Copy - 2 - of Principles of Accounting Note Year 1

FINANCIAL ACCOUNTING
DEFINITION AND NATURE OF ACCOUNTING

Introduction: Any organized group or business, regardless of its size has certain resources and obligations which are influenced by a number of business transactions undertaken by it for the accomplishment of its objectives. It is not possible for a person or a group of persons to remember the occurrence of these events and their impact on business. Therefore these transactions are recorded in certain books known as books of accounts. Not only this, they are also analyzed, interpreted and communicated to the interested parties who use the information as basis for their decision. The person responsible for these processes is called accountant and the system incorporating these processes is known as accounting Many business decisions were taken without reference to any data. Most firms were closed down because of poor methods of recording data. With the introduction of book-keeping, this problem to some extent has been overcome.
What is book-keeping?
It is the art of recording business transactions in terms of money or moneys worth in a regular and systematic manner so that information in regard to them may be readily or quickly obtained. A person who does the work of book-keeping is called a book-keeper; that is he/she keeps the books of accounts.
What is accounting?
There are various ways in which accounting may be defined. Some of them are given below: The American Institute of Accountants defined accounting in 1941 as 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 a financial character, and interpreting the results thereof. The American Accounting Association defined accounting as the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information The rather broad definition is appealing because it highlights the fact that accounting exists for a particular purpose. That purpose is to help users of accounting information to make more informed decisions. If accounting information is not capable of helping to make better decisions then it is a waste of time and money to produce. Sometimes, the impression is given that the purpose of accounting is simply to prepare financial reports on a regular basis. Whilst it is true that accountants undertake this kind of work, it does not represent an end in itself. The ultimate purpose of the accountants work is to influence the decisions of users of the information produced.
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BRANCHES OF ACCOUNTING
Accounting as a discipline is constantly developing and expanding. There are several branches of accounting, the major branches of accounting are: Financial Accounting Cost and Management Accounting Tax Accounting Auditing Public Sector Accounting
Financial Accounting
Financial Accounting focuses on the stewardship function of management by generating reports that explain how financial resources made available by lenders and owners have been applied for the business of the enterprise. Financial Accounting deals mainly with the recording of historical data and the preparation of reports on past events.
Cost and Management Accounting

Cost and Management Accounting focuses on providing information to management to be used for the planning, control and decision making purposes. The emphasis is on making estimates about the cost and benefits of future events so as to ensure that the enterprise achieves its objectives.
Tax Accounting
Tax Accounting is concerned with arranging the tax issues of individuals and organizations. It involves the computation of tax obligations as well as advising on various ways of carrying on business so as to minimize the tax obligation of organizations. Tax Accountants also provide service to government institutions in charge of revenue mobilization for the state. They help in the assessment of taxes.
Auditing
This branch of accounting provides assurance to various users of financial statements that the financial statements are true and fair and that users can reasonably rely on the statements for planning, control and decision making purposes.
Public Sector Accounting

Public Sector Accounting is the branch of accounting that concentrates on public sector organizations such as central government, local government, non-governmental organizations etc. It encompasses financial accounting, cost and management practices in public sector organizations.
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USERS OF ACCOUNTING INFORMATION AND THEIR INFORMATION NEEDS

For accounting information to be useful, the accountant must be clear about for whom the information is being prepared and for what purpose the information will be used. There are likely to be various user groups with interest in a particular organization. The most common users are shown in
MAIN USERS OF FINANCIAL INFORMATION RELATING TO A BUSINESS

Owners Customers Competitors
Managers
Business m
Employees and their representatives
Lenders
Government Suppliers Investment analysts Community representative
Table User Group Customers Employees Use To assess the ability of the business to continue in business and to supply the needs of the customers To assess the ability of the business to continue to provide employment and to reward employees for their labour To assess how much tax the business should pay, whether it complies with agreed pricing policies, etc to assess the likely risks and returns associated with the business in order to determine its investments potential and to advise clients accordingly To assess the ability of the business to pay for the goods and services supplied (liquidity and solvency) To assess the ability of the business to meet its obligations and to pay interest and to repay the principal
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Government Investment/Financial analysts Suppliers Lenders (Banks)
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Managers Owners
To help them to make decisions and plans for the business and to exercise control to try to ensure that plans come to fruition. To assess how effectively the managers are running the business and to make judgments about likely levels of risks and returns in the future
CHARACTERISTICS (DESIRABLE QUALITIES) OF GOOD ACCOUNTING INFORMATION

Good accounting information must have the following qualities:
Relevance
Accounting information must have the ability to influence decisions. Unless this characteristic is present, there really is not any point producing the information. The information may be relevant to the prediction of future events or relevant in helping confirm past events. Relevant implies the following: Timeliness Completeness Appropriateness and suitability to user objective
Timeliness
Since information has an objective, there are usually periods within which these objectives operate. Good information neither is produced too frequently nor is it compiled after it is needed most. For instance, information that reaches a decision-maker after the decision is of limited use in the context of the decision-making process.
Completeness
Good accounting information is complete. This means that it provides intended users with all the information that is necessary to fulfil their information needs and requirements. Completeness also suggests that all necessary information is included in any report that the organisation produces. The assumption is that there would be no error of omission in the information.
Reliability
Accounting information is reliable if it is free from material errors or bias, it is complete and faithfully represents what it purports to represent. Reliability implies reasonable accuracy.
Accuracy
It is almost self-evident that accounting information should be accurate. This does not suggest that you must always state figures and facts down to the last penny or detail. What it means is that information should be accurate enough for its intended purpose (or user), without being unnecessarily detailed.
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Inaccurate information cannot provide a valid representation of reality and can limit the effectiveness or worth of decisions based on it.
Comparability
Accounting information should permit meaningful comparison between one period and another as well as between one company and another. Comparability requires that items which are basically the same should be treated in the same manner for measurement and presentation purposes.
Understandability
Accounting reports should be expressed as clearly as possible and should be understood by those for whom the information is aimed. In other words, information must be understandable before it can be useful.
Cost-efficient
Valuable information should not cost more to produce than it is worth. This is the reason why information that is produced more regularly than required is less useful/ valuable than information that is produced to satisfy a specific need or requirement.
The Characteristics Which Influence the Usefulness of Accounting Information
Relevance
Reliability
Can produce
Useful accounting information
Which will be limited by

