periods Foreign trade Profits made Corporate income tax liability Sales tax liability Contribution to local economy Information about trends in the prosperity of the entity Range of activities provided
Employees
Lenders
Suppliers
Customers
Government and their agencies
Public
25.2
Chapter 2
A The IASCF appoints members to the IASB, IFRIC and SAC. The SAC advises the IASB on its agenda.

A
Chapter 3
Advantages of historic cost (1) (2) (3) The transaction cost of $1 million is a very reliable figure which was quantified at the date of acquisition. Using current market values for the building may lead to volatility in asset values due to changing market prices. Any change in the asset's value will affect the amount of depreciation charged and therefore the entity's profits. This makes comparability more difficult. Asset values generally appreciate over time and so using historic cost will mean that the financial statements contain information which is out of date and therefore less useful for decision making. Sales revenue and costs will be shown at current prices but depreciation will be based on historic cost and therefore too low a figure. Profits will therefore look artificially high.
Disadvantages of historic cost (1) (2)

(a) (b) Historic cost is $1,000 Net realisable value is Selling price (100 $11) Less: completion costs (100 $2) (c) Show inventory at the lower of cost and net realisable value = $900. $ 1,100 (200) 900
25.3
Chapter 4
Own Examples: (i) (ii) (iii) Owe Examples: (i) (ii) (iii) Mortgage Car loan Credit card House Car Cash
Chapter 5
Transaction (a) (b) (c) (d) (e) (f) (g) (h) Sales for cash Sales on credit Purchases for cash Purchases on credit Pay electricity bill Receive cash from a credit customer Pay cash to a credit supplier Borrow money from the bank Debit Cash increase asset Receivables increase asset Purchases expense Purchases expense Electricity expense Cash increase assets Payables decrease liability Cash increase asset Credit Sales income Sales income Cash decrease asset Payables increase liability Cash decrease asset Receivables decrease assets Cash decrease asset Loan increase liability
25.4

Cash Capital Sales $ 5,000 2,100 Rent Electricity Car Drawings $ 500 200 1,000 300 $ 5,000 $ 2,000 $
Capital $ Cash
Trade payables $ Purchases Purchases $ 2,000 Rent Cash $ 500 Electricity $ 200 Car Cash $ 1,000 Drawings $ 300 Trade receivables $ 1,750 Sales $ Trade receivables Cash
Trade payables
Cash
Cash
Sales
$ 1,750 2,100

Dr 2/1 10/1 Sales Sales $ 500 500 1,000 Bal b/d 650 Cash 1/1 Purchases 25/1 Telephone Bal c/d $ 300 50 650 1,000 Cr
25.5

Cash Capital Sales $ 5,000 2,100 Rent Electricity Car Drawings Bal c/d $ 500 200 1,000 300 5,100 7,100
7,100 Bal b/d 5,100
Capital Bal c/d $ 5,000 5,000 Cash Bal b/d Trade payables $ 2,000 Purchases 2,000 Bal b/d Purchases $ 2,000 Bal c/d 2,000 Rent Cash Bal b/d $ 500 500 Electricity Cash Bal b/d $ 200 200 Car Cash Bal b/d $ 1,000 1,000 Drawings $ 300 Bal c/d 300 Trade receivables $ 1,750 Bal c/d 1,750 $ 1,750 $ 300 Bal c/d $ 1,000 Bal c/d $ 200 Bal c/d $ 500 $ 5,000 5,000 5,000 $ 2,000 2,000 2,000 $ 2,000
Bal c/d
Trade Payables Bal b/d
Cash Bal b/d
Sales Bal b/d
25.6
Sales Bal c/d $ 3,850 3,850 Bal b/d Trade receivables Cash $ 1,750 2,100 3,850 3,850
Chapter 6
Trial Balance Cash Capital Trade payables Purchases Rent Electricity Car Drawings Trade receivables Sales Purchases $ 2,000 Bal c/d 2,000 $ 500 500 $ 200 200 $ 3,850 3,850 Income statement 3,850 Income statement Rent Cash Bal b/d Bal c/d Income statement $ 500 500 $ 200 200 $ 1,750 2,100 3,850 3,850 Debit $ 5,100 2,000 500 200 1,000 300 1,750 10,850 Credit $ 5,000 2,000
3,850 10,850 $ 2,000 2,000
Creditors Bal b/d
Electricity Cash Bal b/d Bal c/d Income statement Sales Bal c/d Trade receivables Cash Bal b/d
25.7

Colin Income Statement Sales (20 telephones) Cost of sales Purchases (50 telephones) Less: closing inventories (30 telephones) Gross profit $ 1,000 (600) 400 200 $ 600

Purchases Gross profit c/d Rent Electricity Net profit c/d Income Statement $ 2,000 Sales 2,100 Closing inventory 4,100 500 Gross profit b/d 200 1,400 2,100 Net profit b/d $ 3,850 250 4,100 2,100 2,100 1,400

(e) DOUGLAS INCOME STATEMENT FOR THE MONTH OF JANUARY Sales Less cost of sales: Purchases Less: closing inventories Gross profit Less expenses: Rent Electricity Net profit 500 200 (700) 1,400 $ $ 3,850
2,000 ( 250) 1,750 2,100
25.8
DOUGLAS BALANCE SHEET AS AT 31 JANUARY NON-CURRENT ASSET Motor vehicle CURRENT ASSETS Inventories Trade receivables Cash $ $ 1,000
250 1,750 5,100
7,100 8,100 $
PROPRIETORS INTEREST Capital introduced on 1 January Profit for the year Less: drawings Balance 31 January CURRENT LIABILITIES Trade payables
$ 5,000 1,400 300
6,100 2,000 8,100

