Finance and Accounting Study Aid

Finance and Accounting
An ICM Study Aid

Contents
Introduction 5 Part 4: The Construction of Financial 86

Statements
Part 1: An introduction to 6 22. Financial Statements: The Calculation 87
Accounting of profits
1. What is Accounting? 7 23. Adjustments: Accruals and 92
Prepayments
2. Business organisations and 10 24. Adjustments: Bad Debts and Provision 97
sources of finance for Debtors
3. Introducing Financial Statements 14 25. Depreciation of Fixed Assets 100
4. The Role of the Accountant 20 26. Partnership Accounts 103
Part 2: The Accounting Model 22 27. Company Accounts 107
5. Recording Financial Transactions: 23 28. Cash Flow Statements 112
The ledger system
6. The Running Balance Method 28 29. Accounts of Clubs and Societies 116
7. The Sales Day Book 29 30. The Extended Trial Balance 118
8. The Purchases Day Book 34 Part 5: Using Accounting Information 122
9. The Returns Day Book 39 31. Accounting ratios and Preparing 123
Reports
10. VAT and VAT Returns 43 32. Accounting Standards 129
11. Banking Services 46 33. Accounting for Stocks 134
12. The Cash Book 49 34. Incomplete records 138
13. Bank Reconciliation 53 35. Manufacturing Accounts 141
14. The Petty Cash Book 57 36. Marginal Costing 145
15. Capital Expenditure 59 37. Budgeting 149
16. The Trial Balance, Journal and 61 38. Capital Investment Appraisal 152
Suspense Accounts
Part 3: Supply Information for 69 39. Exams and Exam Success 155
Management Control
17. The Purpose of Management 70
Information
18. The Use of Cost Centres and Cost 74
Coding
19. Providing Comparison on Costs 76
and Income
20. A brief Introduction to Wages 79
21. Control Accounts: Sales and 82
Purchase Ledger Control
© Trainer Bubble Ltd. 2011

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Learning Log
Study Aid Page: Key Learning Point:

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Study Aid Page: Key Learning Point:

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Introduction
The Finance and Accounting Unit covers a range of studies to help you better understand the
fundamentals of finance and accounting in business. We will look at how financial information is
recorded and then used by organisations to help them make better decisions and, ultimately, make
more profit.
At the end of each chapter there is a sample of questions. A number of these will be past paper
questions from previous exams (they will be marked to show you which ones are from past papers).
It is essential that you attempt these questions and keep practicing until you have mastered them. It
is the surest way to be successful in the exams. Making lots of notes from this study aid, or your
textbooks, is useful. But you will not know for sure if you have truly learnt the information until you
attempt a question.
If you find an area of accounting that is difficult, make sure you spend more time trying to
understand it. The exam could test you on any area, but as you will see from past examination
papers on the ICM website, there are some core question types that are likely to be asked again and
again. Make sure you have learnt these.
One additional word of advice: it is vital to learn the concept of double entry. When you fully
understand when a transaction is a credit and when it is a debit, you are in a great position to tackle
any problem.
This self study aid acts as an introduction to the subject and will also help with your revision.
However, we do recommend that you also use the ICM study book Finance & Accounting by Richard
Giles (ISBN 978-1-903260-06-7) as this covers the subject in much more detail.
On pages 3 and 4 of this study aid you will find a learning log. You can use this to note key learning
points or points you would like to study further. This will help you when you revise the subject for
your examination.

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Part 1
An Introduction to Accounting

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Chapter 1: What is Accounting?
Introduction
It is important we understand what we mean by accounting at the beginning of this journey into the
financial world. The widely accepted version of accounting produced by the American Accounting
Association states:
Accounting is the process of identifying, measuring and communicating economic information in

order to permit informed judgements and decisions by users of that information.
Business enterprises are made up of commercial transactions i.e. buying and selling their goods and
services. To do this requires money and a business must be adequately financed in order to survive.
Finance:
Finance is about having sufficient money in business in order
to trade. Finance is essentially about money - the management
of money, the control of it, the raising and spending of it and
of course, the making of it. That is what business is all about,
making profits.
From a business’s point of view, finance wants to know two

things:
 Where it gets its money from.
 What happens to its money. How it is used and
whether the business is making a profit.
Accounting:
Every business organisation needs to maintain accurate accounting records to help it manage and
control its finances more efficiently. Without day to day records it would be difficult to know if it was
making a profit or a loss.
Bookkeeping:
The side of the business that ensures financial records such as receipts and payments, sales,
purchases and expenses are maintained accurately. Allowing informed decisions to be made about
the price to charge for goods and services.
Accounting is a step on from bookkeeping as it is used to communicate financial information to

interested parties such as owners, managers and banks
Financial Statements:
The profit and loss account and the balance sheet represent the two key financial reports that show
how a business is performing. The profit and loss shows exactly that, how much profit or loss a
business has made. The balance sheet shows the value of the business’s resources and how these
resources are financed by the owner’s capital and borrowed money (its liabilities).

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There are three different types of accounting that need to be explained:
Financial Accounting
The recording of financial information and is the bookkeeping side of the business.
By maintaining and monitoring daily financial records, accurate financial statements
can be prepared for a period of time. Put simply: the better the quality of accounting
records, the better control the business has.
Management Accounting
Financial and cost accounting will be used in management accounting
to provide the business with essential information so it can target its
objectives more effectively. Planning, control and the forecasting of
results are important roles of management accounting.
Cost Accounting
This is about how much things cost to make and providing
that information to management to help inform better
decision making. For example, would it cost the same to
produce 100 television sets a week as it would 150?
Who needs accounting information?
Government
Managers Suppliers
Bank Employees
s
Customers Investors

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End of Chapter
1 Test Questions:
1. How does bookkeeping assist in providing information for

accounting?
2. What is meant by the term financial statements?
3. How do financial statements assist owners and manager in business?
4. How does the role of financial accounting differ from that of cost and management accounting?
5. How would you define the meaning of finance?
6. From ‘Who needs accounting information’ answer the following:
a) Who wants to know whether the business is profitable?

b) Who is concerned with taxes and VAT
c) Why does management need accounting information?
d) Why would a bank want accounting information?
7. Why are customers and suppliers interested in accounting information?

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Chapter 2: Business Organisations and
Sources of Finance
Introduction
A countries economy is often mixed, where the production of goods and services is provided by both
the private and public sectors of business.
Private Sector Economic activity in the hands of individuals

Public Sector Economic activity in the hands of government
The Private Sector:
There are three basic types of organisation, with the essential difference being the size of the
business. This size is directly related to the initial investment in the business – that is, the provision
of capital.
A Sole Trader One-man business unit. Capital raised by the private

resources of one person, who may also borrow from
banks.
A Partnership May have as many as 20 partners and therefore able to
raise more capital.
A Limited Company Can either be public limited or private limited companies.
(private or public)
Private – while no limit on the number of shareholders
who contribute capital, a private limited company may
not advertise its shares on the market. The number of
shareholders, therefore, is likely to be limited to friends,
family and acquaintances.
Public – can raise large amounts of capital by issuing a

prospectus (an invitation to the public to buys its shares).
At least £50,000 of share capital must be registered with
the company and 25% must be issued and paid for before
allowed to operate.
Shareholders are part owners of their companies. People own shares for two reasons:
● To receive a dividend payment (a share of the company’s profits)

● The shares increase in value (a capital gain)
Dividends are paid on the nominal value of shares (their face value), not the market value at the
time.

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Classes of Shares (two distinct classes):
Ordinary Shares – Often known as equities, the rate of dividend is dependent on the profit the
company has made and how much the directors choose to pay as dividends and how much to retain
in the business (reserves).
Preference Shares – Shareholders are entitled to a fixed rate of dividend (e.g. 8% preference shares).
More suitable to the investor that wants a regular and fixed dividend, and much less common than
ordinary shares.
Rights Issue – When a company wishes to expand its share capital, the existing shareholders are
invited to buy the new issue first. If existing shareholders do not take up the offer, shares may be
sold on the open market.
Limited companies have an advantage of other business forms as they have ‘limited liability’. This
means that if the company fails, shareholders are protected against the debts of the company. They
will possibly lose their investment, but importantly will not be liable for the larger debts of the
business.
Sole traders and partnerships do not have this legal protection, meaning they are personally liable
for the debts of the company – sometimes meaning personal possessions have to be sold to settle
business debts.
Sources of Finance
Starting a business takes money. For a large manufacturing business it may take millions of pounds,
while for a small florist it may take just a few thousand pounds.
Finance can be a scarce resource and expensive, particularly if you want it quickly. Whether finance
is short or long-term in nature depends on the end use of the money.
Short-term finance is about having sufficient cash flow in the business to pay for the basic things
such as stock, wages and expenses – the day to day costs.
Financing is also often required to buy fixed assets (land, plant and machinery, vehicles etc). To buy
fixed assets, known as capital expenditure, it is common to get a long-term loan from the bank.
Whether short or long, adequate financing of a business is critical. One of the major causes of
business failure is lack of solvency, meaning not having sufficient liquidity (cash) to be able to pay
debts when they fall due.
When a business can’t pay its creditors (the people it owes money to) it is said to be ‘insolvent’. This
can quickly turn to bankruptcy where owners lose their capital and their business, employees lose
their jobs and suppliers lose what is owed to them. Everyone loses out.
Maintaining adequate cash flow and keeping a tight control of its finances are essential for a
business to survive.
When finance is needed, management must consider three things:

● How long the finance is required
● How much it will cost to repay (including interest charges)
● Whether the monthly repayments can be met

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The Major Sources of Finance:
Owner’s Capital A sole trader’s investment in the business (his net worth).
Private limited company shareholders are the owners
Loan Capital Short (e.g. within a year) or long-term loan from a bank for a
specific period, repaid by regular instalments.
Bank Overdraft The most important source of short-term finance for a
business. A short-term loan because the bank can call it in at
anytime.
Debentures Issued to raise finance over a specific time period, usually
secured with company assets. Interest to creditors is fixed
percentage of the nominal value of the stock, independent
of profit.
Profits Sole traders and partners take profits throughout the year as
part of their income, known as drawings. Companies retain
profits as reserves (this is not cash), which are part of the
overall net assets.
Leasing/Hiring of Fixed Assets A business does not need to purchase fixed assets outright
but can lease them. Two basic forms: a finance lease (gives
advantage of acquiring asset but without legal ownership,
depreciation and interest charges are written off against
profits) and an operating lease (a form of rental where an
asset is hired for a fixed charge, also written off against
profits).
Leaseback of Assets By selling property to raise finance and then leasing the
property back from the buyer, a business can still use the
asset while raising valuable funds. However, the advantages
of property ownership (such as capital gains if the asset
increases in value) are lost.
Mortgages A long term loan (usually from a bank or building society)
used to purchase property. The lender secures the mortgage
on the value of the property so that any default in payment
can lead to the sale of the asset to reimburse the loan.
Factor Finance A business can send all their invoices to a debt factoring
company who will immediately pay the business a major
percentage of their value and the rest when the factoring
company collects the full debt. The factoring company
charges interest until the debt is collect and an
administration charge. This allows a business to improve
their cash flow by not having funds tied up in debtors and
sometimes avoiding any loses due to bad debts.
Creditors Suppliers of goods and services provide an important source
of short-term finance or trade credit. Credit facilities are
granted for the purpose of buying goods and services and
are usually short-term.

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End of Chapter 2 Test
Questions:
1. What do you consider the main sources of finance are for:

a. A sole trader?
b. A Plc (public limited company)?
2. What is the essential difference between the private sector of business and the public sector?
3. Clearly differentiate between ordinary and preference shares.
4. Why should a company want to lease its fixed assets rather than purchase them? Compare this
method of raising finance with the leaseback of fixed assets.
5. What are the economic objectives of the government? With regard to taxation, what is the
difference between direct and indirect tax?

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Chapter 3: Introducing Financial
Statements
The Profit and Loss Account and the Balance Sheet
Introduction
Accounting has only FIVE distinct accounting groups:
1. Revenue
2. Expenses
3. Capital
4. Assets
5. Liabilities
A business may have hundreds of accounts recorded in its ledgers (where accounts are recorded)
but all will belong to one of these groups.
An easy way to remember this is the word “RECAL”
Revenue – the income earned by a business when selling goods and services.
Expenses – the day-to-day expenses a business incurs such as stock, wages, advertising etc.
Capital – represents the owner’s investment in a business and is needed to begin trading. Capital
may grow if the business is profitable.
Assets – the things of value which the business owns such as premises, equipment, stock, cash etc.
● Fixed assets (non-current assets) are used on more permanent basis, like premises
and equipment.
● Current assets, like stock, cash and bank are used for daily trading purposes.
Liabilities – the things of value that the business owes

● Current Liabilities are debts expected to be repaid within one year e.g. trade
creditors
● Long-term liabilities are debts expected to be repaid over more than one year e.g. a
bank loan or mortgage.
In business there are TWO key financial statements:
The Profit and Loss Account:
The profit and loss account is a business’s statement of its earnings over a period of time. It shows
its income less its expenses which determines whether the business has made a profit or a loss.
A simplified version of this account is below

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G Harrison profit and loss account for the year ended 31 December
£ £
Sales 75,000
less
Cost of Sales 50,000
Gross Profit 25,000

less
Expenses (overheads)
wages 10,800
advertising 2,100
light, heat 850
business rates 900
stationery 400
motor costs 2,150
insurance 1,200
telephone 550
accountant’s fees 700
general expenses 350 20,000
Net Profit 5,000
Note that profit is divided into two parts:
● Gross Profit: (sales - cost of sales)

● Net profit: (gross profit - expenses)
The gross profit measures the trading profitability of buying or producing the
business’s goods or services. The margin of gross profit is very significant as it
must be sufficient to cover all overheads, otherwise a loss will result.
The net profit is the final outcome of profit after all the other expenses are
deducted from the gross profit. Later you will see that the net profit (or loss) is
transferred to the capital account. Why? Because a profit increases capital and
therefore net assets and a net loss has the reverse effect reducing net assets of
the business.
The Balance Sheet:
The balance sheet is a major financial statement and lists the assets, liabilities and capital of a
business. It is a snapshot of a business showing what it owns less what it owes. The difference
between assets and liabilities represents the owner’s capital.
Capital = assets less liabilities
A balance sheet is called that because it must always balance, no matter how many business
transactions may occur. The value of assets will always equal the value of its capital and liabilities.

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Example 1: A simplified balance sheet
G Harrison balance Sheet as at 31st December:
Assets £ £
Premises 50,000
Equipment 2,500
Motor van 7,500 60,000
Stock 8,000
Debtors 2,500
Bank 1,400
Cash 100 12,000
Total assets: 72,000

Less
Liabilities £ £
Creditors 5,700
Bills unpaid 300 6,000
Mortgage 41,000
Bank loan 5,000 46,000
Total liabilities: 52,000
Net assets: (A – L) 20,000
Note:
Debtors – are customers who owe money to the business.
Creditors – are people and organizations that the business owes money to.
The accounting equation:
A very simple rule links capital, assets and liabilities. The owner/s of a business is worth the value of
assets less the value of liabilities. This is called the ‘Accounting Equation’.
If in the example above G Harrison owned ALL the assets of the business:
Capital = Assets - Liabilities
20,000 = 72,000 - 52,000
Alternatively, the accounting equation can emphasise the business’s point of view from the value of
its assets:
Assets = Capital + Liabilities
72,000 = 20,000 + 52,000

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Profits, drawings and Capital:
What would be the effect on the above balance sheet equation if G Harrison made a profit of
£5,000?

25,000 = 77,000 + 52,000
And then withdrew £4,000 as personal drawings during the year?

21,000 = 73,000 + 52,000
So while profits increase capital, personal drawings reduce it. A £5,000 profit with £4,000 of
drawings therefore only increases capital by £1,000.
The dual effect of business transactions:
For every transaction in business there is always a double entry in the firm’s accounts.
Take one simple transaction: paying £1,000 to your creditors. This will mean your bank balance
decreases by £1,000 and that the amount you owe, your creditors account, will also decrease be
£1,000.
This dual effect of accounting is why the balance sheet will always balance.

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Questions:
1. The accounts of a sole trader, Peter Jackson, as at 30 April were:

£
Sales 48,850
Cost of sales 32,420
Wages 5,280
Motor expenses 3,624
Light, heat 2,100
Rates, insurance 3,400
Advertising 456
Telephone 195
Stationery 100
General costs 485
Required:
a) Prepare a profit & loss account of Peter Jackson as at 30 April.
b) What do you think links the profit and loss account with the balance sheet?
2. The following accounts represent the financial interests of M Crooks on 1 June. He runs a small
business associated with the building trade.
£
Premises 33,500
Machinery and equipment 12,500
Tools 1,500
Motor vehicle 4,200
Furniture in the office 1,500
Stocks (at cost) 15,000
Debtors 1,275
Cash 100
Bank overdraft 1,750
Creditors for supplies 13,450
Bills outstanding 750
Interest payments due 125
Mortgage on premises 22,500
Hire-purchase loan on vehicle (2 years) 1,000
Bank loan (5 years) 10,000
Capital account 20,000

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Required:
a) Group the above accounts in their separate categories – e.g, current asset, fixed asset etc.
b) Prepare the balance sheet of M Crooks as at 1 June.
c) Show the accounting equation which would emphasise the ownership of M Crooks.
d) The liabilities of the owner look rather excessive. Has he sufficient funds to meet his current
debts?
e) Crooks must find at least £2,000 by the end of the month to pay off bills and creditors
outstanding. Suggest how he could pay them.
3. The following represents the financial figures of R. James at at year ended 30 June.
£ £
ASSETS LIABILITIES
Land & building 25,000
Furniture & fittings 5,500 Mortgage 15,500
Equipment 7,000 Bank loan (5 years) 10,500
Motor van 6,500 Interest owing 650
Bank 2,500 Creditors 4,500
Cash 50 Bills outstanding 1,000
Debtors 1,450
Stock 8,000 Capital account ?
Profit from trading 8,250

Proprietor’s personal expenses 4,500
Required:
Prepare the balance sheet of R James as at 30 June

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Chapter 4: The Role of the
Accountant and the Accounts Office
Introduction
The accountant’s role is often varied, interesting and far-reaching in the business world. They are
managers of finance: not only interested in recording financial information, they are also interested
in planning and forecasting results.
Accountants are financial consultants and an integral part of management – being part of a team
which plans, controls and takes decisions. There are four main accounting qualifications:
● The Institute of Chartered Accountants (ACA)

● The Chartered Association of Certified Accountants (ACCA)
● The Chartered Institute of Public Finance and Accountancy (CIPFA)
● The Chartered Institute of Management Accountants (ACMA)
The purpose of auditing accounts

An audit is an examination of the accounts to check that everything is as it should be. Accounts are
subject to annual audits by professional accountants like ACAs or ACCAs.
In the case of limited companies, the audit is a legal obligation. Auditors act as ‘watchdogs’ over the
shareholders’ interests.
The 1985 Companies Act states that limited companies must appoint an auditor (except small
companies) to examine the books and accounts. This is to express an opinion as to whether the
financial statements represent a ‘true and fair’ of the financial position of the company, to the
shareholders of the company.
The Accounts office

The recording of financial information is the key
function of an accounts office. Customers’ and
suppliers’ records must be accurately recorded in
the sales and purchase ledgers, this information
coming from key documents such as invoices and
credit notes.
Finance is one the most important aspects of an

organization because the whole operation is
dependent on its expertise. The preparation of
accounts helps to explain what is happening in the
business: whether it is successful or not, whether
it has sufficient cash to pay its way, whether it
should make this decision or that.

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Questions:
1. People often think that an accountant’s job is boring. Could you offer an alternative adjective(s)?
2. One of the accountant’s functions is to act as an auditor. Find out what this service is.
3. In an accounts office, what may be considered a key function?
4. What would be the difference between working for an accountant in private practice or working
in an organisation which has its own accounting department?
5. If you were employed as a wages clerk, find out what the following abbreviations mean: HMRC,
PAYE, NIC. Why do you think returns of PAYE and NIC and made to HMRC?

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Part Two
The Accounting Model

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Chapter 5: Recording Financial
Transactions
The Ledger System and Trial Balance
Introduction
The ledger is the integral part of the accounting system where business transactions are posted from
documents into accounts. The principle of double-entry bookkeeping is essential to understand. The
recording process is based on the principle that every transaction has TWO ASPCETS to record of
equal value.
The Days Books record transactions on credit, helping to organise transactions before being posted
to the ledgers. So a sale or purchase made on credit will first be recorded in either the sales day
book or purchases day book.
The Cash Books record transactions by cash. When money is received or paid in the form of cash,
cheques and credit cards or directly through the banking system, a cash book can be used.
Financial Transactions
Credit Transaction Cash Transactions
The day books The cash books

The Accounting
Model
Sales day book Cash receipts
Purchase day book Cash payments
Returns in day book Cash discounts
Returns out day book Petty cash expenses
The journal The Ledgers
Bank reconciliation
Sales Ledger Nominal Ledger Purchase Ledger
The Trial Balance
Financial Statements
Profit & Loss account Balance Sheet

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Transactions recorded in the ledger via the double entry system are done so in date order. It is from
these records that the financial affairs of the business can be revealed, monitored and controlled.
The ledger is a series of accounts, which are records of related transactions. For example, the sales
account tells us the value of all sales. These accounts within the ledger are known as ‘T’ accounts,
and this format is the traditional layout of the ledger.
The ‘debit’ is the left-hand side of an account; the ‘credit’ is the right-hand side. When there are
entries on both sides, the ‘balance’ is the difference between them.
Remember:
Debit: When an account RECEIVES money or value
Credit: when an account GIVES (or supplies) money or value
A basic example of a ‘T’ account transaction:

You buy a motor van for £3,000 paying by cheque. The van is RECEIVED and the van account is the
debit entry. Money is GIVEN, therefore the bank account will be the credit entry. The double entry
is:
Debit Motor Van account Credit
Bank £3,000
Debit Bank account Credit
Motor Van £3,000
It is essential that you grasp this fundamental concept of double entry. Take the time to understand
this before you move onto the more complex applications of this recording system.
Recording the FIVE accounting groups:
Account Group Type of Balance To increase value in the To decrease value in

account the account
Revenue Credit Credit Debit
Expenses Debit Debit Credit
Capital Credit Credit Debit
Assets Debit Debit Credit
Liabilities Credit Credit Debit
If a transaction includes an asset or an expense that has to be increased in value, the entry must be
DEBITED. If their value is to be decreased, then the entry is CREDITED.

