Cima c02 - Notes

C02 Fundamentals of Financial Accounting
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CIMA C02

Fundamentals of
Financial Accounting

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Contents Page

Contents Page .............................................................................. 3
Paper Information .......................................................................... 4
How to Pass .................................................................................. 5
The Verb Hierarchy ....................................................................... 6
LEARNING OUTCOMES GRID..................................................... 7
INTRODUCTION TO ACCOUNTING .......................................... 10
THE FRAMEWORK OF FINANCIAL SYSTEMS ......................... 12
DOUBLE ENTRY BOOK KEEPING ............................................ 19
ACCRUALS AND PREPAYMENTS ............................................ 26
BAD DEBTS AND ALLOWANCES FOR RECEIVABLES ............ 30
NON CURRENT ASSETS ........................................................... 33
INVENTORY ............................................................................... 43
PREPARATION OF FINANCIAL STATEMENTS WITH
ADJUSTMENTS .......................................................................... 47
ORGANISING THE BOOKKEEPING SYSTEM ........................... 49
CONTROLLING THE BOOKKEEPING SYSTEM ........................ 58
THE REGULATORY FRAMEWORK OF ACCOUNTING ............ 73
LIMITED COMPANY ACCOUNTS .............................................. 81
CASH FLOW STATEMENTS ...................................................... 90
INCOMPLETE RECORDS .......................................................... 96
INTERPRETATION OF FINANCIAL STATEMENTS ................. 105
MANUFACTURING ACCOUNTS .............................................. 111

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Paper Information

The objective of this paper is to test the students ability to:
Explain the conceptual and regulatory framework of
accounting
Explain the nature of accounting systems
Prepare and interpret accounts for a single entity. Students
should be aware of the format of published accounts but are
not required to prepare them
Calculate and interpret simple ratios
Syllabus Outline
Conceptual and regulatory framework 20%
Accounting systems 20%
Control of accounting systems 15%
Preparation of accounts for single entities 45%

The assessment
The exam will be a computer based exam comprising 50 multiple
choice questions lasting 2 hours.
The pass mark is 50%

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How to Pass

Have sound theoretical knowledge
(attend tuition classes)
Practice application skills
(question practice)
Be prepared!
(attend revision & qbr)
Read the question requirements
Add value to the scenario material

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The Verb Hierarchy

CIMA C02 Fundamentals of Financial Accounting
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LEARNING OUTCOMES GRID
A - Conceptual and regulatory framework 20%
1 Identify the various user groups which need accounting information
and the qualitative characteristics of financial statements
2 Explain and function of, and difference between, financial and
management accounting systems
3 Identify the underlying assumptions, policies and changes in
accounting estimates
4 Explain and distinguish capital and revenue, cash and profit,
income and expenditure, assets and liabilities
5 Identify the difference between tangible and intangible assets
6 Explain the historical cost convention
7 Identify the basic methods of valuing assets on current costs, fair
value and value in use bases and their impact on profit measures
and balance sheet values
8 Explain the influence of legislation ( e.g. companies act, EC
directives) and accounting standards on the production of
published accounting information for organisations

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B - Accounting systems 20%
1 Explain the purpose of accounting records and their role in the
accounting system
2 Prepare cash and bank accounts and bank reconciliation
statements
3 Prepare petty cash statements under an imprest system
4 Prepare accounts for sales and purchases including personal
accounts and control accounts
5 Identify the necessity for financial accounting codes and construct
simple coding system
6 Prepare nominal ledger accounts, prepare journals and a trial
balance
7 Prepare accounts for indirect taxes
8 Prepare accounts for payroll
C - Control of accounting systems 15%
1 Identify the requirements for external audit and the basic processes
undertaken
2 Explain the purpose and the basic procedures for external audit
3 Explain the meaning of fair presentation
4 Explain the need for financial controls
5 Explain the purpose of audit checks and audit trails
6 Explain the nature of errors and to be able to make accounting
entries for them
7 Explain the nature of fraud and basic ideas of fraud prevention

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D - Preparation of accounts for single entities 45%
1 Prepare accounts using accruals and prepayments
2 Explain the difference between bad debts and allowance for
receivables
3 Prepare accounts for bad debts and allowances and receivables
4 Calculate the methods of depreciation
5 Prepare accounts using each method of depreciation and for
impairment values
6 Prepare a non current asset register
7 Prepare accounts for inventories
8 Prepare income statements, statement of changes in equity and
balance sheet from trial balance
9 Prepare manufacturing accounts
10 Prepare income and expenditure accounts
11 Prepare accounts from incomplete data
12 Interpret basic ratios
13 Prepare cash flow statements

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INTRODUCTION TO ACCOUNTING

LEARNING OUTCOME
A1 - Identify the various user groups which need accounting
information and the qualitative characteristics of financial
statements
A2 - Explain and function of, and difference between, financial and
management accounting systems

Introduction
WHAT IS ACCOUNTING?
Accounting is made up of two elements:
I. Recording business transactions - Book keeping
II. Presenting the information
WHAT IS A BUSINESS?
A business is a commercial organisation which exists with a view to
making a profit. There are different types of businesses which will fall
into 3 catagories:
Sole Trader
This is a business that is owned and operated by one person
Partnership
This type of business is owned by several individuals, some of which will
actively be involved in the business
Companies
This type of business is owned by shareholders and is operated on their
behalf by a nominated board of directors. Companies will be covered in
greater detail in later sessions

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Users of accounts
The users of accounts will depend on the type of accounts that are
produced. There are two main types of accounts:
Management accounts
Financial accounts
Management accounts
These are produced as often as a business wants them (usually
monthly). They are produced for internal use and will not, usually be
seen by external people. Management accounts can be prepared using
the companys own internal policies.
Financial accounts
These accounts are usually produced annually. They are based on
historical information and are rarely used internally. Financial accounts
are used by external users for several reasons:
Investors
Lenders
Employees
Government
Public

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THE FRAMEWORK OF FINANCIAL SYSTEMS

LEARNING OUTCOME
A4 - Explain and distinguish capital and revenue, cash and profit,
income and expenditure, assets and liabilities

The Accounting Equation
This states that business net assets always equal the proprietors/owners
funds.
Assets = Liabilities + Capital
Example 1

1) I win $100,000 and decide to start a business, a CD shop.

Dual Effect:
The business has cash of $100,000
The business owes me $100,000

Accounting Equation:
Net Assets = Proprietors Funds
100,000 cash 100,000 capital
Complete the accounting equation for the following:
1) Buy 5000 CDs from Natalie for $7 each for cash.

2) Buy 1000 DVDs from Jenny for $7 on credit.

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3) Buy a computer for $5000.

4) Sell 4000 CDs to Julia for $40,000

5) Sell 500 DVDs to Sue for $5000 on credit

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6) Pay an electricity bill of $1500

7) Get a loan from Naomi of $25,000

8) Pay the Jenny supplier $5,000

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9) Receive payment from Sue of $4,000

10) Withdraw $2,000 from the business for my own use

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The accounting equation and the balance sheet.
The balance sheet is simply the restatement of the assets, liabilities and
capital at a particular time. It is basically a more detailed representation
of the accounting equation.
Proforma set of financial statements for a limited company or Plc
Balance Sheet as at 31 December 2007
Non current assets
Note
Intangible assets 6 200,000
Tangible assets 7 187,999

Current assets

Inventory 8 88,432
Trade receivables 9 97,455
Cash 13,400 199,287

Total assets 587,286

Equity and liabilities

Share capital 100,000
Retained earnings 220,497
Revaluation reserve 7 38,000 358,497

Non current liabilities

Interest bearing borrowings 10 100,000

Current liabilities

Trade payables 77,789
Taxation 5 51,000 128,789

Total liabilities 587,286

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Income Statement for the year ended 31 December 2007
Revenue 233,000

Cost of sales

Opening inventory 12,332
Purchases 119,098
Carriage inwards 1,009
132,439
Closing inventory (13,777) 118,662

GROSS PROFIT 114,338

Discounts received 5,111

Other income 4,000

123,449

Less expenses

Discounts allowed 3,444
Depreciation 10,710
Gas and electricity 14,122
Irrecoverable debts 7,134
Loan interest 4,000
Carriage outwards 5,666
Water rates 8,444
Advertising 15,000
Other expenses 3,142 71,662

NET PROFIT 51,787

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Example 2
Explain briefly what is meant by the following and give an example of
each:
Assets
Liabilities
Capital
Revenue
Expense