Cash Bal b/d Drawings $ 300 Bal c/d 300 Capital Income statement $ 2,000 Sales 2,100 Closing inventory 4,100 500 Gross profit b/d 200 1,400 2,100 1,400 Net profit b/d Capital Balance c/d Drawings Balance c/d $ 5,000 300 6,100 6,400 Cash Balance b/d Net profit Balance b/d $ 5,000 5,000 1,400 6,400 6,100 $ 300 300 $ 3,850 250 4,100 2,100 2,100 1,400
Purchases Gross profit c/d Rent Electricity Net profit c/d Capital

Assets = capital + (profit drawings) + payables 8,100 = 5,000 + (1,400 300) + 2,000
25.9
Chapter 7
Answer to Exercise
(1) (2) Factory buys raw material Manufactures goods and sells to wholesaler Net $ 100 250 Sales tax $ 15.00 Gross $ 115.00
287.50 37.50 22.50 Due to sales tax authority

Purchases $ Trade payables 1,000 Trade payables Purchases $ 1,150
Trade receivables Sales $ 1,725 Trade payables
Sales tax control a/c $ 150 Trade rec. $ 225
Sales $ Trade rec. $ 1,500
Chapter 8
C Transport costs to deliver goods to customers are an example of carriage outwards and should not be included. Administrative overheads do not relate to production and cannot therefore be included. The depreciation of the factory machine is a production overhead and should be included.

Net realisable value is: Estimated selling price Less: costs of completion Less: selling costs $ 35 (12) (1) 22
25.10

(a) Closing inventories (FIFO) Purchases Opening inventories 200 Sales 14 Jan 21 Jan 28 Jan (200) Nil 10 Jan 300 (80) (220) Nil 20 Jan 350 (180) (80) Nil @ $11.50 = $1,035 $4,285 Cost of sales (FIFO) Opening inventories (200 x $10) Purchases Less: closing inventories (b) Closing inventories and cost of sales (AVCO) Units 1.1.X2 10.1.X2 14.1.X2 20.1.X2 21.1.X2 25.1.X2 28.1.X2
$5,255 500
25 Jan 250
250 @ $13.00 = $3,250
$ 2,000 10,530 12,530 (4,285) 8,245 Average Unit Cost $ Total Cost $ 2,000 3,255 5,255 (2,943) 2,312 4,025 6,337 (4,448) 1,889 3,250 5,139 (979) 4,160
$5,139 420 = $12.24
b/f Purchase Sale Purchase Sale Purchase Sale
200 300 500 (280) 220 350 570 (400) 170 250 420 (80) 340 (W2)
$6,337 570
Cost $ 10.00 10.85
Cost of Sales $
(W1) 10.51 10.51 11.50 (W2) 11.12 11.12 13.00
2,943
4,448
(W3) 12.24 12.24
979 8,370
(W1)
= $10.51
= $11.12
(W3)
25.11
Chapter 9
Examples include: (a) (b) (c) (d) Land and buildings Plant and equipment Motor vehicles Furniture and fittings, computers

B The cost capitalised should include the purchase price ($20,000) plus all directly attributable costs (delivery and installation). The cost of the maintenance contract should be shown as an expense in the income statement.

Straight line method: (a) Depreciation charge = = (b) Year 1 2 3 Cost $ 2,500 2,500 2,500 $2,500 - $250 3 years $750 per annum Accumulated depreciation $ 750 1,500 2,250 NBV $ 1,750 1,000 250

Reducing balance method: NBV b/d Year 1 Year 2 Year 3 (6,000 0) (6,000 2,400) (6,000 3,840) Depn rate 40% 40% 40% Depn expense $ 2,400 1,440 864 Accumulated depreciation $ 2,400 3,840 4,704 NBV c/d $ 3,600 2,160 1,296

(a) Journal entry Depreciation expense Accumulated depreciation Being annual depreciation charged on machine Debit $ 750 Credit $ 750
25.12
(b)
Accounting for depreciation: Machine (B/S) $ Cash Bal b/d 2,500 2,500 2,500 Bal c/d $ 2,500 2,500
Depreciation expense (I/S) $ Year 1 Year 2 Year 3 Accumulated depn Accumulated depn Accumulated depn 750 750 750 Year 1 Year 2 Year 3 I/S I/S I/S $ 750 750 750
Accumulated depreciation (B/S) $ Bal c/d Bal c/d 750 1,500 1,500 Bal c/d 2,250 2,250 (c) Income statement (extracts): Year 1 $ Expenses Depreciation Balance sheet (extracts): Cost (Year 1) (Year 2) (Year 3) Machine Machine Machine $ 2,500 2,500 2,500 Accumulated Depreciation $ (750) (1,500) (2,250) Net Book Value $ 1,750 1,000 250 750 Year 2 $ 750 Year 3 $ 750 Year 3 Bal b/d Depreciation expense Year 1 Year 2 Depreciation expense Bal b/d Depreciation expense $ 750 750 750 1,500 1,500 750 2,250
25.13

(a) Sales proceeds NBV at end of year 2 (b) Machine (B/S) Bal b/d $ 6,000 (a) Disposal account $ 6,000 $ 3,000 (2,160) 840
Accumulated depreciation (B/S) $ (b) Disposal account 3,840 Bal b/d $ 3,840
Disposal account (a) Machine Balance = profit on disposal (I/S) $ 6,000 840 (b) 6,840 Accumulated depn 3,840 6,840 (c) Cash $ 3,000

(a) (b) The profit on disposal is still $840, the only difference is that the proceeds were not received in cash, but in the form of a part exchange allowance. Cash paid for the new machine is $7,000 ($10,000 $3,000) Old machine (B/S) Bal b/d $ 6,000 (a) Disposal account $ 6,000
Accumulated depreciation (B/S) (b) Disposal account $ 3,840 Bal b/d $ 3,840
New machine (B/S) (c) Disposal account Cash Bal b/d $ 3,000 7,000 10,000 10,000 Bal c/d $ 10,000 10,000
25.14
Disposal account (a) Machine Profit on disposal (I/S) $ 6,000 840 6,840 (c) (b) New machine (part exchange) Accumulated depreciation $ 3,000 3,840 6,840

