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    C02 Fundamentals of Financial Accounting

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    CIMA C02

    Fundamentals ofFinancial Accounting

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    Contents Page

    Contents Page .............................................................................. 3

    Paper Information .......................................................................... 4

    How to Pass .................................................................................. 5

    The Verb Hierarchy ....................................................................... 6

    LEARNING OUTCOMES GRID..................................................... 7

    INTRODUCTION TO ACCOUNTING .......................................... 10

    THE FRAMEWORK OF FINANCIAL SYSTEMS ......................... 12

    DOUBLE ENTRY BOOK KEEPING ............................................ 19ACCRUALS AND PREPAYMENTS ............................................ 26

    BAD DEBTS AND ALLOWANCES FOR RECEIVABLES ............ 30

    NON CURRENT ASSETS ........................................................... 33

    INVENTORY ............................................................................... 43

    PREPARATION OF FINANCIAL STATEMENTS WITH

    ADJUSTMENTS .......................................................................... 47

    ORGANISING THE BOOKKEEPING SYSTEM ........................... 49

    CONTROLLING THE BOOKKEEPING SYSTEM ........................ 58

    THE REGULATORY FRAMEWORK OF ACCOUNTING ............ 73

    LIMITED COMPANY ACCOUNTS .............................................. 81

    CASH FLOW STATEMENTS ...................................................... 90

    INCOMPLETE RECORDS .......................................................... 96

    INTERPRETATION OF FINANCIAL STATEMENTS ................. 105

    MANUFACTURING ACCOUNTS .............................................. 111

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    Paper Information

    The objective of this paper is to test the students ability to:

    Explain the conceptual and regulatory framework of

    accounting

    Explain the nature of accounting systems

    Prepare and interpret accounts for a single entity. Students

    should be aware of the format of published accounts but are

    not required to prepare them

    Calculate and interpret simple ratios

    Syllabus Outline

    Conceptual and regulatory framework 20%

    Accounting systems 20%

    Control of accounting systems 15%

    Preparation of accounts for single entities 45%

    The assessment

    The exam will be a computer based exam comprising 50 multiple

    choice questions lasting 2 hours.

    The pass mark is 50%

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    How to Pass

    Have sound theoretical knowledge

    (attend tuition classes)

    Practice application skills

    (question practice)

    Be prepared!

    (attend revision & qbr)

    Read the question requirements

    Add value to the scenario material

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    B - Accounting systems 20%

    1 Explain the purpose of accounting records and their role in the

    accounting system

    2 Prepare cash and bank accounts and bank reconciliationstatements

    3 Prepare petty cash statements under an imprest system

    4 Prepare accounts for sales and purchases including personal

    accounts and control accounts

    5 Identify the necessity for financial accounting codes and construct

    simple coding system

    6 Prepare nominal ledger accounts, prepare journals and a trial

    balance

    7 Prepare accounts for indirect taxes

    8 Prepare accounts for payroll

    C - Control of accounting systems 15%1 Identify the requirements for external audit and the basic processes

    undertaken

    2 Explain the purpose and the basic procedures for external audit

    3 Explain the meaning of fair presentation

    4 Explain the need for financial controls

    5 Explain the purpose of audit checks and audit trails

    6 Explain the nature of errors and to be able to make accounting

    entries for them

    7 Explain the nature of fraud and basic ideas of fraud prevention

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    D - Preparation of accounts for single entities 45%

    1 Prepare accounts using accruals and prepayments

    2 Explain the difference between bad debts and allowance for

    receivables

    3 Prepare accounts for bad debts and allowances and receivables

    4 Calculate the methods of depreciation

    5 Prepare accounts using each method of depreciation and for

    impairment values

    6 Prepare a non current asset register

    7 Prepare accounts for inventories

    8 Prepare income statements, statement of changes in equity and

    balance sheet from trial balance

    9 Prepare manufacturing accounts

    10 Prepare income and expenditure accounts

    11 Prepare accounts from incomplete data

    12 Interpret basic ratios

    13 Prepare cash flow statements

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    INTRODUCTION TO ACCOUNTING

    LEARNING OUTCOME

    A1 -Identify the various user groups which need accounting

    information and the qualitative characteristics of financial

    statements

    A2 - Explain and function of, and difference between, financial and

    management accounting systems

    Introduction

    WHAT IS ACCOUNTING?

    Accounting is made up of two elements:

    I. Recording business transactions - Book keeping

    II. Presenting the information

    WHAT IS A BUSINESS?

    A business is a commercial organisation which exists with a view to

    making a profit. There are different types of businesses which will fall

    into 3 catagories:

    Sole Trader

    This is a business that is owned and operated by one person

    Partnership

    This type of business is owned by several individuals, some of which will

    actively be involved in the business

    Companies

    This type of business is owned by shareholders and is operated on their

    behalf by a nominated board of directors. Companies will be covered in

    greater detail in later sessions

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    Users of accounts

    The users of accounts will depend on the type of accounts that are

    produced. There are two main types of accounts:

    Management accounts

    Financial accounts

    Management accounts

    These are produced as often as a business wants them (usually

    monthly). They are produced for internal use and will not, usually be

    seen by external people. Management accounts can be prepared using

    the companys own internal policies.

    Financial accounts

    These accounts are usually produced annually. They are based on

    historical information and are rarely used internally. Financial accounts

    are used by external users for several reasons:

    Investors

    Lenders

    Employees

    Government

    Public

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    THE FRAMEWORK OF FINANCIAL SYSTEMS

    LEARNING OUTCOME

    A4 - Explain and distinguish capital and revenue, cash and profit,

    income and expenditure, assets and liabilities

    The Accounting EquationThis states that business net assets always equal the proprietors/owners

    funds.

    Assets = Liabilities + Capital

    Example 1

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

    Dual Effect:

    The business has cash of $100,000

    The business owes me $100,000

    Accounting Equation:

    Net Assets = Proprietors Funds

    100,000 cash 100,000 capital

    Complete the accounting equation for the following:

    1) Buy 5000 CDs from Natalie for $7 each for cash.

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

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    3) Buy a computer for $5000.

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

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

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    6) Pay an electricity bill of $1500

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

    8) Pay the Jenny supplier $5,000

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    9) Receive payment from Sue of $4,000

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

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    The accounting equation and the balance sheet.

    The balance sheet is simply the restatement of the assets, liabilities and

    capital at a particular time. It is basically a more detailed representation

    of the accounting equation.

    Proforma set of financial statements for a limited company or Plc

    Balance Sheet as at 31 December 2007

    Non current assetsNote

    Intangible assets 6 200,000Tangible assets 7 187,999

    Current assets

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

    Total assets 587,286

    Equity and liabilities

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

    Non current liabilities

    Interest bearing borrowings 10 100,000

    Current liabilities

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

    Total liabilities 587,286

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    Income Statement for the year ended 31 December 2007

    Revenue 233,000

    Cost of sales

    Opening inventory 12,332Purchases 119,098Carriage inwards 1,009

    132,439Closing inventory (13,777) 118,662

    GROSS PROFIT 114,338

    Discounts received 5,111

    Other income 4,000

    123,449

    Less expenses

    Discounts allowed 3,444

    Depreciation 10,710Gas and electricity 14,122Irrecoverable debts 7,134Loan interest 4,000Carriage outwards 5,666Water rates 8,444

    Advertising 15,000Other expenses 3,142 71,662

    NET PROFIT 51,787

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    Example 2

    Explain briefly what is meant by the following and give an example of

    each:

    Assets

    Liabilities

    Capital

    Revenue

    Expense

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    DOUBLE ENTRY BOOK KEEPING

    LEARNING OUTCOMES

    B1

    Explain the purpose of accounting records and their role in

    the accounting system

    B4 Prepare accounts for sales and purchases including personal

    accounts

    B6 Prepare nominal ledgers and trial balance

    C8 prepare income statement and balance sheet from a trial

    balance

    Introduction

    Bookkeeping is the recording of monetary transactions of a business.

