PART 3

LECTURE NOTE

CFAB – ACCOUNTING 1
CHAPTER 1: INTRODUCTION TO ACCOUNTING ....................................... 8

1.1. The purpose of accounting information ......................................................... 8

1.1.1. What is accounting? ................................................................................ 8

1.1.2. Types of business entity .......................................................................... 8

1.1.3. The objective of financial statements...................................................... 9

1.1.4. Who needs financial information .......................................................... 10

1.1.5. Users and their information needs ........................................................ 11

1.2. The regulation of accounting ....................................................................... 12

1.2.1. Generally Accepted Accounting Practice (GAAP)............................... 12

1.2.2. Legislation ............................................................................................. 12

1.2.3. Accounting standards ............................................................................ 12

1.2.4. International Financial Report Standards (IFRS) ................................. 12

1.2.5. UK GAAP ............................................................................................. 13

1.2.6. True and fair view/faithful representation ............................................ 13

1.3. The main financial statements ...................................................................... 13

1.3.1. Statement of financial position ............................................................. 13

1.3.2. Statement of Profit or loss ..................................................................... 14

1.3.3. Presentation of financial statements ...................................................... 15

1.4. Capital and revenue items ............................................................................ 15

1.4.1. Capital and revenue expenditure ........................................................... 15

1.4.2. Capital income and revenue income ..................................................... 16

1.4.3. Capital transactions ............................................................................... 17

1.4.4. Why is the distinction between capital and revenue items important? . 17

1
1.5. Qualitative characteristics of useful accounting information ...................... 18

1.5.1. The fundamental qualitative characteristics.......................................... 18

1.5.2. Enhancing qualitative characteristics .................................................... 18

1.6. Accounting concepts and conventions ......................................................... 18

1.6.1. Fair presentation .................................................................................... 18

1.6.2. Going concern (IAS 1) .......................................................................... 19

1.6.3. Accrual basis of accounting (IAS 1) ..................................................... 20

1.6.4. Consistency of presentation (IAS 1) ..................................................... 20

1.6.5. Materiality and aggregation (IAS 1) ..................................................... 20

1.6.6. Offsetting (IAS 1) ................................................................................. 20

1.6.7. The business entity concept .................................................................. 21

1.6.8. The historical cost convention .............................................................. 21

1.7. Ethical considerations .................................................................................. 21

1.7.1. Accounting concepts and individual judgement ................................... 21

1.7.2. Principles based system......................................................................... 22

CHAPTER 2: ACCOUNTING EQUATION ..................................................... 23

2.1. Assets, liabilities and the business entity concept ....................................... 23

2.1.1. Assets and liabilities .............................................................................. 23

2.1.2. The business as a separate entity........................................................... 24

2.2. The accounting equation: ............................................................................. 25

2.2.1. Definition: ............................................................................................. 25

2.2.2. Example:................................................................................................ 25

2.2.3. Where do profits/losses fit into the accounting equation? .................... 26

2
 2.2.4. Appropriation of profits: Sole trader drawings ..................................... 27

2.3. Credit transactions ........................................................................................ 28

2.3.3. Accruals concept ................................................................................... 30

2.4. The statement of financial position .............................................................. 31

2.4.1. What is a statement of financial position? ............................................ 31

2.4.2. Capital (Sole trader) .............................................................................. 32

2.4.3. Liabilities ............................................................................................... 33

2.4.4. Assets .................................................................................................... 33

2.5. Preparing the statement of financial position ............................................... 36

2.6. The statement of profit or loss ..................................................................... 36

2.6.1. What is the statement of profit or loss?................................................. 36

2.6.2. Relationship between the SPL and the SFP .......................................... 38

CHAPTER 3: RECORDING FINANCIAL TRANSACTIONS ........................ 39

3.1. Computerised accounting system................................................................. 39

3.1.1. Accounting system ................................................................................ 39

3.1.2. Computerised accounting system.......................................................... 40

3.1.3. Accounting software packages.............................................................. 43

3.1.4. Cloud accounting .................................................................................. 46

3.2. Source documents for recording financial transactions ............................... 48

3.3. Recording bank transactions ........................................................................ 53

3.3.1. Electronic banking ................................................................................ 53

3.3.2. Cash at bank account ............................................................................. 53

3.4. Petty cash book............................................................................................. 54

3
 3.4.1. What is the petty cash book used for .................................................... 54

3.5. The payroll ................................................................................................... 54

3.5.1. What is the payroll used for? ................................................................ 54

CHAPTER 4: LEDGER ACCOUNTING AND DOUBLE ENTRY ................. 55

4.1. Ledgers ......................................................................................................... 56

4.2. The nominal ledger....................................................................................... 57

4.3. Double entry bookkeeping ........................................................................... 58

4.3.1. Dual effect (duality concept)................................................................. 58

4.3.2. The rules of double entry bookkeeping................................................. 58

4.4. Journal entries .............................................................................................. 59

4.5. Double entry for petty cash .......................................................................... 62

4.6. The receivables and payables ledgers .......................................................... 63

4.6.1. Nominal ledger accounts and personal accounts .................................. 63

4.6.2. The receivable ledger ............................................................................ 63

4.6.3. The payable ledger ................................................................................ 64

4.7. Accounting for discounts ............................................................................. 65

4.7.1. Trade discounts ..................................................................................... 65

4.7.2. Early settlement discounts..................................................................... 66

4.8. Accounting for VAT .................................................................................... 66

4.8.1. What is VAT ......................................................................................... 66

4.8.2. How is VAT collected? ......................................................................... 67

4.8.3. Registered and non-registered traders ................................................... 67

4.8.4. Irrecoverable VAT ................................................................................ 68

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 4.8.5. VAT and discounts ................................................................................ 68

4.8.6. VAT and irrecoverable debts ................................................................ 68

4.8.7. Summary of accounting entries for VAT .............................................. 69

4.8.8. Calculating VAT from gross amount .................................................... 69

CHAPTER 5: PREPARING BASIC FINANCIAL STATEMENTS................. 72

How to balancing ledger accounts ...................................................................... 72

5.1. The trial balance ........................................................................................... 72

5.1.1. Listing ledger account balances in the trial balance ............................. 73

5.1.2. Potential errors in a TB ......................................................................... 74

5.1.3. Making adjustments after the TB is extracted ...................................... 75

5.1.4. Processing adjustments to the TB ......................................................... 76

5.2. Balancing off ledger accounts ...................................................................... 77

5.3. Preparing the SPL......................................................................................... 78

5.3.1. Preparing the profit and loss ledger account ......................................... 78

5.4. Preparing the SOFP ...................................................................................... 82

5.4.1. Transferring profit/loss to capital account ............................................ 82

5.4.2. Preparing the SOFP ............................................................................... 82

CHAPTER 6: CONTROL ACCOUNTS, ERRORS AND SUSPENSE

ACCOUNT.......................................................................................................... 85

6.1. Reconciling to external documents .............................................................. 85

6.2. Bank reconciliation ...................................................................................... 88

6.2.2. The bank reconciliation ......................................................................... 90

6.3. Types of error in accounting ........................................................................ 94

6.4. Correcting errors .......................................................................................... 96

5
 6.4.1 Journal entries ........................................................................................ 96

6.4.2 Suspense accounts .................................................................................. 96

6.4.3. Using a suspense account when the trial balance does not balance...... 97

6.5. Adjusting the initial TB for errors.............................................................. 102

CHAPTER 7: COST OF SALES AND INVENTORIES................................. 104

IFRS REFERENCE: ......................................................................................... 104

7.1. IAS 2, Inventories (FRS 102 s13) .............................................................. 104

7.1.1. Objective ............................................................................................. 104

7.1.2. Inventories ........................................................................................... 105

7.2. Cost of sales ............................................................................................... 105

7.2.1. Unsold goods at the end of reporting period ....................................... 106

7.2.2. Cost of sales ........................................................................................ 106

7.2.3. Delivery costs ...................................................................................... 106

7.2.4. Inventory written off and written down .............................................. 107

7.2.5. Inventory destroyed or stolen .............................................................. 108

7.3. Accounting for opening and closing inventories ....................................... 108

7.4. Adjusting the TB ........................................................................................ 109

7.5. Counting inventories .................................................................................. 110

7.6. Valuing inventories .................................................................................... 110

7.6.1. Basic valuation: lower of cost and NRV ............................................. 110

7.6.2 Applying the lower of cost and NRV.................................................. 110

7.6.3 Determining the cost of inventory ...................................................... 111

7.6.4. Inventory valuations and profit ........................................................... 112

6
7.7. Using mark-up/margin percentage to establish cost .................................. 112

7.8. Inventory drawings..................................................................................... 113

CHAPTER 8: IRRECOVERABLE DEBTS AND ALLOWANCE FOR

RECEIVABLES ................................................................................................ 113

8.1. Irrecoverable debts ..................................................................................... 114

8.1.1. Writing off irrecoverable debts ........................................................... 114

8.1.2. Dishonoured cheques and irrecoverable debts .................................... 115

8.2. Allowance for receivables .......................................................................... 115

8.3. Accounting for irrecoverable debts and allowance for receivables ........... 116

8.3.1. Irrecoverable debts written off: ledger accounting entries ................. 116

8.3.2. Allowance for receivable: ledger accounting entries .......................... 116

8.4. Adjusting the TB for irrecoverable debts and allowance for receivables .. 119

7
CHAPTER 1: INTRODUCTION TO ACCOUNTING

LEARNING OBJECTIVES

- Specify why an entity maintains financial records and prepares financial

statements;
- Specify the ethical considerations for preparers of financial statements;
- Record and account for transactions and events resulting in income, expenses,
assets, liabilities and equity in accordance with the appropriate basis of accounting
and the laws, regulations and accounting standards applicable to the financial
statements;
- Specify the key aspects of the accrual basis of accounting and the cash basis of
accounting.

1.1. The purpose of accounting information

1.1.1. What is accounting?

Accounting: recording, analysing, summerising transactions of an entity

Recording • In ‘books of original entry’

Analysing • Ledgers
Summerising • Financial statements
1.1.2. Types of business entity
How business organisation differ?

Factor Example

Ownership Private –Public

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 Control Owner themselves – Government regulators

Activities Manufacturing – Health care

Profit/ non-profit orientation Joint Stock Company – non-governmental organization

Legal status Limited company - partnership

Size Small and Medium Enterprise – Multinational company

Sources of finance Borrowing – Share issuance

Technology Computer firms – Small shop

Profit-making business entity (vesus not-for-profit organisation)

•People who work for themselves (personally liable)

Sole traders

•Two or more people sharing risks and rewards

Partnerships (personally liable)

•‘incorporated’ to take advantage of ‘limited liability’

Limited liability companies

1.1.3. The objective of financial statements

Because users want/need to know information in order to make economic

decisions

- Ability to generate • Pay employees/suppliers

cash • Meet interest payments
- Timing and certainty • Repay loans
of cash flows • Pay something (dividends) to owners

When making economic decisions, users need to assess:

· the ability of the business to generate cash

9
· the timing and certainty of cash flows
And to determines whether it can:
· pay its employees and suppliers
· meet interest payments
· repay loans
· pay something to its owners
Large businesses are of interest to a greater variety of people and so we will
consider the case of a large public company, whose shares can be purchased and
sold on a stock exchange.
The objective of financial statements is to provide information about
the financial position, performance and changes in financial position of an
enterprise that is useful to a wide range of users in making economic decisions
(IASB Framework).

1.1.4. Who needs financial information

 Managers/directors
 Owners
 Trade contacts
 Finance providers
 HM Revenue and Customs (HMRC)
 Employees
 Financial analysts and advisers
 Government agencies
 The public
 (Other) bodies such as FCA (to regulate…)
Notes
 Different groups of users may have conflicting needs => maximum number
of primary users

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  Managers: need information to help make planning and control decisions.
Managers can obtain extra information through the Cost and Management
Accounting system
 HMRC or banks: may demand particular information
1.1.4.1. Not-for-profit entities
Not-for-profit entities: also need to prepare financial statements every year
 Charities and clubs
 Government (public sector) organisations

1.1.5. Users and their information needs

 Investors (current and potential owners): risk - return

 Employees: remuneration, benefits, opportunities
 Lenders: interest, principal
 Suppliers and other creditors: payment
 Customers: continuance of customs
 Governments and their agencies: regulate
 Public: employment
 Management
The management of a reporting entity will be interested in financial information
about the entity but does not need to rely on general purpose financial reports
because it is able to obtain the financial information it needs internally. Therefore
instead of being thought of as users of the financial statements, management are
primarily responsible for the preparation and presentation of the financial
statements.
1.1.5.1. Ethical considerations
Question: Should ethical considerations underpin the work of professional
accountants who prepare financial statements?
Answer: Ethical considerations should underpin the work of all professional
accountants, including those in business who prepare financial statements and
those who set the rules and regulations of financial reporting.

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1.2. The regulation of accounting
Factors that have shaped the development of accounting:
 Generally accepted accounting practice (GAAP)
 Legislation
 Accounting standards
 True and fair view/ fair presentation
 Accounting concepts and individual judgement

1.2.1. Generally Accepted Accounting Practice (GAAP)

GAAP: all the rules, from whatever source, which govern accounting

1.2.2. Legislation

Company Act 2006: require limited liability companies to prepare and publish
financial statements annually (forms and contents…)

1.2.3. Accounting standards

 Ethical principles
 Accounting standards: to deal with some kind of subjectivity and to achieve
comparability
 Developed at an international level (by IASB)
 and at UK level (by ASB – an operating body of FRC) (Now
Accounting Council)

1.2.4. International Financial Report Standards (IFRS)

 IASB is responsible for setting IFRS

 The standards and interpretations comprise:
 IFRS
 IAS
 IFRS Interpretations committee
 SIC Interpretations

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1.2.5. UK GAAP

 UK GAAP:
 The CA 2006
 UK and international accounting and financial reporting
standards
(Note: UK financial report standards – FRS 102)
 UK specific terminology

1.2.6. True and fair view/faithful representation

 True and fair view/fair presentation (in all material respects)

 Conceptual Framework: must be ‘relevant and faithfully
represents what it purports to present’
 The CA: FSs should give a true and fair view of financial
position
 IAS 1 (IFRS): FSs should present fairly the financial position
and performance, and cash flows

1.3. The main financial statements

1.3.1. Statement of financial position

 A list of all the assets controlled and all liabilities owed by a business at a
particular date (snapshot)
 Note: Monetary amounts; owner’s interest – equity
 Equity: The amount invested in a business by the owners (owners – equity
holders/shareholders)
 Sum of assets = sum of liabilities + equity/capital
 Factors affecting a company’s financial position:
 Economic resources
 Financial structure

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  Liquidity
 Adaptability to changes in operating environment
 Conceptual Framework: focuses on how information about nature and
amount of economic resources and claims (liabilities) help users identify
reporting entity’s financial strength and weaknesses:
 Liquidity and solvency
 Need for additional financing
 Likelihood of being successful in obtaining new financing
Additionally by gaining knowledge of the economic resources a business controls,
users will be in a better position to predict the entity's ability to generate cash in
the future. Information about an entity's financial structure and liquidity/solvency
can also help financial statement users.
Information on this helps users:
 Financial structure
· to predict future borrowing needs
· to predict how future profits and cash flows will be distributed among
owners and lenders
· to predict how successfully it will be able to raise future finance
 Liquidity/solvency
· to predict its ability to meet financial commitments as they fall due.