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The reverse applies for revenue, liabilities and capital accounts. These are CREDITED when the
accounts are to be increased in value and DEBITED when they are to be decreased in value.
The Trial Balance:

This is a list of balances taken from the ledger and placed in either the debit or credit column,
depending on whether the account itself is a debit or credit.
It is an important test of the accuracy of the double entry principle. As there is always a debit and
credit entry for every transaction, the resulting balances in the accounts should be equal. The
balance of credits must equal the balance of debits. If they do not, you have made an error
somewhere in the ‘T’ accounts of the ledger.
Trial Balance_____________________________
Debit Credit
£ £
R sales 500
E purchases 1,800
E rent 150
C capital 2,000
A bank 1,350
L F James (creditor) _____ _ 800
3,300 3,300
You will notice the example trial balance above is in the RECAL order. Doing this organises the
accounts into a system and helps in the preparation of the profit and loss account and balance sheet
when required.
The recording of stock and returns inward and outward
Stock:
When goods are purchased and then sold the stock account is not affected. Instead all purchase of
stock during an accounting period are recorded in the purchase account at cost price and all stock
sold is recorded in the sales account (as selling price).
At the end of an accounting period, the value of any unsold stock is recorded in the stock account.
The closing stock of one period is the opening stock of the next.
Returns:
If a customer returns goods or is overcharged on an invoice, this is a return. The credit note is the
document that is raised to process the return.
There are two types of return:

● Returns inward (sales returns) from customers
● Returns outward (purchases returns) to suppliers
The double entry for returns inwards is:

Debit: returns inward account Credit: the customer’s (debtors) account
The double entry for returns outward is:

Debit: the supplier’s (creditors) account Credit: returns outward account

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Questions:
Past Paper Question:

1. The following are the first month’s transactions of a new business:
Feb. 01 Put £28,000 into a business bank account, and £1,000 into a business cash box.
Feb. 01 Bought a vehicle for £10,000, paying by cheque.
Feb. 03 Purchased goods costing £5,000 for resale, paying by cheque.
Feb. 05 Paid rent £800, paying cash.
Feb. 08 Paid insurance premium £1,500, paying by cheque.
Feb. 12 Sold goods for £3,500, receiving a cheque for the full amount.
Feb. 14 Paid wages £1,000, paying by cheque.
Feb. 17 Purchased goods costing £7,000 for resale, paying by cheque.
Feb. 25 Bought office supplies costing £750, paying by cheque.
Feb. 25 Sold goods for £5,500, receiving full payment in cash.
Feb. 26 Paid wages £1,000, paying cash.
Feb. 27 Sold goods for £3,500, receiving a cheque for the full amount.
Feb. 28 Banked £4,000 of the cash.
Required:
a) Write up the above transactions in the appropriate ledger accounts. [10]
b) Prepare a trial balance as at 28 February 2011. [4]
c) The above business carried out a stock check at the close of business on 28 February 2011 and
valued the inventory (closing stock) at £3,600. Calculate the gross profit for the first month of
trading. [2]
d) Explain briefly the accounting treatment of VAT. [4]
2. Mrs M Ward decided to commence business by opening a small retail shop in the high street on
1 May. Her finances on that day were: cash, £2,500 and a motor van valued at £1,500. Hire
purchase still outstanding on the vehicle was £1,000. Calculate Mrs Ward’s capital as at 1 May.
During the first month’s trading, the following transactions took place:
May 1 Deposited £2,000 into the business bank account, retaining £500 in cash
2 Rented shop premises paying £250 cheque in advance
4 Cash purchases of goods for resale £300
5 Purchased £550 goods from Arthur Daley on credit
7 Paid £40 cash on stationery items
10 Cash sales £120
12 Sold goods on credit to Jack Smith £180
14 Purchased £750 goods on credit from Donna Steele

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16 Paid motor expenses £30 cheque
17 Cash sales £235 into bank
18 Returned goods to Arthur £150 as stock damage
19 Paid £100 cheque on the hire purchase of van
20 Bought equipment on credit from Land Supplies Ltd £1,800, paying an initial 25% deposit
by cheque, the balance on credit
26 Paid general expenses by cash £80
27 Received 50% of the sum due from Jack Smith, by cheque
28 Sold goods on credit by David Wheelbarrow £330
30 David Wheelbarrow returned 10% of goods to us as being unsuitable
31 Paid Donna Steele £500 on account
31 Paid Land Supplies Ltd on account £270 by cheque
Required:
a) Enter all the above information in the ledger of Mrs M Ward for the month of May.
b) Extract a trial balance as on 31 May
3. a) What is the purpose of the ledger in business?

b) Why are sales and purchase ledgers used in some businesses?
c) What basic principle does the recording of accounts follow? What could happen if this
principle was ignored?
4. What is the purpose of the trial balance?
5. The following represents the ledger accounts of Jack Jones on 1 April:

Debtors: Creditors:
Smith £250 May £85
Lillee £115 Cowdrey £172
Thomson £25
Capital a/c: Jack Jones £18
Bank a/c: £115 (overdrawn)
Transactions occurring during April

April 2 Sold goods to Lillee £287 and to Smith £415
5 Bought goods from Cowdrey £150
10 Sold goods to Thomson £37
15 Settled May’s account of 1 April
17 Smith settled his account of 1 April
21 Paid £75 to Cowdrey on account
22 Sold goods to Thomson £156
25 Thomson paid £62 on account
26 Bought goods from May £195
29 Paid Cowdrey a further £95 on account
30 Received £201 cheque from Lillee
Required:
a) Enter all the above information in Jack’s ledger
b) Extract a trial balance for the month ending 30 April

27
Chapter 6: The Running Balance
Method of Recording
Introduction
As you have seen the traditional style of recording ledger transactions is debit and credit entries
separated by the centre line of the page – the ‘T’ account. The balance was the difference between
the two columns of entries.
The running balance method differs in that its format is like a bank statement with debit and credit
and balance columns adjacent to each other. The main advantage of this style of recording is that
after each transaction, the balance is calculated, giving an immediate up-date of the account.
Example format of a running balance
Date Details Debit Credit Balance___

1/6 Balance 9,000 9,000 Debit
10 Purchases 2,000 7,000
13 Sales 1,840 8,840
14 Rent 400 8,440
15 Wages 520 7,920
18 Stationery 280 7,640
20 Sales 1,800 9,440
24 Purchases 2,600 6,840
27 R Jones 700 7,540
30 H Bates 2,540 5,000
Different types of ledger
All customer accounts are recorded here, allowing the

Sales Ledger
tracking of what individual debtors owe.
All supplier accounts are recorded here, allowing the tracking
Purchase Ledger
of what individual creditors are owed.
Used to track ALL other accounts, revenue expenses, capital,
Nominal Ledger assets and liabilities. It’s the main ledger and also known as
the general ledger).
Personal Account The individual debtors and creditors in the sales and
purchase ledgers.
Nominal Account The impersonal accounts of the business – all revenue and
expenses.
Real Account The assets of the business such as premises, equipment etc.

28
Chapter 7: Recording Transactions
on Credit
The Sales Day Book
Introduction
A major function of the day books (also called journals), is to help classify and summarise
information from data such as invoices and credit notes. This makes it easier to transfer details to
the ledgers.
So when sales invoices (bills of sale) are sent to customers, they are first recorded in the sales day
book before posting to the ledgers.
An example sales day book:
Date Customer’s Invoice Net Sales VAT Total

Account No. Account Account Debtors
4/1 Jones, J 2501 200 35 235
5/1 Smith, R 2502 150 26.25 176.25
6/1 Taylor, C 2503 128 22.40 150.40
8/1 Lewis, D 2504 360 63.00 423.00 _
838 146.65 984.65_
Following this the ledger posting would be:
Debit: Debtor’s Account Returns Inward Day Book

Credit: Sales and VAT Accounts Records sales returns from
customers from credit notes
sent to them.
The Journal
Records transactions that
are outside the scope of
the other day books, for The 5 Major Day Books
example, to correct errors Sales Day Book
or write off bad debts. Records credit sales
from invoices sent to
customers.
Purchases Day Book

Records credit
purchases from Returns Outward Day Book
suppliers’ invoices Records purchases returns to
received. suppliers from credit notes
received from them.

29
Sales Ledger Control Account:
The sales ledger control account (in the nominal ledger) is used as a cross-check with the debtors’
balances in the sales ledger.
VAT
Value added tax is an indirect form of taxation charged on many goods and services. The current
standard rate is 17.5% on the net value of any goods or services. This rate can vary depending on
economic circumstances.
For example, if goods were sold for £200 (gross value) but were subject to a 20% trade discount, the
VAT would be charged on the net value:
£
Gross value of goods 200
Less 20% trade discount (40)
Net value of goods 160
VAT (£160 x 17.5%) 28
Total value of invoice 188
Terms of payment:
A favourable rate to the buyer of goods off the list price,

often in proportion to the amount of goods purchased.
Trade discount
There is no double entry, the net sum payable is recorded,
not the gross.
A discount to encourage prompt payment. E.g. 5% if invoice
Cash discount
is paid with a specific number of days. Part of Double Entry.
A larger trade discount is made available if more is
Bulk discount
purchased.
When the buyer pays for the delivery cost. Known as carriage
Carriage forward inwards as part of the buyer’s cost of sales in their trading
a/c.
Carriage paid The seller pays for the delivery cost of goods.
Cash on delivery Payment is made when goods are exchanged.
Errors and omissions excepted. Indicates the supplier has the
E&OE
right to correct any error or omission on an invoice.
Ex stock Goods will be supplied from stock.
The buyer is responsible for the delivery cost from the
Ex works
factory.
Current standard rate is 17.5%. Other rates are discussed
VAT
later.
This is an example to illustrate how a sale on credit to a customer is recorded via the sales day book
into the ledger. Harrison has sent out invoices for goods purchased on credit and he has also
received payment from debtors during June.

30
G Harrison’s ledger balances as at 1 June
Sales £ Nominal Ledger £______
Thomson 45 Dr Sales a/c 8,500 Cr
Simpson 110 Dr VAT a/c 350 Cr
Jackson 180 Dr Sales Ledger control a/c 335 Dr
335
As you can see the sales ledger control account represents the total value of debtors in the sales
ledger.
Sales Invoices sent in June: Cheques received from customers in June

Customer a/c__Invoice No. Date Net Sales £
Thomson 1136 4/6 180 Thomson £300
Simpson 1137 10/6 200 Simpson £450
Jackson 1139 15/6 360 Jackson £500_
Simpson 1140 20/6 160____ £1250
______________Sales Day Book: Harrison _____________________________

Customer a/c__Invoice No. Date Net Sales £ VAT £ Total Debtors
Thomson 1136 4/6 180 31.5 211.50 Dr
Simpson 1137 10/6 200 35 235 Dr
Thomson 1138 11/6 100 17.5 117.50 Dr
Jackson 1139 15/6 360 63 423 Dr
Simpson 1140 20/6 160 28 188 Dr___
1,000 175 1,175 _____
(Cr) (Cr) (Dr)
___________________________Sales Ledger: Harrison______________

Date Particulars Debit Credit Balance
Thomson a/c £ £ £
1/6 Balance 45 Dr
1/6 Sales & VAT 211.50 256.50
11/6 Sales & VAT 117.50 374
30/6 Bank 300 74___
1/7 Balance 74 Dr
Simpson a/c
1/6 Balance 110 Dr
10/6 Sales & VAT 235 345
20/6 Sales & VAT 188 533
30/6 Bank 450 83__
1/7 Balance 83 Dr
Jackson a/c
1/6 Balance 180 Dr
15/6 Sales & VAT 423 603
30/6 Bank 500 103__
1/7 Balance 103 Dr

31
___________________________Nominal Ledger: Harrison________________
Sales a/c £ £ £
1/6 Balance 8,500 Cr
30/6 Debtors 1000 9,500
1/7 Balance 9,500 Cr
VAT a/c
1/6 Balance 350 Cr
30/6 Debtors 175 525__
1/7 Balance 525 Cr
S/L Control a/c
1/6 Balance 335 Dr
30/6 Sales 1,000
VAT 175 1,510
30/6 Bank 1,250 260_
1/7 Balance 260 Dr
Computerised Accounts:
Using a computer to process accounting transaction is a much more efficient method. Postings to
the ledger can be automated and the double entry transactions completed for you. For example, an
invoice added to the system will debit a customer’s account and credit the sales and VAT accounts.
Computerised accounts also give you the benefit of instant analysis – invoices, credit notes,
customer statements and anything else can be printed at the press of a key.
Credit Control:
It is vital for a business to restrict the outstanding debt of any one customer. The credit control
system is in place to:
● Ensure customers pay their accounts on time
● Provide a credit rating for customers based on historical trading
● Limit goods to customers who do not pay debts on time
● Provide more generous credit terms with customers who do pay debts on time
● Create an aged debtors’ schedule to show how old debts are in months
Bad debts are expenses and reduce profits. If a large customer fails to pay its debts, it could trigger
bankruptcy with the seller.

32
End of Chapter 7 Test Questions:
1. The following credit sales (excluding VAT) took place during February 2011:
£
Feb. 01 Invoice for goods 500 to Alex
02 Invoice for goods 600 to Bella
06 Invoice for goods 400 to Conrad
07 Invoice for goods 800 to Alex
17 Invoice for goods 1,100 to Alex
22 Invoice for goods 900 to Conrad
24 Invoice for goods 500 to Alex
28 Invoice for goods 1,200 to Conrad
All the above invoices are subject to VAT at the standard rate (20%).
Required:
a) Fully record the above transactions in the sales day book. [10]
b) State the amount which should be posted to the sales account. [2]
c) State the amount which should be posted to the VAT account, AND state whether it should
be recorded as a debit or a credit. [2]
d) Explain the purposes of day books. [6]
2. Debtor’s balances on 1 June in G Harrison’s sales ledger were:

£
Arthur 100 Dr
Brian 120 Dr
Colin 150 Dr
During the month of June, Harrison sold on credit:
Invoice £
5/6 Arthur 421 250
8/6 Brian 422 160
15/6 Arthur 423 200
20/6 Colin 424 280
On 28 June, Harrison received cheques from Arthur, Brian and Colin settling their accounts as stated
on 1 June
Required:
a) The sales day book for the month of June

b) Sales ledger accounts of Arthur, Brian and Colin for June
c) The sales account as it would appear in the nominal ledger (opening balance £1,240 Cr)

33
Chapter 8: The Purchases Day Book
Introduction
The purchase day book records invoices received from suppliers before
posting to the purchase and nominal ledger.
An example purchases day book:
Date Supplier’s Invoice Net Purchase VAT Total

Account No. Account Account Creditors
5/1 Metro 7845 200 35 235
7/1 Slazenger 367339 280 49 329
7/1 Auto 1995 400 70 470
8/1 Slazenger 367443 160 28 188____
1,040 182 1,222___
Following this the ledger posting would be:
Debit: Purchases and VAT accounts

Credit: Creditor’s account
The supplier’s account is credited in the purchase ledger with the invoice total, for example Metro
£235 credit. The double entry would be completed with debit entries to the purchases account
£1,040 and VAT £182, in the nominal ledger.
Working capital - Checking Documents:

Working capital is having sufficient finance to meet day to day costs. The purchase day book has a
vital role in providing information about the purchases that the business has made. For example, if
the business purchases too much stock, it may not be able to pay other vital bills, such as overheads
and wages.
If too little stock was acquired the business may run out of certain items and valuable orders could
be lost. Businesses, therefore, need to pay close attention to the way they record supplies so they
can track stock levels, ensure they buy exactly the amount they want and that the invoices received
agree with the terms and conditions of the order.
Goods Received Notes (GRN)

The goods are checked and a GRN created. Copy sent to buying
office to check against original invoice.
Delivery Notes
A record that delivery driver uses to prove that the items have
been delivered as agreed.

34
An invoice that agrees with the purchase order and the GRN can be passed to accounts for recording
and paying. But any errors need to be identified (whether an arithmetic error, or the quantities
received differs from those charged for), helping to make the process a key purchasing control.
Procedure for purchases on credit:
Inquiry
Purchase Order Purchase Invoice Suppliers Statement
Stamped &
Checked
To Accounts
Purchase Day Book
Ledgers
Purchase Ledger
Nominal Ledger
Invoice Control:
When a business has thousands of invoices, it is essential that a full check on each invoice is made.
Invoices are, therefore, stamped with a control grid, like the diagram below:
Control Grid Initials

Date invoice received
Internal reference no
Order price check
Extensions check
Goods received check
Each check above should be initialled by the person authorised to do so. Any errors need to be
investigated. Only when the check is complete and satisfactory can the invoice be passed to the
accounts office for entry into the purchase day book and be authorised for payment.

35
The Purchase Ledger Control Account:
Put simply, it is an account to cross-check the accuracy of the purchase ledger. An example follows.
Information relating to the account of G Harrison on 1 June:
Balance on 1 June:
Nominal Ledger Purchases account (debit) 3,576.50
VAT account (credit) 421.25
Purchase Ledger control account (credit) 5,646.50
Purchase Ledger Decca (credit) 3,465.00

EMI (credit) 1,572.50
Jacksons (credit) 609.00
G Harrison’s purchase day book:

Date Supplier Invoice Purchases VAT Total
No. £ £ Creditors__
4/6 Decca 4242 450 78.75 528.75 Cr
8/6 Decca 5789 200 35.00 235.00 Cr
15/6 EMI 687 360 63.00 423.00 Cr
22/6 Jacksons 1425 120 21.00 141.00 Cr___
1,130.00 197.75 1,327.75____
Dr Dr Cr P/L control
Now we must enter the above balances on 1 June into the ledger of G Harrison and post the month’s
details from the day book to the appropriate ledger accounts. We will also enter the payment details
of cheques paid on 30 June: £1,500 to Decca a/c, £1,000 to EMI a/c and £200 to Jackson’s a/c.
___________________________Nominal Ledger: Harrison________________

Purchases a/c £ £ £
June 1 Balance 3,567.50 Dr
30 Creditors 1,130.00 4,697.50
VAT a/c
June 1 Balance 421.25 Cr
30 Creditors 197.75 223.50
P/L Control a/c

June 1 Balance 5,646.50 Cr
30 Purchases 1,130.00
VAT 197.50 6,974.25
Bank 2,700.00 4,274.25

36
__________________________ _Purchase Ledger: Harrison______________
Decca a/c £ £ £
4 Purchases & VAT 528.75 3,993.75
8 Purchases & VAT 235.00 4,228.75
30 Bank 1,500 2,728.75
EMI a/c
15 Purchases & VAT 423.00 1,995.50
30 Bank 1,000 995.50
Jackson a/c
June 1 Balance 609 Cr
22 Purchases & VAT 141.00 750.00
30 Bank 200 550.00
Finally, we must check that the purchase ledger control account matches the total of the balances in
the purchase ledger.
June 30 P/L control account £4,274.25 Cr
30 Purchase ledger: £
Decca 2,728.75
EMI 995.50
Jackson 550.00
£4,274.25 Cr
When preparing the trial balance, the control accounts show the totals of both debtors and
creditors. If the control accounts cross-check with personal ledgers it’s assumed that double-entry
recording is correct. This is useful in the event the trial balance failed to balance. We would not need
to check all the personal accounts to locate the error(s) if they already agree with the control
account.

37
1. The following credit purchases took place during April 2011:
April 01 Invoice for goods £600 from Arnald
April 01 Invoice for goods £400 from Bruno
April 04 Invoice for goods £500 from Clive
April 18 Invoice for goods £500 from Bruno
April 28 Invoice for goods £1,000 from Bruno
All of the above purchase invoices need 20% VAT (sales tax) added to the goods values.
On 1 April 2011 there was £1,420 owing to Arnald.

On 28 April a cheque amounting to £2,100 was sent to Arnold.
Required:
a) Fully record the above transactions in the purchase day book. [10]
b) State the amount to be debited to the purchases account. [2]
c) Explain the purpose of day books. [4]
d) Write up the ledger account of Arnald for the month of April. [4]
2. The following information concerns the analysed purchase day book of Harriet Prince for the
first fortnight of January:
Date Supplier a/c Footwear a/c Leisure a/c Sports a/c VAT a/c Total a/c
7/1 Foulkes Ltd 850 70
8/1 Johnson 350
9/1 Foulkes Ltd 436 164 80
10/1 Hardcastle 200 325
11/1 Johnson 236 164
12/1 Douglass Ltd 346
12/1 Just Sport 140 825
Required:
a) Complete the totals across including the calculation of VAT at the 17.5% standard rate
b) Total the figures down and cross-check for accuracy
c) Explain how the individual accounts are posted
d) Post the totals to the nominal ledger

38
Chapter 9: The Returns Day Book
Introduction
There are two books to record returns:
The Returns Inward Day Book The Returns Outward Day Book
To record sales returns from Records purchases returns to

customers (debtors) suppliers (creditors)
There are many situations when goods may be returned to the seller:
 Goods may have been damaged in transit

 The wrong product delivered
 The buyer may have changed his mind
 The invoice may have been added incorrectly
 There may be crates or barrels that receive a credit for safe return
The credit note is the documentary evidence for any type of return. It simply means that a reduction
is to be made from the account where the credit note is sent.
Credit notes received and sent to customers to cover the returns are listed in sequence and in date
order. Posting to the ledgers will include:
The Returns Inward Day Book The Returns Outward Day Book
Sales Ledger Nominal Ledger Purchase Ledger Nominal Ledger
Credit debtor’s Debit returns Debit creditor’s Credit returns

a\c with value inward a/c & a/c with value of outward a/c
of return + VAT Debit VAT a/c return and VAT and credit VAT
If control a/c If control a/c

used, credit the used, debit the
total value of total value of
returns, plus returns, plus VAT
VAT if charged, if charged, to the
to the sales purchase ledger
ledger control control account
account

39
Let’s look at an example for both returns inward and returns outward. These will affect the sales and
purchase ledger and we will also show the nominal ledger entries. The opening debtor and creditor
balances on June 1 are:
Debtor Balances Creditor Balances

J Jones £156 Dr Dunlop Sports £96.21 Cr
T Smith £385 Dr Sondico £124.62 Cr
T Dooley £224 Dr Arena Sports £150.00 Cr
______________Returns Inward Day Book: (June) _______________________

Date Customer’s C/N Returns Inward VAT Total Debtor’s
__ A/c No. a/c a/c a/c ____
£ £ £
June 15 T Smith 427 24 4.20 28.20 Cr
23 T Dooley 428 60 10.50 70.50 Cr
30 T Jones 429 10 1.75 11.75 Cr__
94 16.45 110.45 ____
(Dr) (Dr) (Cr S/L control a/c)
______________Returns Outward Day Book: (June) _______________________

Date Customer’s C/N Returns VAT Total Creditor’s
__ A/c No. Outward a/c a/c ______
£ £ £
June 4 Dunlop Sports 142 16.82 2.94 19.76 Dr
18 Sondico 234/C 10.86 1.90 12.76 Dr
26 Arena 67 24.60 4.30 28.90 Dr____
52.28 9.14 61.42 ______
(Cr) (Cr) (Dr P/L control a/c)
___________________________Sales Ledger ____________________________

Date Particulars Debit Credit Balance__
J Jones a/c £ £ £
June 1 Balance 156.00
30 Returns In 11.75 144.25 Dr
T Smith a/c
June 1 Balance 385.00 Dr
15 Returns In 28.20 356.80
T Dooley a/c
23 Returns In 70.50 153.50___
___________________________Purchase Ledger __________________________

Date Particulars Debit Credit Balance___
Dunlop Sports a/c £ £ £
4 Returns Out 19.76 76.45
Sondico a/c
18 Returns Out 12.76 111.86
Arena a/c
26 Returns Out 28.90 121.10____

40
___________________________Nominal Ledger __________________________
Returns Inward a/c £ £ £
June 1 Balance
30 Debtors 94.00 94.00 Dr
VAT a/c
June 1 Balance
30 Debtors 16.45 16.45 Dr
30 Creditors 9.14 7.31
Sales Ledger Control a/c
30 Returns In 110.45 654.55
+ VAT
Returns Outward a/c
June 1 Balance
30 Creditors 52.28 52.28 Cr
Purchase Ledger Control a/c
30 Returns Out 61.42 881.08
+ VAT __________
Statements:
Statements are normally sent once a month to remind customers of their outstanding balances.
Statements are also received from creditors, it is important they are checked with the purchase
ledger control account to check the balances agree. If they do, the statement is passed to the
Cashier for payment. If not, they must be checked and reconciled before any payment is made.
Document Check:
Purchase Order Issued to seller by buyer, lists what is to be bought
Delivery Note Delivered with the goods, signed by customer as evidence of
receipt of order
Goods Received Note Itemises goods checked in to store, copy sent to buying office
Invoice A bill of sale for goods or services send from seller to the buyer
Control Grid Used to stamp invoices as a way of checking their authenticity
and accuracy
Pro Forma Invoice Used for special cases e.g. cash on delivery where goods must
be paid for before they are handed over
Credit Note A document sent be the seller to the buyer usually to reduce
the amount of an original invoice due to an overcharge or
return of goods
Statement A document sent by the seller to the buyer showing the amount
to be paid for goods purchased, usually over a monthly period
Trade Discount Given by the seller to the buyer during trading to reduce goods
from the list price, usually shown as a % e.g. 20% off gross value
Bulk Discount Similar to trade discount, but linked to the size of the order. The
more bought, the larger the trade discount offered
Cash discount Settlement discount to encourage buyer to settle debt early

41
1. Debtor’s balances on 1 June in the books of G Harrison were:
Sales ledger £
Arthur 100 Dr
Brian 120 Dr
Colin 150 Dr
Nominal ledger £
Returns inward a/c 257 Dr
VAT a/c 125 Dr
Sales ledger control a/c 370 Dr
Harrison sent credit notes to customers who had returned goods during June (VAT at 17.5%)
£ Credit Note No
12/6 Brian 60 + VAT 261
20/6 Arthur 20 + VAT 262
24/6 Colin 50 + VAT 263
Required:
a) The returns inward day book for June
b) Sales ledger accounts of Arthur, Brian and Colin for June
c) Nominal ledger accounts for June
2. M Crooks has the following accounts in his ledgers on 1 May (VAT at 17.5%)
Sales ledger: Purchase ledger:
J Hunt £600 Dr R Ball £500 Cr
R Speedie £240 Dr J Carlson £400 Cr
J Milton £400 Dr D Smith £150 Cr
Invoices issued during May: Invoices received during May:

£ £
Hunt 130 + VAT Ball 250 + VAT
Milton 200 + VAT Smith 120 + VAT
Speedie 180 + VAT Carlson 360 + VAT
Credit note received during May: Cheques received during May:

Carlson £200 + VAT Hunt £580 in settlement of a/c of 1 May
Milton £390 in settlement of a/c of 1 May
Speedie £200 on account
Cheques paid during May: settled all creditors accounts due 1 May less 2.5% cash discount
Required:
a) Enter the opening personal accounts in the ledgers of M Crooks
b) Post all the above transactions to these ledger accounts and balance off at the month end.

42
Chapter 10: VAT and VAT Returns
Introduction
VAT is a charge on most goods and services in the UK. It is an indirect source of taxation for the
government. The key point to remember is that the collection of this tax which is charged between
traders, eventually falls to us, the consumers who purchase the product.
Businesses, therefore, are the collectors of the tax, while we, the consumers, pay for it.
Basically, a business charges VAT on sales (output tax) and deducts what it pays on purchases (input
tax). The balance between these two figures is paid quarterly to Her Majesty’s Revenue & Customers
(HMRC).
Registration for VAT is compulsory if taxable sales exceed a certain annual limit (which can change
depending on economic conditions). A business that is registered for VAT has a unique registration
number.
The Cash Accounting Scheme The Annual Accounting Scheme

Allows traders the advantage of accounting Allows a business to make a VAT return just
for VAT at the time cash is actually paid or once a year, coupled with an agreed
received, rather than normal invoice dates. monthly direct debit to HMRC.
The Benefit to the Small Business?
The business pays VAT for the Decreases the frequency of VAT
goods actually bought or sold in returns required, therefore
that period. Making it easier to reduces the cost of business
manage working capital. administration and accounting.
costs.
Input Tax:
Input tax offsets the amount deductible to the VAT office. Most capital and revenue expenditure is
allowable for VAT inputs, if they are for business purposes. Sometimes a business can’t reclaim the
VAT it has paid, e.g:
 Motor cars (except when the vehicle is used to directly generate income e.g taxis)
 Non-business expenses, such as entertainment, meals etc
 The purchase of luxury items for business promotion e.g. racehorses
Output Tax:
Output tax is collected on sales or any other form of taxable supplies. However, other sales may
include:

43
 Goods that are taken for the proprietor’s own use
 Any sales to staff
 Sales of any business assets where VAT is charged
Standard, Zero rate and exempt:

Remember, when sales are made, VAT is charged at the standard rate and is the output tax.
On purchases of goods or services supplied to the trader, the VAT is the input tax.
The VAT account records these outputs (sales) as credit entries, and inputs (purchases) as debit
entries. If outputs in a tax period are greater than inputs, the difference in VAT is owed to the VAT
office. If inputs are greater than outputs, the VAT office will pay the trader the difference.
Zero-rated Supplies Exempt Supplies

Most transactions are at the standard Transactions on which VAT is not
rate or zero rate, which is nil. Zero rated charged. Also, if a trader is exempt from
goods cannot charge VAT in sales but VAT, he must not charge VAT to his
the firm can still recover VAT its paid on customers, or reclaim any VAT he may
purchases. have paid
Zero-rated Supplies Include: Exempt Supplies Include:

 Most food, but not catering  Insurance
 Books and newspapers  Betting, gaming & lotteries
 Children’s clothing  Certain education & training
 Export goods  Doctors, dentists & opticians
 Prescription charges  Letting, leasing and sale of land
 New home construction  Bank accounts & credit services
Foreign Trade - VAT Imports Vs VAT Exports:

Imports and exports are treated differently in terms of VAT.
Imports Exports
Imported goods are subject to same VAT The export of goods from the
rules when goods are available in the UK UK is at the zero rate of tax. The
too. If importing in the EU, it’s no longer exporter must retain evidence
considered an import, so will account for of exports such as shipping or
VAT in the normal way. If non-EU, the airport documentation.
importer will need to account for them
with HMRC at port of entry.
Bad Debts:
If a bad debt occurs for a VAT registered trader, HMRC offers bad debt relief, which can be claimed
as a VAT input when the debt has been owing for a minimum of 6 months AND the debt has been
written off as bad in the accounts.

