Accounting Basics

Accounting

‘the art of recording, classifying, and summarizing in a significant manner and in terms of money,
transactions and events which are, in part at least of financial character, and interpreting the results
thereof”

Bookkeeping

Book-keeping is a process of accounting concerned with recording transactions and keeping records. Book-keeping is a small and
simple part of accounting.

Difference between Bookkeeping and Accounting

Book-keeping: It is concerned with systematic recording of transaction in the books of original entry and
their posting into the ledgers. It involves.
• Journalizing
• Posting into ledger
• Totaling of different accounts in the ledger
• Balancing
Accountancy: Accounting begins where Book-keeping ends. “It means that an accountant comes into the
picture only when the book-keeper has done his job. The functions of accountant can be classified as under:
• Inspecting the work of book keeper
• Preparation of trial balance
• Preparation of Trading and Profit and Loss accountant
• Preparation of Balance Sheet
• Passing Entries for rectification of errors and making adjustments

Heads of Accounts

Assets are the resources controlled by the enterprise as a result of past events and from which future
economic benefits are expected to flow to the enterprise. It is simply what a company owns.
Liabilities are the present obligations of an enterprise arising from past events, the settlement of which is
expected to result in an outflow of resources embodying economic benefits. Liability is what a company
owes.
Capital is the source of fund provided by owner.
Revenue is an inflow of assets in return of services performed or good delivered in accounting period.
Expenses are the cost of producing revenue in a particular accounting period.
Accounting Process

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 Transaction Occurs

Source Documents is prepared

Entry recorded in Books of Prime Entry

Entry posted to ledger

Trial Balance

Financial Statements

Source Documents
A source document is a proof or evidence of a transaction that is carried out in a business

Sales Invoice Credit Sales

Purchase Invoice Credit Purchase
Credit Note Issued Returned by Customer A credit note may be issued by a supplier to reduce
an invoice for returns/overcharge
Credit Note Received Returned by Business (purchase
return)
Wages Sheet/Payroll Payment of wages
Register
Receipt For cash received / Cash payments
counterfoil For cash deposited in bank
Cheque/Deposit Slip For Amount received through Bank
Cheque Counterfoil/Stub For Payment by Bank
Petty cash Voucher / Cash For Petty Cash Transaction
Memo
Bank Statement For Online / Credit Transfer

Other Documents are

Debit Note: A debit note may be issued by a customer to request a reduction in an invoice
Statement of Account: The Statement of account is a document, issued by a supplier to its customer, listing transactions over
a given period, normally monthly. It will include details of invoices, payments received and any credits approved with a
resultant balance payable by the customer.

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Books of Prime Entry

These are also known as book of original entry/ preliminary entry/first entry. Transaction are at first recorded in Book of Prime
Entry then in ledger.

Benefits of maintaining Books of Prime Entry

• Reduces the number of entries in the ledger
• Act as an aid for posting to the ledger
• Helps to gather and summaries accounting information
• Facilitate preparation of control accounts
• Allows work to be divided between several people

Sales Journal Transaction related to credit Sales of goods

Purchase Journal Transaction related to credit purchases of goods
Sales Return Journal Transaction related to Sales Return
Purchase Return Journal Transaction related to Purchase Return
Cash Book Transaction related to Cash and Bank
General Journal / Journal It Contains
• Opening entries,
• Closing entries
• purchases/sale of fixed asset on credit,
• correction of errors,
• writing off bad debt,
• year-end adjustments,
• items which cannot be entered in other books of prime
entry,

Ledger

A ledger is a book in which all accounts are maintained.

Benefits of Division Of ledger

• easier for reference as accounts of the same type are kept together
• helps to locate errors
• deters fraud and reduces the possibility of fraud due to segregation of duties
• allows checking process to be introduced

Sales Ledger (Receivable Ledger) Contains accounts of trade Receivables

Purchase Ledger (Payable Ledger) Contains accounts of trade payables
General Ledger (Nominal Ledger) Contain all accounts except cash bank, receivables and payables
Cash Book Contains accounts of cash and bank

Accounts
Account is an individual record of an asset, a liability, an expense, a revenue or capital in summarized nature. Account is an
individual record which contain summary of same nature of transaction.

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Real Account These are the accounts relating to all assets and properties.
Personal Account Receivables and payables accounts
Nominal Account These are accounts related to loses, expense, Income and gains

CASH BOOK
Cash book is the only book of original entry which is given ruling in such a way that it could act at the same time as a book of
original entry and as a ledger account.

Trade Discount

It is an allowance or deduction given by the supplier to the retailer on the catalogue price or list price.

§ It is given to encourage him to buy in bulk.

§ It is given so that retailer could make some profit.

Note: It is not recorded in the books either by the seller or the buyer.

Cash Discount
It is an allowance or deduction given by the receiver of cash to the payer of cash for prompt payment.

It is of two types discount allowed and discount received.

CONTRA ENTRY: WHEN A TRANSACTION EFFECTS BOTH CASH AND BANK ACCOUNTS AT THE SAME TIME, SUCH ENTRIES ARE
CALLED AS CONTRA ENTRIES.

TRIAL BALANCE
Trial balance may be defined as a statement or a list of all ledger account balances taken from various ledger books on a
particular date to check the arithmetical accuracy. It is not a part of the double entry system of book keeping.

Objectives or Advantages of Trial Balance

1. It checks the arithmetical accuracy of ledger accounts.

2. It is useful in preparing financial statements.
3. To have a proof that the double entry of each transaction is made.

Income Statement
Income statement shows the financial performance of the business for an accounting year. It consists of two sections:

Trading Account: In this gross profit is calculated.

Profit and loss Account: In this profit for the year is calculated.

Statement of Financial Position

It shows the financial position of the business at a certain date. It is based upon accounting equation. It is not a part of the
double entry system. It shows the assets, liabilities and capital of a business.

Advantages of maintaining accounting records using the double entry method.

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• Less risk of errors
• Less risk of fraud
• Easier to refer to previous transactions
• Financial position can be ascertained
• Easier to prepare financial statements
• Easier to make business decisions
• Easier to calculate accounting ratios

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Bad debts and Provision for doubtful debts

Bad debts

A bad debt is an amount written off in respect of a debt that has become bad, that is, money will not
be received from the customer in respect of the amount owed by him. A debt should be written off only
when the business is certain that the customer will not pay. In cases where the business only has doubt
(not sure) when a provision for doubtful debts should be made.

Accounting entries for bad debts

Debit Credit

Bad Debts xx

Customer (ABC) xx

Note: the balance of the bad debts account is transferred to income statement at the end of the financial
year where it is shown as an expense.

Ways in which business could reduce the risk of bad debts

1. Obtain reference from new credit customers

2. Fix a credit limit for each customer
3. Issue invoices and statements promptly
4. Follow up overdue accounts promptly
5. Supply goods on a cash basis only
6. Refuse further supplies until outstanding account is paid

Importance of monitoring and controlling debtors

• It is important to monitor debtors to ensure that they pay the amount owed on the due date.
• To ensure that the debtors do not have overdue debts.
• To ensure that they do not exceed their credit limits.
• To improve the cash flow of the business.
• Because business has to comply with accounting standards e.g. prudence.

Provision for doubtful debts (Pfdd)

Provision for doubtful debts is in amount set aside to provide for a reduction in the value of trade
receivables in anticipation of debts that may prove to become bad in the future. It should be noted that
provision for doubtful debts is completely different from bad debts.

Reason for Providing a Provision for doubtful debts

Prudence concept - that the business should be pessimistic while recording its debtor’s balances and should make
account of all the probable losses on the amount due by his debtors to ensure profits and debtors are not overstated.

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Prudence concept states that profits should be understated, rather than overstated. Creating a provision for doubtful
debts increases the expenses and reduces the profit. Assets should be understated rather than overstated. Provision
is subtracted from debtors thereby reducing assets.

Matching / accrual concept – it emphasis that all expenses incurred should be matched with the income of the
relevant period. So, doubtful debts relating to the current year sales which are likely to be confirmed in next year are
matched against current year’s income.

Matching/Accruals concept states that expenses should be matched to the time period in which that expense was
incurred. Bad debts frequently occur outside the year of sale. The provision matches the likely bad debts to the year
in which the sale of that stock was made so that profit and debtors are not overstated.

In the Statement of financial position, trade receivables should be recorded at their expected net collectible amount
(amounts the business reasonably expects to receive from customers)

Factors to be considered when calculating a provision for doubtful debts

• Rates of bad debts in previous years.
• Specific information about customer in financial difficulties.
• Actual state of economy
• How long each debt is outstanding

Methods of calculating Provision for doubtful debts:

1. By taking a percentage of the total amount owing by customers at end of year. This is known as a
general provision.
Provision for doubtful debts = Rate x Trade receivable at end of year
(trade receivable end of year should be after deducting any bad
debts)
2. By analyzing each individual debt and aggregating those debts that may prove to be bad (specific
provision).

3. A combination of general and specific provisions.

Provision of doubtful debt = General provision + Specific Provision

General Provision Specific Provision

Rate x (Trade receivable – Specific Provision) Given
Provision for doubtful debt = General Provision + Specific Provision

Example: Trade receivable are 20000 and Provision for doubtful debt at beginning is 2000
A specific provision of 400 and 5% of remaining trade receivable.
Solution General provision = Trade receivable – Specific provision x rate
General provision = 20000 – 200 x 5% = 990
Provision of doubtful debt = 990 + 200 = 1190

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Bad debts recovered

A bad debt recovered refers to a situation whereby money is being received in respect of a debt that had
previously been written off as bad. A series of entries have to be made when a bad debt is recovered these
are listed below.
1. Recreate the debt
Debit Credit

Customer(ABC) xx

Bad Debt Recovered xx

2. Record the money received

Debit Credit

Bank xx

Customer (ABC) xx

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Capital and Revenue Transactions

Capital Receipt Revenue Receipt

Capital receipts arise from selling non-current assets revenue receipts arise from day-to-day business
activities
Capital receipts arise from owners/lenders providing Revenue receipts from the sale of goods
additional capital
Capital receipts are recorded in the Statement of revenue receipts are recorded in the income statement
Financial Position.
Loan From bank, sale of non-current asset Commission received, discount received

Capital Expenditure Revenue Expenditure

Expenditure incurred on the purchase, alteration or Expenditure incurred on the day-to-day running
improvement of non-current assets expenses of the business
Purchase of non-current asset Rent, insurance

If Revenue Expenditure treated as Capital Exp.

Then G.P. → No Change

N.P. → Overstated
Capital → Overstated
Fixed Assets → Overstated

If Capital Expenditure Treated as Revenue

G.P. → No Change
N.P. → Understated
Fixed Assets → Understated
Capital → Understated

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Bank Reconciliation Statement

purpose of preparing bank reconciliation statements

• Ascertain the true bank balance at a certain date
• Assist in detecting fraud and embezzlement
• Identify any “stale” cheques
• Demonstrate that any differences between the cash book balance and that on the statement
are due to genuine reasons

Reason why the bank account and bank statement may differ
Difference arises due

1. The different times at which same items are recorded.

Þ Uncredited/Uncleared cheques/ Bank Lodgments.
Þ Unpresented/outstanding cheques.
2. The business not recording certain items in cash book.
Þ Bank charges and bank interest.
Þ Dishonored cheques.
Þ Amount paid directly paid into the bank.
Þ Amount paid directly paid by the bank to others.