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DOUBLE ENTRY BOOK KEEPING

LEARNING OUTCOMES
B1 Explain the purpose of accounting records and their role in
the accounting system
B4 Prepare accounts for sales and purchases including personal
accounts
B6 Prepare nominal ledgers and trial balance
C8 prepare income statement and balance sheet from a trial
balance

Introduction
Bookkeeping is the recording of monetary transactions of a business.
Double entry bookkeeping
Double entry bookkeeping is the fundamental concept underlying
accountancy. All accounting transactions should be recorded using the
double entry system. There are some basic rules that we MUST follow:
1. Every debit must have a credit
2. A debit entry is an ASSET in the BALANCE SHEET or an
EXPENSE in the INCOME STATEMENT
3. A credit entry is a LIABILITY in the BALANCE SHEET or an
INCOME in the INCOME STATEMENT
T accounts
In order to assist us with the preparation of the financial statements we
use T accounts for simplicity. The principles of T accounts are:
Every debit entry has a credit entry
Every T account will belong to the statement of financial position or
the statement of comprehensive income
The closing balance of a T account at the end of the period is
entered into a trial balance
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Example 1
Charlie commences business on 1 April 2009. The following
transactions take place in his first two weeks of trading.
1 April He invests 50,000 in to a business
1 April He purchases 5,000 worth of goods on credit
2 April He sells half of the inventory for 6,000 cash
5 April He issues a cheque to pay for the goods he received
on credit
4 April Pays his rent for April of 450 by cheque
7 April He sells his remaining stock for 6,000 on credit
10 April Purchased goods on credit for 7,000
14 April He purchases a delivery van for 7,000 cash
Required
For the first two weeks of trading prepare:
The T accounts for Charlie (State if the account is Balance Sheet
or Income Statement)
The Trial Balance
The Income statement for the 2 week period ended 14
th
of April
2009
The Balance sheet as at 14
th
April 2009

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Answer to example 1
Bank Account

Capital Account

Purchases

Trade Payables

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Sales

Rent
Dr Cr

Trade Receivables
Dr Cr

Delivery Van
Dr Cr

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Trial Balance
Statement Dr Cr

Bank Account

Capital Account

Purchases

Trade Payables

Sales

Rent

Trade Receivables

Delivery Van

Total

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Charlie
Income Statement
2 Week Period Ended 14 April 2009

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Charlie
Balance Sheet
as at 14 April 2009

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ACCRUALS AND PREPAYMENTS

LEARNING OUTCOME
D1- Prepare accounts using accruals and prepayments

Introduction
The most common application of accruals and prepayments is in
accounting of expenses.
Accruals
These are charges that are brought into the financial statements at the
end of the period because, although goods and services have been
provided, they have not yet been charged by the suppliers. For example
electricity, invoiced in arrears, generally requires an accrual at the end of
each accounting period.
An accrued expense is a liability because it is owed to the relevant
supplier of those goods and services, irrespective of the fact that an
invoice has not yet been received. If the business were to be closed
down at the end of the accounting period the expense would still have to
be paid.
Accounting for an Accrual
Dr Expense
Cr Accrual

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Prepayment
A prepayment is the opposite to an accrual. A prepayment is
expenditure on goods and services for future benefit, which is to be
charged to future operations, for example rent in advance. These
amounts need to be included in current assets.
A prepayment is an asset because the business has yet to enjoy or
utilise the benefit from it. Depending on the type of expense, if the
business were to close down the amount prepaid may be refunded.
Accounting for a prepayment
Dr Prepayment
Cr Expense

Example 1
Electricity
Date Paid Amount Period of payment
10.3.08 96 2 months to 28.2.08
12.6.08 120 Qtr to 31.5.08
14.9.08 104 Qtr to 31.8.08
10.12.08 145 Qtr to 30.11.08

Rates
Date Paid Amount Period of payment
1.2.08 375 3 mths to 31.3.08
6.4.08 1,584 12 mths to 31.3.09

Other info
1st July 2008 we employed an assistant. We pay the assistant 150
each month on the 28
th
of the month
6
th
March 2009 we receive an electricity bill for 168 for quarter to 28
th

Feb 2009.

Task
Complete the T accounts for each entry.

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Reversal of accrual and prepayment

Accrual Prepayment

Dr Accrual Dr Expense
Cr Expense Cr Prepayments
Steps
Step 1
Reverse the opening accrual/prepayment

Step 2
Post cash paid

Step 3
Post closing accrual/prepayment

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Example 2
Electricity charges for the year
Date Paid Amount Period of payment Accounting
12.3.08 168 Feb 2008 Opening accrual
9.6.08 134 May 2008 Cash Paid
12.9.08 118 Aug 2008 Cash Paid
12.12.08 158 Nov 2008 Cash Paid

During march we receive a bill for 189 for the quarter to 28
th
Feb 2009.

Task
Complete the t account for the electricity for the year ( Feb 08 Dec 08)
and calculate the Income statement charge for the year.

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BAD DEBTS AND ALLOWANCES FOR
RECEIVABLES

LEARNING OUTCOMES
D2 Explain the difference between bad debts and allowance for
receivables
D3 Prepare accounts for bad debts and allowances and
receivables

Bad debt
When a business sells good on credit, it assumes that the customer will
pay in full within a agreed credit period. However sometimes a customer
does not pay in full or not even at all. If this is the case then it is incorrect
to retain this balance as an asset, or to treat the sale as having made a
profit.
When it becomes known that the customer is unlikely to pay, the
receivable balance must be removed and transferred to the income
statement as an expense of the period that the bad debt arises.

Accounting for Bad Debt
Dr Bad Debt Expense
Cr Receivables

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Allowances for Receivables
While some debts are definately bad (customer gone into liquidation)
other debts may only be doubtful. If this is the case it would not be
appropriate to eliminate the receivable balance because they may pay
after all. But we have to recognise that the value of the receivable (
asset) is probably less than it appears to be. If this is the case we create
an allowance for receivables.
Specific allowance : an individual doubtful debt
General allowance: after taking into account any bad debts we apply a
% of our receivables to calculate the allowance.
Accounting for allowance/provision of bad debt.
Dr Bad debt expense
Cr Allowance/provision for doubtful debts

Example 1
A business has trade receivables at the end of the year of 26,478. Of
these it is felt that 976 should be written of as bad debt.
What is the double entry for this?
What is the new receivables figure for the year?

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Example 2
For the year ended 31
st
December 2005 a companys receivables
balance was 150,000. They had a general allowance of 5%. At the
year ended 31
st
December 2006 the companys receivables are
135,000 the company would like to maintain a 5% general allowance.
Required
What is the impact on the income statement and how will the receivables
be presented in the Balance sheet for 31
st
December 2005 & 2006?

Example 3
A business has trade receivables of 21680. Of these one debt of 680
is irrecoverable and a provision of 3% is to be made against the
remainder.
Write up the bad debt account, Trade receivables account and the
provision for doubtful debts account to reflect this.

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NON CURRENT ASSETS

LEARNING OUTCOMES
A4 - Explain and distinguish capital and revenue expenditure
A5 - Explain the difference between tangible and intangible assets
D4 - Calculate the methods of depreciation
D5 - Prepare accounts using each method of depreciation and for
impairment values
D6 - Prepare a non current asset register

Introduction
A non-current asset is intended for continued use in a business. This
would generally mean for more than one accounting period. Non-
currents assets can be either TANGIBLE or INTANGIBLE. CIMA C02
concentrates on tangible non-current assets, however a knowledge of
intangible non- current assets is needed.
Tangible non-current assets
These are assets that have physical substance. Examples of tangible
non-current assets would be:
Land and buildings

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Plant and equipment

Motor vehicles
Computers
Fixtures and fittings

Intangible non-current assets
These assets have no physical substance. An example of an intangible
non-current asset would be:
Goodwill
Research and development
Investments
Non-current assets are normally of substantial value and their
accounting can have a material impact on the financial statements. As a
result of this there are large numbers of accounting standards that help
the preparers of financial statements to account for them.
The key accounting standard relevant at this level is IAS 16 Non-Current
Assets

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Non-current asset register
The majority of companies will own a number of non-current assets, and
it is imperative that effective control is kept over them. In order to
ensure management are aware exactly where each item is located and
that they are adequately maintained and serviced, a non current asset
register is maintained.
A non-current asset register is generally maintained in the finance
department. Companies can purchase specifically designed packages
or a register can simply be maintained on an Excel spreadsheet.
A register would include the following information:
Item code
Date of purchase
Item description
Cost
Estimated useful life
Residual value (if any)
Depreciation method
Location
Disposal details