    Double entry bookkeeping

    Double entry bookkeeping is the fundamental concept underlying

    accountancy. All accounting transactions should be recorded using the

    double entry system. There are some basic rules that we MUST follow:

    1. Every debit must have a credit

    2. A debit entry is an ASSET in the BALANCE SHEET or an

    EXPENSE in the INCOME STATEMENT

    3. A credit entry is a LIABILITY in the BALANCE SHEET or an

    INCOME in the INCOME STATEMENT

    T accounts

    In order to assist us with the preparation of the financial statements we

    use T accounts for simplicity. The principles of T accounts are:

    Every debit entry has a credit entry

    Every T account will belong to the statement of financial position or

    the statement of comprehensive income

    The closing balance of a T account at the end of the period is

    entered into a trial balance

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    Example 1

    Charlie commences business on 1 April 2009. The following

    transactions take place in his first two weeks of trading.

    1 April He invests 50,000 in to a business

    1 April He purchases 5,000 worth of goods on credit

    2 April He sells half of the inventory for 6,000 cash

    5 April He issues a cheque to pay for the goods he received

    on credit

    4 April Pays his rent for April of 450 by cheque

    7 April He sells his remaining stock for 6,000 on credit

    10 April Purchased goods on credit for 7,000

    14 April He purchases a delivery van for 7,000 cash

    Required

    For the first two weeks of trading prepare:

    The T accounts for Charlie (State if the account is Balance Sheet

    or Income Statement)

    The Trial BalanceThe Income statement for the 2 week period ended 14thof April

    2009

    The Balance sheet as at 14thApril 2009

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    Answer to example 1

    Bank Account

    Capital Account

    Purchases

    Trade Payables

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    Sales

    Rent

    Dr Cr

    Trade Receivables

    Dr Cr

    Delivery Van

    Dr Cr

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    Trial Balance

    Statement Dr Cr

    Bank Account

    Capital Account

    Purchases

    Trade Payables

    Sales

    Rent

    Trade Receivables

    Delivery Van

    Total

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    CharlieIncome Statement

    2 Week Period Ended 14 April 2009

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    CharlieBalance Sheet

    as at 14 April 2009

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    ACCRUALS AND PREPAYMENTS

    LEARNING OUTCOME

    D1- Prepare accounts using accruals and prepayments

    Introduction

    The most common application of accruals and prepayments is in

    accounting of expenses.

    Accruals

    These are charges that are brought into the financial statements at the

    end of the period because, although goods and services have been

    provided, they have not yet been charged by the suppliers. For example

    electricity, invoiced in arrears, generally requires an accrual at the end of

    each accounting period.

    An accrued expense is a liability because it is owed to the relevant

    supplier of those goods and services, irrespective of the fact that aninvoice has not yet been received. If the business were to be closed

    down at the end of the accounting period the expense would still have to

    be paid.

    Accounting for an Accrual

    Dr Expense

    Cr Accrual

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    Prepayment

    A prepayment is the opposite to an accrual. A prepayment is

    expenditure on goods and services for future benefit, which is to be

    charged to future operations, for example rent in advance. Theseamounts need to be included in current assets.

    A prepayment is an asset because the business has yet to enjoy or

    utilise the benefit from it. Depending on the type of expense, if the

    business were to close down the amount prepaid may be refunded.

    Accounting for a prepayment

    Dr Prepayment

    Cr Expense

    Example 1

    Electricity

    Date Paid Amount Period of payment

    10.3.08 96 2 months to 28.2.08

    12.6.08 120 Qtr to 31.5.0814.9.08 104 Qtr to 31.8.08

    10.12.08 145 Qtr to 30.11.08

    Rates

    Date Paid Amount Period of payment

    1.2.08 375 3 mths to 31.3.08

    6.4.08 1,584 12 mths to 31.3.09

    Other info

    1st July 2008 we employed an assistant. We pay the assistant 150

    each month on the 28thof the month

    6thMarch 2009 we receive an electricity bill for 168 for quarter to 28th

    Feb 2009.

    TaskComplete the T accountsfor each entry.

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    Reversal of accrual and prepayment

    Accrual Prepayment

    Dr Accrual Dr Expense

    Cr Expense Cr Prepayments

    Steps

    Step 1

    Reverse the opening accrual/prepayment

    Step 2

    Post cash paid

    Step 3

    Post closing accrual/prepayment

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    Example 2

    Electricity charges for the year

    Date Paid Amount Period of payment Accounting12.3.08 168 Feb 2008 Opening accrual

    9.6.08 134 May 2008 Cash Paid

    12.9.08 118 Aug 2008 Cash Paid

    12.12.08 158 Nov 2008 Cash Paid

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

    TaskComplete the t account for the electricity for the year ( Feb 08Dec 08)

    and calculate the Income statement charge for the year.

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    BAD DEBTS AND ALLOWANCES FOR

    RECEIVABLES

    LEARNING OUTCOMES

    D2 Explain the difference between bad debts and allowance for

    receivables

    D3 Prepare accounts for bad debts and allowances and

    receivables

    Bad debt

    When a business sells good on credit, it assumes that the customer will

    pay in full within a agreed credit period. However sometimes a customer

    does not pay in full or not even at all. If this is the case then it is incorrect

    to retain this balance as an asset, or to treat the sale as having made a

    profit.

    When it becomes known that the customer is unlikely to pay, the

    receivable balance must be removed and transferred to the income

    statement as an expense of the period that the bad debt arises.

    Accounting for Bad Debt

    Dr Bad Debt Expense

    Cr Receivables

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    Allowances for Receivables

    While some debts are definately bad (customer gone into liquidation)

    other debts may only be doubtful. If this is the case it would not be

    appropriate to eliminate the receivable balance because they may payafter all. But we have to recognise that the value of the receivable (

    asset) is probably less than it appears to be. If this is the case we create

    an allowance for receivables.

    Specific allowance: an individual doubtful debt

    General allowance: after taking into account any bad debts we apply a

    % of our receivables to calculate the allowance.

    Accounting for allowance/provision of bad debt.

    Dr Bad debt expense

    Cr Allowance/provision for doubtful debts

    Example 1

    A business has trade receivables at the end of the year of 26,478. Of

    these it is felt that 976 should be written of as bad debt.

    What is the double entry for this?

    What is the new receivables figure for the year?

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    NON CURRENT ASSETS

    LEARNING OUTCOMES

    A4 - Explain and distinguish capital and revenue expenditure

    A5 - Explain the difference between tangible and intangible assets

    D4 - Calculate the methods of depreciation

    D5 - Prepare accounts using each method of depreciation and for

    impairment values

    D6 - Prepare a non current asset register

    Introduction

    A non-current asset is intended for continued use in a business. This

    would generally mean for more than one accounting period. Non-

    currents assets can be either TANGIBLE or INTANGIBLE. CIMA C02

    concentrates on tangible non-current assets, however a knowledge of

    intangible non- current assets is needed.

    Tangible non-current assets

    These are assets that have physical substance. Examples of tangible

    non-current assets would be:

    Land and buildings

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    Plant and equipment

    Motor vehicles

    Computers

    Fixtures and fittings

    Intangible non-current assets

    These assets have no physical substance. An example of an intangible

    non-current asset would be:

    Goodwill

    Research and development

    Investments

    Non-current assets are normally of substantial value and their

    accounting can have a material impact on the financial statements. As a

    result of this there are large numbers of accounting standards that help

    the preparers of financial statements to account for them.

    The key accounting standard relevant at this level is IAS 16 Non-Current

    Assets

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    Non-current asset register

    The majority of companies will own a number of non-current assets, and

    it is imperative that effective control is kept over them. In order to

    ensure management are aware exactly where each item is located andthat they are adequately maintained and serviced, a non current asset

    register is maintained.