(a) The double entry is Dr Dr Cr Non-current asset building (150 100) Accumulated depreciation building Revaluation reserve () Building (B/S) Bal b/d Revaluation reserve Bal b/d $ 100,000 50,000 150,000 150,000 $ Bal c/d 150,000 150,000 $ 50,000 20,000 $ 70,000
Revaluation reserve
Accumulated depreciation (B/S) $ 20,000 Bal b/d Revaluation reserve (B/S) $ Building Accumulated depreciation Bal b/d
$ 20,000
Bal c/d
70,000 70,000
$ 50,000 20,000 70,000 70,000
(b)
Depreciation charge is
$150,000 = $3,750 40 years

Review of useful life: Year 20X1 20X2 20X3 20X4
40,000 5 40,000 5 24,000 2 24,000 2
= = = =
Depreciation charge $ 8,000 8,000 12,000 12,000 40,000
Accumulated depreciation $ 8,000 16,000 28,000 40,000
NBV $ 32,000 24,000 12,000 0
25.15

Change in method of depreciation: Depreciation charge $ 10,000 7,500 7,000 7,000 7,000 38,500 Accumulated depreciation $ 10,000 17,500 24,500 31,500 38,500 NBV $ 30,000 22,500 15,500 8,500 1,500
20X1 20X2 20X3 20X4 20X5
40,000 25% 30,000 25% 22,500 - 1,500 3
Chapter 10
(1) Market research would take place at an early stage in any development process. Its purpose is to gather information about whether there may be interest in a potential product. At this point in time an entity cannot be certain that the expenditure will lead to profits and so the costs are research costs. $20,000 should be shown as an expense in the income statement. A machine is a tangible non-current asset and is accounted for under IAS 16 regardless of its use. The $100,000 should be capitalised as a tangible non-current asset and depreciated over its useful life of 10 years. Material costs and design and manufacture salaries are part of the development process. They should be capitalised as an intangible non-current asset provided that all of the 'PIRATE' criteria are met. The costs should be amortised in 20X9 once the car is available to be sold on the market.
(2)
(3)

Income statement extracts Expenses Research expenditure Amortisation of development expenditure X1 $ 35,000 X2 $ X3 $ 40,000 X4 $ 40,000 X5 $ 38,000 40,000
Balance sheet extracts Non-current assets Development expenditure Amortisation Net book value
X1 $ 55,000 55,000
X2 $ 120,000 120,000
X3 $ 120,000 (40,000) 80,000
X4 $ 120,000 (80,000) 40,000
X5 $ 120,000 (120,000)
25.16
Chapter 11
(a) Electricity expense Cash paid: 10.3.X7 12.6.X7 14.9.X7 10.12.X7 December expense missing ( 1 $168)
3
$ 96 120 104 145 465 56 521 $ Rent expense Cash paid: 1.2.X7 6.4.X7
12
Less: expense relating to Jan March ( 3 $1,584) (b) & (c) Electricity accrual is $56 Dr Electricity expense (I/S) Cr Accruals (B/S) Being: electricity expense accrued at 31 December 20X7. Rent prepayment is $396 Dr Prepayments (B/S) Cr Rent expense (I/S) Being: rent expense prepaid at 31 December 20X7. $ 396 $ 56
375 1,584 1,959 (396) 1,563
$ 56
$ 396

Electricity expense (I/S) 10.3.X7 12.6.X7 14.9.X7 10.12.X7 31.12.X7 Cash Cash Cash Cash Accruals $ 96 120 104 145 56 521 $
31.12.X7
Transfer to income statement
521 521
25.17
Rent expense (I/S) 1.2.X7 6.4.X7 Cash Cash $ 375 1,584 $ 31.12.X7 31.12.X7 1,959 Accruals (B/S) 31.12.X7 Bal c/d $ 56 56 31.12.X7 1.1.X8 Prepayments (B/S) 31.12.X7 1.1.X8 Rent Bal b/d $ 396 31.12.X7 396 396 Bal c/d $ 396 396 Electricity Bal b/d $ 56 56 56 Transfer to income statement Prepayments 1,563 396 1,959

Working Electricity expense (I/S) 12.3.X8 9.6.X8 12.9.X8 12.12.X8 31.12.X8 Cash Cash Cash Cash Accrual ( 13 $189) $ 168 134 118 158 63 641 Accruals (B/S) 1.1.X8 31.12.X8 Accrual reversed Bal c/d $ 56 63 119 1.1.X8 31.12.X8 1.1.X9 Bal b/d Electricity accrual (W) Bal b/d $ 56 63 119 63 1.1.X8 31.12.X8 Accrual reversed To Income statement $ 56 585
641

B Insurance expense July X6 August X6 ( 212 $24,000) Sept X6 June X7 ( 1012 $30,000) Prepayment 1 June X7 paid ( Less: June X7 (
1 $30,000) 4 1 $7,500) 3
$ 4,000 25,000 29,000 7,500 (2,500) 5,000
25.18
Chapter 12
(a) (b) The balance c/d on the trade receivables account at the end of the year is $50,000. The bad debt expense shown in the I/S is $15,000 Trade receivables (B/S) 31.12.X7 Bal b/d $ 65,000 $ 31.12.X7 31.12.X7 Bad debt expense (Ali $7,000) (Tyson $8,000) Bal c/d 15,000 50,000 65,000
Workings
65,000
Bad debt expense (I/S) $ 31.12.X7 Trade receivables 15,000 31.12.X7 To I/S $ 15,000