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Capital and revenue expenditure
One of the key areas of accounting for non-current assets is deciding
whether expenditure incurred is CAPITAL or REVENUE expenditure.
If it is capital expenditure it will be capitalised in the Balance Sheet and
then depreciated over the useful economical life of the asset. If it is
revenue expenditure it will be expensed through the Income Statement.
We need to classify expenditure incurred as either capital or revenue in
order to ensure appropriate accounting entries are made.
Capital expenditure is expenditure likely to increase the future earning
capacity of the organisation whereas revenue expenditure is regarded
as maintaining the organisations present earning capacity.
Per IAS 16 the following costs may be capitalised on acquisition of a
non-current asset:
Initial cost
Delivery costs
Non-refundable import taxes
Installation costs
Any costs incurred in bringing the asset into intended use
Initial training costs
Subsequent expenditure that ENHANCES the performance of the
asset
Costs that are regarded as revenue expenditure and may not be
capitalised per IAS 16 are:
Insurance costs
Repairs
Maintenance

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Subsequent Expenditure

Subsequent expenditure on property, plant and equipment should only
be capitalised if it improves the asset beyond its originally assessed
standard of performance e.g. faster production or higher quality output.
All other subsequent expenditure should be written off
Depreciation
The cost of the non current asset will contribute to the organisations
ability to earn revenue for a number of accounting periods. It would be
unfair if the whole cost were to be treated as an expense in the income
statement in the year of acquisition. Instead, the cost is spread over all
the accounting periods in which the asset is expected to be making a
contribution to earnings (useful life of the asset). This process is called
depreciation.
By applying depreciation charges, we are consistent with the
ACCRUALS / MATCHING CONCEPT i.e. applying the cost of using the
asset to the Income Statement for the same period.
All tangible non-current assets should be depreciated on a systematic
basis per IAS 16, with the exception of land. This is because land is
seen to appreciate in value.
Intangible non-current assets are amortised over their useful economic
life (IAS 38 Intangible asset term for depreciating this type of asset).

Depreciation policies
Calculating depreciation in a given period are common questions in this
paper. The main methods of calculating depreciation are:
Straight line
Reducing balance

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Straight line depreciation
Depreciation is charged on a straight line basis over the life of the non-
current asset. Thus an equal amount is charged in every accounting
period over the life of the asset.
To calculate the depreciation charge the following formula is used:

Depreciation per
annum
= Original cost estimated
residual value
Estimated useful Life

Example 1
Company A purchased a non-current asset on 1st January for 25,000.
The asset has an expected useful life of 5 years and a residual value of
2,500.
Calculate the depreciation charges for the year ended 31
st
December on
the basis:

Reducing balance
This method of depreciation is generally used for assets which tend to
lose more value in the initial years and require greater maintenance in
the later years. A good example would be a brand new motor vehicle.
Motor vehicles tend to depreciate rapidly in the earlier years and require
very little maintenance.
A fixed percentage is charged to the net book value on an annual basis.
Hence, as the book value of an asset reduces, the depreciation charge
reduces accordingly.

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Machine hour method
Depreciation =
-

Once the depreciation charge has been calculated it should be entered
into the accounts via a journal.
The journal for depreciation is:
Dr Depreciation expense (Income Statement)

Cr Accumulated Depreciation (Balance Sheet)

Example 2
Company C purchases a motor vehicle for 6,000 and will depreciate
it at a rate of 40%.
Calculate the depreciation for the first 4 years.

Example 3
We buy a machine for 120,000 and we anticipate the useful economic
life to be 20,000 hours. At the end of the life of the asset we expect the
machine to be worth 5,000. We anticipate to use the machine for 8,000
hours in year 1, 7000 in year 2 and 5000 year 3.
Calculate the depreciation charge for each year and the net book value
of the asset for each year.
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Disposal of a non-current asset
When a business disposes of an asset it is unlikely that the sale
proceeds will agree with the net book value. Therefore, a gain or loss
will arise from the sale.
NBV < sale proceeds = Profit

NBV > sale proceeds = Loss
Accounting Treatment
1. Transfer original cost of asset to disposal A/C
Dr Disposal a/c
Cr Cost a/c
2. Transfer Accumulated depn to disposal A/C
Dr Accum Depn a/c
Cr Disposal a/c
3. Post sale proceeds
Dr Bank a/c
Cr Disposal a/c
4. Balance off disposal a/c to find profit/loss on disposal
Profit in disposal = Sundry Income in IS
Loss on disposal = expense in IS

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Revaluations
When a non-current asset is purchased we record them at their initial
cost. However, over time these values may materially differ from their
market value.
For example, if a company purchased a property 20 years ago and
therefore subsequently charged depreciation for 20 years, it would be
safe to assume that the book value of the asset would be significantly
different from todays market value.
In order to overcome this issue IAS 16 permits companies to reflect the
market value in the statement of financial position. This policy may be
adopted, and if so the following rules must be applied per the standard:

Example 4
Company C has a motor vehicle with a book value of 6,000 (cost
22,000) and disposes of it for 8,000.
We can establish that there is a gain of 2,000 (proceeds book
value).
The accounting entries will need to follow three steps
1. Clear the cost from the cost account
2. Clear the depreciation from the accumulated depreciation
account
3. Enter the proceeds

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i. If a company chooses to revalue an asset they must revalue all
assets in that category
ii. Revaluations must be regular
iii. Subsequent depreciation must be based on the revalued amounts
iv. Gains from revaluations are not taken to the Income Statement, as
no gain as been realised. This is covered by the PRUDENCE
concept.

Accounting treatment
Dr NCA Cost
DR Accumulated Depreciation
Cr Revaluation Reserve

Example 5
Company X purchased a building for 45,000 15 years ago, and charges
depreciation of 2% on a straight line basis.
The property has been valued by a qualified person at 150,000 during
the current financial year. The directors would like to encompass these
figures in the financial statements.
Required
Complete the necessary journals to account for the revaluation.

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INVENTORY

LEARNING OUTCOME
D7 Prepare accounts for inventories
Introduction
Inventory is the product we purchase and sell in a business.
In a business it is unlikely that all of the inventory will be sold at the end
of an accounting period, therefore there will be an adjustment needed in
the financial statements for the value of the closing inventory.
Opening and closing inventory needs to be included in the Income
Statement in order to calculate the cost of the goods sold with-in a given
period. The Balance Sheet will show the value of the inventory at the
end of the accounting period (the closing inventory).
IAS 2 is the accounting standard that gives us detailed guidance on how
to value our closing inventory.
RULE: Closing inventory should be valued at the lower of cost and
net realisable value (N.R.V.)
Cost is the total cost incurred in bringing the product to its
present location and condition. For bought in items this will
be the cost of the items themselves plus the cost of carriage
associated with obtaining them.

NRV is the selling price of the item less any costs to be
incurred in making the item suitable for sale. These might
include packaging and costs of delivering the item to
consumers.

By applying the IAS 2 rule we ensure our inventory is never overstated
in the Balance Sheet, hence the PRUDENT concept.

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Example 1
Here is the information of the inventory that Q Ltd has in their
warehouse for the year ended 31
st
December 2008.

Product

A B C
Cost 10 12 6
NRV
Selling price 15 16 11
Modification costs

-3 -4
Marketing costs -3.5 -2.5 -1

11.5 10.5 6

Value at:

No of units held 100 200 150

Calculate the value of closing inventory for the year ended 31
st

December 2008.
Valuation of closing inventory
We will cover three methods of valuing the closing inventory:
F.I.F.O. First In First Out
The closing inventory consists of items purchased at the latest dates,
as we assume the items that were purchased first were the items sold
first.
In times of rising prices, closing inventory will have a higher cost and
there profit will be higher.
AVCO Average cost
Under this method we take an average cost of the closing inventory
i.e. we multiply the number of items by the average price paid for that
item.

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L.I.F.O. Last In First Out
The closing inventory consists of items purchased at the earliest date, as
we assume the last item purchased is the first item to be sold.
In times of rising prices the closing inventory will have a lower value and
therefore profit will be lower.
From a practical perspective it is unlikely last items purchased will be
sold first, and as a result of this IAS 2 does not permit L.I.F.O. method of
stock valuation.

