Book 3: Accrual Accounting Explored

B124
Book 3
Accrual accounting explored
Written by Elizabeth Porter
Fundamentals of accounting
This publication forms part of the Open University module B124 Fundamentals of accounting. Details of this and other
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1.1
Contents
Introduction 5
Learning outcomes 6
Chapter 1 Value Added Tax (VAT) 7
Introduction 7
1.1 Direct and indirect taxes 7
1.2 The background to VAT 8
1.3 Taxable supplies 9
1.4 The taxable person 11
1.5 VAT output tax and VAT input tax 11
1.6 Place of supply 14
1.7 Accounting for VAT in the general ledger 15
1.8 Goods taken for own use 17
Answers to activities 18
Summary 21
Chapter 2 Accruals accounting for expenses and

revenue 22
Introduction 22
2.1 Accruals accounting 22
2.2 Accruals 25
2.3 Prepayments 32
2.4 Accrued income (revenue) 35
2.5 Income received in advance (deferred revenue) 37
2.6 Year-end adjustments 40
Summary 51
Chapter 3 Tangible non-current assets and depreciation 53
Introduction 53
3.1 Non-current assets 53
3.2 Depreciation 55
3.3 Choosing a depreciation method 58
3.4 Recording depreciation 64
3.5 Disposal of non-current assets 67
3.6 Disclosure of non-current assets in the financial accounts 73
Summary 81
Chapter 4 Irrecoverable receivables 83
Introduction 83
4.1 Credit control 83
4.2 Writing off irrecoverable receivables 85
4.3 Allowance for irrecoverable receivables 86
4.4 The extended trial balance revisited 89
Summary 98
Book summary 99
Self-assessment questions (SAQs) 102
Answers to self-assessment questions (SAQs) 104
Reference 107
Acknowledgements 108
Introduction
Introduction
Welcome to Book 3. In Book 2 you learned the basics of double-entry
bookkeeping, how profit is calculated, and how to prepare an income
statement. You also learned how to prepare the balance sheet which shows
the financial position of the business. Finally you learned how to prepare
spreadsheets. Book 3 builds on this learning.
Book 3 consists of four chapters.

Chapter 1 considers some basic Value Added Tax (VAT) rules and
principles, and explains the entries required to record VAT in the
accounting records.
Chapter 2 explains the matching principle and how applying the

accruals concept ensures that expenses are matched with revenue.
It also explains how to identify and record accruals and prepayments.
Chapter 3 considers the difference between capital and revenue

expenditure, and how to record transactions involving non-current
assets and the depreciation thereon.
Chapter 4 explains the importance of credit control, how to recognise

irrecoverable receivables, and how to calculate and record an allowance
for irrecoverable receivables.
Now that you are familiar with the terms debit and credit we will replace
them with their accepted abbreviations of Dr and Cr. You may wonder why
we use the abbreviation Dr for debit when there is no r in the word debit.
This is because the double-entry bookkeeping system was designed by the
Italian monk Luca Pacioli. He wrote his book in Latin; debere is the Latin
word for debit and credere is the Latin word for credit.
5
Book 3: Accruals accounting explored
Figure 1 The first modern publication on double-entry bookkeeping was a treatise

published in 1497 by an Italian monk, Pacioli.
Learning outcomes
After you have completed Book 3, you should be able to:
. understand the basics of the indirect tax: Value Added Tax (VAT)
. calculate VAT on sales and purchases and record the appropriate
accounting entries in the general ledger
. understand and explain ‘accruals accounting’ (including accruals,
prepayments, depreciation and irrecoverable receivables) and record the
entries in the general ledger.
6
Chapter 1 Value Added Tax (VAT)

Introduction
By the end of this chapter you should be able to:
. understand the reason for the operation of a sales and purchase tax in
general, and VAT in particular
. calculate VAT on sales and record the accounting entries for VAT charged
on sales and purchases
. deal with the accounting entries for VAT in respect of cash discounts.
In this chapter you will learn a little about the United Kingdom (UK) system
of VAT and how it is charged. You will also learn how VAT is collected, and
how it should be recorded in the general ledger. As this is an introductory
module, this session gives an introduction to VAT and does not therefore
deal with special schemes, such as the cash accounting scheme, the flat rate
scheme for small businesses and second-hand goods margin schemes. If you
wish to know more about these schemes visit the website of Her Majesty’s
Revenue and Customs (HMRC).
1.1 Direct and indirect taxes

Governments raise revenue by using a combination of two types of tax:
direct and indirect.
Direct taxes are borne entirely by the individual person or business that
pays it; it cannot be passed on to another entity. It is levied on the person
or business according to their specific circumstances such as the amount of
someone’s salary or the amount of a company’s profits. For example, an
individual pays income tax (a direct tax) to the government by Pay As You
Earn (PAYE), a system that automatically deducts the tax from the
individual’s earnings.
Indirect taxes are levied by government on consumption, expenditure,
privilege or right, but not on income or wealth. For example, indirect taxes
are charged on a transaction such as purchases or sales rather than on the
individual. They have the following advantages over direct taxes:
. They give a steady flow of income throughout the year because they are
collected at the point of sale or purchase.
. They can reduce the need to raise direct taxes, giving an individual
greater choice in how they spend their money.
. They can be perceived as a fairer way to raise revenue, as anyone can
avoid paying indirect tax by not purchasing the item that it is levied on.
There are, however, some significant disadvantages to indirect taxes:
7
. Governments have to devote a great deal of resources to enforce these

taxes because it is possible to avoid paying them by illegal means such
as smuggling and falsifying accounting records.
. These taxes are complicated and add an administrative burden on
business.
. The rate of tax is the same for every individual, so it is felt more heavily
by those who have less disposable income.
Table 1.1 sets out different types of direct and indirect taxes.
Table 1.1 Direct and indirect taxes
Direct taxes Indirect taxes

Income Tax, which includes PAYE VAT
NI (National Insurance contributions) Customs Duty
Capital Gains Tax Excise Duties
Inheritance Tax Insurance Premium Tax
Corporation Tax Stamp Duty Land Tax
Petroleum Revenue Tax Environmental taxes including:
. Landfill Tax
. Aggregate Levy
. Climate Change Levy
This chapter looks at the indirect tax on goods or services known as Value
Added Tax. VAT is a tax collected by businesses at various stages but it is
actually borne (incurred) by the final purchaser of the goods or services.
1.2 The background to VAT

VAT is a form of indirect taxation levied throughout the European Union
(EU). It is a tax on consumers. Businesses are, however, expected to collect
the tax. In the EU there are standard rules on VAT that are contained in the
VAT Directive, however, the application of VAT varies between different EU
states as set out in each state's VAT regulations.
According to James (2011), the origins of VAT have been attributed to two
sources: the German businessman Wilhelm von Siemens in 1918 and the
American economist Thomas S. Adams in his writings between 1910
and 1921. It was first introduced at a national level in France in 1954;
however, France did not move to full VAT until 1968. The first full VAT in
Europe was enacted in Denmark in 1967. VAT adoption progressed in two
major phases. The first occurred mostly in Western Europe and Latin
America during the 1960s and 1970s. The second phase of adoption
occurred in the late 1980s with the introduction in some high-profile
industrialised countries outside the EU, such as America, Canada, Japan and
Switzerland. During this phase there was also a massive expansion of VAT
in transitional and developing economies mostly in Africa and Asia. By the
beginnings of the early 21st century more than 140 countries had adopted
VAT. For more information on the origins of VAT see James, 2011.
8
VAT was introduced into Britain in 1973 when the country joined the
European Economic Community (now the European Union) because this was
part of the conditions of joining. Since its introduction into Britain the VAT
regulations have greatly increased and the legislation runs to over 3,200
pages. HMRC administers this complex tax.
1.3 Taxable supplies

The rate of VAT varies according to the goods and services supplied. In the
EU the government of the individual member state determines the rate of
VAT charged and the items to which it applies (taxable supplies). An EU
state may have up to four rates: exempt, standard rate and up to two reduced
rates. In the UK there are four categories of supplies: exempt, zero rated,
reduced rate, and standard rate.
Exempt supplies are outside the scope of VAT. They consist principally of
financial (e.g. bank charges and mortgage interest), medical (e.g. dental
treatment) and educational activities (school fees). No VAT is charged on
exempt supplies. Businesses that supply only exempt supplies cannot register
for VAT. Where a business has a mixture of standard or zero rated
supplies and exempt supplies it will be partially exempt and only able to
claim back (recover) some of the VAT it incurs in purchasing goods and
services. It will still have to pay VAT on its purchases. In the UK exempt
supplies include education, finance, and insurance.
The UK has a category of zero rated supplies. These are charged at zero per
cent on items that include most foods (but not meals sold by restaurants and
takeaways), children’s clothing and shoes, books and newspapers, medical
prescriptions and new house sales. 0% is still within the scope of VAT, but
VAT is charged at zero. Businesses that sell only zero rated supplies may not
have to register but will need to apply for exemption from registration.
An example would be an individual who sets up a farm shop that sells
produce bought from local farmers. He may be able to apply for exemption
from registration for VAT, and so not have to record VAT. However, they
will not be able to recover VAT they incur on expenses.
The UK also has a category of reduced rate supplies that includes domestic
power and fuel, contraceptive products, gold, residential conversions, welfare
services and children’s car seats. The reduced rate is 5% at the time of
writing.
Standard rated supplies (20% in the UK at the time of writing) are
supplies that do not fall into one of the categories above. It is the principles
of accounting for VAT that are important rather than worrying solely about
the rate.
Some specific rules regarding VAT that a business should be aware of are
highlighted below.
9
Entertainment – This is defined as hospitality of any kind, e.g.
. provision of food and drink

. provision of accommodation (such as in hotels)
. provision of theatre and concert tickets
. entry to sporting events and facilities
. entry to clubs and nightclubs
. use of capital assets such as yachts and aircraft for the purpose of
entertaining.
VAT cannot be reclaimed on entertainment expenses unless that
entertainment is in respect of entertaining staff. Therefore the books of the
business entertainment of staff will exclude VAT, but on all other
entertainment it will include VAT thereon as an expense.
Motor vehicles – Whilst VAT can be reclaimed on most non-current assets,
it cannot be reclaimed on cars unless they are taxis, used for teaching people
to drive or are rented out as hire cars.
Goods taken for own use, e.g.:
. a butcher taking meat from his shop to give to his wife

. a shopkeeper taking an electronic cigarette for his own use
. a hairdresser getting a member of her staff to cut and blow dry her hair.
If the owner of a business takes goods for his or her own use he/she will be
the consumer of those goods, therefore VAT should be charged on them.
Bad debts – When someone cannot pay the amount owed to a business it is
termed a bad debt by the business. When bad debts are written off (known
as irrecoverables and covered in Chapter 4), the VAT included in them can
be reclaimed providing the debt is over six months old, has been written off
in the accounts of the business, and the customer has been notified.
Cash discounts – Reductions in an invoice price offered for prompt payment
of that invoice. If a cash discount has been offered for prompt payment of an
invoice by the customer, the VAT is calculated on the amount less the cash
discount. It makes no difference whether the customer takes advantage of the
cash discount offered or not.
The above will have shown you that VAT is not a straightforward indirect
tax. Indeed there have been many legal cases contesting VAT legislation and
regulations, one of which was the Jaffa Cake case.
Jaffa Cakes are basically a disk of sponge, topped with a clear orange jam and
chocolate (Figure 1.1 below). Under UK VAT law, biscuits and cakes are zero
rated, however, once biscuits are covered in chocolate they become standard
rated. HMRC classified Jaffa Cakes as a biscuit. McVities who make Jaffa Cakes
said they were cakes and therefore zero rated. The case went to court in 1991
and the courts were forced to consider when a product was a biscuit and when it
was a cake. It was decided that when cakes go stale they go harder however
when biscuits go stale they go softer. This test was carried out, and it was found
that when Jaffa Cakes are left uncovered in the open air they become harder.
The court therefore ruled that they were cakes and they retained their zero rating.
10
Figure 1.1 Jaffa Cakes
1.4 The taxable person

In the UK, businesses that supply taxable goods or services over a set limit
(£83,000 at April 2016) must register for VAT with HMRC. However,
businesses can voluntarily register for VAT if they have turnover of less than
the set limit, providing everything they sell is not in a VAT exempt category
(see above).
Note: all the details above are subject to change. Up-to-date information can
always be found on the HMRC website. A link to the website is on the
B124 website.
Once registered for VAT a business will receive a VAT number that it must
show on all the invoices it issues. It must then:
. charge VAT at the appropriate VAT rate (20%, 5%, or 0%)

. keep a record of all its VAT charged and paid
. keep a VAT account (in its general ledger)
. submit VAT returns to HMRC together with payment (or perhaps a
refund may be due) at set intervals.
A business must keep clear records of all transactions and should retain
documents such as bank statements, invoices, bills and receipts. Records
should be kept for six years as back-up information should HMRC have
cause to examine a business’s VAT history.
1.5 VAT output tax and VAT input tax

The VAT added to the selling price of the goods or services is known as the
output tax of the business.
If the price of an item is £1,000 and the trader has to add VAT at the
standard rate of 20% the net sale value will be £1,000, and VAT will be
£200 giving an invoice price of £1,200.
11
The most progressive tax system so far was operated by Robin Hood.
When a business purchases goods and services, the supplier charges VAT in
addition to the purchase price of the goods or services. This is known as the
input tax of the business.
If output VAT is greater than input VAT in a period, the business pays the
difference in tax to HMRC. If output VAT is less than input VAT in a period,
HMRC will refund the difference to the business. VAT settlement usually
takes place at regular intervals of three months, although there are special
schemes for small and very large businesses. A business that is not
registered for VAT cannot claim back any VAT paid from HMRC and
therefore the VAT is accountable as part of purchases, expenses and non-
current assets. Purchases, expenses and non-current assets will be the full
amount including VAT.
The following example shows how VAT is collected at stages along the
supply chain. It is, however, the consumer of the goods and services that
ultimately pays the VAT, although it has already been collected by HMRC as
explained below.
Example: Collection of VAT

1 A manufacturer of quality greenhouses sells a greenhouse for £2,270 plus
VAT of £454 to a garden centre.
2 The garden centre (retailer) pays the manufacturer £2,724.
3 The manufacturer pays HMRC the VAT of £454.
4 The garden centre (retailer) sells the greenhouse for £3,030 plus VAT of
£606.
5 The customer pays £3,636 to the garden centre (retailer), which included
£606 VAT.
6 The retailer has output tax of £606 from which it deducts input tax of
£454, leaving £152 that it pays to HMRC.
12
The £606 VAT paid by the customer has been collected by HMRC, £454
from the manufacturer plus £152 from the retailer.
Figure 1.2 below illustrates how HMRC collect the VAT:
3
£454
Manufacturer HM Revenue & Customs
£152
1 2 6
Retailer
4 5
Customer
Figure 1.2 Collection of VAT by HMRC
Figure 1.3 below shows how the VAT is paid.
Manufacturer £454 But can be reclaimed from HMRC

Retailer £152 But can be reclaimed from HMRC
Customer £606 (being £454 + £152) Effectively pays all the VAT
Figure 1.3 Payment of VAT
It is important to know how much VAT is included in a transaction so that

the amount due to or from HMRC is correctly identified. For instance, an
accountant charging a fee of £500 will add VAT of £100 (at 20%) and the
client pays £600.
In the UK a retailer selling goods to the public will usually show prices
inclusive of VAT so that if a television is sold for £500 then when recording
the transaction he will calculate the VAT using the VAT fraction of 20/120
(i.e. one sixth) so that the VAT will be £83.33 and the net value of the sale
is £416.67. A common mistake is to calculate the VAT at 20% of the gross
amount (e.g. £500) in which case too much will be paid.
If you do not have a purchase invoice that shows the amount of VAT be
careful not to assume that a payment for goods and services will always
include VAT at 20%. Some items may be zero rated (most food), exempt
(e.g. insurance premiums) or be at the reduced rate (some utility charges).
Also some small businesses may not have to charge VAT if their turnover is
below the registration limit, so the bill from one tradesperson, say, a painter,
might not include VAT but a bill from a larger firm would do.
13
Activity 1.1 Writing up the general ledger

Spend approximately 20 minutes on this activity.
A number of transactions are shown below together with a table for each.
Complete the following tables from the information given.
A cotton mill charges VAT at the standard rate of 20% on sales of £1,000.
Input Output VAT paid to HMRC

VAT VAT £
A curtain-making company purchases the rolls of material for £1,000 plus

VAT. The curtain maker sells curtains for £1,300 plus VAT to a department
store.

VAT VAT £
A department store purchases the curtains for £1,300 plus VAT. The
department store sells curtains for £1,625 plus VAT.

