ACCA Paper F3 (INT)

Financial accounting The Essential Text

British library cataloguing­in­publication data
A catalogue record for this book is available from the British Library.

Published by: Kaplan Publishing UK Unit 2 The Business Centre Molly Millars Lane Wokingham Berkshire RG41 2QZ

ISBN 978 1 84710 537 0

© Kaplan Financial Limited, 2008

Printed and bound in Great Britain

Acknowledgements We are grateful to the Association of Chartered Certified Accountants and the Chartered Institute of Management Accountants for permission to reproduce past examination questions. The answers have been prepared by Kaplan Publishing.

All rights reserved. No part of this publication may be reproduced,stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Kaplan Publishing.

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Contents
Page Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Introduction to accounting Statement of financial position and income statement Double entry bookkeeping Inventory Sales tax Accruals and prepayments Irrecoverable debts and allowances for receivables Non­current assets From trial balance to financial statements Books of prime entry and control accounts Control account reconciliations Bank reconciliations Correction of errors and suspense accounts Applications of information technology Incomplete records Partnerships Company accounts Accounting standards Statement of cash flows The regulatory and conceptual framework 1 9 29 55 75 85 97 113 143 155 175 185 197 211 219 239 259 285 303 329

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chapter Introduction

Paper Introduction

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Introduction

How to Use the Materials

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The learning objectives contained in each chapter, which have been carefully mapped to the examining body's own syllabus learning objectives or outcomes. You should use these to check you have a clear understanding of all the topics on which you might be assessed in the examination. The chapter diagram provides a visual reference for the content in the chapter, giving an overview of the topics and how they link together. The content for each topic area commences with a brief explanation or definition to put the topic into context before covering the topic in detail. You should follow your studying of the content with a review of the illustration/s. These are worked examples which will help you to understand better how to apply the content for the topic.
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Test your understanding sections provide an opportunity to assess your understanding of the key topics by applying what you have learned to short questions. Answers can be found at the back of each chapter. Summary diagrams complete each chapter to show the important links between topics and the overall content of the paper. These diagrams should be used to check that you have covered and understood the core topics before moving on. Question practice is provided at the back of each text.

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Icon Explanations Definition ­ Key definitions that you will need to learn from the core content. Key Point ­ Identifies topics that are key to success and are often examined. Expandable Text ­ Expandable text provides you with additional information about a topic area and may help you gain a better understanding of the core content. Essential text users can access this additional content on­line (read it where you need further guidance or skip over when you are happy with the topic) Illustration ­ Worked examples help you understand the core content better. Test Your Understanding ­ Exercises for you to complete to ensure that you have understood the topics just learned. Tricky topic ­ When reviewing these areas care should be taken and all illustrations and test your understanding exercises should be completed to ensure that the topic is understood.

For more details about the syllabus and the format of your exam please see your Complete Text or go online. On­line subscribers Paper introduction Syllabus objectives Paper­based examinations tips

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Introduction

Study skills and revision guidance
Preparing to study Effective studying Further reading You can find further reading and technical articles under the student section of ACCA's website.

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chapter

1

Introduction to accounting
Chapter learning objectives
Upon completion of this chapter you will be able to: define accounting

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explain the different types of business entity: – sole trader – – partnership limited liability company

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explain who users of the financial statements are and their information needs explain the nature, principles and scope of accounting explain how the accounting system contributes to providing useful information and complies with organisational policies and deadlines.

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Introduction to accounting

1 Definition of accounting

2 Types of business entity
A business can be organised in one of several ways:

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Sole trader – a business owned and operated by one person. Partnership – a business owned and operated by two or more people. Company – a business owned by many people and operated by many (though not necessarily the same) people.

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3 Users of the financial statements

Test your understanding 1 Why do you think the following user groups are interested in a company’s financial statements?

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Management Investors and potential investors Employees and trade union representatives Lenders Government agencies Suppliers Customers Competitors The public.

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Introduction to accounting

4 Types of accounting

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5 How an accounting system contributes to providing useful information
The main features of an accounting system and how it helps in providing information to the business are as follows:

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In a computerised system all information about the business transactions can be quickly accessed. This will help in decision making. It provides details of transactions of the business in the relevant accounts. When the accounts are closed off the balances for each outstanding account are determined. This will give the value of assets and liabilities in the business. It gives a summary of outstanding balances. This summary can then be used for the preparation of financial statements.

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Normally the financial statements are prepared at regular intervals. The accounting system will allow the business to obtain the data and also prepare the financial statements to determine the profitability, liquidity, risks, etc. applicable to the business for a particular period. For internal reporting purposes this could be monthly, whilst for external reporting purposes this is usually yearly.

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Introduction to accounting

Chapter summary

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Test your understanding answers Test your understanding 1

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Management need detailed information in order to control their business and plan for the future. Budgets will be based upon past performance and future plans. These budgets will then be compared with actual results. Information will also be needed about the profitability of individual departments and products. Management information must be very up to date and is normally produced on a monthly basis. Investors and potential investors are interested in their potential profits and the security of their investment. Future profits may be estimated from the target company’s past performance as shown in the income statement. The security of their investment will be revealed by the financial strength and solvency of the company as shown in the statement of financial position. The largest and most sophisticated groups of investors are the institutional investors, such as pension funds and unit trusts. Employees and trade union representatives need to know if an employer can offer secure employment and possible pay rises. They will also have a keen interest in the salaries and benefits enjoyed by senior management. Information about divisional profitability will also be useful if a part of the business is threatened with closure. Lenders need to know if they will be repaid. This will depend on the solvency of the company, which should be revealed by the statement of financial position. Long­term loans may also be backed by ‘security’ given by the business over specific assets. The value of these assets will be indicated in the statement of financial position. Government agencies need to know how the economy is performing in order to plan financial and industrial policies. The tax authorities also use financial statements as a basis for assessing the amount of tax payable by a business. Suppliers need to know if they will be paid. New suppliers may also require reassurance about the financial health of a business before agreeing to supply goods. Customers need to know that a company can continue to supply them into the future. This is especially true if the customer is dependent on a company for specialised supplies. Competitors wish to compare their own performance against that of other companies and learn as much as possible about their rivals in order to help develop strategic plans.

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Introduction to accounting

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The public may wish to assess the effect of the company on the economy, local environment and local community. Companies may contribute to their local economy and community through providing employment and patronising local suppliers. Some companies also run corporate responsibility programmes through which they support the environment, economy and community by, for example supporting recycling schemes.

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chapter

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Statement of financial position and income statement
Chapter learning objectives
Upon completion of this chapter you will be able to:

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explain the main elements of financial statements: – statement of financial position – income statement

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explain the purpose of each of the main statements list the main types of business transactions explain how the accounting equation and business entity convention underpin the statement of financial position define assets and liabilities identify examples of receivables and payables explain how and why assets and liabilities are disclosed in the statement of financial position. draft a simple statement of financial position in vertical format explain the matching convention and how it applies to revenue and expenses explain how and why revenue and expenses are disclosed in the income statement illustrate how the statement of financial position and income statement are interrelated draft a simple income statement in vertical format

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Statement of financial position and income statement

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identify the two sides of each transaction (duality concept) determine the accounting equation after each transaction.

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1 Financial statements
There are two elements to the financial statements:

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Statement of financial position, showing the financial position of a business at a point in time, and Income statement, showing the financial performance of a business over a period of time.

The financial statements show the effects of business transactions. The main types are:

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sales of goods (either for cash or on credit) purchase of inventory for resale (either for cash or on credit) purchase of non­current assets payment of expenses such as utilities introduction of new capital to the business withdrawal of funds from the business by the owner.

The business entity concept

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The business entity concept states that financial accounting information relates only to the activities of the business entity and not to the activities of its owner. The business entity is treated as separate from its owners.

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Statement of financial position and income statement

2 Statement of financial position
The vertical format of the statement of financial position is shown below: W Xang Statement of financial position as at 31 December 20X6 $ Non­current assets: Motor van Current assets: Inventory Receivables Cash at bank Cash in hand $ 2,400 2,390 1,840 1,704 56 ______ 5,990 ______ 8,390 ______ 4,200 3,450 1,000 ______ 8,650 (2,960) ______ 5,690 1,000 1,700 ——— 8,930 ———

Capital account: Balance at 1 January 20X6 Add: Net profit for year Increase in capital

Less: Drawings for year

Non­current liabilities: Current liabilities: Payables

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The top half of the statement of financial position shows the assets of the business. The bottom half of the statement of financial position shows the capital and liabilities of the business.

The accounting equation The statement of financial position above shows the position of W Xang’s business at one point in time – in this case at close of business on 31 December 20X6. A statement of financial position will always satisfy the accounting equation as follows:

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chapter 2 Assets and liabilities An asset is something the business owns or controls such as:

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inventory, e.g. goods manufactured or purchased for resale receivables, e.g. money owed by credit customers, prepaid expenses cash non­current assets and is available for use in the business.

A liability is something owed by the business to someone else, such as:

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payables, e.g. amounts owed to credit suppliers, accrued expenses loans.

Capital is a type of liability. This is the amount that is due to the owner(s) of the business. It will increase each year by any new capital injected into the business and by the profit made by the business. It will decrease by any amounts withdrawn from the business by the owner(s). Disclosure of assets and liabilities in the statement of financial position

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Statement of financial position and income statement

Test your understanding 1 Classify the following items into current and non­current assets and liabilities:

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land and buildings receivables cash loan repayable in two years’ time payables delivery van.

Test your understanding 2 List the following items showing the least liquid items first:

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cash in hand inventory of finished goods cash at bank
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receivables inventory of raw materials.

3 Income statement
The format of the income statement is shown below: Mr W Xang Income statement for the year ended 31 December 20X6 Sales revenue Cost of sales Opening inventory Purchases

$

$

33,700 3,200 24,490 ––––– 27,690 (2,390) ––––– (25,300) –––––– 8,400 3,385 1,200 365 ––––– (4,950) –––––– 3,450 ––––––

Less: Closing inventory Gross profit Wages Rent Sundry expenses

Net profit

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The income statement shows the performance of the business over a period of time, in this case for a full year. The income statement is prepared following the accruals concept. This means that income and expenses are recorded in the income statement as they are earned/incurred regardless of whether cash has been received/paid. The sales revenue shows the income from goods sold in the year, regardless of whether those goods have been paid for. The cost of buying the goods sold must be deducted from the revenue. It is important that the cost of any goods remaining unsold is not included here.

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Statement of financial position and income statement

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The current year’s sales will include goods bought in the previous year, so this opening inventory must be added to the current year’s purchases. Some of this year’s purchases will be unsold at 31 December 20X6 and this closing inventory must be deducted from purchases to be set off against next year’s sales. The income statement is split into two parts, the first part gives gross profit and the second part, net profit. Gross profit divided by sales revenue gives the gross profit margin ratio which illustrates the profitability of the business at a trading level.