Example 2
Phoebe Ltd made the following purchases in June 2009 of Oak wood to
build chairs that they will produce and sell.
Date Units
Unit
price
1.6.09 opening
inventory 300 $12
10.6.09 Purchase 400 $12.50
20.6.09 Purchase 400 $14
25.6.09 Purchase 400 $15

The following sales were made during June 2009
14.6.09 500 units
21.6.09 500 Units
28.6.09 100 units

Calculate the cost of sales using FIFO, LIFO and AVCO method to
calculate the closing inventory for the month of June.

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W.I.P. Work in progress
In some cases, where a company has modified its inventory it is
necessary to take the cost of that modification into account when valuing
closing inventory.
Net realisable value
Net realisable value is the amount we can get from selling inventory less
any further costs to be incurred.

Accounting Entries
The double entry to account for inventory is:
Dr Inventory Balance Sheet
Cr Inventory Income Statement

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PREPARATION OF FINANCIAL STATEMENTS
WITH ADJUSTMENTS

Question 1
The following Trial balance has been extracted by the book keeper of
Sue Large, a dress maker as at the 30
th
June 2008.
Dr Cr

Purchases 31,480
Sales 95,660
Opening stock 7,580
Returns 240 620
Discounts 380 1,080
Drawings 34,720
Premises at cost 100,000
Accumulated depreciation for premises 10,000
Fixtures and fittings 24,000
Accumulated depreciation for F&F 3,000
Wages and salaries 18,620
Advertising 2,260
Rates 8,240
Sundry expenses 7,390
Bank 4,020
Cash 120
Debtors 5,000
Bad debts written off 100
Provision for doubtful debts 520
Creditors 3,740
VAT 3,240
Capital 81,290
Bank Loan 45,000
244,150 244,150

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Notes at 30th June 2008
1) Inventory has been valued at 6060
2) Depreciate premises at 2% using straight line method
3) Depreciate fixtures and fittings at 12.5% using straight line
method
4) Provision for doubtful debts is to be 5% of receivbles
5) Wages accrued are 500, and advertising prepaid is 350.
Required
To prepare the Income Statement for the year ending 30
th
June 2008
and balance sheet as that date.

49

ORGANISING THE BOOKKEEPING SYSTEM

LEARNING OUTCOMES
B1 - Explain the purpose of accounting records and their role in the
accounting system
B4 - Prepare accounts for sales and purchases, including personal
accounts
B2 - Prepare cash and bank accounts
B3 - Prepare petty cash statements under an imprest system
B6 - Prepare nominal accounts and journal entries
B7 - Prepare accounts for indirect taxes (e.g. Sales tax)

Introduction
In session 3 we prepared financial statements from T accounts. The
number of transactions was limited, and therefore the process was
simple to follow. In larger organisations, a single ledger may not be
sufficient to hold all the ledger accounts, there may be too many
transactions for one person to maintain, and it might become difficult to
trace individual accounts. It is common for the ledger accounts to be
divided into sections. Double entry is maintained as before, but ledger
accounts of the same type are grouped together.
The common division of the ledgers are as follows:
All receivable accounts are kept in the Sales ledger (receivables
ledger)
All payable accounts are kept in the purchase ledger (payable
ledger)
All bank and cash accounts are kept in the cash book
All other accounts are kept in the nominal ledger (main
ledger/general ledger)
.
50

Most businesses of any size maintain records of their transactions in the
following books of prime entry:
Sales day book
Purchase day book
Sale returns day book
Purchase returns day book
Cash book
Petty cash book
Journal entries
The transactions are recorded in the prime entry books. They are then
transferred to the nominal (general) ledger and we then extract a trial
balance in order to prepare our financial statements.

Sales day book
This book records all the sales we make on credit. Sales should be
recorded net of trade discount but before any cash (settlement) discount.
Purchase day book
This book of prime entry records all purchases we make on credit.
Sale returns day book
If a credit customer returns goods, this will be recorded in the sale
returns day book.
Purchase returns day book
This book will record all the credit purchases that we return to suppliers.
Cash book
This book will record all the money that we will pay into the bank
account, and any payments we make from the bank account. This will
also record any cash (settlement) discounts we allow or receive.

51

Petty cash book
This records all the small sundry transactions occurring in a business on
a day to day basis.
Journal entries
These are used for ad hoc entries that do not fall into any of the above
categories. They are also used to correct errors, both temporary and
permanent.

Example 1
J & J had the following transactions during the first week in December
2008.
1
st
December 2008
Purchased goods on credit from A Ltd for 595 receiving a trade
discount of 9.5%
Purchased good on credit for 795 from KP Ltd
Sold goods on credit to JK Ltd for 999
3
rd
December
Returned KP Ltd goods as they were defective
Sold goods on credit to A Jones for 995
5
th
December
Sold goods on credit to A Jones for 795
Purchased goods on credit from A Ltd for 995, again with a
9.5% trade discount
NB Sales tax is 17.5%
Required

Prepare the day books for the above transactions of JJ Ltd.
Then post each of the day books to the nominal ledger and subsidiary
ledgers (T accounts)

52

SALES DAY BOOK

DATE INV
NO.
CUSTOMER VALUE SALES
TAX
TOTAL

PURCHASE DAY BOOK

DATE INV
NO.
SUPPLIER VALUE SALES
TAX
TOTAL

PURCHASE RETURNS DAY BOOK

DATE INV
NO.
SUPPLIER VALUE SALES
TAX
TOTAL

53

The Cash Book
For most businesses accounting for cash in both bank and cash
transactions takes place in the cash book.
Cash book , for receipts and payments in cash and through the
bank (cheques and BACS transfers)
Petty cash book for low value expense payments (we will cover
this later)

Uses of the cash book
The cash book brings together the cash and bank transactions of a
business.
Thus it is used to record the money side of the book-keeping
transactions such as:
Cash transactions
- all receipts in cash
- most payments for cash, except low value expense payment
(which are paid through the petty cash book)
54

Bank transactions
- All receipts through the bank (including the payment of cash into
the bank)
- All payments through the bank (including the withdrawal of cash
from the bank)

The cash book is usually controlled by a cashier who:
Records receipts and payments through the bank and in cash
Makes cash payments, and prepares cheques and other bank
transfers for signature by those authorised to sign
Pays cash and cheques received into the bank
Has control over their firms cash, in a cash till or cash box.
Issues cash to the firms petty cashier who operates the firms
petty cash book.
Checks the accuracy of the cash and bank balances at regular
intervals.

55

Cash Book: Receipts CBR 24
Date Details Folio Discount
Allowed
Cash Bank

A cash book is set out in a variety of formats to suit the
requirements of a particular business. Above is an example of
a 3 column money receipts side of a cash book.
The discount column does not form part of the double entry
system but is purely there for memorandum purposes.

The Petty Cash book
The petty cash book usually operates an Imprest system whereby an
agreed balance of cash is held by a nominated individual.
Characteristics of imprest system
Pre set limit say 100
Voucher is filled in when money is taken out
At any time Voucher + Cash = 100
The petty cash book is filled in from the vouchers
The amount used is restored on a regular basis to the pre set limit.

56

The Journal
In a bookkeeping system involving the use of books of prime entry, it is
evitable that there will be transactions that do not correspond with the
main books of prime entry used, that is the day books and cash books.
In order to complete the system another book is needed to capture
sundry items prior to entering them to the ledger. This book is called the
journal and is used for a wide variety of transactions for example:
Depreciation
The write off of bad debt
Purchase or sale of a non current asset
Allowances for receivables
Accruals and prepayments
Year end adjustments
The correction of errors

The journal layout
Date Account name/ details DR CR
Explanation

57

Example 2
Correct the following errors using journals:
1. A sales day book has been under cast by 1,000.
2. Inventory purchased for 1,000 has been posted to stationery
3. A non-current asset has been purchased for 7,000 on credit,
but has not been recorded.

