Passport to Success Level 2 Book-keeping and Accounts

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London Chamber of Commerce and Industry (LCCI) International Qualifications are provided by EDI, a leading international awarding body.

Passport to Success
Level 2 Book-keeping & Accounts

The initials LCCI and the words LONDON CHAMBER OF COMMERCE AND INDUSTRY are registered trademarks belonging to the London Chamber of Commerce and Industry and are used under licence. Every effort has been made to trace all copyright holders, but if any have been inadvertently overlooked the Publishers will be pleased to make the necessary arrangements at the first opportunity. EDI 2008 First published in 2008 exclusively for EDI by Hodder Education, Part of Hachette Livre UK 338 Euston Road London NW1 3BH Impression number 5 4 3 2 1 Year 2012 2011 2010 2009 2008 All rights reserved. Apart from any use permitted under UK copyright law, no part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or held within any information storage and retrieval system, without permission in writing from the publisher or under licence from the Copyright Licensing Agency Limited. Further details of such licences (for reprographic reproduction) may be obtained from the Copyright Licensing Agency Limited, Saffron House, 610 Kirby Street, London EC1N 8TS. Cover photo www.fotolia.com Typeset in 11/13 Garamond ITC Lt by Dorchester Typesetting Group Ltd Printed in Dubai A catalogue record for this title is available from the British Library ISBN: 978 1862 471122

Contents
Introduction 1 Advanced Aspects of Depreciation 2 Adjusting for Accruals and Prepayments 3 Bad Debts and Provision for Doubtful Debts 4 Introduction to Partnership Accounts 5 Admission and Retirement of Partners 6 Dissolution of a Partnership 7 Formation of a Company Meaning, Purpose and Effect 8 Limited Companies The Profit and Loss Account 9 Limited Companies The Balance Sheet 10 Control Accounts 11 Incomplete Records 12 Stock Valuation 13 Manufacturing Accounts 14 Non-trading Organisations 15 Non-trading Organisations: Subscriptions Account and Balance Sheet 16 Errors and the Use of a Suspense Account 17 Calculation and Interpretation of Ratios 18 Preparing Simple Financial Statements Using Ratios 1 2 15 26 32 43 60 74 82 90 100 116 132 144 162

173 188 204 225

Introduction
This workbook has been written specifically to help you prepare for the LCCI IQ Level 2 Book-keeping and Accounts exam. The content is organised and presented in chapters that map directly to the revised syllabus to ensure that you cover all the topics for the exam. Concepts are introduced and sequenced in a way that will help you to develop and build on your bookkeeping and accounting knowledge and skills. To help you bring together and reinforce your learning, examples and exercises are provided with solutions and notes to show how to apply the principles and make the necessary calculations. In addition, you will find the workbook language simple and easy to read. The clear presentation and layout of the book will make it easy for you to find specific concepts and identify key new terms, which are highlighted in blue. To help you make the best of your learning experience the book has been designed with the following features:
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Learning targets stated at the beginning of each chapter these outline what you should learn by the end of the chapter. You can use these as a checklist to make sure that you have met all the learning outcomes for the syllabus topic. Improve your grade these are tips given by the Chief Examiner to help you to do better in the exam. Tips may be given either on the application of key accounting principles, how they are tested in the exam or how you should respond to exam questions on the topic. Think about it these are questions, posed throughout the workbook, which are designed to broaden your knowledge beyond each chapter content and link concepts in each chapter to other concepts in the book. This will help you understand how the different topics relate to each other. Answers are not given in the workbook but are available in the Solutions Booklet. Chapter summary highlights the key points covered in the chapter. This provides you, at a glance, with the important points from the chapter and gives you the opportunity to check your learning. Target practice questions at the end of each chapter to help you consolidate and apply the concepts learnt. These questions are similar to the examination questions and are therefore important for practice and revision purposes. Answers are not provided in the workbook but can be found in the Solutions Booklet, available for download from the qualification page of the LCCI website, www.lcci.org.uk.