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4 Relationship between the statement of financial position and income statement
The link between the statement of financial position and income statement is shown below:

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The statement of financial position are not isolated statements; they are linked over time with the income statement. As the business records a profit in the income statement, that profit is added to the capital section of the statement of financial position, along with any capital introduced. Cash taken out of the business by the proprietor, called drawings, is deducted.

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5 The accounting equation

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The accounting equation is a simple expression of the fact that at any point in time the assets of the business will be equal to its liabilities plus the capital of the business. It follows that assets less liabilities equal the capital of the business. Assets less liabilities are known as net assets. Each and every transaction that the business makes or enters into has two aspects to it and has a double effect on the business and the accounting equation. This is known as the duality concept.

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Illustration 1– The accounting equation This illustration involves a series of transactions using the dual effect of transactions and then the accounting equation to build up a set of financial statements. The transactions are as follows: Day 1 Avon commences business introducing $1,000 cash. Day 2 Buys a motor car for $400 cash. Day 3 Buys inventory for $200 cash. Day 4 Sells all the goods bought on Day 3 for $300 cash. Day 5 Buys inventory for $400 on credit. Using the accounting equation, we will draw up a statement of financial position at the end of each day’s transactions.

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Test your understanding 3 Continuing from the illustration above, prepare the statement of financial position at the end of each day after accounting for the transactions below: Day 6 Sells half of the goods bought on Day 5 on credit for $250.

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Statement of financial position and income statement
Day 7 Pays $200 to his supplier. Day 8 Receives $100 from a customer. Day 9 Proprietor draws $75 in cash. Day 10 Pays rent of $40 in cash. Day 11 Receives a loan of $600 repayable in two years. Day 12 Pays cash of $30 for insurance. Your starting point is the statement of financial position at the end of Day 5, from the illustration above. Once you have dealt with each of the transactions, prepare a statement of financial position at the end of Day 12 and an income statement for the first 12 days of trading.

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Chapter summary

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Statement of financial position and income statement

Test your understanding answers Test your understanding 1

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Land and buildings – non­current asset. Receivables – current asset. Cash – current asset. Loan repayable in two years time – non­current liability. Payables – current liability. Delivery van – non­current asset.

Test your understanding 2 The correct order is:

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inventory of raw materials inventory of finished goods receivables cash at bank cash in hand.

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chapter 2 Test your understanding 3 Day 6: Sells half of the goods bought on Day 5 on credit for $250 This transaction introduces two new concepts:

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Sale on credit. Essentially this is the same as a sale for cash, except that the asset increased is not cash, but receivables. Sale of part of the inventory. In practice this is the normal situation. The important accounting requirement is to separate: – inventory still held as an asset, from – cost of inventory sold. Statement of financial position for Day 6 $ Capital and liabilities 400 Capital introduced 200 Add: Profit to date 250 ($100 + $50) 700 ______ 1,550 ______ Payables ______ 1,150 400 ______ 1,550 ______ 150 $

Assets Motor car Inventory Receivables Cash

1,000

Day 7: Pays $200 to his supplier

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The dual effect of this transaction is:

(a) The business has paid out $200 in cash. (b) The business has reduced the payable (liability) by $200. This is simply the reduction of one liability (payables) and one asset (cash) by a corresponding amount ($200).

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Statement of financial position and income statement
Statement of financial position for Day 7 $ Assets Motor car Inventory Receivables Cash ($700 – $200) Capital and liabilities 400 Capital 200 Add: Profit to date 250 500 Payables ($400 – $200) ______ 1,350 ______ Day 8: Receives $100 from a customer 200 ______ 1,350 ______ ______ 1,150 $

1,000 150

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The dual effect of this transaction is:

(a) The business has received $100 in cash. (b) The receivables of the business have reduced by $100. Statement of financial position for Day 8 Assets Motor car Inventory Receivables ($250 – $100) Cash ($500 + $100) $ Capital and liabilities 400 Capital 200 Add: Profit to date 150 600 Payables ______ 1,350 ______ 1,000 150 ______ 1,150 200 ______ 1,350 ______ $

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Day 9: Proprietor draws $75 in cash This shows on the statement of financial position as a reduction of capital, and as a reduction of cash. Cash or other assets taken out of the business by the owner are called ‘amounts withdrawn’, or ‘drawings’.

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The dual effect of this transaction is:

(a) The business has reduced cash by $75. (b) The business has a drawings balance of $75 which reduces capital. Statement of financial position for Day 9 Assets Motor car Inventory Receivables Cash ($600 – $75) $ Capital and liabilities 400 Capital 200 Add: Profit to date 150 525 Less: Drawings Payables ______ 1,275 ______ $ 1,000 150 ______ 1,150 (75) ______ 1,075 200 ______ 1,275 ______

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Statement of financial position and income statement

Day 10: Pays rent of $40 This is an example of a business expense. The dual effect of this transaction is: (a) The business pays out $40 in cash. (b) The business has a rent expense of $40 which reduces profit. Statement of financial position for Day 10 Assets Motor car Inventory Receivables Cash ($525 – $40) $ Capital and liabilities 400 Capital 200 Add: Profit to date 150 ($150 – $40) 485 Less: Drawings Payables ______ 1,235 ______ ______ 1,110 (75) ______ 1,035 200 ______ 1,235 ______ 110 $ 1,000

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Day 11: Receives a loan of $600 repayable in two years’ time The dual effect of this transaction is: (a) The business receives $600 in cash. (b) The business has a liability of $600. Statement of financial position for Day 11 Assets Motor car Inventory Receivables Cash ($485 + $600) $ Capital and liabilities 400 Capital introduced 200 Add: Profit to date 150 1,085 Less: Drawings Loan Payables ______ 1,835 ______ Day 12: Pays cash of $30 for insurance The dual effect of this transaction is: (a) the business pays out $30 in cash (b) the business has an insurance expense of $30 which reduces profit. ______ 1,110 (75) ______ 1,035 600 200 ______ 1,835 ______ $ 1,000 110

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Statement of financial position and income statement
Statement of financial position for Day 12 Assets Motor car Inventory Receivables Cash ($1,085 – $30) $ Capital and liabilities 400 Capital introduced 200 Add: Profit to date 150 ($110 – $30) 1,055 ______ 1,805 Less: Drawings Loan Payables ______ 1,805 ______ (75) ______ 1,005 600 200 ______ 1,805 ______ ______ 80 $ 1,000

This marks the end of the transactions. The financial statements for the 12 day period can now be considered. Avon, income statement for the 12 days $ Sales revenue: Cash Credit $ 300 250 —— 550

Cost of sales:

Purchases:

Cash Credit

Less: Closing inventory Cost of goods sold Gross profit Rent Insurance

200 400 —— 600 (200) —— (400) —— 150 40 30 —— (70) —— 80 ——
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Net profit

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Avon, statement of financial position as at end of Day 12 $ $ Non­current asset: Motor car (at cost) 400 Current assets: Inventory 200 250 —— Receivables 150 Cash 1,055 550 ——— 1,405 ——— 1,805 ——— 1,000 Capital account: Capital introduced Cost of goods sold Net profit 80 ——— 1,080 Less: Drawings (75) ——— 1,005 Non­current liability: Loan 600 Current liabilities: Payables 200 ——— 1,805 ———

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Statement of financial position and income statement

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chapter

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Double entry bookkeeping
Chapter learning objectives
Upon completion of this chapter you will be able to:

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explain the concept of double entry and the duality concept explain the debit and credit principle explain the meaning of the balance on each type of account record cash transactions in ledger accounts record credit sale and purchase transactions in ledger accounts illustrate how to account for discounts explain sales and purchase returns and demonstrate their recording illustrate how to balance a ledger account extract the ledger balances into a trial balance identify the purpose of a trial balance prepare a simple income statement and statement of financial position from a trial balance explain and illustrate the process of closing the ledger accounts in the accounting records when the financial statements have been completed.

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1 The duality concept and double entry bookkeeping

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Each transaction that a business enters into affects the financial statements in two ways, e.g. A business buys a non­current asset for cash. The two effects on the financial statements are:

(1) There is an increase in non­current assets. (2) There is a decrease in cash.

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To follow the rules of double entry bookkeeping, each time a transaction is recorded, both effects must be taken into account. These two effects are equal and opposite such that the accounting equation will always prove correct:

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Traditionally, one effect is referred to as the debit side (abbreviated to Dr) and the other as the credit side of the entry (abbreviated to Cr).

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2 Ledger accounts, debits and credits

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Transactions are recorded in the relevant ledger accounts. There is a ledger account for each asset, liability, revenue and expense item. Each account has two sides – the debit and credit sides: Debit Credit (Dr) (Cr) Name of account e.g. cash, sales Date Narrative $ DateNarrative$

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The duality concept means that each transaction will affect two ledger accounts. One account will be debited and the other credited. Whether an entry is to the debit or credit side of an account depends on the type of account and the transaction: Credit Increase in: Liability (Statement of financial position) Capital (Statement of financial position)

Debit Increase in: Expense (Income statement) Asset (Statement of financial position) Income (Income statement) Drawings (Statement of financial position)

Summary of steps to record a transaction (1) Identify the two items that are affected. (2) Consider whether they are being increased or decreased. (3) Decide whether each account should be debited or credited. (4) Check that a debit entry and a credit entry have been made and they are both for the same amount. Recording cash transactions Cash transactions are those where payment is made or received immediately. Cheque payments or receipts are classed as cash transactions

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Double entry bookkeeping
Double entry involves the bank ledger:

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a debit entry is where funds are received a credit entry is where funds are paid out.

Test your understanding 1 Recording cash transactions Show the following transactions in ledger accounts: (Tip: the ledger accounts you need are Bank, Rent, Drawings, and Sales) (1) Kamran pays $80 for rent by cheque. (2) Kamran sells goods for $230 cash which he banks. (3) He then takes $70 out of the business for his personal living expenses. (4) Kamran sells more goods for cash, receiving $3,400.

Test your understanding 2 Yusuf enters into the following transactions in his first month of trading: (1) Buys goods for cash for $380. (2) Pays $20 in sundry expenses. (3) Makes $1,000 in sales. (4) Receives a bank loan of $5,000. (5) Pays $2,600 for fixtures and fittings. What is the total entry to the credit side of the cash T account? A B C D $6,000 $6,380 $3,000 $2,620

Recording credit sales and purchases Credit sales and purchases are transactions where goods or services change hands immediately, but payment is not made or received until some time in the future.