Solution
Account Name Description Debit Credit

58

CONTROLLING THE BOOKKEEPING SYSTEM

LEARNING OUTCOMES
C4 - Explain the need for financial controls
C7 - Explain the nature of fraud and basic ideas of fraud prevention
B2 - Prepare bank reconciliations
B4 - Prepare accounts for sales and purchases including personal
accounts and control accounts
C6 - Explain nature of errors and to be able to make accounting
entries for them
B5 - Identify the necessity for financial accounting codes and
construct simple coding system

Preventing errors
There are a number of ways in which errors can be prevented, or at
least limited in their number and effect. Many of these measures also
prevent deliberate fraud.
Authorisation procedures
All cheques and BACS runs requiring 2 signatures
Purchase of non current assets to be authorised by senior
management only
New receivable accounts and payable accounts signed off by
senior manager
All purchase orders signed off by senior manager
All payments made should be approved first e.g.
Payments made to suppliers should be matched against
goods received note, invoice and credit notes
Refunds to customers authorised by management
Payroll should be checked and authorised before making a
payment
59

Documentation
Purchase order used to purchase good
Goods received note/ delivery note to be checked against
purchase order (check number/damage)
Invoice needs to be checked against GRN
Payment to be made once all documentation match against
invoices (take into account of credit notes if any)

Organisation of staff
All staff should be probably recruited, trained and supervised. No one
person should have complete control over any section of the book
keeping system. Duties should be shared out between different
members of staff. This is known as segregation of duty.
For example one member of staff responsible for the following could be
able to cabable of carrying out fraudulent activity
Issuing sales invoices
Issuing credit notes
Credit control
Banking receipts from customers

Detecting errors
Spot checks
Comparison with external evidence - confirm balances with
receivables
Reconciliations bank reconciliation and control account
reconciliation
Carry out an audit

60

Bank Reconciliations
With-in the ledger account is a bank account ledger, and it is important
that the balance in the ledger reconciles to the balance on the actual
bank statement. We call this exercise a bank reconciliation.
Dependant on the size of the company, this can be done on a weekly or
monthly basis, and in some larger companies even daily.
Preparing a bank reconciliation has many advantages. They include:
Provides a check on accuracy of recordings in the cash book
Highlights any errors
Assists in the day to day cash management
Any differences can be identified quickly

Debits and Credits
On a bank statement the balances will be from the perspective of the
bank not that of the business. Therefore, if a bank statement shows a
credit balance, the bank has a creditor. In other words the bank owes
the business and is therefore in a positive position.
If the bank statement shows a debit balance this indicates the business
is overdrawn. i.e. it is an asset from the banks point of view

61

Reconciling Items
It is extremely unlikely that the balance on the ledger account and the
balance on the bank statement will agree. This can be due to the
following reasons:
Cheques issued by the company are immediately entered into the
cash book, but they will not appear on the bank statement until
they are presented to the bank. These are called unpresented
cheques.
Receipts by the business are immediately entered in the cash
book and then banked. This can take a number of days to clear.
There may be items in the bank statement that have not been
processed through the cash book e.g. BACS transfer, standing
orders, direct debits, dishonoured cheques and bank charges.
Omission of items

Proforma bank reconciliation
Balance per bank statement 65,455

Less : Unpresented cheques (1,950)

Add: Outstanding lodgements 1,700

Balance per cash book 65,205

62

Reconciling control accounts and ledger accounts
The control accounts must be checked against the total of balances in
the relevant ledger (Receivables /sales ledger) on a regular basis. If
there is any difference then this must be investigated.
First lets look at what we should be including in our control accounts.
RECEIVABLES LEDGER CONTROL ACCOUNT

Balance b/d X Sales returns X
Credit Sales X Bank X
Returned cheques X Discounts allowed X
Bad debts X
Contra X
Balance c/d X
X X

PAYABLES LEDGER CONTROL ACCOUNT

Purchase returns X Balance b/d X
Bank X Credit purchases X
Discounts received X
Contra X
Balance c/d X

X X

63

Example 1
The following are the balances on Candys ledger accounts in the
month of January
Opening receivables balance 22,500

Sales day book 88,650

Cash sales 23,950

Sale returns day book 5,555

Refunds to customers 3,325



Increase in provision 500

Purchase ledger contra 1,200

Closing receivables ledger 18,650

Required
Calculate total cash received from customers in January
RECEIVABLES CONTROL ACCOUNT
BALANCE SHEET
Dr Cr

64

Example 2
The following are the balances on a companys ledger accounts in the
month of March:
Opening payables balance 12,785

Purchase day book 44,999

Returns outwards daybook 3,950

Returns inwards day book 2,300

Cheques paid to suppliers 37,500


Sales ledger contras 900

Required
Calculate the closing balance for the payables account at the end of March.
Solution
PAYABLES CONTROL ACCOUNT
BALANCE SHEET

Dr Cr

65

Reconciling the control accounts
Normally at the end of each month we check to ensure our control
accounts reconcile to the individual balances on our ledger accounts.
We do this by:
Checking our list of individual balances tie into the control account
balance. If there is an imbalance then it must be investigated. The main
discrepancies are due to:
Casting error in the day books
Posting error
A one sided contra
An entry that has been made in the individual account but not in
the control accounts
An entry being omitted from the control account

66

Example 3
At the financial year end 31 December 2007 Explorer Rain Wear had a
balance on the payables control account of 22,550. The balance on
their purchase ledgers was 20,650. The management accountant
found the following discrepancies:
1. An invoice of 1,200 had been omitted from the control account
2. The purchase day book was overstated by 1,000
3. Goods returned of 1,590 had not been recorded in the control
account
4. Discounts received of 10 had not been posted
5. Contra entries of 500 need to be recorded in the control account
After these adjustments are made the control account should balance.
Solution - Until a full knowledge of double entry is known, the easiest
way to tackle this question is to identify where the error has occurred and
amend accordingly. In this case:
Error No. Location of Error Amend
1 Control Account Control Account

BALANCE SHEET
Dr Cr

Balancer per list

67

Example 4
Hippo Manufacturing had the following balances on their payables /
receivables for the financial year ended 30 June 2006.
Credit sales 450,000
Cash sales 22,000
Credit purchases 300,000
Cash purchases 4,500
Returns inwards 17,000
Returns outwards 14,000
Payments made to payables 263,100
Cash received from receivables 438,580
Contras 17,500

Balance at 1 July 2005:
Payables 53,500
Receivables 51,500
Provision for doubtful debts 3,400

Bad debt provision is to be maintained @ 1.5% of credit sales

Required:
Compute the receivables and payables control account and extract the
closing balances for the financial year end.

68

Solution
This is a common CBA question. It is designed to ensure you know
exactly what should go into control accounts and also your knowledge
of double entry. Again until you are comfortable with debits and credits
it is easier to write exactly where things will go before attempting to
balance the accounts. In this case:
Receivables /
Payables
Debit / Credit

Credit sales
Cash sales
Credit purchases
Cash purchases
Returns inwards
Returns outwards
Discounts allowed
Discounts received
Irrecoverable debts
Payments made
Cash Received
Contra
BALANCE SHEET
Dr Cr

69

Suspense and Correction of errors
At the end of an accounting period we extract a trial balance, and use
this as a basis for preparing the financial statements.
The following are the main purposes of a trial balance:
Account balances are reviewed to check for obscurities
Reconcile all control account balances with the individual ledgers
Ensure debits equal the credits.
If there is an imbalance a SUSPENSE ACCOUNT will be created.
Therefore, a suspense account may have a debit or credit balance.
Errors that will cause a difference in the trial balance are:
Transposition error Entering figures the wrong way round
Single entries Only one side of the transaction has been posted
Both entries entered on the same side of the ledger account
Casting error An account has been incorrectly added

RECEIVABLES CONTROL ACCOUNT
BALANCE SHEET
Dr Cr

70

Although extracting a trial balance proves the above, there are certain
errors that a trial balance will not identify. These are:
Error of principle An entry has been entered in the wrong
financial statement.

Errors of omission A transaction has been missed out.

Errors of commission Entering an amount in the wrong account,
but in the correct financial statement.

Compensating errors Where two or more errors cancel each
other. This is extremely rare.

71

Example 5
Peter has the following balances on its trial balance at the end of the
financial year:
Debit 213,852
Credit 212,390
A suspense account has been created for the difference.
The following errors have been identified by the accountant; after these
errors have been corrected the balance on the suspense account should
be removed.
1. A payment for stationery for 440 was debited to stationery as
780.
2. Discounts allowed of 1,310 have been recorded as a credit.
3. Other income of 3,742 has only been recorded in the cash book.
Required
Correct the entries and clear the suspense account.
Solution
Account Name Description Debit Credit

72

Suspense Account

Accounting coding systems
A company will need to choose a coding system for their accounting
system as there can be a large number of accounts. By having a
coding system it will be quicker and easier to identify the account
involved. For example: is it a non current asset account or an
expense account?
It is generally accepted that codes should be:
Unique
Useful
Compact
Meaningful
Self checking
Expandable
Standard size

73

THE REGULATORY FRAMEWORK OF
ACCOUNTING

LEARNING OUTCOMES
A3- Identify the underlying assumptions, policies and changes in
accounting estimates
A8- Explain the influence of legislation and accounting standards
on the production of published accounting information for
organisations
C1- Identify the requirements for external audit and the basic
processes undertaken
C2 - Explain the purpose and basic procedures of internal audit
C3- Explain the meaning of fair presentation
C5 - Explain the purpose of audit checks and audit trails

The regulatory framework
Companies prepare financial accounts (statutory accounts) and these
are filed at Companies House. They are available for any interested
party to view.
Regulation on the preparation of statutory accounts is governed by two
main areas:
Companies act
International accounting standards
Businesses must comply with the Companies Act, but the international
accounting standards are not legally enforceable. If companies want to
be listed on the stock exchange and have a successful audit then they
must comply with the accounting standards.