Adjusted Control Account (Bank)

Balance b/d xx Balance b/d xx
Credit transfer xx Bank Charges xx
Interest On deposit xx Direct Debits xx

Errors in cash book xx Standing Order xx

Dishonored Cheques xx
Errors in Cash Book xx
c/d (corrected) xx c/d (corrected) xx
xx xx
balance b/d xx balance b/d xx

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 Bank Reconciliation Statement
Balance as per Cash Book Updated xxx/ (xxx)

Add: Unpresented Cheque

Less: Uncredited Cheque

Add/Less: Any Error in bank statement

Balance as per Bank Statement xxx/ (xxx)

Bank Reconciliation Statement

Balance as per bank statement xxx/ (xxx)

Less: Unpresented Cheque

Add: Uncredited Cheque

Add/Less: Any Error in bank statement

Balance as per cash book Updated xxx/ (xxx)

Note: If bank statement balance is Credit then it would be written as positive in BRS and if bank statement balance is Debit/
Overdraft then it would be written as negative in BRS

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Accrual and Prepayments

Accrual Principle
Only items relating to that particular time period should be included in the statement: the timing of the actual receipts and
payments is not relevant.

Accrued Expense : Expense incurred but not paid for (Current Liability)
Accrued Income : Income earned but not received yet (Current Asset)
Prepaid Expense : Expense paid for but not incurred yet (Current Asset)
Pre-Received Income: Income (cash) received but not earned yet (Current Liability)

Expense Payable
Balance b/d(Prepaid) xxx Balance b/d(owing) xxx
Bank/Cash/creditor xxx Bank (Refund) xxx
Income Statement xxx
(Expense of the year)
Balance c/d(owing) xxx Balance c/d(prepaid) xxx
xxx xxx

Income Receivable
Balance b/d(Due) xxx Balance b/d(advance/perceived) xxx
Income Statement xxx Bank/Cash/Debtor xxx
(income of the year)
Bank (Refund) Income written off xxx
Balance c/d(advance/perceived) xxx Balance c/d(due) xxx
xxx xxx

Why accrual and prepayment adjustment should be made

If accrual prepayment adjustment were not done then business would be producing the accounts in contravention of the
accounting standards and good accounting practice if she did not make adjustments for accruals and prepayments.

Businesses must apply the accruals/matching concept which states that revenue and expenditure must be matched to the time
period in which they were incurred not to the time period when they were received or paid.

The net profit figure would be unreliable in the profit and loss account. If all the relevant expenditure for the period had not been
matched with revenue.

The balance sheet would also not show a true and fair view of the business as accruals and prepayments outstanding at the year-
end would not appear under current assets and current liabilities.

Applying the accruals/matching concept each year permits a valid comparison of net profit both year on year and with other
businesses. This also links to the consistency concept.

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It can also be argued that accounting for accruals and prepayments is to some extent an application of the prudence concept as
failure to accrue expenses at the year-end would result in profit and working capital values being overstated.

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Depreciation of Non-Current Assets

IAS 16 defines depreciation as the systematic allocation of the depreciable amount of an asset over its useful life.

In simple terms depreciation is an expense for using the economic benefits of non-current assets. It can also be defined as the
reduction in the book value of an asset.

Reasons of Depreciation
Matching/Accrual Concept – Matching concept requires that all costs incurred in a period should be deducted against income
earned during that period in arriving at profit. Therefore, depreciation being an expense must be charged against revenue when
calculating profits.

Prudence Concept – According to the prudence concept, profits should not be anticipated or overstated but provision should be
made for all possible losses. If depreciation is not charged against revenue for the period, profits as well as assets would be
overstated. Hence this would be against the principle of prudence.

Calculation of Net Book Value (Going concern Concept) – Non-Current assets should be shown in the statement of
financial at their net book value (NBV). Net book value is the difference between the cost of the asset and its accumulated
depreciation. Hence to be able to calculate the net book value, depreciation has to be proved. This treatment is also in line with
going concern concept.

Consistency to assist comparisons of performance between years and using the same depreciation method each year.

Causes of Depreciation
1. Physical deterioration
2. Economic reasons
3. Passage of time
4. Depletion

Factors to be considered when accounting for depreciation are

• Type of asset
• Estimated life of asset
• Cost of asset
• Scrap value of asset at end of life

Methods of Depreciation
STRAIGHT LINE DEPRECIATION METHOD / FIXED INSTALLMENT METHOD

It assures that the asset is used evenly every year throughout its expected life. It is calculated or the amount that is calculated
remains the same throughout each year.

Depreciation= Cost - Scrap value / Estimated useful life (years)

Depreciation= Cost * percentage %

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This is useful for those assets which provide equal benefits to the business for each year of their lives.

ü simple to understand and easy to calculate the amount of depreciation.

ü provides the same amount of depreciation throughout the life of the asset.
ü helps to estimate the amount of depreciation in advance.

û does not take into consideration the seasonal fluctuations in the use of fixed assets. Depreciation amount per
month will remain the same irrespective of the use of machine.
û Equal amount of Depreciation is charged even though the capacity of the machine declines every year.

DECLINING/REDUCING/DIMINISHING BALANCE DEPRECIATION METHOD

This method assures that the asset is used up more in the first years of its life than the next year and so on. It is calculated by
applying a fixed percentage to the reduced value of the asset i.e. (NBV) Net Book Value at the start of the year.

Depreciation = Book value x Depreciation rate

Book value = Cost - Accumulated depreciation

ü Equalizes the yearly burden on statement in respect of both depreciation and repairs. The amount of
depreciation goes on decreasing while the expenses on repairs goes on increasing, so that the total charge
against revenue over different years remains more or less the same.
ü matches the cost and revenue of the business. The greater amount of depreciation provided in initial years is
matched against the higher amount of revenue generated by increased production by the use of new asset.

û charges heavy amount of depreciation in earlier years.

Revaluation Method

This method is used where it is not practical, or is difficult, to keep detailed records of certain types of non-current
assets (Materiality concept). Usually such noncurrent assets include many small value items and they are easily
broken, damaged or lost and have to be regularly replaced.
Examples: loose tools, packing cases, equipment used in offices and laboratories

Depreciation of Loose tools = Loose tools at the start of the year + Purchases of loose tools during the
year – Disposed of Loose tools - Closing stock of Loose tools.

Note: Business can record its value as expense if such items value is insignificant.

Recording of Depreciation
Income Statement xxx
Provision for Depreciation xxx

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 Recording of Disposal

Debit Credit
Removal of Cost

Disposal xx
Non-Current Asset xx
Removal of Accumulated Depreciation

Provision for xx
Depreciation
Disposal xx
Recording of Receipt

Bank/Cash/ABC xx
Disposal xx
Recording of Closing Entry(Loss)

Income Statement xx
Disposal xx
Recording of Closing Entry(Profit)

Disposal xx
Income Statement xx

Why would a company choose one method over another?

A method of depreciation is chosen by a company because of its policy on depreciation and ensuring that
the consistency concept is applied when preparing accounts.

Why SLM is used for leasehold assets and buildings.

The straight-line method is where the same amount of the cost of the asset is written off each year. It is
appropriate in the case of an asset that remains in the business over a long period of time and loses value
slowly, for example assets such as buildings that generate profit over many years.

The straight-line method involves spreading the depreciable amount evenly over the estimated useful life of
the asset. Using this method, the depreciation is the same figure each year, which suggests that the asset is
being used up at an even rate.

Why RBM is used for computer equipment’s and vehicles.

The reducing balance applies a constant percentage to the gradually carrying amount balance so that the
amount of depreciation expense diminishes over the useful life of the asset. The amount written off is high
in early years and reduces each year until written off. This method is appropriate in the case of an asset
which loses most of its value in the years immediately after purchase e.g. vehicles, computer, equipment
etc., (assets that become obsolete quickly because of changes in technology).
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It should be noted that relatively few businesses use the reducing balance method and, where it is used, the
percentage figure is often an approximation.

The general principle of providing depreciation is based on the matching concept.

Can a business reduce rates of depreciation?

This may increase profit and assets in short term but this change would not help profit in long term as lower depreciation charge
means higher losses on disposal. Business should not go for reduction in rates specially in order to increase profit as it is not
accordance with Consistency and Prudence concept

SIMPLE FORMULA TO CALCULATE PROFIT/LOSS ON DISPOSAL

Sale Proceeds – Book Value = Profit (if Positive) / loss (if negative)

Calculation of Depreciation rate if not given

Straight Line Method Reducing balance method

Depreciation rate Depreciation rate
Depreciation expense/Cost of NCA at the year end Depreciation expense/ BV of NCA at the end + Dep expense

Revaluation of NON-CURRENT ASSETS (Only in companies)

Some assets do appreciate in value, e.g. Land and companies are allowed to revalue them. The journal entry for revaluation is

Debit: Asset (Cost)

Debit: Provision for Depreciation. (Accumulated Depreciation)
Credit: Revaluation Reserve

For example:
An asset which cost $60 000 and has provision for depreciation of $8 000 is now revalued at $75 000. In order to handle this,
we should just
Debit: Asset 15 000 (Because it was already at 60 and we want to make it 75)
Provision for Depreciation. 8 000 (this is always done to cancel the depreciation)
Credit: Revaluation Reserve 23000

The 23 000 is the difference between the old Net Book Value (60 000 – 8 000) 52 000 and the new value 75 000.
A relatively simpler case would be where there is no provision for depreciation. Like e.g. Land at $60 000 is now revalued at $75
000.

Debit: Land 15 000

Credit: Revaluation Reserve 15 00

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 Control Account
A control account acts as a check on the purchases ledger/sales ledger. If there is an error in the purchases ledger/sales ledger it
will not be revealed by a control account prepared from the individual accounts in that ledger.

Advantages of control accounts

1. Control accounts can be used to provide totals of debtors and creditors readily. (It is less time
consuming than adding together all the debtors or creditors balances from the sales and purchases ledgers.)

2. Control accounts can be used to identify errors. It identifies the ledger or ledgers in which errors have
been made when there is a difference in trial balance.

3. Control accounts acts as a deterrent against fraud. Segregation of duties helps in the prevention of fraud
because members of staff who complete the control accounts are not involved in completing the sales ledger.

Reasons for a debit balance brought down in the creditor accounts

1. Overpayment of amount due

2. Cash discount not deducted before payment made
3. Returned goods after payment of amount due
4. Payment made to creditor in advance

Reasons for having a credit balance in sales ledger control account

1. Overpayment of amount due by a debtor

2. Cash discount not deducted by debtor before payment made
3. Goods returned by debtor after payment of amount due
4. Payment made in advance by debtor

Limitations of control account

1. Control account do not identify which ledger account may contain an error
2. Some types of errors are not revealed by control account such as errors of omission, errors of
commission, compensating errors and errors of original entry.
3. It requires time in preparation and higher level of skilled staff required to prepare.