Whether you attend classes or study on your own, this workbook is an ideal learning resource.

Advanced Aspects of Depreciation

Introduction
This chapter covers advanced aspects of depreciation and builds on your knowledge from Level 1 Book-keeping. You should make sure that you understand all the areas covered in Level 1, including the calculation of depreciation using the straight-line method and the reducing (or diminishing) balance method.

Learning targets
By the end of this chapter you should be able to:
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explain the importance and purpose of depreciation prepare entries in the Depreciation Expense Account, including the transfer to the Profit and Loss Account at the financial year-end, and the Provision for Depreciation Account explain the effect of using different methods of depreciation on the charge to the Profit and Loss Account and recognise the relationship between the type of asset and the depreciation method chosen prepare an Asset Cost Account and an Asset Disposal Account calculate the profit or loss on disposal of an asset prepare entries for assets sold for cash, traded in or exchanged for a replacement asset.

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1.1 Preparing entries in the depreciation expense account

As fixed assets are used or get older, their value decreases. This fall in value is an expense to the business and is accounted for by using depreciation techniques.

Think about it
What are some of the specific causes of depreciation?

Depreciation is an accounting adjustment that measures the fall in value of a fixed asset over a period of time.

A Depreciation Expense Account is used to record the annual depreciation charge, before its transfer to the Profit and Loss Account. At level 1 Bookkeeping, you were introduced to the Provision for Depreciation Account, which deals with the accumulated depreciation. Depreciation also appears in the Balance Sheet, forming part of the Provision for Depreciation Account. It is usual to calculate depreciation for a specific time period. This could be, for example, monthly, quarterly or annually.

Chapter 1: Advanced Aspects of Depreciation

Depreciation is recorded in the accounting records using double entry principles. It is an expense to the business and so the debit entry is made to the Depreciation Expense Account. The credit entry is posted to the Provision for Depreciation Account, as shown in Example 1. This account acts as a holding account for all the depreciation charged to date. The value on this account will increase each year assuming that none of the assets have been disposed of. It is sometimes referred to as the Accumulated Provision for Depreciation.

Example 1
Depreciation Expense

31/12/X6 Provision for Depreciation

8 500

Provision for Depreciation

31/12/X6 Depreciation Expense

8 500

At the end of the accounting period, the balance on the Depreciation Expense Account is transferred to the Profit and Loss Account. Once this transfer has been done, the balance on the Depreciation Expense Account will be zero (Example 2).

Example 2
Depreciation Expense

31/12/X6 Provision for Depreciation

8 500 8 500

31/12/X6 Profit and Loss

8 500 8 500

At the end of the accounting period, the balance on the Provision for Depreciation Account will be carried forward to the next period (Example 3).

Example 3
Provision for Depreciation

31/12/X6 Balance c/d

8 500 8 500

31/12/X6 Depreciation Expense 01/01/X7 Balance b/d

8 500

8 500 8 500

Exercise 1.1 below shows a comprehensive example including entries in the Depreciation Expense Account, the Provision for Depreciation Accounts and the Fixed Asset Cost Accounts. Exercise 1.1 Kerry leases a small shop. On 1 July 20X4, she purchased fixtures and fittings costing 25 000 and a van costing 12 000. She decided to depreciate the fixtures and fittings at 20% per year on a straight-line basis and the van at 30% per year on a reducing (or diminishing) balance basis.
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LCCI Book-keeping & Accounts 2

Kerry prepares her accounts annually to 30 June.