74

Regulation ensures that companies comply in certain areas with-in their
financial statements. This results in good practice and makes statutory
accounts more comparable with other entities. This aids decision
making and can lead to the success of a business.
International accounting standards are extremely important and are
issued by the International Accounting Standards Board (I.A.S.B.).
There are four separate bodies and the structure is:
International Accounting Standards Committee Foundation
(I.A.S.C.F.)
This committee is responsible for appointing members in the I.A.S.B.,
S.A.C and I.F.R.I.C. It is also their responsibility to ensure the three
bodies have adequate funding.
International Accounting Standards Board (I.A.S.B.)
The I.A.S.B. is responsible for issuing accounting standards (I.A.Ss).
They are also called international financial reporting standards
(I.F.R.Ss)
Standards Advisory Council (S.A.C.)
Their responsibilities include advising the I.A.S.B. on its priorities and
providing the I.A.S.B. information about the implications of I.A.Ss.
International Financial Reporting Interpretations Committee
(I.F.R.I.C.)
This body is responsible for providing guidance on any problems that
emerge relating to issued I.A.Ss.
The members of these bodies are from varying countries and
backgrounds, some are preparers of financial statements and others are
users of financial statements.
Accountants are expected to follow I.A.S. In the U.K. the Financial
Services Authority (F.S.A.) and the Financial Reporting Review Panel
(F.R.R.P.) check companys accounts to ensure they are being followed.

75

The conceptual framework
The framework underpins all accounting standards and provides a
general format for future standards. This ensures all standards are
consistent and thus aids accounting information.
The framework includes the following:
The objective of financial statements
Financial statements should provide useful information to a wide range
of users.
The qualitative characteristics
The I.A.S.Bs Framework says that statements should have certain
qualitative characteristics. These include:
Reliability
Relevance
Understandable
Completeness
Comparable
Timeliness

Accounting conventions
1 The objective of financial statements
To provide information about the financial position, performance and
changes in financial position of an entity that is useful to a wide range of
users in making decisions.

2 Underlying assumptions
Accruals basis the effects of transactions and other events are
recognised when they occur and not when cash transfers. They are
reported in the financial statements in the period to which they relate.
Going concern the financial statements are prepared on the basis that
an entity will continue in operation for the foreseeable future.

76

3 Qualitative characteristics of financial statements
The four main characteristics are:
Understandability assuming users have a reasonable knowledge of
business and a willingness to study information with reasonable
diligence, the financial statements should be readily understandable to
users.
Relevance to be useful, information must be relevant to the decision
making needs of the user.
Reliable
Faithful representation
Reflect the substance
Neutral, free from bias
Prudent
Complete

Comparability users must be able to compare the financial
statements of an entity from period to period and from company to
company

4 The elements of financial statements
Asset is a resource controlled by the enterprise as a result of past
events and from which future economic benefits are expected to flow to
the enterprise.
Liabilities are an entitys obligations to transfer economic benefits as a
result of past transactions or events.
Equity is the residual amount found by deducting all liabilities of the
entity from all of the entitys assets.
Income is increases in economic benefits during the accounting period
in the form of inflows or enhancements of assets or decreases in
liabilities that result in increases in equity, other than those relating to
contributions from equity participants.
Expenses are decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or incurrences of
liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.

77

5 Recognition of the elements of financial statements
In order to recognise anything in the balance sheet and income
statement it must meet all three of the following criteria:
- Meet the definition of the element (as above)
- Probable future economic benefit will flow to or from the entity
- The item can be measured reliably

6 Measurement of the elements of financial statements
Historical cost - cash price or fair value at acquisition or obligation. Most
commonly used but widely criticised
Current cost what would be the cash price today
Realisable value - what could be realised/satisfied today
Present value discounted future cashflows
The Framework does not state which of the four should be used

7 Concepts of capital and capital maintenance.

The Framework refers to two concepts of capital: financial concept of
capital and physical concept of capital.

8 Going Concern
Financial statements shall be prepared on a going concern basis unless
management either intends to liquidate the entity or cease trading, or
has no realistic alternative but to do so.
When financial statements are not prepared on a going concern basis, it
should be disclosed, together with the basis on which the financial
statements are prepared and the reason why the entity is not regarded
as a going concern.

9 Accruals basis of accounting
An entity should prepare its financial statements, other than the cash
flow statement, using the accruals (matching) basis of accounting.
78

Transactions should be recognised in the period to which they relate
rather than when physical cash flows take place and expenses should
be matched in the income statement with the income they generate.

10 Consistency
Presentation and classification of items should be consistent from period
to period unless;
Standards change; or
The nature of the entitys operations changes it is more
appropriate to follow a different presentation or classification

11 Materiality and aggregation
Each material class of similar items should be presented separately in
the financial statements.
Immaterial items should be aggregated with similar items of the face of
the statement or in the notes.

12 Prudence
A business should not claim to have made profits or gains before they
have earned with reasonable certainty, but should anticipate fully any
losses that are expected to occur. This prevents overstating assets and
profits.

Regulations in accounting
There is little regulation regarding the preparation of financial statements
for sole traders and partnerships, other than to satisfy the tax authorities
of the profits made in each accounting period. However for limited
companies there are several types of regulation and guidance to assist
the accountant in preparing the financial statements
79

Company Law
Company law states that companies are required to have their financial
statements audited by a registered auditor. For the UK they are required
to submit them to companies house on a yearly basis.

International accounting standards
For CO2 you do not need to state any specific knowledge of specific
accounting treatment contained in IFRSs.
However you do need to know the influences of the IFRS on financial
statements.
Terminology this text uses the words, phrases and definitions in
IFRSs
Presentation The presentation of the financial statements and
particularly the balance sheet and cashflow statement follow the
IFRS formats
Technical the technical requirements of the IFRS have been
followed ;

Internal and External audit

External Audit Internal audit

Report to shareholders Report to management
Audit
80

Role of external auditor
The purpose of the external audit is to form an opinion on the financial
statements. The auditor will express whether the financial statements
give a fair presentation. E.g. a true and fair view.

True Information is not false, but factual and
conforming with reality
Fair Information is free from discrimination and
bias

Role of internal auditor
Review of accounting systems and controls
Examination of financial/operating information
VFM audit
Review of implementation of corporate policies
Special investigations

81

LIMITED COMPANY ACCOUNTS

LEARNING OUTCOMES
When you have completed this chapter, you should be able to:
Prepare an Income Statement
Prepare a Statement of Changes in Equity
Prepare a Balance Sheet

Introduction
Many businesses are constituted in the form of limited companies. The
owners of limited companies are referred to as shareholders and are
often different from the people that run the company.
The shareholders have very little, if any involvement in the day to day
running of the business and employ directors to run it on their behalf.
Limited company financial statements have very strict requirements
which must be followed by all companies. These are governed by:
Companies act 1985
The International Accounting Standards Board
The format to be adhered to per I.A.S. must be the format we adopt in
our studies. The proforma financial statements for limited companies
were given in session 2, however a copy is given below for reference:

82

Proforma set of financial statements for a limited company or Plc
Balance Sheet as at 31 December 2007
Non current assets
Note
Intangible assets 6 200,000
Tangible assets 7 187,999

Current assets

Inventory 8 88,432
Trade receivables 9 97,455
Cash 13,400 199,287

Total assets 587,286

Equity and liabilities

Share capital 100,000
Revaluation reserve 7 38,000 358,497

Non current liabilities

Interest bearing borrowings 10 100,000

Current liabilities

Trade payables 77,789
Taxation 5 51,000 128,789

Total liabilities 587,286

83

Income Statement for the year ended 31 December 2007
Note
Revenue 385,000

Cost of sales 1 188,000

GROSS PROFIT 197,000

Distribution costs 2 38,500

Administration expenses 3 37,700

PROFIT FROM OPERATIONS 120,800

Finance costs 8,000

PROFIT BEFORE TAX 112,800

Income tax 53,000

PROFIT FOR THE PERIOD 59,800

Statement of Changes in Equity for the year ended 31 December
2007
Share Retained Revalue
Capital Earnings Reserve Total