44
1. Explain the accounting treatment of VAT [5 marks]
2. Janet Jones provides you with the following information for her last quarter for VAT purposes.
Sales (taxable outputs) £393,390 (inclusive of VAT at standard rate)

Purchases (taxable inputs) £281,060 (inclusive of VAT at standard rate)
During this period, Janet paid £9,875 in settlement of the previous quarter’s return. (Open the VAT
account with this as a credit.) Draft the VAT account to record these entries for the quarter.
3. The following data refers to the accounts of Susan Brambles Ltd for the VAT tax period April-
June. Note that all the figures are inclusive of VAT.
£
Sales 14,570
Purchases 11,327
Credits allowed to customers 940
Credits received from suppliers 799
Equipment purchases 987
New motor car for finance chief 8,850
Operating lease allowable by VAT office 846
There was also an overpayment made to the VAT office of £62 in the previous period. Note that
credits refer to returns inward and outward.
Required:
a) Produce the VAT account for the period to 30 June

b) The sales and purchase figures to June (returns inclusive in these)
c) The amounts that will be posted to equipment, vehicles and operating expenses accounts.
4. Answer the following questions in brief:

a) Although VAT is normally collected on a quarterly basis, what are some of the other methods
allowed by the VAT office?
b) At what date is the tax point normally identified?
c) When can bad debt relief be taken as a taxable input?
d) How does a business, which is exempt from VAT, record VAT when it is charged against them?
e) How does a business that is zero-rated deal with VAT in its accounts?

45
Chapter 11: Banking Services
Introduction
The major clearing banks in England and Wales are:
 Barclays
 Lloyds TSB
 National Westminster
 HSBC
These clearing banks receive deposits of money from individuals and

business on one hand and provide overdrafts and loans on the other.
This is their traditional function.
Nowadays, however, they provide a wide range of financial services:

 Home mortgages
 Foreign currency
 Night safe deposit
 Insurance schemes
 Pension plans
 Investment brokers
 Financial consultants
Clearing banks provide TWO major types of accounts:
Deposit Accounts Current Accounts

Also known as an investment account, Used for processing cheques and
this account is used to safely invest making payments through the bank. The
money at higher interest rates. These bank can arrange payments by direct
rates are higher because you agree to debit or standing order for regular
give the bank longer notice before expenses. Current accounts often pay
withdrawing any funds and will vary interest on balances in credit. A current
depending on size of deposit and length a/c is essential for a business, helping it
of withdrawal notice. to organise finances professionally.
Going to the bank:

It is important not to hold too much cash on a business premises as it is a security risk. Many
businesses go to the bank every day to deposit their takings.
A bank form, the paying-in-slip, is used to enter the details of the cash and cheques to be deposited
at the bank. But before the money is taken from the business to go to the bank, it must be recorded
in the business books. The person responsible (often the cashier) counts the sales and will record
details on a daily sales sheet. The paying-in-slip will then be completed and taken to the bank so that
the business bank account can be credited.

46
Payments through the bank:
The main means of payment through a bank, other than by cheque, or by direct debit and credit
cards are standing orders, direct debits and credit transfers (bank giro credit):
Credit Transfer System (BGC) Direct Debits

The bank giro credit system (BGC) is These differ from standing orders as it is
where payments can be made the creditor that claims the amount due
between debtors and creditors. from the customer. The supplier asks the
 Many household bills can be paid customer to sign a direct debit form that
by completing the giro credit slip will instruct the bank to pay the amount
on the bill. The bank debits your agreed on the dates required. The
account and credits the account of supplier sends the direct debit form to
the payee e.g. British Gas. the bank. Useful for varying amounts,
 A business can also pay its such as rates and goods from suppliers.
employees in this way, by sending
a list of names, wages to be paid Standing Orders
and individual bank details. This is an authorisation to the bank to
 Trade creditors of a business can make a payment on your behalf for
also be paid this way. The firm regular expenses. The sum is usually a
provides the list of creditors to be fixed amount and is a safe (as payment
paid, the amount and bank details. is digital, nothing needs to be sent
The system saves time and effort through the post) and convenient way to
as individual cheques are not make payments such as mortgage fees
required. and insurance premiums.
Bank Overdrafts:
A trader can apply for a bank overdraft that lets him have money on credit. Meaning he can spend
more money than he has in his current account.
Many firms are dependent on overdraft facilities to enable them to meet their day to day expenses.
However, interest is charged on a daily basis, so overdrafts can be expensive. Although, not as
expensive as spending more money than your overdraft allows (an unauthorised overdraft), which
can occur fines and payments can ‘bounce’ meaning the payee is not paid - bad news for any
business.
Inter-bank transfers:
BACS (Banker Automated A system set up by the banks to allow electronic
Clearing Service) payments. It’s an efficient way to make many payments.
CHAPS (Clearing House Another electronic payment systems but this time used
Automated Payments System) for high value transactions such as motor vehicles.
Bank Drafts This is a bank cheque, used for large payments and
offering a guarantee the cheque will be paid.
Debit and Credit Cards Once a card is swiped through a machine or PIN entered,
the payment is directly debited to the customer’s account
via a computer link up (EFTPOS – electronic funds transfer
at point of sale). Retailers pay credit companies a set
percentage charge on sales, usually up to 5%.

47
Using the internet for payments:
With the rise of the internet in business, many firms now use
websites as a means of selling their goods and services. Debit or
credit cards are used to purchase goods. This is known as ‘e-
commerce’.
There are some concerns with consumers and businesses about

using the internet to make payments, namely fraud. However,
the authorities work continuously to minimise the risk to users,
and it is now considered a relatively safe environment for
financial transactions.
1. What is the main difference between a deposit account and a current account?
2. Why should you make variations to your journey when going to the bank?
3. Briefly explain why a bank overdraft can be more than useful to a business?
4. Explain briefly the similarities and differences of using BACS and CHAPS as banking services.
5. What is the difference between a direct debit and a standing order?

48
Chapter 12: The Cash Book
Introduction
The cash book is used to record all cash and banking transactions.
It is an extension of the ledger itself. Therefore, instead of having a separate bank and cash account
in the nominal ledger (as we had before), a cash book can be used to keep bank and cash entries
together, making it more convenient.
Below is an example cash book:

Debit Credit
Receipts Payments
Discount Cash Bank Discounts Cash Bank
Allowed Received
£ £ £ £ £ £
Jones 3 57 Fox 4 76
Cash discounts may take one of two forms:

 Discount Allowed: Entered on the left side of the cash book and is given to debtors for
prompt payment of their accounts – treated as an expense.
 Discount Received: Entered on the right side of the cash book and is received from creditors
for prompt payment – treated as revenue.
In practice cash books rarely look the same, but we will work through an example to show you how
to take the raw data, enter it into the cash book and finally make the ledger postings.
January Debit Credit

1 Balances in cash £25, bank £900 cash £25
Bank £900
4 Paid Stationery, by cash £20 stationery £20 cash £20
5 Cash sales £72 cash £72 sales £72
13 Paid rates £125 by cheque rates £125 bank £125
25 Paid cash to creditor, James £115 on a/c James £115 cash £115
28 Paid Fox, another creditor, a cheque £76 Fox £80 (bank £76
In settlement of an £80 account (£4 discount rec’d) (disc. £4
28 Received £57 cheque from Jones (debtor) in (bank £57 Jones £60
settlement of a £60 account (£3 discount allowed) (disc allow £3
29 Received from Smith (debtor) cheque for £152 in (bank £152 Smith £160
settlement of £160 owing (£8 discount allowed) (discount allow £8
Important: Ledger posting from the Cash Book.

To complete double-entry, the ‘opposite side’ rule applies. Entries on debit side are posted on credit
side of respective ledger a/c. However, when posting cash discounts to the ledger, the totals posted
remain on the same side.

49
Solution:
Dr Cash Book Cr
Date Details Disc Cash Bank Date Details Disc Cash Bank
Alld Recd
1 Jan Balance b/d 25 900 4 Jan Stationery 20
5 Jan Sales 72 13 Jan Rates 125
15 Jan Sales 15 25 Jan James 115
26 Jan Sales 80 28 Jan Fox 4 76
28 Jan Jones 3 57
29 Jan Smith 8 152 31 Jan Balance c/d 57 908
11 192 1,109 4 192 1,109
1 Feb Balance b/d 57 908
Note:
To complete the double entry, entries in the cash book are posted to their corresponding ledger
accounts. For example:
Cash Sales: Debit – cash column as above (Asset +)
Credit – sales a/c in the ledger (Revenue +)
Rates: Credit – bank column as above (Asset -)
Debit – rates a/c in ledger (Expense +)
___________________________Nominal Ledger __________________________

Date Details Debit Credit Balance___
Sales a/c £ £ £
1/1 Balance 0
5/1 Cash 72 72 Cr
15/1 Cash 15 87
26/1 Cash 80 167
Stationery a/c
1/1 Balance 0
4/1 Cash 20 20 Dr
Rates a/c
1/1 Balance 0
13/1 Bank 125 125 Dr
Discount Allowed a/c
1/1 Balance 0
31/1 Sundries 11 11 Dr
Discount Received a/c
1/1 Balance 0
31/1 Sundries 4 4 Cr
___________________________Sales Ledger ____________________________

J Jones a/c £ £ £
1/1 Balance 60 Dr
28/1 Bank 57
Discount Allowed 3 0
R Smith a/c
1/1 Balance 160 Dr
29/1 Bank 152
Discount Allowed 8 0_____

50
___________________________Purchase Ledger __________________________
N Fox a/c £ £ £
1/1 Balance 80 Cr
28/1 Bank 76
Discount Rec’d 4 0
R Jones a/c
1/1 Balance 115 Cr
25/1 Cash 115 0______

51
End of Chapter 12
Test Questions:
1. The following transactions need to be written up in a three-column cash book:
01/11 Debit balances brought forward bank £5,000 cash £500.
03/11 Paid rent £1,000 (cheque).
05/11 Received the following cheques: Arun £285, Bruno £475 and Calvin £665.
All three debtors have ALREADY been allowed a 5% cash discount.
06/11 Cash sales £2,400.
09/11 Paid wages £900 (cash).
10/11 Paid cheques to the following suppliers: Dune £190, Emirin £475 and Franco £570.
All three suppliers have ALREADY allowed a 5% cash discount.
13/11 Bought equipment £13,000 (cheque).
20/11 Cash sales £3,900.
24/11 Paid £2,800 of the cash into the bank.
28/11 Paid wages £900 (cash).
29/11 Paid rent £1,000 (cheque).
Note – the balance on the discounts allowed account as at 1 April was £790, and the balance on the
discounts received account as at 1 April was £1,100.
Required:
a) Write up the three-column cash book to record the above transactions. [15]
b) Update the discounts allowed and discounts received accounts. [5]
2. Why, when posting entries from the cash book, do cash discounts remain on the same side in
their respective nominal ledger accounts?
3. A wine shop owned by R Lees kept an analysis Cash Book using extra columns. The daily takings
are banked each day at the local branch. The cash register calculates the VAT separately when a
sale goes through the till. The takings over four days were as follows:
June Wine Beer Spirits Other Sales Total Bank

£ £ £ £ £ £
2 Takings 200 250 80 30
VAT 30 37.5 12 4.5
3 Takings 150 200 50 20
VAT 22.5 30 7.5 3
4 Takings 180 240 60 24
VAT 27 36 9 3.60
5 Takings 300 340 100 60
VAT 45 51 15 9
Required:
a) Prepare a suitable Cash Book using the above columns to analyse the different sale categories.
b) Post the sales and VAT to the ledger
c) Why is it sometimes useful to make analysis columns?

52
Chapter 13: The Bank
Reconciliation
Statement
Introduction
Bank reconciliation is a method of bringing together the bank balance as shown on the bank
statement with the balance as shown in the cash book.
These balances may not agree, because:
Items in the cash book not yet recorded in the bank statement:
 Cheque payments entered on the credit side of the cash book but not yet presented for
payment at the bank – these are ‘un-presented cheques’.
 Cheques, cash entered on the debit side of the cash book, but not yet deposited at the bank
– these are ‘un-deposited cheques, cash’
(These items will then be recorded in the bank reconciliation statement)
Items in the bank statement not yet recorded in the cash book:
a) Payments and charges made by the bank and charged against the business:
 Standing orders
 Direct debits
 Interest and bank charges
 Cheques R/D (referred to drawer, due to insufficient funds)
(These items will be entered on the credit side of the cash book – the payments side)
b) Receipts by the bank on the business’s behalf and not yet recorded in the cash book:
 Cheques from customers paid through Bank Giro
 Interest received on deposits at the bank
 Dividends received from investments
(These items will be entered on the debit side of the cash book – the receipts side)
Procedure for bank reconciliation:

Checking must be made in some systematic order.
1. Tick off all the items that appear on both sets of records (both receipts and payments).
Entries that appear on both sets of records require no further action. It is only those entries
that do not appear on both records (the cash book and the bank statement) that require
further action. Also check the opening balances in the cash book and bank statement for any
differences because these also need action.
2. If there are any un-ticked items on the bank statement, such as bank charges, standing
orders, direct debits or interest received, these need to be first entered in the cash book.
The cash book balance will then have been updated. Once the cash book has been adjusted
the final stage is set for the reconciliation.
3. The bank reconciliation statement is then prepared usually in this format:
a. Balance as per bank statement (end of month balance)
b. Add any un-deposited cheques/cash (from debit side cash book)
c. Deduct any un-presented cheques (from credit side cash book)
d. This should equal the balance as per cash book

53
Let’s work through an example. Here you will see a bank statement and the company cash book.
Each item that appears in both documents will be ticked off, and the items in just one document will
then form the basis of the reconciliation statement.
Bank Reconciliation Statement for K McDonald:
National Bank Plc

K McDonald Statement of Account
Date Details Debits Credits Balance
£ £ £___
Oct 30 Balance 841
Oct 31 606218 23  818
Nov 5 Sundry Credit 46  864
Nov 7 606219 161  703
Nov 9 Direct Debit 18 685
Nov 12 606222 93  592
Nov 19 606223 246  553
Nov 19 Bank Giro Credit 146  699
Nov 20 Bank Giro Credit 246 945
Nov 21 606221 43  902
Nov 21 Sundry Credit 63  ` 965
Nov 22 Bank Giro Credit 79  1,044
Nov 23 Loan Interest 391 653
Nov 26 606220 87  566
Nov 26 Deposit a/c interest 84 650
Nov 27 606226 74  576
Nov 30 606225 185  479 _
Her cash book showed the following details:

£ Cheque No £
Nov 1 Balance b/d 818  Nov 2 Rent 219 161 
Nov 5 B Mason 46  Nov 5 H Gibson 220 87 
Nov 8 K Dean 146  Nov 7 G Wise 221 43 
Nov 14 G Hunt 1 207  Nov 8 T Allen 222 93 
Nov 16 C Charlton 79  Nov 12 Gas 223 246 
Nov 19 D Banks 63  Nov 15 F Chaucer 224 692
Nov 26 P Perry 88  Nov 19 M Lewis 225 185 
Nov 28 A Palmer 29 Nov 23 G Bridges 226 74 
Nov 30 J Dixon 17 Nov 29 L Wilson 227 27
Nov 30 Balance c/d 206 Nov 29 P Brown 228 91
1,699 1,699
Cash Book
Dr _____________Cr
Dec 1 Deposit interest 84 Dec 1 Balance b/d 206 (o/d)
Bank giro credit 246 Direct Debit 18
Balance c/d 285 Loan interest 391
615 615
Balance b/d 285

54
Bank Reconciliation Statement as at November 30
£
1 Balance as per bank statement (30/11) 479 Credit
2 Add deposits not yet credited:
Palmer 29
Dixon 17 46
525
3 Less un-presented cheques:
Chaucer 692
Wilson 27
Brown 91
(810)
4 Balance as per cash book 285 (o/d)
Overdrafts:
It is vital to remember that an overdraft is a debit balance in the bank statement and is a credit
balance in the bank account or cash book. Therefore, when preparing a bank reconciliation the
additions and subtractions need to be reversed, e.g:
£
Balance as per bank statement 479 Dr
Less deposits not yet credited:
Palmer 29
Dixon 17 46
433
Add un-presented cheques:
Chaucer 692
Wilson 27
Brown 91
810
Balance as per cash book 1243 (o/d)

55
1. The following represents the Cash Book and bank statement figures of J Jones for the month
of June:
Cash Bank (bank columns only)

£ £
1/6 Balance b/d 469 6/6 Jones, F 130
14/6 Doyle, C 393 9/6 Singleton, S 63
17/6 Cronin, A 200 20/6 Jackson, J 292
28/6 Smith, W 205 27/6 Hemming R 78
Balance c/d ?
Bank of Education Statement of J Jones – for month of June

Dr Cr Balance
£ £ £
1/6 Balance 469 Cr
5/6 Credit 393 862 Cr
12/6 123971 130 732 Cr
19/6 123972 63 669 Cr
20/6 Credit 200 869 Cr
26/6 Credit (Smith, R) 100 969 Cr
28/6 SO (Leicester BSC) 86 883 Cr
29/6 Charges 19 864 Cr
Required:
a) Bring down the balance of J Jones’s Cash Book and check both sets of records and action
any un-ticked items.
b) Adjust the Cash Book
c) Prepare the bank reconciliation statement as at 30 June

56
Chapter 14: The Petty Cash Book
Introduction
The Petty Cash Book is easy to understand. This diagram shows you what a petty cash book is, how it
works and how the ledger postings work:
What is a petty cash book?

It is a part of the cash book, used to record small
payments of cash. It is a small supply of cash used for
the small everyday payments such as office cleaning,
refreshments, stationery etc.
Why have a petty cash book?

 Work can subdivided, so a junior accounts clerk can control petty cash.
 It frees the cash book from too many insignificant figures.
 Columns can be used to analysis what has been spent, allowing easier
ledger posting
How does it work?

The petty cash book is a cash float (or ‘imprest’, so also
known as the ‘imprest system’). Each time a minor
purchase is used a voucher is completed with the value of
the goods, and the receipt is attached as evidence of
purchase.
How does the double-entry work?

When a sum for the petty cash is to be ‘withdrawn’ from the Cash Book:
 Debit the Petty Cash Book
 Credit the Cash Book
Note: VAT must be separated if voucher includes VAT (debit VAT a/c and
debit appropriate expense ledger.
Keeping control of the petty cash

You can check the accuracy of the petty cash book at
any time. The total value of any vouchers completed
that month added to the balance of cash left, should
equal the petty cash float. Also, the petty cashier can
ensure each voucher is signed by the person requesting
the cash.

57
1. Why is the petty cash book part of the accounting system?
2. Gill Graham runs her petty cash on the imprest system, having a float of £200 per month.
She uses analysis columns for VAT, postage, travel, cleaning, refreshments, stationery and
sundries. At the end of August, she had £28.75 to carry forward to the new month. During
the first three weeks of September, the following transactions occurred:
September
1 Enter the balance brought down from August in the petty cash book
2 Cashier reimburses Gill to bring up to required float
3 Purchased stamps £12.50
5 Rail fares to Bristol £13.60
6 Typing paper, biros, etc. £14.10 (inc. VAT 17.5%)
8 New kettle and cups £18.80 (inc. VAT 17.5%)
11 Window cleaner £10.50
12 Postage stamps £8.75
15 Taxi expenses £7.80
16 Repairs to typewriter £12.80 + VAT 17.5%
18 Window cleaner £10.50
20 Donation for Poppy Appeal £2.00
20 Milk money £6.25
21 Tea, coffee, etc. £4.80
For the remainder of September, there are eight further vouchers to record.
Required:
a) Enter the above petty cash transactions in the Petty Cash Book for Gill Graham and record the
remaining eight petty cash vouchers overleaf.
b) Balance the petty cash book as at 30 September. Post the individual expense columns to the
nominal ledger.

58
Chapter 15: Capital and Revenue
Expenditure
Introduction
A business spends money on two types of expenditure:
Capital Expenditure: Revenue Expenditure:
This is the purchase of fixed assets, such as This is the money spent on running the
vehicles and equipment. Money spent on business with expenses such as purchases of
improving an asset (and therefore its value) stock, wages and salaries, light and heat,
is also considered to be capital expenditure. stationery etc.
The key difference to remember is how these two types of expenditure are treated in the financial
statements. Capital expenditure is listed in the balance sheet under fixed assets, whereas all revenue
expenditure appears in the profit and loss account.
Why is this important? If for example, machinery was purchased and it was wrongly treated as
revenue expenditure, this would have the effect of under-stating the value of fixed assets and over-
stating the value of chargeable expenses. Result: profits are understated and fixed assets are under-
stated, meaning the tax paid to HMRC is incorrect (too low) and the company’s balance sheet would
not accurately represent the value of assets held.
The distinction between capital and revenue income:
Capital Income: Revenue Income:

When fixed assets are sold, the sale value This is the income from normal trading
of them is known as capital income. The activities of the business when it sells its
profit (treated as revenue) or loss (treated goods or services. This includes income
as an expense) from the sale is recorded in such as rent and interest received.
the profit & loss a/c.
Transaction Revenue Expenditure Capital Expenditure

Profit and Loss Account Balance Sheet
New computer £2,500 2,500
Installation of computer £1,000 1,000
Gas and electricity £450 450
Modernisation of premises £8,000 8,000
Office buildings painted £6,000 6,000
Wages and salaries £17,500 17,500
New vehicle for manager £9,500 9,500
Stock for resale £3,200 3,200
Motor expenses £800 800
Purchase of land £20,000 20,000
Solicitor’s fees for purchase £550 550
Running costs of computer £600 600

59
1. Classify the following items as to whether they are capital or revenue expenditure:
a) The purchase of a new IBM computer for the office.

b) Cost of software for the use of the new computer.
c) Cost of computer paper.
d) A refit of the stockroom with new shelving.
e) The payment of gas and electricity bill.
f) The purchase of stock for resale.
g) Discounts allowed on the sale of stock.
h) The acquisition of a new motor vehicle for the supervisor’s use.
i) The road tax and insurance of the vehicle.
J) The repairs and maintenance of the motor vehicle.
k) The cost of new floppy disks for the use of the computer.
l) The complete decoration of the offices to last a number of years.
2. In the setting-up of a new business for Jack Ramsgate, classify the following between capital
and revenue expenditure:
a) The purchase price of premises.

b) The estate and solicitor’s fees.
c) The cost of a computer system.
d) The cost of delivery charges and installation fees of the new computer.
e) The cost of training of personnel on the computer system.
f) Running repairs to the computer.
g) Oil and petrol for the motor vehicle.
h) An extension built on the premises.
i) The extension is painted on completion.
j) The extension is repainted six months later.
k) Improved roofing of the premises is installed two years later.
l) The cost of an advertising campaign which is expected to benefit a number of accounting
periods.

60
Chapter 16: The Trial Balance,
Journal
and Suspense Accounts
The Trial Balance
The trial balance is used to check the arithmetical accuracy of the double-entry system. At frequent
intervals, ledger account balances are listed to check that total debits equal total credits.
If the trial balance fails to balance the ledger accounts need to be checked to locate the errors.
However, the trial balance is not fool-proof. Some errors can occur that will not be detected with
this system. It’s important to understand these types of error:
Errors of compensation Where the error has been made to both sides of the
transaction e.g. a cheque rec’d for £451 incorrectly
entered as £415 on both sides of the ledger.
Errors of principle Where a transaction has been posted to the wrong group
of accounts e.g. office equipment posted to ‘purchases
a/c’ instead of ‘office equipment’.
Errors of omission An error where a transaction has been omitted altogether
e.g. a sales or purchase invoice mislaid.
Errors of commission Where an entry is posted to the correct group of
accounts, but the wrong account within the group e.g. a
nominal a/c like a gas bill posted to another nominal a/c
like office expenses.
Errors of original entry An error that first appeared on an original document such
as an invoice. The error would be posted to both credit
and debit sides, meaning the trial balance would not
identify the mistake.
Errors of reverse entry An entry made the opposite way round to what it should
be e.g. cash sales entered on the credit side of the cash
book.
Locating the errors:
If the trial balance fails to balance, then the errors must be identified, however small the error (as a
small error could be hiding a big one). Depending on the error, it may be necessary to comb through
the ledgers carefully to check for any arithmetical inaccuracies or any obvious double entry error.