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Money that a business is owed is accounted for in the receivables ledger. Money that a business owes is accounted for in the payables ledger. Test your understanding 3 Norris notes down the following transactions that happened in June. (1) Sell goods for cash for $60. (2) Pay insurance premium by cheque – $400. (3) Sell goods for $250 – the customer will pay in a month. (4) Pay $50 petrol for the delivery van. (5) Buy $170 goods for resale on credit. (6) Take $57 out of the business for living expenses. (7) Buy another $40 goods for resale, paying cash. (8) Buy a new computer for the business for $800. Record these transactions using ledger accounts Test your understanding 4 For each of the following individual transactions state the two ledger accounts affected, and whether the ledger account should be debited or credited: (1) Ole purchases goods for $5,000, and pays by cheque. (2) Ole makes a sale to a customer for $500. The customer pays in 30 days’ time. (3) Ole pays a telephone bill amounting to $40, and pays by cheque. (4) Ole receives bank interest income of $150. (5) Ole purchases stationery for $12 and pays cash. (6) Ole makes a sale to a customer for $400. The customer pays cash.

3 Recording sales and purchases returns

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It is normal for customers to return unwanted goods to a business; equally the business will occasionally have cause to return unwanted goods to their supplier.

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Double entry bookkeeping

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The double entries arising will depend upon whether the returned goods were initially purchased on credit: Originally a Originally a credit transaction cash transaction Sales returns Dr Sales returns Dr Sales returns (returns inwards) Cr Cash Cr Receivables Purchases returns Dr Cash Dr Payables (returns outwards) Cr Purchases Cr Purchases returns returns

Test your understanding 5 For each of the following, state the double entry required to record the transaction in the accounts: (1) Alfie invests $10,000 of his life savings into his business bank account. (2) He then buys goods from Isabel, a supplier for $1,000 and pays by cheque. (3) A sale is made for $400 – the customer pays by cheque. (4) Alfie makes a sale for $600 and the customer promises to pay in the future. (5) Alfie then buys goods from his supplier, Kamen, for $500 on credit. (6) Alife pays a telephone bill of $150 by cheque. (7) The credit customer pays the balance on her account. (8) Alfie pays Kamen $340. (9) Bank interest of $30 is received. (10) A cash customer returned $20 goods to Alfie for a refund. (11) Alfie sent goods of $100 back to Kamen.

4 Accounting for discounts
Discounts may be given in the case of credit transactions for prompt payment:

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A business may give its customer a discount – known as Discountallowed. A business may receive a discount from a supplier – known as Discount received.

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The correct double entries are: Discount allowed Dr Discount allowed (expense) X Cr Receivables X The expense is shown beneath gross profit in the income statement, alongside other expenses of the business. Discount received Dr Payables X Cr Discount received (income) X The income is shown beneath gross profit in the income statement. Test your understanding 6 George owes a supplier, Herbie, $2,000 and is owed $3,400 by a customer, Iris. George offers a cash discount to his customers of 2.5% if they pay within 14 days and Herbie has offered George a cash discount of 3% for payment within ten days. George pays Herbie within ten days and Iris takes advantage of the cash discount offered to her. What ledger entries are required to record these discounts? A Dr Cr B Dr Cr C Dr Cr D Dr Cr Payables Discount received Discount allowed Receivables Payables Discount received Discount allowed Receivables 60 60 60 60 50 50 50 50 Dr Cr Dr Cr Dr Cr Dr Cr Discount allowed Receivables Payables Discount received Discount allowed Receivables Payables Discount received 85 85 85 85 102 102 102 102

5 Balancing off a statement of financial position ledger account
Once the transactions for a period have been recorded, it will be necessary to find the balance on the ledger account: (1) Total both sides of the T account and find the larger total. (2) Put the larger total in the total box on the debit and credit side.

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Double entry bookkeeping
(3) Insert a balancing figure to the side of the T account which does not currently add up to the amount in the total box. Call this balancing figure ‘balance c/f’ (carried forward) or ‘balance c/d’ (carried down). (4) Carry the balance down diagonally and call it ‘balance b/f’ (brought forward) or ‘balance b/d’ (brought down). Test your understanding 7 Balance off the following account: Cash Capital Sales $ 10,000 Purchases 250 Rent Electricity $ 200 150 75

Test your understanding 8 Balance off the following account: Bank Capital Sales $ 10,000 Purchases 300 Rent Electricity New van $ 1,000 2,500 750 15,000

6 The trial balance

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Once all ledger accounts have been balanced off a trial balance is prepared. A trial balance is a list of the ‘balance b/f’ on the ledger accounts according to whether they are on the debit or credit side.Trial balance as at 31 December 2005

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Trial balance as at 31 December 2005 Dr $ Name of account Sales Purchases Receivables Payables Capital Cr $ X X X X X _____ X _____ X

What does the trial balance prove?

The trial balance will balance if for every debit entry made, an equal credit entry was made and the balances were correctly extracted and cast (added up!).

• • •

The purpose of a trial balance is: to check that for every debit entry made, an equal credit entry has been made. as a first step in preparing the financial statements.

Note that a number of adjustments will be made after the trial balance is extracted. These adjustments do not therefore appear in the trial balance.

7 Closing off the ledger accounts
At the year end, the ledger accounts must be closed off in preparation for the recording of transactions in the next accounting period.

Statement of financial position ledger accounts

• •

Assets/liabilities at the end of a period = Assets/liabilities at start of the next period, e.g. the cash at bank at the end of one day will be the cash at bank at the start of the following day. Balancing the account will result in: – a balance c/f (being the asset/liability at the end of the accounting period) – a balance b/f (being the asset/liability at the start of the next accounting period).

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Double entry bookkeeping 7.2 Income statement ledger accounts

• • •

At the end of a period any amounts that relate to that period are transferred out of the income and expenditure accounts into another ledger account called the income statement. This is done by closing the account. Do not show a balance c/f or balance b/f but instead put the balancing figure on the smallest side and label it ‘income statement’.

Capital account

• •

At the start of the next accounting period the capital account will have an opening balance, i.e. a balance b/f equal to the amount that is owed to the owner at the start of that period. This amount is equal to what was owed to the owner at the start of the previous period, plus any capital that the owner introduced in the period, plus any profits earned in the period less any drawings taken out in the period.

•

Therefore we transfer the balance on the income statement and the balance on the drawings account to the capital account at the end of the period so that it will have the correct opening balance at the start of the next. Capital $ $ Balance b/f X Loss for year X Profit for year X Drawings X Cash injections X Balance c/f X ____ ____ X X ____ ____ Balance b/f X

Test your understanding 9 Oddjob had $7,800 capital invested in his business at the start of the year. During the course of the year he took $3,100 cash out of the business and also paid his wife, who did some secretarial work for him, $500. The business’ profit for the year was $8,900. Oddjob also paid $350 for a new suit using the business cheque book during the year.

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What is the balance on the capital account at the end of the year? A B C D $12,750 $13,250 $13,600 $13,100

8 Opening balances in the ledger accounts

• • • • •

If a business has been in operation in the previous year, then at the beginning of any accounting period it will have assets and liabilities such as cash and non­current assets. Any opening amounts are shown in statement of financial position ledger accounts as opening balances. The opening balance on an asset account is a debit entry. The opening balance on a liability account is a credit entry. Transactions during the year are then entered as normal in the ledger account, and at the year end it is balanced off taking into account the opening balance.

Note: Income statement ledger accounts do not have an opening balance. Test your understanding 10 Johnny had receivables of $4,500 at the start of 20X5. During the year to 31 December 20X5 he makes credit sales of $45,000 and receives cash of $46,500 from credit customers. What is the balance on the receivables account at 31 December 20X5? A B C D $6,000Dr $6,000Cr $3,000Dr $3,000Cr

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9 Preparation of financial statements
The process seen thus far is as follows:

Examination questions may draw on any particular stage of this process. Test your understanding 11 Matthew set up a business and in the first nine days of trading the following transactions occurred: (1)January Matthew (2)January Matthew (3)January Matthew (4)January Matthew (5)January Matthew (6)January Matthew (7)January Matthew (8)January Matthew (9)January Matthew introduces $10,000 capital by cheque. buys supplies worth $4,000 and pays by cheque. buys a delivery van for $2,000 and pays by cheque. buys $1,000 of purchases on credit. sells goods for $1,500 and receives a cheque of that amount. sells all his remaining goods for $5,000 on credit. pays $800 to his supplier by cheque. pays rent of $200 by cheque. draws $100 for living expenses from the business bank account.

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Required: (a) Complete the relevant ledger accounts. (b) Extract a trial balance. (c) Prepare the income statement for the first nine days. (d) Prepare the Statement of financial position as at 9 January.

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Double entry bookkeeping

Chapter summary

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Test your understanding answers Test your understanding 1 Sales (2) Sales (4) Bank (1) Bank (3) Test your understanding 2 The correct answer is C Cash $ Sales Loan 1,000 Purchases 5,000 Sundry expenses Fixtures and fittings $ 380 20 2,600 $ 70 $ $ $ Bank 230 Rent (1) 3,400 Drawings (3) Sales Bank (2) Bank (4) Rent 80 Drawings $ $ $ 230 3,400 $ 80 70

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Double entry bookkeeping Test your understanding 3 Bank $ Sales (1) $ 60 Insurance (2) Motor expenses (4) Drawings (6) Purchases (7) Non­current assets (8) Sales Bank (1) Receivables (3) Insurance (expense) $ Bank (2) Receivables $ Sales (3) Motor expenses $ Bank (4) $ Payables (5) Cash (7) Payables $ Purchases (5) $ 170 170 40 50 Purchases $ $ 250 $ 400 $ $ 60 250 $ 400 50 57 40 800

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Drawings $ Bank (6) 57 Non­current asset (computer) $ Bank (8) Test your understanding 4 $ 1 2 3 4 5 6 Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Purchases Bank Receivables Sales Telephone expense Bank Bank Interest income Stationery expense Cash Cash Sales 5,000 5,000 500 500 40 40 150 150 12 12 400 400 $ 800 $ $

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Double entry bookkeeping Test your understanding 5 $ 10,000 1,000 1,000 400 400 600 600 500 500 150 150 600 600 340 340 30 30 20 20 100 100 $ 10,000

1 2 3 4 5 6 7 8 9 10 11

Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr

Bank Capital Purchases Bank Bank Sales Receivables Sales Purchases Payables Telephone expense Bank Bank Receivables Payables Bank Bank Interest income Sales returns Bank Payables Purchases returns

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chapter 3 Test your understanding 6 The correct answer is A Payables $ Cash (97% x 2,000) Discount received 1,940 Balance b/f 60 ______ 2,000 ______ $ Balance b/f Receivables 3,400 Cash (97.5% x 3,400) Discount allowed ______ 3,400 ______ Discount received $ Payables Discount allowed $ Receivables 85 $ $ 60 $ 3,315 85 ______ 3,400 ______ ______ 2,000 ______ $ 2,000