Allowance for receivables: (a) (b) The allowance for receivables shown on the balance sheet is $3,500 The doubtful debts expense shown in the I/S is $3,500 Allowance for receivables (B/S) $ Bal c/d 3,500 Doubtful debts expense $ 3,500
Working
Doubtful debts expense (I/S) $ Allowance for receivables Income statement extract Expenses Bad debts (see Lecture Example 1) Doubtful debts expense Balance sheet extract Current assets Trade receivables Less: allowance for receivables 50,000 (3,500) 46,500 3,500 I/S $ 3,500
$ (15,000) (3,500) $
25.19

(a) (b) The allowance for receivables shown in the balance sheet is $1,334 The bad and doubtful debts expense shown in the income statement is $1,674. Trade receivables (B/S) Bal b/d $ 47,440 47,440 Bal b/d 47,100 Allowance for receivables (B/S) Bal c/d Specific General (W) $ 400 934 Bad and doubtful debts expense $ 1,334 Bad & doubtful debts expense Bal c/d $ 340 47,100 47,100
1,334 1,334 Bal b/d
1,334 1,334
Bad and doubtful debts expense (I/S) Trade receivables Allowance for receivables Working (W) General allowance: Trade receivables (net of bad debts written off) Less: specific allowance $ 47,100 (400) 46,700 2% = $934 $ 340 1,334 1,674 $ I/S 1,674 1,674

Bad debts recovered: Trade receivables (B/S) $ 1.1.X8 Bal b/d 50,000 $
Bad debt expense (I/S) $ I/S 7,000 Cash $ 7,000
25.20
Cash (B/S) $ Bad debt expense 7,000

Specific allowance recovered: Trade receivables (B/S) Bal b/d $ 50,000 50,000 Allowance for receivables (B/S) $ (b) Doubtful debts expense 3,500 Bal b/d $ 3,500 (a) Cash Bal c/d $ 3,500 46,500 50,000
Bad and doubtful debts expense (I/S) $ I/S 3,500 (b) Allowance for doubtful debts $ 3,500

$ Dr Cr Allowance for receivables Trade receivables 3,500 $ 3,500

Changes in general allowance: The doubtful debts expense in 20X8 is $500 [(30,000 x 5%) (20,000 x 5%)] Long method Allowance for receivables (B/S) (a) Doubtful debts expense (20,000 5%) Bal c/d $ 1,000 1,500 2,500 (ii) 31.3.X7 Bal b/d ($20,000 5%) $ 1,000
31.3.X8 Doubtful debts expense ($30,000 5%) 1,500 2,500
25.21
Doubtful debts expense (I/S) (ii) Allowance for receivables $ 1,500 1,500 (a) Allowance for receivables I/S $ 1,000 500 1,500
Short method Allowance for receivables (B/S) $ 31.3.X8 Bal c/d ($30,000 5%) 31.3.X7 Bal b/d ($20,000 5%) Doubtful debts expense (increase in allowance) $ 1,000 500 1,500
1,500 1,500 Doubtful debts expense (I/S) $
$ I/S 500
Allowance for receivables
500

A $13,000 Allowance for receivables $ (1) (2) (3) Write off recovered Write off in 20X8 Change in allowance: At 30.9.X7 At 30.9.X8 Decrease required Income statement $ (2,000) 18,000
24,000 21,000 3,000
(3,000) 13,000
Chapter 13
(a) A provision should be made using expected values: ($1m 20%) + ($6m 5%) = $0.5m Dr Cr (b) Dr Cr Warranty cost expense (I/S) Provisions (B/S) Warranty cost expense (I/S) Provisions (B/S) $0.5m $0.5m $0.25m $0.25m
In 20X8 the provision needs to increase by $0.25m ($0.75m $0.5m). Entry is:
25.22
(c)
In 20X9 the provision needs to decrease by $0.45m ($0.75m $0.3m). Entry is Dr Cr Provisions (B/S) Warranty cost expense (I/S) $0.45m $0.45m
Chapter 14
(1) Books of prime entry Sales day book Date 10 Jan X6 10 Jan X6 Customer Customer A Customer B Amount 150 200 350 Purchase day book Date 15 Jan X6 15 Jan X6 Supplier Supplier Y Supplier Z Amount 100 1,300 1,400 Cash receipts book Date 21 Jan X6 Narrative Customer B Total 200 200 Cash payments book Date 21 Jan X6 Narrative Supplier Y Total 100 100 Memorandum ledgers Receivables ledger Customer A $ 150 Bal c/d 150 150 Customer B $ 200 21.1.X6 Payment received 200 $ 150 150 Purchases Payables 100 100 Sales Receivables 200 200
10.1.X6 Bal b/d
Sales
10.1.X6
Sales
$ 200 200
25.23
Payables ledger Supplier Y $ 100 15.1.X6 Purchases 100 Supplier Z $ 1,300 15.1.X6 Purchases 1,300 (2)&(3) Nominal ledger RLCA (B/S) $ 350 21.1.X6 Bank Bal c/d 350 150 PLCA (B/S) $ 100 15.1.X6 Purchases 1,300 1,400 Bal b/d Bank (B/S) $ 200 21.1.X6 PLCA Bal c/d 200 100 $ I/S (4) Sales (I/S) 10.1.X6 RLCA 350 350 $ 350 350 Purchases (I/S) $ 1,400 1,400 I/S $ 200 150 350 $ 100 100 $ 1,300 1,300
21.1.X6
Payment made
Bal c/d
10.1.X6 Sales Bal b/d
21.1.X6 Bank Bal c/d
$ 1,400 1,400 1,300 $ 100 100 200
21.1.X6 RLCA Bal b/d
$ 1,400 1,400
15.1.X6 PLCA
Reconciliation Balance per list of balances Receivables ledger Customer A Customer B Balance per RLCA Balance per list of balances Payables ledger Supplier Y Supplier Z Balance per PLCA $ 1,300 1,300 1,300 $ 150 150 150
25.24