61
The Journal
The journal is used for those transactions that are normally outside the scope of the other subsidiary
books. It provides a system of original entry for those miscellaneous types of transaction that do not
quite ‘fit in’ to the other subsidiary books.
The journal is ideal to use when making corrections of errors. So let us use a series of errors,
corrected using the journal, and then posted to the sales and nominal ledger:
___________________________Journal_______ ___________________________
Date Particulars Debit Credit ______
£ £
8 Bank 36
T Smith 36
(error of compensation, £451 cheque entered as £415)
10 Office Equipment 2,500

Purchases 2,500
(error of principle, asset recorded as an expense)
14 J Jackson 235
Sales 200
VAT 35
(error of omission, invoice No. 2176 had been omitted)
26 Light & Heat 185

Office expenses 185
(error of commission, gas bill entered in office expenses)
30 F Jones 9.50
VAT 9.50
(error of original entry, sales VAT charged at 15%, instead of 17.5%)
30 Bank (cash book) 960

Sales 960
(error of reverse entry, cash sales £480 entered as debit in bank)___
__________________________Error Correction: Sales Ledger _______________

T Smith a/c £ £ £
June 1 Balance 451 Dr
2 Bank 415 36
8 Bank 36 0
J Jackson a/c
14 Sales 235 285
F Jones a/c
15 Sales, VAT 437 557
30 VAT 9.50 566.50___

62
__________________________Error Correction: Nominal Ledger __ __________
Office Equipment a/c £ £ £
June 1 Balance 1,000 Dr
10 Purchases 2,500 3,500
Purchases a/c
10 Office equipment 2,500 350
Light & Heat a/c
26 Office expenses 185 535 Dr
Office Expenses a/c
26 Light & heat 185 410
VAT a/c
14 Sales 35 75
15 Sales 57 132
30 Sales 9.50 141.50
Sales a/c
14 Jackson 200 790
15 Jones 380 1,170
30 Bank 480 690
30 Bank 960 1,650____
The transfer of balances

The correction of errors The opening entries between accounts
in a new accounting
period
Providing adjustments to the Any other adjustments to
final accounts, such as What is a journal is used accounts which are outside
depreciation, accruals, pre- for? the scope of other
payments, etc. subsidiary books
The writing-off of bad debts The purchase or sale of fixed assets

63
The Suspense Account
The purpose of a suspense account is to balance the trial balance temporarily. If the credit and debit
sides do not match, a suspense account can be created by inserting the difference between the trial
balance totals.
A suspense account is then opened in the nominal ledger and is written off when the error(s) are
located. The journal (mentioned above) is then used to process the corrections. Using a suspense
account in a trial balance looks like this:
Extract of trial balance taken from the books of G Harrison 30 June

Account Debits Credits
£ £
Sales 18,600
Purchases 12,500
Furniture and fittings 4,200
General expenses 150
Discount 35
Returns 750
17,600 18,635
Suspense 1,035
18,635 18,635_
How profit can be affected:
Before errors in the trial balance can be corrected via the suspense and journal entries, it is possible
the profit and loss account has been prepared. If so, the corrected errors will change the value of net
profit. To correct this:
 Start with the net profit figure before the errors

 Add the corrected errors that would have increased net profit e.g. sales (under-cast),
discounts received, returns, etc.
 Less the corrected errors that would have decreased net profit e.g. expenses not previously
counted.
 You end with a correct net profit figure.

64
Foundation Accounting: Revision
Section
Ok, now is the time to pause and review this section by testing yourself. If you want to do well in the
exams, this stage is critical. It will test your knowledge and make sure that you understand all the
key points so far.
If you skip this stage, you will almost certainly get a lower mark in the exams. It
will be hard, but your hard work will pay off.
Now answer each of these questions, if you are unsure, try to write an answer
before looking up the solution. You may need to refer to your original text book
for those questions you find most difficult.
1. Write down the accounting equation

2. Briefly explain the principle of double entry
3. How would the following be recorded in the nominal ledger?
a. Cash sales into the bank
b. Purchased goods on credit from XYZ Ltd
c. Owner takes cash for his own use
d. A debtor pays off his outstanding balance (4 marks)
4. How are transactions processed either on credit terms or by cash through an accounting
system to the ledgers?
5. State the posting procedure from the sales journal, including VAT
6. State the posting procedure from the returns outward journal
7. Calculate an invoice that has goods gross £800 less trade discount 30% + VAT
8. Calculate an invoice that has goods gross £1,200 less trade discount 25% and offers 5% cash
discount for early payment. (2 marks)
9. What is the basic rule applied when posting from a cash book to the ledgers?
10. If the total cash paid to creditors was £1,860 and discount received was £40 how is this
posted to the control account? How is the discount posted? (2 marks)
11. How are the following accounts classified under RECAL:
a. Returns in
b. Returns out
c. Drawings
d. Discount received
e. Discount allowed and cash (2 marks)
12. When a bank statement arrives from the bank, why does it rarely agree with the business’s
cash book? (2 marks)
13. Briefly explain the procedure to prepare a bank reconciliation. Also, on a bank statement,
which side would record DDs, STOs and bank charges and how would these be recorded in
the cash book? (2 marks)
14. Why is it an advantage to use multi-columns in journals and cash book records? (2 marks)
15. Write down two functions of the journal. (2 marks)
16. Explain the following briefly:
a. Error of principle
b. Error of commission
c. Error of compensation
d. Error of original entry (4 marks)

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17. Provide two reasons why control accounts are used. (2 marks)
18. When using the petty cash system:
a. How is a reimbursement recorded?
b. How are analysis columns posted to the ledger?
c. What kind of evidence is required before giving out petty cash?
d. What is the difference between petty cash and petty cash expenses? (4 marks)
19. When is the stock account recorded in the ledger? And when stock is purchased or sold or
goods returned, which accounts are used? (2 marks)
20. How is a bad debt written off?
21. What is the basic function of a trial balance? Explain why it is not fool-proof. (2 marks)
Total = 40 marks
How did you do? If you struggled with certain areas, it is best to go back and revisit those sections.
Now you are going to attempt a full exam type question. You will be given a large amount of starting
information and you have to then prepare the accounts up to the trial balance.
AAT Processing Question:

The following transactions take place on 1 June and have yet to be entered in the ledger system. The
bank statement was received on 2 June but contains some items for the bank account relating to 1
June. You work as an accounts assistant for Motormart Ltd and have been made responsible for
keeping the ledgers up to date and producing the trail balance. The following entries are for you to
process.
Sales invoices sent:

Customer Total VAT Net Sales
£ £ £
Auto Ltd 5,492 818 4,674
Salfords Ltd 3,396 506 2,890
Ford Motors Ltd 6,156 917 5,239
Other customers 22,696 3,380 19,316
37,740 5,621 32,119
Purchase invoices received:

Supplier Total VAT Net purchases
£ £ £
Carmart Ltd 8,371 1,247 7,124
Lombards Ltd 7,727 1,151 6,576
Lucas & Co 5,820 867 4,953
Other suppliers 12,676 1,888 10,788
34,594 5,153 29,441
Credit note issued:

Customer Total VAT Net Sales
£ £ £
Ford Motors Ltd 168 25 143

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Journal Debit Credit
£ £
Creditors control a/c 1,450
Debtors control a/c 1,450
Transfer of balances (relating to other customers/other suppliers)
Cheque issued: £
Lombards Ltd 2,817
(Full repayment of debt for £2958)
Cash purchases 1,363
(Inclusive of £203 VAT)
Cheques received: £
Ford Motors Ltd 1,472
(Full repayment of debt for £1,550)
Bank Statement received:

The only items relating to 1 June were:
Bank interest received £122
Bank charges £210
The following balances are available to you at the start of the day on 1 June:
£
Sales ledger
Auto Ltd 24,617
Salfords Ltd 41,561
Ford Motors Ltd 27,124
Other customer balances 627,341
Purchase ledger
Carmart Ltd 28,413
Lombards Ltd 56,987
Lucas & Co 33,792
Other supplier balances 492,853
Nominal ledger
Purchases 2,652,194
Sales 3,122,786
Returns in 6,225
Bank (debit) 4,120
Bank charges 261
Bank interest received 103
VAT (credit) 71,089
Discount allowed 21,408
Discount received 15,194
Debtors control 720,643
Creditors control 612,045

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Task 1:
Draw up the sales and purchase ledger accounts (including other customer and supplier account
balances) and balance at the end of the day 1 June.
Task 2:
Draw up the nominal ledger accounts and post all relevant data from the prime books. Balance at
the end of the day 1 June. Ensure that your sales and purchase ledger totals equal your control
account balances.
Task 3:
Prepare a trial balance as at 1 June (include other debit and credit balances).

68
Part 3
Supply Information for

Management Control

69
Chapter 17: The Purpose of
Management
Information
Introduction
The management of a business need to know information to help them make good decisions. It is
not just about the quantity of information that is important. Good management information is:
 Relevant
 Reliable
 Timely (better to have imperfect information in time to make a decision than perfect
information that arrives too late)
How much will the Can we reduce the

new product cost? selling price and still
make a profit?
How many units do we Can we afford to

need to produce and sell employ more labour?
to break even?
What is the estimated

How many must we sell
monthly profit on output
to cover the advertising
of 2,500 units?
campaign?
Businesses of all sizes require information. Even the sole trader must have knowledge of how sales
are moving and the type of costs the business is incurring. But it is in larger organisations
(particularly manufacturing) where good management information becomes critical.
Management must know the different types of direct and indirect costs which make up the factory
cost. This information allows them to decide what mark-up of profit should be added in order to
decide on the selling price.
The break-even point is an important measurement. It is the point where all costs are covered and
above the break-even point is when profit is made.
Costing:
Where managers need information, costing helps to provide it. Cost accounting is often referred to
as management accounting, because of the information it supplies to help management make
better, more informed decisions.
The most common costing question is: “how much does it cost to make?”
It often depends on the type of information required that determines the costing method used. For
example:

70
 To know the full cost of making a specific unit, absorption costing is used.
 To know the break-even point of the product, then marginal costing is used.
 To predict future costs and compare them with actual results, the technique of budgetary
control is used.
 To compare predetermined costs against actual costs, standard costing is used.
Before we look at the four costing methods, it is important to understand the difference between
fixed and variable costing:
Fixed costs such as rent, rates and insurance costs are relatively insensitive to output change i.e. if
the units produced or sold varied fixed costs remain about the same.
Variable costs are those that ARE sensitive to output change and so will vary with the level of
activity.
Absorption Costing Marginal Costing

All costs are charged to a Refers to variable costs, and
specific cost unit so that answer the question “how
profit is estimated per unit. Cost Information much EXTRA does it cost to
Absorption costing means, a produce one more unit?”
fair proportion of fixed The greater the output, the
costs are also charged to a more diluted the fixed
unit of product – as well as costs, enabling economies
the more obvious direct of scale, thus allowing a
costs e.g. materials. range of selling prices.
Budgeting Standard Costing

A management tool to help Provides management with
form future plans. Forecast predetermined costs to help
costs are compared with with budgetary control.
actual results. The budget Each element of cost is
acts as a yardstick to see if calculated (materials,
things are going to plan, labour etc). This standard
action can then be taken, cost is then compared with
giving management actual cost. The difference
budgetary control. is known as ‘variance’.
The analysis of the variance between what was predicted and what actually occurred is an important
function of management accounting. Variances from the standard costs will sometimes be adverse
i.e. actual costs exceeded the predicted standard cost. Or, favourable i.e. actual costs are less than
the standard, e.g.:
Standard cost per unit Actual cost per unit Variance

Direct labour 2.40 2.50 10p Adverse
Direct materials 5.25 5.00 (25p) Favourable
Factory overheads 8.75 9.35 60p Adverse
Administration overheads 12.55 12.90 35p Adverse

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Job Costing Contract Costing
A method used to satisfy Often used for large jobs,
customers who have their Costing Methods costly to produce and likely to
own specifications (different take a long time to complete.
parts, measurements etc), Contract price estimated in
often requiring a bespoke advance often with clauses to
production run. allow additional charges.
Batch Costing Process Costing

Method used to produce A series of continuous
quantities of output for production processes. At each
similar or identical products. stage the output of one
Unit cost is the total cost of process goes on to form the
the batch, divided by the input of the next. Each stage
output of the batch. is costed to give a total cost.
Cost classification:
There is a real need in industry to classify all costs carefully in their own categories so that the
precise nature of what something costs can be estimated in terms of labour, materials and
overheads. Below is an example of a cost classification: the unit cost of a pair of jeans
£ £
Direct materials
Cotton 1.40
Zip .30
Embroidery .20 1.90
Direct Labour
Machinists .20
Cutters .15
Assemblers .05 0.40
Prime cost 2.30
Indirect costs
Factory indirect wages .12
Rent, rates, insurance .03
Depreciation of plant .20
Factory general expenses .10
Factory overheads .45
Production Cost 2.75
Profit and loss expenses
Admin & distribution overheads 1.25
Total cost 4.00
If management wanted to make a profit of 25% on the total cost (a mark-up) the selling price would
be £5.00 per unit (£4.00 + £1 profit).

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1. Why is there a need for cost accounting?
2. Briefly explain the difference between absorption and marginal costing?
3. How would you classify the following costs of a car manufacturer?

a) component parts f) sales staff salaries
b) factory foreman’s wages g) administration officer’s wages
c) assembly worker h) lubricants for plant & machinery
d) sheet metal body worker i) warehouse costs
e) factory rent, rates and insurance j) manufacturing cleaner’s wages
4. The following information concerns a small manufacturing business:

£
Direct wages 40,000
Direct materials 60,000
Business rates 1,600
Advertising 1,500
Administration 18,500
Rent and Insurance 6,200
a) If it was estimated that 8,000 unites were to be produced, calculate the total (absorption
cost) per unit.
b) Which of the above would you consider as being the variable costs?
c) What would be the total fixed costs?
5. A batch of 5000 units are produced and you have been asked to calculate costs:
£
Materials & components 8,000
Direct wages 7,500
Factory overheads 4,200
Sales & distribution expenses 6,250
Administration expenses 4,650
You have been asked to calculate: (only materials and wages are variable)
a) The direct cost per unit
b) The factory overheads per unit
c) The production cost per unit
d) The total cost per unit
e) If a mark-up was added, what is the unit selling price?
f) What is the break-even point?

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Chapter 18: The Use of Cost
Centres and Coding of Costs
Introduction
What is a cost centre? Why have cost centres?
It is a part of the business – a The monitoring of costs to the
production or service sections of the business that will
location, function or activity – use them helps to maintain a
that incurs costs and where control of costs and allow
those costs can be attributed management to operate with
to cost units. budgetary control.
To find the cost of anything, the direct costs can normally be traced to a cost centre quite easily. The
indirect costs such as rent, rates, insurance, light and heat may not be so easily traceable and may
benefit a number of cost centres.
It is important to have a fair way of apportioning these overheads to various cost centres so that
accurate costs are attributed to them.
Allocating and apportioning of costs

Some costs are easier to allocate than others. Direct costs and some indirect costs (such as indirect
labour and materials) are normally straightforward allocation.
The apportioning of costs applies when a cost is incurred for the benefit of two or more cost centres.
Overheads such as rent, rates and insurance are typical indirect costs that require a fair
apportionment as they benefit more than one cost centre.
Bases of apportionment:
There are a number of ways a cost attributable to multiple cost centres can be apportioned:
Cost type Basis of apportionment

Rent, rates Floor area
Insurance (buildings) Floor area
Insurance (employees) Number of employees
Light, heat, power Floor area of metered units
Canteen expenses Number of employees
Wages, office expenses Number of employees
Distribution costs Value of sales
For example:
The canteen expenses of a factory were
£150,000, with four cost centres: Now we can apportion the canteen costs:
Cost centre 1 50 employees Cost centre 1 £75,000

Cost centre 4 10 employees Cost centre 4 £15,000 £150,000

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The coding of accounts for income and costs:
Each income and cost account needs to have a code number so that it can be properly classified into
its own specific areas or locations. By using a code of numbers for various categories of sales,
purchases, stocks, overheads and any other type of account used, an integrated accounting system
(using computer software) can be built up.
Each account in the nominal, sales and purchase ledgers should have a code number to identify the
type of account it is. For example:
0 – 250 Sales ledger accounts

251 – 750 Purchase ledger accounts
751 – 1000 Nominal ledger accounts
Almost all coding of accounts is based on a numerical system whereby the break-down of numbers
used relates to specific elements such as location, type and description of item coded. Where cost
centres are used, the first two numbers often identify the cost centre. For example:
Code number 01445502

01 Cost centre 1 = administration
44 Stationery
55 Photocopying paper
02 Revenue expenditure
Key point: a coding system needs to be simple and easy to use and easy to recognise. It also needs to
be flexible to be able to meet the changing needs of the business.

Questions:
1. Define a cost centre.
2. Define a cost code
3. Why are overheads more difficult to apportion than direct costs?
4. The floor area of 4 production centres are:

Centre A 150 sq metres
Centre B 75 sq metres
Centre C 25 sq metres
Centre D 50 sq metres
The cost of rent and rates is £240,000. How could this be apportioned to the 4 centres?

75
Chapter 19: Providing
Comparisons on Costs and Income
Introduction
A business prepares a budget to ensure that its financial resources are used in the best possible way.
The budget, therefore, is a management tool used to establish a business’s aims and objectives.
How will the budget How do results

figures compare with compare with those of
the actual results? our main competitors?
Will these be better Is the business

or worse than the increasing its market
forecasts? share or losing it?
It is questions like this that require the comparison of costs and income.
Budgetary Control:
The key stages of budgetary control are:
Create a budget for each Appropriate action taken to

department or cost centre keep the business on target
Communicate these budgets Any key variances are

to all personnel involved disclosed and discussed.
To monitor actual results

against the forecast budget
Comparing results:
In chapter 17 we looked at standard costs and the concept of variance. Management need to
compare forecast with actual results but then ask questions about any variance. For example, these
were a month’s cost (per unit) comparison for producing 2000 units of an electronic component:
Budget Actual Variance
£ £ £
Direct labour 5.67 5.56 0.11p Favourable
Direct materials 23.81 23.85 (0.04p) Adverse
Factory overheads 7.55 7.70 (0.15p) Adverse
Admin overheads 11.67 11.70 (0.03p) Adverse
Total costs 48.70 48.81 (0.11p) Adverse

76
These results could prompt a number of questions and provide a number of insists into the
operation of the business, for example:
 Was labour more efficient, taking less time to produce 2000 units? Or was it that a pay
settlement was lower than expected?
 Direct materials were 4p per unit more. Was this simply an increase in the purchase price or
could it mean there was more wastage than usual in production?
 Factory overheads were the most adverse. Could it have been a higher cost in factory rent,
rates and insurance? Or could it be with factory indirect labour increasing higher than
expected?
A business may not want to investigate every single tiny variance, due to the cost of doing this.
Often particular limits will be set in place, so if the variance exceeds that limit it is investigated and
acted upon. This is known as exception reporting.
Some variances are internal and controllable. Other variances are external and beyond the control of
management (for example, the price of inflation). It is measuring these variances and then explaining
them that gives business crucial operational information and, therefore, control of finances.
The comparison of profit and loss:

A business needs to compare its trading performance in order to check whether it’s improving,
deteriorating or staying at a consistent level. And also needs to compare this with its competitor’s
performance.
Example:
Year 1 Year 2 Year 3
(£000s) (£000s) (£000s)
Sales 120 180 270
Cost of sales 80 135 216
Gross profit 40 45 54
Less expenses:
Distribution costs 18 27 30
Administration costs 10 10 20
Net profit 12 8 4
Net profit % 10% 4.4% 1.48%

(net profit/sales)
At a glance, while gross profit has steadily increased the net profit has fallen steeply from £12,000 in
year 1 to £4,000 in year 3. As you can see the major reason for this is the doubling of administration
expenses by year 3.
Management needs to compare year end figures like this as, in the case, it may highlight
inefficiencies in administration costs. However, this increase in admin costs may have been planned
e.g. an extra employee was hired.
If the company’s major competitors were averaging 12% net profit, serious questions need to be
asked. If the current pattern continued, the business would face an uncertain future.

77
1. What is meant by the term ‘variance’ including those found to be favourable and adverse?
2. Provide examples of external factors which would be out of management’s control.
3. What is reporting by exception? Provide an example to clarify.
4. Study the following figures based on production of 5000 units:

Budget £ Actual £
Direct labour 24,000 24,350
Direct materials 32,500 32,250
Fixed overheads 28,500 28,250
Required:
a) Based on costs per unit, calculate the 3 elements of cost for both the budget and actual figures.
b) Compare the 2 sets of figures, calculating the appropriate variances.
c) Provide possible explanations to these variances which could assist management.
5. A key aspect of budgetary control is to monitor progress. What does this mean?
6. The trading results between two companies in the same line of business were as follows:
Big Ltd Little Ltd
(£000s) (£000s)
Sales 300 360
Cost of sales 200 240
Distribution costs 45 48
Administration expenses 35 40
Interest charges 3 10
Required:
Compare the performance of the two companies in terms of revenue and costs and provide a brief
explanation of which company has performed the better of the two.

78
Chapter 20: A Brief Introduction to
Wages
Introduction
Wages and salaries are a reward for labour. Wages are usually for those paid weekly, whereas a
salary is normally for someone who is paid monthly. Pay is often referred to as remuneration.
There are two distinct ways in which pay can be calculated:
1. Time rates 2. Payment by results

This is by far the most common way This is an alternative method of
of being paid. People are often paid payment that offers an incentive to
a certain sum of money to work a workers to work harder for more
certain number of hours. For pay. Sales people are often paid like
example, 37 hours a week, basic pay this, earning more commission the
£250. Any hours worked overtime, more they sell. Factory workers that
i.e. over 37 hours, are often paid at produce more output can often
a premium rate – say time and a receive more pay. This is known as
half, or double time. piece work.
Gross and net pay:

Gross pay is simply all earnings before any deductions from pay are made, net pay is the gross pay
less all deductions. There are two types of deductions – voluntary and statutory.
Statutory Deductions:
These are deductions legally required by government and refer to income tax and National
Insurance Contributions (NIC). Both of these are automatically collected from your pay if you are an
employee. If you are self-employed, then you are required to send your personal tax return to the
local tax office at the end of your trading period.
Income Tax National Insurance Contributions

In the UK income tax is progressive, Another form of tax an employee
meaning that the more you earn, has to pay, but in return this money
the more you pay. There are also goes to provide funds for benefits
tax bands, which means earnings up like unemployment, sick pay,
to a certain value are taxed at one pension, child support etc. People
percentage, then earnings beyond on low income do not pay the
this hit a higher tax band and are current rate of 11% of taxable
subject to a larger percentage. income.
Voluntary Deductions:
These are deductions agreed to by the employee, e.g. voluntary savings scheme, pension fund, trade
union subscriptions, social club funds etc. Employees contribute to a government pension through
NIC, but many employers also offer a company pension scheme.

79
Example of net pay: £ £
Gross pay for the year 25,915.00
Less deductions:
Taxation 4,585.70
NIC 3,971.60
Trade Union subs 130
Pension fund 400 9,087. 30
Net pay 16,827.70
Recording payroll details in the nominal ledger

When recording payroll data in the nominal ledger, the entries could include the use of a wages
control account ensuring all relevant entries are recorded.
Remember: a control account is a cross checking device to make sure that all the double entry
transactions are recorded. The control account debit entries should balance with the credit entries
when all entries are completed.
The double entry for the above salary figures would look like this:
Debit Credit
Wages account: Wages control account:
Wages £25,915 Wages account £25,915
Employer’s NIC £4,927.85 Employer’s NIC £4,927.85
The payments due to the tax office (Inland Revenue) are credited to the Inland Revenue account and
debited to the wages control account:
Wages control account: Inland Revenue account:
Tax £4,585.70 Tax £4,585.70
Employee’s NIC £3,971.60 Employee’s NIC £3,971.60
Employer’s NIC £4,927.85 Employer’s NIC £4,927.85
The bank account is credited with net wages to be paid & debited to wages control account:
Wages control account: Bank account:
Net pay £16,827.70 Net pay £16,827.70
The pension fund and trade union subscriptions accounts are credited with the sums due to them
and the wages control account debited:
Wages control account: TU subscriptions and pension funds accounts:
TU subscriptions £130 TU subscriptions account £130
Pension funds £400 Pension funds account £400
In summary the wages control account would look like this:

Wages Control Account
31/10 Tax 4,585.70 31/10 Wages 25,915.00
NIC (Employer) 4,927.85 NIC (Employer) 4,927.85
NIC (Employee) 3,971.60
TU subs 130
Pension funds 400
Bank (net pay) 16,827.70_______________________________________
30,842.85 30,842.85

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1. Calculate the following gross weekly wages for Harry, Jack and Fred:
a) Harry Jones has a basic week of 36 hours paid at a flat rate of £4.00 per hour. Overtime is at time
and a half. How much will he earn working 39 hours in a week?
b) Jack works 46 hours and Fred 43 hours per week at only £2.80 per hour. Overtime starts after 38
hours and is paid at time and a quarter. Calculate their gross pay.
2. Charlie is on piece work where the attendance retainer is £1.25 per hour. The piece work is at
the following rates:
0 – 1000 units, 2p unit; 1001 – 1500 units, 3p unit; over 1500 units 2.5p unit.
How much will he earn during a 42 hour week in which he produces 1825 units?
3. Calculate Arthur’s net pay for the week:

Gross pay £226.80. Deductions: pension fund £14 tax free; NIC £16.34; Tax to be deducted.
Arthur has £110 per week as his personal tax allowance on top of his tax free pension. The basic
rate of tax is 20% and there is £3 to be deducted to take account of the lower starter rate.
(Calculate the tax on whole £s only)
4. The details from the month’s payroll week ending 31 December, were:
Gross Pay Tax Employee NIC Pension Funds Employer NIC Net Pay
£138,815 £18,981.55 £12,500.40 £1,055 £13,000.55 £106,278.05
You supervisor has asked you to enter the details from the month’s payroll, ending 31 December in
the nominal ledger.
5. Explain clearly what is meant by statutory deductions from pay.
6. The following information relates to the time sheet of Julie Harris:

Basic time Overtime
Monday 8 hours 1.5 hours
Tuesday 8 hours 0.5 hours
Wednesday 8 hours 2.5 hours
Thursday 8 hours 2.0 hours
Friday 6 hours 0.5 hours
Saturday 3.0 hours
Sunday 2.0 hours
Julie earns a basic rate of £4.80 per hour and is paid time and a quarter for weekend-days, time and
a half for Saturdays and double time on Sundays. Calculate Julie’s gross pay for the week.