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Double entry bookkeeping Test your understanding 7 Cash $ Capital Sales 10,000 Purchases 250 Rent Electricity Balance c/f ______ 10,250 ______ Balance b/f Test your understanding 8 Bank $ Capital Sales Balance c/f 10,000 Purchases 300 Rent Electricity 8,950 New van ______ 19,250 ______ Balance b/f $ 1,000 2,500 750 15,000 ______ 19,250 ______ 8,950 9,825 $ 200 150 75 9,825 ______ 10,250 ______

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chapter 3 Test your understanding 9 The correct answer is B. Capital $ Drawings Drawings (suit) Balance c/f 3,100 Balance b/f 350 Profit for the year 13,250 ______ 16,700 ______ Test your understanding 10 The correct answer is C. Receivables $ Balance b/f Sales Balance b/f 4,500 45,000 Cash received Balance c/f ______ 49,500 ______ 3,000 46,500 3,000 ______ 49,500 ______ $ Balance b/f 13,250 ______ 16,700 ______ $ 7,800 8,900

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Double entry bookkeeping Test your understanding 11 Bank (a) 1 Jan 5 Jan Capital Balance c/f $ Bank $ 10,000 ——— 10,000 ——— Balance b/f 10,000 1 Jan ——— 10,000 ——— Purchases $ 2 Jan 4Jan Bank Payables 4,000 1,000 ———— 5,000 ———— Balance b/f 5,000 2 Jan Balance c/f $ 5,000 ———— 5,000 ———— Balance b/f Capital Sales $ 10,000 1,500 2 Jan 3 Jan 7 Jan 8 Jan 9 Jan Purchases Delivery van Payables Rent Drawings $ 4,000 2,000 800 200 100 ——— 4,400 ———

Balance c/f ——— 11,500 ——— 4,400

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Delivery van $ 3 Jan Bank 2,000 Balance c/f ——— 2,000 ——— Balance b/f 7 Jan Bank 2,000 Payables $ 800 200 ——— Balance c/f Balance c/f $ 1,000 ——— Sales 6,500 5 Jan ——— 6 Jan 6,500 ——— Balance b/f Receivables $ 7 Jan Sales $ 5,000 ______ 5,000 ______ 5,000 Balance c/f ______ 5,000 ______ Balance b/f 5,000 Rent $ 8 Jan Bank 200 Balance c/f ______ 200 ______ Balance b/f
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$ 5,000 ——— 5,000 ———

$ 4 Jan Purchases 1,000 ——— 1,000 ——— Balance b/f Bank Receivables $ 1,500 5,000 ——— 6,500 ——— 6,500 2,00

$ 200 ______ 200 ______

200
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Double entry bookkeeping
Drawings $ 9 Jan Bank 100 Balance c/f ______ 100 ______ Balance b/f 100 100 ______ 100 ______ $

$ Bank Capital 10,000 Purchases 5,000 Delivery van 2,000 Payables 200 Sales 6,500 Receivables 5,000 Rent 200 Drawings 100 Income statement for the period ended 9 January $ $ Sales 6,500 Opening inventory ­ Purchases 5000 Closing inventory ­ ______ ______ 5,000 Gross profit 1,500 Expenses Rent 200 ______ 1,300 Net profit ______

Trial balance as at 9 January Dr $ 4,400

Cr

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Statement of financial positionas at 9 January $ Non current assets Delivery van Current assets Inventory ­ Receivables 5,000 Bank 4,400 ______

$ 2,000

Capital Profit Drawings Current liabilities Payables

9,400 ______ 11,400 ______ 10,000 1,300 (100) ______ 11,200 200 ______ 11,400 ______

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chapter

4

Inventory
Chapter learning objectives
Upon completion of this chapter you will be able to:

• • • • • • • • • •

explain the need for adjustments for inventory in preparing financial statements illustrate income statements with opening and closing inventory explain and demonstrate how opening and closing inventory are recorded in the inventory account explain the IAS 2 requirements regarding the valuation of closing inventory define the cost and net realisable value of closing inventory discuss alternative methods of valuing inventory explain and demonstrate how to calculate the value of closing inventory from given movements in inventory levels, using FIFO (first in first out) and AVCO (average cost) assess the effect of using either FIFO or AVCO on both profit and asset value explain the IASB requirements for inventories explain the use of continuous and period­end inventory records.

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1 Adjustments for inventory in the financial statements

• • •

In order to be able to prepare a set of financial statements, inventory must be accounted for at the end of the period. Opening inventory must be included in cost of sales as these goods are available for sale along with purchases during the year. Closing inventory must be deducted from cost of sales as these goods are held at the period end and have not been sold.

Expandable text

Illustration 1– Adjustments for inventory Peter buys and sells washing machines. He has been trading for many years. On 1 January 20X7, his opening inventory is 30 washing machines which cost $9,500. He purchased 65 machines in the year amounting to $150,000 and on 31 December 20X7 he has 25 washing machines left in inventory with a cost of $7,500. Peter has sold 70 machines with a sales value of $215,000 in the year. Calculate the gross profit for the year ended 31 December 20X7.

Expandable text

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2 Recording inventory in the ledger accounts

• •

Inventory is only recorded in the ledger accounts at the end of the accounting period. In the inventory ledger account the opening inventory will be the brought forward balance from the previous period. This must be transferred to the income statement ledger account with the following entry: Dr Income statement (Ledger account) Cr Inventory (Ledger account).

•

The closing inventory is entered into the ledger accounts with the following entry: Dr Inventory (Ledger account) Cr Income statement (Ledger account).

•

Once these entries have been completed, the income statement ledger account contains both opening and closing inventory and the inventory ledger account shows the closing inventory for the period to be shown in the statement of financial position.

Illustration 2 – Recording inventory in the ledger accounts Continuing from previous Illustration, we will now see how the ledger accounts for inventory are prepared. We will look at the ledger accounts at the following times: (a) Immediately before extracting a trial balance at 31 December 20X7. (b) Immediately after the year­end adjustments and closing off of the ledger accounts. (a)Ledger accounts before extracting a trial balance Inventory 20X7 1 Jan Balance b/f $ 9,500 $

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The inventory is an asset and therefore is a debit entry in the inventory account. Purchases 20X7 Various suppliers $ 150,000 Sales revenue $ 20X7 Various customers $ 215,000 $

•

The balance of $9,500 in inventory account originated from last year’s statement of financial position when it appeared as closing inventory. This figure remains unchanged in the inventory account until the very end of the year when closing inventory at 31 December 20X7 is considered. The closing inventory figure is not usually provided to us until after we have extracted the trial balance at 31 December 20X7. The purchases and sales figures have been built up over the year and represent the year’s accumulated transactions. The trial balance will include opening inventory, purchases and sales revenue in respect of the inventory transactions.

• • •

(b) Ledger accounts reflecting the closing inventory

•

Closing inventory for accounting purposes has been valued at $7,500.

Step 1 The income statement forms part of the double entry. At the year end the accumulated totals from the sales and purchases accounts must be transferred to it using the following journal entries: Dr Sales revenue Cr Income statement Dr Income statement Cr Purchases $215,000 $215,000 $150,000 $150,000

These transfers are shown in the ledger accounts below. Step 2 The opening inventory figure ($9,500) must also be transferred to the income statement account in order to arrive at cost of sales. Dr Income statement $9,500 Cr Inventory $9,500
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Step 3 The income statement cannot be completed (and hence gross profit calculated) until the closing inventory is included. Dr Inventory $7,500 Cr Income statement $7,500 After summarising and balancing off, the ledger then becomes: Inventory 20X7 1 Jan Balance b/f 31 Dec Income statement $ 20X7 7,500 31 Dec Balance c/f ––––– 17,000 ––––– 20X8 1 Jan Balance b/f 20X7 Various dates Payables 20X7 31 Dec Income statement 7,500 Purchases 20X7 31 Dec 150,000 Income statement Sales revenue $ 20X7 Various dates 215,000 $ $ 150,000 $ 7,500 ––––– 17,000 ––––– $ 9,500 9,500 31 Dec Income statement

215,000 Receivables

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Income statement (‘T’ account form) 20X7 31 Dec Purchases Inventory Gross profit c/f $ 20X7 31 Dec 215,000 7,500 –––––– 222,500 –––––– 63,000 9,500 Inventory 63,000 –––––– 222,500 –––––– Gross profit b/f $

150,000 Sales revenue

Expandable text Expandable text Test your understanding 1 The trading position of a simple cash­based business for its first week of trading was as follows: $ 1,000 800 900

Capital introduced by the owner Purchases for cash Sales for cash

At the end of the week there were goods which had cost $300 left in inventory. Write up the ledger accounts for the first week, including the income statement, and then prepare a vertical income statement together with a statement of financial position at the end of the first week.

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Test your understanding 2 The business described in Test your understanding 1 now continues into its second week. Its transactions are as follows: $ Sales for cash Purchases for cash 1,000 1,100

The goods left in inventory at the end of this second week originally cost $500. Write up the ledger accounts for the second week, including the income statement, and then prepare a vertical income statement together with a statement of financial position at the end of the second week.

3 Drawings of inventory
It is not unusual for a sole trader to take inventory from their business for their own use. This type of transaction is a form of drawings. The correct double entry to account for such drawings is: Dr Drawings Cr Cost of sales cost of inventory taken cost of inventory taken

The credit entry ensures that the cost of inventory taken is not included as part of the cost of inventory sold in the income statement.

4 Valuation of inventory
Inventory consists of:

• • • • •

goods purchased for resale consumable stores (such as oil) raw materials and components (used in the production process) partly­finished goods (usually called work in progress – WIP) finished goods (which have been manufactured by the business).

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Inventory

Inventory is included in the statement of financial position at:

Expandable text

Test your understanding 3 Cole’s business sells three products X, Y and Z. The following information was available at the year end: X $ Cost Net realisable value (NRV) Units What is the value of the closing inventory? A B C D $8,400 $6,800 $7,100 $7,200 7 10 100 Y $ 10 8 200 Z $ 19 15 300

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chapter 4 Test your understanding 4 In what circumstances might the NRV of inventories be lower than their cost?

5 Methods of calculating cost of inventory
Method Unit cost Key points

This is the actual cost of Only used when items of purchasing identifiable units inventory are individually of inventory. distinguishable and of high value

FIFO – first For costing purposes, the The cost of closing inventory infirst out first items of inventory is the cost of the younger received are assumed to be inventory. the first ones sold. AVCO – Average cost The cost of an item of inventory is calculated by taking the average of all inventory held. The average cost can be calculated periodically or continously.