1.3.2. Statement of Profit or loss

 A statement displaying items of income and expenses in a reporting period

as components of profit or loss for the period
 Conceptual Framework: how information about business’s financial
performance, is needed by users:
 To understand return on economic resources
 To assess management

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  To help predict future returns
The reporting period chosen will depend on the purpose for which the statement
is produced. The statement of profit or loss which forms part of the published
annual financial statements of a limited liability company will usually be for the
period of a year, commencing from the date of the previous year's financial
statements. On the other hand, management might want to keep a closer eye on a
company's profitability by making up quarterly, monthly, weekly or even daily
statements.
The link between the statement of financial position and the statement of
comprehensive income is provided by the statement of cash flows and the
statement of changes in equity. These are covered in detail later in your
professional studies. However, you will find an introduction to the statement of
cash flows in Chapter 13. The statement of cash flows shows the actual cash
flowing into and paid out of the business.

1.3.3. Presentation of financial statements

 Summaries of accumulated data. For example, the statement of profit or

loss shows a figure for revenue earned from selling goods and services to
customers. This is the total revenue earned from all sales made during the
period. An accountant devises methods of recording such transactions, so
as to produce summarised financial statements from them.
 SFP and SPL: form basis of financial statements (In addition: SCF and
SOCE; notes – required by statute and accounting standards)

1.4. Capital and revenue items

1.4.1. Capital and revenue expenditure

Capital expenditure: expenditure which results in the acquisition of long-term

assets, or an improvement or enhancement of their earning capacity.
Long-term assets are those which will be kept in the entity for more than one
year

15
  Capital expenditure is not charged as an expense in the SPL (a
'depreciation' charge will usually be made to write off the capital
expenditure gradually over time; depreciation expense is shown in the
SPL).
 Capital expenditure on long-term assets appears in the SFP
Revenue expenditure: expenditure which is incurred either:
 For trade purposes, eg. Purchases of raw materials, items for resale,
wages and salaries…
 To maintain existing earning capacity of long-term assets.
Revenue expenditure: is charged to the SPL of a period, provided that it relates
to the trading activity and sales of that particular period.
Worked Example 1.1:
A business buys 10 steel bars for £200 (£20 each) and sells 8 of them during a
reporting period, leaving 2 steel bars left. What is the amount of revenue
expenditure to be charged to the SPL of that period?
Important note:
 Capital expenditure: can include costs incurred in bringing a long-term
asset to its final condition and location, eg. legal fees, duties and carriage
costs borne by the asset's purchaser, plus installation costs.
 Revenue expenditure: eg, repair, maintenance and staff costs in relation
to long-term assets

1.4.2. Capital income and revenue income

Capital income: proceeds from the sale of non-current assets

The profits (or losses) from the sale of long-term assets are included in the SPL
for the reporting period in which the sale takes place. For instance, the business
may sell machinery or property which it no longer needs.
Revenue income: income derived from:
 Sale of trading assets
 Provision of services

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  Interest/dividends from business investments

1.4.3. Capital transactions

Raising additional finds from the owner(s), or raising and repaying loans – capital
transactions. None of these transactions would be reported through SPL.

1.4.4. Why is the distinction between capital and revenue items important?

Because the calculation of profit for any period depends on the correct and
consistent classification of revenue or capital items.
Interactive question 1.1: Capital or revenue?
State whether each of the following items should be classified as 'capital' or
'revenue' expenditure or income.
(a) The purchase of a property (eg, an office building)
(b) Property depreciation
(c) Solicitors' fees in connection with the purchase of property
(d) The costs of adding extra memory to a computer
(e) Computer repairs and maintenance costs
(f) Profit on the sale of an office building
(g) Revenue from sales paid for by credit card
(h) The cost of new machinery
(i) Customs duty charged on machinery when imported into the country
(j) The 'carriage' costs of transporting the new machinery from the supplier's
factory to the premises of the business purchasing it
(k) The cost of installing the new machinery in the premises of the business
(l) The wages of the machine operators

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1.5. Qualitative characteristics of useful accounting information

1.5.1. The fundamental qualitative characteristics

Relevance. Relevant financial information is capable of making a difference in

the decisions made by users
 predictive value – can be used to predict future outcomes.
 confirmatory value – provides feedback about previous evaluations
Information's relevance is affected by its nature and materiality. (We shall
come back to materiality; for now you can think of it as 'important‘).
Faithful representation
 Complete
 Neutral (unbiased)
 Free from error

1.5.2. Enhancing qualitative characteristics

 Comparability
 Verifiability
 Timeliness
 Understandability

1.6. Accounting concepts and conventions

1.6.1. Fair presentation

1.6.1.1. Objectives and scope of IAS 1

 IAS 1: ‘to prescribe the basis for presentation of general purpose FSs, to
ensure comparability…’
 General purpose FSs – those intended to meet the needs of users who are
not in a position to demand reports tailored to meet their particular
information needs

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1.6.1.2. Purpose of financial statements
 To provide information in making economic decisions
 To show management’s stewardship
 To assist in predicting future cash flows (timing and certainty)
1.6.1.3. Fair presentation and compliance with IFRS
 Applying IFRS is presumed to result in fair presentation
 Fair presentation: faithful representation of the effects of transactions, other
events and conditions in accordance with the Conceptual Framework.
1.6.1.4. Departures from IFRS
Departure from IFRS (very rare) may be required to achieve fair representation –
Disclosure required:
 Management confirmation of fair presentation
 IFRS complied with except the departure
 Explanation: nature, why IFRS misleading, treatment adopted
 Financial effect of the departure.

1.6.2. Going concern (IAS 1)

Going concern: The entity is viewed as continuing in operation for the foreseeable
future. It is assumed that the entity has neither the intention nor the necessity of
liquidation or ceasing to trade
Break up basis of accounting: assets are valued at ‘break up’ value – amount they
would sell for (NRV) if they were sold off individually in a forced sale
If going concern assumption is not followed, that fact must be disclosed, together
with:
 the basis on which the FSs have been prepared.
 the reasons why not considered to be a going concern.
When there is uncertainty as to whether the entity is a going concern, this should
be disclosed along with the nature of the uncertainty.

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1.6.3. Accrual basis of accounting (IAS 1)

Accrual basis of accounting: Items are recognised as assets, liabilities, equity,

income and expenses (the elements of FSs) when they satisfy the definitions and
recognition criteria for those elements in the CF.
In other words: transactions are recorded not as the cash is paid or received (cash
accounting), but as the income or expenses are earned or incurred in the reporting
period to which they relate.
Cash basis of accounting: Under this method, a company records customer
receipts in the period that they are received, and expenses in the period in which
they are paid.
Discussion: Compare accruals basis and cash basis of accounting.

1.6.4. Consistency of presentation (IAS 1)

To maintain consistency, the presentation and classification of items in the FSs

should stay the same from one period to the next, unless:
 There is a significant change in the nature of the operations, or a review
of the financial statements indicates a more appropriate presentation.
 A change in presentation is required by an IFRS.

1.6.5. Materiality and aggregation (IAS 1)

Material: Omissions or misstatements of items are material if they could,

individually or collectively, influence the economic decisions of users taken on
the basis of the financial statements.
Materiality depends on the size and nature of the omission or misstatement judged
in the surrounding circumstances

1.6.6. Offsetting (IAS 1)

Assets and liabilities, and income and expenditure must be presented separately.
IAS 1 does not allow these items to be offset against each other
Only when:
 an IFRS requires or permits it; or

20
  gains, losses and related expenses arising from the same/similar
transactions are not material (in aggregate)

1.6.7. The business entity concept

Accountants regard a business as a separate entity, distinct from its owners or

managers.
The concept applies whether the business is a limited liability company (and so
recognised in law as a separate entity), a sole trader or a partnership (in which
case the business is not legally recognised as separate from its owners).

1.6.8. The historical cost convention

A basic principle of accounting is that the monetary amount at which items are
often measured in financial statements is at historical cost
Historical cost: Transactions are recorded at their cost when they occurred.

1.7. Ethical considerations

1.7.1. Accounting concepts and individual judgement

Many figures in financial statements are derived from the application of

judgement in applying fundamental accounting concepts.
Different people exercising their judgement on the same facts could arrive at very
different conclusions
IESBA Code of Ethics for Professional Accountants – fundamental principles

P • ROFESSIONAL BEHAVIOUR
I • NTEGRITY
C • OMPETENCE
C • ONFIDENTIALITY
O • BJECTIVITY

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1.7.2. Principles based system

Places the onus on the individual to actively consider independence, to follow the
spirit/the letter of the guidance.
Prevents individuals interpreting legalistic requirements narrowly to get around
the ethical requirements
Allows for the variations that are found in every individual situation. Each
situation is likely to be different.
Accommodates a rapidly changing environment, such as the one that professional
accountants regularly face.
Contains prohibitions where these are necessary as safeguards are not feasible.

_End of chapter 1_

22
 CHAPTER 2: ACCOUNTING EQUATION Phương trình kế toán

LEARNING OBJECTIVES:
1. Record and account for transactions and events resulting in income,
expenses, assets, liabilities and capital in accordance with the appropriate
basis of accounting and the laws, regulations and accounting standards
applicable to the financial statements.
2. Identify the main components of a set of financial statements and specify
their purpose and interrelationship.

IFRS REFERENCES:
1. IAS 01 – Presentation of Financial statements:
- Basic format of the SOFP and SOCI;
- Current/non-current distinction in the SOFP;
- Definition of current asset;
- Definition of current liability;
2. Conceptual Framework:
- Elements of financial statements;
- Definition of asset, liability, equity;
- Definition of income, expense.

2.1. Assets, liabilities and the business entity concept

quyết định
được mục
đích sử dụng
2.1.1. Assets and liabilities
tài sản
“ resource
Asset: a resource controlled by the entity as a result of past events from which
controlled/
CÓ QUYỀN future economic benefits are expected to flow to the entity.
HƯỞNG LỢI
ÍCH KINH TẾ Asset may be held for the long-term (non-current) or for the short-term as trading
TỪ TÀI SẢN
ĐÓ/ có quyền assets (current assets).
ngăn chặn,
kiện các đối Examples of assets:
tượng có mục
đích xấu  Land and buildings

23
  Motor vehicles
 Plant and machinery
 Fixtures and fittings
 Cash
 Inventory
 Receivables
Required: Classify the assets above into current and non-current assets?
Liability: a present obligation arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic
là khoản đe doạ giảm lợi ích kinh tế của dn - nghĩa vụ hiện tại là nhìn ra nguy cơ
benefits. giamr lợi ích kte từ thời điểm nói
Liabilities are also classified as current and non-current liabilities like assets.
Examples of liabilities:
 Bank loans or overdraft bank overdraft: khấu chi

 Payables
 Taxation
Required: Classify the liabilities above into current and non-current assets?

2.1.2. The business as a separate entity

Business entity concept: a business is a separate entity from its owner.
This concept is considered on two aspects: The legal status of the entity and the
convention adopted by accountants.
On the legal status of the entity aspect: three types of business studied in this
module included: sole trader, partnership and limited liability company (LLC). In
forms of sole trader and partnership, there is no distinguish between the assets and
liabilities of the entity and its owner(s), i.e. not a separate entity. While in a LLC,
the owners’ assets and liabilities and the company’s assets and liabilities are
separated. In another words, the company can own assets and have liabilities in
its own name. On this aspect, whether a business may be a separate entity or not
depending on its legal status.

24
However, in accounting, any business is treated as a separate entity from its
owner(s). This applies whether or not the business is recognized in law as a
separate entity.

2.2. The accounting equation:

2.2.1. Definition
Accounting equation is the rule that the assets of a business will at all time equal
to its liabilities plus capital.

ASSETS = CAPITAL + LIABILITIES

This is also known as the balance sheet equation.

Therefore, CAPITAL (or EQUITY in the context of company) is the residual
interest in the assets of the entity after deducting all its liability.

2.2.2. Example
Worked Example 2.1

(1) 1/1/N, when Liza set up her business, she put £2,500 cash at bank into it. At
the beginning, the assets of the business were formed from the capital that Liza
had contributed.
We have the accounting equation:

(2) 2/1/N, Liza purchased a market stall for £1,800 and some flowers from a
trader in the wholesale market at a cost of £650. After that, she kept £30 in the
bank and held £20 in small change for trading.
The accounting equation now remains the same as:

25
But the components of the business’ assets had changed because of Liza’s
activities to the business.
Assets are now divided into:
 Stall £1,800
 Flowers £650
 Cash at bank £30
 Cash in hand £20

2.2.3. Where do profits/losses fit into the accounting equation?

Worked Example 2.1 (continued)

(3) On 3/1/N, Liza sold all her flowers for £900 cash.
Remember that Liza had purchased those flowers with the cost of £650 the day
before. This means that she had earned and extra amount of £250 by selling all
the flowers that she had purchased. We call this extra amount profit. The profit

26
was retained by the business and was not paid to its owner. So it is called retained
profit or retained earning.
The business’s assets after selling all flowers and receiving £900 cash included:
Stall (£1,800) + Cash (in hand and at bank) (£950) = £2,750.
The business’ capital = £2,500
The business’ liabilities remained £0
And the business’ retained profit = £250
Then the new accounting equation should be:

2.2.4. Appropriation of profits: Sole trader drawings

The owner of a sole tradership does not get paid a wage; they “draw out” or
appropriate some of their capital as drawings.
Drawings is the money and goods taken out of the business by its owner.
Worked Example 2.1 (continued)

(4) 3/1/N, Liza decided to draw out £180 from her business for living expenses.

27
The business’ cash then decreased £180 and its retained profit decreased £180 as
well.
The accounting equation now becomes:

The increase in net assets since trading operations began is now only £70, which
is the amount of the retained profit.