Required: Record the transactions for the purchase and depreciation of the assets for the years ended 30 June 20X5 and 20X6, balancing the ledger accounts at the end of each year. Kerry maintains separate ledger accounts for the cost and accumulated depreciation of each type of fixed asset but only one depreciation expense account. Solution: Fixtures and Fittings Cost

01/07/X4 Bank 01/07/X5 Balance b/d 01/07/X6 Balance b/d

25 000 25 000 25 000

5 000 5 000

25 000 25 000

30/06/X5 Balance c/d 30/06/X6 Balance c/d

25 000 25 000
5 000 5 000

25 000 25 000

Provision for Depreciation of Fixtures and Fittings

30/06/X5 Balance c/d

12 000 12 000 10 000 10 000

30/06/X5 Depreciation Expense 01/07/X5 Balance b/d 30/06/X6 Depreciation Expense 01/07/X6 Balance b/d

5 000
5 000 10 000 10 000

30/06/X6 Balance c/d

Van Cost

01/07/X4 Bank 01/07/X5 Balance b/d 01/07/X6 Balance b/d

12 000 12 000 12 000

3 600 3 600

30/06/X5 Balance c/d 30/06/X6 Balance c/d

12 000 12 000
3 600 3 600

12 000 12 000

Provision for Depreciation of Van

30/06/X5 Balance c/d

6 120 6 120

30/06/X5 Depreciation Expense 01/07/X5 Balance b/d 30/06/X6 Depreciation Expense 01/07/X6 Balance b/d

3 600
2 520 6 120 6 120

30/06/X6 Balance c/d

Chapter 1: Advanced Aspects of Depreciation

Depreciation Expense

30/06/X5 PFD Fixtures and Fittings 30/06/X5 PFD Van 30/06/X6 PFD Fixtures and Fittings 30/06/X6 PFD Van

5 000
2 520 7 520

5 000 3 600 8 600

30/06/X5 Profit and Loss 8 600 8 600 7 520 7 520 Van 12 000 3 600 8 400 2 520 5 880

30/06/X6 Profit and Loss

Depreciation calculations: Fixtures and Fittings 25 000 25 000 20% 5 000 20 000 25 000 20% 5 000 15 000

Purchase cost Depreciation 30 June 20X5 Depreciation 30 June 20X6

12,000 8,400

30% 30%

Improve your grade

Remember that only the value of the fixed asset (and not depreciation) appears in the Fixed Asset Cost Account.

1.2 Other methods of depreciation

It is important to match the type of fixed asset with an appropriate method of depreciation so that its original cost is spread over its useful life. If an asset is expected to lose a lot of value in the early years of its life, then the reducing (or diminishing) balance method would be appropriate. If the asset is expected to lose value evenly throughout its life, then the straight-line method would be used. Businesses may decide to calculate depreciation using methods other than straight-line or reducing balance. You need to know how to calculate depreciation based on revaluation and on machine hours methods. The revaluation method is based on an estimate of the value of the asset at the end of the accounting period. Example 4 shows how this method is applied.

Think about it
Identify three types of fixed assets and say which method would be appropriate for each.

Example 4
Thomas Smith bought some gardening tools for his landscaping business. These tools cost 1750 on 1 January 20X7. He estimated that the tools were worth 980 at 31 December 20X7. Therefore the depreciation charge for the year will be 1750 980 = 770. Depreciation on machinery can also be calculated using the expected number of machine hours for the assets useful life. This means that the charge for a year will be high when the machine is working a large number of hours. The charge will be less for a year when the machine works fewer hours. Example 5 shows how this method works.

Example 5
A machine has a useful life of three years or 30 000 working hours. The machine works 12 000 hours in year 1, 13 500 hours in year 2 and 4500 hours in year 3. If the machine cost 120 000, calculate the depreciation for each year using the machine hour rate method.
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LCCI Book-keeping & Accounts 2

1.5 Preparing entries for assets traded-in or exchanged for a replacement asset
Sometimes, a business will dispose of an asset but will not sell it for cash. Instead, it may give the asset as a trade-in for another asset, or exchange one asset for another. When an asset is traded Where an asset is traded-in (or part exchanged), the proceeds for the disposal is the trade-in value. This value is credited to the Asset Disposal Account as proceeds and debited to the Asset Cost Account as part of the cost of the new asset, as shown in Example 11. Numbered notes are given to explain the entries in the accounts.