    A non-current asset register is generally maintained in the finance

    department. Companies can purchase specifically designed packages

    or a register can simply be maintained on an Excel spreadsheet.

    A register would include the following information:

    Item code

    Date of purchase

    Item description

    Cost

    Estimated useful life

    Residual value (if any)

    Depreciation method

    LocationDisposal details

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    Capital and revenue expenditure

    One of the key areas of accounting for non-current assets is deciding

    whether expenditure incurred is CAPITAL or REVENUE expenditure.

    If it is capital expenditure it will be capitalised in the Balance Sheet and

    then depreciated over the useful economical life of the asset. If it is

    revenue expenditure it will be expensed through the Income Statement.

    We need to classify expenditure incurred as either capital or revenue in

    order to ensure appropriate accounting entries are made.

    Capital expenditure is expenditure likely to increase the future earning

    capacity of the organisation whereas revenue expenditure is regarded

    as maintaining the organisations present earning capacity.

    Per IAS 16 the following costs may be capitalised on acquisition of a

    non-current asset:

    Initial cost

    Delivery costs

    Non-refundable import taxes

    Installation costsAny costs incurred in bringing the asset into intended use

    Initial training costs

    Subsequent expenditure that ENHANCES the performance of the

    asset

    Costs that are regarded as revenue expenditure and may not be

    capitalised per IAS 16 are:

    Insurance costsRepairs

    Maintenance

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    Subsequent Expenditure

    Subsequent expenditure on property, plant and equipment should only

    be capitalised if it improves the asset beyond its originally assessedstandard of performance e.g. faster production or higher quality output.

    All other subsequent expenditure should be written off

    Depreciation

    The cost of the non current asset will contribute to the organisations

    ability to earn revenue for a number of accounting periods. It would be

    unfair if the whole cost were to be treated as an expense in the income

    statement in the year of acquisition. Instead, the cost is spread over allthe accounting periods in which the asset is expected to be making a

    contribution to earnings (useful life of the asset). This process is called

    depreciation.

    By applying depreciation charges, we are consistent with the

    ACCRUALS / MATCHING CONCEPT i.e. applying the cost of using the

    asset to the Income Statement for the same period.

    All tangible non-current assets should be depreciated on a systematicbasis per IAS 16, with the exception of land. This is because land is

    seen to appreciate in value.

    Intangible non-current assets are amortised over their useful economic

    life (IAS 38 Intangible asset term for depreciating this type of asset).

    Depreciation policies

    Calculating depreciation in a given period are common questions in this

    paper. The main methods of calculating depreciation are:

    Straight line

    Reducing balance

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    Straight line depreciation

    Depreciation is charged on a straight line basis over the life of the non-

    current asset. Thus an equal amount is charged in every accounting

    period over the life of the asset.

    To calculate the depreciation charge the following formula is used:

    Depreciation perannum

    = Original costestimatedresidual value

    Estimated useful Life

    Example 1

    Company A purchased a non-current asset on 1st January for 25,000.

    The asset has an expected useful life of 5 years and a residual value of

    2,500.

    Calculate the depreciation charges for the year ended 31stDecember on

    the basis:

    Reducing balance

    This method of depreciation is generally used for assets which tend to

    lose more value in the initial years and require greater maintenance in

    the later years. A good example would be a brand new motor vehicle.

    Motor vehicles tend to depreciate rapidly in the earlier years and require

    very little maintenance.

    A fixed percentage is charged to the net book value on an annual basis.

    Hence, as the book value of an asset reduces, the depreciation charge

    reduces accordingly.

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    Disposal of a non-current asset

    When a business disposes of an asset it is unlikely that the sale

    proceeds will agree with the net book value. Therefore, a gain or loss

    will arise from the sale.

    NBV < sale proceeds = Profit

    NBV > sale proceeds = Loss

    Accounting Treatment

    1. Transfer original cost of asset to disposal A/C

    Dr Disposal a/c

    Cr Cost a/c2. Transfer Accumulated depn to disposal A/C

    Dr Accum Depn a/c

    Cr Disposal a/c

    3. Post sale proceeds

    Dr Bank a/c

    Cr Disposal a/c

    4. Balance off disposal a/c to find profit/loss on disposal

    Profit in disposal = Sundry Income in IS

    Loss on disposal = expense in IS

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    Revaluations

    When a non-current asset is purchased we record them at their initial

    cost. However, over time these values may materially differ from theirmarket value.

    For example, if a company purchased a property 20 years ago and

    therefore subsequently charged depreciation for 20 years, it would be

    safe to assume that the book value of the asset would be significantly

    different from todays market value.

    In order to overcome this issue IAS 16 permits companies to reflect the

    market value in the statement of financial position. This policy may beadopted, and if so the following rules must be applied per the standard:

    Example 4

    Company C has a motor vehicle with a book value of 6,000 (cost

    22,000) and disposes of it for 8,000.

    We can establish that there is a gain of 2,000 (proceedsbook

    value).

    The accounting entries will need to follow three steps

    1. Clear the cost from the cost account

    2. Clear the depreciation from the accumulated depreciation

    account

    3. Enter the proceeds

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    i. If a company chooses to revalue an asset they must revalue all

    assets in that category

    ii. Revaluations must be regular

    iii. Subsequent depreciation must be based on the revalued amounts

    iv. Gains from revaluations are not taken to the Income Statement, as

    no gain as been realised. This is covered by the PRUDENCE

    concept.

    Accounting treatment

    Dr NCA Cost

    DR Accumulated Depreciation

    Cr Revaluation Reserve

    Example 5

    Company X purchased a building for 45,000 15 years ago, and charges

    depreciation of 2% on a straight line basis.

    The property has been valued by a qualified person at 150,000 during

    the current financial year. The directors would like to encompass these

    figures in the financial statements.

    Required

    Complete the necessary journals to account for the revaluation.

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    INVENTORY

    LEARNING OUTCOME

    D7 Prepare accounts for inventories

    Introduction

    Inventory is the product we purchase and sell in a business.

    In a business it is unlikely that all of the inventory will be sold at the end

    of an accounting period, therefore there will be an adjustment needed in

    the financial statements for the value of the closing inventory.

    Opening and closing inventory needs to be included in the Income

    Statement in order to calculate the cost of the goods sold with-in a given

    period. The Balance Sheet will show the value of the inventory at the

    end of the accounting period (the closing inventory).

    IAS 2 is the accounting standard that gives us detailed guidance on how

    to value our closing inventory.

    RULE: Closing inventory should be valued at the lower of cost andnet realisable value (N.R.V.)

    Cost is the total cost incurred in bringing the product to its

    present location and condition. For bought in items this will

    be the cost of the items themselves plus the cost of carriage

    associated with obtaining them.

    NRV

    is the selling price of the item less any costs to beincurred in making the item suitable for sale. These might

    include packaging and costs of delivering the item to

    consumers.

    By applying the IAS 2 rule we ensure our inventory is never overstated

    in the Balance Sheet, hence the PRUDENT concept.

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    Example 1

    Here is the information of the inventory that Q Ltd has in their

    warehouse for the year ended 31st

    December 2008.

    ProductA B C

    Cost 10 12 6

    NRVSelling price 15 16 11Modification costs -3 -4Marketing costs -3.5 -2.5 -1

    11.5 10.5 6

    Value at:

    No of units held 100 200 150

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

    December 2008.

    Valuation of closing inventory

    We will cover three methods of valuing the closing inventory:

    F.I.F.O.First In First Out

    The closing inventory consists of items purchased at the latest dates,

    as we assume the items that were purchased first were the items sold

    first.

    In times of rising prices, closing inventory will have a higher cost and

    there profit will be higher.

    AVCO Average cost

    Under this method we take an average cost of the closing inventory

    i.e. we multiply the number of items by the average price paid for that

    item.

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    L.I.F.O. Last In First Out

    The closing inventory consists of items purchased at the earliest date, as

    we assume the last item purchased is the first item to be sold.