VAT VAT £
1.6 Place of supply

To be within the UK VAT system a supply must be made within the UK, so
a supply made outside the UK is outside of the UK VAT system. This rule
does not apply with digital services (electronic services, telecommunications
and broadcasting) where the place of supply is determined by the location of
the customer who receives the service.
As a small sole trader is unlikely to have the resources to register for VAT in
several European countries, HMRC developed the VAT Mini One Stop
Shop (MOSS) which allows small businesses to file their VAT returns in one
place. A supplier of digital services, for example e-books, therefore has the
choice of either registering for VAT in each EU country to which it makes
supplies or to register to use the VAT MOSS. Registering to use MOSS has
its advantages because it involves less administration; MOSS registers the
small trader in each EU member state and the VAT payable is calculated
automatically using the VAT rates for the various countries. Note: VAT
standard rate in the EU countries varies from 15% to 27%. However, if a
14
small trader uses an e-marketplace to sell its goods then

the e-marketplace is responsible for the VAT.
As well as understanding the place of supply for VAT purposes, it is also
important to understand when the supply is deemed to be made for VAT
purposes.
1.7 Accounting for VAT in the general

ledger
There are two ways to account for VAT in the general ledger.
The first is to open accounts for each of the following:
. output tax
. input tax
. VAT.
At the end of each VAT quarter the balances on the output tax account and
the input tax account are transferred to the VAT account. It is the VAT
account from which VAT is paid to (or a refund is received from) HMRC.
The second and easiest way to account for VAT in the general ledger,
however, is to open one account called VAT (see the example below).
All input VAT is debited to this account and all output VAT is credited to
it. If output VAT is greater than input VAT at the end of an accounting
period – the normal situation – then the credit balance on the account
signifies a liability owing to HMRC. On the other hand, if output VAT is
less than input VAT at the end of an accounting period then the debit balance
on the account signifies an asset owed by HMRC. The VAT account is thus
either a liability account or an asset account depending on whether money is
owed to HMRC or money is owed by HMRC. It is this one account method
that is used in B124.
The following example explains how to prepare a VAT account.
Example: The VAT account

A business starts a three-month VAT accounting period ending 31 March
with a credit balance on its VAT account on 1 January of £10,446. During
the three-month period its input VAT has been £25,164 (relating entirely to
purchases for the business) while its output VAT has been £37,732 (relating
entirely to sales). In the period it also paid the amount due to HMRC from
15
the previous accounting period. The accounting entries in the VAT account
for the period are:
VAT account
Date Dr Date Cr
20X5 £ 20X5 £
31 Mar Bank 10,446 1 Jan Balance b/d 10,446
31 Mar Purchase (input tax) 25,164 31 Mar Sales (output tax) 37,732
31 Mar Balance c/d 12,568 00,000
48,178 48,178
1 April Balance b/d 12,568
Activity 1.2 Preparing the VAT account

Following on from the example above, during the three-month period ending
30 June the company’s input VAT has been £27,858 (relating entirely to
purchases for the business) while its output VAT has been £38,835 (relating
entirely to sales). In the period it also paid the amount due to HMRC from the
previous accounting period.
Open up a VAT account, make the accounting entries and balance off the
VAT account for the period.
You may find the following approach helpful:
Step 1 Head up the account.
Step 2 Enter the opening balance brought down.
Step 3 Enter the month’s transactions.
Step 4 Balance off the account and bring down the balance at 1 July.
Stop and reflect

Who do the VAT rules apply to?
The general rules of VAT apply only to VAT registered traders whose
turnover is above a specified level. Non-registered businesses do not
account for VAT in their records. This means they do not charge VAT on
their sales and all their expenses are charged to their income statement
inclusive of the VAT they paid.
16
Activity 1.3 General ledger entries

Business A is VAT registered. On 20 May 20X2 the business buys a

computer for resale. It cost business A £2,172, of which £362 is input VAT
(20% is the most common rate of VAT and £362 is 20% of £1,810).
Business B is not VAT registered. This business also buys a computer for
resale for £2,172, of which £362 is input VAT.
Complete the accounting entries in the general ledger for the same
transaction for the two businesses.
Stop and reflect

How is a computer purchase recorded in the general ledger?
The computer bought in Activity 1.3 above is for resale; hence it is

accounted for in the purchases expense account. If it had been bought
for use in the business it would have been accounted for as a non-
current asset within an asset account such as plant and equipment.
There would be no difference, however, in the accounting for VAT.
1.8 Goods taken for own use

Where the owner of a VAT registered business takes goods out of the
business for his/her own use this constitutes a VAT taxable supply and VAT
must be accounted for on those goods. The following example explains the
accounting entries needed.
Example: VAT on drawings

Adam owns a garden centre.
. He takes a pot plant to give as a birthday present; this counts as own

use.
. He takes two bags of compost and uses one on a display in the centre
(business use) and takes one home for his garden (own use).
. He drives to the garage in the business’s van to fill it with petrol
(business use) and whilst there fills a can of petrol to take home for his
lawn mower (own use).
17
The accounting entries for goods taken for own use will be:
Dr drawings with value of goods (excluding VAT)
Dr drawings with VAT at 20% on the goods (output tax)
Cr purchases or the expense (excluding VAT)
Cr VAT account (with the VAT amount)
Activity 1.4 Calculating VAT
Lara owns a café and is registered for VAT. Her bank account contains the
following transactions:
(a) Banks £1,200 of takings

(b) Pays £45 for milk bought from the local dairy
(c) Pays wages of £346
(d) Introduces £500 of capital
(e) Pays £600 for new furniture
(f) Pays £50 to a local artist for a painting to display in the café
(g) Pays car insurance of £254
(h) Banks £50 for food supplied for a neighbour’s birthday party
(i) Pays £200 for her car to be serviced
(j) Draws £150 for her own use.
Calculate the VAT contained in each transaction and explain why this is the
case. Assume the rate of VAT is 20%.
Answers to activities
Activity 1.1 Writing up the general ledger

A cotton mill charges VAT at standard rate of 20% on sales of £1,000

VAT VAT £
£200 200
A curtain-making company purchases the rolls of material for £1,000 plus

VAT. The curtain maker sells curtains for £1,300 plus VAT to a department
store.

VAT VAT £
£200 £260 60
18
A department store purchases the curtains for £1,300 plus VAT.

The department store sells curtains for £1,625 plus VAT

VAT VAT £
£260 £325 65
325
The VAT received by HMRC is received in three amounts; £200, £60 and £65.
VAT paid on goods and services purchased, is called input tax. VAT on goods
sold is called output tax. The final consumer ends up paying VAT of £325.
Activity 1.2 Preparing the VAT account

VAT account
Date Dr Date Cr
20X5 £ 20X5 £
30 June Bank 12,568 1 April Balance b/d 12,568
30 June Purchase (input tax) 27,858 30 June Sales (output tax) 38,835
30 June Balance c/d * 10,977 00,000
51,403 51,403
1 July Balance b/d 10,977
* This is the balance left on the account once all the transactions have been posted to
the account. It is the amount owed by the business to HMRC. It is therefore carried
down and brought down as a credit balance (liability).
Activity 1.3 General ledger entries
Business A
Purchases (expense)
Date Dr Date Cr
20X2 £ 20X2 £
20 May Bank 1,810
VAT Account
Date Dr Date Cr
20X2 £ 20X2 £
20 May Bank 362
Bank (asset if a debit balance, liability if a credit balance)

Date Dr Date Cr
20X2 £ 20X2 £
Purchases 1,810
VAT 362
19
Business B
Purchases (expense)
Date Dr Date Cr
20X2 £ 20X2 £
20 May Bank 2,172
Bank (asset if a debit balance or liability if a credit balance)

Date Dr Date Cr
20X2 £ 20X2 £
Purchases 2,172
Business B is not VAT registered and thus does not have to account for VAT
or charge output VAT when the computer is sold. The disadvantage that
Business B has, unlike Business A, is that it cannot reclaim the VAT paid on
the computer.
Activity 1.4 Calculating VAT

(a) £200 The café sales are standard rated so the £1,200 includes
20% VAT.
(b) £nil The supply of food by the dairy is zero rated. Even though
Lara will be using the milk to make standard-rated sales in
the café, she cannot reclaim VAT. The VAT treatment of the
purchaser should usually match that of the seller.
(c) £nil Payment of wages is outside of the scope of VAT.
(d) £nil Capital introduced and cash drawings are outside of the
scope of VAT.
(e) £100 The supply of furniture is standard rated so the £600 includes
20% VAT.
(f) £nil (?) Unless the artist is generating income to exceed the VAT
registration limit there will be no VAT on the payment. If this
was a larger amount Lara would be advised to ask if the artist
was registered as she could then reclaim any VAT that was
being charged.
(g) £nil Insurance is an exempt supply so the payment will not
include VAT.
(h) £nil (?) This will depend on what the food is. If Lara is supplying
ingredients then they are likely to be zero-rated. If she has
made ginger cakes then these will be standard-rated.
The rules on take-away food can be quite complicated.
(i) ? It depends on whether Lara’s car is a business asset. If it is
then she would be able to recover the VAT of £33.33 (20/120
x £200) which will usually be at the standard rate. If the car is
not used in the business then Lara cannot recover the VAT.
(j) £nil Capital introduced and cash drawings are outside of the
scope of VAT.
20
Summary
In this chapter you have learned that governments raise money in the form
of direct and indirect taxes. B124 deals with the indirect tax VAT which, at
the time of writing, is administered in the UK by HMRC. VAT legislation is
complicated therefore this chapter has only given you a brief overview of it.
You also learned that the rate of VAT varies according to the type of goods
or services supplied: exempt, zero rated or partially exempt. Businesses that
supply standard rated supplies and which have turnover over a set limit fixed
by government must register for VAT and are required to keep sufficient
information so that VAT can be accurately reported.
Finally you learned that VAT charged on sales is called output tax. VAT paid
on purchases is called VAT input tax. In the books of a business VAT is
recorded in a VAT account in the general ledger. At regular intervals agreed
with HMRC, a business will pay over to HMRC the total VAT liability of
output tax less the input tax. At the end of a business’s accounting year, the
VAT account will either reflect an asset or a liability on the balance sheet.
Whilst businesses pay VAT to HMRC at various stages along the supply
chain, it is the final consumer who actually bears the full VAT.
21
Chapter 2 Accruals accounting for

expenses and revenue
Introduction
. understand the accruals concept

. calculate accruals and prepayments
. record accruals and prepayments in the general ledger, in the income
statement and on the balance sheet.
In Book 2 Chapter 3 you learned that profit is the measure of the ability of a
business to sell goods or services for more than the expenses incurred in
producing them. You also learned that profits are determined by applying the
matching principle whereby income earned is matched with expenses
incurred in earning that income. This chapter considers how all the expenses
incurred in generating income are determined by applying the accruals
concept, and how accruals are recorded in the appropriate accounting period.
It also looks at income earned but not invoiced until after the year end
(accrued income) and income received in advance of the year end (deferred
income).
2.1 Accruals accounting

In preparing the income statement and determining the profit for the period,
the matching concept requires that costs are matched with the revenues they
help to generate. This means that costs and revenues are recognised in the
accounting period when they are incurred/earned rather than when the
associated cash flow takes place.
To determine profit for the period, it therefore follows that end-of-period
adjustments have to be made. These adjustments should ensure that, for the
period in question, only the income earned and the expenses incurred in the
process of earning that income are recorded in the income statement. For
example under the accruals concept the calculation of gross profit involves
adjusting for opening and closing inventory. Opening inventory will be
brought down on the inventory account from the previous period end, and
taken to the income statement as the opening inventory. Opening inventory
ends up being an expense (debit in the income statement) because it is used
up in the period.
The closing inventory is a deduction (credit) in the income statements, and a
current asset (debit) in the balance sheet. Closing inventory still exists at the
year end.
22
Chapter 2 Accruals accounting for expenses and revenue
Steps to write up the inventory account

Step 1 Credit the inventory account and debit the income statement with the
amount of the balance brought down.
Step 2 Carry and bring down the closing balance.
Step 3 Take the closing inventory to the income statement. Debit the
inventory account and credit the income statement.
Step 4 Enter the totals.
Example: Writing up the inventory account

The balance on the account of £1,220 at 31 March 20X3 is brought down
from the previous year as a debit to the year commencing 1 April 20X3.
Inventory
Date Dr Date Cr
20X3 £ 20X4 £
1 April Balance b/d 1,220 31 March Income statement 1,220
The £1,220 is then debited to the income statement and credited to the
inventory account:
Inventory
Date Dr Date Cr
20X3 £ 20X4 £
0,000 31 March Balance c/d 1,940
0,000 0,000
20X4
The closing inventory of £1,940 at 31 March 20X4 is debited to the inventory

account and credited to the income statement:
Inventory
Date Dr Date Cr
20X3 £ 20X4 £
20X4
31 March Income statement 1,940 31 March Balance c/d 1,940
0,000 0,000
20X4
23
The balance on the account of £1,940 at 31 March is carried down from 20X4
(credit) and brought down to 1 April 20X4 (debit). It will be shown as an asset
in the balance sheet:
Inventory
Date Dr Date Cr
20X3 £ 20X4 £
20X4
31 March Income statement 1,940 31 March Balance c/d 1,940
3,160 3,160
20X4
The effect on the income statement can be seen in Activity 2.1 below.
Stop and reflect

If a business has increased its cash, has it also increased its profit?
Profit need not be related to the increase in cash generated in a period

and it is quite possible for a business to make a significant loss in a
period but experience a dramatic increase in cash. On the other hand, it
is also possible for a business to make a significant profit in a period but
experience a dramatic fall in cash. What many people do not realise is
that if it does not have enough cash, a highly profitable business can
become insolvent, a situation that occurs when a business is not able
to pay liabilities when they fall due because of a shortage of cash. One
of the reasons why profit and cash will differ is due to the application of
the accruals concept.
Activity 2.1 End-of-period adjustment

Charlie’s DVDs is a small cash-only business that buys and sells DVDs. In its
accounting year ending 31 March 20X4 the business sold DVDs to the value
of £22,400. At the beginning of the year Charlie’s DVDs had an opening
inventory of DVDs that was valued at £1,220, and the business made new
purchases of DVDs in the course of the accounting year that cost £9,680.
At the end of March 20X4 Charlie’s DVDs had a closing inventory of DVDs
valued at £1,940.
Using the accruals method of accounting:
(a) Calculate Charlie’s gross profit for the period using the recommended
format. Refer back to Book 2 Section 3.3 for the format if you have
forgotten it.
24
(b) Explain why an end-of-period adjustment to purchases, to reflect the fact

that there is closing inventory, is necessary in Charlie’s accounts.
Other than adjusting for closing inventory the other main types of end-of
period adjustments needed to determine the income earned and revenue
expenses incurred during the relevant accounting period are for:
. accruals (accrued expenses)

. prepayments (expenses paid in advance)
. accrued income (income that has been earned in the year but not
received in the year)
. income received in advance (income received in the year that relates to
subsequent period)
. depreciation of non-current assets (covered in Chapter 3)
. irrecoverable receivables (covered in Chapter 4)
. an increase or decrease in allowance for irrecoverable receivables
(covered in Chapter 4).
2.2 Accruals
A very common adjustment that needs to be made when preparing an income
statement for a period is to recognise accrued expenses, commonly known as
accruals. These are expenses that have been incurred in a period but have
not been paid or recorded in the accounts.
Usually when a business purchases goods and services they are ordered in
advance and invoiced when delivered. The invoice is recorded in the
accounts and the item is treated as an asset or an expense. However, for
some regular transactions the quantities are not ordered in advance and are
25
invoiced after they have been consumed. Typical examples of these expenses
are telephone, heating and lighting, and professional fees.
In many countries, telephone and power supplies are usually invoiced every
three months and reflect the consumption for the previous three months.
This situation means that an expense is going to be invoiced after the period
to which it relates. This is the expense that needs to be ‘accrued’; that is, it
needs to be recorded in the period to which it relates.
Example: Accrued expense

Suppose that Duncan pays a quarterly electricity charge for the periods
November to January, February to April, May to July, and August to
October. Assuming the accounting year follows the calendar year, this would
mean that at 31 December 20X1 the business would have received and
possibly paid the electricity bill (invoice) for the August–October quarter,
but Duncan would not have accounted for any electricity expense for
November and December. Following the accruals concept, the electricity
charge for November and December must be an expense for that year.
This is an accrual or accrued expense incurred but not invoiced or paid.
The time line in Figure 2.1 below shows clearly the two months (November
and December) when the electricity expense needs to be accrued for the
accounting period from 1 January 20X1 to 31 December 20X1.
Electricity
invoice
Electricity expense received
Electricity expense incurred and paid incurred but not paid and paid
J F M A M J J A S O N D
J F
1/1/20X1 Accounting period 31/12/20X1

Figure 2.1 Electricity invoice time line
2.2.1 Accounting for the accrued expense

An adjustment is needed in the situation above to follow the accruals
concept and to record the accrued expense in the accounts.
In the case of the electricity expense for November and December above,
Duncan would need to estimate the expense for these two months given the
actual expense is only revealed when the invoice is received in February.
One way of doing this is to base it on the invoice for the same period in the
previous year. Say the invoice for the period November 20X0 to
January 20X1 was £3,600. Duncan should consider whether this year’s
invoice will be any larger or smaller as a result of events known about or as
a result of the general trend of electricity prices. He can make an estimate
of the electricity accrual needed.
26
Example: Treatment of accruals

Duncan expects the cost of electricity to rise by 10% or more: £3,600 + 10% =
£3,960. The invoice covered three months, and Duncan only wants to estimate
the accrual for the two months November–December 20X1 (2/3 x £3,960 =
£2,640). He can then adjust for the estimated accrual of £2,640.
Duncan now needs to recognise this in the general ledger of his business,
i.e. increase the electricity expense by £2,640 and show an outstanding
liability of £2,640. The adjustment needed for the estimated electricity
expense for 1 November 20X1 to 31 December 20X1 would be:
Dr Electricity expenses Nov–Dec £2,640

Cr Accrued expenses £2,640
The accrued electricity expenses are included in the income statement as

part of the heating and lighting expense, and included in the balance sheet
under current liabilities.
Figure 2.3 shows how the accrual is accounted for in the financial
statements. In the diagram the total payments made in the year to
31/10/20X1 for electricity total £9,420.
Heating & lighting (expense)

£
Cash 9,420
Accrual 2,640
12,060
Income statement for the Balance sheet as at

year ended 31 December 20X1 31 December 20X1
£ £
Current liabilities
Heating & lighting 12,060 Accruals 2,640
Figure 2.3 Treatment of accruals
The accrual would be reflected in the general ledger:
Heating and lighting (expense)

Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Balance b/d* 9,420
(1/1–31/10/
20X1)
31 Dec Accrual 2,640
(Nov–Dec)
27
*There is an existing balance in the heating and lighting account for the period
1/1/20X1 to 31/10/20X1 as this is a known figure based on invoices that have
already been received from the power company.
Accruals (liability)*
Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Heating & Lighting 2,640
* If it does not already have one, the business will normally open a new general
ledger account, called accruals. This is a liability account, reflecting that at
31 December 20X1 the business owes an estimated £2,640 for electricity consumed
but not yet invoiced. At the end of the accounting year the balance on this account
is normally recorded after payables under the sub-heading ‘current liabilities’ in the
balance sheet.
The effect of this adjustment is to increase the expense for heating and
lighting that is taken to the income statement, and also to create a short-term
liability that will be included in current liabilities. In this way the income
statement reflects all the heating and lighting expenses for the year ending
31 December 20X1 and the balance sheet as at the 31 December 20X1
acknowledges that there is a liability for unpaid electricity.
Something to remember
Always remember the AA lesson – to Add Accruals to expenses.
2.2.2 Accounting for the accrued expense in the

following accounting year
At the beginning of the following year, when the invoice is received it is
debited to the relevant expense account. The accruals concept tells us that
the accrued expense should not be included in the accounts for the new
accounting period because it has already been recognised as an expense in
the previous period. It is not correct to record the same expense twice in the
accounts! The accounting entry needed is to debit the accrued expenses
account and credit the relevant expense account. A good way of
remembering this double entry is to realise that the relevant expense account
should at this stage be credited with the expense that it has already
recognised, i.e. the accrual needs to be reversed.
.
28
Activity 2.2 Accrued expenses
Duncan now needs to start his bookkeeping for the year ending
31 December 20X2.
Complete the double entries for the accrued expense in Duncan’s business
above at the beginning of the next accounting period ending
31 December 20X2.