Example 11
Motor Vehicles Cost

01/01/X6 Balance b/d 01/09/X6 Bank (2) 01/09/X6 Asset Disposal (3)

30 000 12 000 4 000

01/09/X6 Asset Disposal (1) 15 000

Asset Disposal

01/09/X6 Motor Vehicles Cost (1)

15 000

01/09/X6 Motor Vehicles Cost (3)

4 000

Notes: 1. The original cost of 15 000 for the old asset is removed from the Cost Account and posted to the Asset Disposal Account. 2. The business paid 12 000 towards the cost of the new asset after the trade-in. 3. The trade-in value is posted to the Cost Account and to the Asset Disposal Account. This means that the total cost of the new asset is 16 000. When an asset is exchanged Where a business exchanges one asset for another then the value of the new asset is also the disposal proceeds for the old asset. The value of the new asset is debited to the Asset Cost Account and credited to the Asset Disposal Account, as in Example 12. Numbered notes are given to explain the entries in the accounts.

Example 12
Motor Vehicles Cost

01/01/X6 Balance b/d 01/09/X6 Asset Disposal (2)

30 000 10 000

01/09/X6 Asset Disposal (1) 15 000

Asset Disposal

01/09/X6 Motor Vehicles Cost (1)

10

15 000

01/09/X6 Motor Vehicles Cost (2)

10 000

Chapter 1: Advanced Aspects of Depreciation

Notes: 1. The original cost of 15 000 for the exchanged asset is removed from the Cost Account and posted to the Asset Disposal Account. 2. The new asset has a value of 10 000. This is treated as the proceeds for the disposal of the old asset. Exercise 1.4 shows an Asset Disposal Account where assets are both traded in and exchanged. Exercise 1.4 Build-It is a manufacturing company that owns three machines. The cost and accumulated depreciation of these machines at 1 January 20X6 is as follows:
Machine 1 45 000 22 000 Machine Machine 2 3 62 500 58 000 34 000 27 000

Cost 1 January 20X6 Accumulated depreciation 1 January 20X6

On 1 April 20X6, Machine 1 was traded-in (part exchanged) for Machine 4. The trade-in value was 20 000 and the company paid an additional 40 000 by cheque. On 31 October 20X6, Build-It exchanged Machine 3 for Machine 5, which was valued at 38 500. The year-end date is 31 October 20X6.
Required: Prepare the Asset Disposal Account to calculate the profit or loss on disposal for Machines 3 and 5. The company does not charge any depreciation in the year of disposal. Solution: Asset Disposal

Date 01/04/X6 Machine 1 Cost

45 000

31/10/X6 Machine 3 Cost 58 000 31/10/X6 Profit on Disposal Machine 3 7 500

110 500
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Date 01/04/X6 Machine 1 Provision for Depreciation 01/04/X6 Machine 4 Cost (trade-in) 01/04/X6 Loss on Disposal Machine 1 31/10/X6 Machine 3 Provision for Depreciation 31/10/X6 Machine 5 Cost (exchange)

22 000 20 000 3 000 27 000 38 500 110 500

The key to calculating depreciation accurately is in the application of the depreciation policy. Examination questions will state the depreciation policy (e.g. charging a full years depreciation in the year of purchase, charging no depreciation in the year of disposal, depreciation charged on a monthly basis etc.). It is important that you pay attention to such notes as they guide you on how to calculate the depreciation. Target practice

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LCCI Book-keeping & Accounts 2