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 Sales Ledger Control Account
Bal B/d xx Bal b/d xx
Credit Balance
Credit Sales xx Receipts (Cash / Cheques received) xx
Dishonored Cheques xx Sales Returns xx
Interest Charged xx Bad Debt xx
Bad Debt Recovered xx Discount Allowed xx
(receipt is recorded as well)
Refund to customers Contra (set off) xx
Bal c/d xx Bal c/d xx
Credit Balance
xx xx
Bal b/d xx Bal b/d xx

Purchase Ledger Control Account

Bal B/d xx Bal b/d xx
(Debit balance)
Purchase Return xx Credit Purchases xx
Payments (Cheques/cash paid) xx Interest charged xx
Discount Received xx Refund by suppliers xx
Contra (Set Off) xx xx
xx
Bal c/d xx Bal c/d xx
(Debit Balance)
xx xx
Bal b/d xx Bal b/d xx

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Correction of Errors

While recording transactions in subsidiary books or the ledgers, errors can be made. Such errors
will normally be discovered when preparing a trial balance, However, it should be noted that the trial
balance has a serious limitation in that it does not detect all errors. Hence, we can say that there are two
categories of errors:

1. Errors not affecting trial balance

2. Errors affecting trial balance

Errors not affecting the trial balance

These are errors that will not be detected by the trial balance since the total of both columns will be the
same.

Below is a list of such errors:

Errors Definition and examples

1. Error of omission The error arises when a transaction has not been recorded at all in
the books, that is, no entries have been made. It has been
completely omitted from both accounts.
Drawings of goods $15 has been completely omitted.
2. Error of Commission This is where an entry has been made in a wrong account which
belongs to the same category of the account where the entry should
have been made. It usually arises with personal and real accounts.
Repair of $15 paid in cash has been recorded in Rent account
3. Error of principle This error occurs when a transaction has been recorded in a wrong
account. However, the wrong account and the correct account
where the entry should have been recorded must be different
categories.
For example, instead of recording in a real account, the entry has
been made in a nominal account.
Motor vehicle expenses of $15 paid in cash has been recorded in
the vehicle account.
4. Error if original entry This error occurs when a wrong amount has been used for
recording a transaction. The amount of the corresponding entries
refers to the two entries of the same transaction.
Cash sale of $156 has been recorded as $165 in both accounts.
5. Error of reversal of It arises when the account which should have been debited, has
entries actually been credited and the other account which should have
been credited, has been debited. This means that both entries are on
the wrong side.
Received commission in cash $20 has been debited to commission
receivable account and credited to cash account.
6. Compensating error The error arises where there are at least two errors. One error on
the debit side cancels out another error of the same amount on the
credit side or two errors of the same amount on the same side

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 cancels out each other.
Sales and purchases account are both overcast by $100.

Errors affecting the trial balance:

These are errors that will be detected by the trial balance since the total of both columns will not be the
same.

Below is a list of such errors:

1. Error of Single Entry The error occurs when only one of the two entries of a transaction
has been recorded, either the debit entry or the credit entry has
been made.
Rent of $43 paid in cash has been recorded in the cash account
only.
2. Error of two debits or This error occurs when the two entries of a transaction have been
two credits recorded on the same side instead of one entry on the debit side and
the second corresponding entry on the credit side.
Furniture of $650 bought by Cheque has been debited to furniture
account and bank account.
3. Error of three entries This error occurs when three entries have been made for a single
transaction. All the entries can be on the same side or two of them
may be on the debit side and one on the credit side or vice versa.
Goods bought from Paul $75 for cash has been credited to both
Paul’s account and cash account and debited to purchase account.
4. Error of different This error occurs when the amount of a debit entry differs from the
amount for amount of its corresponding credit entry.
corresponding entries Cash received from Jack $45 has been correctly recorded in cash
account but entered in Jack account as $54.

5. Arithmetical error This error occurs when an amount has been wrongly calculated. It
usually occurs when computing the totals of subsidiary books or
when balancing of accounts.
The Sales Journal has been overcast by $90.
6. Listing error Listing error is an error arising when transferring a ledger balance
to the trial balance, it does not arise when recording a transaction.
It occurs when an item has been incorrectly listed/entered on the
trial balance, for example, a wrong amount may have been listed
on the correct side or the correct amount written on the wrong
side. Listing error may also arise in the ledger where the correct
balance has been brought forward on the wrong side or a wrong
amount brought forward on the correct side.
Drawings has been wrongly listed on the trial balance as $10 200
instead of $10 000.

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Suspense account

The suspense account is a temporary account which is created when the trial balance disagrees and must be
closed upon the correction of all errors affecting the trial balance. Quite often the importance and uses of
the suspense account is not properly understood. The following issues are important aspects relating the
suspense account.

1. When the totals of the trial balance disagree, the difference has to be calculated and entered on the
trial balance. The difference is listed in the column where there is a shortage by writing suspense
next to it. This means that the difference is posted to a suspense account and will appear in the
suspense account as balance b/d or we can also write “Difference in trial balance”.

2. The balance b/d in the suspense account may either be on the debit side or credit side. It will be on
the debit side it the total on the credit side is lower (shortage on credit side).

3. The suspense account must contain entries for only those errors that affect the trial balance. Errors
not affecting trial balance must not be recorded (corrected) in the suspense account.

Guidelines for correction of errors

1. All errors are corrected by means of a journal. This is because it would provide an explanation of
the error corrected.
2. Most questions on errors starts by providing the transaction followed by the error made and/or
entries recorded in a sentence. Therefore, identity the transaction and write the correct double
entry.
3. Next compare the correct entry with the error made or entries recorded. This will allow you to
identify which one of the twelve errors it is. Here you have to bear in mind that whenever no
information is provided about one of the two corresponding entries which have been made, it means
that the entry has been made correctly. This is a general principle which stems from the fact that if
something is wrong the examiner has to inform us about the mistake otherwise we have to assume
it is correct. In any case we cannot assume that something is wrong since this will give rise to
different assumptions from different students!
4. Once you have identified the type of error made, this will let you know whether an entry in the
suspense account is required or not.
5. To start the correction, locate in which account or accounts the error has occurred. It may be that a
wrong entry has been made or the amount recorded is overstated or understand, hence cancel that
wrong entry or increase/decrease the amount straight away. To cancel an entry or decrease the
amount recorded in an account always record the correction on the opposite side of the
entry/amount. For example, if the wrong entry appears on the debit side, then to cancel it, record on
the credit side. If an amount is overstated on the credit side then to decrease it record on the excess
on the debit side. However, if the amount is understated then to correct it you have to record on the
same side. For example, if the amount recorded on the credit side is understand, then record the
shortage on the credit side itself.
23
 6. After cancelling the wrong entry, next you may be required to record the correct entry which
should have been made.
7. Finally make any entries in suspense account if it is error affecting trial balance

Guidelines for correction of figures in trial balance or Statement of financial position

Items with Correcting entry on Journal Effect on Amount

Debit Balance Entry on debit side Increase
Debit Balance Entry on credit side Decrease
Credit balance Entry on debit side Decrease
Credit balance Entry on credit side Increase
As an example, assume that the item corrected is capital. Capital account has a credit balance. If
a correcting entry has been recorded on the credit side of the capital account, this would increase
the balance of capital whereas if the correcting entry is on the debit side, this would decrease the
balance of capital.

Guidelines for correction of profit

1. Ascertain whether the error corrected has an impact on profit or not by checking if the item being
corrected appears in income statement. Profit is affected and must be corrected only if it is an item
appearing in income statement such as sales, purchases return inwards, return outwards,
inventory, discount received and expenses. Items which do not appear in income statement will not
affect profit such as trade receivables trade payables, bank etc.
2. A correction on the DEBIT SIDE of any item appearing in the income statement will DECREASE
profit except closing inventory which will result is an increase in profit.
3. A correction on the CREDIT SIDE of any item appearing in the income statement will
INCREASE profit except closing inventory whereby profit will decrease.

24
Inventory Valuation

Inventories include assets held for sale in the ordinary course of business (finished goods), assets in
the production process for sale in the ordinary course of business (work in process), and materials and
supplies that are consumed in production (raw material).

Measurement/Valuation of Inventories

According to IAS 2, inventories are required to be stated/valued at the lower of cost and net
realizable value (NRV).

Cost should include all:

Þ Costs of purchase (including taxes, transport, and handling) net of trade discounts received
Þ Costs of conversion (including fixed and variable manufacturing overheads) and
Þ Other costs incurred in bringing the inventories to their present location and condition (e.g.
packaging cost)

Net Realizable Value is the estimated selling price in the ordinary courses of business, less the estimated
cost of completion (any additional processing cost to be incurred on the product so that it can be sold) and
the estimated costs necessary to make the sale.

Methods of cost determination for inventory valuation

1. First in first out (FIFO) Perpetual basis

Periodic basis
2. Average cost (AVCO) Perpetual basiseriodic basis

First in First out (FIFO)

Using the principle of FIFO, it is assumed that the goods purchased earlier are the first to be issued. Hence
the cost of the remaining units will be calculated using the price(s) of the latest batch of batches bought.
Under the perpetual basis the cost of inventory is updated each time goods are received and issued using
and inventory card.

Under the periodic basis the cost of inventory is calculated once in time, for example at the end of the
financial year only. The units in inventory are multiplied by the prices(s) of latest batch or batches bought
during the year.

It is worthwhile to know that under FIFO, the cost of inventory will always be the same whether the
perpetual basis or the periodic basis is being used.

Average cost (AVCO)

Using the principle of AVCO the cost of inventories is calculated using an average price. The method of
calculating the average price depends on the basis being used. There are two basis namely perpetual basis
and the periodic basis.

25
Under the perpetual basis, the cost of inventory is updated each time goods are received and issued
using an inventory card. Under the basis a new average cost is not calculated, the previously calculated
average cost itself is used to compute the cost of inventories.

Under the periodic basis an average cost is not calculated every time a batch is bought, instead the
average cost is calculated at a particular point in time only, for example at the end of the financial year

Calculation of average cost under the perpetual basis

Average cost = [Cost of inventory before purchase of new branch + Cost of new batch received (bought)
Units in inventory after receipt (purchase) of the new batch

Calculation of average cost under the periodic basis

Average cost = [Cost of inventory at start + total cost of purchase)
Units in inventory after receipt (purchase) of the new batch

Calculation of units in inventory at end under the periodic basis (FIFO and AVCO)

Units in inventory at end = Units in inventory at start + total units bought – total units sold.

Advantages of FIFO

1. It is easy to calculate the cost of closing inventory.

2. It is realistic since it is based on the assumption that inventories are issued in the order in which
they are actually received.
3. Values of inventories issued are based on prices actually paid for the goods/raw materials.
4. Cost of closing inventory is based on prices most recently paid. (i.e. their actual cost).
5. FIFO is allowed both by the companies Act and IAS 2.

Disadvantages of FIFO

1. The price at which inventory is issued to production is likely to be out of date.

2. When the prices of inventory rise, the FIFO method values the inventory at the highest prices
(latest prices). This would reduce cost of sales and increase sales and this may lead to paying more
tax.

Advantages of AVCO

1. Variations in the pricing of materials to different jobs are minimized.

2. Average has the effect of smoothing out the cost of production and cost of sales hence rendering
profits of different periods more comparable.
3. The cost of inventory will be fairly close to its actual cost.
4. AVCO is allowed by both Companies Act and IAS 2.

Disadvantages of AVCO

1. It is difficult to calculate the average cost.

26
 2. The average cost does not exist in practice.

Advantages of LIFO (Last in first out)

1. LIFO matches most recent cost with current revenues.

2. Less tax liability at times of high inflation because profit would be less due to low value of
inventory.
3. In some industries it confirms with actual flow of inventory i.e. in Ore Extraction Industry.

Disadvantages of FIFO

1. Inventory is valued at oldest prices so those prices might be irrelevant for decision making.
2. It is not widely acceptable method so it is prohibited in many countries.