Cost/benefit
The lack of
Timelinessess Comparability Understandability
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Constraints/Problems on Relevant and Reliable Information

In theory, financial information should be produced only if the cost of providing that piece of information is less than the benefit, or value, to be derived from its use. Some of the constraints are indicated below. Figure 1.2 above illustrates further. Timeliness Balance between benefit and cost(cost/benefit analysis)
ACCOUNTING STANDARDS
Accounting Standards are pronouncements made by the standard setters which are expected to be used in the preparation of financial statements. The standard setters include Ghana national Accounting Standards Board (GNASB), Accounting Standards Board (ASB) in the U.K, Financial Accounting Standards Board (FASB)in the U.S. The international Accounting Standards Board (IASB) constituting the professional accounting bodies which are members of international Federation of Accountants (IFAC) such as ICA (Ghana), ACCA, ICA(Eng &Wales), AICPA, ICA(Scotland), etc. Standards are not static; but are revised continuously to suit changing business environment .
THE ROLE OF THE ACCOUNTANT IN AN ORGANIZATION

Who is a professional accountant?
The term accountant has been used loosely in the literature to refer to different grades of accounting personnel. We need to distinguish between the qualified self-disciplined, ethically motivated professional chartered accountant from the self-proclaimed accountant. According to the Institute of Chartered Accountants Ghana code of professional conduct, the term professional accountant refers to those individuals, whether they be in public practice, industry, commerce, the public sector or education who are members of an IFAC member body. According to the Chartered Accountants Act 1963, Act 170, the term Chartered Accountant refers to those individuals who have been admitted into membership of the Institute of Chartered Accountants (Ghana) as having successfully completed the qualifying examinations of the institute. The term excludes individuals who have been admitted into membership of the Institute as Practicing Accountant. In accordance with section 13 of the Chartered Accountants Act 1963, Act 170, any person, not being a chartered accountant, who hold any of the qualifications prescribed by the council, shall be eligible for
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registration as an accountant. any person who is registered as such shall be called Practicing Accountant, and shall be entitled to use the expression P.A.: after his name to indicate that he is so registered.
The role of the accountant

In a global economy such as we are experiencing in recent times, which is characterized by changing technology and complex production systems, it is logical that there will continue to be significant changes in the systems of production, commerce and the management of private and public enterprises. In such an environment, the role of the accountant cannot be overemphasized. The role of the accountant can be summarized below: To collect and process financial data and communicate the resultant information for the purpose of decision making and control. Decision making is essentially about making choices. The rate of success in any venture depends on the soundness of decisions impacting on the venture and the effectiveness and efficiency in the implementation of such decisions. The professional accountant is best placed by virtue of his training to provide reliable information for the making of good decisions as well as the effective monitoring of the execution of the decisions to ensure that decisions are well executed. There are five areas that the professional accountant could be identified with. These areas of practice are: Accountants in public practice, Accountants in industry, Accountants in governmental institutions, Accountants in Non-Governmental institutions and Accountants in education.
Accountants in public practice

Public accountants (or the Chartered Accountants or auditors as they are popularly called) are independent professional persons comparable to attorneys or physicians who offer accounting services to clients for a fee. The main areas of accounting covered by public accountants include: auditing, tax services and management advisory services.
Accountants in industry
These are accountants employed by private enterprises in industry. The work of accountants in industry may include the following: designing accounting and internal control systems, performing financial accounting duties; such as managing accounts payable, managing accounts receivable, preparing financial statements etc. Their work also includes performing cost accounting and management accounting functions.
Accountants in government and non-governmental institutions

Central and local government departments and agencies rely on financial information to help them direct the affairs of their departments and agencies. There is therefore the need for these institutions to employ professional accountants to carry out these responsibilities. The case is the same for non-governmental institutions.
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Accountants in education
Research to develop accounting principles and practices which keep pace with changes in the economic and political environment should be a major activity of professional accountants and accounting educators. Accounting is not a closed system but a constantly evolving body of knowledge, a critical examination and review of accounting principles and practices clearly reveal that there are several problems and conflicts in accounting for which fully satisfactory solutions have not been developed. The responsibility for teaching and encouraging research in accountancy and securing the well being and advancement of the accounting profession lies on university accounting lecturers, accounting practitioners and professional accounting organizations. It is thus important to have professional accountants in education to promote research in accountancy.
INTRODUCTION TO DOUBLE ENTRY