Date Dr Date Cr
20X2 £ 20X2 £
Accrued expenses (liability)

Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Balance b/d 2,640
The following activity deals with the account process for the invoice for the
heating and lighting when it arrives in the course of 20X2.
Activity 2.3 Effect of an incorrect estimate

Continuing on from Activity 2.2, the business was expecting an invoice

of £3,960 from the power company in 20X2 covering the period
1 November 20X1 to 31 January 20X2. The expected figure of £3,960
comprised an estimate of £2,640 which was accrued for the year ending
20X1 and the estimated cost for January 20X2. Instead, the business
received an invoice in February 20X2 for £4,000 from the power company for
electricity consumed over the three months in question.
(a) Complete the double entries for the receipt of the invoice.
(b) Explain the effect of the incorrect estimate of the heating and lighting
expense on the business’s accounts.
The following example explains how to account for accrued expenses in the
general ledger.
29
Example: Accounting for accrued expenses in the general ledger

Later in the year the above business receives the following invoices:
Invoice received £ Period covered

5 May 20X2 3,800 1 February 20X2 to 30 April 20X2
8 August 20X2 2,500 1 May 20X2 to 31 July 20X2
16 November 20X2 4,150 1 August 20X2 to 31 October 20X2
The business pays its invoices on the last day of each month.
At the business year end of 31 December it is estimated that the accrual

for heating and lighting covering the period 1 November 20X2 to
31 December 20X2 will be £2,800.
The general ledger accounts at 31 December are shown below:

Date Dr Date Cr
20X2 £ 20X2 £
28 Feb Power company 4,000 1 Jan Accrued expenses 2,640
5 May Power company 3,800
8 Aug Power company 2,500
16 Nov Power company 4,150 31 Dec Income statement * 14,610
31 Dec Accrued expenses 2,800 00,000
17,250 17,250
* This is the difference between the total debits and the credits posted to the account.
It is therefore the charge for heating and lighting that will be shown in the income
statement at the year ending 31 December 20X2.
Power company (liability)

Date Dr Date Cr
20X2 £ 20X2 £
28 Feb Bank 4,000 28 Feb Heating and lighting 4,000
31 May Bank 3,800 5 May Heating and lighting 3,800
31 Aug Bank 2,500 8 Aug Heating and lighting 2,500
30 Nov Bank 4,150 16 Nov Heating and lighting 4,150
14,450 14,450

Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Heating and lighting 2,640

31 Dec Heating and lighting 2,800
At the financial year end of 31 December 20X2 the heating and lighting
expenses in the income statement is £14,610. The power company’s invoices
30
have all been paid, and the balance on the accrued expenses account is
£2,800. This accrual will appear in the balance sheet under current liabilities.
Stop and reflect

What are accruals?
Accruals are where we have to deal with items of expenditure paid after
the end of the accounting period, part or all of which belong to the
accounting period. Debit the expense account and credit the accrued
expenses account.
A business normally has a number of accrued expenses that occur

every year and these are normally all removed from the accrued
expenses account in one block at the beginning of the following year by
debiting the accrued expenses account and crediting the relevant
expense accounts. This is known as reversing out the entries.
Activity 2.4 Calculating charges and accruals

Imagine that your accounting period ends on 30 June 20X1 and that the
administrative expenses of your business normally include the telephone bill.
In August 20X1 you pay the quarterly bill of £900 for the months May, June
and July.
What are the charges and/or accruals for each of the two accounting periods,
ending 30 June 20X1 and 30 June 20X2, with respect to this bill? Rather
than show the general ledger accounts, show a working and then state which
account should be debited and which credited for the year ending 30
June 20X1. Your working could be in the format of a time line.
Activity 2.5 Applying accruals
A business with a financial year end 30 June pays machinery rental, which is
due for payment every three months. The quarterly charge is £300.
Machinery rental due Date paid

30 September 20X1 30 September 20X1
31 December 20X1 2 January 20X2
31 March 20X2 31 March 20X2
30 June 20X2 3 July 20X2
Prepare the machinery rental account for the year ended 30 June 20X2.
31
2.3 Prepayments
The opposite situation to accrued expenses arises when the business pays in
advance for goods or services, known as a prepayment. This happens
routinely for transactions such as rental of premises or equipment, and
insurance. The accruals concept applies just the same.
For example, rent may be payable quarterly in advance. This would mean
that rent for the period January to March would be payable by the end of
December the previous year. This means that the business has paid in one
year an expense that belongs in the income statement for the following year.
The time line in Figure 2.4 below shows clearly how a rent invoice for the
next accounting period – 1 January 20X2 to 31 December 20X2 – is
received and paid for in the previous accounting period – 1 January 20X1 to
31 December 20X1.
Rent invoice for next
quarter received and paid
Rent expense incurred and paid
J F M A M J J A S O N D J F M
1/1/20X1 Accounting period 31/12/20X1
Figure 2.4 Rent invoice time line
This payment in December 20X1, covering the period 1 January 20X2 to

31 March 20X2 is called a prepayment (or a prepaid expense). It is treated
with the same logic as accrued expenses, i.e. use the accruals principle to
match the expenditure to the relevant accounting period. At the time the
business makes the payment (e.g. rent) it is in effect purchasing an asset,
i.e. a right to use the rented premises for the next three months. This asset
will only start being used up in the next accounting period.
Activity 2.6 Prepayments
A small business had a financial year that ended on 31 December 20X1.
At 31 December 20X1 the business had paid five quarterly rent payments of
£4,000 each. The last payment covered the quarter for January 20X2 to
March 20X2.
Prepare the rent account and the prepayment account for the year ending
31 December 20X1. Remember to close each account, and bring the balance
down on the prepayment account.
32
Remember the RE rule – to REduce expenses by pREpayments.
Or you may prefer
The MP lesson – Minus Prepayments from expenses.
On the first day of a new accounting period the prepayment will need to be
reversed, so that it becomes part of the charge (expense) of the current year.
The accounting entries are:
Debit: The appropriate expense account
Credit: Prepayment account
Activity 2.7 Reversal of a prepayment

Following on from Activity 2.6, it is now 1 January 20X2.
Reverse the prepayment ready for writing up the general ledger for the year
ended 20X2.
Activity 2.7 on prepayments above was straightforward because the expense

payment referred entirely to the following accounting year. In the next
activity you will need to use your knowledge of the accruals concept to
allocate the payment of an expense over two accounting periods.
Reminder: Prepayments are items of expenditure made during an accounting
period that belong to a future accounting period.
Activity 2.8 Making adjustments

Imagine that your accounting period ends on 30 June 20X1 and an insurance
premium of £900 is included in your expenses. You paid this premium on
1 January 20X1 and it covers insurance for the year ending
31 December 20X1.
Calculate the adjustments that would need to be made at the end of the
accounting period. Rather than show the general ledger accounts, show a
working and then state which account should be debited and which credited.
You may find the use of a time line helpful here.
The prepayment for insurance is excluded from the income statement and
included in the balance sheet under current assets.
Figure 2.5 below shows how a prepayment is accounted for in the financial
statements. The ‘£400 charge 1 July 20X0 to 31 December 20X0’ is last
33
year’s prepayment that relates to the first six months of 20X1 but which was
paid in last year’s accounts.
Charge Insurance (expense)

1 July 20X0
£
to 31 Dec 20X0 400
Cash 900
Prepayment (450)
850
Income statement for the Balance sheet as at

year ended 30 June 20X1 30 June 20X1
£ £
Current assets
Insurance 850 Prepayments 450
Figure 2.5 Treatment of prepayments
The following will give you practice in accounting for prepayments. When
you reach Unit 5 you should be pleased that you undertook this practice.
Activity 2.9 Accounting for prepayments

A small business had a financial year that ended on 31 December 20X5.

The business bought a delivery truck on 1 August 20X5 and paid £1,800 the
same day to insure the truck for the following 12 months.
Complete the double entries in the general ledger for the following:
(a) insurance payment on 1 August 20X5

(b) adjustment required to reflect the prepayment at the year end
(c) reversal of the prepayment at the beginning of the next financial year.
Activity 2.10 Accruals and prepayments

Jefferson runs a business. During the year ending 31 December 20X1 he

made the following payments:
£
Electricity 6,800
Insurance 2,600
At 31 December 20X0 his accruals and prepayments were:
Electricity Accrual £800
Insurance Prepayment £600
34
At 31 December 20X1 his accruals and prepayments were:
Electricity Accrual £1,000
Insurance Prepayment £700
Calculate the income statement charges for electricity and insurance that will
appear in the 31 December 20X1 financial statements, and prepare the
electricity and insurance general ledger accounts.
The way to answer this question is:
Step 1 Open up the electricity account and the insurance account.
Step 2 Post the opening balances (accrual and prepayment).
Step 3 Post the payments.
Step 4 Post the closing balances (accrual and prepayment).
Step 5 Balance the account and enter the income statement figure.
The following activity sets out information in a way that could appear in
part of a TMA question.
Activity 2.11 Accounting for prepayments and accruals

Hayley started trading on 1 January 20X1. Her first set of accounts will cover
the year to 31 December 20X1. She immediately pays £15,000 representing
15 months’ rent paid in advance. She also enters into an agreement with an
advertising agency for them to provide promotional materials for a cost of
£10,000 per year. The £10,000 is to be paid in arrears in two equal
instalments on the 1 July 20X1 and 1 January 20X2.
Prepare accounts for rent and advertising for the year ending
31 December 20X1 clearly showing the income statement charges for
these expenses.
2.4 Accrued income (revenue)

Accrued income is relevant to a business that delivers a product or a service
over a period of time. The business accrues or earns income before an
invoice is sent to the customer and recorded in the accounts.
Example: Accrued income over a period of time

A business has a contract to provide IT maintenance to a client on a time
basis, but only invoices them at the end of every six months. If the
maintenance company had a financial year ending on 31 December but
started a £70,000 contract with a client on 1 October 20X1, the client would
not be invoiced for the £70,000 until 31 March 20X2.
35
If no adjustments were made, the business would show no revenue from that
contract in 20X1, even though three months’ work had been done.
Consequently, an accounting adjustment needs to be made. Based on the
time sheets for the period 1 October 20X1 to 31 December 20X1, the
bookkeeper needs to work out the income earned for the business in this
period. The calculation for work done to 31 December 20X1 comes to
£30,000.
The accrued income of £30,000 for the accounting period ending

31 December 20X1 would be recorded as follows:
IT maintenance (income)
Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Accrued income 30,000
Accrued income (asset)

Date Dr Date Cr
20X1 £ 20X1 £
31 Dec IT maintenance 30,000
At the financial year end the £30,000 income would be taken to the income
statement and the accrued income would be carried down to the next
accounting period.
Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Income statement 30,000 31 Dec Accrued income 30,000

Date Dr Date Cr
20X1 £ 20X1 £
31 Dec IT maintenance 30,000 31 Dec Balance c/d 30,000
20X2 £ 20X2 £
In the balance sheet accrued income would appear alongside receivables as

a current asset, reflecting that the client owes for three months’ maintenance
not yet invoiced.
36
To remove the accrued income of £30,000 from the accrued income account
at the beginning of the next accounting period the bookkeeping entries
would be:
Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Accrued income 30,000

Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Balance b/d 30,000 1 Jan IT maintenance 30,000
The accrued income account will now have a nil balance. The IT
maintenance income account balance will show a debit balance of £30,000,
to reflect that £30,000 worth of income has already been included in the
previous period, the year ending 31 December 20X1.
Activity 2.12 Accounting entries

On 31 March 20X2 the above business sends its customer T. Arbuthnot an

invoice of £70,000 to reflect maintenance income of £70,000 from
1 October 20X1 to 31 March 20X2.
Show the accounting entries needed to record this transaction in the general
ledger.
2.5 Income received in advance

(deferred revenue)
An example of income received in advance is a publishing business where
customers pay in advance when taking out a subscription to a magazine.
The publisher then has the problem of allocating this revenue to appropriate
accounting periods.
The example below explains how this might work in practice.
Example: Payment in advance

A publisher had a financial year that ended on 31 December 20X3.
A customer bought an annual magazine subscription for £120 cash for
the year on 1 April 20X3. The following entries will need to be made in the
general ledger accounts:
(a) sale of the magazine subscription on 1 April 20X3
37
(b) accounting adjustment at the year end to reflect the income received in
advance
(c) reversal of the income received at the beginning of the next financial
year.
General ledger entries:
(a) Sale of the magazine subscription on 1 April 20X3
Magazine sales (income)

Date Dr Date Cr
20X3 £ 20X3 £
1 April Bank 120
Bank (asset)
Date Dr Date Cr
20X3 £ 20X3 £
1 April Magazine sales 120
(b) Accounting adjustment at the year-end to reflect the income received in

advance

Date Dr Date Cr
20X3 £ 20X3 £
31 Dec Income in advance 30 1 April Bank 120
31 Dec Income statement 90 000
120 120
The balance on the magazine sales account to be taken to the income

statement is thus £90 (£120 – £30), reflecting that £90 worth of magazine
sales income was earned in the period ending 31 December 20X3.
Income received in advance (liability)

Date Dr Date Cr
20X3 £ 20X3 £
31 Dec Magazine sales 30
31 Dec Balance c/d 30 00
30 30
20X4 20X4
1 Jan Balance b/d 30
This balance of £30 will be shown as a current liability in the balance sheet.
38
(c) Reversal of the income received at the beginning of the next financial year
Income received in advance (liability)

Date Dr Date Cr
20X4 £ 20X4 £
1 Jan Magazine sales 30 1 Jan Balance b/d 30

Date Dr Date Cr
20X4 £ 20X4 £
1 Jan Income in advance 30
Activity 2.13 Gosport Golf Club
The Gosport Golf Club has 200 members who each pay a subscription. Some
pay on time, some pay in advance. For the year ended 30 September 20X2
the subscription was £120 a year; this rose to £140 a year for the year ended
30 September 20X3.
The club treasurer has provided you with the following information:
. Cash received in the year ended 30 September 20X3 was £21,400.