2.3. Credit transactions

A business does not always pay immediately for goods or services it buys. It is
common business practice to make credit purchase, with a promise to pay within
a certain payment period.
A credit purchase arises when payment for purchase of goods is not made at the
time of transaction and is deferred to a future date (due date).
Example: A buys goods costing £2,000 on credit from B, B sends A an invoice
for £2,000, dated 1 March, with credit terms that payment must be made within
30 days. If A then delays payment until 31 March, B will be a creditor of A
between 1 and 31 March for £2,000.
From A's point of view, the amount owed to B is a trade payable and B is A’s
creditor.
A creditor is a person to whom a business owes money. In a credit purchase
transaction, a credit supplier is a creditor.
A trade payable is the amount due to a credit supplier. It is a liability of the
business. When the debt is finally paid, the trade payable 'disappears’ and cash
decreases.
On the contrary, from B’s point of view, we have a credit sale. And the amount
that A owes B is a trade receivable and A is B’s debtor.
A credit sale is a purchase made by a customer for which payment is delayed.
Delayed payments allow customers to generate cash with the purchased goods,
which is then used to pay back the seller. Thus, a reasonable payment delay

28
allows customers to make additional purchases. The use of credit sales is a key
competitive tool in some industries, where longer payment terms can be used
to attract additional customers.
A debtor is a person who owes money to the business. In a credit sale transaction,
a credit customer is a debtor.
A trade receivable is the amount owed by a credit customer. It is an asset of a
business. When the debt is finally paid, the debtor 'disappears' as an asset, to be
replaced by 'cash at bank and in hand'.
Worked Example 2.1 (continued)

(5) 5/1/N, Liza bought flowers costing £1,000 from Pete, a wholesaler. Of these
purchases, £750 are paid in cash, with the remaining £250 on seven days’ credit.
(6) 7/1/N, Liza sold all the flowers and collected £1,450 in cash and £50 was owed
by Mrs. Jenny who promised to pay within 7 days. Liza decided to make the
settlement of £250 to the wholesaler.
Solution:
(5) After the credit purchase on 5/1/N, the accounting equation is:
Assets (£) = Capital (£) + Liabilities (£)

(6) After the transactions on 7/1/N, the accounting equation is:

Assets (£) = Capital (£) + Liabilities (£)

29
2.3.3. Accruals concept
The accruals (or matching) concept requires that income earned is matched with
the expenses incurred in earning it, not the expenses that had been paid for.
Worked Example 2.1 (continued)

(7) 8/1/N, Liza persuaded her Uncle Henry to lend her £500. Uncle Henry agreed
to lend her with indefinite payment time but offered an interest of £5 per week.
(8) During the week, Liza had bought flowers for the total cost of £1,700 and had
sold all of them for £2,550 total sales, £250 of which was owed with a payment
term of 7 days. Mrs. Jenny had also paid £50. And at the end of the week, Liza
decided to pay the interest to Uncle Henry the next time she met him.
Solution:
(7) Liza asked her Uncle Henry to lend her as an investment but didn’t offer him
a partnership in the business. Thus, to the business, Uncle Henry was just a long-
term creditor and the money that he lent to Liza is a long-term loan.
After this transaction, the accounting equation should be:
Assets (£) = Capital (£) + Liabilities (£)

(8) When Liza decided to pay her Uncle Henry the interest for the week and had
not paid it yet, according to the accruals concept, the interest was an expense of
the business. And because it had not been paid yet, it became a liability of the
business.

30
Mrs. Jenny had also paid £50 that she owed, that made the trade receivables item
decreased £50, and cash item increased £50.
The profit then may be calculated as:
£ £
Sales 2,550
Cost of goods sold 1,700
Interest 5
(1,705)
Profit for the week 845
And the accounting equation should be:
Assets (£) = Capital (£) + Liabilities (£)

2.4. The statement of financial position

2.4.1. What is a statement of financial position?

The business's SFP shows its financial position at a particular moment in time.
It contains 03 key elements of financial statements: liabilities, capital and assets
A SFP is very similar to the accounting equation. In fact, there are 02 differences
between them:
 The manner or format in which the liabilities and assets are presented;
 The extra detail in SFP.
A statement of financial position is divided into two halves, and is presented in
either of the following ways.

31
  Capital and liabilities in one half and assets in the other (the IAS 1 format);
 Capital in one half and net assets in the other (the UK GAAP format for the
balance sheet that is looked at in Chapters 14 and 15).
Format of SFP in accordance to IAS 01, Presentation of financial statements:
Name of business
Statement of financial position as at (date)
£
Assets (item by item) X
Capital X
Liabilities X
X

2.4.2. Capital (Sole trader)

Capital is usually analysed into its component parts.
£ £
Beginning capital (ie, capital b/f or b/d) X
Add additional capital introduced X
X
Add profit earned (or less losses incurred) X
Less drawings (X)
Retained profit for the period X
Capital as at the end (ie, capital c/f or c/d) X
'Brought forward' means that the amount is brought forward from the previous
period.
‘Carried forward' means carried forward to the next period.
The carried forward amount at the end of one period is therefore the brought
forward amount of the next period.

32
Question: When is c/f amount equal to b/f amount?
The capital or equity side of a company's statement of financial position is more
complicated than a sole trader's. We shall look at it in detail in Chapter 11.

2.4.3. Liabilities
IAS 1 requires distinction between non-current liabilities and current liabilities

2.4.3.1. Current liabilities

Current liabilities are debts which are payable within one year

Examples of current liabilities:

 Loans repayable within one year, incl. the element of a long term loan that
is repayable within one year.
 A bank overdraft
 Trade payables
 Other payables
 Taxation payable to HMRC with respect to corporation tax.
 Accruals.

2.4.3.2. Non-current liabilities

Non-current liabilities are debts which are payable after one year

Examples of non-current liabilities:

 Loans which are not repayable for more than one year, such as a bank loan
or a loan from an individual to a business.
 Loan stock or debentures

2.4.4. Assets
IAS 1 requires distinction between non-current assets and current assets:

33
2.4.4.1. Non-current assets
Non-current assets are acquired for long-term use within the business, not to sale
to a customer. They are normally valued at cost less accumulated depreciation.
Components of non-current assets in SFP:
 Property, plant and equipment (PPE) (ie, 'Tangible' assets: physical assets
that can be touched)
 Intangible non-current assets (patent, goodwill): assets which do not have
physical existence; they cannot be “touched”.
 Long-term investments.
To be classified as a non-current asset, an item must satisfy two conditions:

 It must be used by the business. For example, the owner's own house
would not normally appear on the business statement of financial position.
 The asset must have a 'life' in use (useful life) of more than one reporting
period or year.

2.4.4.2. Non-current assets and depreciation

Non-current assets are held and used by a business for a number of years, but
they wear out or lose their usefulness in the course of time. Every tangible non-
current asset has a limited life. The only exception is freehold land, although this
too can be exhausted if it is used by extractive industries (eg, mining).

The FSs of a business reflect that the cost of a non-current asset is gradually
consumed as the asset wears out. This is done by gradually 'writing off' the asset's
cost in the statement of profit or loss over several reporting periods. For example,
in the case of a machine costing £1,000 and expected to wear out after ten years,
it is appropriate to reduce the value in the statement of financial position by £100
each year. This process is known as depreciation.

If a statement of financial position were drawn up four years after the asset was
purchased, the amount of depreciation accumulated over four years would be 4 ×

34
£100 = £400. The machine would then appear in the statement of financial
position as follows.

* ie, the value of the asset in the books of account, net of accumulated
depreciation. After ten years the asset would be fully depreciated and would
appear in the statement of financial position with a carrying amount of zero.

The amount that is written off over time does not have to be the full cost of the
asset if it is expected to have a resale – or 'residual' – value at the end of its useful
life.

2.4.4.3. Current assets

Current asset: An asset is current when it is expected to be realised in, or
intended for sale or consumption in, the entity's normal operating cycle, or it is
held for being traded, or it is expected to be realised within 12 months of the date
of the statement of financial position, or it is cash or a cash equivalent.

Current assets take one of the following forms.

(a) Items owned by the business with the intention of turning them into
cash in a short time, usually within one year (see the worked example below).

(b) Cash, including money in the bank, owned by the business.

These assets are 'current' in the sense that they are continually flowing through
the business; they are always realisable in the near future.

There are some other categories of current asset.

 Short term investments.

 Prepayments.

2.4.4.4. Trade and other receivables

 A receivable can be due from anyone who owes the business money

35
  Two types of receivable:

 Trade receivables represent customers who owe money for goods or

services bought on credit in the course of the trading activities
 Other receivables are due from anyone else owing money to the business,
such as an insurance company, HMRC for VAT, or employees for season
ticket loans.

2.5. Preparing the statement of financial position

How is a basic statement of financial position prepared?

Worked Example 2.2: Prepare a statement of financial position of Liza’s

business

2.6. The statement of profit or loss

2.6.1. What is the statement of profit or loss?

The statement of profit or loss is a statement in which two key elements of
financial statements – income and expenses – are matched to arrive at a profit or
loss. Many businesses distinguish them between gross profit and profit for the
period (sometimes referred to as net profit).

2.6.1.1. Gross profit

Gross profit is the difference between:
 The value of sales revenue and
 The purchase or production cost of the goods sold: cost of sales
Gross profit = revenue from sales, less cost of sales
In a retail business, the cost of the goods sold is their purchase cost from suppliers.
In a manufacturing business, the production cost of goods sold is the cost of raw
materials in the finished goods, plus labour costs required to make the goods, plus
an amount of production 'overhead' costs. In many types of business the cost of
sales also includes:

36
  the cost of employing those people directly involved in making or
providing a service.
 maintenance and depreciation on non-current assets used directly in making
sales, plus losses on their disposal.
Gross profit can be presented as a percentage of revenue, called the gross profit
margin.

𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
Gross profit margin = x 100
𝑅𝑒𝑣𝑒𝑛𝑢𝑒

The gross profit margin can be used to compare the results of different periods to
see how well the costs of sales are being controlled as revenue changes. It can also
be used to compare the results of different businesses in the same industry.

2.6.1.2. Profit for the period

Profit for the period = Gross profit + Non-trading income - Expenses

Non-trading income are income from other sources, such as:

 Profit on disposal of NCA;
 Dividends or interest received from investments;
 Rental income from property owned but not otherwise used by the business;
 Amounts due in respect of insurance claims;
 Payment discounts from suppliers for early payments.
Expenses are business expenses not directly related to cost of sales in the
statement of profit or loss under one of three headings:
 Distribution costs;
 Administrative costs;
 Finance costs.

37
As far as possible, items of expense should be grouped (distribution costs,
administrative expenses, and finance costs) but this is not something that you need
worry about at this stage.
Required: Recall the definitions of these types of costs in previous accounting
related subjects.

A SPL can be presented in various formats, but here we will use a vertical format
similar to the one used in IAS 1. (It is not exactly the same.)

A good format that students should remember at this stage:

Name of the business
Statement of profit or loss
For the (accounting period: month, three months, year) ended (reporting date)
Revenue
Cost of sales
Gross profit

Other income
Distribution costs
Administrative costs
Finance costs
Profit for the year/net profit

However, in this stage, you do not need to group those expenses, just to name
them enough.

2.6.2. Relationship between the SPL and the SFP

 Net profit/loss in SPL (for a sole trader) is transferred to SFP as an addition
to/deduction from the owner's capital in SFP

38
  Drawings are appropriations of profit and not expenses. They must not be
included in the SPL.

_End of chapter 2_

CHAPTER 3: RECORDING FINANCIAL TRANSACTIONS

LEARNING OBJECTIVES:

 Identify the sources of information for the preparation of accounting

records and financial statements;

 Record transactions and events resulting in income, expenses, assets,

liabilities and equity in accordance with the appropriate basis of accounting
and the laws, regulations and accounting standards applicable to the
financial statements.

3.1. Computerised accounting system

3.1.1. Accounting system

An accounting system is a system to allow a business to record, process and store

financial information.

An accounting system allows a business to keep track of all types of financial

transactions, including purchases (expenses), sales (invoices and income),
liabilities (funding, accounts payable), etc. and is capable of generating
comprehensive statistical reports that provide management or interested parties
with a clear set of data to aid in the decision-making process.

39
Today, the system used by a company is generally automated and computer-
based, using specialised software and/or cloud-based services (Computerised
accounting system). However, historically, accounting systems were a complex
series of manual calculations and balances (Manual accounting system).

3.1.2. Computerised accounting system

A computerised accounting system is an accounting information system that

processes the financial transactions and events to produce financial reports to meet
users’ requirements. Every accounting system, manual or computerised, has two
aspects. First, it has to work under a set of well-defined concepts called
accounting principles. Another, that there is a user-defined framework for
maintenance of records and generation of reports.

In a computerised accounting system, the framework of storage and processing of

data is called operating environment that consists of hardware as well as software
in which the accounting system, works. The type of the accounting system used
determines the operating environment. Both hardware and software are
interdependent. The type of software determines the structure of the hardware.
Further, the selection of hardware is dependent upon various factors such as the
number of users, level of secrecy and the nature of various activities of functional
departments in an organization.

Modern computerised accounting systems are based on the concept of database.

A database is implemented using a database management system, which is define
by a set of computer programmes (or software) that manage and organise data
effectively and provide access to the stored data by the application programmes.
The accounting database is well-organised with active interface that uses
accounting application programs and reporting system.

40
AISs, whether computerized or manual, generally involve three stages: input,
processing, and output. We enter raw data into our system at the input stage and
try to correct any errors prior to going on to the next stage of processing the data.
We ultimately produce “output,” which is in the form of useful information.

Inputting data

A source document is the original document that provides evidence that a

transaction occurred. If you hire a company to paint your house, it will most likely
provide a document showing how much you owe. That is the company’s sales
document and your invoice. When you pay, your check or digital transaction
record is also a source document for the company that provided the service, in this
case, the home painter.

Businesses need a way to input data from the source document such as a sales
invoice or purchase order. This was previously done with pen and paper and is
currently done by keying it in on a computer keyboard; scanning, with a scanner
such as one that reads MICR (magnetic ink character recognition) symbols (found
on bank checks) or POS system scanners at cash registers that scan product bar

41
codes/UPC symbols; or receiving it by e-transmission (or electronic funds transfer
[EFT]). Input often involves the use of hardware such as scanners, keypads,
keyboards, touch screens, or fingerprint readers called biometric devices. Once
data has been input, it must be processed in order to be useful.

Processing Data

Companies need the accounting system to process the data that has been entered
and transform it into useful information. In manual accounting systems,
employees process all transaction data by journalizing, posting, and creating
financial reports using paper. However, as technology has advanced, it became
easier to keep records by using computers with software programs specifically
developed for accounting transactions. Computers are good at repetition and
calculations, both of which are involved in accounting, and computers can
perform these calculations and analyses more quickly, and with fewer errors, thus
making them a very effective tool for accounting from both an input and an output
standpoint.

Output: Presenting Information

An AIS should provide a way to present system output (printed page, screen
image, e-transmission). Any accounting software application such as that used by
large companies (an ERP system) or one used by smaller businesses
(QuickBooks) can easily print financial statements and other documents as well
as display them on the screen.