(a) Sales $ 1.1.X7 RLCA $ 10,000 $ 1.1.X7 Sales 10,000 RLCA (B/S) $
(b) Bank (B/S) 4.1.X7 RLCA $ 9,000 $ $ 1.1.X7 Sales 10,000 RLCA (B/S) $ 4.1.X7 Bank 9,000 Discounts 1,000 allowed 10,000
10,000
Discounts allowed (I/S) 4.1.X7 RLCA (c) Bank $ 4.1.X7 RLCA 10,000 $ RLCA (B/S) $ 1.1.X7 Sales 10,000 10,000 $ 4.1.X7 Bank 10,000 10,000 $ 1,000 $

(a) Purchases PLCA (b) Bank $ Bank $ 4,750 Bank Discounts received PLCA (B/S) $ 4,750 250 5,000 5,000 Purchases $ 5,000 $ 5,000 $ PLCA (B/S) $ Purchases $ 5,000
25.25
Discounts received (I/S) $ PLCA (c) Bank $ PLCA $ 5,000 Bank $ 5,000 Purchases PLCA (B/S) $ 5,000 $ 250

B List price Less: trade discount (12%) Record purchase at this value Less: settlement discount (4%) Calculate sales tax on this value Sales tax at 15% $ 50,000 (6,000) 44,000 (1,760) 42,240 6,336
$50,336

(a) Balance b/d Sales RLCA $ 614,000 Bank 302,600 Discounts allowed Contras (PLCA) Bad debts Bal c/d 916,600 $ 311,000 3,400 8,650 32,000 561,550 916,600
(b)
Reconciliation RLCA $ 561,550 3,600 565,150 Bal c/d $ 565,150 565,150 $ 563,900 (900) 2,150 1,250 565,150
Bal b/d (part (a)) (i) Sales (SDB undercast)
Balance per list of balances (ii) Credit balance included as a debit (2 $450) Customer balance omitted
25.26
Chapter 15
Adjustment of cash book balance Balance b/d Bank interest (3ii) Cash account $ 204 Standing order (3i) 18 Bank charges (3iii) Balance c/d 222 $ 35 14 173 222 $ 2,618 723 (3,168) 173
Bank reconciliation statement Balance per bank statement at 31 March 20X8 Unrecorded lodgements Outstanding cheques Balance per cash book at 31 March 20X8

B (1) is a bank error, (4) is an outstanding cheque (2), (3) and (5) have all been processed correctly by the bank but need recording in the cash book.
Chapter 16
(a) Journal entries (1) (2) (3) (4) (5) (6) (b) Brought forward (102,800 85,240) Cash at bank (4) Rent and rates Trade receivables Discounts allowed Trade receivables Trade receivables Cash at bank Suspense account Cash at bank Stationery and postage Suspense account Capital Suspense account Suspense account $ 17,560 1,900 19,460 Stationery and postage (5) Capital (6) Dr $ 350 500 2,620 1,900 1,900 1,460 1,460 18,000 18,000 $ 1,460 18,000 19,460 Cr $ 350 500 2,620
25.27

Adjustment of profits statement for the year ended 30 April 20X2 Increases $ Decreases $ 350 500 1,460 (2,310) 9,990 $ 12,300
Draft profit Adjustments Rent (1) Discounts allowed (2) Stationery (5) Total adjustments Revised profit

B Draft profit Adjustments: (1) sales returns (2 $2,700) (2) depreciation (W) Adjusted profit (W ) Depreciation charge was 33 13 % ($15,000 2/4) = $2,500 Depreciation charge should have been $15,000 4 years = $3,750 Incremental depreciation to be charged $1,250 Increases $ Decreases $ 5,400 1,250 6,650 $ 112,400
(6,650) 105,750
Chapter 17
(a) (1) Dr Cr (2) Dr Cr Drawings (12 $10) Wages $ 120 $ 120 Inventories (B/S) Closing inventories (I/S) Dr $ 647 Cr $ 647
Being: adjustment to record year end closing inventories.
Being: correction of cash drawings posted as wages.
25.28
(3) Dr Cr Depreciation expense (I/S) Accumulated depreciation: Motor vehicles ($1,740 25%) Furniture and fittings ($829 20%) $ 601 $ 435 166
Being: adjustment to record depreciation for the year (4) Dr Cr (5) Dr Cr (6) Dr Cr (7) Dr Cr Rent expense (600 500) Accruals $ 100 $ 100 $ 90 $ 90 Drawings Purchases $ 63 $ 63 Bank (2 $180) Suspense account $ 360 $ 360 Bad debt expense Trade receivables $ 37 $ 37
Being: write off of irrecoverable customer balance.
Being: adjustment to correct cash receipt from trade receivables.
Being: adjustment for goods drawn from business (removed at cost value)
Being: accrual of rent expense. Dr Cr (8) Dr Cr (b) Suspense account Bal b/d $ 433 $ (5) Bank (8) Discounts allowed 360 73 433 Discounts allowed (I/S) Suspense account $ 73 $ 73 Prepayments ($180 6/12) Electricity expense
Being: prepayment of electricity expense.
Being: adjustment for discounts allowed omitted.
433
25.29
(c)
Mugg Income statement for the year ended 31 December 20X7 Sales Less: cost of sales Opening inventories Purchases (9,876 63) Less: closing inventories Gross profit Discounts received Less expenses: Rent (500 + 100) Electricity (240 ( 612 180)) 600 150 120 1,514 635 601 192 37 73 3,922 2,073 $ 510 9,813 10,323 647 9,676 5,866 129 5,995 $ 15,542
Insurance Wages (1,634 120) Repairs Depreciation Travel and entertaining Bad debts Discounts allowed Profit for the period
Mugg Balance sheet as at 31 December 20X7 Cost $ Non-current assets Motor vehicles Furniture and fixtures Current assets Inventories Trade receivables (672 37) Prepayments Cash and bank balances (5 + 762 + 360) 1,740 830 2,569 Accumulated depreciation $ 870 332 1,202
NBV $ 870 498 1,368 647 635 90 1,127 2,499 3,867 $ 2,377 2,073 (1,383) 3,067 700 100 800 3,867
Capital Capital as at 1 January 20X7 Profit for the period Less: drawings (1,200 + 63 + 120) Current liabilities Trade payables Accruals
25.30
Chapter 18
Sales COS GP % 100 60 40 $ 476,000 285,600 190,400 x 60%