Balance as at 1

Jan 2007 100,000 188,697 40,000 328,697

Profit for the period 59,800 59,800

Surplus depreciation 2,000 (2,000)

Dividend paid (30,000) (30,000)

Closing balance 100,000 220,497 38,000 358,497

84

A limited company must file their statutory accounts with companys
house. A full set of statutory accounts will include:
1. Income Statement
2. Statement of Changes in Equity
3. Balance Sheet
4. Cash flow statement
These statements are supported by notes explaining the balances in the
financial statements.
One of the key differences between a company and a sole trader is that
a company is classed as a separate legal entity. This means that a
company is deemed to be a person in its own right. Therefore, a
company can sue individuals and can also be sued. The name limited
company comes from the fact that the shareholders have limited liability,
in other words their liability is restricted to the amount they have paid for
their shares.
Profits of a company are distribution by the way of dividend payments.
These payments are on the directors discretion.
Double entry for a share issue

Dr Bank
Cr Share Capital

85

Example 1
Freedom Limited has 100,000 ordinary shares in issue. The nominal
value (par value) is 1.00 and the directors decide to pay a dividend of
75p per share.
If this is the case the company would pay 75,000 (100,000 x 0.75) in
dividends
Preference shares
This type of share is known as a non-equity share, and gets a fixed
return on the value of the share. Preference share holders will receive
their dividend every year providing the company has distributable profit.
Ordinary share holders will receive a dividend if the directors decide to
pay one.
86

Example 2
The following information relates to Voyager Limited
Year ended 31
st
December 2007
Share capital (25p shares) 100,000
6% Preference shares 50,000

The directors propose an ordinary dividend of 75p per share.
Required:
Calculate the dividend payable.

Solution
Ordinary shares

Preference shares

Total dividends paid

87

Share premium
If a company issues shares after the initial corporation, it is unlikely they
will issue them at a nominal/par value. As the company has established
itself, the net worth of the company would increase. This would be
reflected in the share price.
Example 3
The following relates to Radiance Limited
Capital and reserves
Share capital (1.00) 200,000


Revaluation reserve 125,000

Say the market value price per share is 3.85 and the directors wish to
issue a further 50,000 shares for cash injection purposes.
The double entry would be:

The Capital and reserves would now be:
Share capital (1.00)

Share premium

Retained earnings

Revaluation reserve

88

Capital reserve
The share premium account is classed as a Capital reserve. This
means that the account cannot be used to pay out dividends. The use
of capital reserves is very limited. The key use of the reserve would be
to finance a bonus issue of shares. This is when the directors distribute
free shares to existing shareholders.
The accounting entry for this would be:
Cr Share capital
Dr Share premium

Dividends
As we have seen previously in this chapter, dividend payments are used
to distribute profit to shareholders. In order that a dividend can be paid,
the company must have reserves that are distributable i.e. they cannot
be paid out of any reserve that is not realised (Revaluation reserve).
Final dividends are paid after the year end; once the financial statements
have been completed, and the directors have decided the dividend
amount.
An interim dividend can also be paid mid way through the year.

89

Example 4
Share capital (50p) 200,000

10% Preference shares 25,00

An interim dividend of 8p per share was paid during the year and the
directors would like to propose a final dividend of 9p per share.
Required:
Calculate the total dividend payable for the year ended 31
st
May 2007.
Solution
Ordinary shares

Preference shares

Taxation
All companies have to pay tax on the taxable profits. The tax charge is
normally estimated at the end of the financial year and charged to the
statement of comprehensive income, and is paid in the following year.
The accounting entry for taxation would be:
Dr Taxation Income Statement
Cr Taxation liability Balance Sheet

90

CASH FLOW STATEMENTS

LEARNING OUTCOME
D13 Prepare cash flow statements
Introduction
The cash flow statement is a primary financial statement and provides
fundamental information to the user of accounts. It highlights the key
areas where a business has generated and spent physical cash.
Good cash management ensures a business has sufficient cash to run
its day to day operations.
Prior to this session we have focused on profit, but cash is equally vital
for the success of a business, especially in the short term. If a business
has limited cash funds available it will struggle to survive in the short
term.
Advantages
Cash flow balances are matter of fact and are not distorted by
accounting policies
Cash flow balances are objective, unlike profit which is subjective
Users of financial statements can establish exactly the cash
generation of a business
Users can identify exactly how this cash has been utilised
Users can assess the liquidity of a business and assess its ability
to repay debts as they fall due
Loans repaid and received are clearly listed in the cash flow
statement
Users can assess management attitude to capital expenditure
Interest payments are highlighted in the cash flow

91

IAS 7
IAS 7 lays down the requirements of a cash flow statement. It gives us a
detailed proforma and certain definitions:
Cash
Cash that is available on demand. An example would be cash in the
bank less any overdraft.
Cash equivalents
Short term, highly liquid investments (will be stated as a current assets)
I.A.S. 7 has three main headings. Students should familiarise the layout
of a cash flow as questions in the exam will test this area.
The three main headings are:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financial activities
Proforma

Net cash flow from operating activities

Net profit before tax X

Adjustments

Interest payable X
Depreciation X
(Profit) / loss on the disposal of a non current
asset
(X) X

Operating profit before working capital
adjustments
X

92

Working capital adjustments

(Increase) / Decrease in inventories (X) X
(Increase) / Decrease in receivables (X) X
Increase / (Decrease) in payables X (X)

Cash generated from operations X

Interest paid (X)
Taxation paid (X)

NET CASH FROM OPERATING ACTIVITIES X

NET CASH FROM OPERATING ACTIVITIES X

Cash flow from investing activities

Purchase of a non-current asset (X)
Disposal of a non-current assets X
Interest received X
Dividends received X

CASH FLOW FROM INVESTING ACTIVITIES X

Cash flow from financing activities

Proceeds from the issue of shares X
Receipt of loans X
Repayment of loans (X)
Dividends paid (X)

X
93

CASH FLOW FROM FINANCING ACTIVITIES

NET CASH FLOW X

Cash and cash equivalents at the beginning of
the period
X

Cash and cash equivalents at the end of the
period
X

94

Example 1
Moon Shine Limited
Balance Sheet as at
31 December
2006 2007
Non-current assets
Cost 180 220
Accumulated depreciation (78) (92)

Current assets
Inventory 12 17
Trade receivables 2 10
Bonds 10 10
Cash 3 16

Capital and reserves
Share capital 45 65
Share premium 10 12
Accumulated profit 24 68

Non-current liabilities
Loan 30 20

Current liabilities
Payables 19 13
Tax 1 3

Notes
The tax charge in the statement of comprehensive position is 6,000.
Loan was repaid at the end of the financial year.
Required
Prepare the cash flow statement for the year ended 31
st
December 2007.

95

Direct Method
The direct method involves added together the cash inflows and
deducting the cash outflows.
Example 2
The following information relates to Empress Limited:
Cash sales 55,000
Cash received from customers 44,000
Cash purchases 33,000
Cash paid to suppliers 12,000
Cash expenses 11,000
Cash wages and salaries 20,000

Calculate the cash generation for Empress Limited

96

INCOMPLETE RECORDS

LEARNING OUTCOME
D11 Prepare accounts from incomplete data

Introduction
As the name suggests, incomplete records are any form of accounting
records other than the full double entry system.
In reality, accountants come across incomplete records almost daily.
This is because their clients are not likely to fully understand the double
entry system. We still however, need to prepare a set of financial
statements for the client.
During the exam, students will often come across incomplete records.
The main reason is often due to a flood or fire at the business premises.
Calculating profit
If a business has very little information about its transactions, it may only
be possible to calculate its net profit for the year. This can be done by
using the accounting equation. The accounting equation can be written
as:
Net Assets =Capital +Profit - Drawings
Or
Change in net assets =Capital introduced +Profit Drawings
You make realise that this is very similar to the Balance Sheet.
97

Example 1
A sole traders statement of financial position at 31
st
December 2006
shows that the business has net assets of 5,000. The Balance Sheet
at 31
st
December 2007 shows that the business has net assets of
8,000. The owners drawings for the year amounted to 2,500 and he
didnt introduce any further capital in the year
Required
Calculate the profit for the year ended 31
st
December 2007.
Solution:
Change
in net
assets
Capital
introduced
Profit
for the
year
Drawing
in
period