Inventory Take

Inventory take/(stocktaking) – This is an activity which in practice is carried out at the end of the financial
year whereby the inventories are being physically counted for the purpose of inventory valuation.
Sometimes it may happen that the physical inventory count and valuation cannot take place at the end of
the financial year and is therefore carried out a few days later. However, for the purpose of preparing
financial statement we need the value of inventory at the end of financial year. Hence the value of
inventory obtained after the end of the financial year has to be adjusted for transactions that have taken
place between the end of the financial year and the date on which the inventory take has been carried out.

Goods sent on a sale or return basis

It is a system used in practice whereby goods are being issued to another business on the condition that if
they are not sold by a particular date have to be returned. In substance, therefore the goods being issued
represents neither a sale for the business sending the good nor a purchase for the business receiving the
goods. However, if the goods are sold by the receiver before the date of return, then it should be recorded as
a sale by the issuer and a purchase by the receiver.

In addition, the goods remain the property of the issuer and should be included in its inventory unless they
have been sold by the receiver. The receiver should not include the goods in its inventory. The basis can
also be used to issue goods to private individuals and the goods issued should not be recorded as a sale until
the person informs the business that he accepts the goods.

Layout of Statement to adjust inventory

Statement to adjust inventory

Inventory is given xxxx

Add: Sales during the period (at cost) xxxx
Goods sent on a sale or return basis (at cost) xxxx
Return outwards xxxx
Inventory undercast/omitted xxxx
Drawings of goods (at cost) xxxx
Less: Purchases during the period (xxxx)
27
 Return inwards (at cost) (xxxx)
Inventory overcast/to be scrapped (xxxx)
Goods sold before end of financial year awaiting delivery (xxxx)
Goods received on a sale or return basis (xxxx)
Inventory at end of financial year xxxx

Concept of Sale or Return basis:

If we send goods on sale or return basis which means goods can be returned by the customer if not sold. When goods are send
nothing is recorded, just a memorandum is kept. These goods should not be included in sales and should be included in closing
stock (since they belong to us).

If this is recorded as sales and not included in closing stock, then we need to:

Correct sales: Cancel them

Debit: Sales

Credit: Debtor

Correct Closing Stock which is understated

Note: We won’t have to correct the stock if the goods were included in closing stock.

28
 Incomplete Record

Guidelines and techniques to obtain missing information

1. Calculation or profit or loss for the year without preparation of income statement
Statement to calculate profit/loss for the year
$
Capital at end (net assets at end) xxx
Add Drawings xxx
Less capital introduced (xxx)
Less capital at start (net assets at start) (xxx)
Profit for the year xxx

Note: Capital = Total Net book value of assets – Total liabilities

2. Calculation of Sales revenue

Revenue (sales. Takings) = Cash sales + Credit sales

= Cost of sales + Gross profit
= Gross profit ÷ Margin

3. Calculation of cost of sales

Cost of sales = Opening inventory + Net cost of purchase ---- Closing inventory
= Sales --- Gross profit
= Rate of inventory turn x Average inventory
= Gross profit ÷ Mark-up

4. Calculation of gross profit

Gross profit = Net revenue --- Cost of sales
= Mark-up x Cost of sales
= Margin x Net revenue
= Profit for the year + Total Expenses

5. Prepare a cash account to obtain a missing information as balancing figure

A cash account contains enormous information. Most sole traders keep only a cash account which
serves as the basis for preparing their financial statements. Certain questions on incomplete records
require preparation of a cash account to obtain a missing item as balancing figure. Below is summary
of a cash account highlighting the various information that can be derived as balancing figure.

29
 Cash Account
$ $
Balance b/d xxx Expenses xxx
Cash sales* xxx Bank (cash deposited at bank) * xxx
Receipts from customers* xxx Drawings* xxx
Cash stolen* xxx
Balance c/d* xxx
xxx xxx
* Any one of these items can be the missing information.

Prepare a bank account to obtain a missing information as balancing figure

The bank account also highlights massive information. Sole traders usually rely on the bank statement to
prepare their bank account. As with a cash account, the bank account also can reveal missing items as
balancing figure. Below is summary of a bank account highlighting the range of information that can be
derived as a balancing figure.

Bank Account
$ $
Balance b/d xxx Expenses xxx
Cash (cash deposited at bank) * xxx Drawings xxx
xxx Balance c/d* xxx

(xxx) (xxx)

Reconstruct a sales ledger control account to obtain a missing information as balancing figure
In question on incomplete records, very often a receivables control account has to be reconstructed to
obtain credit sales. However, of credit sales is provided then the balancing figure may represent receipts

Sales Ledger Control Account

$ Receipt from customers* $

30
Balance b/d xxx Discount allowed xxx
Credit sales * xxx Bad debts xxx
Return inwards xxx
Balance c/d* xxx

Reconstruct a purchase ledger control account to obtain a missing information as balancing

figure
Purchase Ledger Control Account
$ $
Payment to suppliers* xxx Balance b/d xxx
Discount received xxx Credit purchases* xxx
Return outwards xxx
Balance c/d* xxx

(xxx) (xxx)

Reconstruct a non-current asset account at net book value to obtained depreciation.

Equipment Account at NBV
$ $
Balance b/d (Net Book Value) xxx Disposal at Net Book Value xxx
Acquisition (cost price) xxx Income statement (depreciation)* xxx
Balance c/d
xxx

(xxx) (xxx)

WHAT ARE THE BENEFITS OF KEEPING FULL DOUBLE ENTRY RECORDS FOR THE
BUSINESS?
1. Helps in preparation of Trial Balance
2. Helps in preparation of Financial Statements
3. Less Chances of Errors
4. Less Chances of Frauds
5. Improves the Accuracy of Accounting Records

Detailed analysis if business do not keep full double entry system

31
If a sole trader does not keep adequate records then the business may not have records of the transactions, then the business will
be unaware of the total sales and purchases in a period. This may result in it not having records of its stockholdings which could
result in it and running out of certain lines of stock. Therefore, being unable to meet customer demand, this could result in the
loss of future business.

The business may not have a record of debtors and therefore it will not be able to send out invoices and reminders of amounts
owing from debtors. This may lead to debtors not paying their accounts, which could lead to bad debts and hence less profit and
cash flow difficulties.

The business may not have a record of creditors, which could lead to the business not paying the amounts owed to its suppliers.
This could lead to suppliers refusing to supply further goods and this could eventually lead to the failure of the business.

The business may not have records of expenses that have been paid or those which are owed; therefore, it will not have any
control of these, which may lead to overspending on expenses and, therefore, cash flow difficulties.

The business will be unable to prepare a trial balance and final accounts and, therefore, be unable to calculate how much profit or
loss it has made in a period.

If the business cannot provide details of its profits banks will be reluctant to loan it money, as there is no adequate record of its
ability to repay the money. It will also not have adequate records for HMRC to calculate the taxation due, which could lead to
fines.

The risk of errors and fraud will increase if transactions are not recorded and this could be difficult to trace

32
 Introduction to Financial Statements of Companies

A company is a business organization which is owned by shareholders but managed by a board of

directors. Unlike sole traders and partnerships, a company is an incorporated business, that is, it has a
legal identity of its own; hence the shareholders have limited liability. The capital of a company is divided
into units of small denomination. One of the units into which the capital of a company is divided is called a
share. A share is an amount of investment in a company evidenced by a share certificate.

Authorized share capital

Authorized capital is the maximum amount of share capital a company is allowed to issue

Issued Capital
The amount of capital actually required be issued to shareholders and this is known as the issued share capital.

Called up capital
Called-up capital is the total amount of capital a company has requested from its shareholders.

Paid up Capital
Paid-up capital is that part of the called-up capital for which a company has actually received the money
from its shareholders.

Shareholders fund
The total of issued share capital and the reserves is known as the shareholders fund

Participating preference shares are shares that are entitled are entitled to participate in the distribution
of the residential profit of the company. Residual profit is the profit remaining after paying preference
dividend and a certain percentage of ordinary dividend. Non-participating preference share will not receive
any part of the residual profit being distributed.

Redeemable preference shares are shares that have been issued with the intention of being repurchased
at a specific date in the future whereas non-redeemable share is issued without such intention. Redeemable
preference shares are to be classified as a non-current liability it will be redeemed after one year.

Public Issue

This is normal issue of shares to general public. A company can issue shares to public to raise more capital,
this is done at the market price. Public issues have higher cost of issue (this means the company has to
incur high expenses when issuing the shares I.e. advertising and administration). The main advantage of
issuing shares is that no interest has to be paid on it and the company only have to provide a return when
they actually make profits.

Right Issue of Shares

33
A right issue is an issue of share to existing shareholders in proportion to their shareholdings (in
proportion to the shares actually held by the shareholders). Rights issue is made in proportion to
shareholdings so as not to after the proportion of shares held by each shareholder after the issue. A rights
issue also can be made either at par at a premium. The following entries are made to record a right issue.

Dr Cash/Bank A/C
Cr Ordinary share capital A/C (nominal value only)
Cr Share Premium A/C (with the total amount of premium receive on the issue)

Advantages of Rights Issue over Public issue

• Rights issue are cheaper to administer and less risky way of raising capital
• Shareholders will get some incentive as they will get shares at a lower price.
• A rights issue will generate a cash inflow for the company.
• A rights issue gives the existing shareholders an opportunity to increase their shareholding and
potential earnings for future dividends
• A rights issue is an alternative to raising finance from a bank with a loan which would increase the
gearing of the company
• The goodwill of the company increases for the existing shareholders.
• The cost of a rights issue of such shares will also be lower than a full issue of shares.
• If the rights issue of shares is taken up by existing shareholders it shows that the financial
position of the company is good.

Disadvantages
• Market price will fall
• The company could have raised more funds through a public issue

Bonus Issue of Shares

A Bonus issue is an issue of shares to existing ordinary shareholders only, in proportion to their
shareholdings. Unlike public issue and rights issue, which can be made at a premium, bonus issue, is made
at par only and no cash is received from shareholders. A bonus issue is simply a book adjustment whereby
the reserves of the company are being converted into ordinary share capital. A bonus issue reduces the
reserves of a company. The accounting entries are as follows:
Dr Capital reserves/ Revenue reserves A/C
Cr Ordinary share capital A/C
Note: while issuing bonus shares, the priority is to use (debit) capital reserve. If the latter is un-sufficient,
then the revenue reserves should be used (use general reserve before retained earnings).

ADVANTAGES OF BONUS SHARES

• Bonus issue allows the company to conserve cash for reinvesting back into the business.
• It has a signaling effect and gives a positive sign to the market that company believes in its
long-term growth story.
• Sometimes, the company may not be in a position to pay any cash, so bonus issue is the only
means to satisfy the shareholders’ desire for a dividend.

34
 • Increasing the number of outstanding shares through a bonus issue increases the participation
of smaller investors in the company’s shares and hence enhances the liquidity of the stock.
• The Increase in the issued share capital increases the perception of company’s size.
• Keep existing shareholders happy and may be attractive to potential investors.

DISADVANTAGES OF BONUS SHARES

• Bonus issue increases the number of outstanding shares of the company and this will decrease the
future EPS and cash dividend yield. This can have a negative impact on the market’s perceived
value of the company.
• The company doesn’t receive any cash upon issuing bonus shares. So, the company’s ability to raise
money by follow-on offerings is reduced.
• The cost of administering a Bonus Share Plan is more than that of paying a cash dividend. This
cost can add up over the years if the company keeps on issuing bonus shares.