81
Chapter 21: Control Accounts:
Sales and Purchase Ledger
Control
Introduction
The sales and purchase ledger control accounts represent the totals of debtors’ and creditors’
balances. So the sales ledger control account is often referred to as the debtors’ control account,
while the purchase ledger as the creditors’ control account.
From a management viewpoint, it is essential to know how much is owed by debtors as well as how
much is owed to creditors. When can a business expect to receive its cash? When can it be in a
position to pay its creditors? These are two vital questions affect the future cash flow of the
business.
The location of errors:

If either of the two control accounts does not verify the total balances of the sales and purchase
ledgers, a detailed check is required to locate any errors. Both the individual balances of customers
and suppliers need to be checked for errors, as well as the control accounts.
It could be a simple incorrect addition of figures, or an entry posted to the wrong side of the
account, e.g. a returns inward on the debit side of a debtor’s account instead of the credit.
Terms used with control accounts:

Some entries in the control accounts may need clarification:
 Cheques dishonoured – refer to customer’s cheques that have been stopped by the bank,
usually because the customer has insufficient funds to pay the debt. (These are debited in
the sales ledger control and debited in the individual customer a/c.)
 Contra entries – are sums offset between debtors’ and creditors’ balances when a business
both sells and buys goods from the same organisation. (Debit the purchase ledger control
and credit sales ledger control accounts, as well as debiting the individual accounts in the
purchase ledger and crediting them in the sales ledger.)
 Bills receivable are notes from customers promising to pay at a future date. (They are
treated like a post dated cheque and are credited to the sales ledger control account.)
 Bills payable are the reverse of bills receivable in that the business promises to pay its
suppliers at a future date. (These are debited to the purchase ledger control a/c.)
Example 1: Sales Ledger Control (Debtors control account)

The following are balances from the ledger of ABC Ltd:
£
Sales ledger Dr balances at 1 June 7,300
Credit sales (June) 12,500
Cash sales 2,840
Cash/cheque received from debtors 11,500
Returns from customers 400
Discounts allowed to customers 280
Debtors’ cheques returned from bank
Marked ‘R/D’ – cheque dishonoured 330
Sales ledger Dr balances at 30 June 7,950

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Debtors Control Account___________________ ______
Dr Cr Balance
30 Sales 12,500 19,300
Bank/cash 11,500 8,300
Discounts 280 8,020
Returns inward 400 7,620
Cheques dishonoured 330 7,950___
Note:
 The 30 June balance of £7,950 is verified with the sales ledger control account.
 The cash sales £2,840 are not included because they are not associated with selling goods to
debtors, that is, on credit.
Example 2: Purchases Ledger Control (Creditors control account)

£
Purchases ledger Cr balances at 1 June 12,500
Credit purchases for June 19,750
Cheques paid to suppliers 18,200
Discounts received 478
Returns to suppliers 545
Debit note from suppliers, resulting from under-charge 50
Credit balances from purchase ledger at 30 June 13,427
Creditors Control Account___________________ ______

Dr Cr Balance
June 1 Balance 12,500
30 Purchases 19,750 32,250
Bank 18,200 14,050
Discounts received 478 13,572
Returns outward 545 13,027
Debit note, under-charge 50 13,077___
Note: There is a discrepancy of £350 between the purchase ledger (13,427) and the control account
(13,077). Somewhere an error has occurred and records must be checked to locate it.
Correcting Errors: (continuing our example)

The above discrepancy of £350 has had the errors located for you:
 A cheque to a supplier £200 has not been recorded in the purchase ledger, but the total
cheques payable to suppliers had been posted to the P/L control account.
o Correction: Debit supplier’s account £200
 A supplier’s balance brought forward £75 debit (due to overpayment) had been incorrectly
brought forward as £75 credit.
o Correction: Debit supplier’s account £150
Finally, we need to reconcile the purchase ledger control account and the purchase ledger:
£ £
Purchase ledger balances 13,427 credit
Less
Cheque to supplier 200 debit
Balance brought forward 150 debit (350)
Balance as per P/L control account 13,077

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1. The following balances relate to the accounts of Karina who has many credit customers, and will
shortly be preparing the annual final accounts:
£
1 April total debtors (accounts receivable) 126,000
1 April opening debit balance – Rhona 900
1 April credit balance – provision for doubtful debts 6,600
Transactions in April:
Cash sales 79,000
Credit sales 139,000
Credit purchases 4,000
Discounts allowed 2,000
Returns inwards 800
Bad debt (Rhona) written off in April 900
Receipts from debtors (accounts receivable) 114,000
Payments to creditors (accounts payable) 51,000
Contras (set offs) 2,400
Increase in provision for doubtful debts 600
Required:
a) Write up the sales ledger control account for April. [8]
b) Write up the account for Rhona as at the end of April. [3]
c) Write up the provision for doubtful debts as at the end of April. [4]
d) Explain why Karina maintains a provision for doubtful debts account. [5]
2. The following information has been taken from the books of Harry Jones relating to the month
ended 31 January:
£
Sales ledger control balance 1 Jan 2,246
P/L control balance 1 Jan 1,608
Transactions for the month:
Credit sales 38,127
Cash sales 9,750
Purchases on credit 27,121
Receipts from customers 27,560
Payments to suppliers 19,422
Discount allowed 810
Dishonoured cheques from customers 925
Returns outward 316
Returns inward 1,427
Required:
Prepare the sales and purchase ledger control accounts for the month ended 31 January.

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3. You have the following details re. the sales and purchase ledgers of a medium-sized business.
£
Feb. 01
Total creditors 149,000
Total debtors 278,000
Transactions in February:
Cash sales 13,000
Credit sales 279,000
Discounts received 4,000
Returns to suppliers 1,000
Returns from customers 2,500
Set offs (contras) 3,500
Bad debts written off in the month 1,000
Increase in provision for bad debts 1,500
Payments to creditors 152,000
Receipts from debtors 285,000
Required:
a) Prepare the sales ledger control account as at 28 February 2011. [8]
b) Prepare the purchase ledger control account as at 28 February 2011. [7]
c) Explain the purpose of maintaining control accounts. [5]
4. You work as an accountant’s assistant for a manufacturing company, Rock Ltd, and have to write
up the control accounts for the month of February. Details of transactions are as follows:
£
February 1 P/L control (credit balance) 26,100
Sales ledger control (debit balance) 41,400
Total transactions in the month of February:

Bad debts written off 420
Returns outwards 510
Returns inwards 1,480
Cheques paid to creditors 24,270
Cheques received from debtors 47,360
Contras between s/l & p/l 800
Dishonoured cheques (from debtors) 140
Credit sales 74,900
Cash sales 9,250
Discount allowed 1,840
Discount received 960
Cheque received from a supplier 460
Required:
a) Prepare the sales ledger control a/c for Feb. (The sales ledger schedule total was £74,540)
b) Prepare the purchase ledger control a/c for Feb. (The purchase ledger schedule total was £37,510)
c) Which of the two control accounts agreed? How much was the discrepancy in the account that did
not balance?

85
Part 4
The Construction of Financial

Statements

86
Chapter 22: Financial Statements:
The Calculation of Profits
Introduction
Financial statements states what has occurred in a business’s financial period. Has it made a profit or
suffered a loss? Is the business financially secure?
The financial period:

A financial period is seen as the business’s financial year. This could be from 1 January to 31
December, or any twelve month period. Many businesses match their financial year with the
government’s tax year which is April to March.
The need to make profits:

Businesses need to calculate profit or loss on a frequent basis; therefore an accounting period could
be seen as monthly as well as annually. If a forecast of monthly profit is prepared, the actual results
can be compared with them to see if any corrective action is required.
Making profits is the most significant part of any business, without profits there is no return on the
owner’s investment and the business would have difficulty surviving.
VAT and the Profit and Loss account:

For a VAT registered business, both revenue and expenses must be recorded excluding VAT because
it belongs to HMRC. Any VAT owing (a credit balance) is recorded in the balance sheet as a current
liability (or a current asset if VAT is a debit balance).
Recap: A profit and loss account is the difference between revenue and expenses. The balance sheet
identifies the business’s assets, liabilities and capital.
In this example we will calculate George Harrison’s final accounts (the profit and loss and balance
sheet) from a trial balance.
G Harrison’s Trial Balance as at 31 December

Account £ £
Capital: G Harrison 10,000
Drawings 2,600
Premises 12,000
Fixtures and Fittings 2,000
Equipment 3,000
Motor Van 1,250
Building society Mortgage 8,000
Bank Loan 1,000
Stock (1 January) 1,000
Bank/Cash 400
Debtors 850
Creditors 950
Sales 11,000
Returns Inward 250
Purchases 5,000
Returns Outward 350
Salaries 850

87
Light and Heat 300
Printing and Stationery 100
Telephone 155
Delivery expense 125
Advertising 300
Packing materials 340
Discount allowed 65
Rates and Water 285
Motor Expenses 500
Interest paid 140
Commission received 85
31,510 31,510
Required:
a) Prepare the trading profit and loss account of G Harrison for the year ended 31 December
b) Prepare a balance sheet as at that date, 31 December
Solution:
G Harrison
Trading and profit and loss account for the year ended 31 December
£ £
Sales 11,000
- returns inward 250 10,750
Less cost of sales

Stock (1/1) 1,000
+ purchases 5,000
6,000
- returns outward 350
5,650
- stock (31/12) 1,500 4,150
Gross profit 6,600
Less other expenses

Salaries 850
Printing and stationery 100
Telephone 155
Delivery expenses 125
Advertising 300
Discount allowed 65
Rates and water 285
Motor expenses 500
Interest paid 140
Light and heat 300 3,160
3,440
Add other revenue

Commission 85 210
Net profit 3,650

(transferred to Capital account)
Note: The balance of the closing unsold stock 31 December is also entered in the balance sheet as a
current asset.

88
G Harrison
Balance sheet as at 31 December
£ £ £
Fixed Assets (as cost)
Premises 12,000
Fixtures and fittings 2,000
Equipment 3,000
Motor van 1,250 18,250
Current Assets
Stock (at cost) 31/12 1,500
Debtors 850
Bank/cash 400 2,750
Less Current Liabilities

Creditors 950 950
Working Capital (net current assets) 1,800
Capital Employed 20,050
Less Long-term Liabilities

Mortgage (Building Society) 8,000
Bank loan 1,000 9,000
Net Assets 11,050
Finance by:
Capital: G Harrison (1/1) 10,000
+ Net profit 3,650 13,650
- Drawings (2,600) 11,050
Transfer of nominal ledger accounts to the profit and loss account:
All revenue and expense balances are transferred to the profit and loss account at the end of an
accounting period. Once profit and loss has been calculated, revenue and expense accounts will start
the new accounting period with zero balances.

89
1. The following represents the trial balance of Jack Armstrong as at 31 December.

Dr Cr
£ £
Premises 27,000
Motor van 2,000
Fixtures and fittings 5,300
Bank 4,250
Cash 250
Stock (1 Jan) 8,000
Debtors 3,100

Interest owing 1,000
Creditors 9,000
Capital: J Armstrong 7,000
Sales 71,000
Discount 300
Returns outward 1,000
Rate and water 500

Motor and travel expenses 2,500
Purchases 34,000
Returns inward 2,250
Light and heat 600
Advertising 590
Wages 16,500
Insurance 360
General expenses 2,100
109,300 109,300
Note: The value of closing stock on 31 December was £4,200 at stock-taking.
Required:
a) Prepare the trading and profit and loss account of J Armstrong for the period ended 31 December.
b) Prepare the balance sheet as at 31 December, and clearly show working capital.
2. What is the basic difference between gross and net profit?
3. Why is sufficient working capital important to the well being of a business?

90
4. James Roberts has a small business enterprise. The following trial balance was extracted from his
ledgers at the financial year end 30 April:
Dr Cr
£ £
Capital: J Robert 18,000
Drawings 2,800
Bank overdraft 725
Premises 15,700
Motor van 1,000
Equipment 1,400
Debtors 2,900
Creditors 3,850
Stock (beg.) 3,500
Purchases 28,400
Sales 42,650
Rent received 750
Wages 8,500
Rates and insurance 270
Light and heat 195
Administrative expenses 325
Selling and distribution costs 500
VAT 275
Returns inward 400
Returns outward _____ 190
66,165 66,165
Note: Stock unsold on 30 April was valued £5,280

VAT is not an expense. HMRC owe the money to J Robert and is entered as a current asset in the
balance sheet.
Required:
a) The profit and loss account for the year ended 30 April.
b) A balance sheet as at this date.
5. Complete the following accounting equations:

C = A - L
a) 8,000 96,000
b) 1,500 22,500
c) 14,700 104,500
d) 16,740 14,340
e) 100 1,000

91
Chapter 23: Adjustments,
Prepayments
And Drawings
Introduction
For financial transactions which specifically belong to an accounting period, whether paid or
incurred (due to be paid), they must be included within the accounts of that period. This is known as
the ‘accruals’ concept and can often lead to adjustments to the final accounts.
For example, if wages of £2,500 are owed at year end, this sum must be included in the accounts for
the year, even though they are yet to be paid. The benefit of this labour was received in the financial
year, so the cost of it (the wages) should also be included in the same accounting period.
Similarly, if an expense was paid in advance of the accounting period, the sum prepaid for the next
financial period must be deducted from the accounts of the current financial year.
These adjustments are part of the matching concept in accounting, which attempts to match as
exactly as possible the revenue earned in one period with the expenses incurred in the same period,
in order to arrive at a ‘true and fair’ assessment of profit (or loss).
Types of adjustment:
1. Closing stock - value of stock still unsold

2. Accrued expenses - expenses still owing
3. Prepaid expenses - expenses paid in advance
4. Revenue accrued - income owed to the business
5. Revenue prepaid - income paid in advance
6. Owners drawings - value taken for personal use such as stock
Each of these adjustments will have a TWO-FOLD effect as they will affect the profit and loss account
and they are included in the balance sheet as they affect the value of assets, liabilities or capital.
How do these adjustments affect the profit and loss account and balance sheet?
Type of adjustment Profit and loss account Balance sheet

1. Closing stock reduced cost of sales current asset
2. Accrued expenses increase expenses current liability
3. Prepaid expenses reduce expenses current asset
4. Revenue accrued increase revenues current asset
5. Revenue prepaid reduce revenues current liability
6. Owners drawings reduce expenses reduce capital
Closing Stock:
If at the end of a financial period the business has any unsold stock, it first needs to be valued and
then deducted from the cost of sales in the trading account. Any unsold stock is not an expense in
the current accounting period, but is an expense as the opening stock in the new period, when it is
part of the new period’s cost of sales.
This is part of the matching process between revenue and expenses.

92
We will now work through example adjustments to the final accounts of G Harrison that we looked
at in the previous chapter.
Adjustments as at 31 December:
 The value of closing stock was £1,500
 Accrued expenses: gas owing £54, salaries owing £34
 Prepaid expenses: rates and water £40, stationery unused £20, packing materials unused
£60
 Revenue accrued: commission due £120, rent received in advance £240
 Revenue prepaid: commission paid in advance £25
 Drawings: owner takes £500 stock and £50 for personal telephone calls
Accrued Expenses:
These are expenses incurred in the financial period but not yet paid for. Any outstanding expenses
must be charged to the profit and loss account for the year in which they were used.
So we need to adjust the accounts for a gas bill (£54) and salaries (£34) owing. We will use the same
trial balance as the previous chapter.
Profit & loss account and balance sheet (extract)

£ £
Profit & loss account
Light and heat 300
Accrued expense 54 354
Salaries 850
Accrued expense 34 884
Balance sheet
Current liabilities
Accrued expense 88
Nominal ledger – accrued expenses

Dr Cr Balance
Light and heat a/c
31/12 Balance 300 Dr
Accrued 54 354
Profit & loss 354 0
1/1 Accrued 54 54 Cr
Salaries a/c
Accrued 34 884
Profit & loss 884 0
1/1 Accrued 34 34 Cr
Note: the accrued expenses are brought down as credit entries in the new accounting period as
these expenses are still to be paid.
Prepaid Expenses (prepayments):

These are expenses that are paid in advance of the current financial period. Expenses that are likely
to be paid in advance are rent, rates, insurance premiums and advertising.

93
£ £
Rates and water 285
Prepaid (40) 245
Printing & stationery 100
Prepaid (20) 80
Prepaid (60) 280
Balance sheet
Current assets
Prepaid expenses 120
Nominal ledger – recording prepaid expenses

Dr Cr Balance
Rates and water a/c
Prepaid 40 245
Profit & loss 245 0
1/1 Prepaid 40 40 Dr
Printing and stationery a/c
Prepaid 20 80
Profit & loss 884 0
Packing materials a/c
Prepaid 60 280
Profit & loss 280 0
Note: The prepayment is brought down as a debit entry in the new period to indicate that this
expense belongs to the new financial period.
Revenue Accrued:
If any income is owing to the business at the end of the financial period, this must be included just
like in the previous adjustments. Revenue accrued (or income accrued) should be added to the
appropriate revenue account in the profit and loss account.

£ £
Other income:
Commission 85
Revenue accrued 120 205
Rent rec’d accrued 240
Balance sheet
Current assets
Prepaid expenses 120
Revenue accrued 360

94
Nominal ledger – recording revenue accrued
Dr Cr Balance
Commission received a/c
31/12 Balance 85 Cr
Profit & loss 205 0
1/1 Revenue accrued 120 120 Dr
Rent received a/c
31/12 Balance 125 Cr
Profit & Loss 365 0
Revenue Prepaid:
Revenue prepaid is the exact opposite to revenue accrued. In this case, income is paid in advance of
the current accounting period and should therefore be deducted from the income already received.
Debit: Commission received £25 (revenue decrease)

Credit: Revenue prepaid £25 (current liability)
Nominal ledger – accrued expenses

Dr Cr Balance
Commission received a/c
31/12 Balance 85 Cr
Revenue prepaid 25 180
Profit & loss 180 0
Revenue accrued 25 95 Dr
The owner’s drawings:
When the owner of the business takes out cash for his benefit, the sum withdrawn is debited to the
drawings account and the bank or cash account is credited. The same principle applies if the owner
takes anything of value, including stock and telephone calls as in out example.
Task: Now prepare the final profit and loss account and the balance sheet from the workings we
have gone through in this chapter. Each step is now just a logical placement of the accrual,
prepayment and additional drawings.
Remember that after making these adjustments the new profit (or loss) figure must be entered into
the ‘financed by’ section of the balance sheet and the balance sheet itself must balance.

95

1. You work as an accountant to Sammi and the following trial balance has been extracted on 28
February 2011: Dr Cr
£ £
Sales 541,000
Purchases 227,000
Rent, rates and insurances 49,000
Returns inwards 2,000
Carriage inwards 3,000
Advertising costs 38,000
Energy costs 34,000
Inventory (stock as at 01 03 10) 24,000
Wages and salaries 146,000
Communication expenses 27,000
Discounts received 1,000
Interest paid 3,000
Owner’s drawings 28,000
Equipment at cost 60,000
Premises 300,000
Depreciation (equip. at 01 03 10) 25,000
Capital (at 01 03 10) 334,000
Long-term loan 60,000
Accounts receivable (debtors) 48,000
Accounts payable (creditors) 30,000
Bank overdraft 4,000
----------- -----------
Totals 995,000 995,000
Notes at 28 February 2011:

 Inventory (stock) was valued at £28,000.
 Salaries owing amounted to £7,000.
 Advertising costs prepaid amounted to £3,000.
 Equipment is to be depreciated at 20% on cost.
Required:
a) Prepare the income statement (trading and profit and loss account) of Sammi for the year ended
28 February 2011. [11]
b) Prepare the position statement (balance sheet) of Sammi as at 28 February 2011. [9]

96
Chapter 24: Adjustments – Bad
Debts and Provisions for Debtors
Introduction
Any business that offers credit to its customers and therefore creates debtors must make every
effort to ensure debts are paid. This means having an effective credit control system. Accounts must
be monitored on a regular basis and customers chased if they are late making payments.
A large number of businesses do have to write off some of their debt from time to time. This is costly
because a debtor (asset) is written off as an expense. The double entry is:
Debit: bad debts account (expense +)

Credit: debtor’s account (asset -)
Types of Adjustment:
 Provisions for bad debts
 Recovery of bad debts
 Provisions for cash discounts
How do these adjustments affect the profit and loss account and balance sheet?
Type of adjustment Profit and loss account Balance sheet

1. Create provision for bad debts increase expense debtors – provision
2. Increase provision for bad debts increase expense debtors – provision
3. Reduce provision for bad debts reduce expense debtors – provision
4. Recovery of bad debts reduce expense increase banks
5. Create provision for discounts increase expense debtors – provision
6. Increase provision for discounts increase expense debtors – provision
7. Reduce provision for discounts reduce expense debtors – provision
Provisions for bad and The recovery of bad The provision of

doubtful debts debts debtors discounts
Accountants should be If a customer pays back If it is the policy of the
prudent (cautious) a debt that had business to allow
when it comes to previously been written customers to have cash
valuing a business’s off, either in part or in discounts on their sales,
assets. If some full, the debt must first it may be prudent to
customers in the sales be reinstated in the make a provision,
ledger are slow in customer’s sales ledger similar to a provision for
paying their bills, it is a/c. Once the cheque doubtful debts. The
normal procedure to has been received and provision must be
make an allowance banked, the posting to calculated on the net
against debtors in the the ledger account value of debtors: that is,
event they fail to pay clears the debt. after deducting the
their debts. provision for bad debts.

97
A credit controller may
be hired to chase up the
A business must restrict older debts.
the total of outstanding
debts due.
Are You In Control… A credit rating shows how
good or bad a customer is
Control is needed to ensure when paying bills.
customers pay on time.
Credit ratings of customers

An aged list of debtors is can change as they become
essential to show how old more or less reliable
debts are.
Of Credit Control?

98
1. It has been said that if a customer is written off as ‘bad’ it is recognised that an asset has
changed to an expense. Explain this and use the double entry principle to clarify your point.
2. The following information represents the accounts of James Hunt on 31 December:

Account £
Capital: J Hunt 8,000
Drawings 2,500
Cash 100
Bank 400
Equipment 400
Motor Vehicle 1,500
Stock (1/1) 4,800
Debtors 2,500
Creditors 3,130
Sales 12,200
Purchases 7,000
Returns outward 250
Rent 160
Stationery 90
Wages 3,000
Rates 150
Adjustments: 31 December
 Stock unsold £4,300
 Rates pre-paid £38
 A provision for bad debts is to be made to equal 5% of debtors
 Wages outstanding £120
 Stationery unused £40
Required:
a) A profit and loss account for the year ended 31 December

b) A balance sheet as at that date.
3. Explain the double entry principle on the occasion that a customer once written off as a bad
debt, repays half the sum which was owed.
4. Given a business has a high value of debtors, why should an accountant be prudent and on what
basis would he/she make his/her calculations?
5. At the end of a financial year, the balance of bad debts account could be transferred to the
provision for bad debts account. Would this have an effect on what is transferred to the profit
and loss account?