. As at 1 October 20X2 150 member subscriptions had been received in
advance.
. At 30 September 20X3 110 member subscriptions had been received in
advance.
Prepare the membership subscriptions account and calculate the income
statement figure for the year ending 30 September 20X3. Show your
workings.
Activity 2.14 Tington Tennis Club

The Tington Tennis Club has 400 members who each pay a subscription.
Some pay on time, some in advance and some in arrears. For the year
ended 31 May 20X1 the subscription was £150 a year; this rose to £160 a
year for the year ended 31 May 20X2, and £165 for the year ended 31
May 20X3.
The club treasurer has provided you with the following information:
. As at 1 June 20X1 60 member subscriptions were in arrears, and 210

member subscriptions had been received in advance.
. At 31 May 20X2 40 member subscriptions were in arrears, and 230
member subscriptions had been received in advance.
39
Prepare the membership subscriptions account and calculate the amount of

cash received in the year ended 31 May 20X2. Show your workings.
2.6 Year-end adjustments

Year-end adjustments are necessary because some information required for
the preparation of the financial statements only becomes available after the
end of the accounting period. In addition some things are either paid early
(rent and telephone line rental) or paid late (telephone call charges) and
certain judgements need to be made concerning non-current assets, the state
of receivables and the valuation of inventory. Many of these period-end
adjustments have been explained in this chapter; others have been explained
in Book 2 or will be explained in Chapter 3 of this book.
End-of-period adjustments may be classified as:
. Inventory (covered in Book 2) – goods for sale that are unsold at the end
of the accounting period, and in the case of a manufacturer the cost of
raw materials and work in progress.
. Accruals – expenses that belong to the current accounting period but
which are unpaid at the end of the accounting period.
. Prepayments – items of expenditure included in the accounts contained in
the trial balance, which belong to the future accounting period, but which
were paid during the current accounting period.
. Accrued income – income that belongs to the current accounting period
but which has not been paid by the customer at the end of the accounting
period.
. Income received in advance, sometimes called deferred income – income
contained in the accounts and in the trial balance but which belongs to
the future.
. Depreciation (covered in Chapter 3) – which charges a proportion each
year of the cost of non-current assets to the income statement.
. Irrecoverable receivables (covered in Chapter 4) – the writing off of
debts due from customers that will not be received.
. Allowance for irrecoverable receivables (covered in Chapter 4) – an
allowance deducted from receivables for potentially non-paying
customers.
All these adjustments will arise after the trial balance has been extracted
from the general ledger. Once the accounts have been prepared, these
adjustments will be put through the general ledger. The ledger will be closed
off so that all the balances carried down and brought down on the general
ledger will agree with the balances in the balance sheet.
40
The production of the financial statements is shown in Figure 2.6 below.
accounting transactions
double entry in general ledger
trial balance
end-of-period adjustments
income statement and balance sheet
Figure 2.6 Production of financial statements
The following example shows how the adjustments required for accruals and
prepayments are reflected in the balance sheet.
Example: Silva's advertising agency

Duarte Silva’s advertising agency has the following trial balance at
31 March 20X6.
£ £
Sales 157,730
Wages 102,491
Rent 14,550
Heating and lighting 2,671
Motor expenses 5,292
Telephone 2,121
Printing and stationery 1,024
Subscriptions 1,230
Sundry expenses 1,872
Office equipment 3,520
Motor vehicles 18,600
Receivables 64,890
Bank 24,112
Capital account 74,704
Drawings 32,850
Payables 000,000 42,789
275,223 275,223
41
The following information is available:
(a) accrued income £23,450

(b) income received in advance £7,200
(c) rent of £2,050 has been prepaid
(d) heating bill of £750 covering the period to 31 March was received on
20 April 20X6
(e) motor insurance has been prepaid of £400
(f) telephone bill was received on 18 April included a charge for calls of
£825 for the period to 31 March
(g) subscriptions of £250 were prepaid.
Below are the income statement for the year ending 31 March 20X6 and a
balance sheet as at 31 March 20X6. The workings are shown in italic.
Duarte Silva’s advertising agency

Income statement for the year ending 31 March 20X6
£ £
Sales (£157,730 + accrued income £23,450 – income 173,980
received in advance of £7,200) (a)(b)
Less Expenses
Wages 102,491
Rent (£14,550 – prepayment £2,050) (c) 12,500
Heating and lighting (£2,671 + accrual £750) (d) 3,421
Motor expenses (£5,292 – prepaid insurance £400) (e) 4,892
Telephone (£2,121 + accrual £825) (f) 2,946
Printing and stationery 1,024
Subscriptions (£1,230 - prepayment £250) (g) 980
Sundry expenses 1,872
130,126
Net profit 43,854
42
The other half of each adjustment appears in the balance sheet as follows:
Duarte Silva's advertising agency

Balance sheet as at 31 March 20X6
£ £
Non-current assets
Office equipment 3,520
Motor vehicles 18,600
22,120
Current assets
Receivables 64,890
Prepayments (rent £2,050, motor insurance £400,
subscriptions £250) (c) (e) (g) 2,700
Accrued income (a) 23,450
Bank 24,112
115,152
Total assets 137,272
Capital
Opening balance 74,704
Add: Net profit 43,854
118,558
Less: Drawings (32,850)
85,708
Current liabilities
Payables 42,789
Accruals (heating and lighting £750,
telephone £825) (d) (f) 1,575
Income received in advance (b) 7,200
51,564
Total capital and liabilities 137,272
When given a question containing a trial balance and additional
information, entries in the trial balance are recorded in the financial
statements (income statement or balance sheet) once because the trial
balance is the result of double-entry bookkeeping. Additional information
is recorded in the financial statements twice: one debit and one credit.
43
Activity 2.15 Explanation of adjustment needed

Costas runs a small hotel and prepares his annual accounts to

30 September. The following is an extract from his bank account. It contains
six transactions that will require an adjustment at the year-end if his accounts
are to reflect the accruals concept:
£ £
1 Sept Paid gas bill for the quarter ended 31 July 570
3 Sept Paid butcher for August purchases, no invoice 345
has been received for September purchases
7 Sept Banked takings 1,200
12 Sept Paid bookkeeper for August 250
13 Sept Paid for advertising in holiday guide 135
15 Sept Paid insurance on car for the year commencing 340
20 September
19 Sept Paid decorator for painting kitchen 425
20 Sept Banked deposit for Christmas Party 200
23 Sept Paid staff wages for September 2,890
29 Sept Paid rent for quarter commencing 1 October 6,000
30 Sept Banked takings 3,400
Explain in words the adjustments needed.
Activity 2.1 End-of-period adjustment

(a) Calculation of gross profit
£ £
Sales 22,400
Less: Cost of sales
Opening inventory 1,220
Add: Purchases 9,680
10,900
Less: Closing inventory ( 1,940)
8,960
Gross profit 13,440
(b) Explanation
The end-of-period adjustment to purchases is necessary so that only the cost
of DVDs that is actually incurred or ‘used up’ in a period is included in the
cost of sales for the period. This is in line with the accruals concept.
The closing inventory will be a credit in the income statement and a debit
under current assets in the balance sheet. The closing inventory in this
period will be the opening inventory in the next period so if inventory is not
44
adjusted for, gross profit would not only be understated in the period shown
above, but the gross profit would be overstated in the next accounting
period.
Activity 2.2 Accrued expenses

Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Accrued expenses 2,640

Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Heating and lighting 2,640 1 Jan Balance b/d 2,640
Activity 2.3 Effect of an incorrect estimate

(a) The double entries

Date Dr Date Cr
20X2 £ 20X2 £
28 Feb Power company 4,000 1 Jan Accrued expenses 2,640
Power company (liability)

Date Dr Date Cr
20X2 £ 20X2 £
28 Feb Heating and lighting 4,000
(b) Explanation
The balance on the heating and lighting account at this stage of the
accounting period ending 20X2 is £1,360 (£4,000 – £2,640), reflecting the
business’s underestimation of its usage of electricity by £40 (£4,000 invoice
received – £3,960 estimated invoice = £40) for the relevant three-month
period. This error in estimation is taken into the income statement for 20X2
as the accounts for 20X1 have already been closed. In this way the known
heating and lighting expense for the period is fully accounted for.
45
Activity 2.4 Calculating charges and accruals

Your accounting period
1 July 20X0 to 30 June 20X1
Quarterly telephone invoice £900
1 May 20X1 to 31 July 20X1 invoice
paid
May and June July

August
belongs to belongs to
20X0/1 20X1/2
accounting period accounting period
Figure 2.7 Telephone charge timeline
Figure 2.7 above shows that May and June: £900 × 2/3 = £600 belongs to
20X0/1 accounting period.
July: £900 × 1/3 = £300 belongs to 20X1/2 accounting period.
The accounting entry would be to debit the telephone expenses account with
£600 and credit the accruals account with £600.
Activity 2.5 Applying accruals

Machinery rental account (expense)
Date Dr Date Cr
20X1 £ 20X2 £
30 Sept Bank 300 30 June Income statement 1,200
20X2
2 Jan Bank 300
31 March Bank 300
30 June Accruals account 300 0,000
1,200 1,200
The rent paid on 3 July 20X2 will be recorded in the books of the business for
the year ending 30 June 20X3. The machinery rental charge that will appear in
the income statement for the year is £1,200 (£300 × 4). However to make the
debit side equal the £1,200 on the credit side, an accrual needs to be made.
Debit machinery rental account £300 and credit the accruals account.
Activity 2.6 Prepayments

Rent (expense)
Date Dr Date Cr
20X1 £ 20X1 £
Bank 4,000
Bank 4,000
Bank 4,000
Bank 4,000 31 Dec Prepayment 4,000
Bank 4,000 31 Dec Income statement 16,000
20,000 20,000
46
Prepayments (asset)
Date Dr Date Cr
20X1 £ 20X2 £
31 Dec Rent 4,000 31 Dec Balance c/d 4,000
4,000 4,000
20X2
By adjusting for the payment in advance, the 20X1 accounts will show
the correct expense of £16,000 (£4,000 × 4), not the overstated £20,000
(£4,000 × 5) debited to the account. (The prepayment account will be shown
as an asset in the business balance sheet at 31 December 20X1 – a current
asset because it will no longer be an asset by the end of March 20X2.)
Activity 2.7 Reversal of a prepayment

Rent (expense)
Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Prepayment 4,000
Prepayments (asset)
Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Balance b/d 4,000 1 Jan Rent 4,000
4,000 4,000
In this way the expense, rent, has been matched to the period to which it
relates – the year ending 31 December 20X2 – instead of to the period in
which the cash flow took place – the year ending 31 December 20X1.
Activity 2.8 Making adjustments

The insurance period does not coincide with your accounting period.
Figure 2.8 should explain this:
Your accounting period

1 July 20X0 to 30 June 20X1
Period of insurance
1 January 20X1 to 31 December 20X1
Total insurance invoice

£900 paid on 1 Jan 20X1
Half belongs to Half belongs to

accounting year accounting year
ended 30 June 20X1 ended 30 June 20X2
Figure 2.8 Insurance charge timeline
47
Figure 2.8 above shows that only 6/12 of the £900 insurance bill (£450)
belongs to the accounting period ended 30 June 20X1.
The accounting entry would be to credit the insurance account with £450
and debit the prepayments account with £450.
Activity 2.9 Accounting for prepayments

General ledger accounts for the Y/E 31 December 20X5 (insurance payment
on 1 August 20X5 and adjustment required to reflect the prepayment at the
year end).
Note: Y/E is an acceptable abbreviation for year ended.
Bank (asset)
Date Dr Date Cr
20X5 £ 20X5 £
1 Aug Insurance 1,800
Insurance (expense)
Date Dr Date Cr
20X5 £ 20X5 £
1 Aug Bank 1,800 31 Dec Prepayment * 1,050
* This reflects that part of the insurance premium of £1,800 that relates to the next
accounting period. 7/12 of £1,800, or £1,050, is thus a prepayment for the year ending
31/12/20X6, leaving 5/12 of £1,800, or £750, as an expense for the accounting year
ending 31/12/20X5.
Prepayments (asset)
Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Insurance 1,050
General ledger accounts for the Y/E 31 December 20X6 (reversal of the
prepayment at the beginning of the next financial year.)
Insurance (expense)
Date Dr Date Cr
20X6 £ 20X6 £
1 Jan Prepayments 1,050
Prepayments (asset)
Date Dr Date Cr
20X6 £ 20X6 £
1 Jan Balance b/d 1,050 1 Jan Insurance 1,050
48
Activity 2.10 Accruals and prepayments

Electricity
Date Dr Date Cr
20X2 £ 20X2 £
Bank 6,800 1 Jan Accrual 800
31 Dec Accruals 1,000 31 Dec Income statement 7,000
7,800 7,800
Insurance
Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Prepayment b/d 600
Bank 2,600 31 Dec Prepayment 700
0,000 31 Dec Income statement 2,500
3,200 3,200
Activity 2.11 Accounting for prepayments and accruals

Rent
Date Dr Date Cr
20X1 £ 20X1 £
1 Jan Bank 15,000 31 Dec Prepayment c/d 3,000
0,000 31 Dec Income statement 12,000
15,000 15,000
20X2 20X2
1 Jan Prepayment b/d *3,000
Promotional materials
Date Dr Date Cr
20X1 £ 20X1 £
1 July Bank 5,000
31 Dec Accrual c/d 5,000 31 Dec Income statement 10,000
10,000 10,000
20X2 20X2
1 Jan Accrual b/d *5,000
*Instead of opening a prepayments account and an accruals account, the balances
have been carried down and brought down on the individual accounts. Both methods
are acceptable. The method shown here saves reversing out figures from a
prepayments account and from an accruals account at the start of the next financial
year.
49
Activity 2.12 Accounting entries

Receivable - T. Arbuthnot (asset)
Date Dr Date Cr
20X2 £ 20X2 £
31 Mar IT maintenance 70,000
Date Dr Date Cr
20X2 £ 20X2 £
1 Jan Accrued income 30,000 Receivables 70,000
The balance on the IT maintenance account will thus be £40,000 (£70,000 –

£30,000) for the three months ending 31 March 20X2. This is the income to
be reflected in 20X2, £30,000 having been shown in 20X1.
Activity 2.13 Gosport Golf Club

Workings
1 October 20X2 150 subscriptions in advance 150 × £120 = £18,000
30 September 20X3 110 subscriptions in advance 110 × £140 = £15,400
Membership subscription receivable

Date Dr Date Cr
20X2 £ 20X2 £
1 Oct Advances 18,000
20X3 20X3
30 Sept Advances 15,400 30 Sept Cash 21,400
30 Sept Income statement 24,000
39,400 39,400
The income statement figure can be checked. There are 200 members and the
income for the year ended 30 September 20X3 is £24,000. Income for the year
is therefore: number of members 200 × subscription £120 = £24,000.
Activity 2.14 Tington Tennis Club

Workings
Opening balances:
. 1 June 20X1 60 subscriptions in arrears 60 × £150 = £9,000

. 1 June 20X1 210 subscriptions in advance 210 × £160 = £33,600
Closing balances:
. 31 May 20X2 40 subscriptions in arrears 40 × £160 = £6,400

. 31 May 20X2 230 subscriptions in advance 230 × £165 = £37,950
50
Membership subscription receivable

Date Dr Date Cr
20X1 £ 20X1 £
1 June Arrears 9,000 1 June Advances 33,600
20X2 20X2
31 May Income statement 64,000 31 May Cash 70,950
31 May Advances 37,950 31 May Arrears 6,400
110,950 110,950
Cash received in the year ended 31 May 20X2 was £70,950.

As there are 400 members the income for the year ended 31 May 20X2 is
£64,000 (number of members 400 × subscription £160 = £64,000).
Activity 2.15 Explanation of adjustment needed

. The last gas bill paid is to 31 July. An accrual for two months will be
needed.
. The butcher’s bill for September has not been received so an accrual is
needed.
. An accrual needs to be made for the bookkeeper’s pay for the month of
September.
. The deposit for the Christmas party is income received in advance.
. A prepayment will be needed for the car insurance.
. A prepayment will be needed for the rent. All of the quarter’s rent falls
into the next financial year.
Summary
In this chapter you learned that the matching principle and the accruals
concept are fundamental to working out the profit or loss of a business for
an accounting period.
You also learned that income in the income statement should reflect all the
income relating to the accounting period. Expenses in the income statement
should reflect all the costs relating to the relevant accounting period.
Finally you learned that to arrive at the appropriate figure for expenses in an
accounting period, the accruals concept should be applied. This includes
making adjustments for:
. Accruals – expenses that have been incurred in a period but for which no
invoice has been received. Also if a cash item, payment has been made
after the end of the accounting period, but the charge relates to the
current period. This will usually entail making an estimate of the amount
to be accrued, or apportioning an invoice if an invoice has been received
after the period end but before the accounts are produced. It could also
mean apportioning a cash payment paid after the year end part of which
51
related to the current year. The accounting entry will result in a debit to
expenses in the income statement and a credit under current liabilities in
the balance sheet.
. Prepayments – goods or services have been paid for in advance.
This may entail apportioning an invoice received prior to the period end.
The accounting entry will result in a credit to expenses in the income
statement and a debit under current assets in the balance sheet.
. Accrued income – a business delivers goods or services over a period of
time, which straddles one or more accounting periods. Income to be
accrued will be calculated from details contained in a contract.
The accounting entry will result in a credit to revenue in the income
statement and a debit under current assets in the balance sheet.
. Income received in advance – income should be apportioned over the
various accounting periods to which it relates. The accounting entry will
result in a debit to revenue in the income statement and a credit under
current liabilities in the balance sheet.
Effect on income
statement Effect on balance sheet
Accruals Increases expenses Increases current liabilities
Decreases profit
Prepayments Reduces expenses Increases current assets
Increases profit
Accrued income Increases profit Increases current assets
Increases income
Income received in Reduces income Increases current liabilities
advance Reduces profit
All adjustments made to arrive at the appropriate figures for income and
expenses in one accounting year affect the figures for the following
accounting year.
In Chapter 3 a further adjustment required under the accrual concept, that of
depreciation, will be explained. In Chapter 4 you will be introduced to
irrecoverable receivables; adjustments for these are required under the
accruals concept.
52
Chapter 3 Tangible non-current assets and depreciation
Chapter 3 Tangible non-current

assets and depreciation
Introduction
. distinguish between capital expenditure and revenue expenditure

. understand the two main methods of depreciation
. calculate depreciation using the two main methods of depreciation
. record depreciation in the general ledger accounts
. understand the use of a disposal of non-current assets account to
calculate the profit or loss on the disposal of a non-current asset
. present depreciation in the balance sheet and income statement.
This chapter considers the difference between capital and revenue
expenditure and how non-current assets that are capital items are presented
in the balance sheet. It also explains the term depreciation. This matches the
use of the non-current assets with the period in which those non-current
assets generate income. The chapter considers two methods of calculating
depreciation, how depreciation is recorded in the general ledger, and how
depreciation is presented in financial statements. The charging of
depreciation is an extension of the accruals concept, which was considered
in Chapter 2.
3.1 Non-current assets

In Book 2 you learned that non-current assets are assets purchased by the
business for continuing use in the long term. Examples of such assets
include tangible assets of land and buildings, computer equipment and motor
vehicles, and intangible assets such as patents and copyrights. Expenditure
on non-current assets is known as capital expenditure. It consists of the
initial cost and the cost of any additional expenditure known as additions,
for example, the cost of building an extension.
Two accounting concepts come into play here: the historical cost concept
and the going concern concept. The historical cost concept states that the
value of assets should be based on the acquisition cost (its historical cost).
The going concern concept implies that a business will continue to operate
in the foreseeable future; therefore, there is no intention to close down the
business. This allows assets to be valued at the historical cost to the business
less depreciation even if this is more than the scrap /disposal value for which
they would be sold should the business close.
Under the going concern concept we assume that a business will continue to
operate into the foreseeable future, therefore it is wise to continue to base
the value of its assets shown in the financial statements on the historical cost
53
convention. However, if it is known that the business will close down in,
say, June then all the assets including the non-current assets will have to be
valued at the price they can be disposed of in June. As the going concern
concept will only be rejected when a business is forced to close, this module
will apply the going concern concept in all examples and activities.
3.1.1 The distinction between capital and revenue