    In times of rising prices the closing inventory will have a lower value and

    therefore profit will be lower.

    From a practical perspective it is unlikely last items purchased will be

    sold first, and as a result of this IAS 2 does not permit L.I.F.O. method of

    stock valuation.

    Example 2

    Phoebe Ltdmade the following purchases in June 2009 of Oak wood to

    build chairs that they will produce and sell.

    Date Units

    Unit

    price1.6.09 openinginventory 300 $1210.6.09 Purchase 400 $12.5020.6.09 Purchase 400 $1425.6.09 Purchase 400 $15

    The following sales were made during June 2009

    14.6.09 500 units21.6.09 500 Units

    28.6.09 100 units

    Calculate the cost of sales using FIFO, LIFO and AVCO method to

    calculate the closing inventory for the month of June.

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    W.I.P. Work in progress

    In some cases, where a company has modified itsinventory it is

    necessary to take the cost of that modification into account when valuing

    closing inventory.

    Net realisable value

    Net realisable value is the amount we can get from selling inventory less

    any further costs to be incurred.

    Accounting Entries

    The double entry to account for inventory is:

    Dr Inventory Balance Sheet

    Cr Inventory Income Statement

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    PREPARATION OF FINANCIAL STATEMENTS

    WITH ADJUSTMENTS

    Question 1

    The following Trial balance has been extracted by the book keeper of

    Sue Large, a dress maker as at the 30thJune 2008.

    Dr Cr

    Purchases 31,480

    Sales 95,660Opening stock 7,580

    Returns 240 620

    Discounts 380 1,080

    Drawings 34,720

    Premises at cost 100,000

    Accumulated depreciation for premises 10,000

    Fixtures and fittings 24,000

    Accumulated depreciation for F&F 3,000Wages and salaries 18,620

    Advertising 2,260

    Rates 8,240

    Sundry expenses 7,390

    Bank 4,020

    Cash 120

    Debtors 5,000

    Bad debts written off 100Provision for doubtful debts 520

    Creditors 3,740

    VAT 3,240

    Capital 81,290

    Bank Loan 45,000

    244,150 244,150

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    Notes at 30th June 2008

    1) Inventory has been valued at 6060

    2) Depreciate premises at 2% using straight line method

    3) Depreciate fixtures and fittings at 12.5% using straight line

    method

    4) Provision for doubtful debts is to be 5% of receivbles

    5) Wages accrued are 500, and advertising prepaid is 350.

    Required

    To prepare the Income Statement for the year ending 30thJune 2008

    and balance sheet as that date.

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    ORGANISING THE BOOKKEEPING SYSTEM

    LEARNING OUTCOMES

    B1 - Explain the purpose of accounting records and their role in the

    accounting system

    B4 - Prepare accounts for sales and purchases, including personal

    accounts

    B2 - Prepare cash and bank accounts

    B3 - Prepare petty cash statements under an imprest system

    B6 - Prepare nominal accounts and journal entries

    B7 - Prepare accounts for indirect taxes (e.g. Sales tax)

    Introduction

    In session 3 we prepared financial statements from T accounts. The

    number of transactions was limited, and therefore the process wassimple to follow. In larger organisations, a single ledger may not be

    sufficient to hold all the ledger accounts, there may be too many

    transactions for one person to maintain, and it might become difficult to

    trace individual accounts. It is common for the ledger accounts to be

    divided into sections. Double entry is maintained as before, but ledger

    accounts of the same type are grouped together.

    The common division of the ledgers are as follows:

    All receivable accounts are kept in the Sales ledger (receivables

    ledger)

    All payable accounts are kept in the purchase ledger (payable

    ledger)

    All bank and cash accounts are kept in the cash book

    All other accounts are kept in the nominal ledger (main

    ledger/general ledger)

    .

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    Most businesses of any size maintain records of their transactions in the

    following books of prime entry:

    Sales day book

    Purchase day bookSale returns day book

    Purchase returns day book

    Cash book

    Petty cash book

    Journal entries

    The transactions are recorded in the prime entry books. They are then

    transferred to the nominal (general) ledger and we then extract a trialbalance in order to prepare our financial statements.

    Sales day book

    This book records all the sales we make on credit. Sales should be

    recorded net of trade discount but before any cash (settlement) discount.

    Purchase day book

    This book of prime entry records all purchases we make on credit.

    Sale returns day book

    If a credit customer returns goods, this will be recorded in the sale

    returns day book.

    Purchase returns day book

    This book will record all the credit purchases that we return to suppliers.

    Cash book

    This book will record all the money that we will pay into the bank

    account, and any payments we make from the bank account. This will

    also record any cash (settlement) discounts we allow or receive.

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    Petty cash book

    This records all the small sundry transactions occurring in a business on

    a day to day basis.

    Journal entries

    These are used for ad hoc entries that do not fall into any of the above

    categories. They are also used to correct errors, both temporary and

    permanent.

    Example 1J & J had the following transactions during the first week in December

    2008.

    1stDecember 2008

    Purchased goods on credit from A Ltd for 595 receiving a trade

    discount of 9.5%

    Purchased good on credit for 795 from KP Ltd

    Sold goods on credit to JK Ltd for 999

    3rdDecember

    Returned KP Ltd goods as they were defective

    Sold goods on credit to A Jones for 995

    5thDecember

    Sold goods on credit to A Jones for 795Purchased goods on credit from A Ltd for 995, again with a

    9.5% trade discount

    NB Sales tax is 17.5%

    Required

    Prepare the day books for the above transactions of JJ Ltd.

    Then post each of the day books to the nominal ledger and subsidiary

    ledgers (T accounts)

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    SALES DAY BOOK

    DATE INV

    NO.

    CUSTOMER VALUE SALES

    TAX

    TOTAL

    PURCHASE DAY BOOK

    DATE INVNO.

    SUPPLIER VALUE SALESTAX

    TOTAL

    PURCHASE RETURNS DAY BOOK

    DATE INVNO.

    SUPPLIER VALUE SALESTAX

    TOTAL

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    The Cash Book

    For most businesses accounting for cash in both bank and cash

    transactions takes place in the cash book.

    Cash book , for receipts and payments in cash and through the

    bank (cheques and BACS transfers)

    Petty cash book for low value expense payments (we will cover

    this later)

    Uses of the cash book

    The cash book brings together the cash and bank transactions of a

    business.

    Thus it is used to record the money side of the book-keeping

    transactions such as:

    Cash transactions

    - all receipts in cash

    - most payments for cash, except low value expense payment

    (which are paid through the petty cash book)

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    Bank transactions

    - All receipts through the bank (including the payment of cash into

    the bank)

    - All payments through the bank (including the withdrawal of cash

    from the bank)

    The cash book is usually controlled by a cashier who:

    Records receipts and payments through the bank and in cash

    Makes cash payments, and prepares cheques and other banktransfers for signature by those authorised to sign

    Pays cash and cheques received into the bank

    Has control over their firms cash, in a cash till or cash box.

    Issues cash to the firms petty cashier who operates the firms

    petty cash book.

    Checks the accuracy of the cash and bank balances at regular

    intervals.

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    Cash Book: Receipts CBR 24

    Date Details Folio Discount

    Allowed

    Cash Bank

    A cash book is set out in a variety of formats to suit the

    requirements of a particular business. Above is an example of

    a 3 column money receipts side of a cash book.

    The discount column does not form part of the double entry

    system but is purely there for memorandum purposes.

    The Petty Cash book

    The petty cash book usually operates an Imprestsystem whereby an

    agreed balance of cash is held by a nominated individual.

    Characteristics of imprest system

    Pre set limit say 100

    Voucher is filled in when money is taken out

    At any time Voucher + Cash = 100

    The petty cash book is filled in from the vouchers

    The amount used is restored on a regular basis to the pre set limit.