99
Chapter 25: Depreciation of Fixed
Assets
Introduction
The concept of depreciation is that fixed assets lose their value over periods of time and that loss is
recorded as an expense (charged to the profit and loss account)
A fixed asset will have a ‘useful life’, that is the time that it is useful to the business.
What would happen if a business did not depreciate their fixed assets?
Imagine a business buys a new delivery truck. There will come a point
(due to wear and tear) when this truck will become so old that it will
have very little re-sale value. But without depreciating the value of the
asset in the accounts the business is still recording the truck at the price
it paid for it new. Clearly, then, this business is overstating the value of
its fixed assets. This is why depreciation is so important.
Depreciation is, therefore, a charge against the fixed asset spread over
its useful life. The measurement of the depreciation charge is not an exact science and will depend
on:
 The type of fixed asset
 The method chosen to depreciate it
 An estimation of how long the fixed asset will last over its useful life
 An estimation of how much the residual (or scrap) value of the fixed asset will be when it is
disposed of.
Note: Fixed assets should be depreciated on an equitable and consistent basis. Once a suitable
method has been adopted, the same method should be used throughout its useful life.
Methods of Depreciation:
There are a number of methods, but the two main ways to depreciate fixed assets:
The Straight Line Method The Reducing Balance Method

This charges the same amount of depreciation This is when a fixed percentage rate is
each year, because a fixed percentage is applied on the net book value of the asset
calculated on the cost price. each year.
Furniture, fixtures and fittings are often This means the depreciation charge gets
depreciated in this way as it is seen as equitable. less over the life of the asset.
Straight Line = Cost – Residual Value Rate % = 1 - 4√ Residual Value

Estimated life (years) Cost of Asset

100
Which method to depreciate?
The key principle is an equitable charge must be made. That means the fairest way of depreciating
the asset over its useful life.
If the benefit of using a fixed asset is highest in the earlier years and
less so in the later years, then the depreciation charge should be
greater during that earlier period.
The reducing balance method is often used for assets such as plant,
machinery, equipment and motor vehicles. These assets often
reduce in value more in the first years of their life.
Additionally, as these types of asset become older and more wear and tear occurs, the cost of
servicing and maintaining them increase. Therefore charging higher depreciation in the early years,
and reducing this is the latter years, spreads the overall cost of operating the asset more evenly
throughout its useful life.
If the asset brings benefit more or less equally throughout its useful life, then the straight line
method is best.
Disposal of Fixed Assets + The use of a Fixed Asset Register:

When an asset is sold or scrapped, the fixed asset account and its
corresponding depreciation can be transferred to a ‘disposal of fixed
asset’ account.
The purchase of capital transactions can cost a business large sums of

money. We can use the journal as a book of prime entry to record the
buying of the assets, but this is not the best way to monitor fixed assets
across a large business. There may be a long list of valuable fixed assets
across the company, in various departments and buildings.
What is required is a fixed asset register which lists all fixed assets and keeps other important
information.
The date of purchase Description of asset
What Information is kept in the

The disposal proceeds Fixed Asset Register? Identification number
Disposal date of asset The location of the asset
Estimated useful life The cost of the asset
Estimated scrap/sale value The method of depreciation

101

1. The following fixed asset transactions took place during the period January 2007 to 31 December
2010:
1 January 2007 purchased vehicle A for £12,000.
1 January 2008 purchased vehicle B for £16,000.
3 March 2010 purchased vehicle C for £18,000.
3 March 2010 sold vehicle A for £2,800.
Notes
 Vehicles are depreciated at 25% per year using the straight line method.
 In the year of purchase a full year of depreciation is to be provided.
 In the year of disposal no depreciation is to be provided.
Required:
a) Write up the vehicles at cost account for the period ended 31 December 2010. [4]
b) Write up a provision for vehicle depreciation account for the period ended 31 December. [9]
c) Write up the vehicle disposal account. [4]
d) Explain briefly the purpose of maintaining depreciation accounts. [3]

2. The following are the fixed assets purchased by a new business between 1 January 2007 and 31
December 2009:
01 01 07 Machine costing £20,000 (no estimated residual value)
10 01 07 Vehicle costing £16,000 (no estimated residual value)
05 02 07 Computer equipment costing £60,000 (no estimated residual value)
The policy is to apply a full year’s depreciation charge in the year of purchases and none in the year
of disposal.
 Machinery is written off at 25% pa. on cost.
 Vehicles are written off at 25% pa. on cost.
 Computer equipment is written off at 30% pa. on cost.
Required:
a) Write up the three relevant depreciation accounts for the three-year period to 31 December. [9]
b) Show the tangible fixed asset (non-current assets) section of the balance sheet (position
statement) as at 31 December 2009. [3]
c) Explain the role of:
i) an auditor
ii) a trial balance [4 each]
3. What purpose does the journal serve relating to capital transactions?
4. Outline the need the a business to maintain a fixed asset register.

102
Chapter 26: Partnership Accounts
Introduction
A partnership is defined as two or more persons in business with a view to making profit. There is
little legal constraint and a partnership can be set up without complex documentation.
The 1890 Partnership Act and the 1907 Partnership Act apply to all
partners and limited partners respectively.
Written Agreements:
While there is no obligation to have a written agreement, it is
advisable. A ‘Deeds of Partnership’ is such as agreement, where a
contract is signed by each partner and witnessed.
What May be Included in

The amount of capital to be a Deed of Partnership? Whether salaries are to be
contributed by each partner paid
How profits and losses are to The level of control each

be shared partner is entitled too
The procedure for admitting The procedure to follow to

new partners or existing dissolve the partnership
partners leaving
Whether interest is to be paid on capital or Whether loans by partners to the

charged on drawings business are to be charged interest
If there is no partnership agreement then the 1890 Partnership Act comes into play. It states:
Profit and loss is to No partnership

be borne equally salaries are to be
between partners paid
No interest is to be Loans by partners to

paid on capital or be paid interest at
charged on drawings 5% per annum

103
Partnership Appropriation account:
The finals accounts of a partnership are prepared identically to a normal business as far as the
calculation of profit and the preparation of a balance sheet are concerned – the principles are
exactly the same.
However, partnerships are different as they have an ‘appropriation account’, which simply shows
how profits (or losses) are to be shared between partners.
Example:
Peter and Jane agreed to share profits of £7,500 equally. Other items: salaries £1,500 each, 5%
interest paid on capital accounts (£5,000 capital each) and interest charged on drawings £200 for
Peter and £150 for Jane, are to be accounted for.
Profit and Loss Appropriation Account of Peter and Jane Year Ended 31 December
£ £ £
Net Profit 7,500
Less:
Salary: Peter 1,500
Jane 1,500 3,000
Interest on Capital (5%):
Peter 250
Jane 250 500 3,500
4,000
Add:
Interest charged on drawings:
Peter 200
Jane 150 350
4,350
Share of Profits:
Peter 2,175
Jane 2,175 4,350
Partner’s Current Accounts:

A current account is a record of a partner’s personal finances in the business. Additions to the
account are things such as: share of profits, interest paid on capital, salary awarded. Deductions are
mainly drawings of cash or stock and the interest charged on drawings.
Example Nominal Ledger entries:

Dr Cr Balance
Current a/c: Peter
Dec 31 Balance 200 Cr
Salary 1,500 1,700
Interest on capital 250 1,950
Profit 2,175 4,125
Drawings 2,000 2,125
Interest charged 200 1,925 Cr

104
Balance sheet (extract) of Peter and Jane as at 31 December
£ £ £__
Net Assets 13,700
Financed by:
Capital accounts:
Peter 5,000
Jane 5,000 10,000
Current accounts:
Peter 1,925
Jane 1,775 3,700 13,700
Goodwill The Writing Off of Goodwill

The term ‘goodwill’ in business is used to It has been standard practice to write off
describe the value that a good name or the goodwill arising from the purchase or
reputation built up over time has. When commencement of a new business
a business is sold goodwill is the value partnership. It’s recognised in FRS 10 (a
paid over and above the net value of the financial reporting standard) that it is
total assets. It recognises that the difficult to separate goodwill from the
business is more than a collection of business as a whole. If there is an agreed
assets – it has a customer base and sum for goodwill, it should be written off
brand, for example. based on the profit- sharing ratio.

105
Questions:
1. Arinda and Birinda are in partnership. Interest is allowed on capital and on the opening current
account balances at 5% pa. Arinda is to be credited with a salary of £15,000 in recognition of
extra duties. Interest is charged on drawings (see note). Arinda and Birinda agree to share profits
equally. The following trial balance was drawn up on 30 August 2010:
£ £
Capital accounts – Arinda 50,000
Birinda 50,000
Current accounts – Arinda 10,000
Birinda 10,000
Drawings – Arinda 22,000
Birinda 21,000
Purchases 350,000
Sales 549,000
Returns 2,000 1,000
Carriage inwards 3,000
Staff wages 85,000
Rent and insurance 20,000
Bad debts written off 3,000
Stock (inventory) (01 09 09) 46,000
Equipment at cost 90,000
Debtors (accounts receivable) 45,000
Creditors 32,000
Cash and bank 4,000
Prov. for doubtful debts 1,000
---------- ----------
703,000 703,000
======= =======
Notes at 30 August 2010:
 Stock (inventory) was valued at £50,000.
 Staff wages owing amounted to £4,000.
 Insurance prepaid amounted to £2,000.
 The provision for doubtful debts is to be increased to £3,000.
 BOTH partners are to be charged £500 re. interest on drawings.
Required:
a) Prepare the firm’s trading and profit and loss account (income statement), including the
appropriation section for the year ended 30 August 2010. [9]
b) Prepare the partners’ current accounts for the year ended 30 August 2010. [4]
c) Prepare the firm’s balance sheet (position statement) as at 30 August 2010. [7]

106
Chapter 27: Company Accounts
Introduction
The most important difference between a limited company and other forms of business is the
concept of limited liability. The owners of limited companies have the advantage that they are not
personally liable for the debts of the business.
There are two distinct types of company:
 Private Limited Company (Ltd)

 Public Limited Company (Plc)
The formation of a company only needs a minimum of two founder members who are willing to
subscribe to share capital. Companies are regulated by the Companies Act 1985.
The key difference between the two is that a private company can only sell its shares privately,
where a public company can issue a prospectus to the public and freely advertise its shares.
A limited company is restricted, by law, from advertising to sell it shares and, therefore, has a limited
ability to raise share capital. Most limited companies are small ventures with a small number of
members – rarely employing more than 20 people.
A public company, on the other hand, can raise vast amounts of share capital. They can have
thousands of members and employees and are listed on the Stock Exchange.
Company Documentation:
To form a company (whether private or public) it requires a greater amount of paperwork and cost
than, say, a sole trader (who has virtually no legal constraint).
A limited company must prepare two key documents:
Memorandum of Association Articles of Association

This document gives the This document gives the
external view of the company internal view of the company,
to the public, including name, it details the rules and
address, registered office, regulations governing the
share capital and, most internal organisation of the
important, its objectives (i.e. company, such as voting
what it proposes to do). rights, power of directors, etc.
Once these documents are approved, a company is issued a Certificate of Incorporation. This gives
the company a separate legal identity from the owners (i.e. the shareholders).
For a public company, a Certificate of Trading is issues once the minimum amount of share capital is
raised.

107
The preparation of company accounts:
The 1985 Companies Act gives guidance as to the format of financial accounts relating to companies.
You have seen this format in the shape of the trading, profit and loss account and balance sheet.
The appropriation account (similar to the concept explored in Partnership Accounts chapter) is the
division of profits before tax. Basically, profits maybe distributed by:
 Provision for taxation

 Dividends to shareholders
 Transfer of any profit to the company reserves (profits retained in the company)
The capital of limited companies:

There are a number of terms relating to a limited companies share capital that you need to become
familiar with:
Issued capital – is the

Authorised capital – is the
nominal capital issued to
nominal capital of the
shareholders and cannot be
company and is normally the
in excess of authorised
maximum amount of capital it
capital
can issue. It is the company’s
registered capital
Paid up capital – refers to issued
capital paid up by shareholders. If Called up capital – refers to shares which have been
some shareholders have not yet paid allotted to shareholders but have only called up part
for their shares, they are debtors to of the sum due on the shares. For example, a
the company until they do pay. company could allot £500,000 £1 shares and only call
Continuing our example, if only up 50p a share. It will receive £250,000 as paid up
£245,000 had been received from the capital, even though it has issued £500,000 of share
called up capital, the £5,000 capital. The balance due is uncalled capital.
represents unpaid capital.
Capital and revenue reserves:

Capital reserves are not retained profits as seen in the appropriation account because these are
revenue reserves.
Capital reserves can include sums transferred to the share premium account (shares sold at a higher
sum than the nominal value) or a revaluation reserve (an increase in the value of, say, a premises).
Shares and Debentures:

There are two classes of shares that may be issued to shareholders: ordinary shares and preference
shares. (Please note: preference shares rarely feature in limited companies today.)
Ordinary share – the rate of dividend depends on how much profit is being made and how much is
distributed. When shareholders vote on actions of the business, one share equals one vote.
Preference share – paid a fixed rate of dividend and holders entitled to be paid first before ordinary
shares. These shares have no voting rights.

108
Debentures – represent loan capital and not share capital. They are paid a fixed rate of interest over
the specific period of the loan. The interest paid to the debenture holder is an expense on the profit
and loss account.
The 1985 Companies Act

Every limited company must The final accounts must follow a
keep accounting records, with certain format and include:
reasonable accuracy.  A profit and loss a/c
 A balance sheet
 An auditors’ report
 A directors’ report
Financial records must be
kept daily, including
receipts and payments of Public companies must have Annual reports must be
money and the assets and at least 2 directors, private filed with the Registrar,
liabilities. companies, one. Companies House.
International terminology
The financial statements of limited companies are now being asked to be prepared using the
international terminology rather than the present UK terms.
UK Term International Term

Profit and loss account Income statement
Turnover/sales Revenue
Taxation Tax expense
Fixed assets Non-current assets
Tangible fixed assets Property, plant and equipment
Stock Inventory
Debtors Receivables
Creditors Payables
Long-term liabilities Non-current liabilities
Debentures Loan stock
Capital and reserves Equity
Profit and loss account Retained earnings
Capital and reserves (consolidated a/c) Equity attributed to equity holders of parent

109
1. The following list of balances as at 28 February 2010 of ALZ Ltd has been taken from the books
AFTER the trading account has been completed:
£000 £000
Dr Cr
Gross profit for the year 410
Equipment at cost 300
Equipment depreciation (01 03 09) 120
Ordinary share capital (£1) 200
Distribution costs 140
Administration expenses 90
Interim dividend paid 10
Stock (inventories) at 28 02 10 210
Trade debtors 250
Trade creditors 70
Cash and bank 10
5% Debentures (redeemable 2016) 100
Profit and loss account (01 03 09) 110
1,010 1,010
=== ===
Notes:
 Interest on debentures is still unpaid.
 Corporation tax of £15,000 is to be provided.
 The directors have declared a final dividend of 9 pence per share.
Required:
a) Prepare the profit and loss account (income statement) for the year ended 28 February 2010. [8]
b) Prepare the balance sheet (position statement) as at 28 February 2010. [8]
c) Calculate the EPS. [2]
d) Calculate the profit before tax as a percentage of shareholders’ total capital. [2]

110
2. The following trial balance has been taken from the accounts of Simric Ltd as at 31 May 2010:
£000 £000
Turnover 1,400
Purchases 930
Stock (inventory) (01 06 09) 64
Postage, telephone, fax expenses 25
Rent rates and insurance 46
Marketing expenses 42
Energy costs 20
Wages and salaries 261
Debenture interest 2
Debtors (accounts receivable) 95
Creditors (accounts payable) 65

Cash and bank 10
4% Debentures (repayable 2016) 100
Equipment at cost 350
Depreciation of equip. (01 06 09) 100
Provision for doubtful debts (01 06 09) 4
£1 Ordinary share capital 200
Premises 250
Depreciation of premises (01 06 09) 60
Profit and loss account (01 06 09) 166
--------- ---------
2,095 2,095
===== =====
Notes at 31 May 2010:
£000
 Stock (inventory) is valued at 67
 Energy costs owing amounted to 8
 Rates prepaid amounted to 2
 The provision for doubtful debts is to be increased to 7
==
 The equipment is to be depreciated by 25% on cost.
 The premises are to be depreciated by 2% on cost.
 The outstanding debenture interest is due for payment on 3 June 2010.
 The directors wish to provide 2 (£000) for taxation.
 The directors have declared an ordinary dividend of 12p per share.
Required:
a) Prepare the profit and loss account (income statement) for the year ended 31 May 2010. [11]
b) Prepare the balance sheet (position statement) as at 31 May 2010. [9]

111
Chapter 28: Cash Flow Statements
Introduction
In 1990 the newly formed Accounting Standard Board (ASB) was created to govern accounting
practices. In recognition of the importance of a business’s cash flow position, their first Financial
Reporting Standard was: The Cash Flow Statement.
The purpose of the cash flow statement is to emphasis a business’s inflow and outflow of cash
during the financial year. It shows the liquidity position of the business. That is, the cash or near
cash funds the business has to cover debts – in other words, the working capital of the business.
A cash flow statement is reported under eight standard headings.
There are three distinct stages to preparation:
1. Reconcile the company’s operating profit for the year and the net cash flow from operating
activities.
2. The figure calculated in step one is then the starting figure to the second stage, which is to draw
up the actual cash flow using the eight headings.
3. The final stage is to prepare a reconciliation of net cash flow to the movement of debt.
What are the eight standard cash flow statement headings?
1. Operating activities:
a) Net profit on normal trading activities (before tax)
b) Non-cash flow expenses like depreciation
c) Adjustments to the movements in working capital
2. Returns on investments and servicing finance:
a) Interest or dividends received
b) Interest paid
3. Taxation
4. Capital expenditure and financial investment:
a) Purchase of fixed assets
b) Disposal of fixed assets
5. Acquisitions and disposals:
a) Cash flow from the acquisition of a business
b) Cash flow from the disposal of a business
6. Equity dividends paid:
a) Dividends paid to equity shareholders (but excluding advanced corporation tax)
7. Management of financial resources:
a) Cash flow from the acquisition or disposal of short-term investments (current assets)
8. Financing:
a) The issue of shares or debenture stocks
b) Repayment of shares or debenture stocks
c) Repayment of other loans
As usual, the best way to understand the cash flow statement is to follow a complete example.

112
Duran Ltd: Balance Sheet as at 31 December
Year 1 Year 2
£ £ £ ` £
Fixed assets
Cost 60,000 100,000
Less cumulative depreciation 20,000 34,000
40,000 66,000
Investments at cost 40,000 20,000
80,000 86,000
Current Assets
Stock 40,000 120,000
Debtors 44,000 96,000
Bank 2,000 6,000
86,000 222,000
Current Liabilities
Tax owing 12,000 28,000
Dividend owing 8,000 10,000
Creditors 14,000 20,000
34,000 52,000 58,000 164,000
132,000 250,000
Long term loans _20,000 28,000
112,000 222,000
Financed by:
Ordinary shares 80,000 100,000
Share premium account - 20,000
Profit and loss account balance 32,000 102,000
112,000 222,000
Duran Ltd Abbreviated profit and loss accounts for Year ended 31 December
Year 2
£
Sales 1,500,000
Cost of sales (1,200,000)
Gross profit 300,000
Total expenses (inc depreciation) (196,500)
Operating profit for year 103,500

Add profit on sale of investments 8,000
Less interest payable (3,500)
108,000
Less tax provision (28,000)
80,000
Add retained profits 32,000
112,000
Less proposed ordinary dividend (10,000)
Retained profits c/f 102,000
Note: No tangible fixed assets were disposed of during the year but £20,000 of investments had
been sold for £28,000.

113
Required: Prepare a cash flow statement for the year ended 31 December (year 2)
Solution:
Duran Ltd Cash flow statement for the year ended 31 December (Year 2)
£ £
1. Operating activities *
Cash outflow (8,500)
2. Returns on investments and servicing finance:
Interest paid (3,500)
3. Taxation (12,000)
4. Capital expenditure and financial investment:
Purchase of fixed assets (40,000)
Sales of fixed assets 28,000 (12,000)
5. Acquisitions and disposals -
6. Equity dividends paid:
Ordinary shares (8,000)
7. Management of financial resources 0
(44,000)
8. Financing:
Issue of ordinary shares 20,000
Share premium account 20,000
Long term loan 8,000 48,000
Net cash inflow 4,000
*Calculation of operating activities: (working for Step 1)

£
Operating profit 103,500
+ depreciation charges 14,000
117,500
Working Capital:
+ stock (80,000)
+ debtors (52,000)
(14,500)
+ creditors 6,000
(8,500)
Reconciliation of net cash flow to movement in net debt

£ £
Increase in net cash flow 4,000
Cash from increase in debt (loan 20k to 28k) (8,000)
Change in net debt (4,000)
Net debt in year 1 - Bank 2,000
- Loan (20,000) (18,000)
Net debt in Year 2 - Bank 6,000
- Loan (28,000) (22,000)
Change in net debt (4,000)

114
1. The summarised financial statements of Kandy Ltd for 2008 and 2009 were as follows:
Kandy Ltd balance sheets (position statements) as at 31 December:

2008 2009
£000 £000 £000 £000
Fixed assets at cost 16,000 19,000
Depreciation (7,000) 9,000 (9,000) 10,000
Current assets
Stock (inventory) 7,000 9,000
Debtors (a/cs receivable) 9,000 8,000
Bank 2,000 7,000
-------- --------
18,000 24,000
-------- --------
Current liabilities
Creditors (a/cs payable) 4,000 3,000
Taxation 4,000 6,000
Dividends 4,000 6,000
-------- --------
12,000 15,000
-------- --------
Working capital 6,000 9,000
Long-term loans (3,000) (5,000)
-------- --------
12,000 14,000
-------- --------
Capital and reserves:
Ordinary shares (£1) 7,000 8,000
Profit and loss account 5,000 6,000
-------- --------
12,000 14,000
-------- --------
Kandy Ltd profit and loss account (income statement) for the year ended 31 December 2009:
£000
Operating profit 15,000
Interest paid (2,000)
Profit before tax 13,000
Taxation (6,000)
Profit after tax 7,000
Dividend (6,000)
Retained profit 1,000
Required:
a) Prepare a cash flow statement for Kandy Ltd for the year ended 31 December 2009. [10]

115
Chapter 29: Accounts of Clubs
and Societies
Introduction
Most private sector businesses are profit motivated. However, there are non-
profit organisations that are not set up to make money. These are often clubs
and societies organised for specific purposes, for example, social, sporting and
political ventures.
The money that comes in (member’s subscriptions)

and the money that goes out of a social organisation
should be properly accounted for, in order to
safeguard members’ interests. It is therefore
necessary to keep some basic records of the accounts.
A social organisation may elect honorary members: a chairman (the figure-

head), the club secretary (responsible for paperwork) and a treasurer
(responsible for the accounts).
The treasurer’s accounting reports:

Formal accounting methods tend to be uncommon, but the principles of accounting remain the
same. The following reports are usually prepared for the club or society’s yearly activity.
 A receipts and payments account

 Any specialised accounts such as a bar account
 An income and expenditure account
 A balance sheet showing the organisation’s state of affairs.
The receipts and payments account:

This is a summary of all cash receipts and payments of the organisation and is a
simplified cash book, the purpose being to show where the cash has come from
and where it has gone.
The income and expenditure account:

This is the equivalent of the business’s trading, profit and loss account, where expenses are matched
against income. Just like in company accounts, adjustments such as accruals, pre-payments and
depreciation are also accounted for because they affect the profit and loss for the year.
Instead of the words profit and loss, a social organisation uses the terms ‘surplus’ or ‘deficit’.
The balance sheet:

This statement is prepared in the same way as any other organisation. The net resources of the club
or society are financed by the ‘accumulated funds’ - that is, the capital or net worth of the
organisation.
Accumulated funds represent assets less liabilities in the same way as capital. Any surplus from the
income and expenditure account is added the funds. Any deficit is reduced.

116
1. The following are the details in respect of subscriptions for a sports club:
£
1 June 2009 subscriptions in advance 145
1 June 2009 subscriptions in arrears 55
Total subscriptions received in year 13,200
31 May 2010 subscriptions in advance 165
31 May 2010 subscriptions in arrears 70
There were no bad debts in the year.
Required: Write up the subscriptions account for the year ended 31 May 2010. [6]
2. Included in the assets and liabilities of the Nelson Cricket Club on 1 January 2010 was the
following: Club premises £150,000; equipment £30,000; bar stock £4,200; long-term
investments £35,000; bar wages owing £400; subscriptions in arrears £300; subscriptions paid in
advance £700.
The following is a summary of the club’s receipts & payments for the year ended 31 December 2010:
RECEIPTS PAYMENTS
£ £
Cash in hand 1 January 2010 1,100 Bar purchases 57,400
Investment income 950 Wages (bar) 32,300
Subscriptions received 52,300 General expenses 15,800
Bar sales 125,600 Competition prizes 3,700
Cricket competition receipts 2,100 New equipment 45,000
Postage/stationery 6,100
Insurance and rates 7,900
Investments 10,000
Balance c/f 3,850
---------- ----------
182,050 182,050
====== ======
NOTES at 31 December 2010:
 Bar stock was valued at £5,200.
 Insurance prepaid amounted to £300.
 Bar wages owing amounted to £600.
 All equipment is to be depreciated by 25%.
 Subscriptions in arrears amounted to £400.
 Subscriptions paid in advance amounted to £900.
 The club’s accumulated fund on 1 January 2010 was £219,500
Required:
a) Prepare the club’s bar trading account for the year ended 31 December 2010. [5]
b) Prepare the club’s income and expenditure account for the year ended 31 December 2010. [8]
c) Prepare the club’s balance sheet as at 31 December 2010. [7]

117
Chapter 30: The Extended Trial
Balance
Introduction
If you remember, the trial balance is test of arithmetical accuracy of the
double entry system. The trial balance is extracted from the accounts of
the nominal ledger in order to prepare the final accounts. All adjustments
relating to the end of the period must also be taken into account to
ensure correct matching of revenue with expenses.
The extended trial balance (ETB) has additional columns in order to accommodate any adjustments
which may be required before the preparation of the final accounts.
In reality the number of columns can be large (including bank and cash transaction, accruals and
prepayments) but for examination purposes it is often shortened to the following:
Details Trial Balance Adjustments Profit and Loss Balance Sheet

Dr Cr Dr Cr Dr Cr Dr Cr
Sales 95,100 95,100
Purchases 52,150 52,150
Telephone 1,325 50 1,375
Light, heat 1,540 75 1,615
Stationery 890 100 790
Wages 14,745 100 14,845
Motor van 2,450 2,450
Depreciation of van 490 490 980
Equipment 1,500 1,500
Depreciation of Equip 150 150 300
Accruals 225
Prepayments 100
Depreciation of fixed assets 640 640
Notes:
 The trial balance column lists all figures concerning the trial balance at the period end
 The adjustments column is used for making the balance day adjustments including accruals,
prepaid expenses, writing off bad debts, making provisions for depreciation, bad debts or
discounts and for adjusting figures for VAT.
 The final two columns are used to extend the figures across to either the profit and loss
account or the balance sheet
 The difference between the columns in the profit and loss account will indicate either profit
or loss that is then transferred to the balance sheet.