The Accounting Equation
The whole of financial accounting is based on a very simple idea. This is called the accounting equation. Resources In The Business=Resource Supplied By The Owner This implies that the resources supplied by the owner to set up a firm are all the resources the business has. Again, this confirms the saying that A business owns nothing and therefore does not owe. What it owns it owes. In accounting the amount of resources supplied by the owner is called CAPITAL. The actual resources that are then in the business are called ASSETS. Therefore the accounting equation can be related as ASSETS = CAPITAL Usually, however, people other than the owner e.g. Banks, lenders etc. have supplied some of the assets. Liabilities are the name given to the amount owing to the people for these assets. The equation has now changed to: ASSETS = CAPITAL + LIABILITIES It can be seen that the two sides of the equation will have the same total. This is because we are dealing with the same thing from two viewpoints. It is: Resources: which are (Assets) = Resources: who supply them (Capital + Liabilities) It is fact that the totals of each side will always equal one another, and that this will always be true no matter the number of transactions there may be. The actual assets, Capital and liabilities may change, but the total of the assets will always equal the total of the capital + liabilities. ILLUSTRATION The following information relates to Ashili Enterprise for the month of January, 2008. a) Started business with GH25,000cash.
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b) Deposited GH15,000 in a newly opened bank account. c) Bought goods costing GH5,500, on credit from Jalal. d) Purchase machinery GH10,000 paying GH7,000 immediately by cheque. e) f) g) h) i) Sold goods costing GH2500 to Zidan on credit for GH3, 000. Borrowed GH4,000 cash from Sham. Cash purchases of goods GH5,300, Zidan paidGH2,200, cash in partial settlement of his debt. Goods withdrawn for personal use GH500. You are required to show the effect of each transaction on the accounting equation and prepare a balance sheet as at 31st January, 2008.
ANALYSIS OF ILLUSTRATION a) Started business with GH25,000cash ASSETS = LIABILITIES Cash 25,000 b) = = 0 0
+ + +
CAPITAL Capital 25,000
Deposited GH15,000 in a newly opened bank account. Cash + Bank = = = = Capital 25,000 0 25,000
Old bal. 25,000 + 0 Effects (15,000) + 15,000 10,000 c) + 15,000
Bought goods costing GH5,500, on credit from Jalal. Cash + Bank + Stock = Creditors + = = 0 5,500 = 5,500 + + Capital 25,000 0 25,000
Old bal. 10,000 + 15,000 + 0 Effect New 0 + 0 + 5,500
10,000 +
15,000 5,500
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d)
Purchase machinery GH10,000 paying GH7,000 immediately by cheque. Cash + Bank + Stock + Machinery= Creditors + Capital
Old bal. 10,000 + 15,000 + 5,500 + Effects New 0 + (7,000) + 10,000 + 8,000
= = =
5,500 + 3,000 +
25,000 3,000
0 + 10,000 +5,500 + 10,000
8,500 + 25,000
e)
Sold goods costing GH2500 to Zidan on credit for GH3, 000. Cash + Bank + Stock + Machinery + Debtors = Creditors+ Capital
Old bal. 10,000 + 8,000 + 5,500 Effects 0 10,000 +
+ 10,000 + 0 0 + 3,000 3,000
= 8,500 + 25,000 = +0 + 500 25,500
0 + (2,500) + 8,000 3,000
10,000
8,500
f)
Borrowed GH4,000 cash from Sham. Cash + Bank + Stock + Machinery + Debtors= Creditors + Loan+ Capital 3,000 = 8,500 + 0 = 0 0 + 25,500 0 25.500
Old bal.10,000 + 8,000 + 3000 + 10,000 + Effects New 4,000 + 14,000 0+ 8,000 0+ 3,000 0 10,000 +
+ 4,000 + 4,000
3,000 = 8,500
g)
Cash purchases of goods GH5,300, Cash + Bank + Stock + Machinery + Debtors= Creditors + Loan+ Capital
Old bal.14,000 + 8,000 + 3000 + 10,000 Effects (5,300) + New 8,700 0 8,000 + 5,300 + 8,300 0 10,000
+ 3,000 +
= 8,500 0 = 0
0 + 25,500 + 4,000 + 4,000 0
3,000
= 8,500
25.500
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h)
Zidan paidGH2,200, cash in partial settlement of his debt Cash + Bank + Stock + Machinery + Debtors= Creditors + Loan+ Capital 25,500 0 25.500
Old bal. 8,700 + 8,000 + 3000 + 10,000 + Effects 2,200 + 0 + 5,300 + New 10,900 8,000 8,300 0 10,000
3,000 = 8,500 + 0 8,500
0 +
+ (2,200) = 800 =
+ 4,000 + 4,000
i)
Goods withdrawn for personal use GH500. Cash + Bank + Stock + Machinery + Debtors= Creditors + Loan+ Capital 25,500
Old bal.10, 900 + 8,000 + 8300 + 10,000 + Effects New 0+ 10,900 0+ 8,000 (500) + 7,800 0 10,000 +
800 = 0 = 800 =
8,500 + 0 8,500
0 +
+ 4,000 + (500) 4,000 25.000
Ashili Enterprise Balance Sheet as at 31 January 2008 GH 25,000 GH Fixed Assets Machinery Current Assets: Stock Debtors Bank Cash GH 10,000 7,800 800 8,000 10,900 27,500 37,500
Capital Long term Liabilities: Loan Current Liabilities: Creditors
4,000
8,500 37,500
The balance sheet attempts to show the financial position of a business at a point in time. There is currently one professional way of setting out the balance sheet vertical as illustrated below;
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Kofi Wayo Balance sheet as at 31December 2009 Fixed Assets/Non-Current Assets: Cost Dep. Land and building Plant and Machinery Motor Vehicles Furniture and Fittings Fixtures Current Assets: Stock/Inventory Debtors/ Receivables Less provision for bad debts Prepayments Bank Cash Less Current Liabilities: Creditors/Payables Accruals/Owings Bank overdraft WORKING CAPITAL NET ASSETS Financed by: Capital Add net Profit Less Drawings Long Term Liability: Loan . Quiz. *** *** *** *** *** **** (***) (***) (***) (***) (****) *** *** (***) *** *** *** *** ****
NBV *** *** *** *** *** ****
*** *** ***
(****) ***** **** *** *** **** (***) *** *** ****
Dr. Commando started a business on 31st December 20x1. Before he actually starts to sell anything, he has bought fixtures 200,000 Motor vehicle 500,000 and stock of goods 350,000. Although he has paid in full for the fixtures and the motor vehicle, he still owes 140,000 for some of the goods. Mr. John had lent him 300,000. Dr. Commando, after the above, has 280,000 in the business bank account and 100,000 cash in hand.
You are required to calculate his capital and draft his balance sheet.
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THE RECORDING PROCESS

Most companies employing more than a handful of staff use the system of recording called double entry bookkeeping. This system records both cash and credit transactions as they occur at their different times. The name double entry derives from the fact that each individual transaction is entered twice, recognizing two aspects. These two aspects are referred to by accountants as debits and credits.
THE DOUBLE ENTRY SYSTEM

We have seen in our previous studies that every transaction affects two items. For example if a business purchases stock worth 200,000 and issues cheque, the transaction affects stock of goods i.e. Stocks increase by 200,000 and cash at bank decrease by 200,000. In this case for each transaction bookkeeping entry will have to be made to show an increase in stock and decrease in cash at bank. This is double entry system. Double entry system of bookkeeping is good because drawing up balance sheet after every transaction will not give enough information about the business. It does not for instance tell who the debtors are and how each one of them owes. Lets recall the double entry rules
DOUBLE ENTRY RULES ARE:

ACCOUNTS Assets TO RECORD An increase A decrease Liabilities An increase A decrease Capital An increase A decrease Expenses An increase A decrease Revenue/Income An increase A decrease ENTRY IN THE ACCOUNT Debit Credit Credit Debit Credit Debit Debit Credit Credit Debit
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ELEMENTS OF BALANCE SHEET STATEMENTS 1. 2. 3. Assets Liabilities Equity/Capital
The these three elements are directly related to the measurement of financial position. Assets Resources controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Assets are classified as current and noncurrent. Noncurrent Assets Are expected to be in the business for more than one year (12 calendar months) are referred to noncurrent assets. E.g. Equipment, plant, Land and buildings, Investment property etc. Current Assets are expected to be realized or intended for sale or consumption in the entitys normal operating cycle Assets held primarily for trading Assets expected to be realized within 12 months after balance sheet date. Cash or cash equivalents Liabilities An entitys indebtedness to third parties. Claims against the assets of the business by outsiders Liabilities can be current or noncurrent Current Liabilities are liabilities expected to be settled in the entitys normal operating cycle liabilities held primarily for trading Liabilities due to be settled within 12 months after the balance sheet date. Noncurrent Liabilities Liabilities due to be settled more than 12 months after the balance sheet date Long-term interest-bearing liabilities to be settled within 12 months after the balance sheet date can be classified as noncurrent if the original term is greater than 12 months it is the intention to refinance or reschedule the obligation The agreement to refinance or reschedule is completed on or before the balance sheet date.
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AN ACCOUNT
An account is a statement, which records all the transactions of a specific class, which have taken place during a given period. Account in its simplest form, has three elements: (1) a title consisting of a particular assets, liability or owners equity; (2) a left side, which is called debit side; and (3) a right side, which is called the credit side This form of account, illustrated below, is called a T account because of its resemblance to the letter T. Account Title Left Side (Debit) Date Details Folio Amount Right side (Credit) Date Details Folio Amount
CLASSIFICATION OF ACCOUNT
Personal and Impersonal Account (divided into Real and Nominal Accounts) Ledger accounts which bear the names of individuals, partnerships or companies are called Personal Accounts; All other accounts are called Impersonal Accounts. Impersonal accounts may be further sub-divided into two classes: Real Accounts Recording transactions in property and material objects. (E.g. motor van, Land and Building, stock, cash etc) Nominal Accounts records expenses, losses, revenue, incomes or gains. (E.g. sales, purchases, rent and rates, interest paid and receive, etc) A diagram of the types of accounts commonly used Accounts
Personal Accounts Debtors Accounts Creditors Account
Impersonal Accounts Real Accounts for Possessions Nominal Accounts for Expenses, Income
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LEDGER
A ledger is the principal book of account. It is a collection of accounts, maintained by transfers from the books of original entry. The ledger may be sub divided as follows: Sales ledger (Debtors ledger)- this ledger contains the personal account of all customers Purchases ledger (creditors ledger) - this ledger contains the personal account of all suppliers. General ledger (nominal ledger) this ledger contains all other accounts relating to assets, liabilities, expenses, income, capital and drawings.
ACCOUNTING CYCLE (PROCESS)

1. 2. The process of recording, classifying and summarizing which is repeated in the same order each accounting period is referred to as the ACCOUNTING CYCLE. Several steps are involved from recording of transactions, analysis of those transactions to the generation of financial statements. These steps are collectively called the Accounting Cycle. Analyse the transactions in terms of its effects on the accounting equation Pass the entry in the journal Post the entry to the ledger Balance accounts and extract trial balance Pass and post adjusting entries Prepare financial statements (Income statement, Balance sheet and Cash flow statement)
BALANCING OFF ACCOUNTS

Before a trial balance can be drawn up the ledger must be balanced. At the end of each accounting period the firm will wish to balance its accounts off. An accounting period is normally one year but most firms will wish to balance off their accounts on a more frequent basis - usually every month. The more frequently a firm balances its accounts off, the less likely it is to make mistakes. The process of balancing accounts off should not be rushed. It is, in effect, the final part of the double entry system of bookkeeping. Once accounts have been balanced off then the firm can begin to assess whether it has made a profit and if so how much profit has been generated. The balance on each account is simply the difference in the totals of the debit side of the account and the credit side of the account. For example, if the debit side of an account added up to GH190 but the credit side of the account added up to GH330, then we would say that the account had a credit balance of GH330 - GH190 = GH140. Some things to remember when balancing off accounts are:
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1. The totals for each column should always be on the same level on the page - never at split-levels. 2. The balance brought down must always be on the opposite side to the balancing figure of the balance to be carried down. 3. The actual balance on the account is the balance brought down not the balance carried down. 4. An account is not really finished until the balance has been brought down to the next period. Note: Balance carried down (c/d) is known as closing balance, the balance brought down (b/d) is open balance.
THE TRIAL BALANCE

When entering transactions in the double entry accounts we see that for every entry made on the debit side of the account there will always be a credit entry made in another account for the same amount of money. When we balance off the individual accounts in the ledgers, we should therefore find that the total of all the debit balances should be exactly equal to the total of credit balances. If the totals are not the same then a mistake must have been made in the bookkeeping. To see if the two totals are equal we draw up a trial balance at the end of an accounting period. When the totals of the trial balance are equal we say that the trial balance totals agree. The uses of the trial balance as follows:

It provides a check on the accuracy of the ledger account balances - ensuring that entries have been made correctly. It makes preparation of the final accounts easier - we can simply use the balances from the trial balance, rather than having to refer to all the individual accounts. Certain errors will be highlighted or avoided as outlined below.
The trial balance will ensure that the following errors are avoided or highlighted: Only entering one half of the transaction (e.g. a debit but no credit entry) Entering different figures for the two halves of the transaction Entering two debits or two credits for a transaction
If any of the above errors have been made then the trial balance totals will not agree and investigative work can begin to see where the mistakes are. Technically, it could be possible for these errors to be made and the trial balance would appear as if the mistakes had not taken place. For example, if we missed out an entry of GH50 on the debit side of an account and then later we missed out on another transaction a credit entry of GH50, the trial balance totals would still agree. However as far as examination questions go, you will know when you are dealing with errors - it will be indicated in the question itself.
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Even if the trial balance totals do agree this does not mean that the books are completely correct. These errors outlined here could have been made:

Entering correct figures in the wrong account (but on the correct side) Reversing entries so that both entries are made on the incorrect side of the each account Entering the incorrect total on both sides of the account.
We would need to know how to identify these errors, how to correct them and also how to recalculate the firm's profits if they have been affected. A lot of students believe that the profit or loss account, and the balance sheet could not be constructed without a trial balance. This is not true. We would, if we wished, use the balances from each account. However this approach would take a lot longer and we would not have the check on the accuracy that the trial balance provides. As a rule the entries for the trial balance will be as follows: Type of account Assets, expenses & drawings Liabilities, revenues & capital Entry Debit Credit
The following is a trial balance for S Halls, which was extracted from the books on 31 December 2010 S Halls - trial balance as on 31 December 2010
Dr (GH) Capital Cash Bank S Knight (Accounts Payable) Purchases Office supplies Sales K Curnock (Accounts receivable) A Hynam (Accounts receivable) Returns out Wages Office fixtures 140 350 1294 87 95 118 24 210 270
Cr (GH) 1000
66
216
12
1294
18
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The title of any financial statement is very important. It should always contain the following three pieces of information: Who it is for. In this case it is for S Halls. What it is. In this case it is a trial balance. When it is for. In this case it is as at 31 December 2010. Remember! Who? What? When? In this trial balance we have the balances from three personal accounts. S Knight is a creditor of the firm (it is in the credit column - indicating that it is a liability). A Hynam and K Curnock are both debtors (in the debit column - indicating that they are an asset). Normally, debtors and creditors are listed in a trial balance as just 'debtors' or 'creditors', rather than as their individual names. Also, if a firm has unsold stocks of goods left at the end of a period, these will be listed underneath the trial balance. This is because the account for closing stock is not part of the double entry system. However, any stock that was in the firm at the start of a period will be listed in the debit balances of the trial balance.
DAY BOOKS AND LEDGERS

When a business is very small, all the double entry accounts can be kept in one book, which we would call a 'ledger'. As the business grows it would be impossible just to use one book, as the large number of pages needed for a lot of transactions would mean that the book would be too big to handle. Also, suppose the firm has several bookkeepers. They could not all do their work properly if there were only one ledger. The answer to this problem is for us to use more books- more ledgers. When we do this, we put similar types of transactions together and have a book for each type. In each book, we will not mix together transactions, which are different from each other.
DAYBOOKS - BOOKS OF ORIGINAL ENTRY

When a transaction takes place, we need to record as much as possible of the details of the transaction. For example, if we sold goods to A Smith on credit. We would also want to record the address and contact information of A Smith and the date of the transaction. Some businesses would also record information like the identity of the person who sold them to A Smith and the time of the sale. Ledger accounts cannot give us all this information so, as a further system of keeping records, firms will also keep books of original entry.
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Books of original entry are the books in which we first record transactions. These are not accounts; they are simply books that records the details of a transactions, almost like a diary. The firm will have a separate book for each kind of transaction. The type of the transaction will affect which book it, is entered into. Sales will be entered in one book, purchases in another book, cash in another book, and so on. The books of original entry are used to record the following:

The date on which each transaction took place - the transactions should be shown in date order; Details relating to the sale are entered in a 'details' column; A folio column entry is made cross-referencing back to the original 'source document', e.g. the invoice; The monetary amounts are entered in columns included in the books of original entry for that purpose. An Example of a Day Book/Books of Prime Entry Date Particulars L/F Amounts GH
ADVANTAGES OF KEEPING BOOKS OF ORIGINAL ENTRY

1. Accounts can be found more easily by the use of the cross referencing nature of the books of original entry being kept. 2. If records are lost then the ledgers and the books of original entry act as a backup for each other. 3. Acts as a 'listing device' for posting totals to various accounts, thereby saving labour
TYPES OF BOOKS OF ORIGINAL ENTRY

Books of original entry are also known as either 'journals' or 'daybooks'. The term 'day book' is, perhaps, more commonly used, as it more clearly indicates the nature of these books of original entry entries are made to them every day. The commonly used books of original entry are: 1. Purchases Day Book/JOURNAL: to record purchases of merchandise on credit. The total of the purchases book is posted to the debit of purchases account. Names of the suppliers appear in the purchases book. These parties have supplied the goods. They are, therefore, credited with the amount appearing against their respective names. The double entry will thus be completed.
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2. Purchases Returns Day Book: to record returns of goods to supplier or grant of allowances by the supplier due to defects or some other reasons. The source document for making entries into the purchases returns day book is either the debit note issued by the business to its credit suppliers or the credit note issued by the supplier to the business. The total of the purchases returns or returns outwards book is credited to returns outward account or purchases return account (being the goods sent out). Individual suppliers to whom goods are returned are debited (because they receive the goods). 3. Sales Day Book/JOURNAL: to record sales of merchandise on credit. The total of the sales book is credited to sales account. Customers whose names appear in the sales book are debited with the amount appearing against their names. Double entry is thus completed. 4. Sales Returns Day Book / JOURNAL: to record the return of goods by customers due to defects or other reason. The source document used for recording into the sales returns day book is the credit note issued by the business to the customer or the debit note issued by the customer to the business. The returns inwards book or sales returns book is debited to returns inwards account or sales returns account. The customers who have returned the goods are credited with the amount shown against their names.
SOURCE DOCUMENTS
All the daybooks are constructed on the basis of transfers from original source documents. These are items of business use that contain financial data related to business transactions. The main source documents a firm is likely to use are as follows:

Purchase invoice: Received by the firm from suppliers when buying goods on credit Sales invoice: Sent by the firm when selling goods on credit Debit notes: Received by the firm from suppliers when goods purchased are returned to the original supplier Credit notes: Sent by the firm to customers who have returned the goods Cheque counterfoils: From the chequebook to show cheques paid out Paying slip; Evidence of money paid into bank accounts Till rolls: Evidence of cash being received Petty cash vouchers: Slips to indicate small amounts of cash being paid Bank statements: A summary of the bank account from the banks point of view.
The following daybooks are constructed by the use of each of the following source documents:
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Daybook Sales daybook Purchases daybook Returns inwards daybook Returns outwards daybook Cashbook The journal
Source document(s) Sales invoice Purchases invoice Credit notes Debit notes Cheque counterfoils, paying in slips, till rolls, etc. Everything else not covered by above
THE USE OF FOLIO COLUMNS

Each double entry account will contain the name of the other account in which the other half other transaction is contained. Apart from very small firms, this does not necessarily make it any easier to locate the other account - there may be hundreds of separate accounts. A method of speeding up the ability to find an account is the use of folio columns. These are found in both accounts and also in daybooks. An extra column, usually quite small is placed besides the details of each transaction. In this folio column is placed an abbreviated reference to which ledger or daybook the transaction can be located in, and on what page of the relevant book. For example, if a credit sale was record in the sales daybook with the folio reference SL54, then this would tell us that the customer's account could be found on page fifty-four of the sales ledger. If we actually looked at this relevant account then we would see that it also had a folio reference sending us back to the sales daybook itself. Common abbreviations are as follows: SL Sales ledger PL Purchases ledger GL General ledger CB Cashbook If the entry 'C' appears in the folio column then this refers to a contra entry. This means that both halves of the transaction are contained in the same account. An example of this is dealt with in the section on cashbooks.
CASH BOOKS AND PETTY CASHBOOKS