Sales COS GP % 130 100 30 $ 221,000 170,000 51,000 x 100/130
Purchases: Cost of sales Opening inventory + Purchases Closing inventory
$ 43,000 174,500 47,500 170,000

B Cost structure: 25% mark up. Sales COS Gross profit Cost of sales Opening inventories Purchases Less: cost of sales Closing inventories should be Closing inventories is inventory lost in fire $ 620,000 700,000 1,320,000 (788,000) 532,000 (180,000) 352,000 = = 125% 100% 25% = = $ 985,000 788,000 197,000
25.31

Trade payables $ Till Bank Balance c/d * Dr Purchases (I/S) Cr Trade payables 430 167,224 43,825 211,479 Bal b/d Purchases* $173,029 $173,029 $ 38,450 173,029 211,479

Cash Bal b/d Receipts from Trade receivables (1) $ 50 General expenses Drawings Bankings Bal c/d $ 4,500 6,250 28,454 50 39,254 $ 39,204 1,928 41,132
39,204 39,254
Bal b/d Sales* (2)
Trade receivables $ 1,447 Cash (deduced from 39,685 cash a/c) Bal c/d 41,132

$4,050 Cost structure: Sales COS Gross profit = = 100% 80% 20% = = $ 23,750 19,000 4,750 $ 5,200 500 1,200 12,800 4,050 1,000 24,750
Balance b/d Sales
Cash $ 1,000 Wages Stationery 23,750 Electricity Bankings drawings Bal c/d 24,750
25.32
Chapter 19
(a) (i) Tick $ 50,000 50,000 Capital accounts Cast Balance $ $ 30,000 20,000 Bank 30,000 20,000 Bal b/d Tick $ 50,000 50,000 50,000 Cast $ 30,000 30,000 30,000 Balance $ 20,000 20,000 20,000
Bal c/d
(ii) Appropriation account for the year ended 31 December 20X4 $ $ Profit b/d from the 15,000 income statement 6,000 3,600 2,400 11,500 6,900 4,600 $ 50,000
Salary Balance Interest on capital (12% Tick Cast Balance Profit share Tick (5/10) Cast (3/10) Balance (2/10)
12,000
23,000 50,000
50,000
(iii) Tick $ 6,000 11,500 17,500 Current accounts Cast Balance $ $ 4,000 8,800 Salary 6,500 13,200 Interest on capital Profit share 10,500 22,000 Tick $ 6,000 11,500 17,500 Cast $ 3,600 6,900 10,500 Balance $ 15,000 2,400 4,600 22,000
Drawings Bal c/d
25.33
(iv) TICK, CAST AND BALANCE Balance Sheet as at 31 December 20X4 (extract) $ Capital accounts Tick Cast Balance Current accounts Tick Cast Balance 50,000 30,000 20,000 $
100,000
11,500 6,500 13,200
31,200 131,200
(b)
Alternative answer to parts (ii) and (iii) (including interest on drawings) (ii)
Appropriation account for the year ended 31 December 20X4 $ $ Profit b/d Salary Balance 15,000 Interest on drawings Tick (6,000 x 10% x 6/12) Interest on capital (12%) Cast (4,000 x 10% x 3/12) Tick 6,000 Cast 3,600 Balance 2,400 12,000 Profit share Tick (5/10) 11,700 Cast (3/10) 7,020 Balance (2/10) 4,680 23,400 50,400 (iii) Tick $ 6,000 300 11,400 17,700 Current accounts Cast Balance $ $ 4,000 8,800 Salary Interest on 100 capital 6,520 13,280 Profit share 10,620 22,080 Bal b/d Tick $ 6,000 11,700 17,700 11,400 Cast $ 3,600 7,020 10,620 6,520
$ 50,000 300 100
50,400
Drawings Interest on drawings Balance c/d
Balance $ 15,000 2,400 4,680 22,080 13,280
25.34

Salaries Interest on capital Profit share (6:3:1) Total profit for the year (W) (W) Profit before loan interest Loan interest ($10,000 12% 6/12) X $ 15,000 400 25,320 Y $ 400 12,660 Z $ 8,000 400 4,220 Total $ 23,000 1,200 42,200 66,400
( )
$ 67,000 (600) 66,400

B Salary PSR (1st half) PSR (2nd half) M $ 90,000 110,000 200,000 S $ 20,000 30,000 66,000 116,000 $ 10,000 30,000 44,000 84,000 $ 400,000 40,000 440,000 $ Profit ($440,000 x 6/12) Expense relevant to first half of year Salary S (40,000 x 6/12) A (20,000 x 6/12) PSR M 60% S 20% A 20% (90,000) (30,000) (30,000) $ 220,000 (40,000) 180,000 (20,000) (10,000) 150,000 A
Profit for year Add bank expense relating to first half of year 1st Half
(150,000) $ 220,000 220,000
2nd Half $ Profit ($440,000 x 6/12) Salary PSR M 50% S 30% A 20% (110,000) (66,000) (44,000)
(220,000)
25.35