Capital expenditure must not be confused with revenue expenditure.
Revenue expenditure is expenditure on inputs that are consumed in the day
to-day running of the business and does not result in the increase in value of
a non-current asset. An example would be the repair of a motor vehicle.
Capital expenditure is expenditure on non-current assets or on improving the
earning capacity of non-current assets. An example would be the purchase of
a piece of equipment.
Stop and reflect

How is an asset classified between non-current and current?
How an asset is classified between non-current and current will vary

according to the nature of the business. A business selling cars will hold
its motor vehicles as inventories (current assets), whilst a business
hiring out cars or having a fleet of cars used by its sales representatives
will hold its motor vehicles as non-current assets.
If expenditure is wrongly classified as either capital expenditure or revenue

expenditure it will result in profits being under or overstated and the balance
sheet values being over or understated.
Activity 3.1 Revenue or capital

Chadwick Joinery had the following items in its accounts:
. Purchasing a computer
. Purchasing a docking station for the computer
. Purchasing a stapler for £5
. Buying factory machinery
. Electricity cost of running the machinery
. Spending £5,000 on improving the machinery
. Spending £700 on repairing machinery
. Buying a van
. Expenditure on signwriting on the van giving the name of the firm with its
logo
54
. Road tax for the van

. Petrol for the van
. Painting a new building
. Painting an existing building.
Required: State which of the items are capital and which are revenue items.
3.1.2 Materiality
The concept of materiality states that information is material if omitting it or
misstating it could influence decisions that users make on the basis of
financial statements. It is important that every business decides what is to be
considered as material to the business, so that time is not wasted looking at
individual items and agonising over whether they are material or not.
The staples in a stapler would not be counted at the year end and carried
down on the stationery account as a current asset (stationery supplies)
because their value is considered to be immaterial. However, a large supply
of boxes of unused staples is likely to be counted and carried down to the
next accounting year on the stationery account. Likewise an inexpensive
stapler would be charged as a revenue expense and not as a non-current
asset, whilst a large industrial stapler would be expensive and capitalised as
a non-current asset.
Determining materiality is a subjective exercise because there is no
accounting rule that states what the materiality limit should be. A small
business might capitalise (i.e. include in non-current assets in the balance
sheet) items costing £100 or more and record them as non-current assets.
In a larger business it might capitalise items costing £500 or more. In a large
business £1,000 or more might be the figure used to distinguish between
revenue and capital items. Generally the smaller the business the lower the
materiality limit.
3.2 Depreciation
Another aspect of the accruals concept is the question of what happens to
non-current assets as they are consumed (used up) in a business over several
accounting periods. The business has to charge the cost of using an asset
against the relevant accounting period. The annual measure of the cost
consumed is called depreciation; it is charged as an expense in the income
statement. The aim of the accounting treatment for non-current assets is to
allocate, as fairly as possible, the original cost less residual value to the
income statement over the accounting periods that benefit from the use of
the asset (see Figure 3.1).
55
Income statement Balance sheet
Annual depreciation is an and Depreciation is deducted from

expense the cost of the non-current
asset to give the net book
value (or carrying value) for
the non-current asset.
Figure 3.1 Depreciation
Reliance will have to be placed on estimates, but essentially it is just a

question of experience and judgement.
Applying the accruals concept, the cost of using an asset should be allocated
to each of the years in which the asset is used. This expense is called
depreciation.
In order to calculate depreciation the accountant will need to know for each
asset:
. purchase cost
. estimated useful life
. estimated residual value.
3.2.1 Cost
Cost is the purchase price including any import duties paid, but excludes
VAT if the business is VAT registered, plus any costs directly attributable to
bringing the asset into a working condition. For example:
. initial delivery (carriage inwards) and handling costs

. the cost of preparing the site, such as preparing a base for the machine
to stand on
. installation and assembly costs
. professional fees (engineers, architects, and legal fees)
. costs of testing the asset to see that it works properly
. staff costs arising from directly constructing or acquiring the asset
(this does not include the cost of training the staff to use the asset).
Added to the purchase price is any subsequent expenditure that increases
the future economic benefits generated by the non-current asset.
3.2.2 The estimated useful life

Non-current assets can have both a physical life and an economic life.
The physical life is used up by the passing of time and by wear and tear.
It may, however, be extended by good maintenance and added
improvements. The economic life is determined by technological
improvements and changes in demand, for example the products produced
by a piece of machinery. The economic life may therefore be much shorter
than the physical life; for example a computer may have a physical life of
56
ten years but may only be of use in a business for three years. In calculating
depreciation of non-current assets the number of years a business can use
the non-current asset to generate revenue (estimated useful life) is needed.
Therefore to determine the estimated useful life of a non-current asset the
accountant has to make a decision, in advance, about how to allocate the use
of the asset from the beginning of its working life to when the asset is no
longer used by the business. The accountant may be able to refer to past
patterns of usage or information gleaned from other businesses. Factors that
should be considered include expected wear and tear, and obsolescence.
Wear and tear depends on circumstances such as how long a machine will be
run for. Obsolescence may be due to technological advances or new
products being available.
3.2.3 The residual value

When a business sells a non-current asset, it may still be of value to other
people. For example a business may exchange its cars every four years or
only keep computer equipment for three years. These assets will have a
value when sold. The residual value is the estimated amount that an asset
could be disposed for at the end of its estimated useful life to the business,
less any estimated costs of disposal. Determining the residual value at the
end of an asset’s useful life is purely a matter of judgement.
Figure 3.2 below shows how depreciation is calculated.
Year 1
depn
less equals Over the
number of
Residual Depreciable Year 2 years of the
Cost
value amount depn useful life
of the asset
Year 3
depn and
further
years
Figure 3.2 Calculating depreciation

Depreciation calculated each year is deducted from the depreciable amount over
the life of the asset.
The following example explains how the depreciable amount should be

calculated.
Example: Calculating the depreciable amount

A van costing £40,000 is bought by Mr Smith in 20X1. The business plans
to keep the van for five years and estimates it will get £2,500 by selling it
after this period. Mr Smith’s accounting policy is to use straight line
depreciation (see Section 3.3.1 below).
To calculate the figure to be charged against income for the use of the van
over the five years you need to work out the cost to the business of using
the van. In this example it is £37,500 (£40,000 – £2,500). This would be the
figure that the business would have to charge in total against income over
the five years of the van’s use. It is the depreciable amount.
57
This depreciable amount can be charged as an expense in the income

statement by one of two methods: the straight line method or the reducing
balance basis.
When depreciating intangible non-current assets (those with no physical
form) we do not call the amount depreciation we call it amortisation.
For example we amortise (rather than depreciate) brands or copyrights.
3.3 Choosing a depreciation method

We will now consider the two depreciation methods: the straight line method
and the reducing-balance method.
3.3.1 Straight line method of depreciation

The most common way to allocate the depreciable amount of £37,500 is to
allocate the same amount to each year. Dividing the expected cost (net of
any residual value) by the expected useful life results in the same amount of
depreciation being charged each year. This method is known as the straight
line method. The following example demonstrates this method.
Example: Straight line depreciation

Using the straight line method of depreciation, calculate the depreciation
expense that would be charged to the income statement of Mr Smith each
and every year over the five-year useful life of the van.
The expected life of the van is five years, so £37,500 / 5 gives £7,500
charged to the income statement every year.
£
Cost of van 40,000
Year 1 Depreciation 7,500
Net book value at end of year 1 32,500
Figure 3.3 below shows the written down value of the non-current asset
decreasing in a straight line.
58
£45,000
£40,000
£35,000
£30,000
Written down value
£25,000
£20,000
£15,000
£10,000
£5,000
£0
0 1 2 3 4 5
Asset life
Figure 3.3 Straight line depreciation
Another way of calculating straight line depreciation is to calculate it using a

fixed percentage per annum, e.g. 20%.
Activity 3.2 Calculating depreciation using the straight line

method
A business buys a pickup truck for £57,000 and it is considered to have a

residual value of £5,000 at the end of its useful life in the business. The
pickup truck is to be depreciated over 5 years using the straight-line method
of depreciation.
Calculate the depreciation expense that would be charged to the income

statement of each and every year over the five-year useful life of the truck,
and calculate the net book value of the truck at the end of each of the five
years. (Hint: Deduct the residual value from the cost before calculating the
depreciation to be charged each year).
It would not be appropriate to use the straight line method to depreciate all
non-current assets because it assumes that the asset is consumed by the
business simply by the passage of time. Time is considered to flow evenly
throughout the life of the asset. The cost of some assets is used up more in
the early years than in later years, for example with motor vehicles. Non-
current assets may also be affected by changes in technology, so when the
asset is bought it may be the latest specification, but as the asset is
consumed, new technology may be developed that has a much higher
specification.
59
3.3.2 Reducing balance method of depreciation

The most common alternative method is called the reducing balance
method. This method involves applying a fixed percentage depreciation
charge to the cost of the asset after deducting any previous depreciation.
The following example demonstrates this method.
Example: Reducing balance depreciation

Taking the example of Mr Smith’s van above (which cost £40,000 and had a
residual value of £2,500), but this time using the reducing balance method of
depreciation, calculate the depreciation expense for the van for each of the
five years it is intended to be kept. This time the depreciation rate will be
42.56% because that will give a residual value of roughly £2,500.
£
Cost of van 40,000
Year 1 Depreciation (£40,000 × 42.56%) 17,024
Note that when applying the reducing balance basis of depreciation we do

not deduct the residual value from the cost. The residual value will be the
figure we are left with having depreciated the asset over the whole of its
useful life. In the example above the residual value was £2,500, and the
figure left at the end of its five-year useful life was £2,501.
In your TMAs and in your exam you will always be given the depreciation
rate. However, for those of you who would like to know how the above
depreciation rate was calculated the formula is given in the box below.
For those of you who do not like formulae, do not worry it will not be
needed in this text and you will not need it in your TMAs or in your exam.
Box 3.1 Calculating the reducing balance basis

depreciation rate
To find the percentage to apply with this method the following formula
should be used:
rffiffiffi
r ¼ 1 ns
c
where n = number of years
s = the net realisable value
c = cost of the asset.
60
Using the reducing balance method, the net book value (NBV) can also
be calculated using the formula:
NBV = Cost × (1 – r)n
where:
r = the depreciation rate as a decimal
n = the number of years.
Using the formula, the NBV for the example van at the end of year 2 is:
£40,000 × (1 – 0.4256)2= £40,000 × (0.5744)2 = £40,000 × (0.3299353)

= £13,197.
Figure 3.4 below shows how the written down value of the non-current asset
reduces less steeply in later years.
£45,000
£40,000
£35,000
£30,000
Written down value
£25,000
£20,000
£15,000
£10,000
£5,000
£0
0 1 2 3 4 5
Asset life
Figure 3.4 Reducing balance depreciation
Activity 3.3 Calculating reducing balance depreciation

A business buys a truck for £57,000. It is considered to have a residual value

of approximately £18,700 at the end of its useful life in the business. The
truck is to be depreciated over 5 years using the reducing balance method of
depreciation. Assume a depreciation rate per year is set at 20%.
61
Calculate the depreciation expense that would be charged to the income

statement of the business each and every year over the five-year useful life
of the truck, and the net book value of the truck at the end of each year
(Hint: if a calculation does not give a whole number round up if 0.5 or above,
round down if under 0.5)
As can be seen in the above activity, the reducing balance basis method uses
the same percentage of the cost that remains at the start of the year, therefore
the annual depreciation charge gets smaller as the asset gets older. This is a
fairer method to use when assets tend to be used up quickly in early years,
but as the asset gets older the consumption of cost slows down, so that the
cost charged against profit will get progressively smaller. This method is
commonly used for motor vehicles because as the depreciation charge falls
each year, expenses on motor repairs are likely to rise. Older machines
usually need more attention than new machines, and therefore the overall
cost balances out under the matching concept.
62
3.3.3 Comparing the two methods

The two methods of depreciation can be compared using the example of
Mr Smith’s van.
Straight line method of Reducing balance method

depreciation
Annual Accumulated Year- Annual Accumulated Year-
expense depreciation end expense depreciation end
NBV NBV
£ £ £ £ £ £
Year 1 7,500 7,500 32,500 17,024 17,024 22,976
Year 2 7,500 15,000 25,000 9,779 26,803 13,197
Year 3 7,500 22,500 17,500 5,617 32,420 7,580
Year 4 7,500 30,000 10,000 3,226 35,646 4,354
Year 5 7,500 37,500 2,500 1,853 37,499 2,501
In the first year the reducing balance method produces a larger figure for the
depreciation charge than the straight line method. This difference reverses in
the next four years. The straight line method of depreciation should be used
if the business gains an equal benefit from the van over its useful life of five
years. The reducing balance method should be used if the business gains
more benefit in earlier than later years.
How depreciation should be estimated is up to the business, therefore the
appropriate method may vary from one class of asset to another. For
example the depreciation method for plant and equipment may differ from
the method used for motor vehicles. It may also vary from one business to
another. Depreciation should, however, be accounted for in a consistent
manner that reflects a fair way in which the asset’s economic benefits are
consumed by the business. Once a method has been chosen and used it
should not be changed. This is because of the application of another
accounting concept known as consistency.
Stop and reflect

Do you think depreciation is allowed for taxation purposes?
While businesses may choose their depreciation method, these are not
necessarily valid for tax purposes. Many governments, including the
UK government, ignore depreciation when measuring taxable profit, and
substitute a figure (called a ‘capital allowance’ in the UK) based upon
its own rules.
63
3.4 Recording depreciation

Depreciation is recorded like other transactions using our system of double
entry. In addition to this asset account and the bank account we will need
two new accounts:
. depreciation
. accumulated depreciation
The depreciation account is an expense account that will appear in the
income statement, whilst the accumulated depreciation account will be
deducted from the cost of the asset in the balance sheet. This is explained in
Section 3.4.2.
3.4.1 Accounting for non-current assets and

depreciation in the general ledger
Using the example of the Mr Smith’s van above, when the van is purchased,
the entries in the general ledger are:
Motor vehicles (asset)

Date Dr Date Cr
20X1 £ 20X1 £
1 Jan Bank 40,000
Bank (asset)
Date Dr Date Cr
20X1 £ 20X1 £
31 Jan Motor vehicles 40,000
At the end of year 1, using the reducing balance method of depreciation, the
entries in the general ledger before closing them off would be:
Depreciation (expense)
Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Acc *
depreciation 7,500
* Acc is the accepted abbreviation for 'accumulated'.
Accumulated depreciation (balance sheet)

Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Depreciation 7,500
The accumulated depreciation is the total depreciation that has been

charged on the asset to date.
64
To close the accounts off the entries would be:
Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Acc depreciation 7,500 31 Dec Income statement 7,500
7,500 7,500

Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Balance c/d 7,500 31 Dec Depreciation 7,500
20X2 £ 20X2 £
Activity 3.4 Recording depreciation in the general ledger

Record the depreciation of Mr Smith’s van in the general ledger at the end of
its second year of use, using the reducing balance basis of depreciation.
3.4.2 Presenting depreciation in the financial

statements
The annual expense called depreciation is recorded in the income statement
as an expense. It spreads the cost of the asset, less any residual value over
the economic life of the asset to the business.
The accumulated depreciation is the total depreciation that has been charged
on the asset to date. It is deducted from the cost of the non-current asset to
arrive at the net book value (NBV). The net book value is the value at
which a business carries an asset on its balance sheet.
The double entry is:
Dr: Depreciation expense in the income statement
Cr: Accumulated depreciation in the balance sheet.
The NBV is therefore the cost of the asset less the accumulated depreciation
that has been charged on the non-current asset since it was purchased by the
business. The year-end NBV, however, is recorded in the balance sheet under
non-current assets.
65
The following gives an extract of a summary of the accounts of Mr Smith in

Section 3.3.1 above using the straight line method of depreciation.
Income statement 20X1 20X2 20X3 20X4 20X5

£ £ £ £ £
Expenses
Depreciation 7,500 7,500 7,500 7,500 7,500
Balance sheet
Non-current assets
Cost 40,000 40,000 40,000 40,000 40,000
Less accumulated depreciation 7,500 15,000 22,500 30,000 37,500
Net book value 32,500 25,000 17,500 10,000 2,500
The following activity will give you further practice at calculating

depreciation using the reducing balance method, and help you understand
how depreciation will appear in the financial statements.
Activity 3.5 Completing the depreciation table

In the example above Mr Smith’s van had the following depreciation

calculated on the reducing balance basis:
£
Cost of van 40,000
Using the reducing balance method of depreciation shown above complete

the table below for the business of Mr Smith.