This can be written as:

Profit =

As you can see it is impossible to know the make-up of the net profit
figure due to lack of information.
Preparing financial statements from incomplete records
In the majority of cases a business will keep limited amount of records.
In these types of questions you will be given information regarding the
opening and closing balances of assets and liabilities of the business.
You will also be given information about certain transactions during the
period; this is usually a summary of the cash book.
There are two main techniques used in complete records:
1. Balancing figures in ledger accounts
2. Ratios for mark-up or margin

98

Balancing figures
The balancing figure approach is commonly used the following way:
Ledger Account Missing Figure

Accounts receivable Sales
Money received from accounts
receivable
Accounts payable Purchases
Money paid to accounts payable
Cash at bank Drawings
Money stolen
Cash in hand Cash sales
Cash stolen

Example 2
Suppose that the opening balance on the accounts receivables ledger
was 50,000, there had been receipts from account receivables in the
year of 45,000, irrecoverable debts have been written off worth 5,000
and the closing balance was 55,000.
Required:
What were the credit sales for the year?
Account Receivables

99

Example 3
Suppose that the opening accounts receivables balance was 30,000,
there have been total receipts from customers of 55,000 of which
15,000 relates to cash sales and 40,000 relates to receipts from
accounts receivables. Discounts allowed in the year totalled 3,000 and
the closing balance was 37,000.
Required:
What are the total sales for the year?
Due to the information given in the question we can approach this in 2
different ways. We can calculate credit sales as above and then add on
cash sales, or we can use the ledger account to calculate total sales.
Both methods are shown below:
Solution 1 - Total sales
Account Receivables

Solution 2 - Separate sales
Account Receivables

100

Example 4
The opening balance on the accounts payable ledger was 30,000.
Payments made to account payables during the year were 33.000,
discounts received are 4,000 and the closing balance was 26,000.
Required:
What was the total purchases figure for the year?
Solution:
Account Payables

Example 5
On 1
st
January the bank is overdrawn by 1,367, payments in the year
totalled 8,536 and on 31
st
December the closing balance was a
positive balance of 2,227.
Required:
What is the total receipts figure for the year?
Solution:
Cash Book

101

Example 6
Scott has a cash float at the beginning of the year of 900. During the
year cash of 10,000 was banked, 1,000 was paid out for drawings
and wages of 2,000 was paid. Scott decided to increase the float to
1,000 at the end of the year.
Required:
How much cash was received from customers during the year?
Solution:
Cash Account

102

Ratios Mark-up and Margin
The gross profit of a company can be expressed as a percentage. This
percentage can be calculated based on the sales figure or the cost of
sales figure.
Gross Profit Mark-up Based on Cost of Sales
Gross Profit Margin Based on Sales
If we look at the following trading account:
Sales 5,000

Cost of sales 4,000

Gross profit 1,000

Example 7
Margin 25% Sales 1,000
Required:
What is the gross profit and cost of sales?
Sales

Cost of sales

Gross profit

103

Example 8
Mark-up 25% Cost of sales 600
Required:
What is gross profit and sales?
Sales

Cost of sales

Gross profit

Example 9
Mark-up 10%
Sales 6,600
Opening inventory 300
Closing inventory 500
Required:
Complete a trading account from the above information.
Sales

Cost of sales

Opening inventory
Purchases (Balancing Figure)
Closing inventory

Gross profit

104

Cost of lost inventory
In incomplete record questions, it is likely that inventory has been lost
due to the infamous fire or flood.
Closing inventory that has not been lost is subtracted in cost of sales
because by definition, the inventory has not been sold in the year.
Lost inventory has also not been sold in the year and therefore also
needs subtracting with-in cost of sales.
Therefore, to work out the cost of lost inventory, complete the trading
account from the information given and then lost inventory can be
calculated as a balancing figure.

Example 10
Margin 20%
Sales 100,000
Opening inventory 10,000
Closing inventory (after fire) 3,000
Purchases 82,000
Required:
Complete a trading account from the above information.
Sales

Cost of sales

Opening inventory
Purchases
Closing inventory
Inventory lost in fire (balancing figure)

Gross profit

105

INTERPRETATION OF FINANCIAL
STATEMENTS

Introduction
Financial statements provide a great deal of information. However one
difficulty with these statements is that they show only absolute figures for
a particular period and at the end of that period. To enable users to
make informed decisions, the statements on their own do not always
provide sufficient information.

We are going to look at ratio analysis as a way to interpret a companys
performance and current position.

Using ratios
Here is a list of ratio formulae that need to be learned.

Profitability

1) Gross Margin

100
Sales
Profit Gross

106

2) Operating Margin

100
Sales
Profit Operating

3) Net Margin

100
Sales
Profit Net

4) Asset Turnover

Employed Capital *
Sales

5) Return on Capital Employed

Employed Capital *
Tax and Interest Before Profit

* Capital Employed = Shareholders Funds + long term debt.

107

Liquidity

1) Current Ratio

s liabilitie current
assets current

2) Quick Ratio

s liabilitie current
inventory assets current

3) Inventory holding period

365
sales of cost
Stock

4) Average collection period

365
credit on sales 1 *
Debtors

5) Average payment period

365
credit on purchases 2 *
Creditors

*1 total sales may be used instead.
*2 total purchases or cost of sales may be used instead.

108

Gearing/Risk

1) Gearing Ratio

100
employed capital
Debt

OR

2) 100
funds) ers (sharehold Equity
Debt

If questions do not specify, either one of these may be used.

3) Interest Cover

payable interest
interest before Profit

4) Dividend Cover

Dividends
tax after Profit

109

Example 1
Summarised Financial Statements of Megan for the year to 31
December 2006
Profit and loss accounts
2006 2005
m m
Turnover 250 150
Cost of sales (190) (100)
Gross profit 60 50
Operating Expenses (30) (25)
Operating Profit 30 25
Interest payable (15) (5)
Profit before tax 15 20
Tax (6) (5)
Profit after tax 9 15

Megan declared and paid a dividend of 5m in 2005 and 2m in 2006.

Balance Sheets
2006 2005
m m
Fixed Assets
Tangibles 240 180
Goodwill 10 10

Current Assets
Inventory 180 100

110

Receivables

140

80
Cash/Bank 10
_____
50
_____

330 230
Current Liabilities (143) (39)
____ _____
187 191
Non-Current
Liabilities
(100) (50)

337 331

Share Capital 200 200
Reserves 110 106
Minority Interest 27 25

337 331

1) Depreciation for 2006 was 25m (2005 15m)

2) Credit sales were 100% of total sales for both years

Required:
Calculate the following for 2005 and 2006:
Profitability ratios
Liquidity Ratios
Gearing Ratios

111

MANUFACTURING ACCOUNTS

Introduction
So far we have been concentrating our studies on businesses that
purchases goods for onward sale to customers retail and wholesale
businesses. We now need to look at manufacturing businesses.
The need for manufacturing accounts
Manufacturers may sell their finished products directly to the public, or
may sell it to a wholesaler/retailer or to another trade organisation. The
income statement is used to bring together the revenue and expenditure
of trading and operating the business, and this still applies to a
manufacturing business. However the calculation of the cost of goods
sold by retail and wholesale businesses are pretty straight forward;
calculating the costs of manufacturing products is often more complex.
This is due to the fact that the firm not only incur the cost of materials but
also labour costs and other expenses incurred in manufacturing. The
manufacturing account is used to bring together the costs of
manufacturing during the period.

112

Proforma of manufacturing and trading accounts

$ $ $ $
Sales

750,000
Less Costs of sales
Opening inventory of
closing goods

110,000

Opening inventory raw
materials

15,000
Purchases of raw
materials

250,000

265,000
Closing inventories of
raw materials

(14,000)
Raw materials consumed

251,000
Direct manufacturing
wages

167,000
Direct Factory expenses

17,000
Prime costs

435,000
Productions overheads
Factory supervisors
wages

35,000
Heating and light

15,000
Factory light

10,000

60,000
Factory costs incurred

495,000
Opening work in
progress

31,000
closing work in progress

25,000

6,000
Factory costs of goods
completed

501,000

611,000
Less closing stock

(35,000)
Cost of goods sold

(576,000)

Gross Profit

174,000

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C02 Fundamentals of Financial Accounting

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