Goodwill 1 Sept 1 Dec Capital a/c Capital a/c $ 180,000 210,000 1 Sept 1 Dec Capital a/c Capital a/c $ 180,000 210,000
Capital account K $ 102,857 90,000 C $ 77,143 60,000 H $ S $ 60,000 K $ 80,000 120,000 C $ 60,000 90,000 H $ 40,000 S $
1 Sept Goodwill 1 Dec Goodwill
1 Sept Goodwill 1 Dec Goodwill
Chapter 20
Rab Co Dr Cash (200,000 80c) Cr Share capital (200,000 50c) Cr Share premium account (200,000 30c) Balance sheet (extract) as at 1 June 20X0 Equity Share capital 50c ordinary shares (50,000 + 100,000) Share premium account $ 150,000 60,000 210,000 $ 160,000 $ 100,000 60,000

Bonus Issue New share capital: Double entry: Dr Share premium account Cr Share capital Balance sheet Share capital 50c ordinary shares (150,000 + 37,500) Share premium account (60,000 37,500) Retained earnings
300,000 50c = $37,500 4
$ 37,500
$ 37,500 $ 187,500 22,500 200,000 410,000
25.36

Rights Issue $ New share capital:
375,000 50c 5 375,000 $1 5
$ 37,500
Share premium:
75,000
Dr Cash Cr Share capital Cr Share premium account Rab Co Balance Sheet (extract) Share capital 50c ordinary shares Share premium account Retained earnings
$ 112,500
$ 37,500 75,000
$ 225,000 97,500 230,000 525,500

ABC Co Reconciliation of movement in retained earnings for year ended 31 December 20X6 $ Retained earnings at beginning of year Profit for the period Dividends preference ordinary 6,000 10,000 (16,000) 159,000 $ 125,000 50,000
Retained earnings at end of year

(1) Income tax expense (I/S) 31.12.X5 Current tax payable 30.9.X6 Current tax payable $ 62,000 3,000 43,000 31.12.X5 Income statement $ 62,000
31.12.X6 Current tax payable
25.37
Current tax payable (B/S) 31.12.X5 Balance c/d 30.9.X6 Bank $ 62,000 62,000 65,000 43,000 108,000 31.12.X5 Income tax expense 1.1.X6 Balance b/d 30.9.X6 Income tax expense 31.12.X6 Income tax expense 1.1.X7 (2) Tax note for the year ended 31 December 20X6 Tax charge for the year Under provision in respect of prior periods $ 43,000 3,000 46,000 Balance b/d $ 62,000 62,000 62,000 3,000 43,000 108,000 43,000
31.12.X6 Bal c/d
Chapter 21
Arrow Income statement for the year ended 30 September 20X6 Revenue Cost of sales (W3) Gross profit Distribution costs Administrative expenses (W1) Finance costs (W6) Profit before tax Income tax expense Profit for the period Arrow Balance sheet as at 30 September 20X6 $'000 ASSETS Non-current assets Property, plant and equipment Current assets Inventories Trade receivables Cash and cash equivalents (W2) Total assets 5,000 5,000 610 1,000 1,170 2,780 7,780 $'000 12,740 7,040 5,700 2,060 2,375 72 1,193 270 923
25.38
EQUITY AND LIABILITIES Equity Share capital (1,500 + 250) (W5) Share premium account (200 + 385) (W5) Revaluation reserve (800 + 600) (W7) Retained earnings (W4) Non-current liabilities Long term borrowings Current liabilities Trade payables Other payables (W6) Current tax payable Short term provisions Total equity and liabilities Workings (W1) Administrative expenses Bad debts written off Office expenses Administrative staff salaries Increase in warranty provision (80 50) (W2) Cash and cash equivalents Per trial balance Issue of shares (W5) Dividend paid (W3) Cost of sales Purchases Opening inventories Closing inventories (W4) Retained earnings Per trial balance Less: dividend paid Profit for period (per I/S)
$'000 1,750 585 1,400 1,873 5,608 1,200 1,200 550 72 270 80 972 7,780
$'000 45 1,800 500 30 2,375 $'000 835 635 (300) 1,170 $'000 7,200 450 (610) 7,040 $'000 1,250 (300) 923 1,873
25.39
(W5) Rights issue Number of shares in issue before rights issue (1,500,000 2) Rights issue 1 for 6 basis (3,000,000 6) Record as: Dr Cr Cr Bank (500,000 $1.27) Share capital (500,000 50c) Share premium account (500,000 77c) $635,000 $250,000 $385,000 3,000,000 500,000
(W6) Loan interest $1,200,000 6% = $72,000 (W7) Revaluation Revalued amount PPE per trial balance Increase $'000 5,000 (4,400) 600

Share capital Balance at 30 September 20X5 Gain on revaluation of property, plant and equipment Net income recognised directly in equity Profit for period Total recognised income and expense for the period Dividends Issue of share capital Balance at 30 September 20X6 1,500 200 $'000 1,500 Share premium account $'000 200 Revaluation reserve $'000 800 600 600 923 1,400 2,713 (300) 250 1,750 385 585 1,400 1,873 Retained earnings $'000 1,250 Total equity $'000 3,750 600 600 923 5,273 (300) 635 5,608
Chapter 22
B 1 and 3 are non-adjusting events as the condition did not exist at the balance sheet date.
25.40
Chapter 23
Income taxes paid Income tax payable Income tax paid Bal c/d $'000 116 156 272 Bal b/d I/S $'000 168 104 272