£ £ £ £ £
Expenses
Depreciation
Balance sheet
Non-current assets
Cost
Less accumulated depreciation
Net book value
66
In the individual balance sheet of a business the balance sheet presentation

is usually in the following format.
ABC sole trader

Extract from the balance sheet as at 31 December 20X5
Cost Acc depreciation NBV
£ £ £
Non-current assets
Motor vehicles
Activity 3.6 Depreciation – income statement and balance sheet

entries
Using the format of the tables in Activity 3.5, show extracts from the balance
sheet and income statement for Mr Smith’s van at the end of year 5 if the
business uses the:
(a) the straight line method of depreciation

(b) the reducing balance method of depreciation.
3.4.3 Additions to non-current assets

When a non-current asset is purchased at the beginning of the financial
year, a full year’s depreciation will usually be charged on it. If a non-current
asset is purchased part way through the financial year, depreciation will
usually be charged from the date of acquisition. However, some businesses
adopt an accounting policy of charging a full year’s depreciation in the year
the non-current asset was purchased, and none in the year of sale. When
answering B124 questions you will be given the depreciation policy of the
business under consideration.
3.5 Disposal of non-current assets

At the end of its useful economic life within the business, a non-current
asset will be disposed of. If the asset has no remaining value it will be
thrown away. If it still has remaining value it may be sold on for further use
by another business, sold for scrap or given in part exchange for a new
asset. Any value received on disposal of the non-current asset is called the
disposal proceeds. These proceeds are posted to (entered into) the credit of a
non-current asset disposal account often just called disposal account for
short.
67
Dealing with non-current assets involves a number of estimates:
. useful life of the asset to the business

. net realisable value at the end of its useful life to the business
. depreciation rate to be applied.
There is bound to be some degree of error, and this will be revealed as a
profit or loss on disposal.
When a non-current asset is disposed of, the cost must be removed from the
non-current asset account and posted to a disposal of non-current asset
account.
The depreciation to date (accumulated depreciation) on the assets must also
be removed from the accumulated depreciation account and posted to the
disposal of non-current asset account.
The sale proceeds are also posted to the disposal account. The balancing
figure on the disposal account is either a profit (debit) or a loss (credit) on
disposal. A profit on disposal will be shown as a credit in the income
statement, and a loss on disposal will be a debit in the income statement.
Although termed profit or loss on disposal, these balances are not actual
profits or losses but merely adjustments or corrections to previous estimates.
Accounting entries for the disposal proceeds

Step 1 Account for the disposal proceeds
Dr Bank or person owing money to the business if the sale is on credit
Cr Disposal account
Disposal account (income statement)

Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Bank xxx
Step 2 Remove the non-current asset cost

Dr Disposal account
Cr Non-current asset cost account

Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Cost of asset xxx 31 Dec Bank xxx
sold
68
Step 3 Remove the accumulated depreciation

Dr Accumulated depreciation account
Cr Disposal account

Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Cost of asset sold xxx 31 Dec Bank xxx
31 Dec Acc depreciation on xxx
asset sold
Step 4 Finding the profit on disposal by balancing the account (if a loss on
disposal these entries are reversed)
Dr Disposal account (if a profit)
Cr Income statement
The disposal account in the general ledger is now balanced off.

Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Cost of asset sold xxx 31 Dec Bank xxx
31 Dec Profit to Income xxx 31 Dec Acc depreciation on xxx
statement asset sold
xxx xxx
3.5.1 Sale at the end of the year

Continuing to use the example of Mr Smith’s van, the van is sold at the end
of year 5 for £3,600.
The NBV of the van to the business is the cost less accumulated depreciation
over the previous five years. Using the straight line method of depreciation,
the NBV as given above is £2,500 (£40,000 – (5 × £7,500)). Selling the van
for £3,600 at this time represents a profit of £1,100 that would be shown in
the income statement for that year.
The profit or loss on the sale of any non-current asset will be recorded in
a disposal of non-current assets account, or disposal account for short.
The following three amounts are transferred to the disposal account:
. cost of the asset from the relevant non-current asset account

. total depreciation from the relevant accumulated depreciation account
. proceeds of the disposal of the non-current asset.
The following example explains how to calculate depreciation when there is
a disposal and how to account for it in the general ledger.
69
Example: Depreciation when there is a disposal

Using the straight line method of depreciation, the double entries in the
general ledger for the sale of Mr Smith’s van for £3,600 at the end of year 5,
(assuming the depreciation charge entry for year 5 had already been posted)
are:

Date Dr Date Cr
20X5 £ 20X5 £
1 Jan Balance b/d 40,000 31 Dec Disposal account 40,000
40,000 40,000
Bank (asset)
Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Disposal account 3,600
Accumulated depreciation (expense)

Date Dr Date Cr
20X5 £ 20X5 £
Dec 31 Disposal account 37,500 Dec 31 Balance b/d 37,500
37,500 37,500

Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Motor vehicles 40,000 31 Dec Bank 3,600
31 Dec Income statement * 1,100 31 Dec Acc depreciation 37,500
41,100 41,100
* The profit on sale goes to the income statement
Activity 3.7 Accounting for the sale of a non-current asset

In the previous table it states that Mr Smith's van above was sold for £3,600
at the end of year 5.
Using the reducing balance method of depreciation, post the double entries in
the general ledger account to record the sale, assuming that the depreciation
charge entry for year 5 had already been posted.
70
3.5.2 Sale part way through the year

When an asset is sold part way through the year, the depreciation should be
calculated (debit depreciation account – expense account, credit accumulated
depreciation – balance sheet account). A business will have an accounting
policy for this situation, such policies include:
(a) Provide depreciation up to the date of sale. If the asset is sold during a
month, there are three possible methods:
1 work out on a daily basis, e.g. 20 days out of 30
2 not depreciate in the month of sale
3 depreciate for a full month in the month of sale.
(b) Do not provide any depreciation in the year of sale.
(c) Provide a full year’s depreciation in the year of sale.
In B124 the method to be used will be stated in the question asked.
Example: Sale of a non-current asset part way through an

accounting period
A business with a financial year end of 30 September 20X9 disposes of
furniture on 31 March for £8,000. The asset originally cost £30,000 on
1 October 20X1, and was depreciated at 10% on the straight line basis and
there is no residual value. Accumulated depreciation at the year ended
30 September 20X8 was £21,000. A full month’s depreciation is charged in
the month of sale.
The depreciation for the period 1 October 20X8 to 31 March 20X9 can be
calculated as £30,000 × 10% × 6/12 = £1,500. The disposal can then be
recorded in the general ledger as follows.
Furniture (asset)
Date Dr Date Cr
20X8 £ 20X9 £
1 Oct Balance b/f 30,000 31 Mar Disposal account 30,000
30,000 30,000

Date Dr Date Cr
20X9 £ 20X8 £
31 Mar Disposal 22,500 1 Oct Balance b/d 21,000
account 20X9
00,000 31 Mar Depreciation 1,500
22,500 22,500
71
Date Dr Date Cr
20X9 £ 20X9 £
31 Mar Acc depreciation 1,500

Date Dr Date Cr
20X9 £ 20X9 £
31 Mar Furniture 30,000 31 Mar Bank 8,000
30 Sept Profit on sale * 500 31 Mar Acc depreciation 22,500
30,500 30,500
* A credit in the income statement
From these activities it can be seen that a business can make a profit or a
loss on disposal of an asset. The fact that a business has made a profit on
the sale of an asset means that the business made an over-provision for
depreciation over the life of a non-current asset. Similarly, a loss on disposal
means that a business has made an under-provision for depreciation.
Activity 3.8 Accounting for a sale part way through the year
Mr Sen’s business has a financial year-end of 31 August 20X4 and disposes

of a motor vehicle on 20 February 20X4 for £13,000. The motor vehicle
originally cost £42,000 on 1 September 20X1, and was depreciated at 25%
on the reducing balance basis. Accumulated depreciation at the year ending
31 August 20X3 was £24,280. The business provides no depreciation in the
month of sale. Prepare the motor vehicle account, the accumulated
depreciation account, the depreciation account and the disposal of non-
current asset account. Remember always work in round pounds.
3.5.3 Disposal in part exchange

A part exchange is when an asset is purchased from a supplier who takes an
old asset in part exchange for a new one. The transaction involves an
acquisition and a disposal.
Activity 3.9 Accounting for a disposal with a part exchange

Mr Kodwani’s business purchases new computer equipment for £80,000 on

16 April 20X4. The supplier accepts the old computer in part exchange at a
trade-in value of £3,000.
The computer disposed of originally cost £50,000 and has accumulated

depreciation of £24,400. The depreciation policy of the business for computer
72
equipment is 20% per annum on the straight line basis; with a full month’s
depreciation in the month of sale, no depreciation is provided in the month of
purchase. The financial year-end of the business is 31 July.
Write up the general ledger accounts for the year ended 31 July 20X4.
Depreciation is an estimate and it is only when the asset is disposed of that

the correct amount of depreciation that should have been charged can be
known.
3.6 Disclosure of non-current assets in the

financial accounts
Showing only the following on the face of the balance sheet does not really
provide the reader of the financial accounts with much information on non-
current assets:
ABC sole trader

£ £ £
Non-current assets
Motor vehicles
The reader of the accounts also needs to know the additions, disposals and
movements on depreciation; therefore, the information is given in a table as
a note to the accounts:
Computer Motor
equipment vehicles Total
£
£ £
Cost
At 1 January 20X5 680,000
174,000 854,000
Additions 70,000
30,000 100,000
Disposals ( - )
( 27,000) ( 27,000)
At 31 December 20X5 750,000
177,000 927,000
Depreciation
At 1 January 20X5 230,000
108,000 338,000
Charge for the year 72,000
3,700 75,700
On Disposals ( - )
( 25,000) ( 25,000)
At 31 December 20X5 302,000 86,700 388,700
At 31 December 20X5 448,000 90,300 538,300

At 1 January 20X5 450,000 66,000 516,000
73
The balance in the note to the accounts above for 31 December, is referred
to as the net book value on the balance sheet.
Activity 3.10 Completing a depreciation table

Hadley’s trial balance at 1 January 20X5 shows the following balances

relating to non-current assets:
. Fixtures & fittings (F & F) cost £160,000 (debit)

. Accumulated depreciation F & F £32,000 (credit)
. Motor vehicles (MV) cost £80,000 (debit)
. Accumulated depreciation MV £35,000 (credit)
During the year fixtures and fittings were purchased for £40,000, on
1 July 20X5.
There were two disposals in the year:
. 1 April 20X5 fixtures and fittings originally costing £50,000, with

accumulated depreciation at 1 January 20X5 of £11,250.
. On 1 January 20X5 motor vehicles originally costing £32,000, with
accumulated depreciation at 1 January 20X5 of £14,000 were sold.
The depreciation policy is:
. Fixtures & fittings 10% per annum straight line basis

. Motor vehicles 25% reducing balance basis
. A full month’s depreciation is provided in the month of purchase, but no
depreciation is provided in the month of sale.
Required: Calculate the depreciation for the year, and complete the table
below:
Fixtures & fittings Motor vehicles Total

£ £ £
Cost
At 1 January 20X5
Additions
Disposals ( ) ( ) ( )
At 31 December 20X5
Depreciation
At 1 January 20X5
Charge for the year
On Disposals ( ) ( ) ( )
At 31 December 20X5
At 31 December 20X5
At 1 January 20X5
74
Activity 3.1 Revenue or capital

Expenditure Type of expenditure
Purchasing a computer Capital. This is an item purchased for
long-term use in the business.
Purchasing a docking station for the
Capital. This is also an item
computer
purchased for long-term use in the
business.
Purchasing a stapler for £5
Revenue. This is a small value item,
which while kept for long-term use is
too small to be considered as
something that should be capitalised.
Buying factory machinery Capital. An item purchased for long
term use in the business.
Electricity cost of running the Revenue. This is an everyday
machinery expense, incurred in running the
business.
Spending £5,000 on improving the Capital. This is an improvement to a
machinery capital item.
Spending £700 on repairing machinery Revenue. These repairs are likely to
only benefit the year in which they are
carried out. They are therefore treated
as a charge in the income statement.
Buying a van Capital. An item purchased for long
term use in the business.
Expenditure on signwriting on the van Capital. This becomes part of the cost
giving the name of the firm with its of the van.
logo
Road tax for the van Revenue. This will cover a short
period of time, six months or a year
depending on how much was paid.
It is therefore a revenue expense.
Petrol for the van Revenue. This will last for a short
period of time and is an expense in
running the business.
Painting a new building Capital. This is part of the cost of the
new building.
Painting an existing building Revenue. This is similar in nature to a
repair, although the paint may last for
more than one accounting period.
It does not however add value to the
building.
Capital expenditure increases non-current assets, and is included in the

balance sheet. We sometimes say an item is capitalised when it is included
on the balance sheet in this way.
75
Whilst the stapler can be termed machinery its cost is such that it is
considered too small to capitalise. The accounting concept here that comes
into play is materiality.
Activity 3.2 Calculating depreciation using the straight

line method
Cost £57,000 less residual value £5,000 gives a depreciable amount of
£52,000. £52,000 / 5 = an annual depreciation charge of £10,400.
£
Cost of pickup truck 57,000
Activity 3.3 Calculating reducing balance depreciation

Cost £57,000 is the depreciable amount.
£
Cost of truck 57,000
Year 1 Depreciation 20% 11,400
Activity 3.4 Posting depreciation to the general ledger

Date Dr Date Cr
20X2 £ 20X2 £
31 Dec Acc Depreciation 6,400 31 Dec Income statement 6,400
6,400 6,400
76

Date Dr Date Cr
20X2 £ 20X2 £
20X3 20X3
14,400 14,400
20X4
Looking at the difference in the accounts between year 1 and year 2 it can
be seen that the depreciation expense is written off each year to the income
statement, but the accumulated depreciation balance increases each year and
appears in the balance sheet.
Activity 3.5 Completing the depreciation table

£ £ £ £ £
Expenses
Depreciation 17,024 9,779 5,617 3,226 1,853
Balance sheet
Non-current assets
Cost 40,000 40,000 40,000 40,000 40,000

Less accumulated depreciation 17,024 26,803 32,420 35,644 37,499
Net book value 22,976 13,197 7,580 4,354 2,501
Activity 3.6 Depreciation – income statement and

balance sheet entries
(a) Using the straight line method
Mr Smith
Cr Acc depreciation NBV
£ £ £
Non-current assets
Motor vehicles 40,000 37,500 2,500
Mr Smith
Extract from the income statement for the year ended 31 December 20X5
£ £
Expenses
Depreciation 7,500
77
(b) Using the reducing balance method
Mr Smith
£ £ £
Non-current assets
Motor vehicles 40,000 37,499 2,501
Mr Smith
Extract from the income statement for the year ended 31 December 20X5
£ £
Expenses
Depreciation 1,853
Activity 3.7 Accounting for the sale of a non-current asset

Date Dr Date Cr
20X5 £ 20X5 £
1 Jan Balance b/d 40,000 31 Dec Disposal account 40,000
40,000 40,000
Bank (asset)
Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Bank 3,600

Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Disposal account 37,499 31 Dec Balance b/d 37,499
37,499 37,499

Date Dr Date Cr
20X5 £ 20X5 £
31 Dec Motor vehicles 40,000 31 Dec Bank 3,600
31 Dec Profit on disposal 1,099 31 Dec Acc depreciation 37,499
41,099 41,099
* The profit on sale goes to the income statement
78
Activity 3.8 Accounting for a sale part way through the

year
Calculate the depreciation for the period 1 September 20X3 to 20
February 20X4 (£42,000 – £24,280) × 25% × 5/12 = £1,846.
Motor vehicle (asset)

Date Dr Date Cr
20X3 £ 20X4 £
1 Sept Balance b/f 42,000 20 Feb Disposal account 42,000
42,000 42,000

Date Dr Date Cr
20X3 £ 20X3 £
1 Sept Balance b/d 24,280
20X4 20X4
20 Feb Disposal account 26,126 20 Feb Depreciation 1,846
26,126 26,126
Date Dr Date Cr
20X4 £ 20X4 £
20 Feb Acc depreciation 1,846

Date Dr Date Cr
20X4 £ 20X4 £
20 Feb Motor vehicles 42,000 20 Feb Bank 13,000
20 Feb Acc depreciation 26,126
00,000 20 Feb Loss on sale * 2,874
42,000 42,000
* A debit in the income statement
Activity 3.9 Accounting for a disposal with a part

exchange
Old computer depreciation: 1 August 20X3 to 30 April 20X4 = £50,000 ×
20% × 9/12 = £7,500
New computer depreciation: 1 May 20X4 to 31 July 20X4 = £80,000 ×
20% × 3/12 = £4,000
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Computer (asset)
Date Dr Date Cr
20X3 £ 20X4 £
1 Aug Balance b/d 50,000 16 April Disposal account 50,000
50,000 50,000
20X4 20X4
16 April Disposal a/c: trade in * 3,000 31 July Balance c/d 80,000
16 April Bank 77,000 80,000
80,000
* This is the value of the old computer taken in part exchange for the new computer.

Date Dr Date Cr
20X4 £ 20X4 £
16 April Disposal account 31,900 1 Sept Balance b/d 24,400
00,000 16 April Depreciation 7,500
31,900 31,900
31 July Balance c/d 4,000 31 July Depreciation 4,000
4,000 4,000
1 Aug Balance b/d 4,000
Date Dr Date Cr
20X4 £ 20X4 £
16 April Acc depn (old) 7,500
31 July Acc depn (new) 4,000 31 July Income account 11,500
11,500 11,500

Date Dr Date Cr
20X4 £ 20X4 £
16 April Computer 50,000 16 April Computer trade in 3,000
16 April Acc depreciation 31,900
00,000 16 April Loss on sale * 15,100
50,000 50,000
* A debit in the income statement
Activity 3.10 Completing a depreciation table

Fixtures and fittings depreciation:
. On cost at 1 January 20X5 for 3 months £160,000 × 10% × 3/12 =

£4,000
80
. On cost less disposal for 9 months £110,000 × 10% × 9/12 = £8,250

. On additions for 6 months £40,000 × 10% × 6/12 = £2,000
. Total £4,000 + £8,250 + £2,000 = £14,250
Motor vehicles depreciation:
. Cost £80,000 less sale on 1 January £32,000 = £48,000.