Expandable text

Test your understanding 5 Sam started her business on 1 January and provides details of the following transactions: Purchases (1) January 5 units at $4/unit (2) January 5 units at $5/unit (3) January 5 units at $5.50/unit She then sold 7 units for $10/unit on 5 January. (a) Calculate the value of the closing inventory at the end of the first week of trading using the FIFO and the AVCO methods. (b) Prepare the income statement for the first week of trading under both FIFO and AVCO.

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Inventory Test your understanding 6 A business commenced on 1 January and purchases are made as follows: Month Jan Feb Mar Apr May Jun No of units 380 400 350 420 430 440 –––––– 2,420 –––––– Unit price $ 2.00 2.50 2.50 2.75 3.00 3.25 Value $ 760 1,000 875 1,155 1,290 1,430 –––––– 6,510 ––––––

In June, 1,420 articles were sold for $7,000. What is the cost of closing inventory and gross profit for the period using the FIFO method: Closing inventory $ A B C Expandable text 2,690 2,310 3,077 Gross profit $ 3,180 2,800 3,567

6 IAS 2 Inventories
The key requirements of IAS 2 Inventories are:

• • •

Inventories are valued at the lower of cost and net realisable value. Cost includes costs of purchase, costs of conversion and other costs incurred in bringing the inventory to its present location and condition. Costs which must be excluded from the cost of inventory are: – selling costs – – – storage costs abnormal waste of materials, labour or other costs administrative overheads.

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• •

Cost should be unit cost (if identifiable), FIFO or AVCO. Disclosures must be made about the accounting policy for inventory and classification of inventory included in the financial statements.

Keeping inventory records A business may choose to keep inventory records on a continuous basis throughout the year or only count inventory at the period end. Expandable text Test your understanding 7 IAS 2 Inventories defines the items that may be included in computing the value of an inventory of finished goods manufactured by a business. Which one of the following lists consists only of items which may be included in the statement of financial position value of such inventories according to IAS 2? A B C D Foreman’s wages, carriage inwards, carriage outwards, raw materials. Raw materials, carriage inwards, costs of storage of finished goods, plant depreciation. Plant depreciation, carriage inwards, raw materials, foreman’s wages. Carriage outwards, raw materials, foreman’s wages, plant depreciation.

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Chapter summary

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Test your understanding answers Test your understanding 1 First, the transactions are entered into the ledger accounts, and the accounts are balanced. Revenue and purchases are then transferred to the income statement ledger account. Capital $ $ Capital Sales revenue 1,000 Purchases 900 Balance c/f –––––– 1,900 –––––– Balance b/f 1,100 Sales revenue $ Income statement 900 Cash –––––– Purchases $ Cash 800 Income statement –––––– $ 900 –––––– $ 800 –––––– Cash Cash $ 1,000 $ 800 1,100 –––––– 1,900 ––––––

Next, the closing inventory must be accounted for in the inventory account and the income statement account. There is no opening inventory as this is the first week of trading for the business. Inventory $ Income statement 300 Cash $ 1,000

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Inventory
Income statement Purchases Gross profit c/f Income statement Cash $ 800 Sales revenue 400 Closing inventory ––––– 1,200 ––––– Gross profit b/f Sales revenue $ 900 Cash ––––– Purchases $ 800 Income statement $ 900 ––––– $ 800 ––––– $ 900 300 ––––– 1,200 ––––– 400

–––––

The income statement is prepared in the vertical format by rearranging the income statement ledger account. Cash $ Balance b/f Sales revenue Balance b/f 1,100 Purchases 1,000 Balance c/f ––––– 2,100 ––––– 1,000 $ 1,100 1,000 ––––– 2,100 –––––

The statement of financial position is prepared by listing the balances brought down from the ledger accounts

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Statement of financial position as at Week 1 Inventory Cash Capital Profit for the week 300 1,100 ––––– 1,400 ––––– 1,000 400 ––––– 1,400 –––––

Statement of financial position as at Week 1 Inventory Cash Capital Profit for the week Test your understanding 2 First, the ledger accounts must be written up. You must remember that there are opening balances on the statement of financial position accounts (cash and capital) but the income statement accounts have no opening balances as they were transferred to the income statement in Week 1. 300 1,100 ––––– 1,400 ––––– 1,000 400 ––––– 1,400 –––––

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Inventory
Cash $ Sales revenue Cost of goods sold: Purchases Less: Closing inventory $ 900 800 (300) ––––– (500) ––––– 400 ––––– Sales revenue $ Income statement 1,000 Cash –––––– Purchase Cash $ 1,100 Income statement –––––– Income statement $ Purchases 1,100 Sales revenue –––––– $ 1,000 –––––– $ 1,100 –––––– $ 1,000 ––––––

Gross profit

The opening inventory must be transferred to the income statement, and the closing inventory entered into the ledger accounts (inventory and income statement) leaving the balance carried forward which will be included in the statement of financial position. Inventory $ Balance b/f Income statement 300 Income statement 500 $ 300

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Income statement Purchases Opening inventory Gross profit c/f $ 300 Closing inventory 100 –––––– 1,500 –––––– Gross profit b/f Income statement for week 2 $ $ 1,000 300 1,100 ––––– 1,400 (500) ––––– (900) ––––– 100 ––––– $ Inventory Cash 500 1,000 ––––– 1,500 ––––– 1,400 100 ––––– 1,500 ––––– –––––– 1,500 –––––– 100 $ 1,000 500 1,100 Sales revenue

Sales revenue Cost of goods sold: Opening inventory Purchases

Less: Closing inventory

Gross profit Statement of financial position as at week 2

Capital at start of Week 2 Profit for Week 2

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Inventory Test your understanding 3 The correct answer is B X Y Z Total Test your understanding 4 NRV may be relevant in special cases, such as where goods are slow­ moving, damaged or obsolete. However, most items of inventory will be stated at cost. Test your understanding 5 Units purchased (5 x 3) = 15 Units sold = 7 _________________ Closing inventory = 8 (a) FIFO 3 units @ $5 = $15.00 5 units @ $5.50 = $27.50 ––––––– $42.50 AVCO Average cost per unit: ((5 x $4) + (5 x $5) + (5 x $5.50))/15 = $4.83 Closing inventory = 8 x $4.83 = $38.64 $7 $8 $15 (cost) x 100 (NRV) x 200 (NRV) x 300 = = = $700 $1,600 $4,500 ––––––– $6,800

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(b) FIFO $ Sales (7 x $10) Cost of sales Purchases (5 x $4) + (5 x $5) + (5 x $5.50) Less: Closing inventory $ 70

72.50 (42.50) _______ (30) ______ 40

Profit $ Sales (7 x $10) Cost of sales Purchases (5 x $4) + (5 x $5) + (5 x $5.50) Less: Closing inventory

$ 70

72.50 (38.64) _______ (33.86) ______ 36.14

Profit

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Inventory Test your understanding 6

• • •

The correct answer is C Inventory valuation (inventory in hand 2,420 – 1,420 = 1,000 units) FIFO – inventory valued at latest purchase prices $ 1,430 1,290 357 –––––– 3,077

440 430 130 –––––– 1,000

articles at $3.25 articles at $3.00 articles at $2.75

Calculation of gross profit: $ Sales revenue Purchases Less: Closing inventory Cost of goods sold Gross profit Test your understanding 7 The correct answer is C The other three answers contain items which cannot be included in inventory according to IAS 2. 6,510 (3,077) ______ (3,433) ______ 3,567 $ 7,000

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5

Sales tax
Chapter learning objectives
Upon completion of this chapter you will be able to:

• • •

explain the general principles of the operation of a sales tax calculate sales tax on transactions correctly enter sales tax on sales and purchases into the ledger accounts.

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1 Principles of sales tax

• • • • • • • • •

Sales tax is a form of indirect taxation. A business that is registered for sales tax is essentially a collection agent for the government. Sales tax is charged on purchases (input tax) and sales (output tax). Sales tax is excluded from the reported sales and purchases of the business. Periodically the business pays the sales tax to the tax authorities. If output tax exceeds input tax, the business pays the excess to the tax authorities. If input tax exceeds output tax, the business is repaid the excess by the tax authorities. Sales tax is sometimes called value added tax (VAT) or goods and services tax. Sales tax is charged on most goods and services.

2 Calculation of sales tax

• •

It is common for a rate of 17.5% sales tax to be charged on the selling price. The following is therefore true:

Net selling price (tax exclusive price) 100.0% Sales tax 17.5% Gross selling price (tax inclusive price) 117.5%

• • •
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The net selling price is the amount that the business wishes to achieve. The gross selling price is the price charged to customers. The difference is paid to the tax authorities.
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chapter 5 Illustration 1 – Calculation of sales tax Calculation of sales tax Orlando sells the following goods: (1) to Bruno at a tax inclusive price of $470. (2) to Cosmo at a tax exclusive price of $700. How much sales tax is Orlando collecting on behalf of the government? Expandable Text Test your understanding 1 Lorenzo purchases goods for $170,625 (including sales tax) and sells goods for $230,500 (including sales tax). What amount of sales tax is ultimately payable to the tax authorities? A B C D $8,918 $14,926 $4,471 $10,479

The sales tax rate is 17.5%.

3 Accounting entries for sales tax
The usual bookkeeping entries for purchases and sales are only slightly amended by sales tax, the main addition being the introduction of a sales tax account, which is a receivable or payable account with the tax authorities. Sales tax paid on purchases (input tax) Dr Purchases cost excluding sales tax (net cost) Dr Sales tax Sales tax Cr Payables/cash Cost including sales tax (gross cost)

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Sales tax

• •

The purchases account does not include sales tax because it is not an expense – it will be recovered. The payables account does include sales tax, as the supplier must be paid the full amount due.

Sales tax charged on sales (output tax) Dr Receivables/cash sales price including sales tax (gross selling price) Cr Sales sales price excluding sales tax (net selling price) Cr Sales tax Sales tax

• •

The sales account does not include sales tax because it is not income – it will have to be paid to the tax authorities. The receivables account does include sales tax, as the customer must pay the full amount due.

Payment of sales tax Dr Sales tax amount paid Cr Cash amount paid

•

If output tax exceeds input tax, a payment must be made to the tax authorities. Receipt of sales tax Dr Cash amount received Cr Sales tax amount received

•

If input tax exceeds output tax, there will be a receipt from the tax authorities.