Chapter summary
Important points to remember from this chapter:
1 Fixed assets may also be depreciated using the revaluation and machine hour methods. 2 A separate account should be maintained for the Accumulated Provision for Depreciation and the Depreciation Expense Account. 3 The Provision for Depreciation Account acts as a holding account for all the depreciation charged to date. 4 The Depreciation Expense Account is used to record the annual depreciation charge, prior to its transfer to the Profit and Loss Account. 5 Asset Cost Accounts and accounts for the accumulated provision of depreciation should be balanced at the end of each financial year as these balances will be required for the trial balance and later for the Balance Sheet. 6 An appropriate method of depreciation should be chosen for each type of asset. 7 A separate Disposal Account should be used to calculate the profit or loss on the disposal of an asset. 8 If an asset is sold, the proceeds are credited to the Disposal Account. 9 Where an asset is traded-in, then the trade-in value is used as the disposal proceeds and credited to the Disposal Account.

Target Practice
1. Complete the missing words in these sentences:
(a) Depreciation is an accounting adjustment which _______________ the fall in _____________ of a ___________ ______________. (b) The charge for deprecation is posted to the ___________ side of the Depreciation Expense Account and the ____________ side of the Provision for Depreciation Account.

2. Denholm Ltd purchased a machine on 1 January 20X5 for 120 000 and two motor vehicles costing 14 000 each. The company depreciates its assets on the following bases: Machinery 10% straight-line Motor vehicles 25% reducing balance.
Required: Record the relevant entries in the ledger accounts for Motor Vehicle Cost, Accumulated Provision for Depreciation and Depreciation Expense for each of the years ended 31 December 20X5 and 20X6. You may assume that the company maintains separate accounts for Cost and Accumulated Depreciation for each class of asset, but only one Depreciation Expense Account.

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Chapter 1: Advanced Aspects of Depreciation

3. Silas Ltd purchased four machines on 1 January 20X7, Machine A 35 000 Machine B 42 000 Machine C 22 500 Machine D 50 000 The company depreciates its machines on an annual 12% straight-line method basis. Depreciation is calculated monthly from the date of acquisition to the date of disposal. On 30 April 20X7, the company sold Machine C for 15 360 and on 31 October 20X7 Machine A was sold for 28 600.
Required: Record the relevant entries in the Machinery Cost, Accumulated Provision for Depreciation, Depreciation Expense and Asset Disposal Ledger Accounts for the year ended 31 December 20X7.

N.B. It is customary that a business would keep its fixed assets for longer than indicated in the question above. However, for ease of illustration, the fixed assets, in this case, have been maintained for less than two years. 4. Thaw Ltd purchased four trucks on 1 April 20X5. The trucks are depreciated at 25% based on the straight-line method on a monthly basis. You have been supplied with the following information:
Truck 1 Cost 1 April 20X5 Accumulated depreciation 1 April 20X6 Sold 30 September 20X6 Sold 31 December 20X6 25 000 6 250 Truck 2 30 000 7 500 27 500 22 800 Truck 3 36 000 8 750 Truck 4 40 000 11 250

Required: (a) Calculate the depreciation charge on each truck for the year ended 31 March 20X7.
Truck 1 Depreciation for year ended 31 March 20X7 Truck 2 Truck 3 Truck 4

(b) Record the relevant entries in the ledger accounts for Truck Cost, Accumulated Provision for Depreciation, Depreciation Expense and Asset Disposal for the year ended 31 March 20X7.

5. Weber Industries started in business on 1 April 20X5 and purchased three machines for 30 000 each. Depreciation is charged on the machines using the reducing balance method at 35% per annum. On 1 April 20X6 the accumulated depreciation for each machine was 10 500. On 1 July 20X6, Weber Industries traded in one of the machines for a truck. The trade-in value was 18 000 and the business paid an additional 21 000 in cash. The truck is to be depreciated at 25% using the straightline method.
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LCCI Book-keeping & Accounts 2

On 1 October 20X6, one of the machines was exchanged for a newer model with a value of 25 000. Depreciation is charged on an annual basis with a full years charge in the year of purchase and none in the year of disposal.
Required: Prepare the asset disposal account for the year ended 31 March 20X7.

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