. Accumulated depreciation at 1 January 20X5 £35,000 less £14,000
accumulated depreciation on disposal = £21,000.
. Net book value after sale is therefore £48,000 less £21,000 = £27,000.
Depreciation charge for the year £27,000 × 25% = £6,750.
Fixtures Motor
& fittings vehicles Total
£ £ £
Cost
At 1 January 20X5 160,000 80,000 240,000
Additions 40,000 - 40,000
Disposals ( 50,000) (32,000) ( 82,000)
At 31 December 20X5 150,000 48,000 198,000
Depreciation
At 1 January 20X5 32,000 35,000 67,000
Charge for the year 14,250 6,750 21,000
On Disposals ( 11,250) (14,000) ( 25,250)
At 31 December 20X5 35,000 27,750 62,750
At 31 December 20X5 115,000 20,250 135,250

At 1 January 20X5 128,000 45,000 173,000
Summary
In this chapter you learned that expenditure is classified as either revenue
expenditure or capital expenditure. Revenue expenditure is incurred in the
day-to-day running of the business. Capital expenditure is expenditure
incurred in the purchase of non-current assets or additions to non-current
assets.
You also learned that the consumption of non-current assets over a period of
time is called depreciation. Depreciation is caused by wear and tear,
obsolescence or depletion. (Depletion refers to extracting materials from the
land.) Under the accrual concept of accounting, depreciation should be
charged to the income statement according to the benefit consumed in the
accounting period. The cost of the non-current asset, less any residual value,
is charged to the income statement over its useful life.
We looked at the most common methods of calculating depreciation. These
are the straight line method and the reducing balance method. These are the
only two methods we will use in B124. The straight line method allocates
the cost of the non-current asset, less any residual value, to the income
statement evenly over the life of the asset. The reducing balance basis
81
allocates a fixed percentage of the cost of the non-current asset after the
deduction of any accumulated depreciation. Using a fixed percentage results
in more depreciation being charged to the income statement in the early
years. For each class of non-current asset, one general ledger account is used
to record the initial cost and one to record the accumulated depreciation.
The accounting entries are: debit depreciation (an expense account) and
credit accumulated depreciation. Accumulated depreciation is deducted from
the cost of the non-current asset in the balance sheet to show the net book
value of the asset.
Finally we looked at the disposal of a non-current asset. The figures for
initial cost and depreciation must be removed from both the non-current
asset account and from the accumulated depreciation account. They are taken
to a non-current asset disposal account where the profit or loss on disposal
will be calculated.
In Chapter 4 another aspect of the accruals concept is explained, that of
accounting for irrecoverable receivables.
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Chapter 4 Irrecoverable receivables
Chapter 4 Irrecoverable
receivables
Introduction
. understand the role of credit control

. calculate and record the writing off of irrecoverable receivables
. calculate and record an allowance for irrecoverable receivables and any
amounts subsequently recovered.
Irrecoverable receivables are debts that will not be paid, and which therefore
have to be written off as a debit in the income statement.
Allowance for irrecoverable receivables (doubtful debts), however, means
that the asset called receivables is of uncertain value and adjustments need to
be made in the accounts to cover the possibility of some debts becoming bad
in the future. As there is still some hope that it will be paid, it is not yet
written off, but is still kept as an asset in the receivables account.
4.1 Credit control

A business that sells goods on credit should ensure customers pay their
accounts on time. Good practice will include:
. checking that a new customer has a satisfactory credit history before

allowing them to buy on credit
. having clear guidelines for customers as to when payment is expected
(e.g. 30 days after delivery)
. checking regularly what cash has been received and having credit control
procedures to chase overdue amounts.
At regular intervals and at the financial year-end, it is good practice for a
business to list all the balances of amounts owed to the business by its
customers, and show how long each debt is outstanding. This list is known
as an aged receivables list. An example of such a list is shown below,
however, the list is not complete as in practice lists could go over several
pages. Note that M. O’Sullivan owes the business £750 and that the amount
has been outstanding for two months. This means that the business sold
goods on credit to M. O’Sullivan two months ago and that M. O’Sullivan
has still not paid for these goods.
83
Current Outstanding 3 months

Customer Total month 1 month 2 months or more
£ £ £ £ £
D. Singh 1,235 1,235
McKenzie Ltd 12,875 3,500 2,750 6,625
A. Macey 457 457
M. O’Sullivan 750 750
*
Robinsons Ltd 23,789 9,850 7,540 6,399

B. Owen 7,500 7,500
M. Pope 564 564
L. Akinola 4,590 2,300 1,250 1,040 0,000
Totals 243,856 120,610 74,356 34,765 14,125
* The blank line indicates that figures are missing because there is insufficient space
here to produce the whole list.
The business should check to see which customers have not paid within the
business’s set credit limit (often 30 days), and issue reminders to them either
by letter, email or telephone. If customers do not pay their invoices on time
then the business may stop supplying that customer. Legal action may also
be taken. Investigation into why debts are not paid on time may lead to
writing off the debt as an irrecoverable receivable.
84
4.2 Writing off irrecoverable receivables

An irrecoverable receivable (bad debt) is recorded in the accounts when a
business decides a customer will not pay for a good or service bought on
credit. It is often the final stage of a long process involving reminders,
threats of legal action and lawyers’ letters.
Irrecoverable receivables are recorded in the income statement as an
expense, and deducted from receivables in the balance sheet. Receivables are
amounts due from credit customers.
Dr Irrecoverable receivables (income statement account)
Cr Receivables (balance sheet account)
This is in line with the accruals concept because it is important to match all
expenses or losses to the accounting period to which they relate.
Activity 4.1 Accounting for an irrecoverable receivable

George Grey’s business, Newport Novelties, had a long-term outstanding

debt of £380 from a customer, Peter Hinds. After paying a solicitor to send
Peter a letter of demand, George was finally informed that Peter had left
the country. As a result, George reluctantly decided to write off the debt at
31 December 20X2, the last day of the accounting period. The total
receivables at this date, including Peter’s, amounted to £4,560. This
irrecoverable receivable was the first that George had suffered since
opening the business.
Complete the double entries for the irrecoverable receivable (bad debt) in the
accounts of Newport Novelties at 31 December 20X2.
4.2.1 Subsequent recovery of an irrecoverable

receivable
Sometimes a debt written off as an irrecoverable receivable will be recovered
or partly recovered. For example a debt of £1,000 owed by a company that
has gone into liquidation is written off as an irrecoverable receivable. Six
months later it is announced that the company will pay 20p in the pound on
all debts. Therefore £200 will be received and the following entries need to
be made in the general ledger to record this.
Dr: Receivables £200
Cr: Irrecoverable receivables

£200
When the £200 is received the entries in the general ledger will be:
Dr: Cash £200
Cr: Receivables
£200
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4.3 Allowance for irrecoverable receivables

A business can never be certain that all its customers are going to pay the
amounts that they owe to the business.
Stop and reflect

What are receivables?
The total amount owed by all customers is called receivables.

Receivables are shown under current assets in the balance sheet.
Each customer that buys goods on credit has its own account, and the
balance of each customer’s account will show how much the customer
owes the business.
Experience may suggest that some percentage of customer balances will not
be received. For instance a local newspaper may find that on average 3% of
the balances on its receivables ledger, after writing off irrecoverable debts,
will not be received. The possible loss resulting from this should therefore
be provided for in its income statement. This provision is referred to as an
allowance for irrecoverable receivables.
Example: Allowance for irrecoverable receivables

At the end of M. Wilson’s first year of trading she lists all the amounts due
from customers, which total £165,800. After writing off an irrecoverable
receivable of £200, she estimates (after taking advice from a friend operating
in the same trade) that 1% of her customers will not pay the amounts owing.
She therefore estimates that £1,656 may not be received – 1% of (£165,800
– £200) = £1,656 – and she needs to open an account called Allowance for
irrecoverable receivables in the general ledger to record this.
Dr: Allowance for irrecoverable receivables £1,656
(income statement)
Cr: Allowance for irrecoverable receivables £1,656

(balance sheet)
The result will be that £1,656 will be charged as an expense against profit in
the income statement. A credit balance of £1,656 will be carried down in the
general ledger at the end of the year to create an opening balance at the
beginning of the next accounting year. In the balance sheet the allowance for
irrecoverable receivables will be deducted from receivables.
At the end of each accounting year the allowance for irrecoverable
receivables will be recalculated and the balance on the allowance for
irrecoverable receivables will be increased or reduced as necessary. It is the
increase or decrease in the allowance that will be taken to the income
statement. In the balance sheet the full new allowance will be deducted from
receivables.
86
To increase the allowance:

Dr: Allowance for irrecoverable receivables (income statement)
Cr: Allowance for irrecoverable receivables (balance sheet)
To reduce the allowance

Dr: Allowance for irrecoverable receivables (balance sheet)
Cr: Allowance for irrecoverable receivables (income statement)
Following on from the example above, at the end of year 2, M. Wilson has
amounts owing from customers of £285,250. One customer has written to
her to say that due to financial difficulties he is unable to pay his account of
£250. This amount therefore has to be shown under expenses in the income
statement as an irrecoverable receivable. The accounting policy of writing
off 1% of customers’ balances proves to be a good estimate, and will again
have to be accounted for at the end of year 2.
£ £
Total due from customers at the end of year 2 285,250
Less: Irrecoverable receivable 250
285,000
Allowance for irrecoverable receivables (1% x £285,000) 2,850
Brought forward balance 1,656
Increase in allowance for irrecoverable receivables 1,194
General ledger (year 2)
Irrecoverable receivables (expense)

Date Dr Date Cr
20X2 £ 20X2 £
31 Dec Receivables 250 31 Dec Income statement 250
250 250
Allowance for irrecoverable receivables (balance sheet account)

Date Dr Date Cr
20X2 £ 20X2 £
31 Dec Balance c/d 2,850 31 Dec Allowance for 1,194
irrecoverable
receivables
2,850 2,850
Balance b/d 2,850
Allowance for irrecoverable receivables (expense)

Date Dr Date Cr
20X2 £ 20X2 £
31 Dec Allow for irrecoverable 1,194 31 Dec Income statement 1,194
receivables
1,194 1,194
87
Activity 4.2 Calculating an allowance for irrecoverable

receivables
Following on from the example above, at the end of year 3, M. Wilson has
amounts owing from customers of £190,000. One customer has been
declared bankrupt therefore the amount owing from her of £400 will have to
be written off as an irrecoverable receivable. The accounting policy of writing
off 1% of customers’ balances still applies.
Calculate the new allowance for irrecoverable receivables and show the
general ledger accounts as above for year 3.
Activity 4.3 Accounting for irrecoverable receivables

George Grey’s business, Newport Novelties, had the following balances on its
receivables ledger at the end of each of the following years. These balances
were after irrecoverable receivables had been written off, but before providing
an allowance for irrecoverable receivables:
20X1 £4,600
20X2 £5,320
20X3 £4,840
George used an estimate of 5% of total receivables to calculate the
allowance for irrecoverable receivables at the end of each of the three years:
20X1 £230 (£4,600 × 5%)
20X2 £266 (£5,320 × 5%)
20X3 £242 (£4,840 × 5%)
For each of:
(a) 20X1
(b) 20X2
(c) 20X3
(i) Prepare the general ledger accounts for the financial year 31 December.
(ii) Show how receivables should be presented in the balance sheet at
31 December.
(iii) Show how the changes in the allowance for receivables should be
presented in the income statement for the year ended 31 December.
In the income statement the irrecoverable receivables will be shown as an
expense (a debit) and the decrease in the allowance for irrecoverable
receivables will be a negative number (a credit). In the balance sheet the
irrecoverable receivables is deducted first from receivables, then the full
allowance for irrecoverables (not just the change in the allowance) is
deducted.
88
Activity 4.4 Presenting irrecoverable receivables in the financial

statements
Claudine runs an interior design business. The following is an extract from

her accounting records:
Year ended 30 June 20X5 20X6 20X7

Receivables £100,000 £150,000 £60,000
Irrecoverable receivables £10,000 £8,000 £1,000
Allowance for irrecoverable receivables 5% 5% 5%
Note: There is no allowance for irrecoverable receivables brought forward at

1 July 20X4. The irrecoverable receivables and the allowance for irrecoverable
receivables have not yet been written off.
Show how the information will be reflected in Claudine’s income statement

and balance sheet in each of the years 20X5 to 20X7.
4.4 The extended trial balance revisited

The following example allows you to build on your knowledge of extended
trial balances gained in Book 2 and appreciate how many of the adjustments
to the trial balance explained in this book are dealt with in the extended trial
balance. You may like to attempt to answer the question and then check your
answer with the answer given, or as this is the first detailed extended trial
balance you meet in this module, you may prefer to just carefully check
through the extended trial balance ensuring that you understand where all the
figures come from. Part (a) asks for an extended trial balance. Parts (b) and
(c) ask for an income statement and a balance sheet both of which can be
prepared using the information shown in the extended trail balance given in
the answer to part (a).
Example: Accounts preparation using an extended trial

balance
John Black has extracted a trial balance from his general ledger for the year
ended 30 June 20X5 (overleaf).
89
Dr Cr
£ £
Sales 263,000
Purchases 198,000
Carriage inwards 1,960
Rent 12,600
Advertising 2,090
Office expenses 1,060
Carriage outwards 980
Discount allowed 2,540
Loan interest 1,010
Motor vehicle 32,480
Accumulated depreciation – motor vehicles 14,210
Furniture 6,100
Accumulated depreciation – furniture 3,660
Receivables 16,650
Bank account 6,450
Loan 9,850
Payables 6,400
VAT 13,000
Capital account 17,500
Drawings 32,850 000,000
327,620 327,620
Additional information available that needs to be taken into account in producing his financial
statements (income statement and balance sheet):
1 The closing inventory is valued at a cost of £10,500.
2 The electricity bill for June has not yet been received. Mr Black estimates that based on past experience an
accrual of £300 will be needed in the accounts.

3 Rent of £3,000 has been paid for the period 1 June to 31 August.
4 Depreciation on the motor vehicle is provided at 25% per annum on the reducing balance method.
5 Depreciation on furniture is provided at 10% per annum on the straight line basis.
6 Mr Black estimates that £850 due from Street Limited will not be received because he has heard that
the business is in financial difficulties.
7 No allowance for irrecoverable receivables is to be made.
Note: Everything in the trial balance above goes into the financial statements once because the trial
balance is the result of double-entry bookkeeping. All the additional information after the trial balance
is entered in the financial statements twice: one debit and one credit.
The following are shown below:
(a) an extended trial balance for Mr Black’s business for the year ended 30 June 20X5
(b) an income statement for the year ended 30 June 20X5
(c) a balance sheet as at 30 June 20X5.
90
(a) Mr Black extended trial balance at 30 June 20X5

Trial balance Adjustments Income statement Balance sheet
Dr Cr Dr Cr Dr Cr Dr Cr
£ £ £ £ £ £ £ £
Sales 263,000 263,000
Purchases 198,000 198,000
Opening inventory 9,600 9,600
Carriage inwards 1,960 1,960
(3)
Rent 12,600 2,000 10,600
Heating and lighting 3,250 300(2) 3,550
Advertising 2,090 2,090
Office expenses 1,060 1,060
Carriage outwards 980 980
Discount allowed 2,540 2,540
Loan interest 1,010 1,010
Motor vehicle 32,480 32,480
Acc depreciation (MV) 14,210 4,568(4) 18,778
Furniture 6,100 6,100
(4)
Acc depreciation (F) 3,660 610 4,270
Receivables 16,650 850(5) 15,800
Bank account 6,450 6,450
Loan 9,850 9,850
Payables 6,400 6,400
VAT 13,000 13,000
Capital account 17,500 17,500
Drawings 32,850 32,850
327,620 327,620
Year-end adjustments
Closing inventory 10,500(1) 10,500
(income statement)
Irrecoverables 850(5) 850
Depreciation 5,178(4) 5,178
(1)
Closing inventory 10,500 10,500
(balance sheet)
Accruals 300(2) 300
(3)
Prepayments 2,000 2,000
18,828 18,828
Net profit (balancing 36,082 36,082

figure)
273,500 273,500 106,180 106,180
91
The accounting adjustments (are listed below):

1 The closing inventory is £10,500. Dr: Closing inventory in the balance
sheet. Cr: Closing inventory in the income statement.
2 The electricity bill accrual for June of £300. Dr: Heating and lighting.
Cr: Accruals.
3 Rent of £3,000 has been paid for the quarter commencing 1 June.
A prepayment for two months is £3,000 × 2/3 = £2,000.
Dr: Prepayments. Cr: Rent.
4 Depreciation:
Motor vehicle 25% p.a. on the reducing balance: cost £32,480 less
accumulated depreciation to date £14,210 = £18,270 multiplied by
25% = £4,567.50. As accounts are prepared in round pounds this is
rounded up to £4,568. Dr: Depreciation in the income statement.
Cr: Motor vehicle accumulated depreciation in the balance sheet.
Furniture 10% p.a. on a straight line basis: cost £6,100 multiplied by
10% = £610. Dr: Depreciation in the income statement. Cr: Furniture
accumulated depreciation in the balance sheet.
Total depreciation for the year (motor vehicles £4,568 + furniture £610)
= £5,178.
5 It is estimated that £850 of receivables will not be recovered.