Property, plant and equipment Plant and equipment cost Bal b/d Addition $'000 200 100 300 Disposal Bal c/d $'000 20 280 300
Accumulated depreciation Disposal Bal c/d $'000 9 111 120 Bal b/d ... Charge $'000 80 40 120
Profit/loss on disposal: Net book value of asset sold Sales proceeds Loss on sale The entries in the cash flow statement for 20X9 would be: (i) Cash flows from operating activities (extract) Adjustments for Depreciation Loss on sale of plant (ii) Cash flows from investing activities (extract) Purchase of property, plant and equipment Proceeds from sale of plant
$ 11,000 (8,000) (3,000)
40,000 3,000 43,000 (100,000) 8,000 (92,000)
25.41

Dividends paid Dividends payable Dividends paid Bal c/d $'000 50 45 95 Bal b/d Retained earnings $'000 35 60 95

Emma Co Cash flow statement for the year ended 31 December 20X8 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation Interest expense Increase in trade receivables (168 147) Increase in inventories (214 210) Increase in trade payables (136 121) Cash generated from operations Interest paid Income taxes paid (W2) Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment (W1) Net cash used in investing activities Cash flows from financing activities Proceeds from issue of shares (250 + 70 200 60) Proceeds from issue of debentures Dividends paid (W3) Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Workings (W1) Property, plant and equipment at NBV $000 Bal b/d 514 Depreciation Revaluation during the year 10 Bal c/d (110 100) Additions 146 670 $000 42 628 670 $000 87 42 8 137 (21) (4) 15 127 (8) (20) 99 (146) (146) 60 30 (22) 68 21 (14) 7 $000
25.42
(W2) Income tax paid Bal c/d
Income tax payable $000 20 Bal b/d 39 Income tax expense (I/S) 59 Dividends payable $000 22 Bal b/d 18 Dividend for year 40
$000 28 31 59
(W3) Dividends paid Bal c/d
$000 16 24 40

Emma Co Cash flow statement for the year ended 31 December 20X8 (extract) $'000 Cash flow from operating activities Cash receipts from customers (W1) Cash payments to suppliers and employees (W2) Cash generated from operations Interest paid* Income taxes paid* Net cash from operating activities * (W1) Bal b/d Revenue (I/S) These amounts are the same amounts as in Lecture Example 4. Trade receivables $'000 147 cash received 600 Bal c/d 747 (W2) cash paid Bal c/d (W3) Cost of sales Add: closing inventories Less: opening inventories Purchases Other expenses Less: depreciation Trade payables $'000 Bal b/d 452 Expenses (W3) 136 588 $'000 319 214 (210) 186 (42) Workings $'000 579 168 747 $'000 121 467 588 $'000 579 (452) 127 (8) (20) 99 $'000
323 144 467
25.43
Chapter 24
Information that may be included in a database file for a non-current asset register: (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) Code/item number to identify asset Details of category of asset (motor vehicles, machine etc) Serial number of the asset Details of physical location of the asset Person responsible for the asset Cost of the asset Date of purchase Depreciation policy for the asset Accumulated depreciation charged to date Net book value of the asset Insurance details
END OF ANSWERS TO LECTURE EXAMPLES
25.44
Pilot Paper Questions only
26.1
26.2
26: PILOT PAPER (QUESTIONS ONLY)
26.3
26.4
26.5
26.6
26.7
26.8
26.9
26.10
26.11
26.12
26.13
26.14
26.15
26.16
26.17
END OF PILOT PAPER (QUESTIONS ONLY)
26.18

F3 BPP Notes

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Financial Accounting

Paper F3 (International) Course Notes ACF3CN07 (INT)

F3 Financial Accounting (INT) (Paper Based Exam) Study Programme

End of Day 1 refer to Course Companion for 6 7 8 9 10 11

End of Day 2 refer to Course Companion for 12 13 14 15

End of Day 3 refer to Course Companion for 16 17 18 19 20 21 22 23 24 25 26

End of Day 4 refer to Course Companion for

End of Day 5 refer to Course Companion for

Revision of syllabus Testing of knowledge Question practice Exam technique practice

Introduction to Paper F3 Financial Accounting (INT)

Links with other papers

Financial Reporting (P7)

Accountant in Business (F1)

Financial Accounting (F3)

Assessment methods and format of the exam

The use of double entry and accounting systems

Recording transactions and events

Preparing a trial balance

Preparing basic financial statements

Classroom tuition and Home study

BPP Learn Online

Question practice from the Study Text

Section reference in the Study Text

Syllabus Guide Detailed Outcomes

Users of financial information

Types of business entities

Limited liability company

Concept of separate entity

Proforma financial statements

Profit for the period

Users of financial information

Governments and their agencies

Types of business entities

Limited liability company

The sole trader is the simplest of these forms.

The concept of business entity (separate entity)

1.1 1.2 1.3

Home study chapter The regulatory framework

Syllabus Guide Detailed Outcomes

Understand the role of International Financial Reporting Standards (IFRS)

2: HOME STUDY CHAPTER - THE REGULATORY FRAMEWORK

2: HOME STUDY CHAPTER - THE REGULATORY FRAMEWORK

Standards Advisory Council (SAC)

International Accounting Standards Board (IASB) (14 Board members)

International Financial Reporting Interpretations Committee (IFRIC)

Key: Appoints Reports to Advises

International Accounting Standards Committee Foundation (IASCF)

International Accounting Standards Board (IASB)

2: HOME STUDY CHAPTER - THE REGULATORY FRAMEWORK

International Financial Reporting Interpretations Committee (IFRIC)

Standards Advisory Council (SAC)

The role of International Financial Reporting Standards (IFRS)

2: HOME STUDY CHAPTER - THE REGULATORY FRAMEWORK

Exam standard question for 1 mark

2: HOME STUDY CHAPTER - THE REGULATORY FRAMEWORK

Syllabus Guide Detailed Outcomes

Qualitative characteristics of financial information

Elements of financial statements

Concepts and conventions

Alternative valuation bases

IAS 8: Accounting policies, changes in accounting estimates and errors

4) The elements of financial statements

5) Recognition of the elements of financial statements