Some financial information must be provided to other sources such as banks or

government agencies, and though in past decades everything was presented and
submitted on paper, today, most of this information is submitted electronically,
and AISs help facilitate having the information in the necessary electronic format.
Many banks require electronic data, and the Internal Revenue System (IRS)

42
accepts your information as a digital transmission instead of a paper form. In
2017, 92 percent of all taxpayers who filed their own taxes did so
electronically. Most corporations choose to file their taxes electronically, and
those with assets over $10 million are required to file electronically with the
IRS. Since May 5, 1996, all publicly traded companies are required to submit their
filings, such as financial statements and stock offerings, to the SEC
electronically. The SEC places all the data into an electronic database known as
the Electronic Data Gathering, Analysis, and Retrieval System (EDGAR). This
database allows anyone to search the database for financial and other information
about any publicly traded company. Thus, AISs facilitate not only internal access
to financial information, but the sharing of that information externally as needed
or required. Just as the EDGAR system used by the SEC stores data for retrieval,
an AIS must provide a way to store and retrieve data.

Storing Data

Data can be stored by an AIS in paper, digital, or cloud formats. Before computers
were widely used, financial data was stored on paper, like the journal and ledger.
As technology has evolved, so have storage systems—from floppy disks to CDs,
thumb drives, and the cloud. The hard drive on your computer is a data storage
device, as is an external hard drive you can purchase. Data that is stored must have
the ability to be retrieved when needed.

3.1.3. Accounting software packages

Accounting software describes a type of application software that records and

processes accounting transactions within functional modules such as accounts
payable, accounts receivable, journal, general ledger, payroll, and trial balance. It
functions as an accounting information system. It may be developed in-house by
the organization using it, may be purchased from a third party, or may be a
combination of a third-party application software package with local

43
modifications. Accounting software may be on-line based, accessed anywhere at
any time with any device which is Internet enabled, or may be desktop based. It
varies greatly in its complexity and cost.
Every Computerised Accounting System is implemented to perform the
accounting activity (recording and storing of accounting data) and generate
reports as per the requirements of the user. From this perspective, the accounting
packages are classified into the following categories:
(a) Simple “off-the-shelf” (Ready-to-use) programmes
(b) Fully integrated (Customised) systems
(c) Bespoke (Tailored) accounting systems
Each of these categories offers distinctive features. However, the choice of the
accounting software would depend upon the suitability to the organization
especially in terms of accounting needs.

3.1.3.1. Off-the-shelf programmes

Off-the-shelf programme is ready-to-use right from the very beginning. It is a
product developed for the mass-market, which means it is expected to respond to
the needs of as many users as possible, offering many more features than a
bespoke solution would.

Off-the-shelf accounting software is suited to organisations running

small/conventional business where the frequency or volume of accounting
transactions is very low. This is because the cost of installation is generally low
and number of users is limited. Off-the-shelf software is relatively easier to learn
and people (accountant) adaptability is very high. This also implies that level of
secrecy is relatively low and the software is prone to data frauds. The training
needs are simple and sometimes the vendor (supplier of software) offers the
training on the software free. However, these software offer little scope of linking
to other information systems.

44
3.1.3.2. Fully integrated (customized) systems
Many organizations use a mix of best of breed business software systems to
manage their processes. However, this approach has many shortcomings in data
integration, data handling, usability, security, etc. It is not always reliable if you
integrate all standalone business management applications each other forming a
complex system to process data; you would rather go for a fully integrated
system.

Accounting software may be customised to meet the special requirement of the

user. Standardised accounting software available in the market may not suit or
fulfil the user requirements. For example, standardised accounting software may
contain the sales voucher and inventory status as separate options. However, when
the user requires that inventory status to be updated immediately upon entry of
sales voucher and report be printed, the software needs to be customized.

Fully integrated system is suited for large and medium businesses and can be
linked to the other information systems. The cost of installation and maintenance
is relatively high because the high cost is to be paid to the vendor for
customisation. The customisation includes modification and addition to the
software contents, provision for the specified number of users and their
authentication, etc. Secrecy of data and software can be better maintained in
customised software. Since the need to train the software users is important, the
training costs are therefore high.

3.1.3.3. Bespoke (tailored) accounting systems

The accounting software is generally tailored in large business organisations with

multi users and geographically scattered locations. These software requires
specialised training to the users. The tailored software is designed to meet the
specific requirements of the users and form an important part of the organizational

45
MIS. The secrecy and authenticity checks are robust in such softwares and they
offer high flexibility in terms of number of users.

3.1.4. Cloud accounting

Cloud accounting software is similar to traditional, on-premises, or self-install

accounting software, only the accounting software is hosted on remote servers,
similar to the SaaS (Software as a Service) business model. Data is sent into “the
cloud,” where it is processed and returned to the user.

All application functions are performed off-site, not on the user’s desktop. In
cloud computing, users access software applications remotely through the Internet
or other network via a cloud application service provider. Using cloud accounting
software frees the business from having to install and maintain software on
individual desktop computers. Cloud accounting solutions also allow employees
in other departments, remote or branch offices to access the same data and the
same version of the software.

46
 The benefits of cloud accounting:

The cloud accounting software landscape encompasses many solutions designed

to serve a number of accounting/bookkeeping functions. For instance, XERO is
cloud-based accounting software, whereas EXPENSIFY is a cloud-based solution
to help manage employee expenses.

Although benefits will vary between solutions, on a general level, some of the
benefits of cloud accounting applications include the following:

 The ability to automate many manual accounting and bookkeeping

processes. These automation capabilities enable accountants/bookkeepers and
their clients to save time and increase efficiency, allowing them to spend more
time on business growth.

 The ability for data to be accessed regardless of location or device. This

facilitates remote services and “anytime” communication, which will help to build
stronger relationships between an accountant/bookkeeper and their clients.

 The ability for data to be updated in real-time. Being able to access financial
data and information quickly (i.e., in real time) will empower businesses to make
informed decisions sooner rather than later.

 The ability to easily scale to meet growing business needs. Let’s say your
business currently makes 0-100 transactions per month, but experiences rapid
growth that causes this number to jump to 10,000+ transactions per month. Your
cloud accounting software should be able to easily support this growth.

 The ability to facilitate a paperless environment. This will eliminate the need
to physically store and manage paper documents, which is not only beneficial
from a cost and office space perspective, but also for the environment.

47
 The ability to provide automatic updates. This will help to further improve the
functionality of the application and better enforce security.

 The ability to reduce costs. Cloud-based software does not incur the costs
associated with traditional software (including maintenance, upgrades, system
administration, etc.).

 The ability to integrate with other cloud solutions. These integration

capabilities will improve the efficiency and increase the power of your cloud
accounting technology stack.

3.2. Source documents for recording financial transactions

A source document is a starting point to record transaction. A source document is

an original record which contains the detail that supports or substantiates a
transaction that will be (or has been) entered in an accounting system. In the past,
source documents were printed on paper. Today, the source documents may be an
electronic record. Remember that there are many source of documents relating
with all information recorded in a business, but not all of them are source
documents for the accounting system.

For example, whenever a business transaction takes place involving sales or

purchases, receiving or paying money, or owing or being owed money, it is usual
for the transaction to be recorded on a source document. These documents are the
source documents of all information recorded by a business, but only invoices and
credit notes are source documents for accounting system.

48
Financial information contained in the source documents is recorded in the
computerised accounting system.

Sales system

49
 Customer order – sales order

Dispatch goods – delivery

note

Raise invoice – Sales invoice

Receive payment

Purchases system

50
 Placing order – purchase
order

Receive goods – goods

received note (GRN)

Receive invoice – (Purchase)

invoice

Make payment

An invoice is a source documents (sales INV, purchase INV)

A credit note is a document issued to a customer relating to returned goods, or

refunds when a customer has been overcharged for whatever reason. It can be
regarded as a negative invoice.

Example and discussion:

Suppose China Supplies sent out a sales invoice to a customer (a shop) for 20
dinner plates, but the person creating the invoice accidentally typed in a total of
£162.10, instead of £62.10. The shop has been overcharged by £100. What is
China Supplies to do?

Another shop received 15 plates from China Supplies but found that they had all
been broken in the post. Although the shop has received an invoice for, say,

51
£45.60, it has no intention of paying it because the plates were substandard. Again,
what is China Supplies to do?

A debit note might be issued to a supplier as a means of formally requesting a

credit note from that supplier. A debit note is not a source document.

Activity: Which ones are source documents?

 Debit notes

 Credit notes

 Sales invoice

 Purchase invoice

 Sales order

 Purchase order

 Goods received notes

 Cheques

 Bank transfer slip

Value added tax (VAT) is sales tax added to most sales invoices in UK. VAT
ultimately be paid to or received from HMRC

Question: For sales and purchases on credit – can you name some source
documents?

Other source documents:

 Settlement of credit transactions (cheque, card payment, bank

transfer)

 Cash

 Wages

52
3.3. Recording bank transactions

3.3.1. Electronic banking

Electronic banking has changed how business record transactions through the
bank

 Traditionally: separate cash book – records all bank cash transactions (At the
end of month: reconcile with bank statement).
 Electronic banking: constant access to bank accounts – use bank information
to update accounting records on regular basis.
Transaction report is a source document which is uploaded into computerised
accounting system.

 ‘Known’ transaction – matched and the system processes.

 ‘Unknown’ transaction (temporary account (suspense account) – exception
report).
3.3.2. Cash at bank account
Cash at bank account is record all receipts and payments (uploaded from
transaction report).

Physical cash and cheques are also be recorded in cash at bank account. Total
amounts withdrawn or paid into the bank will be shown on the transaction report
downloaded from electronic banking system and are likely to be identified as
unmatched exceptions by the accounting system. Once investigated and
identified, these payments or deposits will be entered into the accounting system,
in the cash at bank account as described above.

Petty cash (notes and coins) is kept in business premises to make occasional
payments – separate account.

53
3.4. Petty cash book

3.4.1. What is the petty cash book used for

 Petty cash book: book/spreadsheet in which payments and receipts of petty
cash are recorded – source document
 Imprest system: amount of money in petty cash is kept at an agreed sum -
the imprest amount or ‘float’ (ie, £250 in the illustration p.76)
 Worked Example 3.1: Expense items are recorded on vouchers as they
occur:
£

Cash still held in petty cash 195

Plus vouchers for payments (25 + 5 + 10 + 15) 55

Must equal the agreed sum or float 250

The total float is made up regularly (to £250, or whatever the agreed sum is) by
means of a cash payment from the bank account into petty cash. The amount of
the 'top up' into petty cash will be the total of the voucher payments since the
previous top up.

3.5. The payroll

3.5.1. What is the payroll used for?

Payroll is the record of wages and salaries costs – source document. The payroll
records all the individual amounts that appear on employees' payslips:

 Gross pay to employees:

 PAYE income tax

 Employee's NI contributions

54
  Employee's pension contributions

 Net pay (cash paid to employees)

 Additional costs for the employer:

 Employer's NI contributions

 Pension contributions

Gross pay is not the amount paid to the employee. The employer needs to make
deductions from gross pay before paying net pay to the employee.

_End of Chapter 3_

CHAPTER 4: LEDGER ACCOUNTING AND DOUBLE ENTRY

LEARNING OBJECTIVES:
 Identify the sources of information for preparation of accounting records
and financial statements
 Record and account for transactions and events resulting in income,
expenses, assets, liabilities and equity in accordance with the appropriate

55
 basis of accounting and laws, regulations and accounting standards
applicable to financial statements.
 Prepare journals for nominal ledger entry and correct errors in draft
financial statements

4.1. Ledgers
Let’s go back to the old days of paper and real accounting paper books. A journal
records all the transactions in date order. Then, they are sorted and “posted” to a
book which is organized by type of account, the ledger. “Accounts” are defined
by the “chart of accounts” which is basically a listing of the various asset, liability,
equity, income and expense types. The Ledger accounts sort the transactions by
type, so that we can see how much of each category we have received, spent, have
left over, etc. In the old days, there would be a page for each account, upon which
would be written the journal entries which affected that account. The running
balance would be shown. In other words, it is a classification process that allows
us to summarize further into the financial statements, the balance sheet and
income statement. That let’s us know what our income is, what assets we have,
and what liabilities we owe, in summary. This whole process was turned upside
down by the computer.

In a computerized system, we maintain a database. When we view the database

by date, we have a journal. When we view the database by “account” or type, we
have a ledger. So, we no longer have “ledger accounts” per say. We just view the
database in a certain way.

There three main types of ledgers that any accounting system may use to record
and analyze its major transactions and events:

 Nominal ledger: contained a separate ledger account for each type of

income, expense, asset, liability and capital

56
  Receivables ledger: contained a separate ledger account for each credit
customer
 Payables ledger: contained a separate ledger account for each credit
supplier

4.2. The nominal ledger

Nominal ledger (also commonly referred to as the general ledger) is a main
accounting record in which financial transactions are recorded.

The nominal ledger is the main area where all of your accounting transactions are
held. The ledger contains the records of all of the payments, expenses,
and assets of a company that take place over the lifetime of the business. The
information contained in the nominal ledger is used to compile the financial
reports (such as the profit & loss report and the balance sheet) at the end of
each accounting period or when the reports are needed.

Following image shows the format of a nominal ledger

57
4.3. Double entry bookkeeping
Double entry bookkeeping: Each transaction has an equal but opposite effect.
Every accounting event must be entered in ledger accounts both as a debit and
a credit

4.3.1. Dual effect (duality concept)

Dual effect (Duality concept): Every transaction has two effects

Eg. When you purchase a car; or if you got a bank loan; or when you pay the
garage to have the exhaust repaired…

Ledger accounts, with their debit and credit sides, are kept in a way which allows
the two sided nature of every transaction to be recorded. This is known as double
entry bookkeeping, because every transaction is recorded twice in the ledger
accounts.

4.3.2. The rules of double entry bookkeeping

A debit entry will:

· increase an asset · decrease a liability

· increase an expense · decrease capital

· decrease income

A credit entry will:

· decrease an asset · increase a liability

· decrease an expense · increase capital

· increase income

Required: Draw the T account for each type of accounts: Asset, Liability, Capital,
Income, Expense?

Required: Fulfill the format of the Nominal Ledger?

58
4.4. Journal entries
A journal entry is a way of presenting the required double entry (debits and
credits) for a transaction.

Any transaction can be presented by a journal entry. However, journal entries are
generally used to record unusual or one off transactions, such as correction of an
error.

In manual accounting or bookkeeping systems, business transactions are first

recorded in a journal...hence the term journal entry.

Journal entries that are recorded in a company's general journal will consist of
the following:

 the appropriate date

 the account(s) and amount(s) that will be debited
 the account(s) and amount(s) that will be credited
 a short description/memo/reference

59
The journal entries appear in a journal in order by date and are then posted to the
appropriate accounts in the general ledger.

Computerized accounting systems will automatically record most of the business

transactions into the general ledger accounts immediately after the software
prepares the sales invoices, issues checks to creditors, processes receipts from
customers, etc. Hence, we will not write journal entries for most of the business
transactions.