118
Now let us work through an example of this simplified extended trial balance.
Example:
The trial balance of Arthur Jones did not balance as on 30 June and a suspense account was entered
in the ETB as £690 credit. Since then, the following errors were located:
 Equipment £500 had in error been posted to the purchases account

 A gas bill £85 had been paid but not put through the books
 Discount allowed £68 had not been posted to the ledger
 Sales had been under-cast by £800
 A cheque from a debtor £150 had been recorded as £105 in debtor’s account but correctly
recorded in the corresponding account
 The total from the returns inward account £87 had not been posted to the ledger
 Cash sales £900 into bank had in error been posted in reverse.
In addition to these entries, on 30 June the closing stock value was £2,150 and wages owing were
£240. Depreciation of the van equipment is at 10% per annum and buildings valued £12,000, at 2%
per annum.
The solution:
Firstly, we need to make the appropriate corrections in the journal and then directly in the ETB,
entering the suspense account on the opposite side of the adjustment column. This is to offset
errors that affect the suspense account.
Journal
Date Details Debit Credit
June 30 Equipment 500
Purchases 500
Light and heat 85
Bank 85
Discount allowed 68
Suspense 68
Suspense 800
Sales 800
Suspense 45
Debtors 45
Returns inward 87
Suspense 87
Bank 1,800
Sales 1,800
Now we can complete the extended trial balance:

119
The ETB of Arthur Jones
Details Trial Balance Adjustments Profit and Loss Balance Sheet
Dr Cr Dr Cr Dr Cr Dr Cr
Premises 20,000 20,000
Motor vehicle 500 500
Equipment 2,100 500 2,600
Opening stock 1,860 1,860
Debtors 675 45 630
Creditors 1,155 1,155
Capital 12,500 12,500
Bank 455 1,800 85 1,260
Sales 35,750 800 38,350
1,800
Purchases 20,195 500 19,685
General expenses 1,250 1,250
Wages 3,970 240 4,210
Suspense 690 690
Light and heat 85 85
Discount allowed 68 68
Returns in 87 87
Closing stock 2,150 2,150 2,150 2,150
Accrued expenses 240 240
Depreciation:
Van 50 50
Equipment 260 260
Buildings 240 240 550 540
Net Profit 12,695 12,965
50,550 50,550 6,170 6,170 40,500 40,500 27,140 27,140

120
1. The following figures relate to the financial data of Harry Smith. Prepare a draft extended trial
balance for the client as well as a set of final accounts.
Trial balance as at 31 May Debit Credit

£ £
Premises 50,000
Equipment 15,100
Provision for depreciation of equipment 2,500
Motor vehicle 6,040
Provision for depreciation of vehicle 3,480
Debtors 8,800
Creditors 8,130
Opening stock 10,300
Bank 7,451
Mortgage repayments (inc. interest) 2,460
Capital 62,500
Purchases, sales 38,058 49,603
Stationery 672
Light and heat 403
VAT 885
British Telecom* 423
Motor expenses* 1,598
Wages 10,960
Maintenance & repairs 935
General overheads 1,350
Bank & interest charges 298
Discounts 445 225
Bad debts 190
Petty cash float 200 ______
156,568 156,568
*VAT is inclusive of these figures and needs to be extracted in the ETB.
Further information provided as on 31 May:
 Stock: the closing value was £15,400
 The owner, Harry Smith, has taken £550 cash per month from sales takings for personal use and
this has NOT been recorded in any of the books.
 Depreciation of fixed assets: Vehicle, 25% reducing balance; Equipment, 20% on cost.
 Gas and electricity bills in arrears: £190; wages by £420. Stationery unused was valued at £80.
 A provision of 5% for bad or doubtful debts is to be made against debtors.
 Of mortgage repayments, £1,020 was interest charged.
 Harry Smith has rented part of premises to a client for £900 p/a, starting in April. Payment will
not be received until 30 June.
Required:
a) Prepare an extended trial balance from the above information.
b) Prepare a draft copy of the profit and loss account and balance sheet for period ended 31 May.

121
Part 5
Using Accounting Information

122
Chapter 31: Accounting Ratios
and Preparing Reports
Introduction
Ratios help to measure the performance of a business and provide important indicators of how well
a business is doing. They show trends in current years and help make comparisons from one year to
another and between different business organisations.
Ratios help owners and managers to improve their decision making. Although, one ratio in isolation
may tell you very little, so it is important to compare to past performance or with businesses in the
same category. It is also important to be consistent with the way ratios are calculated when
comparing different periods.
Ratios can be analysed into various groups:

 Profitability
 Liquidity (short-term solvency)
 Efficiency
 Liquidity (long-term solvency)
 Investment
Profitability Ratios:
These ratios are used to measure the trading performance of a business in terms of profit to sales or
profit to capital.
 The gross profit % = Gross profit x 100

Net sales
 The net profit % = Net profit x 100

Net sales
 Return on capital employed = Net profit x 100

Capital employed
 Return on net worth = Net profit x 100____

Net worth (owner’s equity)
 Return on total assets = Net profit x 100

Total assets
Liquidity Ratios (short-term solvency):

These ratios indicate the business’s ability to have sufficient cash to meet current debts.
Working capital ratio = Current assets__

Current liabilities
Quick asset ratio = Current assets (less stock)

Current liabilities

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Working capital needs to be adequate to enable the business to
trade with reasonable ‘comfort’. It should be enough to finance
short-term debt, so if creditors demand payment the business is in a
sound enough financial position to meet those demands.
Liquidity is just as important as profit earning. A business can be in

an attractive profit earning position and yet still fail because it has
disregarded its liquidity.
The quick asset ratio is an immediate test of liquidity because the value of stock is deducted from
current assets. It answers the question: can a business, without relying on its stock, meet its
immediate debts?
Efficiency Ratios (effective resource use):

These ratios are used to try and identify the strengths and weaknesses of a business using a variety
of different ratios, including money incurred on expenses, stock turnover, debt collection, the
investment of assets to turnover and productivity.
Expense percentages:
 Cost of sales % = Cost of sales x 100

Sales
 Distribution expenses % = Distribution expenses x 100

Sales
 Administration expenses % = Administration expenses x 100

Sales
 Financial expenses % = Financial expenses x 100

(Interest payments) Sales
The rate of stock turnover:

This ration refers to the number of time the stock is sold within an
accounting period. It gives an indication of a business’s selling efficiency.
 Rate of stock turnover = Cost of sales

Average stock
The speed of stock turnover depends on the nature of goods sold. A large supermarket, for example,
will have a high turnover rate because it sells goods required everyday.
The collection of debt:

This ratio is an indication of how long it takes debtors to pay their debts. The ratio has a significant
bearing on both the efficiency of credit control and the accuracy of liquidity.
 Av. credit taken by debtors = Debtors x 365

Credit sales

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Creditors’ payment period:
This measurement links with the collection of debt from customers. If debtors pay promptly, it
makes it easier to make payments to creditors (assuming they’re in the same proportion).
 Av. Credit obtained from supplies = Creditors x 365

Credit Purchases
The higher the number of days it takes to pay creditors in comparison to the time it takes debtors to
settle debts the higher the liquidity advantage to the company. However, this liquidity advantage
needs to be balanced with the financial advantages of prompt payment discounts.
Asset usage:
There are a number of ratios that can be used to identify the amount of investment in assets which
will generate turnover (sales).
 Asset turnover = Sales______

Capital employed
 Sales/Trading assets = Sales___

Current assets
The trading assets ratio shows the amount of sales you are generating for every one pound invested.
Productivity:
Two ratios may be used to identify productivity in terms of the number employed.
 Sales: Employees = Turnover

Employee
 Profit (before tax): Employees = Profit__

Employees
Productivity has always been seen to be an important contributory factor to efficiency in business.
The greater the productivity, the greater the profit and the more resources are available for
distribution. If productivity increases, a business could afford to pay its workforce more. If
productivity falls, employees are producing less in terms of units to man-hours – the business has
become less efficient.
Structure Ratios (long-term solvency):

These measure the relationship between the members’ capital and the extent of liabilities. The term
structure refers to financial structure, not physical structure.
 The owner’s stake = Capital (net worth)

Assets (total assets)
This first ratio shows how much the owners are worth in the business, compared with the creditors
of the business.
 Interest cover = Net profit (before tax, interest)
Interest payable
The interest cover ration shows the number of times the interest liability can be paid from profits.

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Capital Gearing:
This is a key ratio and is a measure of how heavily burdened the company
is with long-term debt. A company which is high-geared has a high
proportion of borrowed capital relative to ordinary shares. If creditors
hold the balance of financial power they can call in loans and accelerate
the collapse of a company. A company is said to be low-geared if the
opposite is true.
 Capital Gearing = Long-term debt

Capital employed
Investment Ratios:
As you now know, the shares of public limited companies can be bought and sold on the Stock
Exchange. It is these stocks and shares that are published daily in the newspapers.
The Financial Times Index (FTI) is the barometer of the Exchange, and its rise or fall each day
indicates how the market responds to the demand for stocks and shares.
If the market believes there is confidence in the economy, demand for

shares could increase and the market is said to be ‘bullish’ and share
prices are likely to rise.
On the other hand, if confidence falls, demand can dry up and

investors may rush out to sell, causing share prices to fall. This is a
‘bear’ market.
A good way to remember the difference between a bull market and a bear market is to think about
the way these two animals attack.
A bear is standing on its back legs and sweeps a

paw down on its target – representing a market
going down.
A bull, on the other hand, starts with its head

low down and raises its head rapidly to use its
horns as a weapon – representing a market
going up.

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 Earnings per share = Net profit (after tax) – Preference dividend
No. of ordinary shares
 Percentage dividend = Sum to ordinary share holders x 100

Issued & paid up capital
 Yield percentage = Dividend per share x 100

Market value per share
 Cover = Net profit (after tax – Preference dividend)

Dividend on ordinary shares
 Price/Earnings ratio = Market price per share

EPS
The EPS is one of the most publicised ratios when companies report their half-yearly or yearly
results. It indicates the earning potential of each ordinary share, and is therefore of great interest to
investors.
The price earnings ratio indicates the market value in relation to the number of years’ profits it
represents – generally speaking, the higher the P/E ratio, the better. It indicates what the market is
prepared to pay for them.
The Limitations of
Accounting Ratios Bankers and creditors who
There have been a number of lend money to the business
cases where accounting ratios will use the financial
have indicated a sound accounts and ratios but will
financial position, but on usually refer to specialist
closer inspection it was organisations in assessing
revealed the organisation was credit rating. A sign of how
far from sound. much value the lenders of
money give basic ratio
analysis.
Not all organisations are the

same - in the way they On their own, they often
operate or are structured. Ratios that appear to show provide little benefit. They
Often more careful thought a healthy position can hide must always be used in
needs to go into inter- big problems. Over-reliance comparison with other
company comparisons. on them can be dangerous. figures.

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1. The following data relates to two different companies, which operate in the same business
sector:
A B
£000 £000
Sales in year (all on credit) 4,900 8,700
Cost of sales for the year 2,600 4,300
Total expenses for the year 1,100 1,900
-------- --------
Opening inventory (stock) value 160 300
Closing inventory (stock) value 180 320
Closing debtors (accounts rec.) 350 510
Closing total current assets 560 880
Closing total current liabilities 290 550
Required:
a) For each company calculate the following:
i gross profit to sales percentage
ii net profit to sales percentage
iii expenses to sales percentage
iv stock turnover in days
v debtor collection period
vi current ratio
vii acid test ratio [2 each]
b) Comment on the financial performance of the two companies. [6]

2. The following details have been obtained from the final accounts of Rebluck plc for the last three
years:
2007 2008 2009
£m £m £m
Sales all on credit 180 230 310
Cost of sales 85 100 110
Total expenses 75 90 100
Closing debtors (accounts receivable) 15 18 19
Average stock (inventory) 17 20 17
Total purchases (all on credit) 82 101 119
Closing creditors (accounts payable) 8 8 9
Required:
a) Prepare the summarised profit and loss account for EACH of the three years. [2]
b) Calculate for EACH of the three years:
i the gross profit percentage
ii the net profit percentage
iii the expenses to sales percentage
iv the debtor collection period in days
v the stock turnover period in days
vi the creditor payment period in days [18]

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Chapter 32: Accounting Standards
Statements of Standard Accounting Practice and

Financial Reporting Standards
Introduction
Statements of Standard Accounting Practice and
Financial Reporting Statements represent the
profession’s accounting standards. Their aim is to
standardise the preparation of final accounts for the
benefit of all stakeholders – looking for objectivity,
reliability and consistency.
The Accounting Standards Board (ASB) was formed in

1990 and is the authority tasked with the issuing of new
accounting standards, called FRSs.
GAAP:
This is a generally accepted accounting principle. These are governed by the rules of the accounting
profession and company law, such as the Companies Act 1985. When these rules, mandatory or
otherwise, become consistently adopted by businesses, they then become the accepted practice of
the accounting profession.
The International Accounting Standards Committee (IASC):

The aim of this committee was to promote greater standardisation in the preparation of financial
statements in many areas of the world, through the creation of International Accounting Standards
(IAS). A balance sheet, for example, prepared in Europe, Australia or the USA should look like a
balance sheet in the UK and follow the same principles.
The statement: ‘true and fair’
“Accounting standard are authoritative statements and compliance with

accounting standards will normally be necessary for financial statements to
give a true and fair view.”
The concept of cost:

The recording of accounts is traditionally on a historical cost basis which means that the recording of
transactions is in relation to what the business paid for them. But there are a number of ways to
value an asset:

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Cost price – to value an asset at historical Current replacement cost – the current
cost price simplifies the recording process. market cost of replacing an asset in order
The price paid for the asset is the price to acquire the same service from it.
recorded in the accounts.
Present value – applies

to investment
Net realisable value – it estimates opportunities and
the current value of the asset i.e. compares the returns
what it would sell for less selling an asset could provide,
expenses (such as advertising). in terms of future
earnings potential
discounted to present
Cost less depreciation – a fixed asset has a charge against it to
day interest rates.
account for the decreasing value of the asset during its useful
life to the business. The difference between historical cost and
depreciation becomes the net book value of the asset.
These methods of asset valuation link to the concept of ‘capital maintenance’. This is about
comparing the value of net assets in one period to the value in the following period, to see how well
off a business is at the end of that period.
We will now look at some specific accounting standards and explore some of the key concepts that
have come from them.
FRS 18: Disclosure of accounting policies
The four fundamental concepts that came from the standard are:
 Going concern
 Accruals concept
 Consistency concept
 Prudence concept
Going concern concept:

The value of an organisation’s assets is based on the assumption that the firm will continue trading.
If the business faces bankruptcy, this would affect the value of the assets on its balance sheet. There
may also be other liabilities that need to be accounted for, such as redundancy payments.
Accruals concept:
This concept is about the matching of revenue and expenses with the period in which they were
earned or incurred.
Realisation concept:
Only profits realised at the period end should be included as income. Uncertain income should not
be included.

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Prudence concept:
Accounts must be prepared with a degree of caution so as not to over value the company’s assets.
Prudence is especially required in areas of uncertainty about the value of assets, liabilities, gains or
loses.
Objectives and constraints in the selection of accounting policies:
“Business entities should use those policies that are the most appropriate to their particular
circumstances for the purpose of giving a true and fair view. These policies are determined against
the objectives of relevance, reliability, comparability and understandability.”
Relevance:
Financial information is only relevant is it has ability to influence the economic decisions of users.
The choice of accounting policy should be most relevant to the business. For example, deciding
whether to use the straight line method or reducing balance method of asset depreciation.
Reliability:
Financial information is reliable if it can be depended upon by its users to represent somewhat
faithfully, what it is supposed to represent.
Comparability:
Information about an entity’s financial statements gains more credibility when figures can be
compared more readily with other similar organisations. This is achieved through a consistent
approach and disclosure of financial information.
Understandability:
Information in financial statements needs to be understood by a variety of users of that information.
The figures should have been calculated correctly and conform to basic principles of arriving at profit
that are seen as true and fair.
Other concepts:
Substance over form:
A transaction should be accounted for with the view of representing its economic substance, not
simply its legal form. Hire-purchase fixed assets, for example, should have their value recorded in
the balance sheet even though there is no legal ownership until the last payment has been made to
the hire-purchase company.
Materiality concept:
This is the view that small, insignificant items may be excluded from the normal accounting policy.
The size of the business will dictate what is materially relevant. For example, a fixed asset under
£500 is insignificant to a large organisation, so it could be treated as an expense item and written off
in the same year, rather than being depreciated over a number of years.
SSAP 5: Accounting for Value Added Tax
We have covered VAT in previous chapters, so the key point to take from this accounting standard is:
Businesses that are registered with HMRC should exclude VAT on all taxable inputs and taxable
outputs. In other words, sales, purchases, taxable expenses and fixed assets are recorded net
(excluding VAT). The VAT charges are to be recorded in a separate VAT account. At the end of the

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financial period, any VAT owing would be listed as a current liability (a credit balance), or a current
asset (a debit balance) in the balance sheet.
With expenditure that is not VAT deductable or for expenses the VAT office will not allow recovery,
the full amount will appear in the profit and loss account and balance sheet. The same applies for
non-registered businesses which are exempt from VAT.
SSAP 13: Accounting for research and development:
The question is can research and development costs be classified as revenue expenditure or capital
expenditure. Remember: revenue expenditure relates to expenses charged to the profit and loss
account. Capital expenditure is a charge to the fixed assets in the balance sheet (to be written off in
future accounting periods to the profit and loss account).
Research is seen as revenue expenditure to be written off in the profit and loss account in the period
it was incurred.
Development relates to improving products from the research stage. If future benefits are to be
gained, then some development costs can be capitalised and spread over a number of periods.
FRS 15: Accounting for depreciation
The standard defines depreciation as:
“Depreciation is the measure of the wearing out of a fixed asset through use, time, or obsolescence
and that charges of depreciation should be spread fairly over the fixed asset’s life. It is the measure
of the cost of the economic benefits of the fixed asset that have been consumed during that period.”
This basically says if the benefit gained from using a fixed asset is greater at the beginning of its life,
the depreciation charge should reflect this (using the reducing balance method, for example). If the
benefit gained is spread across the asset’s useful life, the straight line method would be more
appropriate.

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1. Explain the importance of Financial Reporting Standards. [10]
2. Present value takes into consideration the future estimated returns. Explain what this actually
means.
3. FRS 18 is seen to be of fundamental importance to the accounting profession. Why is this the
case?
4. An historic cost basis is traditionally used in preparing final accounts. In times of inflation, it has
been said that these final accounts may mislead users of financial information.
a) Explain the alternative approaches in the preparation of inflation-adjusted accounts.
b) The likely effect on the measurement of profits and fixed assets when these alternatives are
adopted.
c) What may be considered as capital expenditure in SSAP 13?
5. In FRS 15 the term ‘impairment’ arises.
a) What does this imply as far as depreciation is concerned?
b) If an asset is to be re-valued what effect has this on the rate of depreciation?
6. Why is it important when preparing financial statements, to comply with accounting standards
set by the Accounting Standards Board?

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Chapter 33: Accounting for Stocks
Introduction
The purchase of stock is of great importance to many organisations, particularly in manufacturing. If
a business over-spent on stock, it could tie up too much of its working capital on materials, which in
a serious case could cause the collapse of the company.
Running out of stock when sales of your product are high can also be costly in terms of lost sales and
reputation.
Being in control of stock means proper planning and proper documentation.
Purchase requisition An internal request for stock items from the storekeeper
or production manager to those responsible for ordering
materials.
Purchase order The buyer will make out the order to send to the
appropriate supplier, considering: price, delivery dates
and reliability of supplier.
Progress of deliveries It is the responsibility of the buyer to ensure orders are
chased up and arrive on time.
Delivery of materials The delivery note is the document that accompanies the
goods on arrival and is signed by the person receiving the
goods as proof of delivery.
Goods received note The document made once the goods have been checked
in, inspected and signed for. A copy is sent to buying
office to check against incoming invoice.
Issues to store Materials issued from stores to production as and when
required, the stores issue voucher is an authorisation to
release stocks and record of usage.
Stock bin card Details of goods received and issued for each stock item.
Kept with physical stock and helps to control stock
movements.
Stock Control Levels:
Each bin card should indicate the following levels of control:

a) The minimum stock level
b) The maximum stock level
c) The re-order level
A business needs to estimate, for each stock item, the average usage and the anticipated delivery
time (lead time), so that as stock levels fall to the re-order level, an order can then be placed to
replenish the stock item.

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In theory, at least, by the time the stock order has come in, the stock item would be at the minimum
level.
The difference between then minimum stock held and zero is referred to as ‘buffer stock’, which
gives a vital few days to chase up any supplier whose order is delayed. As the optimum level of stock
should be carried for each item, it is important to calculate the re-order, minimum and maximum
levels required for each stock item. The formulae for these are:
Re-order level = maximum usage x maximum lead time

Minimum stock level = re-order level less (average usage x average lead time)
Maximum stock level =re-order level + re-order quantity less (minimum usage x minimum
lead time)
Example:
A business uses the following data for an item of its stock:
Average usage = 400 units per day
Maximum usage = 500 units per day
Minimum usage = 200 units per day
Minimum lead time = 15 days
Maximum lead time = 25 days
Economic re-order quantity = 4,000 units
We will now calculate the re-order, minimum and maximum levels of stock:
Re-order level = 500 x 25 = 12,500 units

Minimum stock level = 12,500 - (400 x 20) = 4,500 units
Maximum stock level = 12,500 + 4,000 – (200 x 15) = 13,500 units
The economic re-order quantity refers to the optimum order level i.e. the best amount of stock to
order at any time the stocks need replenishing to the levels wanted. The formula for this is:
Q = √2AC Q = the economic re-order quantity

H A = the annual demand of the stock item
C = the cost of ordering one consignment
H = the cost of holding 1 unit in stock
The economic re-order level in the above example was 4,000 units, this was calculated from:
A = the annual demand: 400 units per day x 240 working days = 96,000 units
C = the cost of ordering one consignment from suppliers, estimated £12.50 on average
H = the cost of holding one unit in stock, estimated at 15p per unit.
Q= 2 x 12.50 x 96,000 = 2,400,000 = √16,000 = 4,000 units

√ 0.15 √ 0.15

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Continuous Stocktaking Methods of Stock Taking: ABC Inventory
This is a system whereby This system attempts to put the
a certain proportion of emphasis on the most
stock items are checked significant items in stock, in
each day. Over the terms of relative annual cost.
course of a year, all items Often, about 20% of stock items
are checked at least account for about 80% of stock
once. purchasing – so it makes sense
to focus the checks on the 20%.
Periodic Stocktaking
This is usually required on
an annual basis, at the end Perpetual Inventory
of the accounting period, so This stock recording system is where the balance is shown
the stock end figure can be on the record for a stock item after every movement,
used in final accounts. This either receipt or issue. The balances on the stock record
can be a big task and can cards represent the stock on hand and can be used for
interrupt production times. preparing the periodic accounts.
SSAP No. 9 (Stocks and Work-in-Progress):

This states that stock should be valued at its cost or, if lower than cost, at its net realisable value (i.e.
its expected selling price).
Costing direct materials:

Stocks of materials are normally held in stores and issued to production as and when required.
When costly parts (such as car engines) are valued, the cost price of each is clearly known and used
for stock valuation purposes.
However, for low value stock items purchased frequently in large quantities (such as nuts, bolts,
brackets etc) it may not be possible or desirable to itemise the value of each item – particularly
when costs vary over time.
To cost these types of products, there are three distinct methods of valuation:
 FIFO – First-in, first-out (stock in first is the first stock out)
 LIFO – Last-in, first-out (stock in last is the first stock out)
 AVCO – Average cost of stock (takes the weighted average of units in stock)
Example:
Stock received: 300 @ £1 = £300 January
200 @ £1.20 = £240 March
Stock issued: 400 between January to March
Using the three methods of stock valuation, what is the value of stock still in hand for each method?
FIFO = 100 x £1.20 = £120
LIFO = 100 x £1.00 = £100
AVCO 100 x £1.08 = £108 (£540/500 = £1.08)
So for valuation purposes the FIFO method values stock the highest (when prices rise) and LIFO the
lowest. Most organisations tend to use either the FIFO or AVCO. LIFO is rarely used because in times
of rising prices it values stock the lowest and so under-states profit.