Dr: Irrecoverable receivables. Cr: Receivables.
(b) Mr Black income statement for the year ended 30 June 20X5
£ £
Sales 263,000
Less: cost of sales
Add: Purchases 198,000
Carriage inwards 1,960
209,560
Less: Closing inventory 10,500
199,060
Gross profit 63,940
Less: Expenses
Rent 10,600
Advertising 2,090
Office expenses 1,060
Discount allowed 2,540
Depreciation 5,178
Carriage outwards 980
Irrecoverable receivables 850
Loan interest 1,010
27,858
Net profit 36,082
92
(c) Mr Black balance sheet as at 30 June 20X5
Acc
Cost depreciation NBV
£ £ £
Non-current assets
Furniture 6,100 4,270 1,830
Motor vehicles 32,480 18,778 13,702
38,580 23,048 15,532
Current assets
Inventory 10,500
Receivables 15,800
Prepayments 2,000
Bank 6,450
34,750
Total assets 50,282
Capital
Opening balance 17,500
Add: Net profit 36,082
53,582
Less: Drawings 32,850
20,732
Non-current liabilities
Loan 9,850
Current liabilities
Payables 6,400
Accruals 300
VAT 13,000
19,700
Total capital and liabilities 50,282
Activity 4.1 Accounting for an irrecoverable receivable

Date Dr Date Cr
20X2 £ 20X2 £
31 Dec Receivables 380
93
Receivables (asset)
Date Dr Date Cr
20X2 £ 20X2 £
31 Dec Balance b/d 4,560 31 Dec Irrecoverable 380
receivables
The income statement for the year ended 31 December 20X2 would include
the figure of £380, under expenses, as irrecoverable receivables. The balance
sheet as at 31 December 20X2 would include, under current assets, the
figure of £4,180 (£4,560 – £380) as receivables.
Income statement for the year ended 31 December 20X2 (extract)

£ £
Expenses include:
Irrecoverable receivables 380
Activity 4.2 Calculating an allowance for irrecoverable

receivables
£ £
Total due from customers at the end of year 3 190,000
Less: Irrecoverable receivable 400
189,600
Allowance for irrecoverable receivables (1% × £189,600) 1,896
Brought forward balance 2,850
Decrease in allowance for irrecoverable receivables ( 954)
Note: the irrecoverable receivable must be deducted from the trade

receivables before the allowance for irrecoverable receivables is calculated.
General ledger (year 3)

Date Dr Date Cr
20X3 £ 20X3 £
31 Dec Receivables 400 31 Dec Income statement 400
400 400
Allowance for irrecoverable receivables (balance sheet account)

Date Dr Date Cr
20X3 £ 20X3 £
31 Dec Allowance for 954 1 Jan Balance b/d 2,850
irrecoverable receivables
31 Dec Balance c/d 1,896 20X4 0,000
2,850 1 Jan 2,850
Balance b/d 1,896
94
Allowance for irrecoverable receivables (expense)

Date Dr Date Cr
20X3 £ 20X3 £
31 Dec Income statement * 954 31 Dec Allowance for 954
irrecoverable
receivables
954 954
* This will be shown as a negative figure under expenses in the income statement.
Activity 4.3 Accounting for irrecoverable receivables

(a)
(i) 20X1
Allowance for irrecoverable receivables (balance sheet)

Date Dr Date Cr
20X1 £ 20X1 £
31 Dec Allowance for 230
irrecoverable
receivables
Allowance for irrecoverable receivables (income statement)

Date Dr Date Cr
20X1 £ 20X1 £
irrecoverable
receivables
(ii)
Balance sheet as at 31 December 20X1 (extract)

£ £
Current assets
Receivables 4,600
Less: Allowance for irrecoverable receivables ( 230)
4,370
(iii)

£ £
Expenses include:
Allowance for irrecoverable receivables 230
95
(b)
(i) 20X2

Date Dr Date Cr
20X2 £ 20X2 £
31 Dec Balance c/d 266 31 Dec Increase in allowance 36
266 266
20X3
Allowance for irrecoverable receivables (income statement)

Date Dr Date Cr
20X2 £ 20X2 £
irrecoverables
£266 allowance needed for 20X2 less £230 already provided in 20X1 = £36 increase
in allowance needed.
20X2

£ £
Current assets
Receivables 5,320
5,054
20X2

£ £
Expenses include:
Increase in allowance for irrecoverable receivables 36
(c)
(i) 20X3

Date Dr Date Cr
20X3 £ 20X3 £
31 Dec Income statement 24 1 Jan Balance b/d 266
31 Dec Balance c/d 242 000
266 266
20X4
96
£242 allowance needed at 31 December 20X3. There is already an

allowance of £266 at 1 January 20X3, which will be decreased by
£24 to £242. The decrease of £24 will be credited to the income
statement in the list of expenses.

£ £
Current assets include:
Receivables 4,840
4,598

£ £
Separate income after gross profit:
Less: Allowance for irrecoverable receivables (24)
Activity 4.4 Presenting irrecoverable receivables in the

financial statements
Year ended 30 June 20X5
Income statement (extract) £
Expenses:
Irrecoverable receivables 10,000
Increase in Allowance for irrecoverable receivables 4,500
Balance sheet (extract) £

Current assets:
Receivables (£100,000 – £10,000) 90,000
Less: Allowance for irrecoverable receivables (£90,000 × 5%) ( 4,500)
85,500

Expenses:
Increase in Allowance for irrecoverable receivables 2,600
(this year’s minus last year’s £7,100 – £4,500)

Current assets:
Receivables (£150,000 – £8,000) 142,000
Less: Allowance for irrecoverable receivables (142,000 x 5%) ( 7,100)
134,900
97

Expenses:
Decrease in Allowance for irrecoverable receivables (4,150) *
(£2,950 – £7,100)

Current assets:
Receivables (£60,000 – £1,000) 59,000
Less: Allowance for irrecoverable receivables (£59,000 × 5%) ( 2,950)
56,050
* In the income statement the irrecoverable receivables will be shown as an expense

(a debit) and the decrease in the allowance for irrecoverable receivables will be a
negative number (a credit). In the balance sheet the irrecoverable receivables is
deducted first from receivables, then the full allowance for irrecoverables (not just the
change in the allowance) is deducted.
Summary
In this chapter you learned that irrecoverable receivables are debts that are
very unlikely to be received. An allowance for irrecoverable receivables is
made where it is uncertain as to whether debts will be collected in the
future, so an allowance of a set percentage is made against those debts.
This is a further application of the accruals concept.
You learned that the accounting treatment (i.e. how it is dealt with in the
accounts) is:
Income statement Balance sheet

treatment treatment
Irrecoverable Debit expenses Remove the irrecoverable debt
receivables from the receivables balance
Allowance for Debit any increase Deduct from total receivables to

irrecoverable arrive at balance sheet figure for
receivables or receivables
Credit any decrease
All the above adjustments can be made on an extended trial balance.

Finally you learned that to help keep irrecoverable receivables to a minimum
it is good practice for a business to:
. check the credit history of a customer before allowing them to buy on credit
. provide its customers with clear guidance as to when they are expected to
pay invoices issued
. have credit control procedures in place so that any slow paying
customers can be chased for monies owed, and if necessary irrecoverable
receivables can be written off on a timely basis.
98
Book summary
Book summary
This book has covered a number of key areas in the recording of financial
transactions.
You learned that governments raise taxation from charging direct and
indirect taxes. VAT is a complex indirect tax about which this book gave a
brief explanation. HM Revenue and Customs collect this tax at stages along
the supply chain. At each stage, other than the last, it is possible for a trader
to reclaim the VAT. The tax itself falls on the final consumer. How to record
VAT in the general ledger was considered. The VAT account at the financial
year end could be in credit reflecting the fact that VAT is owed to HMRC or
it could be in debit indicating that a VAT refund is awaited.
You also learned that the accruals concept states that sales (and other forms
of income) as well as expenses or costs must be recognised because they are
earned or incurred respectively, not when cash is received or paid. Therefore,
end-of-period adjustments have to be made to ensure that only the expenses
incurred and the income earned in a period are recorded in the income
statement. Period end adjustments include:
. Accrued expenses, that is expenses that have been incurred and a benefit
received but which have not been invoiced by the supplier, or paid for, at
the accounting period end.
. Prepayments, expenses that have been invoiced to the business or paid
for before the current accounting period end, which relate to a future
period end.
. Accrued income where the income is earned by the business but for
which an invoice has not been rendered to the customer.
. Income received in advance where the customer pays in advance for
goods or services.
. Depreciation, which charges the cost of non-current assets consumed in
an accounting period to the income statement.
. Irrecoverable receivables that have to be written off to the income
statement and an allowance for irrecoverable receivables that has to be
provided for by a charge in the income statement.
99
We considered the accounting treatment of:
Income statement Balance sheet treatment

treatment
Accrued expenses Debit expenses Credit accruals under
current liabilities
Prepayments Credit expenses Debit prepayments under

current assets
Accrued income Credit income Debit accrued income

under current assets
Income received in Debit income Credit income received in

advance advance under current
liabilities
Depreciation Debit depreciation as Credit accumulated

an expense depreciation account and
deduct it from the cost of
non-current assets
Irrecoverable receivables Debit expenses Remove the irrecoverable

debt from the receivables
balance i.e. credit
receivables.
Allowance for Debit any increase Deducted from total

irrecoverable receivables or balance on the receivables
Credit any decrease account to arrive at
balance sheet figure for
receivables
You learned that expenditure is classified as either revenue or capital

expenditure. Revenue expenditure is the day-to-day running expenses of the
business and is charged to the income statement. Capital expenditure is the
purchase of non-current assets or the cost of additions to non-current assets.
As stated above, applying the accruals concept requires that the cost of
capital items (e.g. the cost of a non-current asset) be spread over the
economic useful life of the asset in the form of depreciation.
Two methods of calculating depreciation are used in B124, straight line and
reducing balance. The cost of assets disposed of and their accumulated
depreciation should be removed from their respective accounts in the general
ledger and posted to a non-current asset disposal account. To this account
will also be posted the sale proceeds; the resulting balance on the account
will be either the profit or loss on disposal, which will be taken to the
income statement.
We considered the application of credit control procedures, which should
identify irrecoverable receivables that are to be written off. A business will
also account for an allowance for irrecoverable receivables. This is
calculated using a fixed percentage that is applied to the receivables figure
after any irrecoverable receivables have been written off.
Finally you learned that all the above adjustments, if appropriate, could be
shown in an extended trial balance. Using an extended trial balance is one
100
Book summary
means of arriving at the income statement and balance sheet. An income

statement is prepared for a period of time and will therefore always have
‘for the period ended’ or ‘for the year ended’ in its title. A balance sheet is
prepared at a point in time and will therefore have ‘as at’ in its title. Both
statements should have the name of the business above the title of the
statement.
In Books 2 and 3 you learned about the general ledger. In Book 4 you will
learn that the general ledger is an impersonal ledger and that there are two
additional subsidiary ledgers known as personal ledgers. Control over all
these ledgers is an important aspect of accounting.
Before you move on to Book 4, the following self-assessed questions
provide you with the opportunity to check whether you have understood the
materials in this book.
101
Self-assessment questions (SAQs)
It is important that you attempt to answer the question yourself first and
only then check the suggested solutions, which are in the next section.
SAQ 1
The bookkeeper of AB Transport has prepared a trial balance for the year
ended 31 May 20X8, however, he has asked for your help with the year-end
adjustments.
He has provided you with the following information:
. Photocopier hire charge of £2,400 was paid on 1 January for the year to
31 December 20X8.
. The business has a loan of £30,000. Interest is paid 6 monthly in arrears
on the loan. Payment dates are 1 January and 1 July every year.
The interest rate is 5%.
. Rent of £15,000 for an office was paid on 1 April. It covered the three
months ended 30 June 20X8.
. The telephone bill for the three months ended 30 June 20X8 is expected
to be received in July 20X8. The invoice is expected to be of a similar
amount to the previous quarter, which was £600.
. Deposits for furniture removals of £6,000 have been received prior to
31 May 20X8 for removals to be carried out in June 20X8.
Calculate the adjustments necessary.
SAQ 2
Mr Jones sets up a small printing company in January 20X1. He buys a
printing machine costing £60,000. He estimates the machine will have an
economic useful life of five years. The residual value at the end of the five
years is estimated to be £10,000. The accounting policy is to depreciate
machines at 20% per annum on a straight line basis and provide a full year’s
depreciation in the year of purchase but none in the year of disposal. After
using the machine for two years six months a more technologically improved
machine is available so he sells the machine for £35,500 on 30 June 20X3,
and purchases a new one, that operates at twice the speed of the old
machine, for £54,000 on 1 July 20X3.
The new machine will have an economic useful life of four years.
The residual value at the end of the four years is estimated to be £10,000.
102
Self-assessment questions (SAQs)
(a) Write up the relevant general ledger accounts (including the disposal
account but exclude the bank account) for years 20X1 to 20X3.
(b) What is the purpose of depreciation? Give an example relating to
Mr Jones in your answer.
(c) What is the meaning of the net book value figure in the balance sheet at
the end of 20X1?
103
Answers to self-assessment
questions (SAQs)
SAQ 1
Photocopy machine hire
The accounting entries will be:
Dr Prepayments £1,400
Cr Photocopier £1,400
£2,400/12 = £200 per month. Prepayment 1 June to 31 December, 7 months
= £200 × 7 = £1,400. Prepayment = £1,400.
Loan interest
Dr Loan interest £625
Cr Accruals £625
£30,000 × 5% = £1,500 per annum.
Payment 1 July 20X8 is £1,500/2 = £750 covering the period 1
January 20X8 to 30 June 20X8. Accrual of 5 months to 31 May 20X8 =
5/6 × £750 = £625.
Rent
Dr Prepayment £5,000
Cr Rent £5,000
One month’s rent represents a prepayment of £15,000 × 1/3 = £5,000.
Telephone
Dr Telephone £400
Cr Accruals £ 400
An invoice of £600 is expected. It will cover the three months ended
30 June 20X8. Accrual April to May 2/3 × £600 = £400.
Deposits received
Deposit for furniture removals of £6,000 whilst received prior to 31 May
was for removal jobs booked for the month after the year-end. Income
received in advance is therefore £6,000.
104
Answers to self-assessment questions (SAQs)
SAQ 2
(a)
Machinery (asset)
Date Dr Date Cr
20X1 £ 20X3 £
1 Jan Balance b/f 60,000 30 June Disposal account 60,000
20X3
1 July Bank 54,000
Date Dr Date Cr
20X1 £ 20X1 £
20X2 20X2
20X3 20X3

Date Dr Date Cr
20X1 £ 20X1 £
Depreciation 10,000
20X2 20X2
20,000 20,000
20X3 20X3
30 June Disposal 20,000 1 Jan Balance b/d 20,000
account

Date Dr Date Cr
20X3 £ 20X1 £
20 Feb Machinery 60,000 30 June Bank 35,500
30 June Acc depreciation 20,000
00,000 30 June Loss on sale 4,500
60,000 60,000
Workings
Depreciation 20X1 and 20X2
(£60,000 – £10,000) × 20% = £10,000
105
(b) The purpose of depreciation is to allocate the cost of a non-current asset

over the expected useful economic life of the asset to the business.
Under the accruals concept the benefit of using the non-current asset is
matched against the revenues generated by it. In the case of Mr Jones’
business the benefit from using the printing machine to be gained is
equal in each year, which is why he has chosen to use the straight line
method of depreciation. Had he considered that the benefit would be
greater in earlier years than later ones he would have applied the
reducing balance basis of depreciation.
(c) The net book value in the balance sheet at the end of year 20X1 is the
original cost less accumulated depreciation.
106
Reference
Reference
James, K. (2011) ‘Exploring the origins and global rise of VAT’, Tax Analysts,
pp. 15-22. Available online at: http://www.taxanalysts.com/www/freefiles.nsf/
Files/JAMES-2.pdf/$file/JAMES-2.pdf (Accessed 11 July 2015).
107
Acknowledgements
Grateful acknowledgement is made to the following sources:
Front Cover: © Norwich Castle Museum and Art Gallery
Figure 1.1: © Danicek/www.istockphoto.com
Every effort has been made to contact copyright holders. If any have been
inadvertently overlooked the publishers will be pleased to make the
necessary arrangements at the first opportunity.
108

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B124

Written by Elizabeth Porter

The Open University, Walton Hall, Milton Keynes MK7 6AA

ISBN 978 1 4730 04429

Chapter 1 Value Added Tax (VAT) 7

1.1 Direct and indirect taxes 7

1.2 The background to VAT 8

1.3 Taxable supplies 9

1.4 The taxable person 11

1.5 VAT output tax and VAT input tax 11

1.6 Place of supply 14

1.7 Accounting for VAT in the general ledger 15

1.8 Goods taken for own use 17

Chapter 2 Accruals accounting for expenses and

2.1 Accruals accounting 22

2.4 Accrued income (revenue) 35

2.5 Income received in advance (deferred revenue) 37

2.6 Year-end adjustments 40

Chapter 3 Tangible non-current assets and depreciation 53

3.1 Non-current assets 53

3.3 Choosing a depreciation method 58

3.4 Recording depreciation 64

3.5 Disposal of non-current assets 67

3.6 Disclosure of non-current assets in the ﬁnancial accounts 73

Chapter 4 Irrecoverable receivables 83

4.1 Credit control 83

4.2 Writing off irrecoverable receivables 85

4.3 Allowance for irrecoverable receivables 86

4.4 The extended trial balance revisited 89

Self-assessment questions (SAQs) 102

Answers to self-assessment questions (SAQs) 104

Book 3 consists of four chapters.

Chapter 2 explains the matching principle and how applying the

Chapter 3 considers the difference between capital and revenue

Chapter 4 explains the importance of credit control, how to recognise

Figure 1 The ﬁrst modern publication on double-entry bookkeeping was a treatise

Chapter 1 Value Added Tax (VAT)

1.1 Direct and indirect taxes

. Governments have to devote a great deal of resources to enforce these

Table 1.1 Direct and indirect taxes

Direct taxes Indirect taxes

1.2 The background to VAT

1.3 Taxable supplies

Entertainment – This is deﬁned as hospitality of any kind, e.g.

. provision of food and drink

. a butcher taking meat from his shop to give to his wife

Figure 1.1 Jaffa Cakes

1.4 The taxable person

. charge VAT at the appropriate VAT rate (20%, 5%, or 0%)

1.5 VAT output tax and VAT input tax

Example: Collection of VAT

Figure 1.2 Collection of VAT by HMRC

Figure 1.3 below shows how the VAT is paid.

Manufacturer £454 But can be reclaimed from HMRC

Figure 1.3 Payment of VAT

It is important to know how much VAT is included in a transaction so that

Activity 1.1 Writing up the general ledger

Complete the following tables from the information given.

Input Output VAT paid to HMRC

A curtain-making company purchases the rolls of material for £1,000 plus

Input Output VAT paid to HMRC

Input Output VAT paid to HMRC

1.6 Place of supply