There are several types of journal entries, including the following:

 Adjusting entry. An adjusting entry is used at month-end to alter the

financial statements to bring them into compliance with the relevant
accounting framework, such as Generally Accepted Accounting
Principles or International Financial Reporting Standards. For example,
you could accrue unpaid wages at month-end if the company is on the
accrual basis of accounting.
 Compound entry. A compound journal entry is one that includes more than
two lines of entries. It is frequently used to record complex transactions, or
several transactions at once. For example, the journal entry to record
payroll usually contains many lines, since it involves the recordation of
numerous tax liabilities and payroll deductions.
 Reversing entry. This is typically an adjusting entry that is reversed as of
the beginning of the following period, usually because an expense was to
be accrued in the preceding period, and is no longer needed. Thus, a wage
accrual in the preceding period is reversed in the next period, to be replaced
by an actual payroll expenditure.
In general, do not use journal entries to record common transactions, such as
customer billings or supplier invoices. These transactions are handled through
specialized software modules that present a standard on-line form to be filled out.

60
Once you have filled out the form, the software automatically creates the
accounting record. Thus, journal entries are not used to record high-volume
activities.

Examples of Journal Entries

Even with computerized accounting systems some general journal entries are
necessary. Common general journal entries are the adjusting entries. For example,
prior to issuing the company's financial statements there will be an adjusting entry
to record depreciation. This journal entry will debit Depreciation Expense and
will credit Accumulated Depreciation.

Another example of a general journal entry is the adjusting entry to accrue

interest on a bank loan. This journal entry will debit Interest Expense and will
credit Interest Payable.

Format of a journal entry is as follows.

Date Debit Credit

£ £

Account to be debited X

Account to be credited X

A narrative explanation should accompany each journal entry. It is required for

audit and control, to indicate the purpose and authority of every transaction which
is not first recorded in a book of original entry

A computerised accounting system will not allow a journal entry to be processed

if the debit entries do not equal the credit entries.

Worked Example 4.1

61
Required: Give examples of the following transactions and record them into the
General Journal.

4.5. Double entry for petty cash

Worked Example 4.2

Suppose five payments were made out of petty cash during March 20X9, none of
which attracted VAT. The petty cash book might look as follows:

Total Date Narrative Total Postage Travel

receipts payments
£ £ £ £
250.00 1.3.X9 Cash
2.3.X9 Stamps 12.00 12.00

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 8.3.X9 Stamps 10.00 10.00
19.3.X9 Travel 16.00 16.00
23.3.X9 Travel 5.00 5.00
28.3.X9 Stamps 11.50 11.50
250.00 54.50 33.50 21.00

Required: Complete the petty cash book for March 20X9.

4.6. The receivables and payables ledgers

4.6.1. Nominal ledger accounts and personal accounts

Nominal ledger accounts relate to types of income, expense, asset, capital and
liability – rent, sales, trade receivables, payables and so on

There is also a need for personal accounts, most commonly for receivables and
payables - contained in the receivables ledger and the payables ledger. Keeping
each credit customer's account separately enables us to identify at any moment
how much that customer owes us; similarly, the technique enables us to tell
exactly how much we owe each credit supplier. Any disputes with customers or
suppliers can thereby be more easily resolved.

These are memorandum accounts only, in memorandum ledgers; they are not
part of the double entry system.

The accounts receivable ledger is also known as the accounts receivable subledger
or accounts receivable subaccount.

4.6.2. The receivable ledger

Definition: The receivable ledger, also called the customers ledger, is a subsidiary
ledger that lists all the customers that owe money to the company along with their
current balances. In other words, the Receivable ledger is a summary of all current

63
and outstanding accounts receivable at the end of a period. This individual detail
of every customer’s balance is not listed or recorded in the general ledger.

Example

When a customer purchases a product on credit, the store debits its Account
receivable balance and credits a sale account. When the customer makes a
payment to pay down his account balance, the debits cash and credits the A/R
balance. Both of these transactions are tracked in the subsidiary ledger, so at the
end of the period the bookkeeper can print a report with the total balances owed
by each customer. They can also use this ledger for debt collection purposes on
customers who aren’t making their payments.

4.6.3. The payable ledger

Definition: The accounts payable ledger, also called the creditors ledger, is a
subsidiary ledger that lists all of the vendors and suppliers that a company owes
along with their account balances and details. In other words, the A/P ledger is a
summary of all the current and outstanding accounts payable. This is a list that is
not detailed in the general ledger of all the vendors and other companies that are
owed money.

Example

The accounts payable ledger does just this. It tracks the amounts owed to different
vendors along with the dates, order quantities, and other purchase information
without cluttering up the general ledger with all of this detail. The general ledger
simply pulls total balances from the accounts payable ledger and reports it in one
accounts payable account.

The A/P ledger can be used to provide current information about vendor balances.
It also acts as an internal control. Bookkeepers and managers can compare the
subsidiary balance with the general ledger balance to help prevention errors. It

64
also acts as an internal control by segregating the duties of employees. The
employee who records the transactions on a daily basis is not the person who
checks for errors.

4.7. Accounting for discounts

Discount is a reduction in the price of goods below the amount at which those
goods would normally be sold to other customers.

There are two types of discount: trade discount and early payment discount (or
early settlement discount).

4.7.1. Trade discounts

Trade discount is a percentage discount deducted from the list price of goods
owing to the nature of the trading transaction.

Examples of trade discount

 A customer is quoted a price of £1 per unit for a particular item, but a lower
price of 95p per unit if the item is bought in quantities of 100 units or more
at a time. This is sometimes called bulk discount.
 An important customer or a regular customer is offered a discount on all
the goods they buy, regardless of the size of each individual order, because
the total volume of their purchases over time is so large.
Accounting for trade discounts

 Purchases: recorded net of trade discounts received. Trade discount

received should be deducted from the gorss cost of purchases by the
supplier. The cost of purchases in the payables ledger will be stated at gross
cost minus discount, ie, the invoiced amount.

 Sales: recorded net of trade discounts allowed. Trade discount allowed

should be deducted from the gross sales price by the business, so that

65
 revenue will be reported at invoice value net of trade discount allowed, ie,
the invoiced amount.

4.7.2. Early settlement discounts

Early settlement discount, also called a prompt payment or cash discount, is
a percentage reduction in the amount payable in return for payment within an
agreed period.

If you are a buyer and receive a £1,000 Net 30 invoice. If you pay the invoice
within 10 days of receiving it, you may be able to deduct 2%, or £20, from the
payment. On the invoice, these terms would be noted as 2/10 – net 30. In other
words, if you pay in 10 days or less, the invoice can be settled for £980 instead of
£1,000. If you pay after 10 days, you must pay the full £1,000.

Accounting for early settlement discounts offered to customers:

 When sale is recorded, the business should determine whether they expect
customer to take the discount or not.

 When payment is made, if customer does not behave as expected =>

adjustments.

Accounting for early settlement discounts received from suppliers:

 When purchase is recorded, the business should determine whether they

expect to take the discount or not.

 When payment is made, if the business does not behave as expected =>
adjustments.

4.8. Accounting for VAT

4.8.1. What is VAT

VAT is an indirect tax on the supply of goods and services

66
VAT is collected at each transfer point but consumer bears the VAT in full

Worked Example 4.3

A manufacturing company, A Ltd, purchases raw materials at a cost of £1,000

plus VAT at the standard rate of 20%. From the raw materials A Ltd makes
finished products which it sells to a retail outlet, B plc, for £1,600 plus VAT at
20%. B plc sells the products to customers at a total price of £2,000 plus VAT at
20%. How much VAT is paid at each stage in the chain?

4.8.2. How is VAT collected?

Although it is final consumer who bears the full VAT (£400), the sum is collected
and paid by the traders who make up the chain, provided they are registered for
VAT

Each trader must collect and pay over VAT at appropriate rate (*) on full sales
value (output tax)

Trader normally entitled to reclaim VAT paid on his own purchases of goods,
expenses and noncurrent assets (input tax) and so makes a net payment to
HMRC

4.8.3. Registered and non-registered traders

Traders whose sales below a certain level need not register for VAT although they
may do so voluntarily(*)

Unregistered traders neither charge output VAT nor are entitled to reclaim input
VAT (**)

All outputs of registered traders are either taxable or exempt. Traders carrying on
exempt activities (eg, banks) cannot charge output VAT and consequently cannot
reclaim input VAT

Taxable outputs are chargeable at one of three rates

67
Zero rate (eg, printed books; newspaper)

Reduced rate (5%) (eg, domestic fuel)

Standard rate (20%)

Most traders account quarterly to HMRC for VAT

General rule: VAT should not be included in income or expenses (WHY?)

4.8.4. Irrecoverable VAT

Non-registered traders

Registered traders carrying on exempted activities

Non-deductible inputs

Cars purchased and used by business (*)

Business entertaining (except staff entertaining) (**)

4.8.5. VAT and discounts

Rule: output VAT is accounted for on the amount actually received from the
customer => 2 options

Invoice issued in normal way + credit note

Invoice states full value + footnote detailing terms of early settlement discount +
statement ‘customer can only recover input tax actually paid to supplier’ (*)

Note: option (ii) is adopted in this S/M

4.8.6. VAT and irrecoverable debts

Most registered persons are obliged to record VAT when a supply is made or
received (regardless of cash payment) => output tax may have to be paid to
HMRC before it has all been received from customers.

68
If an a/m due is subsequently written off as irrecoverable, the VAT element may
not be recoverable from HMRC for some time after the sale.

4.8.7. Summary of accounting entries for VAT

Sales revenue shown in SPL must exclude output VAT. Trade receivables will
include VAT (WHY?)

The double entry for credit sales of £500,000 excluding VAT:

DEBIT Trade receivables (incl. VAT/gross) 600,000

CREDIT Sales (excl. VAT/ net) 500,000

VAT a/c (20% x £500,000) – output tax 100,000

b) Expenses shown in SPL must exclude input VAT. Trade payables will include
input VAT (WHY?)

Double entry for purchases of £400 (VAT exclusive):

DEBIT Purchases expense (net) 400

VAT (20%x£400) – input tax 80

CREDIT Trade payables (gross) 480

c) Sales revenue received and expenses paid as cash transactions must have the
VAT recorded and then posted as above in (a) and (b) (HOW?)

(d) Irrecoverable VAT on expenses or NCA must be included in the cost of the
expense or NCA

(e) The net amount due to HMRC should be included in other payables (or other
receivables) in SFP

4.8.8. Calculating VAT from gross amount

Worked example 4.4

69
A sale of £200 attracts VAT at 20%, i.e. £40. The gross amount is £240. To get
back to the VAT element: £240 x 1/6 = £40

Interactive question 4.1

Mussel is preparing financial statements for the year ended 31 May 20X9.
Included in its statement of financial position as at 31 May 20X8 was a balance
for VAT due from HMRC of £15,000.

Mussel’s summary statement of profit or loss for the year to 31 May 20X9 is as
follow:

£‘000
Revenue (net) (all standard rated) 500
Purchases (net) all standard rated) (120)
Gross profit 380
Expense (see note) (280)
Net profit 100

£‘000
Note: Expenses
Wages and salaries (exempt of VAT) 162
Entertainment expenditure (£40 + 48
irrecoverable VAT £8)
Other (net) (all standard rated at 20%) 70
280

In respect of VAT payments of £5,000, £15,000 and £20,000 have been made in
the year to HMRC and repayment of £12,000 was received.

Requirement

70
What is the balance for VAT in the statement of financial position as at 31 May
20X9? Assume a 20% standard rate of VAT (Hint: Use a T account for VAT)

_End of Chapter 4_

71
CHAPTER 5: PREPARING BASIC FINANCIAL STATEMENTS

LEARNING OBJECTIVES:

1. Prepare a trial balance from accounting records and identify the uses of a
trial balance
2. Prepare an extended trial balance
3. Prepare and present a statement of financial position, statement of profit or
loss and statement of cash flow (or extracts) from the accounting records
and trial balance in format which satisfies the information requirements of
the entity

How to balancing ledger accounts

A ledger account is balanced by:

- First, totaling both sides of the accounts, giving two separate totals;
- Then, subtracting the smaller amount from the larger one;
- And inserting this as balance on the side which had the smaller total.

5.1. The trial balance

Trial balance is a list of nominal ledger account balances shown in debit and
credit columns at a point in time. It is a method of testing the accuracy of double
entry bookkeeping. The trial balance is not part of the double entry system. It is
the starting point to preparing FSs.

The trial balance is not a financial statement. It is mainly an internal report that
is/was useful in a manual accounting system. If the trial balance did not "balance"
it signaled an error somewhere between the journal and the trial balance. Often
the cause of the difference was a miscalculation of an account balance, posting a
debit amount as a credit (or vice versa), transposing digits within an amount when
posting or preparing the trial balance, etc.

72
Today's accounting software has been written to eliminate those errors. Hence,
the trial balance is less important for bookkeeping purposes since it is almost
certain that the general ledger and the trial balance will have the debits equal to
the credits.

The trial balance continues to be useful for auditors and accountants who wish to
show:

1. The general ledger account balances prior to their proposed adjustments;

2. Their proposed adjustments;
3. All of the account balances after the proposed adjustments.

The adjusted amounts make up the adjusted trial balance, and the adjusted
amounts will be used in the organization's financial statements.

5.1.1. Listing ledger account balances in the trial balance

Example:

Debit (£) Credit (£)

Cash at bank 6,530
Capital 7,000
Bank loan 1,000
Purchases 5,000
Trade payables 0
Rent 3,500
Shop fittings 2,000
Sales 12,500
Trade receivables 0
Discount received 20
Discount allowed 100
Bank loan interest 1,900
Other expenses 1,500
Drawings 1,500
20,550 20,550

It does not matter in what order the various accounts are listed in the trial balance

73
5.1.2. Potential errors in a TB

 In conputerised accounting system, the TB will always balance because the

system will only accept the entry of transactions in which the debits equal the
credits. (In manual accounting system, TB provides a good check that the rules
of double entry have been maintained)

 Usage: to check reasonableness of nominal ledger account balances

 Note: even when TB balances, potential error types:

 Omission errors: A transaction is completely omitted, either in the nominal

ledger, or the trial balance itself, so neither a debit nor credit is made

 Commission errors: a debit or credit is posted to the correct side of the

nominal ledger, but to a wrong account, eg, rent paid are debited to other
expense account

 Compensating errors: one error is exactly cancelled by another error

elsewhere.

For example: although unlikely, in theory two transposition errors of £540 might
occur in extracting ledger balances, one on each side of the double entry. In the
administration expenses account, £2,282 might be written instead of £2,822.
Meanwhile, in the sundry income account, £8,391 might be written instead of
£8,931. Both the debits and credits would be £540 too low, and the mistake would
not be apparent when the TB is cast.

 Errors of principle: Making a double entry in the belief that the transaction
is being entered in the correct accounts, but subsequently finding out that
the accounting entry breaks the “rule” of an accounting principle or
concept.