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Test your understanding 2 Net Sales tax $ $ 180,000 31,500 260,000 45,500 Total $ 211,500 305,500

Purchases Sales

(all on credit) (all on credit)

Record these transactions in the ledger accounts. Test your understanding 3 Valerie’s business is registered for sales tax purposes. During the quarter ending 31 March 20X6, she made the following sales, all of which were subject to sales tax at 17.5%: $10,000 excluding sales tax $7,402 including sales tax $6,745 excluding sales tax $11,632 including sales tax. She also made the following purchases all of which were subject to sales tax at 17.5%: $15,000 excluding sales tax $12,455 including sales tax $11,338 including sales tax $9,870 including sales tax. What is the balance on the sales tax account on 31 March 20X6? A B C D $7,639 Dr $1,875 Dr $7,639 Cr $1,875 Cr

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Chapter summary

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Test your understanding answers Test your understanding 1 The correct answer is A $ Output tax: Sales (including sales tax) Sales tax (17.5/117.5) Input tax: Purchases (including sales tax) Sales tax (17.5/117.5) Payable to tax authorities: Output tax – Input tax (34,330 – 25,412) 230,500 34,330 _______ 170,625 25,412 _______ 8,918 _______

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Sales tax Test your understanding 2 Sales $ Receivables $ 260,000 _______ 260,000 _______

Note that sales are recorded excluding sales tax, as this is not income for the business. Purchases Payables $ $

180,000 _______ 180,000 _______

Note that purchases are recorded net of sales tax, as this is not a cost to the business. Receivables Sales/Sales tax $ $

305,500 _______ 305,500 _______

Receivables are recorded including sales tax (the gross amount) as the customer must pay to the business the cost of the goods plus the sales tax. Payables $ Purchases/Sales tax $ 211,500 _______ 211,500 _______

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As with receivables, the payables must be recorded inclusive of sales tax, as the business needs to pay its suppliers the gross amount. Sales tax account(a personal account with tax authorities) Payables Balance c/f $ 31,500 Receivables 14,000 _______ 45,500 ________ Balance b/f $ 45,500 _______ 45,500 _______ 14,000 _______

Note: As the balance on the sales tax account represents a normal trade liability it is included in accounts payable on the statement of financial position. Test your understanding 3 The correct answer is B Sales tax Purchases: 15,000 x 17.5% 12,455 x 17.5/117.5 11,338 x 17.5/117.5 9,870 x 17.5/117.5 Balance b/f $ Sales: 2,625 10,000 x 17.5% 1,855 7,402 x 17.5/117.5 1,689 6,745 x 17.5% 1,470 11,632 x 17.5/117.5 Balance b/f ______ 7,639 ______ 1,875 $ 1,750 1,102 1,180 1,732 1,875 ______ 7,639 ______

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Sales tax

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chapter

6

Accruals and prepayments
Chapter learning objectives
Upon completion of this chapter you will be able to:

• •

explain the need for adjustments for accruals and prepayments in preparing financial statements illustrate the process of adjusting for accruals and prepayments in preparing financial statements.

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1 Accruals basis of accounting
The accruals basis of accounting means that to calculate the profit for the period, we must include all the income and expenditure relating to the period, whether or not the cash has been received or paid or an invoice received. Profit is therefore: Income earned Expenditure incurred Profit X (X) ___ X

Expandable text

2 Accrued expenditure
An accrual arises where expenses of the business, relating to the year, have not been paid by the year end. In this case, it is necessary to record the extra expense relevant to the year and create a corresponding statement of financial position liability (called an accrual):

Dr Expense account X Cr Accrual X An accrual will therefore reduce profit in the income statement.

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chapter 6 Illustration 1 – Accrued expenditure Accrued expenditure A business’ electricity charges amount to $12,000 pa. In the year to 31 December 20X5, $9,000 has been paid. The electricity for the final quarter is paid in January 20X6. What year­end accrual is required and what is the electricity expense for the year? Show the relevant entries in the ledger accounts. Expandable text Test your understanding 1 John Simnel’s business has an accounting year end of 31 December 20X1. He rents factory space at a rental cost of $5,000 per quarter, payable in arrears. During the year to 31 December 20X1 his cash payments of rent have been as follows:

• • •

31 March (for the quarter to 31 March 20X1) $5,000 29 June (for the quarter to 30 June 20X1) $5,000 2 October (for the quarter to 30 September 20X1) $5,000

The final payment due on 31 December 20X1 for the quarter to that date was not paid until 4 January 20X2. Show the ledger accounts required to record the above transactions.

3 Prepaid expenditure
A prepayment arises where some of the following year’s expenses have been paid in the current year.

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Accruals and prepayments In this case, it is necessary to remove that part of the expense which is not relevant to this year and create a corresponding statement of financial position asset (called a prepayment): Dr Prepayment X Cr Expense account X A prepayment will therefore increase profit in the income statement. Illustration 2– Prepaid expenditure The annual insurance charge for a business is $24,000 pa. $30,000 was paid on 1 January 20X5 in respect of future insurance charges. What is the year­end prepayment and what is the insurance expense for the year? Show the relevant entries in the ledger accounts. Expandable text Test your understanding 2 Tubby Wadlow pays the rental expense on his market stall in advance. He starts business on 1 January 20X5 and on that date pays $1,200 in respect of the first quarter’s rent. During his first year of trade he also pays the following amounts:

• • • • •

3 March (in respect of the quarter ended 30 June) $1,200 14 June (in respect of the quarter ended 30 September) $1,200 25 September (in respect of the quarter $1,400 ended 31 December) 13 December (in respect of the first quarter of 20X6) $1,400

Show these transactions in the rental expense account.

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4 Proforma expense T account
Expense Balance b/f (opening prepaid expense) Bank (total paid during the year) Balance c/f (closing accrued expense) $ X X X Balance b/f (opening accrued expense) Income statement (total expense for the year) Balance c/f (closing prepaid expense) $ X X X –––– X –––– X

Balance b/f (opening prepaid expense)

–––– X –––– X Balance b/f (opening accrued expense)

Test your understanding 3 On 1 January 20X5, Willy Mossop owed $2,000 in respect of the previous year’s electricity. Willy made the following payments during the year ended 31 December 20X5:

• • • •

6 February $2,800 8 May $3,000 5 August $2,750 10 November $3,100

At 31 December 20X5, Willy calculated that he owed $1,800 in respect of electricity for the last part of the year. What is the electricity charge to the income statement? A B C D $1,800 $11,450 $11,650 $13,450

5 Accrued income
Accrued income arises where income has been earned in the accounting period but has not yet been received.

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Accruals and prepayments
In this case, it is necessary to record the extra income in the income statement and create a corresponding asset in the statement of financial position (called accrued income): Dr Accrued income (SFP) X Cr Income (IS) X Illustration 3– Accrued income Accrued income A business earns bank interest income of $300 per month. $3,000 bank interest income has been received in the year to 31 December 20X5. What is the year­end asset and what is the bank interest income for the year? Show the relevant entries in the ledger accounts. Expandable text

6 Prepaid income
Prepaid income arises where income has been received in the accounting period but which relates to the next accounting period. In this case, it is necessary to remove the income not relating to the year from the income statement and create a corresponding liability in the statement of financial position (called prepaid income): Dr Income (IS) X Cr Prepaid Income (SFP) X

Illustration 4 – Prepaid income Prepaid income A business rents out a property at an income of $4,000 per month. $64,000 has been received in the year ended 31 December 20X5. What is the year­end liability and what is the rental income for the year? Show the relevant entries in the ledger accounts.

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chapter 6 Expandable text

7 Proforma income T account
Income Balance b/f (opening accrued income) Income statement (total revenue for the year) Balance c/f (closing prepaid income) $ X Balance b/f (opening prepaid income) X Cash (total received during the year) X Balance c/f (closing accrued income) ––– X ––– Balance b/f (opening X prepaid income) $ X X X ––– X ––– X

Balance b/f (opening accrued income) Test your understanding 4 Accrued and prepaid income

Libby Farquar receives income from two rental units as follows: Unit 1 $ 2,100 2,150 2,150 2,200 2,200 2,200 Unit 2 Received 30.9.X4 27.12.X4 25.3.X5 21.6.X5 21.9.X5 29.12.X5

Period 1.10.X4 – 31.12.X4 1.1.X5 – 31.3.X5 1.4.X5 – 30.6.X5 1.7.X5 – 30.9.X5 1.10.X5 – 31.12.X5 1.1.X6 – 31.3.X6

$ 1,300 1,300 1,300 1,400 1,400 1,400

Received 2.1.X5 4.4.X5 1.7.X5 6.10.X5 2.1.X6 4.4.X6

What is Libby’s rental income in the income statement for the year ended 31 December 20X5? A B C D $5,400 $8,700 $14,000 $14,100

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Chapter summary

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Test your understanding answers Test your understanding 1 Rental expense $ 31 March cash 29 June cash 2 October cash Accrual c/f 5,000 5,000 5,000 5,000 Income statement –––––– 20,000 –––––– Accrual b/f Test your understanding 2 Rental expense $ 1 January cash 3 March cash 14 June cash 25 September cash 13 December cash 1,200 1,200 1,200 1,400 Income statement 1,400 Prepayment c/f –––––– 6,400 –––––– Prepayment b/f 1,400 5,000 1,400 –––––– 6,400 –––––– $ 20,000 –––––– 20,000 –––––– 5,000 $

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Accruals and prepayments Test your understanding 3 The correct answer is B Electricity expense $ 6 February cash 8 May cash 5 August cash 10 November cash Accrual c/f 2,800 Accrual b/f 3,000 2,750 3,100 Income statement 1,800 ––––––– 13,450 ––––––– Accrual b/f ––––––– 13,450 ––––––– 1,800 11,450 $ 2,000

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chapter 6 Test your understanding 4 The correct answer is D Rental income (Unit 1) $ Prepaid income b/f 25.3.X5 cash 21.6.X5 cash 8,700 21.9.X5 cash 2,200 29.12.X5 cash ––––––– 10,900 ––––––– Prepaid income b/f Rental income (Unit 2) $ Income statement 4.4.X5 cash 1.7.X5 cash 5,400 6.10.X5 cash Accrued income c/f ––––––– 6,700 ––––––– Accrued income b/f 1,400 1,300 2.1.X5 cash

Income statement Prepaid income c/f Accrued income b/f

$ 2,150 2,150 2,200 2,200 2,200 ––––––– 10,900 ––––––– 2,200 $ 1,300 1,300 1,300 1,400 1,400 ––––––– 6,700 –––––––

Total income: $8,700 + $5,400 = $14,100

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Accruals and prepayments

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chapter

7

Irrecoverable debts and allowances for receivables
Chapter learning objectives
Upon completion of this chapter you will be able to:

• • • • • • • •

identify the benefits and costs of offering credit facilities to customers explain the purpose of an aged receivables analysis explain the purpose of credit limits prepare the bookkeeping entries to write off an irrecoverable debt record an irrecoverable debt recovered identify the impact of irrecoverable debts on the income statement and statement of financial position prepare the bookkeeping entries to create and adjust an allowance for receivables illustrate how to include movements in the allowance for receivables in the income statement and how the closing balance of the allowance should appear in the statement of financial position.