Cash Book / JOURNAL is used to record transactions relating to receipts and payments of cash. It serves a dual purpose- as a book of prime entry for all cash transactions as well as the ledger account for the cash and bank account Types of cash books are the one column, the two column and the three column cash books. For Every entry made in the cash book there must be a proper voucher. Vouchers
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are documents containing evidence of payment and receipts. When money is received generally a printed receipt is issued to the payer but counterfoil or the carbon copy of it is preserved by the cashier. The copy receipts are called debit vouchers, and they support the entries appearing on the debit side of the cash book. Similarly when payment is made a receipt is obtained from the payee. These receipts are known as credit vouchers. All the debit and credit vouchers are consecutively numbered. For ready reference the numbers of the vouchers are noted against the respective entries. A column is provided on either side of the cash book for this purpose.
SINGLE COLUMN CASH BOOK

A cashbook is the cash account and the bank account combined into one single account. We already know how to maintain a separate cash account and bank account. The two accounts below are just straightforward examples of double-entry accounts: BANK Date 2011 1 Jan 5 Jan 12 Jan 18 Jan 1 Feb Details Capital Sales W Green Rent Balance Amount GH CB 2,500 GL 150 SL 320 GL 85 3,055 b/d 1,915 F Date 2011 2 Jan 8 Jan 15 Jan 31 Jan Details Office furniture T McClure Purchases Balance F GL PL GL c/d Amount GH 750 140 250 1,915 3,055
CASH Date 2011 2 Jan 7 Jan Details B Griffin H Spence Folio SL SL Amount GH 250 430 Date 2011 2 Jan 11 Jan 14 Jan 21 Jan 31 Jan Details Office expenses Insurance Motor expenses P Yarrow Balance Folio GL GL GL PL c/d Amount GH 50 55 120 320 135 680
1 Feb
Balance
b/d
680 135
However the cashbook combines the two separate accounts into one joint account. The example below is just the two separate examples from above combined into a cashbook format:
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DOUBLE COLUMN CASHBOOK
Date Jan 1 2 5 7 12 18
Details Capital B Griffin Sales H Spence W Green Rent
Folio CB SL GL SL SL GL
Cash GH 250
Bank GH 2,500 150
430 320 85
Date Jan 2 2 8 11 14 15 21 31
Details Office expenses Office furniture T McClure Insurance Motor expenses Purchases P Yarrow Balances
Folio GL GL PL GL GL GL PL c/d
1/2
Balances
b/d
680 135
3,055 1,915
Cash Bank GH GH 50 750 140 55 120 250 320 135 1,915 680 3,055
Notice that the accounts have not altered at all. They are still balanced off separately at the end of the month and the balances will obviously be the same as before. The above example is known as a twocolumn cashbook - the two columns being bank and cash columns. It is possible to have a closing balance which is a debit balance for the cash account but a credit balance for the bank account. The account should simply have balances drawn in for both sides. It is impossible for the cash account to be a credit balance, this would mean that the firm had a negative amount of cash. This cannot be the case one can have either some cash or no cash but not a negative amount. The bank account can be a credit balance and this means that the firm is overdrawn on the account - the firm has drawn more from the bank account than is actually there and the firm now owes the bank money. Cash paid into the bank Frequently, firms will pay cash into the firm's bank account and also, draw money out of the bank for use elsewhere. The double entry required to record this sort of transaction is unusual because both 'halves' of the transaction are now going to be found in the same account - the cashbook. Cash discounts Although firms will offer terms of credit to their customers, the firm would prefer it if customers settled their account as quickly as possible (i.e. paid what they owed) fairly quickly because the cash flow will be important to most firms. Many firms will offer discounts in return for prompt payments. These are known as cash discounts (also known as settlement discounts) and are usually given as a percentage of the overall invoice total (e.g. 5% off the sales value).
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The term cash discount does not mean that the amount has to be paid in cash - cash or cheques would both qualify if they were paid within the given time limit. The term cash discount is used to distinguish it from trade discounts. The cash discount offered and the terms and conditions will normally be found on the invoice. There are two types of cash discounts that are recorded in the ledger accounts: Discounts allowed Cash discounts allowed by a firm to its customers when they pay their accounts quickly. Discounts received Received by a firm from its suppliers when it pays their accounts quickly. Discounts columns in cashbook Both discount accounts are kept in the general ledger. There is the danger that, with frequent purchases and sales, these accounts will quickly become cluttered with many small entries. An alternative approach, which avoids this clutter, is to make use of a three-column cashbook. The three-column cashbook incorporates the cash discounts for each relevant entry into a third column. At the end of each month (or other relevant period) when the cashbook is balanced off, the totals form these discount column would then be transferred to the discount accounts in the general ledger. Discounts received are entered in the discounts column on the credit side of the cashbook, and discounts allowed in the discounts column on the debit side of the cashbook. The cashbook, if completed for the two examples so far dealt with, would appear as follows:
THREE COLUMN CASHBOOK

Date Nov 5 /11 Details Folio Dis Cash Bank All GH GH GH 7 273 Date Nov 3/11 Details Folio Dis Cash Bank Rec GH GH GH PL 23 437
D Jackson
SL
J O'Neill
There is no alteration to the method of showing discounts in the personal accounts. When balancing the accounts off at the end of the period, you must take care to note that the discounts columns are not balanced off against each other. The discounts columns are simply totalled up and then transferred to the relevant discount account. Therefore the totals are likely to be different for the discount columns.
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QUIZ: 2010 October 1 October 3 October 9 October 13 October 19 October 20 October 22 October 25 October 30 Balances brought forward: Cash GH 215, Bank 190 (Cr.) Paid creditors by cheque; G Dawes GH440 L Lewes GH120 (before discount) and received a 5% discount on invoice totals. Paid GH100 cash into bank account Received cheques from suppliers for accounts totals as follows: R Kirk GH360 and C Watson GH120, in each case allowing a 2.5% discount. Cash purchases GH78 Paid rent by cheque 56 Received cheque of GH90 from H Knight in settlement of sales worth GH95. Cash withdrawn from bank for personal use GH50 Received commission by cash GH46
PETTY CASH BOOK