For example, a company may record personal expenses as business expenses. An

error of principle is different than failing to record the item in question (“error of

74
omission”), or recording the wrong value in the correct account (“error of
commission”). These errors are referred to as input errors. They're especially
problematic in taxes.

Worked Example 5.1: An expense is treated as revenue expenditure instead of

capital expenditure

(a) Repairs to a machine costing £150 should be treated as revenue

expenditure, and debited to a repair account. If, instead, the repair costs are added
to the cost of the NCA (capital expenditure) an error of principle would have
occurred. As a result, although total debits still equal to total credits, the repairs
account is £150 less than it should be and the cost of the NCA is £150 greater than
it should be
(b) The proprietor of the business sometimes takes cash out of the till for their
personal use and during a certain year these withdrawals on account of profit
amount to £280. The bookkeeper states that they have reduced cash sales by £280
so that the cash book could be make to balance. This would be an error of
principles, and the result of it would be that the withdrawal account is understated
by £280, and so is the total value of sales in the sales.

Errors that can be detected by a TB

 Errors of transposition
 Errors of omission (if the omission is one-sided)
 Errors of commission (if one-sided, or two debit entries are made)

5.1.3. Making adjustments after the TB is extracted

 Adjustments: for errors or period end journals after TB extracted

 Adjustments: must be recorded in nominal ledger accounts using

adjustment journals => adjust the TB (final TB)

 Worked example 5.2: Trial balance and adjustment journals

75
As at 31.3.20X9, a business, which is not registered for VAT, has the following
nominal ledger balances

Balance (£)
Bank loan 12,000
Cash at bank 11,700
Capital 13,000
Rent 1,880
Trade payables 11,200
Purchases 12,400
Sales 34,600
Other payables 1,620
Trade receivables 12,000
Bank loan interest 1,400
Other expenses 11,020
Non-current assets 22,020

On 31.3.X9 the business made the following transactions after the balances listed
above had been calculated

 Bought materials for £1,000, half for cash and half on credit
 Made sales of £1,040, £800 of which were on credit
 Paid wages to shop assistants of £260 in cash

Required: Draw up a trial balance showing the balances as at the end of 31.3.X9

5.1.4. Processing adjustments to the TB

 An alternative way of presenting the adjustments is using a columnar

approach:

 Additional debit column and credit column are created.

 Final TB created

Extended TB

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Another way to present this information is extended TB. This has debit and credit
columns for the initial TB, plus debit and credit columns for adjustment journals.
A revised TB is then created by cross casting horizontally

To a debit balance in the TB, add debits and subtract credits from the adjustment
columns. If the result is positive, insert it in the debit column of the revised trial
balance. If it is negative, insert it in the credit column of the revised trial balance.

To a credit balance in the TB, subtract debits and add credits. If the answer is
positive, insert it in the credit column of the revised trial balance. If it is negative,
insert it in the debit column of the revised trial balance.

TB Adjustment Revised TB
Debit Credit Debit Credit Debit Credit
Bank loan 12,000 12,000
Cash at bank 11,700 240 760 11,180
Capital 13,000 13,000
Rent 1,880 1,880
Trade payables 11,200 500 11,700
Purchases 12,400 1000 13,400
Sales 34,600 1040 35,640
Other payables 1,620 1,620
Trade
12,000
receivables 800 12,800
Bank loan
1,400
interest 1,400
Other expenses 11,020 260 11,280
Non-current
22,020
assets 22,020
72420 72420 2300 2300 73,960 73,960

5.2. Balancing off ledger accounts

For Income & expense accounts: balance is transfered to a profit and loss ledger
account, leaving nil balance in the income or expense account

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For asset, liability & capital: balance is carried down and brought down to give
the opening balance for next period

How a cash at bank account is balanced (4 steps):

(i) First, the debits, and then the credits are totalled, giving two separate totals.
(ii) The larger total is placed in the total columns on both the debit and credit
side of the account.
(iii) The smaller total is then subtracted from the larger total – this amount is
inserted as a balance on the side which had the smaller total – balance c/d
(iv) The balance c/d at end of one period becomes balance b/d at start of the
following priod.

5.3. Preparing the SPL

5.3.1. Preparing the profit and loss ledger account

 Create a new ledger account in the nominal ledger – the P&L ledger account
 Transfer all ledger account balances relating to the SPL (ie, income and
expense) to the P&L account. When we transfer or 'clear' these accounts, we
double underline both sides of the ledger account we are transferring from to
show that the balance is now zero

PURCHASES

£ £

Trade
payables 5,000 P/L a/c 5,000

78
 RENT

£ £

Cash at bank 3,500 P/L a/c 3,500

SALES

£ £

P/L a/c 12,500 Cash at bank 10,000

T/Receivables 2,500

12,500 12,500

DISCOUNT RECEIVED

£ £

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 Trade
P/L a/c 50 payables 50

DISCOUNT ALLOWED

£ £

Trade
receivables 20 P/L a/c 20

BANK LOAN INTEREST

£ £

Cash at bank 100 P/L a/c 100

OTHER EXPENSES

£ £

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Cash at bank 1,900 P/L a/c 1,900

PROFIT AND LOSS LEDGER ACCOUNT (P/L a/c)

£ £

Purchases 5,000 Sales 12,500

Discount
Rent 3,500 received 50

Discount
allowed 20

Bank loan
interest 100

Other expenses 1,900

Profit for the

period 2,030

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 12,550 12,550

5.4. Preparing the SOFP

5.4.1. Transferring profit/loss to capital account

 The owner's capital comprises

 Cash introduced (contained in capital account)

 Plus any profits (Less any losses) (ie, balance of P&L a/c)

 Less any drawings (contained in drawings account)

 To determine the closing capital balance we combine these in the capital

account

5.4.2. Preparing the SOFP

 Balances of accounts representing assets, capital and liabilities of the

business (not income and expenses) are carried down in the books of the business
(*)

 Important note (**):

 A debit balance brought down denotes an asset

 A credit balance brought down denotes a liability

Worked example 5.3:

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A business is established with capital of £2,000 paid by the owner into a business
bank account, which has an overdraft facility. During the first year’s trading, the
following transactions occurred:

£
Purchases of goods for resale, on credit 4,300
Payment to suppliers 3,600
Sales, all on credit 5,800
Payments from customers 3,200
Non-current assets purchased for cash 1,500
Other expenses, all paid in cash 900

Required: Prepare ledger accounts, a statement of profit or loss for the year and
a statement of financial position

Interactive question 5.1: P/L ledger account

Polly had the following transactions in her first year of trading as a beauty
therapist visiting clients at home

1.1.X1 Opened a bank account with £400. Took out bank loan for
£5,000, and agreed an overdraft limit of the same account
1.1.X1 Bought car for £2,500 cash. Insured it for £300 cash.
Bought other equipment for £1,500, and consumable items
for £500, both on credit
During year: Charged customers £15,945, all on credit
During year: Purchased further consumables for £3,690 on credit, and
diesel for car for £650 in cash
During year: Took £1,250 in cash for ATMs for herself
By the end of Received £12,935 from customers and paid £3,250 to
year: suppliers

Required: Prepare Polly’s ledger accounts including a P/L ledger account, and
draw up a statement of profit or loss and SOFP in respect of her first year of
trading.

_End of Chapter 5_

83
84
CHAPTER 6: CONTROL ACCOUNTS, ERRORS AND
SUSPENSE ACCOUNT

LEARNING OBJECTIVES:
Prepare a trial balance from accounting records and identify the uses of a trial
balance

Identify omission and errors in accounting records and financial statements and
demonstrate how the required adjustments will affect profit or losses

Correct omissions and errors in accounting records and financial statements using
control account reconciliations and suspense accounts

6.1. Reconciling to external documents

Account reconciliation is the process of comparing internal financial records
against monthly statements from external sources—such as a bank, credit card
company, or other financial institution—to make sure they match up. Knowing
how to reconcile your accounts accurately is essential for the financial health of
your business, as it helps to detect any errors, discrepancies, or fraud.

Definition:

 Trade receivables acount vs receivables ledger:

 Trade receivables account ( A receivable control account) is a nominal

ledger account in which records are kept of transactions involving all
receivables in total. The balance on the receivable control account at any
time will be the total amount due to the business from all its credit
customers.
 Receivable ledger: Record each transaction for individual customer. This is
not part of double entry system if control accounts are maintained.

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At any time the balance on the trade receivables account should be equal to the
sum of the individual personal account balances on the receivables ledger.

Most receivable control accounts have balances on debit. Some customers may
have credit balances due to over paid, returns of paid goods or prepayments from
customers.

 Trade payables acount vs payables ledger

 Trade payables account (a payable control account) is a nominal ledger

account in which records are kept of transactions involving all payables in
total, and the balance on this account at any time will be the total amount
owed by the business to all its credit suppliers
 Payables ledger: Record each transaction for individual supplier. This is not
part of double entry system if control accounts are maintained.
 At any time the balance on the trade payables account should be equal to
the sum of the individual personal account balances on the payables ledger.

At any time the balance on the trade payables account should be equal to the sum
of the individual personal account balances on the payables ledger.

Most payables control accounts have balances on credit. Some suppliers may have
debit balances due to over paid, returns of paid goods or prepayment to suppliers.

Worked Example 6.1:

A payables control account contains the following entries:

£
Bank 79,500
Credit purchases 83,200
Discount received 3,750
Contra with receivables control account 4,000

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Balance c/d at 31 December 20X9 12,920

There are no other entries in the account. What was the opening balance brought
down at 1 January 20X9?

 Contra accounts:

When a person or business is both a customer and a supplier, amounts owed by

and owed to the person may be “netted off” by means of contra:

Dr. Payables control account (and personal account in the payable ledger)

Cr. Receivable control account (and personal account in the receivable

ledger)

Note:

Manual system: important to reconcile trade receivables/payables account to

receivables/payable ledger because in this system, the data is input twice …..

Computerised system: no need to reconcile (WHY?)

However: reconcile to external documents

 Bank reconciliation:

 Source document for entries into accounting system

 External record against which accounting records are checked

 Supplier statement reconciliation:

 Compare transactions listed in payables ledger to those detailed on supplier

statements
 Eg. of discrepancies: early settlement discount/return of goods not shown
on supplier statement; credit note not shown on payables ledger…

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6.2. Bank reconciliation
A bank reconciliation is the process of matching the balances in an entity's
accounting records for a cash account to the corresponding information on a bank
statement. The goal of this process is to ascertain the differences between the two,
and to book changes to the accounting records as appropriate. The information on
the bank statement is the bank's record of all transactions impacting the entity's
bank account during the past month.

Comparing transactions and balances is important because it helps to avoid

overdrafts on cash accounts, catches fraudulent or overcharged credit card
transactions, explains timing differences, and highlights other negative activity,
such as theft or incorrectly recorded income and expense entries. This saves your
company from paying overdraft fees, keeps transactions error-free, and helps
catch improper spending and issues such as embezzlement before they get out of
control.

Reconciling accounts and comparing transactions also helps your accountant

produce reliable, accurate, and high-quality financial statements. Because your
company balance sheet reflects all money spent—whether cash, credit, or loans—
and all assets purchased with those funds, the accuracy of the balance sheet
strongly depends on the accurate reconciliation of your company's financial
accounts.

6.2.1. Cash at bank account and bank statement

 Cash at bank a/c: one of nominal ledger’s accounts

 Bank statement: record maintained by bank – mirror image of cash at bank

a/c:

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  Cash is an asset (dr balance) in business’s cash at bank a/c – but an
obligation from the bank’s perspective => dr balance in business’s books
will be shown as cr blance on bank statement!
 Similar: overdraft!
 Bank statement: A record of transactions on the business’s bank account
maintained by the bank in its own accounting record (why cash receipt -> credit
on bank statement)

 Bank reconciliation process: comparing cash at bank a/c to bank statement

Disagreement between cash book and bank statement due to:

 Error: Errors in calculation, or recording revenue and payments, may have

been made in the business cash book, by the bank or by both
 Unrecorded bank charges or bank interest: The bank might charge interest
or make charges for its services, which the customer is not informed about
and so cannot record until the bank statement is received
 Automated payments and receipts: Payments processed automatically by
the bank system (direct debits and standing orders), and receipts processed
automatically, may be shown on the bank statement, by not yet recorded in
the cash book
 Dishonoured cheques: When a customer sends in a cheque and it is banked,
the business debits the cash book. However, it may be returned unpaid or
“dishonourned” by the customer’s bank, usually because the customer has
insufficient funds. The dishonoured of the cheque will appear on the bank
statement and will need to be “written bank” in the ledger accounts”
DR Receivables

CR Cash at bank

 Timing differences:

89
 - There may be some cheques received, recorded in the cash book and paid
into the bank, but which have not yet been “cleared” (paid by the bank) and
added to the account by the bank. So although the business’s records show
that some cash has been added to the account, it has not yet been
acknowledged by the bank – although it will be soon, once the cheque has
cleared
- Similarly, the business might have made some payment by cheque, and
reduced the balance in the cash book accordingly, but the person who
receives the cheque might not bank it for a while. Even when it is banked,
it takes a day or two for the bank to process the bank to process it and for
the money to be deducted from the account.
All these differences need to be identified and eradicated, using the bank
reconciliation process.

6.2.2. The bank reconciliation

Bank reconciliation: a comparision of a bank statement (sent weekly,
monthly,….) by the bank with the cash book. Diffrences between the balance on
the bank statement and the balance in the cash book should be identified and
satisfactorily reconciled

 Errors in cash book (cash a/c adjustments?)

Errors such as transposition errors or cheque sent out but omitted from the cash
book. The correct amount appears on the bank statement and the cash book must
be updated.

Corrections and adjustments to the cash book:

- Payments made into or from the bank account by way of debit card,
standing order, direct debit or online transfer which have not yet been
entered in the cash book
- Bank interest and bank charges, not yet entered in the cash book

90
 - Dishonoured cheques not yet entered in the cash book
 Errors in bank statement (cash a/c adjustments?):

Errors like transposition errors, payments or receipts recorded twice or interest

and fee deducted incorrectly. The correct amount appears in the cash book and
the balance per the bank statement must be corrected (show in the bank
reconciliation)

 Items reconciling cash a/c to bank statement (timing differences)

- Unpresented cheques: cheques paid out by the business and credited in the
cash book which have not yet been presented to the bank, or cleared and so
not not yet appear on the bank statement.
- Uncleared lodgements: cheques received by the business, paid into the bank
and debited in the cash book but not yet been cleared and entered in the
bank account, and so do not yet appear on the bank statement.
Worked example 6.2: Bank reconciliation I

At 30 September 20X9, the balance in Wordsworth Co’s cash book was £805.15
debit. A bank statement on 30 September 20X9 showed Wordsworth Co to be in
credit at the bank by £1,112.30. On investigation of the difference, it was
established that:

(a) The cash book had been undercast by £90 on the debit side
(b) Cheques paid in but not yet credited by the bank were £208.20
(c) Cheques drawn not yet presented to the bank were £425.35

We need to show the correction to the cash book, the prepare a statement
reconciling the balance per the bank statement to the balance per the cash book

Worked example 6.3: Bank reconciliation II

91
At his year end of 30 June 20X0, Cook’s cash book showed that he had an
overdrafted of £300 on his current account at the bank. A bank statement as at 30
June 20X0 showed that Cook has an overdraft of £35.