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1 The provision of credit facilities
The majority of businesses will sell to their customers on credit and state a defined time within which they must pay (a credit period). The main benefits and costs of doing so are as follows: Benefits

• • •

The business may be able to enter new markets. There is a possibility of increased sales. Customer loyalty may be encouraged.

Costs

• • •

Can be costly in terms of lost interest since the business is accepting payment later. Cash flow of the business may deteriorate. There is a potential risk of irrecoverable debts.

Aged receivables analysis Where credit facilities are offered, it is normal for a business to maintain an aged receivables analysis.

• •

Analysis is usually a list, ordered by name, showing how much each customer owes and how old their debts are. The credit control function of a business uses the analysis to keep track of outstanding debts and follow up any that are overdue.

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•

Timely collection of debts improves cash flow and reduces the risk of them becoming irrecoverable.

Credit limits It is also normal for a business to set a credit limit for each customer. This is the maximum amount of credit that the business is willing to provide. The use of credit limits may:

• • •

reduce risk to business of irrecoverable debts by limiting the amount sold on credit help build up the trust of a new customer be part of the credit control strategy of a business.

2 Irrecoverable debts

• • • • •

The accruals concept dictates that when a sale is made, it is recognised in the accounts, regardless of whether or not the cash has been received. If sales are made on credit, there may be problems collecting the amounts owing from customers. Some customers may refuse to pay their debt or be declared bankrupt and unable to pay the amounts owing. Some customers may be in financial difficulties or may dispute the amount owed and there may be some doubt as to whether their debt will be paid. If it is highly unlikely that the amount owed by a customer will be received, then this debt is known as an irrecoverable debt. As it will probably never be received, it is written off by writing it out of the ledger accounts completely. If there is some doubt whether a customer can or will pay his debt, an allowance for receivables is created. These debts are not yet irrecoverable. However the creation of an allowance for receivables means that the possible loss is accounted for immediately, in line with the concept of prudence. The amount of the original debt will still remain in the ledger account just in case the customer does eventually pay.

•

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3 Accounting for irrecoverable debts
An irrecoverable debt is a debt which is, or is considered to be, uncollectable.

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Irrecoverable debts and allowances for receivables With such debts it is prudent to remove them from the accounts and to charge the amount as an expense for irrecoverable debts to the income statement. The original sale remains in the accounts as this did actually take place. The double entry required to achieve this is: Dr Irrecoverable debts expense Cr Receivables Test your understanding 1 Araf & Co have total accounts receivable at the end of their accounting period of $45,000. Of these it is discovered that one, Mr Xiun who owes $790, has been declared bankrupt, and another who gave his name as Mr Jones has totally disappeared owing Araf & Co $1,240. Calculate the effect in the financial statements of writing off these debts as irrecoverable.

4 Accounting for irrecoverable debts recovered
There is a possible situation where a debt is written off as irrecoverable in one accounting period, perhaps because the customer has been declared bankrupt, and the money, or part of the money, due is then unexpectedly received in a subsequent accounting period. When a debt is written off the double entry is: Dr Irrecoverable debts expense Cr Receivables (removing the debt from the accounts) When cash is received from a customer the normal double entry is: Dr Cash Cr Receivables When an irrecoverable debt is recovered, the credit entry (above) cannot be taken to receivables as the debt has already been taken out of the receivables balance. Instead the accounting entry is: Dr Cash Cr Irrecoverable debts expense

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Some businesses may wish to keep a separate ‘irrecoverable debts recovered’ account to separate the actual cost of irrecoverable debts in the period. Expandable text Test your understanding 2 Celia Jones had receivables of $3,655 at 31 December 20X7. At that date she wrote off a debt from Lenny Smith of $699. During the year to 31 December 20X8 Celia made credit sales of $17,832 and received cash from her customers totalling $16,936. She also received the $699 from Lenny Smith that had already been written off in 20X7. What is the final balance on the receivables account at 31 December 20X7 and 20X8? 20X7 $ 2,956 2,956 3,655 3,655 20X8 $ 3,852 3,153 4,551 3,852

A B C D

5 Allowance for receivables
There may be some debts in the accounts where there is some cause for concern but they are not yet definitely irrecoverable. It is prudent to recognise the possible expense of not collecting the debt in the income statement, but the receivable must remain in the accounts in case the customer does in fact pay up. An allowance is set up which is a credit balance. This is netted off against trade receivables in the statement of financial position to give a net figure for receivables that are probably recoverable. There are two types of allowance that may appear in the organisation’s accounts:

•

There will be some specific debts where the customer is known to be in financial difficulties, is disputing their invoice, or is refusing to pay for some other reason (bad service for example), and therefore the amount owing may not be recoverable. The allowance for such a debt is known as a specific allowance.
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Irrecoverable debts and allowances for receivables

•

The past experience and history of a business will indicate that not all of its trade receivables will be recoverable in full. It may not be possible to identify the amount that will not be paid but an estimate may be made that a certain percentage of customers are likely not to pay. An additional allowance will be made for these items, often known as a general allowance.

6 Accounting for the allowance for receivables
An allowance for receivables is set up with the following journal: Dr Irrecoverable debts expense Cr Allowance for receivables If there is already an allowance for receivables in the accounts (opening allowance), only the movement in the allowance is charged to the income statement (closing allowance less opening allowance). As the allowance can increase or decrease, there may be a debit or a credit in the irrecoverable debts account so the above journal may be reversed. When calculating and accounting for a movement in the allowance for receivables, the following steps should be taken: (1) Write off irrecoverable debts. (2) Calculate the receivables balance as adjusted for the write­offs. (3) Ascertain the specific allowance for receivables required. (4) Deduct the debt specifically provided for from the receivables balance (be sure to deduct the full amount of debt rather than the amount of specific allowance). (5) Multiply the remaining receivables balance by the general allowance percentage to give the general allowance required. %(closing receivables – irrecoverable debts – debts specifically allowed for). (6) Add the specific and general allowances required together. (7) Compare to the brought forward allowance. (8) Account for the change in allowance.

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chapter 7 Test your understanding 3 On 31 December 20X1 Jake Williams had receivables of $10,000. From past experience Jake estimated that the equivalent of 3% of these customers were likely never to pay their debts and he therefore wished to make an allowance for this amount. During 20X2 Jake made sales on credit totalling $100,000 and received cash from his customers of $94,000. He still considered that the equivalent of 3% of the closing receivables may never pay and should be allowed for. During 20X3 Jake made sales of $95,000 and collected $96,000 from his receivables. At 31 December 20X3 Jake still considered that the equivalent of 3% of his receivables should be allowed for. Calculate the allowance for receivables and the irrecoverable debt expense as well as the closing balance of receivables for each of the years 20X1, 20X2, 20X3. Test your understanding 4 John Stamp has opening balances at 1 January 20X6 on his trade receivables account and allowance for receivables account of $68,000 and $3,400 respectively. During the year to 31 December 20X6 John Stamp makes credit sales of $354,000 and receives cash from his receivables of $340,000. At 31 December 20X6 John Stamp reviews his receivables listing and acknowledges that he is unlikely ever to receive debts totalling $2,000. These are to be written off as irrecoverable. Past experience indicates that John should also make an allowance equivalent to 5% of his remaining receivables after writing off the irrecoverable debts. What is the amount charged to John’s income statement for irrecoverable debt expense in the year ended 31 December 20X6? A B C D $2,700 $6,100 $2,600 $6,000

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Irrecoverable debts and allowances for receivables Test your understanding 5 Gordon’s receivables owe a total of $80,000 at the year end. These include $900 of long overdue debts that might still be recoverable, but for which Gordon has created an allowance for receivables. Gordon has also provided an allowance of $1,582, which is the equivalent of 2% of the other receivables’ balances. What best describes Gordon’s allowance for receivables as at his year end? A B C D A specific allowance of $900 and an additional allowance of $1,582 based on past history. A specific allowance of $1,582 and an additional allowance of $900 based on past history. A specific allowance of $2,482. A general allowance of $2,482.

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Chapter summary

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Irrecoverable debts and allowances for receivables

Test your understanding answers Test your understanding 1 As the two debts are considered to be irrecoverable, they must be removed from receivables: Receivables Balance at period end $ $ 45,000 Irrecoverable debts – Mr Xiun Irrecoverable debts – Mr Jones Balance c/f 45,000 ______ Balance b/f 42,970 Irrecoverable debts expense $ Receivables – Mr Xiun Receivables – Mr Jones 790 1,240 Income statement 2,030 _____ 2,030 2,030 _____ $ 1,240 42,970 45,000 ______ 790

Note that the sales revenue account has not been altered and the original sales to Mr Xiun and Mr Jones remain. This is because these sales actually took place and it is only after the sale that the expense of not being able to collect these debts has occurred.

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chapter 7 Test your understanding 2 The correct answer is A 20X7 Receivables $ 31 Dec 3,655 Irrecoverable debts – Lenny Smith Balance c/f 3,655 _____ Balance b/f 2,956 Irrecoverable debts expense $ Receivables – Lenny Smith 699 Income statement 699 ____ Receivables $ Balance b/f Sales Balance b/f 2,956 17,832 Cash received Balance c/f 20,788 ______ 3,852 Irrecoverable debts expense $ Income statement 699 Cash 699 ____ $ 699 699 ____ 16,936 3,852 20,788 ______ 699 699 ____ $ $ 699 2,956 3,655 _____ $

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Irrecoverable debts and allowances for receivables Test your understanding 3 20X1 Receivables $ At 31 December 10,000 Balance c/f 10,000 ______ Balance b/f 10,000 Allowance required: $10,000 x 3% = $300 Allowance for receivables $ Balance c/f 31 Dec Allowance for receivables Current assets Receivables 300 31 Dec Irrecoverable debts 300 ____ Balance b/f Irrecoverable debts expense $ 31 Dec 300 Income statement 300 ____ Statement of financial position presentation $ 10,000 (300) 9,700 $ 300 300 ____ $ 300 300 ____ 300 $ 10,000 10,000 ______

$

Less: Allowance for receivables

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20X2 Receivables Balance b/f Sales Balance b/f $ $ 94,000 16,000 110,000 10,000 100,000 Cash Balance c/f 16,000 110,000 Allowance required: $16,000 x 3% = $480 Allowance for receivables $ Balance b/f Balance b/f 480 31 Dec increase in allowance 480 ____ 31 Dec Allowance for receivables Balance b/f Irrecoverable debts expense $ 31 Dec 180 Income statement 180 180 ____ $ 180 480 _____ 480