Why Company may issue bonus shares

• To release reserve to shareholder with no impact on cash flow.
• To match long-term assets with long-term capital.
• To keep existing shareholders happy and it may be attractive to potential investors.
• To liquidate capital reserve that cannot be used to pay dividends.
• To improve the perception of company size by increasing the issued share capital of the company

Why Capital reserves are used before revenue reserve

• To retain reserve in the most distributable form.
• Revenue reserves are needed to fund the payments of dividends.

Debenture
Debenture is a medium to long-term debt instrument used by large companies to borrow money, at a fixed
rate of interest.

Characteristics of debentures
1. Debenture holders are entitled to a fixed rate of interest (not dividend) Debenture interest must be
paid even if the company is making losses.
2. The debenture holders have priority for being reimbursed on liquidation of the company.
3. The debenture holders are not entitled to voting rights.
Double entry for Issue of loan notes/Debentures
If issued at par
Dr Cash/Bank A/C
Cr Loan notes/Debentures A/C
If issued at a discount
Dr Cash/Bank (total cash received)
Dr share premium A/c/Retained earnings (amount of discount)
Cr Loan notes/Debentures (nominal value of Debentures)

35
Calculation of Ordinary share dividend

Interim Ordinary share dividend

Rate (%) of interim Ordinary dividend x Total nominal value of paid-up /issued Ordinary share capital
OR
Dollar of interim Ordinary dividend per share x Number of paid-up/issued Ordinary share capital

Final Ordinary share dividend

Rate (%) of final Ordinary dividend x Total nominal value of paid-up /issued Ordinary share capital
OR
Dollar of final Ordinary dividend per share x Number of paid-up/issued Ordinary share capital

Calculation of Preference share dividend

Interim Preference share dividend

Rate (%) of interim Preference dividend x Total nominal value of paid-up/issued Preference
share capital

Final Preference share dividend

Total Preference share dividend minus Interim Preference share dividend

Total Preference dividend

Fixed rate (%) of Preference dividend x Total nominal value of paid-up/issued Preference
share capital

36
Income statement- Recommended layout illustrating classification of expenses by function

Income statement for the year ended ………

Revenue xxx
Cost of sales (xxx)
Gross profit xxx
Other income xx
Distribution costs (xx)
Administrative expenses/Office Cost (xx)
Profit or loss from operations/Operating profit or loss xx
Investment income xx
Profit before finance charge xx
Finance charges (x)
Profit before tax xx
Tax (x)
Profit for the year attributable to equity holders xx

Each of the above items represents a sub total which may include more than one item as explained below.

1. Revenue is net revenue, that is, sales revenue less return inwards.
2. Cost of sales would include all expenses incurred in bringing the goods to their present location
and conditions. The calculation of cost of sales would take into account opening inventory,
purchases, return outwards, carriage inwards, custom duty and closing inventory. Note that only
the amount of cost of sales will be shown in the income statement, the details have to be shown in
workings.
3. Other income would include rental income, profit on disposal and royalty’s income.
4. Distribution costs are expenses incurred directly on making sales whereas administrative expenses
are those relating to general administrative activities the following table attempts to provide a
useful classification of distribution cost and Administrative expenses.

Distribution costs Administrative Expenses

Carriage outwards and Warehousing cost Salaries of administrative staff
Selling expenses and advertising Discount allowed and Bad debts
Depreciation of delivery vehicles Creation and increase in provision for doubtful
debts
Salaries of sales and distribution staff/Sales Decrease in provision for doubtful debts and
commission discount received are shown as a deduction in the
calculation of total administrative expenses.

37
 5. Investment income consists of interest income and dividend received.

Finance charges would include interest on overdraft, interest on loan, debenture interest as well as
redeemable preference share dividend.

A Layout of the statement of changes in equity is shown below.

Statement of charges in Equity for the year ended….

Ordinary Non- Share Revaluation General Retained Total
share Redeemable Premium reserve reserve earnings
Preference
Share*
Balance of start xxx xx xx x x xx xxxx

Public/Rights xx xx - - - - xxx
issue of shares
(nominal values)

Premium on - - xx - - - xx
Public/Rights
issue
Bonus issue xx - (x) (x) (x) (x) -
Discount on - - (x) - - (x) (x)
issue of
Debentures
Revaluation - - - xx - - xx
gain
Profit of the year - - - - - xx xx
Transfer to - - - - xx (xx) -
General reserve
Ordinary - - - - - (x) (x)
dividend paid
Non-Redeemable - - - - - (x) (x)
Preference
dividend paid
Balance at end xxx xxx xx xx xx xx xx

Advantages of preference shares

38
 • Preference shares will give a cash injection and increase the financing of the company.
• Control of the company will not be changed because the preference shareholders do not possess voting rights in the
company.
• The dividends that are paid to the preference shareholders are fixed unlike the ordinary shareholders.
• Preference share are an alternative to borrowing from a bank because the assets of the company will not be required for
security unlike a bank loan.
• By issuing preference shares the company is attracting a wider range of investors especially those who want lower risks
because
• the preference share pays a fixed rate of interest and is paid before the equity holders dividends.
Disadvantages of preference shares
• The Company may have to pay higher rates of dividends to the preference shareholders as compared to the equity
shareholders.
• Preference shares are debt capital and will increase the gearing ratio of the company.
• Preference shareholders have preferential rights over the company assets in case of winding up of the company unlike
the equity. shareholders.
• If the preference shares are cumulative this could place a financial burden on the company because the dividends would
have to be paid when profits are available unlike dividends to the equity holders.
• If the company issued redeemable preference shares then the company would have to repay the share capital to the
shareholders at a given time which could cause a cash flow problem.

Difference Between ordinary and preference shares

Preference Shares Ordinary shares

Receive a fixed rate of dividend Dividend may vary according to profits
They do not usually carry voting rights They usually carry voting rights
Capital is returned before the ordinary share capital in a Ordinary shares are the last to be repaid in a winding up.
winding up.

Differences between preference shares and debentures

Preference shares receive a fixed rate of dividend Debentures receive a fixed rate of interest.
Preference shareholders are members of the company Debenture holders are not members of the company.
Preference shares are part of the capital of the company Debentures are long term loans.
Preference shareholders are repaid after the debenture holders debenture holders are paid before the preference shareholders
in the event of the company being wound up. in the event of the company being wound up.

39
Finance Decision: Share Issue or Debenture Issue

Share Issue (Public Issue) Debenture Issue

Permanent source of capital (not to be repaid) Temporary source of capital (to be repaid)
Dividend do not reduce profit Interest reduces profit
expensive process. takes more time to issue takes less time
will not increase gearing will increase gearing
dividend is discretionary interest is mandatory
may not require security may require security
may dilute ownership will not dilute ownership
Dividend is variable Interest is fixed

Reserve

Reserves are one of the most notable appropriations of profits. Companies create reserves so they can be
ready to face any contingencies in near future.

Reserves in a company can be divided into two broad categories – one is capital reserve and another is
revenue reserve.

Capital Reserve

Capital reserves are created as a result of non-trading activities. Capital reserves cannot be used to fund
dividend payments. Capital reserves are non-distributable. Example of capital reserve are share premium
and revaluation reserve.

Share Premium

Share premium is a non-distributable reserve. It cannot be used for purposes not defined in the company’s
laws.
Purpose of share Premium
1. Share premium can usually be used for paying equity related expenses such as underwriter’s fees.
2. It can also be used to issue bonus shares to the shareholders.
3. The costs and expenses relating to issuance of new shares can also be paid from the share premium.
4. It can also be used to write off company formation expenses.
5. It can be used to pay premium on the redemption of debentures.

Revenue Reserve
40
Revenue reserve are created as a result of trading activities. Companies create revenue reserve to quickly
expand the business. Revenue reserves are used to fund dividend payments. Revenue reserves are
distributable. Examples of revenue reserves are retained earnings and general reserve.

General Reserve
General Reserve is amount set aside from the retained profit to assist in expansion and other purposes of
the company.

Purpose of General Reserve

• A general reserve is retained profit for a non-specific purpose
• Used to fund the general growth of the business and its assets
• Can be used to cover future shareholders dividend
• To conserve cash and working capital

41
Financial Statements of Partnerships

A partnership is a business organization consisting of a minimum of two and a maximum of twenty owners known as
partner. There are two types of partners namely a limited partner and an unlimited or general partner.

A limited partner is once whose liability is limited, that is, in case of bankruptcy of the partnership.

Partnership Deed

When a group of person is about to start a partnership, it is advisable that they prepare a partnership deed. The partnership deed
is an agreement containing the rules and regulations that will govern the business. It can be a verbal or written agreement, but
it is preferable to have it on paper so as to avoid any misunderstanding between partners. The following would normally be
included in a partnership deed:

1. Any interest payable on partner’s capital.

2. Any interest to be charged on partners’ drawings.
3. Any salary, bonus or commission payable to the partners.
4. Any interest payable on any loan by a partner to the partnership.
5. The profit and loss sharing ratio.
6. Rules for the admission and retirement of partners

In the absence of a partnership deed, Section 24 of Partnership Act 1890 will govern the situation and contains the following
provisions:

1. No interest in payable on partners’ capital.

2. No interest is to be changed on partners’ drawings.
3. No salary is payable to partners.
4. Any loan by a partner to the partnership will carry interest at the rate of 5% per annum.
5. Profits and losses are to be shared equally.

Types of Capital Account

1. Fixed capital and Current account

2. Floating/Fluctuating capital account

The fixed capital account is used to record only the initial capital invested and any additional capital introduced by
partners. When we have a fixed capital account, we need to have a current account which will contain all the other items related
to the partners as shown below.

42
Reasons for keeping separate accounts for current and capital accounts

• To keep capital invested separate from profit and drawings

• To help avoid the possibility of partners overdrawing
• To reward the partner who has invested more capital with interest on the amount invested
• To identify partners drawings in order to calculate interest on drawings

Partners may want separate capital accounts to

• Show the permanent investment.

• Show the impact of any changes in capital (e.g. goodwill, capital introduced, revaluations).
• Facilitate the calculation of interest on capital.
Partners may want separate current accounts to

• Show the ongoing transactions between the partners and the partnership.
• Show the amount of drawings compared with the share of profit.
• Facilitate the calculation of interest on drawings.

Reasons for charging interest on drawing

• To ensure cash is retained and reinvested within the business

• To restrict partners drawing
• To reward partner with lower drawings
Reasons for charging interest on capital

• To reward the partner for business investment

• To encourage partners to introduce more capital
• To reward partners for the lost opportunity cost of capital invested

Current account

A ($) B ($) A ($) B ($)

Jan 1 Bal b/d xx - Jan 1 Bal b/d - xx

Drawings xx xx Interest on capital xx xx

Interest on drawings x x Salary x

Salary paid x x Share of profit* xx xx

Share of loss* x x Interest on partner’ x

loan
Bal c/d
Bal c/d
Dec 31 xx x

xxx xxx xxx xxx

Note: Interest on loan from a partner is debited to income statement and credited to the partner’s current account

43
Format of the Appropriation Account

Profit and loss appropriation account for the year ended ………

$ $

Profit for the year xx

Add Interest on drawings: Mr.A xx

Mr.B xx xx

Less Appropriations

Interest on capital: Mr.A xx

Mr.B xx

Salary for Alex xx xx

Residual Profits to be shared xx

Share of residual profits: Mr. A x

Mr. B x xx

Extract of Balance Sheet showing the capital structure of a partnership, that is, the section “Financed by” only.