On checking the cash book and the bank statement you find the following

(a) Cheques drawn, amounting to £500, had been entered in the cash book but
had not yet been presented
(b) Cheques received, amounting to £400 had been entered in the cash book
but had not yet been credited by the bank
(c) On instructions from Cook on 30 June 20X0 the bank had transferred £60
interest received on his savings account to his current account, but it only recorded
the transfer on 5 July 20X0. This amount was credited in the cash book on 30 June
20X0
(d) Bank charges of £35 shown in the bank statement had not been entered in
the cash book
(e) The payments side of the cash book had been undercast by £10
(f) Dividends received of £200 had been paid direct into bank and not been
entered in the cash book
(g) A cheque for £50 from Sunil was recorded and banked on 24 June. This
was returned unpaid on 30 June and then shown as a debit on the bank statement.
No entry has been made in the cash book for the unpaid cheque.
(h) A cheque issued to Jones for £25 was replaced when it was more than 6
month old, at which time it had become ‘out of date’ and the bank would have
refused to pay it. It was entered again in the cash book, no other entry being made.
Both cheques were included in the total of unpresented cheques shown above.

We need to make the appropriate adjustments in the cash book, then prepare a
statement reconciling the amended balance with that shown in the bank statement.

Interactive question 6.1: Bank reconciliation

92
A bank reconciliation statement is being prepared. Using the table select the effect
of each of the following on the closing balance shown by the bank statement of
£388 in hand. (The closing balance shown by the cash book is £106 in hand)

Increase Decrease No effect

A. The bank has made a mistake in
crediting the account with £110 belonging to
another customer – an error not yet rectified
B. £120 received by the bank under a
standing order arrangement has not been
entered in the cash book
C. Cheques totaling £5,629 have been
drawn, entered in the cash book and sent out to
suppliers but the have not been presented for
payment
D. Cheques totaling £5,577 have been
received and entered in the cash book but not
yet credited in the bank statements

Interactive question 6.2: Bank reconciliation

Tilfer’s bank statement shows £715 direct debits and £353 investment income not
recorded in the cash book. The bank statement does not show a customer’s cheque
for £875 entered in the cash book on the last day of the reporting period. The cash
book has a credit balance of £610. What balance appears on the bank statement?

93
6.3. Types of error in accounting

 Transposition errors: two digits in an amount are accidentally recorded

wrong way round

Example: A sale is credited in the sales account as £6,843, but debit the receivable
control account as £6,483. In consequence total debit is different from total credit:
£6,843 - £6,483 = £360. You can often detect a transposition error by checking
whether the difference between debits and credits can be divided exactly by 9
(360/9 = 40)

 Errors of omission: entire transaction is omitted

Example: A business receive an invoice from a supplier for £250, and the
transaction is omitted form the book. As a result, both total debit and total credit
will be wrong by £250

94
 Errors of principle: accounting entry breaks the ‘rules’ of accounting
principle concept

Example: a business owner takes £280 cash out of the till for his personal use.
The bookkeeper incorrectly debits sales by £280 when they should have debited
drawings. This is an error of principle, so the drawings and sales are both
understated by £280

 Errors of commission: wrong account (*)

Example: Putting a debit entry or credit entry in the wrong account

Casting error: daily credit sales in the sales day book of £28,425 are incorrectly
added up (miscast) as £28,825. This amount is credited to sales and debited to
receivables control. Although total debits and total credits are still equal, the
nominal ledger is incorrect by £400. Note that if the correct individual entries are
made in the receivables ledgers, the total on the list of balances will be right, but
it will not agree with the receivable control account balance.

 Compensating errors: errors cancel the others out

Example: Administrative expenses of £2,822 are entered as £2,282 in the

administrative expenses ledger account. At the same time, income of £8,931 is
shown in the sales account as £8,391. Both debits and credits are £540 lower, and
the mistake would not be apparent when the trial balance is cast.

Once an error has been detected, it needs to be put right

- If the correction involves a double entry in the nominal ledger accounts,

then it is recorded via an entry in the journal
- When the error breaks the rule of double entry, then it is corrected via a
journal entry using a suspense account to complete the double entry

95
6.4. Correcting errors
- Errors which have not caused an imbalance are corrected via journals
- Errors which have broken the rules of double entry bookkeeping and result
in the trial balance failing to balance can be corrected by (1) setting up a suspense
account and then (2) clearing it with correcting journals.
- A suspend account may also be deliberately set up when a bookkeeper does
not know where to put one side of an entry.
- Suspense accounts are always temporary and should never appear in
financial statements; these should not be prepared until the errors have been
corrected and the suspense account has been cleared.
- Some corrections of errors will result in adjustments to a draft profit
calculated while there were still errors in the accounts.

Errors that leave total debits and credits in the ledger accounts in balance can be
corrected just using journal entries

Where errors mean that the TB does not balance, a suspense account has to be
opened first, later cleared by a journal entry.

6.4.1 Journal entries

The journal requires a debit and an equal credit entry for each correction.

- If total debits equal total credit before a journal entry is made then they will
still be equal after the journal entry is made. For example, the original error was
a debit wrongly posted as a credit and vice versa.
- If total debits equal total credit are unequal before a journal entry is made,
they will still be unequal (by the same amount) after it is made.

6.4.2 Suspense accounts

Suspense accounts is an account showing a balance equal to the difference in a
trial balance

96
A Suspense accounts is a temporary account which can be opened for the
following reasons

- A TB is drawn up which does not balance

- The bookkeeper of a business knows where to post one side of a transaction,
but does not know where to post the other side. For example, a cash payment must
obviously be credited to cash, but the bookkeeper does not know what the
payment is for, and so will not know which account to debit. To complete the
double entry, he debits suspend accounts.

In both case, a suspense account is opened up until the problem is resolved

6.4.3. Using a suspense account when the trial balance does not balance
When an error has occurred which results In an imbalance between total debits
and total credits in the ledger accounts:

Step 1: Open a suspense account with the amount of the imbalance

Step 2 Use a journal entry to clear the suspense account and correct the error, It is
good practice for the correcting side of the double entry to appear first in the
journal, then the suspense account entry.

Worked example 6.4: Suspense account: An accountant draws up a trial balance

and finds that total debits exceed total credits by £162.

He knows that there is an error somewhere, but for the time being he opens a
suspense account with a credit balance of £162. This serves two purposes:

As the suspense account rnow exists, the accountant will not forget that there is
an error (of £162) to be sorted out.

Now that there is a credit of £162 in the suspense account, the trial balance
balances.

97
When the cause of the £162 discrepancy is tracked down, it is corrected by means
af a journal entry. Suppose the error was an omitted credit of £162 to the purchases
account. The correcting journal entry

CREDIT Purchases

DEBIT Suspense a/c

To close off suspense a/c and correct error of omission

Worked example 6.5 Suspense account and transposition error.

Instead of entering the correct amount of £37,453 in the sales account, a

bookkeeper entered £37,543 Trade receivables were posted correctly, so on the
trial balance credits exceeded debits by £(37,543 - 37,453) = £90.

Step 1: Equalise the total debits and credits by posting a debit of £90 to the
suspense account.

Step 2: Correcting journal entry; sales need to be reduced, and the suspense
account needs to be cleared.

DEBIT Sales

CREDIT Suspense a/c

To close off suspense a/c and correct transposition error

Worked example 6.6: Error of omission

A cheque payment of £250 was correctly credited to the cash account, but the
bookkeeper omitted to debit the expense account. On the trial balance, credits
exceeded debits by £250.

Step 1 Debit £250 to the suspense account, to equalise the total debits and total
credits.

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Step 2 Correcting journal entry: expenses need to be increased, and the suspense
account cleared

DEBIT Expenses account

CREDIT Suspense a/c £250

To close off suspense a/c and correct error of omission

Worked example 6.7: Error of commission

A cheque received for £460 is debited to cash but also debited to receivables
control, instead of being credited.

The total debit balances now exceed the total credits by 2 x £460 = £920.

Step 1 Make a credit entry of £920 in a suspense account, to equalise debits and
credits.

Step 2 Correcting journal entry: decrease trade receivables, and clear the suspense
account.

CREDIT Trade receivables

DEBIT suspense a/c

To close off suspense a/c and correct error of commission

Using a suspense account to complete the double entry

When a bookkeeper does not know where to post one side of a transaction, it can
be temporarily recorded in a suspense account. A typical example is when the
business receives cash through the post from a source which cannot be
determined, The double entry in the accounts would be a debit in the cash book,
and a credit to a suspense account.

Worked example 6.8: Not knowing where to post a transaction Windfall

Garments banks a cheque for £620 from RJ Beasley. The business has no idea

99
who this person is, nor why he should be sending £620. The bookkeeper opens a
suspense account:

DEBIT Cash

CREDIT Suspense a/c £620

It transpires that the cheque was in payment for a debt owed by the haute Couture
Corner Shon and OZ93 paid out of the owner's personal bank account. The
suspense account can now be cleared, as follow:

CREDIT Trade receivables

DEBIT Suspense a/c £620

Suspense accounts might contain several items

All errors and unidentifiable postings in a reporting period are merged together in
the suspense account; until the cause of each error is discovered, the bookkeeper
is unlikely to know exactly how many errors there are.

An exam question might give you a suspense account balance, together with
information to make corrections which will leave a nil balance on the suspense
account and correct balances on the nominal ledger accounts.

Suspense accounts are temporary

It must be stressed that a suspense account should only be temporary. Postings to

a suspense account made when the bookkeeper doesn't know yet what to do, or
when an error has occurred.

Threre should be no suspense account when it comes to preparing the statement

of profit or loss id statement of financial position. The suspense account should
be cleared and all correcting entries made before the final financial statements are
drawn up.

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Adjustment of profits for errors

Correcting errors can affect either the statement of financial position, the
statement of profit or loss, or sometimes both. An error of omission corrected by
debiting sales and crediting suspense with £90 meant that sales decreased, so gross
profit was reduced by £90 as a result of the error being corrected.

If there are still errors to be corrected after the trial balance and initial statement
of profit or joss and statement of financial position have been prepared, then
corrections will alter those draft financial statements.

You may need to demonstrate how draft financial statements are affected by error
corrections by calculating:

- How much gross or net profit is increased or reduced as a result of error

correction
- The final gross or net profit after the error correction

Interactive question 5.3: Errors

At T Down & Co year end, the trial balance contained a suspense account with a
credit balance ot £1,040. Investigations revealed the following errors.

(i) A sale of goods on credit for £1,000 had been omitted from the sales
account.

(ii) Delivery and installation costs of £240 on a new item of plant had been
recorded as revenue expenditure in the distribution costs account.

(iii) Cash discount of £150 had been taken on paying a supplier, W, even though
the payment was made outside the time limit. JW is insisting that £150 is still
payable

(iv) A raw materials purchase of £350 had been recorded in the purchases account
as £850, but the trade payables account was correctly written up.

101
(v) The purchases day book included a credit note for £230 as an invoice in the
total column. The correct entry was made in the purchases account.

Requirements

(a) Prepare journal entries to correct each of the above errors. Narratives are
not required
(b) Open a suspense account and show the correction to be made
(c) Before the errors were corrected, T Down & Co's gross profit was
calculated at £35,750 and the net profit for the year at £18,5500. Calculate the
revised gross and net profit figures after correction of the errors.

6.5. Adjusting the initial TB for errors

The journals which correct errors and make other adjustments can be put through
the adjustments columns of the extended trial balance. Section overview In
Chapter 5 we saw how an extended trial balance made the preparation of the
statement profit or loss and statement of financial position easier and more clear-
cut. The ETB is also useful when the balance has been prepared. This is especially
the case where a suspense account had to be used to to make the trial balance
agree.

Worked example 6.9: Error correction on the ETB

Handle extracted a trial balance and created a suspense account. He inserted the
TB on his extended trial balance as follows:

Ledger Trial balance Adjustments SOPL SOFP

balance Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
£ £ £ £ £ £ £ £
Cash at bank 5,415

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Opening 10,000
capital
Loan 5,000
NCA 30,000
Trade 18,689
payables
Expenses 6,781
Purchases 21,569
Sales 38,974
Trade 9,445
receivables
Suspense 6,400
Drawings 5,853
Net profit
79,063 79,063

Hanlde has now discovered the following matters:

(a) An amount of £1,000 was credited on the bank statement in the year and
entered in the cash book, but no other entry was made as the bookkeeper did not
know what the receipt was in respect of. Hanlde tells you it was a payment on
account from a major customer.

(b) A non-current asset was purchased on credit just before the year end, for
£9,300. This was incorrectly entered in trade payables account via a journal as
£3,900, but the correct entry was made in non-current assets.

How can Hanlde correct these errors?

_End of Chapter 6_

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 CHAPTER 7: COST OF SALES AND INVENTORIES
LEARNING OBJECTIVES:
1. Identify:
 the accounting principles behind cost of sales;
 the accounting principles behind accounting for inventory;
 the purpose of an inventory count;
 the correct value for inventory using FIFO and AVCO;
 how to account for drawings of inventory and for substantial losses of
inventory;
 the effects of opening and closing inventory on gross and net profit in the
P/L.
2. Specific:
 the components of cost of sales in the statement of profit or loss;
 what is included in the cost of inventory;
3. How to use mark-up and margin to:
 calculate closing inventory;
 revenue or cost of sales
4. How to calculate:
 net realizable values;
 the figure in the statement of financial position for inventory.

IFRS REFERENCE:
 IAS 02 – Inventory
 UK GAAP – FRS 102 – S13)

7.1. IAS 2, Inventories (FRS 102 s13)

7.1.1. Objective
Objective of IAS 2: Accounting treatment for inventories:

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  Guidance on determination of cost

 Subsequent recognition as an expense

 Net realisable value

7.1.2. Inventories
 Definition: Inventories are assets that are:

 Held for sale in the ordinary course of business (finished goods

(purchased or produced inhouse))
 In the process of production for such sale (WIP)
 In the form of materials or supplies to be consumed in the production
process or in the rendering of services.

7.2. Cost of sales

 Cost of sales = Opening inventory + purchases + carriage inwards – closing
inventory.

 Cost of sales comprises:

Opening inventory X

Purchases X

Carriage inwards X

Closing inventory (X)

Cost of sales X

 Question: Where is inventory account held in FSs?

 Reality: Inventory, both opening and closing, features in the statement of

profit or loss whereas you might expect it to feature only in the statement
of financial position, as an asset. How is this so?