$ 300

180 ____ Statement of financial position presentation $ $ 16,000 (480) _____

Current assets Receivables Less: Allowance for receivables

15,520

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Irrecoverable debts and allowances for receivables
20X3 Receivables $ $ Balance b/f 16,000 Sales 95,000 Cash 96,000 Balance c/f 15,000 111,000 ———— ———— 111,000 Balance b/f 15,000 Allowance required: $15,000 x 3% = $450 Allowance for receivables $ $ 31 Dec Balance b/f 480 decrease in 30 allowance Balance c/f 450 ____ ____ 480 480 ____ ____ Balance b/f 450 Irrecoverable debts expense $ $ 31 Dec 31 Dec Income statement 30 Allowance for 30 receivables ___ ___ 30 30 ___ ___ Statement of financial position presentation $ $ Current assets Receivables 15,000 Less: Allowance for (450) receivables _____ 14,550

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chapter 7 Test your understanding 4 The correct answer is C Receivables 20X6 1 Jan Balance b/f 31 Dec Sales revenue $ 20X6 68,000 31 Dec cash 354,000 31 Dec Irrecoverable debts 31 Dec Balance c/f _______ 422,000 _______ 80,000 Irrecoverable debts expense $ 20X6 2,000 31 Dec 600 Income statement _____ 2,600 _____ 2,600 _____ 2,600 _____ $ 80,000 _______ 422,000 _______ 2,000 $ 340,000

20X7 1 Jan Balance b/f 20X6 31 Dec Receivables 31 Dec Allowance for receivables

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Irrecoverable debts and allowances for receivables
Allowance for receivables 20X6 31 Dec Balance c/f $ 20X6 1 Jan Balance b/f 4,000 31 Dec Irrecoverable debts _____ 4,000 _____ 20X7 1 Jan Balance b/f 4,000 600 _____ 4,000 _____ $ 3,400

Note that only the one irrecoverable debts expense account is used both to write off irrecoverable debts and to increase or decrease the allowance for receivables. There is no need to use separate accounts for each type of expense. Working – Allowance for receivables 5% x $80,000 = $4,000 Test your understanding 5 The correct answer is A There is a specific allowance for the debt of $900 which has still not been written off as irrecoverable, and an additional allowance equivalent to 2% of the remaining balance based on past history.

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chapter

8

Non­current assets
Chapter learning objectives
Upon completion of this chapter you will be able to:

• • • • • • • • • • • • •

define non­current assets distinguish between capital and revenue expenditure explain the function and purpose of an asset register explain and illustrate the ledger entries to record the acquisition of non­current assets define and explain the purpose of depreciation explain the straight­line and reducing balance methods of depreciation and make necessary calculations explain and illustrate how depreciation expense and accumulated depreciation are recorded in ledger accounts explain and illustrate how depreciation is presented in the income statement and statement of financial position explain the relevance of consistency and subjectivity in accounting for depreciation make the necessary adjustments if changes are made in the estimated useful life/residual value of a non­current asset explain and illustrate the ledger entries to record the disposal of non­current assets for cash explain and illustrate the ledger entries to record the disposal of non­current assets through part exchange explain and illustrate the inclusion of profits or losses on disposal in the income statement

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• • •

explain and record the revaluation of a non­current asset in ledger accounts and in the statement of financial position explain the impact of a revaluation on accounting for depreciation and disposal of a non­current asset explain and illustrate how non­current asset balances and movements are disclosed in company financial statements.

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chapter 8

1 Non­current assets
Non­current assets are distinguished from current assets by the following characteristics: they:

• • • • •

are long­term in nature are not normally acquired for resale are could be tangible or intangible are used to generate income directly or indirectly for a business are not normally liquid assets (i.e. not easily and quickly converted into cash without a significant loss in value).

2 Capital and revenue expenditure
It follows that a business’ expenditure may be classified as one of two types:

3 Non­current asset registers
Non­current asset registers are, as the name suggests, a record of the non­ current assets held by a business. These form part of the internal control system of an organisation.

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Non­current assets Expandable text

4 Acquisition of a non­current asset
A non­current asset register is maintained in order to control non­current assets and keep track of what is owned and where it is kept. It is periodically reconciled to the non­current asset accounts maintained in the general ledger.

•

The cost of a non­current asset is any amount incurred to acquire the asset and bring it into working condition Excludes Revenue expenditure such as:

Includes Capital expenditure such as :

• • • • •

purchase price repairs delivery costs renewals legal fees repainting subsequent expenditure which enhances the asset

• • •

repairs renewals repainting

The correct double entry to record the purchase is: Dr Non­current asset X Cr Bank/Cash/Payables X

•

A separate cost account should be kept for each category of non­ current asset, e.g. motor vehicles, fixtures and fittings.

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Test your understanding 1 Acquisition of a non­current asset Bilbo Baggins started a business providing limousine taxi services on 1 January 20X5. In the year to 31 December he incurred the following costs: $ Office premises 250,000 Legal fees associated with purchase of office 10,000 Cost of materials and labour to paint office in Bilbo’s favourite 300 colour, purple Mercedes E series estate cars 116,000 Number plates for cars 210 Delivery charge for cars 180 Road licence fee for cars 480 Drivers’ wages for first year of operation 60,000 Blank taxi receipts printed with Bilbo Baggins’ business name 450 and number What amounts should be capitalised as ‘Land and buildings’ and ‘Motor vehicles’? A B C D Land and buildings 260,000 250,000 250,300 260,300 Motor vehicles 116,390 116,870 116,390 116,870

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5 Depreciation

• • • •

IAS 16 defines depreciation as ‘the measure of the cost or revalued amount of the economic benefits of the tangible non­current asset that has been consumed during the period’. In simple terms, depreciation is a mechanism to reflect the cost of using a non­current asset. Depreciation matches the cost of using a non­current asset to the revenues generated by that asset over its useful life. This is achieved by recording a depreciation charge each year, the effect of which is twofold (‘the dual effect’): – Reduce the statement of financial position value of the non­current asset by cumulative depreciation to reflect the wearing out. – Record the depreciation charge as an expense in the income statement to match to the revenue generated by the non­current asset.

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6 Methods of calculating depreciation

Straight­line method Depreciation charge = (Cost – Residual value)/Useful life Or X% x cost

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chapter 8 Residual value: the estimated disposal value of the asset at the end of its useful life. Useful life: the estimated number of years during which the business will use the asset. Expandable text Reducing balance method Depreciation charge = X % x Net book value (NBV) NBV: original cost of the non­current asset less accumulated depreciation on the asset to date. Assets bought/sold in the period If a non­current asset is bought or sold in the period, there are two ways in which the depreciation could be accounted for:

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provide a full year’s depreciation in the year of acquisition and none in the year of disposal monthly or pro­rata depreciation, based on the exact number of months that the asset has been owned.

Illustration 1 – Reducing balance method Dev, a trader, purchased an item of plant for $1,000 on 1 August 20X1 which he depreciates on the reducing balance at 20% pa. What is the depreciation charge for each of the first five years if the accounting year end is 31 July?

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Test your understanding 2 Karen has been running a successful nursery school ‘Little Monkeys’ since 20X1. She bought the following assets as the nursery grew:

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a new oven for the nursery kitchen at a cost of $2,000 (purchased 1 December 20X4). a minibus to take the children on trips for $18,000 (purchased 1 June 20X4).

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Non­current assets
She depreciates the oven at 10% straight line and the minibus at 25% reducing balance. A full year’s depreciation is charged in the year of purchase and none in the year of disposal. What is the total depreciation charge for the year ended 31 October 20X6? A B C D Test your understanding 3 The following information relates to Bangers & Smash, a car repair business: Machine 1 $12,000 1 August 20X5 20% straight line pro rata Machine 2 $8,000 1 October 20X6 10% reducing balance pro rata $2,531 $2,700 $4,231 $2,731

Cost Purchase date Depreciation method

What is the total depreciation charge for the years ended 31 December 20X5 and 20X6? 20X5 $ A B C D 2,400 1,000 2,400 1,000 20X6 $ 2,600 2,600 3,200 3,200

7 Accounting for depreciation
Whichever method is used to calculate depreciation, the accounting remains the same: Dr Depreciation expense (IS) X Cr Accumulated depreciation SFP

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The depreciation expense account is an income statement account and therefore is not cumulative.
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The accumulated depreciation account is a statement of financial position account and as the name suggests is cumulative, i.e. reflects all depreciation to date.

On the statement of financial position it is shown as a reduction against the cost of non­current assets: $ Cost X Accumulated depreciation (X) ___ NBV X Illustration 2– Accounting for depreciation Santa runs a large toy shop in Windsor. In the year ended 31 August 20X5, she bought the following fixed assets:

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A new cash register for $5,000. This was purchased on 1 December 20X4, in time for the Christmas rush, and was to be depreciated at 10% straight line. A new delivery van, purchased on 31 March 20X5, at a cost of $22,000. The van is to be depreciated at 15% reducing balance.

Santa charges depreciation on a monthly basis.

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What is the depreciation charge for the year ended 31st August 20X5? Show the relevant ledger accounts and statement of financial position presentation at that date.

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Test your understanding 4 Coco acquired two fixed assets for cash on 1 August 20X5 for use in her party organising business:

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a 25­year lease on a shop for $200,000 a chocolate fountain for $4,000.

The fountain is to be depreciated at 25% pa using the reducing balance method.

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Non­current assets
A full year of depreciation is charged in the year of acquisition and none in the year of disposal. Show the ledger account entries for these assets for the years ending 31 October 20X5, 20X6 and 20X7.

8 Consistency and subjectivity when accounting for depreciation
The following are all based on estimates made by the management of a business:

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depreciation method residual value useful life.

Different estimates would result in varying levels of depreciation and, consequently, profits. It can be argued that these subjective areas could therefore result in manipulation of the accounts by management. In order to reduce the scope for such manipulation and increase consistency of treatment, IAS 16 Property, Plant andEquipment requires the following:

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Depreciation method should be reviewed at each year end and changed if the method used no longer reflects the pattern of use of the asset. Residual value and useful life should be reviewed at each year end and changed if expectations differ from previous estimates.

Illustration 3 – Changes to estimates Alfie purchased a non­current asset for $100,000 on 1 January 20X2 and started depreciating it over five years. Residual value was taken as $10,000. At 1 January 20X3 a review of asset lives was undertaken and the remaining useful life was estimated at eight years. Residual value was estimated as nil. Calculate the depreciation charge for the year ended 31 December 20X3 and subsequent years.

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chapter 8 Expandable text Test your understanding 5 Alberto bought a wood­burning oven for his pizza restaurant for $30,000 on 1 January 20X0. At that time he believed that the oven’s useful life would be 20 years after which it would have no value. On 1 January 20X3, Alberto revises his estimations: he now believes that he will use the oven in the business for another 12 years after which he will be able to sell it second­hand for $1,500. What is the depreciation charge for the year ended 31 December 20X3? A B C D $2,000 $2,125 $1,875 $2,375

9 Disposal of non­current assets
Profit/Loss on disposal Proceeds (cash or part disposal allowance) > NBV at disposal date Proceeds (cash or part