Financed by $ $ $

Capital: Mr. A XXX

Mr. B XXX

Current account: Mr. A (Dr balance - minus) (X)

Mr. B (Cr balance - add) X XXXX

44
CHANGES IN THE PARTNERSHIP

A change in partnership is when the agreement has to be changed between the partners due to

- Admission of a new partner

- Retirement of an existing partner

- Or simply change in profit sharing ratio.

Benefits of admission of new partner

• Admitting New partner into the partnership could bring additional expertise which would allow the partners to
specialize in a particular area of the business.
• New partner would bring extra capital into the partnership, this would allow the business to expand and grow and
possibly diversify into new areas leading to increased profit and cash flow.
• The partners would be able to share the workload, decision making and responsibilities, this could reduce stress on the
partners. Having more partners would also provide more cover for sickness and holidays, which would reduce the
pressure on partners at these times.
• New partner reputation could bring additional customers to the business helping to increase the size of the business

Revaluation

Whenever there is a change in a partnership, partners are allowed to revalue their assets. This is done to make the
situation fair for all parties. Since the values on the statement of financial position might be different from the
market so any gain or loss is first adjusted between the old partners for this purpose, they make a revaluation
account.

In case of admission of new partner revaluation helps to assess true and fair value of assets and liabilities and as a
result actual worth of investment of each partner. Likewise, in case of retirement of an existing partner, revaluation
become necessary to find out the real and fair value of investment of retiring partner.

In revaluation account, we simply record the gains or losses on each asset due to revaluation. This account is then closed by
transferring the balance to partners’ capital account in the old profit sharing ratio.

Revaluation Account

Assets (Book Value) xxx Assets (Revalued Value) xxx

Liabilities (Revalued value) xxx Liabilities (Book value) xxx

Gain on Revaluation (Balancing Figure) xxx Loss on Revaluation (balancing Figure) xxx

(Distribute in old Partners in Old ratio) (Distribute in old Partners in Old ratio)

xxx xxx

Alternative Method of Revaluation

45
Revalued value Book value Gain / Loss

Assets Assets xxx / (xxx)

Liabilities Liabilities (xxx) / xxx

Gain / Loss on revaluation (distribute in old partners in old ratio) xxx

Goodwill

This is an added advantage which an old business has over a similar new business, due to its location, brand value,
customer base, skilled workforce, quality product, reliable supplier etc.

Whenever there is a change in partnership, we need to adjust for goodwill, so that the old partners benefit and get
the credit of the efforts they have done to make good reputation of the business.

If the business has generated goodwill in the past, then it is only that the old partners are given credit for goodwill
in their profit sharing scheme. An incoming partner must compensate the existing partners for his acquired share of
goodwill in addition to his capital investment whereas an outgoing partner receives his share of goodwill in
addition to capital.

The adjustment is done in the capital accounts, where we first create the goodwill in the old profit sharing ratio (thus giving
credit to the old partners), and then we write it off (always) in the new ratio (so that the partner who is gaining stake in the
business actually pays for it).

Reasons to writing off goodwill

As goodwill has no objective value (matter of opinion) so it cannot be sold individually unless business is subject to sale. So,
writing off goodwill enables to show true and fair value of business assets.

Moreover, it is prudent to write off goodwill as it is progressively replaced by the goodwill created by the new management of
business likewise the value could be subject to sudden change for example if a problem arose which caused damage to the
partnership’s reputation

Moreover, accounting standards do not allow showing any non-purchased goodwill in the books of accounts as an asset. This
must be written off against the capital account balances of the partners in their new profit sharing ratios.

Record of Goodwill (Old Ratio)

Debit Goodwill xxx

Credit Old partner A xxx

Credit Old Partner B xxx

Removal of Goodwill (New Ratio)

46
Goodwill has to be removed if it is not being retained in books.

Debit New Partner A xxx

Debit New Partner B xxx

Credit Goodwill xxx

Note: If goodwill is not being retained in books then other way is by adjusting with sacrificing ratio.

Statement to calculate amount to be paid to retired partner

Capital balance xxx

Add: Current A/C (Credit Balance) xxx

Add: Gain on Revaluation xxx

Add: Goodwill Raised xxx

Less: Loss On revaluation (xx)

Less: Current A/C (Debit Balance) (xx)

Less: Asset taken (agreed Value) (xx)

Total Amount to be paid / recover xx / (xx)

Dissolution of Firm

A partnership may dissolve in following cases

• Mutual agreement of the partners to dissolve the business.

• Completion of a project for which the partnership was formed
• Expiry of the agreed term of the partnership if it was for pre-determined period.
• Death or retirement of all partners or all except one partner
• Disagreements between all the partners
• Formation of a limited company to take care of the partnership business.
• When the partnership business is no longer profitable.

47
Accounting Treatment

Dissolution / Realization A/C

Assets (Book Value) xxx Liabilities xxx

Except Cash / Bank Except Loan
Bank xxx Bank xxx
(amount paid for liabilities) (Amount received from realization of
assets)
Partner Capital xxx
(asset taken over by partner)
Bank xxx
(Dissolution cost/ or any expense
incurred on dissolution)

AA Capital xxx AA Capital xxx

BB Capital xxx BB Capital xxx
(Gain on Realization) (loss on Realization)
xxx xxx

Capital Account

AA BB AA BB

Current A/C xxx xxx balance xxxx xxx

(debit Balance)
Realization xxx Current A/C xxx xxx
(any asset taken by partner) (credit balance)
Loss On realization xxx Loan xxx
(by Partner)
Gain on Realization xxx xxx
Bank xxx xxx Bank xxx xxx
(balancing entry) (balancing entry)
xxx xxx xxx xxx

Bank A/C
Balance b/d xxx Balance b/d (overdraft) xxx
Realization xxx Realization xxx
(Amount received from realization of (Amount paid for liabilities)

48
assets)
Loan xxx
(payment for loan other than given by partner)
Partner Capital xxx Partner Capital xxx
(deposited by Partner) (Withdrawn by Partner)
Realization xxx
(Expenses paid for realization)
xxx xxx

49
 Ratio Analysis

Profitability Ratios

Gross Profit Margin

• This measures the success in selling goods
• The ratio shows the gross profit earned per $100 of sales

Ways to increase gross profit

• Selling goods at higher prices
• Reducing the rate of trade discount to customers
• Buying goods at cheaper prices
• Using different sales mix i.e. selling some new items at higher prices (price skimming)

Reasons of low gross profit margin

• Business may be selling some products at lower prices

• Some products may be outdated obsolete so business might be selling them at lower price.
• Business may be buying goods at higher prices
• Business may not be able to pass increase in cost price to customer
• Business may be selling some new items at lower margin (penetration pricing)

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 Profit Margin
• This measures the overall success of the business
• The ratio shows the net profit earned per $100 of sales
• The ratio indicates how well the business controls its expenses

Ways to increase profit

• Reduce expenses e.g. reduce staffing levels, reduce advertising etc.

• Increase gross profit e.g. reduce purchase price, increase selling prices etc.
• Increase other income e.g. rent out part of premises, earn more discount etc.
• Increase sales volume by more seasonal sales promotions.

Return on capital employed (ROCE)

• The ratio shows the profit earned per $100 employed in the business
• The ratio measures the profitability of the investment in the business
• The ratio shows how efficiently the capital is being employed

Reasons of increase of ROCE

• Reduction of capital employed i.e. payback of loan, decrease in drawings
• Controlling expenses to increase profit

Liquidity Ratios

Current ratio
A business needs sufficient working capital for the day-to-day running of the business to pay expenses, liabilities, etc. as they
fall due so to measure liquidity we use current ratio.

It shows whether the business has sufficient current assets to meet its current liabilities.

Its benchmark is 2:1

Quick Ratio/ Liquid Ratio

The quick ratio shows whether the business would have any surplus liquid funds if all the current liabilities were paid
immediately from the liquid assets.

Its benchmark is 1:1

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Stock is not included in calculation because stock is not regarded as a liquid asset – a buyer has to be found and then the money
collected.

Ways to improve liquidity of business

• Introduce more capital (issue shares if limited company)
• Sell non-current assets
• Get loan
• Reduce inventory
• Extend trade payables
• Reduce trade receivables
• delaying drawings
• Sell of bonus share instead of paying dividend (For Limited Company)

Disadvantages to a business of having insufficient working capital.

• May have problems paying debts as they fall due
• May not be able to take advantage of cash discounts
• Cannot make the most of opportunities as they occur
• Difficulties in obtaining further supplies

Efficiency Ratios

Trade Receivable Turnover

It shows how frequently business is covering the amount from trade receivables. Early recovery is desirable.

Ways to reduce trade receivables turnover

4. Refuse credit terms to late payers
5. Offer cash discount for prompt payment
6. Charge interest on overdue accounts
7. Ask for cash with order / increase cash sales

Trade Payable Turnover

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It shows how frequently business is paying its trade payables. Late payment in line with industry average is desirable.

Impact of increasing trade payables turnover

8. Loss of cash discounts which would have impact on profits.
9. Cause some suppliers to refuse credit terms which would have an adverse effect on liquidity.
10. May create a bad relationship with supplier
11. May incur interest charges
12. Force the business to find alternative suppliers who are unable to supply goods on the same quality.

Comment on trade receivable and trade payable turnover

(Understand it)

• For good condition Trade Receivable turnover should be greater than trade payable turnover. If Trade payable would be
greater than it means business is paying earlier than recovering the amount so it might create liquidity issues.
• If previous year data is given then do comparison, for good condition business needs to be recovering the amount earlier
than previous years as well as industry average and paying the trade payables according to industry average.
• If business is recovering the amount later than previous year or industry average then this shows poor credit control
and it might lead to liquidity issues and bad debts.
• If business is paying trade payables earlier than previous year or industry average than it might be good for supplier
but for business it is not desirable as it shows some idle cash which can be utilized elsewhere to earn more return.

Non-Current Asset Turnover

This ratio shows the efficiency of non-current assets in order to generate sales.

it calculates how efficiently a company is a producing sale with its machines and equipment.

A high turnover indicates that assets are being utilized efficiently and large amount of sales are generated using a small
amount of assets. It could also mean that the company has sold off its equipment and started to outsource its operations. A high
turnover shows a smooth long-term growth.

A low turnover, on the other hand, indicates that the company isn’t using its assets to their fullest extent. This could be due to
a variety of factors. For example, they might be producing products that no one wants to buy. Also, they might have
overestimated the demand for their product and overinvested in machines to produce the products.

Ways to improve non-current asset turnover

• Purchased improve and updated non-current assets
• Use existing non-current assets more efficiently.

Inventory Turnover
It shows how frequently business is able to convert its inventory into sales.

Ways to increase rate of inventory turnover

53
 • Reduce inventory level (just in time method of inventory).
• Reduce mark up to be more competitive
• Promotions such as advertise products
• Offer cash discounts to encourage sales.

Disadvantages of holding too much stock

• Deterioration of inventory
• Obsolescence
• Space required for storage
• Risk of theft
• Cost of storage

Uses of Ratio Analysis

1. Helps to compare with competitors.
2. Helps to compare with industry averages.
3. Allow managers to measure their performance by setting targets/benchmark.
4. Helps to compare with previous year.
5. Provides information to users/potential investors.
6. Aids decision making by measuring profitability, liquidity, efficiency.