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7.2.1. Unsold goods at the end of reporting period
 Unsold goods are held in inventory

 Question: should this value be included in COS?

Worked Example 7.1:

The Umbrella Shop’s financial year ends on 30 September each year. On 1

October 20X8 it had no goods in inventory. During the year to 30 September
20X9, it purchased 30,000 umbrellas costing £60,000 from umbrella suppliers. It
resold the umbrellas for £5 each, and sales for the year amounted to £100,000
(20,000 umbrellas). At 30 September there were 10,000 unsold umbrellas left in
inventory, valued at cost of £2 each.

Requirement: What was The Umbrella Shop’s gross profit for the year?

7.2.2. Cost of sales

Interactive Question 7.1:

On 1 January 20X9, Grand Union Food Stores had goods in inventory valued at
£6,000. During 20X9 its owner purchased supplies costing £50,000. Sales for the
year to 31 December 20X9 amounted to £80,000. The cost of goods in inventory
at 31 December 20X9 was £12,500.

Requirement: Calculate the business’s gross profit for the year.

7.2.3. Delivery costs

 The cost of delivery inwards is added to the cost of purchases (and is
therefore included in the calculation of cost of sales and gross profit)

 The cost of delivery outwards is a distribution cost deducted from gross

profit in the statement of profit or loss.

Interactive Question 7.2:

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Gwyn Tring imports and resells clocks. He pays for the cost of delivering the
clocks from his supplier in Switzeland to his shop, called Clickety Clocks, in
Wales.

He resells the clocks to other traders throughout the country, paying carriage costs
for deliveries from his business premises to his customers.

On 1 July 20X8, he had clocks in inventory valued at £17,000. During the year to
30 June 20X9, he purchased more clocks for £75,000. Delivery inwards amounted
to £2,000. Sales for the year were £162,100. Other business expenses amounted
to £56,000, excluding delivery outwards which cost £2,500. The value of the
clocks in inventory at the year end was £15,400.

Requirement: Prepare the SOPL of Clickety Clocks for the year ended 30 June
20X9.

7.2.4. Inventory written off and written down

 Inventories might:

 Be lost or stolen

 Be damaged and become worthless

 Become obsolete and be sold at low price.

Worked Example 7.3:

Lucas Wagg ends his financial year on 31 March. At 1 April 20X8 he had goods
in inventory valued at £8,800. During the year to 31 March 20X9, he purchased
goods costing £48,000. Fashion goods which cost £2,100 were held in inventory
at 31 March 20X9 and Lucas believed that these can only be sold at a sale price
of £400. Goods still held in inventory at 31 March (including the fashion goods)
had an original purchase cost of £7,600. Sales for the year were £81,400.

Requirement: Calculate Lucas’ gross profit for the year ended 31 March 20X9.

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7.2.5. Inventory destroyed or stolen
 Where material amount of inventory stolen/destroyed?

 Solution: taking the cost of goods stolen/destroyed out of purchases and

including in expenses

 Insurance claim: other income.

Worked Example 7.4:

Ethel had £15,000 of inventory as at 1 January 20X9. During the year to 31

December 20X9 she purchased inventory for £98,000, incurring carriage inwards
of £150. She made sales of £150,000, incurring delivery costs to her customers of
£2,400. At 31 December 20X9 she realized that she has inventory costing only
£200 left, goods costing £18,000 have been stolen. The insurance company has
agreed to pay her claim for 75% of the cost.

Requirement: Prepare the SOPL for the year ended 31 December 20X9.

7.3. Accounting for opening and closing inventories

 Opening Inventory: expense in the SPL:

DEBIT Cost of sales £X

CREDIT Inventory account (SFP-OI) £X

 Closing Inventory: deducted from COS in the reporting period

DEBIT Inventory account (SFP-CI) £X

CREDIT Cost of sales (SPL) £X

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7.4. Adjusting the TB
 Closing Inventory is entered into both adjustment columns of the ETB for
inventory. The DEBIT is taken across to the SFP; the CREDIT is taken to
the SPL.

 OI is taken straight to the SPL as a DEBIT.

Worked Example 7.5:

Sam’s Music Shop

Trial balance at 31 December 20X9
Debit (£) Credit (£)

Cash at bank 5,123

Opening capital 10,000

Loan 12,000

Non-current assets 20,000

Trade payables 6,800

Expenses 12,785

Purchases 18,425

Sales 38,745

Trade Receivables 3,546

Inventories at 1.1.X9 8,754

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 Drawings 9,158

72,668 72,668

Requirement: Complete Sam’s ETB and calculate his net profit for the year

7.5. Counting inventories

The inventory count establishes quantities held in inventory at the end of the
reporting period

7.6. Valuing inventories

 Inventory is valued at the lower of (historical) cost of purchase, and net
realisable value (NRV).

 NRV is the expected selling price less any costs to be incurred in achieving
that sale.

 Cost comprises: purchase price, carriage, duties and conversion costs to

bring item to its present location and condition

7.6.1. Basic valuation: lower of cost and NRV

According to IAS2, Inventory should be valued at the lower of cost and net
realisable value.

7.6.2 Applying the lower of cost and NRV

If a business has many inventory items on hand the comparison of cost and NRV
should be carried out for each item separately. It is not sufficient to compare the
total cost of all inventory items with their total NRV.

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7.6.3 Determining the cost of inventory
 Cost of inventories: All costs of purchase, of conversion (eg, labour) and
of other costs incurred in bringing the items to their present location and
condition.

 Cost of purchase: The purchase price, import duties and other non-
recoverable taxes, transport, handling and other costs directly attributable
to the acquisition of finished goods and materials.

 Conversion costs: Any costs involved in converting raw materials into final
product, including labour, expenses directly related to the product and an
appropriate share of production overheads (but not sales, administrative or
general overheads).

7.6.3.1 What is included in the total cost of an item?

The total cost of an item includes all costs incurred in bringing the item to its
present location and condition. This consists of:

 the purchase cost of raw materials

 carriage
 import taxes and duties
 conversion costs

7.6.3.2 What is the total cost of items left in inventory?

 FIFO (first in, first out): Items are used in the order in which they are
received from suppliers, so oldest items are issued first. Inventory
remaining is therefore the newer items.
 LIFO (last in, first out): Items issued originally formed part of the most
recent delivery, while oldest consignments remain in the bin. This is
disallowed under IFRS.
 AVCO (average cost): As purchase prices can change with each new
consignment received, the average value of an item is constantly changing.

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 Each item at any moment is assumed to have been purchased at the average
price of all the items together, so inventory remaining is therefore valued
at the most recent average price
 Weighted average method (AVCO periodic)
 Moving average method (AVCO perpetual)

Interactive Question 7.1:

An inventory record card shows the following details in February 20X9:

1.2.X9 50 units in inventory at cost of £40 per unit

7.2.X9 100 units purchased at a cost of £45 per unit

14.2.X9 80 units sold

21.2.X9 50 units purchased at a cost of £50 per unit

28.2.X9 60 units sold

Requirement: Calculate the value of inventory at 28 February 20X9 using FIFO

and AVCO methods.

7.6.4. Inventory valuations and profit

Different methods of inventory valuations will provide different profit figures.

7.7. Using mark-up/margin percentage to establish cost

 Mark-up is calculated on cost.

Gross profit mark-up = Gross profit/Cost *100%

Net profit mark-up = Net profit/Cost*100%

 Margin is calculated on sales.

Gross profit margin = Gross profit/Sales*100%

Net profit margin = Net profit/Sales*100%

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  Margin and mark-up can help us to establish the cost of an item of inventory

7.8. Inventory drawings

 Provided inventory actually held is valued at the lower of cost and NRV,
no inventory write-off entries are needed.

 When an owner draws out inventory:

DEBIT Drawings

CREDIT Purchases

_End of Chapter 7_

CHAPTER 8: IRRECOVERABLE DEBTS AND ALLOWANCE

FOR RECEIVABLES

LEARNING OBJECTIVES:
1. Identify the accounting principles behind accounting for irrecoverable
debts and allowance for receivables;
2. Identify journals for writing off irrecoverable debts, receiving cash in
respect of debts previously written off, and setting up or adjusting
allowances for receivables;
3. Calculate the figure in the statement of financial position for receivables;
4. Identify the statement of profit or loss figure for irrecoverable debts
expense;
5. Identify the effects of irrecoverable debts and allowance for receivables on
gross and profit for the period in the statement of profit or loss;
6. Specify how to adjust the initial balance to take account of irrecoverable
debts and allowance for receivables.

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IFRS REFERENCE:
 IFRS 9: a company required to look forward and estimate expected future
losses on trade receivables balance

 UK GAAP – FRS 102 – no forward-looking criteria

8.1. Irrecoverable debts

8.1.1. Writing off irrecoverable debts

Irrecoverable debts (bad debts) are specific debts owed to a business which it
decides (or considers) never going to be paid. If a debt is definitely irrecoverable,
the prudence concept dictates it should be written off to the statement of profit or
loss as a bad debt.

When a business decide that a particular debt will not be paid:

 Reduce revenue?

 Increase expense?

DEBIT Irrecovarable Debts Expenses

CREDIT Trade Receivalbles

8.1.1.1. Irrecoverable debts written off and subsequently paid

DEBIT Cash at bank

CREDIT Irrecoverable debts expense

Question: Do we need to credit trade receivables?

Worked Example 8.1:

 1.1.X9: ABC LTD sells goods to DEF LTD for £500 on credit.

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  1.3.X9: ABC LTD subsequently finds out that DEF LTD is being liquidated
and therefore the prospects of recovering its dues are very low. ABC LTD
therefore writes off the receivable from its books.

 1.4.X9: The administrator appointed to oversee the liquidation of DEF LTD

instructs the company to pay £500 to ABC LTD in full settlement of its
dues.

Requirement: Make journal entries for these transactions?

8.1.2. Dishonoured cheques and irrecoverable debts

Question: Dishonoured cheques? – write off receivable?

Worked Example 8.2:

 25.3.X9: ABC Ltd. received a cheque from customer X who owed the
business £300 for his last purchase.

 31.3.X9: In bank reconciliation, the accountant of ABC found that this

cheque was dishonoured.

Requirement: Make journal entries for these transactions?

8.2. Allowance for receivables

If a debt is possibly irrecoverable, an allowance for the potential irrecoverability
of that debt should be made.

DEBIT Irrecoverable debts expense (SPL)

CREDIT Allowance for receivables (SFP)

 When an allowance already exists, but is subsequently increased, the amount

of the increase in allowance is debited to irrecoverable debt expense, and
credited to the allowance.

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 When an allowance already exists, but is subsequently reduced, the amount of
the decrease in allowance is credited to irrecoverable debt expense in the
statement of profit or loss for the period in which the reduction in allowance
is made, and debited to the allowance.

8.3. Accounting for irrecoverable debts and allowance for

receivables

8.3.1. Irrecoverable debts written off: ledger accounting entries

In the receivables ledger, personal accounts of the customers whose debts are
irrecoverable will be credited off the ledger.

 When it is decided that a particular debt will not be paid:

DEBIT Irrecoverable debts expense

CREDIT Trade receivables

Question: What else shall we record?

 At the end of the reporting period

DEBIT Profit and loss ledger account

CREDIT Irrecoverable debts expense

 Where an irrecoverable debt is recovered

DEBIT Cash

CREDIT Irrecoverable debts expense

8.3.2. Allowance for receivable: ledger accounting entries

 An allowance account is set up:

DEBIT Irrecoverable debts expense

CREDIT Allowance for receivables

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  When preparing the SFP, the credit balance on the allowance account is
deducted from the balance on the receivables account

In subsequent reporting periods: The prior period: made allowance: X. In this

period: bad debts: a => X-a

 Carry down the new allowance required: Y

 Calculate the charge or credit to SPL

 If the allowance has risen: (X-a)<Y: additional allowance

CREDIT Allowance for receivables (Y-(X-a))

DEBIT Irrecoverable debts expense (Y-(X-a))

 If the allowance has fallen: reversal allowance (X-a)>Y

DEBIT Allowance for receivables

CREDIT Irrecoverable debts expense

Worked Example 8.3:

A company reports an accounts receivable debit balance of £1,000,000 on June

30. The company anticipates that some customers will not be able to pay the full
amount and estimates that $50,000 will not be converted to cash.

Allowance for receivables (CB) = 50,000

 NRV of trade receivables @ June 30 = 1,000,000 – 50,000

DR Irrecoverable debts expense 50,000

CR Allowance for Trade receivables 50,000

If the allowance for receivables began with a balance of £10,000 in June, we

would make the following adjusting entry:

DR Irrecoverable debts expense 40,000

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 CR Allowance for Trade receivables 40,000

If the allowance for receivables began with a balance of £60,000 in June, we

would make the following adjusting entry:

 Reversal of allowance:

DR Allowance for Trade receivables 10,000

CR Irrecoverable debts expense 10,000

If the allowance for receivables began with a balance of £60,000 in June. Bad
debts in June is £20,000. We would make the following adjusting entry:

Write-off bad debts:

DR Allowance for Trade receivables 20,000

CR Trade receivables 20,000

Adjust allowance:

DR Irrecoverable debts expense 10,000

CR Allowance for Trade receivables 10,000

Later, a customer who purchased goods totaling £10,000 on June 25 informs the
company on August 3 that it already filed for bankruptcy and will not be able to
pay the amount owed.

DR Allowance for Trade Receivables 10,000

CR Trade Receivables 10,000

The customer who filed for bankruptcy on August 3 manages to pay the company
back the amount owed on September 10. The company would then reinstate the
account that was initially written-off on August 3.

DR Cash 10,000

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 CR Irrecoverable debts expense 10,000

8.4. Adjusting the TB for irrecoverable debts and allowance for

receivables
 Calculate the amount of allowance for receivables

 Percentage of Credit Sales

If a company and the industry reported a long run average of 2% of credit sales
being uncollectible, the company would enter 2% of each period’s credit sales as
a debit to bad debts expense and a credit to allowance for receivables.

 Accounts Receivable Aging

The accounts receivable aging method is a report that lists unpaid customer
invoices by date ranges and applies a rate of default to each date range.

 Calculate the amount of irrecoverable debts expense

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  Direct write-off method

This method involves the write-off to the receivables account. When it’s clear that
a customer invoice will remain unpaid, the invoice amount is charged directly to
bad debt expense and removed from the account accounts receivable. The bad
debt expense account is debited, and the accounts receivable account is credited.
Under this method, there is no allowance account.

 Allowance method

Under this method, the bad debts are anticipated even before they occur. An
allowance for doubtful accounts is established based on an estimated figure. This
is the amount of money that the business anticipated losing every year.

This contra-asset account reduces the loan receivable account when both balances
are listed in the balance sheet.

 Prepare journal entries

 Adjustments columns

 Cross-cast = Initial TB + Adjustments

_End of Chapter 8_

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