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    The Journal

    In a bookkeeping system involving the use of books of prime entry, it is

    evitable that there will be transactions that do not correspond with the

    main books of prime entry used, that is the day books and cash books.In order to complete the system another book is needed to capture

    sundry items prior to entering them to the ledger. This book is called the

    journaland is used for a wide variety of transactions for example:

    Depreciation

    The write off of bad debt

    Purchase or sale of a non current asset

    Allowances for receivables

    Accruals and prepayments

    Year end adjustments

    The correction of errors

    The journal layout

    Date Account name/ details DR CR

    Explanation

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    Example 2

    Correct the following errors using journals:

    1. A sales day book has been under cast by 1,000.

    2. Inventory purchased for 1,000 has been posted to stationery

    3. A non-current asset has been purchased for 7,000 on credit,

    but has not been recorded.

    Solution

    Account Name Description Debit Credit

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    CONTROLLING THE BOOKKEEPING SYSTEM

    LEARNING OUTCOMES

    C4 - Explain the need for financial controls

    C7 - Explain the nature of fraud and basic ideas of fraud prevention

    B2 - Prepare bank reconciliations

    B4 - Prepare accounts for sales and purchases including personal

    accounts and control accounts

    C6 - Explain nature of errors and to be able to make accountingentries for them

    B5 - Identify the necessity for financial accounting codes and

    construct simple coding system

    Preventing errors

    There are a number of ways in which errors can be prevented, or at

    least limited in their number and effect. Many of these measures also

    prevent deliberate fraud.

    Authorisation procedures

    All cheques and BACS runs requiring 2 signatures

    Purchase of non current assets to be authorised by senior

    management only

    New receivable accounts and payable accounts signed off bysenior manager

    All purchase orders signed off by senior manager

    All payments made should be approved first e.g.

    Payments made to suppliers should be matched against

    goods received note, invoice and credit notes

    Refunds to customers authorised by management

    Payroll should be checked and authorised before making a

    payment

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    Documentation

    Purchase order used to purchase good

    Goods received note/ delivery note to be checked against

    purchase order (check number/damage)

    Invoice needs to be checked against GRN

    Payment to be made once all documentation match against

    invoices (take into account of credit notes if any)

    Organisation of staffAll staff should be probably recruited, trained and supervised. No one

    person should have complete control over any section of the book

    keeping system. Duties should be shared out between different

    members of staff. This is known as segregation of duty.

    For example one member of staff responsible for the following could be

    able to cabable of carrying out fraudulent activity

    Issuing sales invoices

    Issuing credit notes

    Credit control

    Banking receipts from customers

    Detecting errors

    Spot checksComparison with external evidence - confirm balances with

    receivables

    Reconciliationsbank reconciliation and control account

    reconciliation

    Carry out an audit

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    Bank Reconciliations

    With-in the ledger account is a bank account ledger, and it is important

    that the balance in the ledger reconciles to the balance on the actual

    bank statement. We call this exercise a bank reconciliation.

    Dependant on the size of the company, this can be done on a weekly or

    monthly basis, and in some larger companies even daily.

    Preparing a bank reconciliation has many advantages. They include:

    Provides a check on accuracy of recordings in the cash book

    Highlights any errors

    Assists in the day to day cash managementAny differences can be identified quickly

    Debits and Credits

    On a bank statement the balances will be from the perspective of the

    bank not that of the business. Therefore, if a bank statement shows a

    credit balance, the bank has a creditor. In other words the bank owes

    the business and is therefore in a positive position.

    If the bank statement shows a debit balance this indicates the business

    is overdrawn. i.e. it is an asset from the banks point of view

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    Reconciling Items

    It is extremely unlikely that the balance on the ledger account and the

    balance on the bank statement will agree. This can be due to the

    following reasons:

    Cheques issued by the company are immediately entered into the

    cash book, but they will not appear on the bank statement until

    they are presented to the bank. These are called unpresented

    cheques.

    Receipts by the business are immediately entered in the cash

    book and then banked. This can take a number of days to clear.

    There may be items in the bank statement that have not been

    processed through the cash book e.g. BACS transfer, standing

    orders, direct debits, dishonoured cheques and bank charges.

    Omission of items

    Proforma bank reconciliation

    Balance per bank statement 65,455

    Less : Unpresented cheques (1,950)

    Add: Outstanding lodgements 1,700

    Balance per cash book 65,205

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    Reconciling control accounts and ledger accounts

    The control accounts must be checked against the total of balances in

    the relevant ledger (Receivables /sales ledger) on a regular basis. If

    there is any difference then this must be investigated.

    First letslook at what we should be including in our control accounts.

    RECEIVABLES LEDGER CONTROL ACCOUNT

    Balance b/d X Sales returns X

    Credit Sales X Bank X

    Returned cheques X Discounts allowed X

    Bad debts X

    Contra X

    Balance c/d X

    X X

    PAYABLES LEDGER CONTROL ACCOUNT

    Purchase returns X Balance b/d X

    Bank X Credit purchases X

    Discounts received X

    Contra X

    Balance c/d X

    X X

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    Example 1

    The following are the balances on Candys ledger accounts in the

    month of January

    Opening receivables balance 22,500

    Sales day book 88,650

    Cash sales 23,950

    Sale returns day book 5,555

    Refunds to customers 3,325

    Discounts allowed 6,786

    Irrecoverable debts 4,455

    Increase in provision 500

    Purchase ledger contra 1,200

    Closing receivables ledger 18,650

    Required

    Calculate total cash received from customers in January

    RECEIVABLES CONTROL ACCOUNTBALANCE SHEET

    Dr Cr

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    Example 2

    The following are the balances on a companys ledger accounts in the

    month of March:

    Opening payables balance 12,785

    Purchase day book 44,999

    Returns outwards daybook 3,950

    Returns inwards day book 2,300

    Cheques paid to suppliers 37,500

    Discounts received 1,400

    Sales ledger contras 900

    Required

    Calculate the closing balance for the payables account at the end of March.Solution

    PAYABLES CONTROL ACCOUNTBALANCE SHEET

    Dr Cr

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    Reconciling the control accounts

    Normally at the end of each month we check to ensure our control

    accounts reconcile to the individual balances on our ledger accounts.

    We do this by:

    Checking our list of individual balances tie into the control account

    balance. If there is an imbalance then it must be investigated. The main

    discrepancies are due to:

    Casting error in the day books

    Posting error

    A one sided contra

    An entry that has been made in the individual account but not inthe control accounts

    An entry being omitted from the control account

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    Example 3

    At the financial year end 31 December 2007 Explorer Rain Wear had a

    balance on the payables control account of 22,550. The balance on

    their purchase ledgers was 20,650. The management accountant

    found the following discrepancies:

    1. An invoice of 1,200 had been omitted from the control account

    2. The purchase day book was overstated by 1,000

    3. Goods returned of 1,590 had not been recorded in the control

    account

    4. Discounts received of 10 had not been posted

    5. Contra entries of 500 need to be recorded in the control account

    After these adjustments are made the control account should balance.

    Solution - Until a full knowledge of double entry is known, the easiest

    way to tackle this question is to identify where the error has occurred and

    amend accordingly. In this case:

    Error No. Location of Error Amend

    1 Control Account Control Account2 Control Account Control Account3 Control Account Control Account4 Control Account Control Account5 Control Account Control Account

    PAYABLES CONTROL ACCOUNTBALANCE SHEET

    Dr Cr

    Balancer per list

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    Example 4

    Hippo Manufacturing had the following balances on their payables /

    receivables for the financial year ended 30 June 2006.

    Credit sales 450,000Cash sales 22,000Credit purchases 300,000Cash purchases 4,500Returns inwards 17,000Returns outwards 14,000Discounts allowed 11,000

    Discounts received 12,000Irrecoverable debts 2,500Payments made to payables 263,100Cash received from receivables 438,580Contras 17,500

    Balance at 1 July 2005:

    Payables 53,500Receivables 51,500Provision for doubtful debts 3,400

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

    Required:

    Compute the receivables and payables control account and extract the

    closing balances for the financial year end.