Limitation of Ratio Analysis

1. A ratio on its own is isolated (We need to compare it with some figures)
2. Depends upon the reliability of the information from which ratios are calculated.
3. Different industries will have different ideal ratios.
4. Different companies have different accounting policies. E.g. Method of depreciation used.
5. Ratios do not take inflation into account.
6. Ratios only consider the financial data it does not consider outside influences and qualitative factors e.g. world economy,
trade cycles.
7. Ratios do not explain the cause so after calculating ratios we still have to analyze them in order to derive a conclusion.
8. Ratios are based on historical data i.e. market value might differ

business people who would be interested in Business final accounts.

Bank manager
• Assessment of prospects of any requested loan/overdraft repaid when due
• Assessment of prospects of any interest on loan/overdraft being paid when due
• Assessment of the security available to cover any loan/overdraft

Lenders
• Assessment of prospects of any requested loan when due
• Assessment of prospects of any interest on loan being paid when due
• Assessment of the security available to cover any loan

Creditor for goods

54
• Assessment of the liquidity position
• Identifying how long the business takes to pay creditors
• Identifying future prospects of the business
• Identifying what credit limit is reasonable

55
 Accounting Concepts

Business Entity

Transaction related to a business must be separately recorded from those of its owners

Historical Cost

Assets should be recorded in the books of accounts at the amount originally paid to acquire the asset

Money Measurement

Business should only record an accounting transaction if it can be measured in monetary terms

Going Concern (continued)

Assumption that an entity will remain in business for foreseeable future.

Consistency

Once a business adopts accounting principle or method, it should continue following it consistently in
future accounting periods

Prudence (concept of conservatism)

A business should record all its expected losses in order to avoid overstatement of assets and profits.

Þ Depreciation
Þ PFDD
Þ Inventory lower Cost and NRV

56
Realisation

Revenue can only be recognized once goods associated with that revenue have been delivered to customer

Þ Sales on approval

Duality (dual aspect)

Every transaction has an equal but opposite effect i.e a credit and debit effect.

Materiality

A business can ignore accounting standards if the net impact of that action on financial statements will
not mislead a user of financial statement.

Matching (Accrual basis)

Revenue earned is matched with expense incurred in earning that revenue.

Þ Accrued Prepayment
Þ Depreciation
Þ PFDD

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58
59
 Substance over form
Substance over form requires that if the substance of a transaction differs from its legal form, then such transaction should be
accounted for in accordance to its commercial substance and financial reality. This means that a transaction should be recorded
according to the real intention in the mind of those undertaking the transaction although it contradicts the content of the
written agreement. The existence of this concept is mainly to deal with off balance sheet finance. An example is where an item
bought on hire purchase is recorded in the buyer’s book as a non-current asset although the seller is the legal owner until the last
installment is paid. The rationale behind this is that information contained in the financial statements should represent the
business essence of transactions not merely their legal aspects in order to provide a true and fair view. Substance over form
concept entails the use of judgment on the part of preparers of financial statements in order for them to derive the business sense
from the transactions and to present them in a manner that best reflects their true essence.

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 Overhead/Absorption Costing

Overhead costing is concerned with indirect production expenses (production overheads). These costs cannot be
charged directly to a product hence will have to be absorbed (added) indirectly using an overhead absorption rate (OAR).

The aim of overhead costing therefore is to establish an overhead absorption rate (OAR) which will be used to calculate
a fair amount of overhead to be added to/included in the cost of a product to obtain the total production cost of that product.
There are two approaches for establishing an overhead absorption rate namely:

1. Departmental rates
2. Factory wide rate/Blanket rate.

Factory-wide Overhead Absorption Rate (OAR)

As an alternative to departmental overhead absorption rates, some businesses establish a single overhead rate for the factory as a
whole and rate will be used to absorb production overheads to the products irrespective of the departments in which they were
produced. This single rate is known as the factory-wide or the blanket rate.

Factory wide OAR = Total budgeted factory overheads

Total budgeted activity

Benefits of Single Rate

ü Easier to calculate
ü Cheaper to calculate

Issues with single rate

Ó Less accurate
Ó Different product may spend different time in each department

Departmental Overhead Absorption Rates (OAR)

Business using a departmental overhead absorption rate (OAR) will calculate an OAR for each production department. Hence,
we may have two, three or four different rates depending on the number of production departments in the factory. Each
production department will therefore have its own overhead absorption rate for the purpose of absorbing production overheads to
the products passing through it.

61
Steps involved in calculating the overhead absorption rate (OAR) for each production department

1. Allocation or appointment of overheads to cost centres (departments)

2. Re-appointment of service cost centers’ total overheads to production cost centre’s.
3. Calculation of overhead absorption rate for each production cost centre using a suitable basis.

Allocation of overheads

Overhead allocation is the process of attributing overheads to particular department. Overheads are allocated/attributed to a
specific cost centre (department) when they arise directly as a result of the activities of the cost centre only. e.g. salary of a
manager of a particular department.

Allocation means charging overheads/cost to a specific cost centre where those overhead are clearly identified
with that cost centre.

Apportionment of overheads

Apportionment means charging overheads/cost that cannot be clearly identified with a specific cost centre, to a
cost centres on appropriate basis.

Overhead apportionment is the process of sharing overheads between various departments (Cost centres). Overheads have
to share between different cost centre’s when they cannot be allocated to a specific cost centre. Such overheads usually arise
as a result of the activities of various cost centre’s Heat and light, rent and power. An appropriate basis has to be used for
the purpose apportionment. Below is an attempt to provide a suitable basis for the purpose of sharing overheads between
various department.

Apportionment Basis

Overhead Basis
Rent of Building / factory Floor area
Insurance of Building / factory Floor area
Heating and lighting (Points used) Floor area / Kilowatt hours
If Power and Heat and light both are given then heat and light
should be apportioned on basis of Floor area. If only heat and
light is given as indirect cost then kilowatt hours are most
appropriate.
Indirect wages Number of employees
Depreciation of Equipment Cost / book value of assets
Insurance of equipment Cost / book value of assets
Repairs and maintenance of equipment Machine hours
consumable consumables
Supervision Number of employees

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Canteen cost Number of employees
Stores Number of issues / number of reacquisitions
Power Horse power / KW hours
inspection Number of inspection

Overhead absorption

The absorption of overhead is also known as the recovery of overheads. It refers to the entire process starting with allocation or
appointment of overhead, followed by calculation of OAR and ending the inclusion of overheads into product cost. In other
words, the process of ascertaining the total overheads costs of each unit of output or job by using overhead rate is
known as the absorption of overheads.

Cost centre – a cost centre can be a person, location, department, or function to which costs may be attributed/allocated. It is
also known as a responsibility centre.

Cost unit – a cost unit is a quantitative unit of a product in relation to which cost may be calculated e.g. meters of cloth, kilo of
sugar, liters of milk, ton of coal, batch of shirts, barrel of bear etc. …

Why Reapportionment is done

Overhead cost is reapportioned from service cost centres so that each unit of production contains a share of total overhead costs.

Basis commonly used for calculating overhead absorption rate (OAR)

1. OAR per machine hour = Budgeted overheads

Budgeted machine hours = $ per machine hour

2. OAR per labour hour = Budgeted overheads = $ per labour hour

Budgeted labour hours

3. OAR per unit = Budgeted overheads = $ per unit

Budgeted units of production

4. OAR as a percentage of = Budgeted overheads = % of direct wages/labour

direct wages/labour Budgeted direct wages/labour cost

5. OAR as a percentage of Budgeted overheads = % of direct material

direct material = Budgeted direct material costs

6. OAR as a percentage of Budgeted overheads = % of prime cost

Prime cost = Budgeted prime costs

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Any over-absorption or under-absorption of overheads is to be adjusted in the income statement to arrive at the final profit
figure. The amount of over-absorption is added whereas the amount under-absorption is deducted in arriving at the final profit
figure.

Overheads absorbed = OAR X Actual activity

Overheads absorbed > Actual overheads = Over-absorption
Overheads absorbed < Actual overheads = Under-absorption

Overheads absorbed minus Actual overheads = positive figure (means Over-absorption

= negative figure (means Under-absorption

Reasons of Over absorption

a. Actual Overhead is lower than absorbed overhead
b. Actual overhead is lower than budgeted/forecasted overhead.
c. Actual Activity is higher than budgeted activity.
d. Calculation error

Reasons of Under absorption

1. Actual Overhead is greater than absorbed overhead
2. Actual overhead is greater than budgeted/forecasted overhead.
3. Actual Activity is lower than budgeted activity.
4. Calculation error

Consequences of over absorption and under absorption

Over absorption, too much overhead charged to production, overpriced and uncompetitive, fall in demand and subsequent loss of
revenue/reduction in profit.

Under absorption, insufficient overhead charged to production, lower price to customer, costs not covered and subsequent
reduction in profits

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Job Costing

Job Costing is a method of costing which is usually being used where the cost of a tailor-made job has to be calculated. A tailor-
made job is a specific order made by a whereby specific criterion have to be observed.

Statement to calculate cost of Job X

$ $
Direct material: Dept. A xx
Dept. B xx
Dept. C xx xxx

Direct labour: Dept. A xx

Dept. B xx
Dept. C xx xxx

Production overheads: Dept. A xx

Dept. B using departmental rates xx
Dept. C xx xxx
Alternatively, where a factory wide rate is in use then only a single rate
will be used to calculate the amount of overheads to be added. Instead of
having an amount for each department, there will be only one figure.

Total production cost xxx

Add Administrative overheads xx
Total cost of the job xxx
Add profit xx

Selling price xxxx

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Benefits of Absorption Costing

1. Using absorption costing as a basis to take decisions ensures that the firm is taking less risk since
total costs (fixed & variable) are being considered so useful in setting selling price for a product.
2. Accounting standards recommend the use of absorption costing for financial reporting as it values
inventory in accordance with IAS 2
3. Absorption costing takes account of all cost so it confirms to the matching principle which require
cost to be matched to revenue for a period.

Limitation of Absorption Costing

1. More complex/ may require specialist knowledge

2. Problems in forecasting activity level for the purpose of calculating overheads recovery rates.
3. Problems of over-absorption and under-absorption of production overheads.
4. If actual activity turns out to be different that forecast (normal), an incorrect amount of overhead
will be included in inventory.
5. Focusing on total cost for decision making may result in the firm losing out contracts which would
have increased the firm’s overall profit.
6. The basis used to apportion and absorb overheads may be arbitrary (random choice/subjective).
7. Irrelevant in short term decision making as fixed cost don’t change.

Accepting order below normal selling price

• Contribution
• Profit
• Spare capacity
• Will new customer become regular customer or will bring more orders?
• Effect of reduction of price on existing customer i.e. they will pressurize for reduction in prices.