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1. Make a list of all the significant documents used in the acquisition of materials.
2. Why is it important to have a system of stock control in a large manufacturing organisation?
3. You are given the following information regarding material stock code Q242:
 The average demand for the material is 400 kilos per week, 50 weeks of the year.
 The cost of ordering is £150 per order
 Q242 costs £6.00 per kilo and carrying costs (holding costs) are 331/3% of this figure for
each kilo held.
 The maximum usage in any one week is 600 kilos, the minimum 400 kilos
On average, the orders take between 1 and 3 weeks to be delivered. Note that these figures are
based on weeks rather than days of use.
Required:
a) The optimum order quantity to be placed

b) The re-order level
c) The minimum stock level
d) The maximum stock level
4. Write short notes which will clearly differentiate between:

 Continuous stocktaking
 Periodic stocktaking
 Perpetual stock level
5. Calculate the normal stock control levels from the following information:
Economic order quantity 12,000 kilos
Lead time 10 – 14 working days
Average usage 600 kilos per day
Minimum usage 400 kilos per day
Maximum usage 800 kilos per day

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Chapter 34: Accounting for
Incomplete Records
Introduction
Many small businesses do not keep a full set of adequate accounting records. Sole traders, in
particular, keep only partial records. It is the role of the accountant to use the financial information
that is available (invoices, till rolls, bank statements etc.) to prepare a set of accounts.
The procedure:
Establish the owner’s capital (net worth) at the beginning of the

financial year by listing assets against liabilities.
Prepare a bank/cash summary (simplified cash book) identifying

receipts and payments of money in and out of the business.
Establish sales and purchases for the year using invoices, credit
notes etc. Possibly reconstruct debtors’ and creditors’ accounts.
Extract a trial balance and prepare an

extended trial balance (if required).
Prepare the profit and loss account,

(including items for adjustments)
and a balance sheet.
Example: The valuation of stock, following loss through theft or fire:
During the night, the premises of Match Ltd were damaged by fire. It destroyed a quantity of stock
and all the stock records. The destroyed stock was covered by insurance and so the company needs
to work out how much to claim for. The following information is available:
(On 1 January) (On 17 June)

£000 £000
Stock at cost 132
Trade creditors 45 53
Trade debtors 39 47

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The following transaction took place between 1 January and 17 June
£000
Cash purchases 17
Payments to creditors 274
Cash received from debtors 314
Cash sales 80
Discounts received 10
Discounts allowed 8
A physical stock take carried out first thing in the morning on 18 June showed the remaining stock to
have a cost of £91,000. Match Ltd earns a gross profit of 30% of selling price on all of its sales.
Required: Calculate the cost of the stock destroyed by the fire.
Solution: Match: Finding sales and purchases

Debtors account
1/1 Balance 39,000 17/6 Bank 314,000
17/6 Sales 330,000 Discount 8,000
_______ Balance 47,000
369,000 369,000
Balance b/d 47,000
Creditors account
17/6 Bank 274,000 1/1 Balance 45,000
Discount 10,000 Purchases 292,000
Balance 53,000 _______
337,000 337,000
Balance b/d 53,000
Trading account as on 17 June

£ £ £
Sales: Credit 330,000
Cash 80,000 410,000
Cost of sales: Stock 132,000
Purchases: Credit 292,000
Cash 17,000 309,000
441,000
Stock undamaged (91,000)
350,000
Stock loss (63,000) 287,000
Gross profit 123,000

139

1. The following are the records of a business which has not kept a full set of accounts:
Assets and liabilities £ £
01 09 09 30 08 10
Fixed assets (book value) 80,000 ?
Debtors (accounts receivable) 17,000 22,000
Creditors (accounts payable) 8,000 9,000
Stock (inventory) 33,000 36,000
Wages owing 1,800 2,300
Prepaid insurance 800 1,200
Balance at bank 5,000 ?
Summary of the bank transactions in the year:
Payments Receipts
£ £
Purchase of new fixed assets 20,000
Wages 69,000
Insurance 19,000
Rent and rates 18,000
Communication exps. 15,000
Payments to suppliers 152,000
Misc. expenses 16,000
Drawings 24,000
Receipts from debtors 324,000
It has been decided to depreciate fixed assets by 20%.
Required:
a) Calculate the opening capital. [2]

b) Calculate the bank balance as at 30 August 2010. [3]
c) Calculate the total amount of sales for the year. [2]
d) Calculate the total amount of purchases for the year. [2]
e) Prepare the profit and loss account (income statement) for the year ended 30 August 2010. [6]
f) Prepare the balance sheet (position statement) as at 30 August 2010. [5]

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Chapter 35: Manufacturing
Accounts
Introduction
A manufacturing organisation which makes its own products
wants to know, among other things, how much it costs to
produce its goods and how these costs are divided in terms of
costs directly or indirectly related to production.
It needs to know this to set the correct selling price. The selling
price is determined by adding a sum to the total cost, a margin
considered to be what the market will pay.
A manufacturing account is a way to calculate the cost of production i.e. the factory cost as distinct
from other costs in the profit and loss.
Direct Costs:
Costs directly involved in making the product.
1. Direct labour – factory wages of those workers actively involved in production
2. Direct materials – raw materials specifically used to make the product
3. Direct expenses – fewer of these because most tend to be indirect overheads. Direct
expenses include direct power, leasing of specialist equipment or payment of royalties for
patents used in production.
The total of direct costs = the PRIME COST
Indirect Costs:
These refer to the factory overheads.
1. Indirect labour – This relates to the factory employees but excludes direct wages. Factory
store men, cleaners and engineers are examples.
2. Indirect materials – these may relate to lubricants, stationery, safety material, but excludes
direct materials.
3. Indirect expenses – relate to factory rates, insurance, light and heat, power, rent,
depreciation of factory equipment.
The total of indirect costs = the FACTORY OVERHEAD COST
Now we will work through an example, taking raw data and creating a manufacturing account and
finally a profit and loss account:

141
Figures relating to the accounts of ABC Ltd (T.V manufacturers) for year ended 31 December
£000s
Stocks of raw materials 1 January 3,186
Stocks of raw materials 31 December 4,479
Stocks of finished goods 1 January 4,264
Stocks of finished goods 31 December 9,651
Purchase of raw materials 23,766
Sales of finished goods net 79,695
Rent and rates 3,292
Manufacturing wages 23,463
Manufacturing power 765
Manufacturing heat and light 237
Manufacturing expenses and maintenance 819
Salaries and wages 13,870
Advertising 2,217
Office expenses 786
Depreciation of plant and machinery 745
Hiring of plant 504
One half of salaries and wages and three-quarters of the rent and rates are to be treated as a
manufacturing charge.
Work-in-progress (1 January) 1,156
Work-in-progress (31 December) £1,066
Required: Manufacturing and profit loss accounts for the year.
ABC’s Manufacturing account year ended 31 December

£000s £000s £000s
Direct costs
Stocks of raw materials (1/1) 3,186
Purchases of raw materials 23,766
26,952
Less stocks of raw materials (31/12) 4,479
22,473
Direct wages 23,463
Direct expenses 504
46,440
Indirect Costs
Indirect wages and salaries 6,935
Indirect expenses:
Depreciation: plant 745
Manufacturing heat and light 237
Expenses and maintenance 819
+ power 765
+ rent 2,469
11,970
Add 58,410
Work-in-progress (1/1) 1,156
59,566
Less
Work-in-progress (31/12) 1,066
Factory Cost (transferred to profit and loss) 58,500

142
ABC’s profit and loss account year ended 31 December
£ £
Sales 76,695
- Cost of sales
Stocks of finished goods (1/1) 4,264
Factory cost 58,500
62,764
- Stocks of finished goods (31/12) 9,651 53,113
Gross profit 26,582
- Other expenses
Rent and rates
Wages and salaries 823
Advertising 6,935
Office expenses 2,217
786 10,761
Net Profit 15,821
Note: the total cost of output is £58,500 + £10,761 = £69,261
Mark-up and margins of profit:

The ‘mark-up’ is usually expressed as a percentage and is added to the cost price of goods in order
to arrive at the selling price.
The ‘margin’ is always based on the selling price. The margin price is a useful indicator of profit
calculated on the value of sales.
There is a distinct relationship between these concepts of profit. For example, a 50% mark-up is
always a 33.333% margin.
If a product cost £4 to manufacture and 50% mark up was added, the selling price would = £6. The
margin therefore would = 33.333% (2/6). The following mark-up percentages will always equal their
respective margin percentages:
Mark Up Margin
100% 50%
50% 33.333%
33.33% 25%
25% 20%
20% 16.666%

143
1. Jallow & Jagne (Manufacturing) Ltd presented a trial balance as at 31 December 2010 as follows:
£ £
Stock of raw materials (01/01/2010) 14,000
Finished goods stock (01/01/2010) 45,000
WIP (01/01/2010) 26,000
£1 Ordinary share capital 300,000
Profit and loss account balance (01/01/2010) 175,000
Land and buildings at cost 360,000
Manufacturing equipment at cost 80,000
Prov. for depreciation of equipment (01/01/2010) 35,000
Debtors/creditors 54,000 32,000
Bad debts written off in the year 2,000
Bank balance 5,000
Cash 1,000
Direct wages 132,000
Purchase of raw material 182,000
Production overheads 101,000
Insurance of buildings (see notes below) 30,000
Indirect factory wages 41,000
Misc. office overheads 61,000
Selling expenses 38,000
Sales 630,000
---------- ----------
1,172,000 1,172,000
======= =======
NOTES at 31 December 2010:

 Stock of raw material was £16,000; WIP was valued at £28,000; and the finished goods stock
was valued at £49,000.
 The manufacturing/factory occupies 80% of the building.
 The manufacturing equipment is to be depreciated by 25% on cost.
 The directors propose:
i) A provision for taxation of £8,000
ii)
An ordinary share dividend of 3 pence per share
Required:
a) Prepare the manufacturing account for the year ended 31 December 2010. [10]
b) Prepare the profit and loss account for the year ended 31 December 2010. [10]

144
Chapter 36: Marginal Costing
Introduction
Marginal costing is related to those costs that can be directly traceable to a specific unit. For
marginal costing to take place, it is necessary to divide costs into variable and fixed:
Variable costs:
Variable costs are those direct costs traceable to a unit such as direct materials and direct labour
which are sensitive to output change. If output goes up, so do variable costs.
Fixed costs
Fixed costs are far less sensitive to output changes and are the indirect costs such as rent, rates,
insurance etc. If output increased the factory rent, for example, would not increase.
It is important to make this distinction because the level of activity will have a direct bearing on the
amount of profit or loss on a given output of production.
When more units are produced, the fixed cost per unit will decrease, increasing potential profits. If
output levels fall, then the fixed costs per unit will increase, reducing the profit level.
The importance of contribution:

Contribution is an easy figure to calculate, but important as it is used in a number of formulae
(calculating break-even, for example).
Contribution = selling price – variable cost
Example: A product is sold for £15 a unit. The variable cost is £10 per unit. Fixed costs are estimated
to be £12,000. Calculate the estimated profit on an output of 4,000 units and the break-even point.

£5 £15 £10
Estimated profit = (output x contribution) – fixed costs

(4,000 x £5) £12,000
= £8,000
Break-even point = fixed costs

Contribution per unit
= £12,000
£5
= 2,400 units

145
The contribution to sales ratio:
This can be used to estimate profit on a known sales revenue figure. If that year there were £76,800
sales to date, what profit is estimated on this revenue? Assume fixed costs of £25,000.
Profit = Revenue x Contribution/Sale ratio (C/S ration) less fixed costs
Contribution/Sales ratio = Contribution 5

Sales 15
Therefore, contribution on estimated revenue = £76,800 x ⅓ = £25,600
Less fixed costs £25,000
Estimated profit = £600
A summary of costing formula
Profit or Los: (output x contribution/unit) – Fixed costs
Break-even point = Fixed costs

Contribution/Unit
% Margin of safety: (Planned output – Break-even point)

Planned output
Contribution/Sales Ratio: (C/S) = Contribution per unit

Sales per unit
Break-even Revenue = Fixed costs

Contribution/Sales Ratio
Estimated Profit from Sales Value = (Sales x Contribution/Sales Ratio) – Fixed costs

146
The break-even point taken from a profit and loss account:
Estimating the break-even point from, say, the monthly forecast of the profit and loss account, can
be a useful indicator of the minimum sales required to break-even.
Gross profit must be sufficient to cover all overhead costs – break-even has then been achieved.
For example, if overheads were £25,000, then gross profit would need to be at least the same figure.
If the gross per cent margin was known, then the estimated sales to break-even could be calculated
by dividing the margin into the overhead expenses.
Example: estimated sales for March

£
Sales 80,000
Cost of sales 48,000
Gross profit (40%) 32,000
Less
Operating expenses 25,000
New profit (8.75%) 7,000
Estimate the sales required to break-even:

= Operating expenses
Gross margin %
= 25,000
0.40
= £62,500 sales to break-even
Note:
The amount of contribution per unit a business makes is essential to profit. The greater the
contribution, the greater the potential to make profits.
If a company made two or more products and there was some constraint of some sort in the
production or demand for the products, it may have to make a choice on the products that will
achieve the greater contribution.
A final note on marginal costing:
The use of marginal costing assists management by providing further information with which to
improve decision making, in particular when output levels differ from those planned, or special
prices for special orders need to be calculated.
In the real world, however, you must remember that solutions are not always based on figures
alone.
You may decide through marginal costing, for example, that one customer’s order is more profitable
to the business to fulfil. However, the customer that is less profitable may be your most valued
customer and the likelihood of additional orders from this customer would mean you may choose
the less profitable short-term decision, for the more profitable long-term gain.

147
1.
a) Explain the benefits of including an element of ‘payment by results’ in a factory wages

system. [6]
b) Virinda Ltd expects to be able to sell 75,000 items of a product at £120 per unit. The cost
data is as follows:
£
Direct material per unit 25
Direct labour per unit 40
Variable cost per unit 30
Fixed costs allocated to the product 950,000
Maximum possible production without incurring extra fixed costs is 105,000 units.
Required:
i) Calculate the budgeted profit. [3]

ii) Calculate the breakeven point in units.[2]
2. You are arranging a ‘gig’ at a medium-sized live music venue. You have carried out some
research, and have established the following cost data:
£
Cost of hiring the band 800
Cost of hiring the venue 500
Insurance costs 300
Casual wages 400
Cost of leaflets and advertising 400
The maximum possible capacity is 500 customers.
The owners of the venue will sell the tickets for you at a cost of £2 per ticket sold. It is a
condition of the agreement that they are the sole agent for ticket sales.
The owners of the venue will run the bar etc., and take any associated profits.
The budgeted number of tickets sold is 400.
Required:
a) Calculate the cost per ticket (excluding the £2 commission). [3]

b) Calculate the total cost per ticket. [2]
c) On the basis that you decide to sell tickets to customers at a price of £15 each:
i) Calculate the breakeven number of tickets to be sold
ii) Calculate the profit if 400 tickets were sold
iii) Calculate the profit if 500 tickets were sold
iv) Calculate the profit/loss if 300 tickets were sold
v) Calculate the profit/loss if 150 tickets were sold [2 each]

148
Chapter 37: Budgeting
Introduction
The budget is a key financial plan of a business. It attempts to forecast a number of months ahead, in
order to make best use of its resources.
In a well-structured organisation the budget is at the centre of the financial control system. The
basic purpose of a budget is to control the organisation’s expenditure and to plan ahead for the
future. Expenditure can be planned, profits estimated and targets set.
Actual results are then compared with the budget and any variances are analysed and acted on.
The main types of budget are:
The personnel budget The production budget

Does the business have the right Production must be able to meet the demands set by
manpower and the financial support to the sales budget. It must be in control of stocks and
meet recruitment and training needs. ensure the necessary materials, labour, machinery,
etc. are there to meet sales budgets.
The sales budget

The sales budget must start with The operating budget
the expected level of sales. Sales This represents a forecast of
are the lifeblood of business, so the profit and loss account. It is
accurate estimation of sales are about planning objectives to
important. ensure a satisfactory return on
capital employed.
The cash budget

Otherwise known as cash flow The capital expenditure
forecast, it is the key budget. It budget
involves all the other budgets in The administration This takes into account capital
its forecast as it must include all budget costs and involves the purchase
sources of revenue and Considers the of fixed assets like equipment
expenditure. overheads of the and premises. The budget
business and involves needs to plan for their
costs such as rent, rates, replacement or expansion
stationery, heating, etc. purposes.
If a budget needs adjustment because circumstances have changed, then forecasts need to be
amended to reflect changes. In this way, a budget becomes a very significant management tool to
help them make better decisions and improve forward planning.

149
Example: The cash budget
A new company has gathered the following information for six months from 1 January to 30 June.
 Sales (in units) £40 per unit:
o Jan 200; Feb 300; Mar 200; Apr 400; May 300; June 400 (units)
 Production is 300 units per month for the whole 6 months
 Fixed overhead costs will be £3,000 per month, payable in the month after production.
 Variable overhead costs will be £15 per unit payable in the month of production.
 Direct wages will be £5 per unit payable in the month of production.
 Equipment costing £10,000 will be purchased in February and paid for in March. Once
installed, it will allow production to increase to 500 units per month.
 Materials will cost £8 per unit and suppliers will be paid in the month following purchases.
 All sales of units are on credit. Debtors are expected to pay in the month following their
purchases.
 Cash at bank on 1 January = £10,000
Required:
A separate schedule of payments and a cash budget for the six month period, January to June.
Solution: Schedule of payments

Jan Feb Mar Apr May June
£ £ £ £ £ £
Fixed assets 3,000 3,000 3,000 3,000 3,000
Var. overheads 4,500 4,500 4,500 4,500 4,500 4,500
(300 x 15)
Direct wages 1,500 1,500 1,500 1,500 1,500 1,500
(300 x £5)
Equipment 10,000
Materials
(300 x £8) 2,400 2,400 2,400 2,400 2,400
6,000 11,400 21,400 11,400 11,400 11,400
Cash Budget
Jan Feb Mar Apr May June
£ £ £ £ £ £
Bank balance b/f 10,000 4,000 600 (8,800) (12,200) (7,600)
+ receipts* - 8,000 12,000 8,000 16,000 12,000
10,000 12,000 12,600 (8,000) 3,800 4,400
- payments 6,000 11,400 21,400 11,400 11,400 11,400
Bank balance c/f 4,000 600 (8,800) (12,200) (7,600) (7,000)
* Receipts calculated at £40 unit sales, allowing one month credit.
Analysis:
It is important for the exams to be able to analyse the cash budget you will be asked to prepare. As
you can see in this example, the company does have sufficient cash resources to finance the above
plan. It would have to either lease the equipment or raise more capital in March. Without this cash
budget, this company may not have been prepared for a deficit in cash like this.

150
1. Justine is to open a gift shop in a large tourist venue. On 1 April 2011 Justine will deposit £90,000
in a business bank account. Her plans are as follows:
 On 1 April to pay rent of £24,000.

 On 1 April to buy equipment etc. costing £90,000. Half of the £90,000 is to be paid in
April, and there will be two further payments (£22,500 each) in May & June.
 Goods for resale will be purchased according to the following schedule:
April and May £7,000
June and July £9,000
August and September £10,000
 Suppliers will give one month’s credit.
 Sales are expected to be £16,000 in each of the first three months, and will rise to
£21,000 a month in July. All sales are on a cash basis.
 Monthly wages of £2,200 are payable in each month.
 Justine will take £1,000 per month in drawings.
 Justine will spend £1,000 per month on marketing. Half of the £1,000 is payable in the
same month, and the other half is payable in the following month.
 Other expenses of £2,900 per month are expected – payable in the same month.
 Justine will depreciate the equipment at 25% pa on cost.
Required:
a) Prepare a cash budget for the period 1 April to 30 September 2011. [10]
b) Comment on the potential performance of the business. [5]
c) Explain the benefits of cash budgeting. [5]
2. Explain the importance of budgetary control. [10]

151
Chapter 38: Capital Investment
Appraisal
Introduction
Often management needs to make financial decisions about investment proposals or opportunities.
Capital investment appraisal is a way of ensuring a business invests its money in the best long-term
capital projects.
There are three major methods of capital investment appraisal:
Discounted Cash Flow

This is about looking at the future earnings
of an investment and seeing those values
in terms of what they are worth today
against the interest that could have been
earned doing nothing. There is no point
investing resources for a project that
returns less than simply holding the
money in a bank account and receiving
interest.
The Net Present Value (NPV) converts the
future cash flow into present values after The Pay-Back Method
deducting the original investment from This method approaches capital appraisal with
the total. The project which reveals the the question, how long will it take to pay back
most favourable net cash flow at present the original cash sum invested. Cash flow refers
values would be seen as the most to the actual movement of cash. Cash flow in is
profitable. the cash received, the cash flow out is the cash
paid. Net cash flow is the difference between
these two flows.
When using this method of capital appraisal, the

project with the fastest pay-back time in terms
of net cash flow will be taken as the best.
The Return on Investment Method

The ROI is the average profit for the project
expressed as a percentage of the capital
invested. This method is also referred to as the
‘accounting rate of return’ (ARR).
ROI = Average profit x 100

Average investment
We will now look at a couple of examples:

152
Example: The Pay-back method:
A business has £70,000 to invest and the estimated net cash returns (NCR) from each project over a
given time of six years are as follows:
Year Project A Project B Project C
£ £ £
1 25,000 16,000 15,000
2 23,000 18,000 17,000
3 18,000 18,000 17,000
4 14,000 16,000 16,000
5 10,000 16,000 15,000
6 8,000 12,000 10,000
Total returns: 98,000 96,000 90,000
Which of these projects pays back its original £70,000 the fastest?
Project A = 3 years 4.8 months - (25,000+23,000+18,000+4/10,000 of 1 year)

Project B = 4 years 1.5 months - (16,000+18,000+18,000+16,000+2/16,000 of 1 year)
Project C = 4 years 4 months - (15,000+17,000+17,000+16,000+5/15 of 1 year)
Example: ROI
From the above figures, and taking into account depreciation of 50% for each of the three projects,
calculate the average ROI.
Project A Project B Project C
Total returns: £ £ £
(over 6 years) 98,000 96,000 90,000
Less 50% depreciation 49,000 48,000 45,000
Net profit 8,167 8,000 7,500
Average profit: 11.67% 11.43% 10.71%
(divide by 6 years)
ROI is calculated for Project A as: Average profit x 100

Average investment
= 8,167 x 100
70,000
= 11.67%
Alternatively the average investment could take into account its residual value (if any) at the end of
the appraisal period.

153
1. Vijay Ltd is considering investing in a project which has the following cash flows:
£000
Initial investment 2,900
Cash flows:
Year 1 900
Year 2 1,000
Year 3 1,100
Year 4 600
Year 5 200
The cost of capital is 8%
Extracts from NPV (DCF) tables:
Rate of discount 8% 9% 10%

Year 0 1.000 1.000 1.000
Year 1 .926 .917 .909
Year 2 .857 .842 .826
Year 3 .794 .772 .751
Year 4 .735 .708 .683
Year 5 .681 .650 .621
Year 6 .630 .596 .564
Required:
a) Calculate the payback period (in years and months). [2]

b) Calculate the ARR (accounting rate of return). [2]
c) Calculate the NPV (net present value). [4]
d) Explain briefly if you think that the project is viable. [4]
e) Explain the benefits of using investment appraisal techniques in the allocation of large capital
sums. [8]

154
Chapter 39: Exams and
Examination
Success
Introduction
The most important thing is to be prepared. That means learning the material in depth and most
importantly going through past exam papers.
Thoughts on Revision:
Make a list of all the major topic areas of the examination. Revise each topic carefully and ensure
you understand its basic underlying principles.
You will need to organise and manage your time carefully, to

ensure you are fully prepared for the exams you wish to take.
If you are attempting a number of exam papers, try to organise

certain days of the week so that you spend an adequate time
on each subject.
Ensure you have sufficient exam questions to practise on and

always try to obtain the recommended answers so that you
can check your progress.
Wherever possible, nearer the exam time, try to set up your own ‘mock
exam’ at a week-end and attempt to do four or five different questions
within the time limits. Many examinations are of a 3-hour duration, so set
yourself the requisite number of questions and a time to complete them. It
is of essential importance to know how long you have to complete each
question.
The exam:
 Always arrive to the exam in plenty of time
 Relax and have confidence that you know the material
 Read the paper briefly before starting any questions (ensuring you select the best ones)
 Attempt the easier question first to get your pen flowing and your confidence up
 Write quickly, but ensure your handwriting is neat and legible
 Use a ruler to draw lines rather than do it freehand. Major totals should always be
underscored. It improves presentation and makes your work look more organised.
 If you have any time left at the end, always go over the questions again, checking for any
obvious errors.
 Ensure that you have your name and candidate number on the examination booklet and also
on any extra pages that you may have used.
Preparation is key. Put the work in and it WILL pay off in the exams. Revise in advance and make
sure that last evening is free for you to relax. It can only help you to achieve great success. Good
luck.

155

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Finance and Accounting

An ICM Study Aid

Introduction 5 Part 4: The Construction of Financial 86

© Trainer Bubble Ltd. 2011

Study Aid Page: Key Learning Point:

© Trainer Bubble Ltd. 2011

© Trainer Bubble Ltd. 2011

© Trainer Bubble Ltd. 2011

© Trainer Bubble Ltd. 2011

Accounting is the process of identifying, measuring and communicating economic information in

From a business’s point of view, finance wants to know two

Accounting is a step on from bookkeeping as it is used to communicate financial information to

© Trainer Bubble Ltd. 2011

Who needs accounting information?

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1. How does bookkeeping assist in providing information for

2. What is meant by the term financial statements?

3. How do financial statements assist owners and manager in business?

5. How would you define the meaning of finance?

6. From ‘Who needs accounting information’ answer the following:

a) Who wants to know whether the business is profitable?

7. Why are customers and suppliers interested in accounting information?

© Trainer Bubble Ltd. 2011

Private Sector Economic activity in the hands of individuals

The Private Sector:

A Sole Trader One-man business unit. Capital raised by the private

Public – can raise large amounts of capital by issuing a

● To receive a dividend payment (a share of the company’s profits)

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When finance is needed, management must consider three things:

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© Trainer Bubble Ltd. 2011

1. What do you consider the main sources of finance are for:

3. Clearly differentiate between ordinary and preference shares.

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An easy way to remember this is the word “RECAL”

Liabilities – the things of value that the business owes

In business there are TWO key financial statements:

The Profit and Loss Account:

A simplified version of this account is below

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Gross Profit 25,000

Net Profit 5,000

Note that profit is divided into two parts:

● Gross Profit: (sales - cost of sales)

The Balance Sheet:

Capital = assets less liabilities

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Total assets: 72,000

Total liabilities: 52,000

Net assets: (A – L) 20,000

Debtors – are customers who owe money to the business.

The accounting equation:

Capital = Assets - Liabilities

20,000 = 72,000 - 52,000

Assets = Capital + Liabilities

Sales Day Book: Harrison _______________

_____________Sales Ledger: Harrison