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    Solution

    This is a common CBA question. It is designed to ensure you know

    exactly what should go into control accounts and also your knowledge

    of double entry. Again until you are comfortable with debits and credits

    it is easier to write exactly where things will go before attempting to

    balance the accounts. In this case:

    Receivables /Payables

    Debit / Credit

    Credit salesCash salesCredit purchasesCash purchasesReturns inwards

    Returns outwardsDiscounts allowedDiscounts receivedIrrecoverable debtsPayments madeCash ReceivedContra

    PAYABLES CONTROL ACCOUNTBALANCE SHEET

    Dr Cr

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    Suspense and Correction of errors

    At the end of an accounting period we extract a trial balance, and use

    this as a basis for preparing the financial statements.

    The following are the main purposes of a trial balance:

    Account balances are reviewed to check for obscurities

    Reconcile all control account balances with the individual ledgers

    Ensure debits equal the credits.

    If there is an imbalance a SUSPENSE ACCOUNT will be created.

    Therefore, a suspense account may have a debit or credit balance.

    Errors that will cause a difference in the trial balance are:

    Transposition errorEntering figures the wrong way round

    Single entriesOnly one side of the transaction has been posted

    Both entries entered on the same side of the ledger account

    Casting errorAn account has been incorrectly added

    RECEIVABLES CONTROL ACCOUNTBALANCE SHEET

    Dr Cr

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    Although extracting a trial balance proves the above, there are certain

    errors that a trial balance will not identify. These are:

    Error of principleAn entry has been entered in the wrong

    financial statement.

    Errors of omissionA transaction has been missed out.

    Errors of commissionEntering an amount in the wrong account,

    but in the correct financial statement.

    Compensating errorsWhere two or more errors cancel eachother. This is extremely rare.

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    Example 5

    Peter has the following balances on its trial balance at the end of the

    financial year:

    Debit 213,852

    Credit 212,390

    A suspense account has been created for the difference.

    The following errors have been identified by the accountant; after these

    errors have been corrected the balance on the suspense account should

    be removed.

    1. A payment for stationery for 440 was debited to stationery as

    780.

    2. Discounts allowed of 1,310 have been recorded as a credit.

    3. Other income of 3,742 has only been recorded in the cash book.

    Required

    Correct the entries and clear the suspense account.Solution

    Account Name Description Debit Credit

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    Suspense Account

    Accounting coding systems

    A company will need to choose a coding system for their accounting

    system as there can be a large number of accounts. By having a

    coding system it will be quicker and easier to identify the accountinvolved. For example: is it a non current asset account or an

    expense account?

    It is generally accepted that codes should be:

    Unique

    Useful

    Compact

    Meaningful

    Self checking

    Expandable

    Standard size

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    THE REGULATORY FRAMEWORK OF

    ACCOUNTING

    LEARNING OUTCOMES

    A3- Identify the underlying assumptions, policies and changes in

    accounting estimates

    A8- Explain the influence of legislation and accounting standards

    on the production of published accounting information for

    organisations

    C1- Identify the requirements for external audit and the basic

    processes undertaken

    C2 - Explain the purpose and basic procedures of internal audit

    C3- Explain the meaning of fair presentation

    C5 - Explain the purpose of audit checks and audit trails

    The regulatory framework

    Companies prepare financial accounts (statutory accounts) and these

    are filed at Companies House. They are available for any interested

    party to view.

    Regulation on the preparation of statutory accounts is governed by two

    main areas:

    Companies act

    International accounting standards

    Businesses must comply with the Companies Act, but the international

    accounting standards are not legally enforceable. If companies want to

    be listed on the stock exchange and have a successful audit then they

    must comply with the accounting standards.

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    Regulation ensures that companies comply in certain areas with-in their

    financial statements. This results in good practice and makes statutory

    accounts more comparable with other entities. This aids decision

    making and can lead to the success of a business.

    International accounting standards are extremely important and are

    issued by the International Accounting Standards Board (I.A.S.B.).

    There are four separate bodies and the structure is:

    International Accounting Standards Committee Foundation

    (I.A.S.C.F.)

    This committee is responsible for appointing members in the I.A.S.B.,

    S.A.C and I.F.R.I.C. It is also their responsibility to ensure the threebodies have adequate funding.

    International Accounting Standards Board (I.A.S.B.)

    The I.A.S.B. is responsible for issuing accounting standards (I.A.Ss).

    They are also called international financial reporting standards

    (I.F.R.Ss)

    Standards Advisory Council (S.A.C.)

    Their responsibilities include advising the I.A.S.B. on its priorities and

    providing the I.A.S.B. information about the implications of I.A.Ss.

    International Financial Reporting Interpretations Committee

    (I.F.R.I.C.)

    This body is responsible for providing guidance on any problems that

    emerge relating to issued I.A.Ss.

    The members of these bodies are from varying countries and

    backgrounds, some are preparers of financial statements and others are

    users of financial statements.

    Accountants are expected to follow I.A.S. In the U.K. the Financial

    Services Authority (F.S.A.) and the Financial Reporting Review Panel

    (F.R.R.P.) check companys accounts to ensure they are being followed.

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    The conceptual framework

    The framework underpins all accounting standards and provides a

    general format for future standards. This ensures all standards are

    consistent and thus aids accounting information.

    The framework includes the following:

    The objective of financial statements

    Financial statements should provide useful information to a wide range

    of users.

    The qualitative characteristics

    The I.A.S.Bs Framework says that statements should have certain

    qualitative characteristics. These include:

    Reliability

    Relevance

    Understandable

    Completeness

    Comparable

    Timeliness

    Accounting conventions

    1 The objective of financial statements

    To provide information about the financial position, performance andchanges in financial position of an entity that is useful to a wide range of

    users in making decisions.

    2 Underlying assumptions

    Accruals basis the effects of transactions and other events arerecognised when they occur and not when cash transfers. They arereported in the financial statements in the period to which they relate.

    Going concernthe financial statements are prepared on the basis thatan entity will continue in operation for the foreseeable future.

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    3 Qualitative characteristics of financial statements

    The four main characteristics are:

    Understandabilityassuming users have a reasonable knowledge ofbusiness and a willingness to study information with reasonablediligence, the financial statements should be readily understandable tousers.

    Relevanceto be useful, information must be relevant to the decisionmaking needs of the user.

    Reliable

    Faithful representationReflect the substance

    Neutral, free from biasPrudentComplete

    Comparability users must be able to compare the financialstatements of an entity from period to period and from company tocompany

    4 The elements of financial statements

    Asset is a resource controlled by the enterprise as a result of pastevents and from which future economic benefits are expected to flow tothe enterprise.

    Liabilitiesare an entitys obligations to transfer economic benefits as aresult of past transactions or events.

    Equity is the residual amount found by deducting all liabilities of theentity from all of the entitys assets.

    Income is increases in economic benefits during the accounting periodin the form of inflows or enhancements of assets or decreases inliabilities that result in increases in equity, other than those relating tocontributions from equity participants.

    Expenses are decreases in economic benefits during the accountingperiod in the form of outflows or depletions of assets or incurrences ofliabilities that result in decreases in equity, other than those relating todistributions to equity participants.

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    5 Recognition of the elements of financial statements

    In order to recognise anything in the balance sheet and incomestatement it must meet all three of the following criteria:

    - Meet the definition of the element (as above)

    - Probable future economic benefit will flow to or from the entity

    - The item can be measured reliably

    6 Measurement of the elements of financial statements

    Historical cost - cash price or fair value at acquisition or obligation. Mostcommonly used but widely criticised

    Current costwhat would be the cash price todayRealisable value - what could be realised/satisfied today

    Present valuediscounted future cashflows

    The Framework does not state which of the four should be used

    7 Concepts of capital and capital maintenance.

    The Framework refers to two concepts of capital: financial concept of

    capital and physical concept of capital.