66
Marginal and Absorption costing

Marginal Costing
Marginal Costing also known as direct costing or variable costing is a basis of costing which is commonly
used for short term decision making. Under this basis emphasis is laid on the variable cost of a product and
its contribution. Furthermore, inventory is valued at variable production cost only. The fixed production
costs are not included in production cost and inventory valuation, instead they are treated as an expense
for the period.
Statement of profit under Marginal costing

$ $
Revenue (units sold x selling price) xx
Less variable costs
Opening inventory (units x variable production costs per unit) xx
Add Variable Production Cost xx
(units produced x variable production overhead per unit
Less closing inventory (units x variable production costs per unit) (xx)
Add variable selling and distribution costs xx
(units sold x variable selling costs per unit)

Total variable costs (xx)

Contribution (revenue – total variable costs) xx
Less fixed costs: fixed production overheads (actually incurred) (x)
fixed selling and distribution costs (x)
Profit of the year xx

Calculation of units of inventory (Marginal and Absorption costing)

Opening inventory xx
Add units produced xx
Less units sold (xx)
Closing inventory xx

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Calculation of value of inventory (Marginal costing)

Value of inventory = Units in inventory x variable production cost per unit

Variable production cost per unit = + Direct/variable material cost per unit
+ Direct/variable labour cost per unit
+ Variable production overheads per unit

Absorption costing
Absorption costing also known as total costing or full costing is a basis of costing under which the fixed
production overheads also are included in the cost of production and inventory valuation. The fixed
production overheads are absorbed (added) into units of production using a pre-determined rate per unit
known as overhead absorption rate (OAR).

OAR per unit = Budgeted fixed production overheads

Budgeted or normal activity level (units)

If actual activity turns out to be higher or lower than budgeted activity or actual overheads is higher or
lower than budgeted overheads, this will result in over-absorption or under-absorption of overheads and
has to be adjusted in the income statement.

Overheads absorbed = OAR x Actual activity

Overheads absorbed > Actual overheads = Over-absorption
Overheads absorbed < Actual overheads = Over-absorption

Calculation of value of inventory (Absorption costing)

Value of inventory = Units of inventory x Total production cost per unit

Total production cost per unit = + variable material cost per unit
+ variable labour cost per unit
+ variable production overheads per unit
+ fixed production overheads per unit (OAR)

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 Statement of profit under Absorption costing
$ $
Revenue (units sold x selling price) xx
Less cost of sales
Opening inventory (units x total production costs per unit) xx
Add Variable Production Cost (Units Produced * VPC/unit) xx
Add Fixed production overheads Absorbed (OAR x Actual units produced) xx
Less closing inventory (units x total production cost per unit) (xx)

Cost of sales (xx)

Gross profit xx
Add over-absorption of overheads* x
Less under-absorption of overheads* (x)
xx
Less Expenses
Variable selling and distribution costs (units sold x variable selling costs per unit) (x)
Fixed selling and distribution costs (x)

Profit of the year xx

Statement reconciling profit under Absorption costing with profit under Marginal costing
$
Profit under Absorption costing xx
Add difference in opening inventory x
Less difference in closing inventory (x)

Profit under Marginal costing xx

OAR per unit = Difference between Absorption costing profit and Marginal costing profit
Difference in units of opening inventory and closing inventory

The above formula can be applied if the cost structure is unchanged, that is variable production cost per
unit and fixed production cost per unit (OAR per unit is constant over the years.

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 Benefits of Marginal Costing

1. Easier to operate.
2. Aids short-term decision making.
3. Enables optimum allocation of resources.
4. Avoids the problems of over/under absorption.

Limitation of Marginal Costing

1. Difficult to classify costs as either fixed or variable due to the existence of semi fixed and semi variable costs.
2. Does not value inventory according to IAS 2.
3. Ignores fixed cost in decision making hence taking greater risks.

Why profit is changed under both costing methods

In marginal costing inventory is valued at variable production cost and fixed production overhead are considered as period cost
whereas in absorption costing fixed production overhead is considered as product cost and inventory is valued at full production
cost i.e. fixed production cost is part of inventory valuation so due to difference in inventory valuation profit differs.

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 Cost-Volume-Profit Analysis

Cost-volume-profit analysis examines the interaction of a firm’s sales volume, selling price, cost structure
and profitability. It is a widely used and very powerful tool in managerial accounting that’s helps to take
better marketing, production, investment, and financing decisions. Its provides answers to the following
issues:
1. How many units a firm must sell to break-even?
2. How many units must be sold to earn a certain amount of profit?
3. By how much sales may fall before the business start incurring losses?
4. Should the business invest in highly automated machinery and reduce its labour force?
5. Should the business advertise more to improve sales and profit?

Cost-volume-profit analysis is therefore a simplified cost accounting model, useful for elementary
instruction and short-term decisions. As with any other models, cost volume profit analysis also is based
on a series of assumptions.
The assumptions underlying cost-volume-profit analysis are as follows:
1. Costs can be classified accurately as either fixed or variable.
2. Fixed cost remains constant.
3. The behavior of both variable cost and sales revenue is linear throughout the relevant range of
activity, the implies that unit variable cost and selling price remain constant.
4. Changes in activity (volume) are the only factor affecting cost and revenue.
5. All units produced are sold, meaning that there is no inventory or inventory levels are
constant.
6. Where a business is selling more than one product, the sales mix is constant, that is the ratio of
each product sales to total sales remains unchanged.

Methods of calculating Break-even point

One of the focuses of CVP analysis is break-even analysis. As mentioned earlier, the break-even point is
that level of activity where the business is neither earning profit nor incurring losses. Hence at that level,
total revenue must be equal to total cost. There are two methods for ascertaining this break-even point
namely the equation method and the graphical method.

Equation Method

A little bit of simple math can help us solve numerous cost-volume-profit questions. We know that profit
(P) is the difference between total revenue (TR) and total cost (TC). Since at break-even profit is zero,
hence, total revenue is equal to total cost. We also know that total cost is made up of total fixed cost (FC)
and total variable cost (VC). Total revenue and total variable cost can be obtained by multiplying units
sold (Q) by selling price per unit (SP) and total variable cost per unit (UVC) respectively. By putting this
information into a simple equation, we come up with a method of answering CVP type questions.

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 Profit = TR – TC
Profit = TR –VC –FC
Profit = (SP x Q) – (UVC x Q) - FC

Profit =
Contribution – Fixed cost
Unit contribution x Margin of safety in units
Contribution to sales ratio x Margin of safety in dollars

Total contribution =
Sales revenue – Total variable costs
Unit contribution x Sales in units
Fixed costs + Profit
Contribution to sales ratio x Sales revenue

Contribution

Contribution is the amount remaining after all variable cost have been subtracted from revenue.

Contribution is the amount available to service the fixed cost.

Unit contribution
Selling price – Total variable cost per unit
Total contribution ÷ Sales in units
Contribution to sales ratio x Selling price
Fixed cost ÷ Break-even points in units
Change in profit ÷ Change in sales volume
Fixed cost per unit + profit per unit

Contribution to sales ratio

Total contribution ÷ Sales revenue
Unit contribution ÷ Selling price
1- Variable cost to sales ratio

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 Change in profit ÷ Change in sales revenue

Break-even point in units

We can use the profit equation to calculate the break-even point.

Again, mathematical manipulation can provide us with a series of equation for computing the break-even
point in units.

Break-even point in dollars =

Fixed costs ÷ Contribution to sales ratio
Break-even point in units x Selling price
Actual sales revenue – Margin of safety in dollars
Fixed costs + (Break-even point in units x Total variable cost per unit

Margin of safety in units

The margin of safety indicates by how much sales may fall before the business starts incurring losses. It
highlights the risk of losing money that a business faces. Margin of safety in units is the excess of the
budgeted or actual sales in units over the break-even point in units.

Importance of margin of safety

It provides an assessment of risk by indicating the extent to which expected output can fall, before a loss is
made.

It shows the ability to withstand adverse trading conditions. The greater the margin of safety, the greater
are profits and the safer is the company’s position.

Margin of safety in units =

Actual sales in units – Break-even point in units
Profit ÷ unit contribution
Margin of safety in dollars ÷ Selling price

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Margin of safety in dollars

Margin of safety can also be expressed in terms of dollars.

Margin of safety in dollars =

Actual sales revenue – Break-even point in dollars
Profit ÷ contribution to sales ratio
Margin of safety in units x Selling price

Margin of safety as a percentage

The excess of the actual sales over the break-even sales expressed as a percentage of the actual sales is the
margin of safety percentage.

Margin of safety as a percentage =

Margin of safety in units ÷ Actual sales in units x 100
Margin of safety in dollars ÷ Actual sales in dollars x 100

Target Profit

Cost-Volume-Profit analysis can also be used when a company is trying to determine the level of sales
necessary to achieve a target profit.

Sales volume required to earn target profit =

(Fixed cost + Target profit) ÷ unit contribution
Sales revenue required to earn target profit ÷ Selling price

Sales revenue required to earn target profit =

(Fixed cost + Target profit) ÷ Contribution to sales ratio
Sales volume required to earn target profit x Selling price

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Budgeting and Budgetary Control

Business Planning
The management of the business need to plan in advance in order to run a successful business.

Planning can be broken down into two parts

Long term Planning (Strategic or Corporate Planning)

Management identifies the current position of the business by looking at the accounting data. This is the starting point for all
future strategies. After analyzing the current position, they try to analyze the circumstances that the business is likely to
encounter in the period of the plan for e.g. likely future demand of the product, influence of competition etc.

Short Term Planning: (Operational Planning)

Operational plans on short term basis are called budgets. They show what management hope to achieve in a future time period
in terms of overall plans and individual departmental plans.

Benefits of planning for the future

1. Identify underperforming products

2. Ensure sufficient skilled is available to meet production.
3. Ensure sufficient finance is available to continue operations and any planned investments.
4. Ensure the correct quality/cost of material can be obtained from suppliers.
5. Be able to adapt to changes in the future/provides alternatives if financial targets are not being met.

Benefits of Budgetary Control

1. Increase in motivation of managers if they are involved in setting budgets

2. Managers efficiency could be improved as a result of clear objectives
3. Will provide clear indication of individual managers areas of responsibility and therefore improve coordination between
departments
4. Facilitates planning which enables targets to be set and improve performance by analyzing variances.
5. Facilitates profit maximization
6. Facilitates working capital requirement planning
7. Enables capital expenditure planning
8. Enhanced cash management by identifying future inflows and outflows.

Limitation of Budgetary Control

1. Could result is demotivation if targets are unrealistic

2. Can be a time consuming and costly operation.
3. May be problems implementing the control system, employees may be resistant to change.
4. Can restrict staff innovation
5. May require specialist staff
6. Budgets are an estimate and could be inaccurate
7. Could lead to conflict between department

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Decision Making

Quantitative Factors

• Contribution
• Level of Profit
• Breakeven
• Margin of Safety

Note: on commenting related to proposal / options…. first comment on additional profit / additional
contribution generated and comment may be proceeding further if breakeven or margin of safety
calculation possible.

Qualitative Factors
Decision related to Overtime

Advantages Disadvantages
Knows ability of workers Workers may refuse
Knows quality of work Possibility of lower quality (low productivity)
Demand will be meet Additional other costs (training/power)
There would be no delivery implications due to in- Trade union pressure
house production

Decision related Buy-in

Advantages Disadvantages
If there is spare capacity it can be used for other Doesn’t know quality / reliability of supplier
products (use of idle resources)
May be more expensive (Delivery issues)
Demand will be meet May allow competition into market
May not be able to save all cost (selling cost)
Effect on morale of staff if using external supplier

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 Decision related to special order (below normal selling price)

Advantages Disadvantages
Increase in customer base An over reliance on special orders is not a long-term solution and
the company should put priority on achieving full price orders
small effect on fixed costs Loyal customers paying full price will be annoyed to discover
other paying less
Better utilization of spare capacity Reaction of competitors needs consideration. They may
respond by cutting their prices and start a price war.
Special orders are not a long-term solution, fixed costs must be
covered.

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