    8 Going Concern

    Financial statements shall be prepared on a going concern basis unlessmanagement either intends to liquidate the entity or cease trading, orhas no realistic alternative but to do so.

    When financial statements are not prepared on a going concern basis, it

    should be disclosed, together with the basis on which the financialstatements are prepared and the reason why the entity is not regardedas a going concern.

    9 Accruals basis of accounting

    An entity should prepare its financial statements, other than the cashflow statement, using the accruals (matching) basis of accounting.

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

    10 Consistency

    Presentation and classification of items should be consistent from periodto period unless;

    Standards change; orThe nature of the entitys operations changes it is moreappropriate to follow a different presentation or classification

    11 Materiality and aggregation

    Each material class of similar items should be presented separately inthe financial statements.

    Immaterial items should be aggregated with similar items of the face ofthe statement or in the notes.

    12 Prudence

    A business should not claim to have made profits or gains before theyhave earned with reasonable certainty, but should anticipate fully any

    losses that are expected to occur. This prevents overstating assets and

    profits.

    Regulations in accounting

    There is little regulation regarding the preparation of financial statements

    for sole traders and partnerships, other than to satisfy the tax authorities

    of the profits made in each accounting period. However for limited

    companies there are several types of regulation and guidance to assistthe accountant in preparing the financial statements

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    Company Law

    Company law states that companies are required to have their financial

    statements audited by a registered auditor. For the UK they are required

    to submit them to companies house on a yearly basis.

    International accounting standards

    For CO2 you do not need to state any specific knowledge of specific

    accounting treatment contained in IFRSs.

    However you do need to know the influences of the IFRS on financial

    statements.

    Terminologythis text uses the words, phrases and definitions in

    IFRSs

    PresentationThe presentation of the financial statements and

    particularly the balance sheet and cashflow statement follow the

    IFRS formats

    Technicalthe technical requirements of the IFRS have been

    followed ;

    Internal and External audit

    External Audit Internal audit

    Report to shareholders Report to management

    Audit

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    Role of external auditor

    The purpose of the external audit is to form an opinion on the financial

    statements. The auditor will express whether the financial statements

    give a fair presentation. E.g. a true and fair view.

    True Information is not false, but factual and

    conforming with reality

    Fair Information is free from discrimination and

    bias

    Role of internal auditor

    Review of accounting systems and controls

    Examination of financial/operating information

    VFM audit

    Review of implementation of corporate policies

    Special investigations

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    LIMITED COMPANY ACCOUNTS

    LEARNING OUTCOMES

    When you have completed this chapter, you should be able to:

    Prepare an Income Statement

    Prepare a Statement of Changes in Equity

    Prepare a Balance Sheet

    Introduction

    Many businesses are constituted in the form of limited companies. The

    owners of limited companies are referred to as shareholders and are

    often different from the people that run the company.

    The shareholders have very little, if any involvement in the day to day

    running of the business and employ directors to run it on their behalf.

    Limited company financial statements have very strict requirements

    which must be followed by all companies. These are governed by:

    Companies act 1985

    The International Accounting Standards Board

    The format to be adhered to per I.A.S. must be the format we adopt in

    our studies. The proforma financial statements for limited companies

    were given in session 2, however a copy is given below for reference:

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    Proforma set of financial statements for a limited company or Plc

    Balance Sheet as at 31 December 2007

    Non current assets

    NoteIntangible assets 6 200,000Tangible assets 7 187,999

    Current assets

    Inventory 8 88,432

    Trade receivables 9 97,455Cash 13,400 199,287

    Total assets 587,286

    Equity and liabilities

    Share capital 100,000Retained earnings 220,497

    Revaluation reserve 7 38,000 358,497

    Non current liabilities

    Interest bearing borrowings 10 100,000

    Current liabilities

    Trade payables 77,789

    Taxation 5 51,000 128,789

    Total liabilities 587,286

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    Income Statement for the year ended 31 December 2007

    NoteRevenue 385,000

    Cost of sales 1 188,000

    GROSS PROFIT 197,000

    Distribution costs 2 38,500

    Administration expenses 3 37,700

    PROFIT FROM OPERATIONS 120,800

    Finance costs 8,000

    PROFIT BEFORE TAX 112,800

    Income tax 53,000

    PROFIT FOR THE PERIOD 59,800

    Statement of Changes in Equity for the year ended 31 December

    2007

    Share Retained RevalueCapital Earnings Reserve Total

    Balance as at 1Jan 2007 100,000 188,697 40,000 328,697

    Profit for the period 59,800 59,800

    Surplus depreciation 2,000 (2,000)

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

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

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    A limited company must file their statutory accounts with companys

    house. A full set of statutory accounts will include:

    1. Income Statement

    2. Statement of Changes in Equity3. Balance Sheet

    4. Cash flow statement

    These statements are supported by notes explaining the balances in the

    financial statements.

    One of the key differences between a company and a sole trader is that

    a company is classed as a separate legal entity. This means that a

    company is deemed to be a person in its own right. Therefore, acompany can sue individuals and can also be sued. The name limited

    company comes from the fact that the shareholders have limited liability,

    in other words their liability is restricted to the amount they have paid for

    their shares.

    Profits of a company are distribution by the way of dividend payments.

    These payments are on the directors discretion.

    Double entry for a share issue

    Dr Bank

    Cr Share Capital

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    Example 1

    Freedom Limited has 100,000 ordinary shares in issue. The nominal

    value (par value) is 1.00 and the directors decide to pay a dividend of

    75p per share.

    If this is the case the company would pay 75,000 (100,000 x 0.75) in

    dividends

    Preference shares

    This type of share is known as a non-equity share, and gets a fixed

    return on the value of the share. Preference share holders will receive

    their dividend every year providing the company has distributable profit.

    Ordinary share holders will receive a dividend if the directors decide to

    pay one.

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    Example 2

    The following information relates to Voyager Limited

    Year ended 31stDecember 2007

    Share capital (25p shares) 100,0006% Preference shares 50,000

    The directors propose an ordinary dividend of 75p per share.

    Required:

    Calculate the dividend payable.

    Solution

    Ordinary shares

    Preference shares

    Total dividends paid

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    Share premium

    If a company issues shares after the initial corporation, it is unlikely they

    will issue them at a nominal/par value. As the company has established

    itself, the net worth of the company would increase. This would bereflected in the share price.

    Example 3

    The following relates to Radiance Limited

    Capital and reserves

    Share capital (1.00) 200,000

    Retained earnings 233,456

    Revaluation reserve 125,000

    Say the market value price per share is 3.85 and the directors wish to

    issue a further 50,000 shares for cash injection purposes.

    The double entry would be:

    The Capital and reserves would now be:

    Share capital (1.00)

    Share premium

    Retained earnings

    Revaluation reserve

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    Capital reserve

    The share premium account is classed as a Capital reserve. This

    means that the account cannot be used to pay out dividends. The use

    of capital reserves is very limited. The key use of the reserve would beto finance a bonus issue of shares. This is when the directors distribute

    free shares to existing shareholders.

    The accounting entry for this would be:

    Cr Share capital

    Dr Share premium

    Dividends

    As we have seen previously in this chapter, dividend payments are used

    to distribute profit to shareholders. In order that a dividend can be paid,

    the company must have reserves that are distributable i.e. they cannot

    be paid out of any reserve that is not realised (Revaluation reserve).

    Final dividends are paid after the year end; once the financial statementshave been completed, and the directors have decided the dividend

    amount.

    An interim dividend can also be paid mid way through the year.

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    Example 4

    Share capital (50p) 200,000

    10% Preference shares 25,00

    An interim dividend of 8p per share was paid during the year and the

    directors would like to propose a final dividend of 9p per share.

    Required:

    Calculate the total dividend payable for the year ended 31stMay 2007.

    Solution

    Ordinary shares

    Preference shares

    Taxation

    All companies have to pay tax on the taxable profits. The tax charge is

    normally estimated at the end of the financial year and charged to thestatement of comprehensive income, and is paid in the following year.

    The accounting entry for taxation would be:

    Dr Taxation Income Statement

    Cr Taxation liability Balance Sheet

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    CASH FLOW STATEMENTS

    LEARNING OUTCOME

    D13 Prepare cash flow statements

    Introduction

    The cash flow statement is a primary financial statement and provides

    fundamental information to the user of accounts. It highlights the key

    areas where a business has generated and spent physical cash.

    Good cash management ensures a business has sufficient cash to run

    its day to day operations.

    Prior to this session we have focused on profit, but cash is equally vital

    for the success of a business, especially in the short term. If a business

    has limited cash funds available it will struggle to survive in the short

    term.

    Advantages

    Cash flow balances are matter of fact and are not distorted byaccounting policies

    Cash flow balances are objective, unlike profit which is subjective

    Users of financial statements can establish exactly the cash

    generation of a business

    Users can identify exactly how this cash has been utilised

    Users can assess the liquidity of a business and assess its abilityto repay debts as they fall due

    Loans repaid and received are clearly listed in the cash flow

    statement

    Users can assess management attitude to capital expenditure

    Interest payments are highlighted in the cash flow

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    IAS 7

    IAS 7 lays down the requirements of a cash flow statement. It gives us a

    detailed proforma and certain definitions:

    Cash

    Cash that is available on demand. An example would be cash in the

    bank less any overdraft.

    Cash equivalents

    Short term, highly liquid investments (will be stated as a current assets)

    I.A.S. 7 has three main headings. Students should familiarise the layout

    of a cash flow as questions in the exam will test this area.

    The three main headings are:

    Cash flows from operating activities

    Cash flows from investing activities

    Cash flows from financial activities

    Proforma

    Net cash flow from operating activities

    Net profit before tax X

    Adjustments

    Interest payable XDepreciation X(Profit) / loss on the disposal of a non currentasset

    (X) X

    Operating profit before working capitaladjustments

    X

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    Working capital adjustments

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

    Increase / (Decrease) in payables X (X)

    Cash generated from operations X

    Interest paid (X)Taxation paid (X)

    NET CASH FROM OPERATING ACTIVITIES X

    NET CASH FROM OPERATING ACTIVITIES X

    Cash flow from investing activities

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

    Interest received XDividends received X

    CASH FLOW FROM INVESTING ACTIVITIES X

    Cash flow from financing activities

    Proceeds from the issue of shares XReceipt of loans XRepayment of loans (X)Dividends paid (X)

    X

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    CASH FLOW FROM FINANCING ACTIVITIES

    NET CASH FLOW X

    Cash and cash equivalents at the beginning ofthe period

    X

    Cash and cash equivalents at the end of theperiod

    X

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    Example 1

    Moon Shine LimitedBalance Sheet as at

    31 December2006 2007

    Non-current assets

    Cost 180 220Accumulated depreciation (78) (92)

    Current assets

    Inventory 12 17

    Trade receivables 2 10Bonds 10 10Cash 3 16

    Capital and reserves

    Share capital 45 65Share premium 10 12

    Accumulated profit 24 68

    Non-current liabilitiesLoan 30 20

    Current liabilities

    Payables 19 13Tax 1 3

    Notes

    The tax charge in the statement of comprehensive position is 6,000.

    Loan was repaid at the end of the financial year.

    Required

    Prepare the cash flow statement for the year ended 31stDecember 2007.

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    Direct Method

    The direct method involves added together the cash inflows and

    deducting the cash outflows.

    Example 2

    The following information relates to Empress Limited:

    Cash sales 55,000Cash received from customers 44,000Cash purchases 33,000Cash paid to suppliers 12,000Cash expenses 11,000Cash wages and salaries 20,000

    Calculate the cash generation for Empress Limited

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    INCOMPLETE RECORDS

    LEARNING OUTCOME

    D11 Prepare accounts from incomplete data

    Introduction

    As the name suggests, incomplete records are any form of accounting

    records other than the full double entry system.

    In reality, accountants come across incomplete records almost daily.

    This is because their clients are not likely to fully understand the doubleentry system. We still however, need to prepare a set of financial

    statements for the client.

    During the exam, students will often come across incomplete records.

    The main reason is often due to a flood or fire at the business premises.

    Calculating profit

    If a business has very little information about its transactions, it may onlybe possible to calculate its net profit for the year. This can be done by

    using the accounting equation. The accounting equation can be written

    as:

    Net Assets = Capital + Prof i t - Drawings

    Or

    Change in net assets = Capital introduced + Prof i t Drawings

    You make realise that this is very similar to the Balance Sheet.

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    Example 1

    A sole traders statement of financial position at 31stDecember 2006

    shows that the business has net assets of 5,000. The Balance Sheet

    at 31stDecember 2007 shows that the business has net assets of

    8,000. The owners drawings for the year amounted to 2,500 and he

    didnt introduce any further capital in the year

    Required

    Calculate the profit for the year ended 31stDecember 2007.

    Solution:

    Changein netassets

    Capitalintroduced Profitfor theyear

    Drawinginperiod

    This can be written as:

    Profit =

    As you can see it is impossible to know the make-up of the net profit

    figure due to lack of information.

    Preparing financial statements from incomplete records

    In the majority of cases a business will keep limited amount of records.

    In these types of questions you will be given information regarding theopening and closing balances of assets and liabilities of the business.

    You will also be given information about certain transactions during the

    period; this is usually a summary of the cash book.

    There are two main techniques used in complete records:

    1. Balancing figures in ledger accounts

    2. Ratios for mark-up or margin

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    Balancing figures

    The balancing figure approach is commonly used the following way:

    Ledger Account Missing Figure

    Accounts receivable SalesMoney received from accountsreceivable

    Accounts payable PurchasesMoney paid to accounts payable

    Cash at bank DrawingsMoney stolen

    Cash in hand Cash salesCash stolen

    Example 2

    Suppose that the opening balance on the accounts receivables ledger

    was 50,000, there had been receipts from account receivables in the

    year of 45,000, irrecoverable debts have been written off worth 5,000

    and the closing balance was 55,000.

    Required:

    What were the credit sales for the year?

    Account Receivables

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    Example 3

    Suppose that the opening accounts receivables balance was 30,000,

    there have been total receipts from customers of 55,000 of which

    15,000 relates to cash sales and 40,000 relates to receipts from

    accounts receivables. Discounts allowed in the year totalled 3,000 and

    the closing balance was 37,000.

    Required:

    What are the total sales for the year?

    Due to the information given in the question we can approach this in 2

    different ways. We can calculate credit sales as above and then add on

    cash sales, or we can use the ledger account to calculate total sales.Both methods are shown below:

    Solution 1 - Total sales

    Account Receivables

    Solution 2 - Separate sales

    Account Receivables

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    Example 4

    The opening balance on the accounts payable ledger was 30,000.

    Payments made to account payables during the year were 33.000,

    discounts received are 4,000 and the closing balance was 26,000.

    Required:

    What was the total purchases figure for the year?

    Solution:

    Account Payables

    Example 5

    On 1stJanuary the bank is overdrawn by 1,367, payments in the year

    totalled 8,536 and on 31stDecember the closing balance was a

    positive balance of 2,227.

    Required:

    What is the total receipts figure for the year?

    Solution:

    Cash Book

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    Example 6

    Scott has a cash float at the beginning of the year of 900. During the

    year cash of 10,000 was banked, 1,000 was paid out for drawingsand wages of 2,000 was paid. Scott decided to increase the float to

    1,000 at the end of the year.

    Required:

    How much cash was received from customers during the year?

    Solution:

    Cash Account

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    Ratios Mark-up and Margin

    The gr