Some firms actually keep a separate cashbook and a petty cash book. The petty cash book is for dealing with small items of money. Some firms will have lots of transactions which involve relatively small amounts of money (e.g. petrol costs, postage costs and so on). If these were entered in the cashbook then it would quickly become cluttered up with entries for small amounts of money. To stop this happening some firms will keep a petty cashbook, which deals with these items. At the end of each month the monthly totals can then be transferred to the main cashbook. This has the other advantage of allowing another member of staff (usually a junior) the responsibility of dealing with petty cashbook alone and this frees up time for the main cashier of the firm to deal with the main cashbook. Some very large firms may actually use the petty cashbook for dealing with all cash items of expenditure. The main cashbook would then only be used for bank transactions. Imprest system The most common system used to maintain the petty cash book is known as the imprest system. This involves co-ordination between the cashier responsible for the cashbook and the cashier responsible for the petty cash book. The cashier will give the petty book cashier just enough money to cover the petty cash transactions of a period of time - usually one month. At the end of the month, the amount actually spent will be totalled up and the amount will be refunded from the main cashbook as follows:
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Entries needed to refund amount spent on petty cash
Debit Petty cashbook
Credit Cashbook
In this way, the balance on the petty cashbook will always be the same at the start of each period. This opening balance is known as the float or imprest. The float can be changed if it is observed that the petty cash is either being spent too quickly, or is not being spent at all. The idea is that the float should cover the periods' expenses. Most firms who maintain petty cashbooks will do so in a format which categorises different types of petty cash expenditure. This is known as an analytical petty cashbook because it analyses the different types of expenditure. The petty cashbook still follows the rules of any double entry account. However, the credit side of this account will be split into the various categories of expenditure. The following are details of petty cash transactions for the month of February 2011. The business transactions that occur are as follows: Feb 1 The chief cashier debits the petty cashbook with GH 70 to restore the float
GH Feb 4 Feb 5 Feb 9 Feb 8 Feb 15 Feb 16 Feb 21 Feb 24 Petrol costs Stationery Coffee for office Bus fares Milk and tea Rail fares New paper for printer Folders for office 10 4 3 6 2 17 9 4
Feb 28
The chief cashier debits the petty cashbook with GH 55 to restore the float
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The GH55 received on February 28 is exactly the amount that was spent during February on petty cash transactions. The analysis columns that are to be used in this example are:

Travel expenses Stationery Miscellaneous
There are no strict rules on what columns should be used or how many of them there should be. It makes sense not to have too many because it may become confusing when filling in the petty cashbook.
Advantages of maintaining a petty cashbook

1. It stops the main cashbook being cluttered up with small items of expenditure. 2. It allows the firm to delegate these small times to a junior member of staff, which frees up the time of the main cashier to concentrate on other areas. 3. As the petty cashier cannot draw as and when he likes, it prevents unnecessary accumulation of cash in his hand thus the chances of defalcation of cash are minimised. . FORMAT OF THE PETTY CASH BOOK: Date Details Voucher Total Payment Analysis E.g. No Motor Exps Cleaning Sundry Ledger Exp Folio Ledger Account
Receipt F
PROCESS illustration; Step I: The cashier gives the petty cashier. The petty cashier pays out in the period. The petty cash now in hand. The cashier now gives the petty cashier the amount spent. Petty cash in hand at the end of period 1. The petty cashier pays out in the period. Petty cash now in hand. The cashier now gives the petty cashier the amount spent. Petty cash in hand at the end of period 2
Step II:
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A DIAGRAM OF THE BOOKS COMMONLY USED All Business Transactions
Classify put same types of transactions together
Credit sales
Credit purchase s
Returns inwards
Returns outwar ds
Cash receipts / payments
Other types
Enter in sales day book
Enter in purchase s Day Book
Enter in Returns Inwards Day Book
Enter in Returns Outwar ds Day
Enter in Cash Book
Enter in Journal
Enter in double entry accounts in the various ledgers Sales Ledger Purchases Ledger General Ledger
JOURNAL PROPER/GENERAL JOURNAL

Definition and Explanation: Journal proper is book of original entry (simple journal) in which miscellaneous credit transactions which do not fit in any other books are recorded. It is also called miscellaneous journal. The form and procedure for maintaining this journal is the same that of simple journal.
USES OF JOURNAL PROPER/ GENERAL

1. The recording of Opening and Closing entries 2. Correction of Errors 3. Recording purchases and Sales of Fixed Assets on credits
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4. Recording the issues (sales) of shares by companies, etc. 5. Writing off bad debts. Opening Entries: When a businessman wants to open the book for a new year, it is necessary to journalise the various assets and liabilities before the new accounts are opened in the ledger. The journal entries so passed are called "opening entries". Suppose a businessman opens a new set of books on January 1, 2010 with cash in hand GH100, debtors GH200, stock in trade GH320, machinery GH700, furniture GH 150, bank loan GH 300, capital GH1,070 the respective opening entry in the journal will be: GH Cash Sundry debtors Stock in trade Machinery Furniture & fitting To Sundry creditors To Bank loan To Capital 100 200 320 700 200 150 300 1,070 GH
(Being the opening balance of assets, liabilities and capital at this date) Closing Entries: When the books are balanced at the close of the accounting period with a view to prepare final accounts, it is necessary that balance of all the income and expenses accounts must be transferred to trading and profit and loss account. The process of transferring balances to the trading and profit and loss account at the end of year is called closing the books and entries passed at that time are called closing entries. For example on 31st December, 2010 the balance in expenses accounts are: Salary GH500; rent GH 200; Stationary GH50; legal charges GH100; and income accounts are: commission received GH 50. These balances will be recorded in profit and loss account though the following closing entries: GH Profit and loss account To Salary To Rent To Stationary 850 500 200 50 GH
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To Legal charges (Being the closing entry)
100
Commission received account To Profit and loss account (Being the closing entry) Transfer Entries:
50 50
When accounts are transferred from one account to another for combination of allied items, it is necessary to pass transfer entry. For example, Drawings GH500 is transferred from the drawings account to the capital account to find out the net capital. The transfer entry will be passed as follows: Capital Account To Drawings account (Being the transfer entry) Adjusting Entries: Modification of the accounts at the end of an accounting period is called adjustments. If there be any event affecting the related period of accounts but left out of the books, the same should be incorporated in the books before the preparation of the final accounts. This is done by means of adjusting entries through the journal proper. For example at the end of the year it is found that rent GH50 is outstanding. It is not recorded in the books. It will be taken into account by means of adjusting entry which is as follows: Rent account To Outstanding rent account (Being outstanding rent recorded) Rectification Entries: When an error is detected in the books, the same is rectified through an entry in the journal proper; thus is called rectification entry. For example, it was detected that an expenditure of GH100 on repair to building was charged to building account. It is corrected through the following entry in the journal proper:
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500 500
50 50
Building repair account To Building account Entries of which there is No Special Journal:
100 100
When a trader cannot record the entries in the above mentioned sub-journals, the same are entered in the journal proper. The common transactions which cannot be recorded in any of the book of original entry are:

Distribution of goods as free sample. Distribution of goods as charity. Goods destroyed by fire. Goods stolen away by employees. Exchange of one asset for another asset etc.
Entries for Rare Transactions: In a business it may happen sometimes that transactions are usually rare. Journal proper is used for such rare This book is used for all other transactions that cannot be captured by any of the books of original entry already discussed.
Date
A Table showing the formation of a Journal/General Journal Details L/F DR
CR
In the date column, the date of the transaction is entered. In the particulars column, the name of account to be debited or credited is recorded. The account to be debited is listed first beginning at the left margin of the column. The word Dr. is written against these accounts at the extreme right of this column. The accounts to be credited appear below the debit entries and are indicated. The names of these accounts are preceded by the word To: beneath this should be written a brief explanation of the above entry containing all information essential for better understanding of the transaction. This is called the narration of the entry. In the LF (Ledger Folio) column, we enter the page number of the ledger account where the entry is made at the time of posting. This indicates that entries have been posted to the relevant ledger account.
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An entry in the general journal is entered only when an analysis of the transaction is made and the accounts to be debited or credited determined. This takes into effect principles of double entry. Illustration The following transactions took place in the books of B. Hanan Enterprise for the month of July, 2008 July 1. Started business with GH4,230 cash 3. Bought goods for cash GH1,755 8. Bought goods on credit GH2,000 from Lincoln 10. Sold goods for cash GH3,000 14. Deposited GH1,800 in a newly opened bank Account 15. Bought motor van by cheque GH820 16. Sold goods on credit to Saani GH8,000 17. Received cheque GH6,000 from Saani as part-payment of his account 20. Paid for stationary GH1,150 by cash 22. Paid GH1,200 cheque to Lincon as part payment of his account 25. Paid Wages and salaries by cheque GH3,500 27. Cash withdrawn by the proprietor for his personal use GH250 31. Paid the following expenses by cash; electricity GH25 and insurance GH30 Requirement: Journalise the above transactions and post in a ledger account, balance off the accounts and extract a trial balance.
GENERAL JOURNAL EXAMPLE Date Description
Post Dr. Ref 4,230
Cr.
Cash a/c 1/7/08 Capital a/c (Being cash invested by the owner) Purchases a/c 3/7/08 Cash a/c (Being cash purchase of goods)
4,230
1,755 1,755
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8/7/08
Purchases a/c Creditor (Lincoln ) a/c (Being goods bought on credit from Lincoln)
2,000 2,000
Date
Description
Post Dr. Ref. 3,000
Cr.
10/7/08
Cash a/c Sales a/c (Being goods sold for cash)
3,000
14/7/08
Bank a/c Cash a/c (Being cash deposited in a newly open bank) a/c
1,800 1,800
15/7/ 08
Motor van a/C Bank a/c (Being motor van bought by cash)
820 820
16/7/08
Debtor (Saani) a/c Sales a/c (Being credit sales of goods to saani)
8,000 8,000
17/7/08
Bank a/c Debtor (Saani) a/c (Being part payments of goods sold to Saani)
6,000 6,000
Date
Description
Post Ref.
Dr.
Cr .
20/7/08
Stationery a/c
1,150
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Cash a/c (Being stationery bought in cash) 22/7/08 Creditor (Lincoln) a/c Bank a/c (Being part payment of goods bought on credit) 25/7/08 Wages and salaries a/c Bank a/c (Being wages paid by cheque) 27/7/08 Drawings a/c Cash a/c (Being cash withdrawn by the business owner) 31/7/08 Electricity a/c Insurance a/c Cash a/c (Being electricity and insurance paid by cash) 25 30 250 3,500 1,200
1,150
1,200
3,500
250
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POSTING ENTRIES TO THE LEDGER

Posting refers to transferring accounting entries from the journal on to the ledger. As a matter of fact, every debit entry has a corresponding credit entry and vice versa. Account titles take name of the corresponding entry.
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The General Ledger Capital Account GH 31/7/08 Balance c/d 4,230 1/8/08 Balance b/d 4,230 1/7/08 Cash GH 4,230 4,320 4,320
Cash A/c GH 1/7/08 10/7/08 Capital Sales 4,230 3,000 3/7/08 Purchases GH 1,755 1,800 1,150 250 25 30 2,220 7,230
14/7/08 Bank 20/7/08 Stationery 7/7/08 Drawings 31/7/08 Electricity 31/7/08 Insurance 31/7/08 Balance c/d
7,230 1/8/08 Balance b/d 2,220
Purchases Account GH 3/7/08 Cash 8/7/08Lincoln(creditor) 1,755 2,000 3,755 1/8/08 Balance b/d 3,755 31/7/08 Balance c/d
GH 3,755
3,755
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Lincoln (Creditor) Account GH 22/7/08 31/7/08 Bank Balance c/d 2,000 1/8/08 Balance b/d 1,200 800 8/7/08 Purchases
GH 2,000
2,000 800
Sales Account GH 31/7/08 Balance c/d 11,000 10/7/08 Cash 16/7/08 Saani (Debtor) 11,000 1/8/08 Balance b/d GH 3,000 8,000 11000 11,000
Bank Account GH 14/7/08 17/7/08 Cash Saani 1,800 6,000 15/7/08 Motor Van GH 820 1,200 3,500 2,280 7,800
22/7/08 Lincoln (creditor) 25/7/08 Wages and Salary 31/7/08 Balance c/d
7,800 1/8/08 Balance b/d 2,280 Motor Van Account GH 15/7/08 Bank 820 820 1/8/08 Balance b/d 820 31/7/08 Balance c/d
GH 820 820
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Saanis (debtor) Account GH 16/7/08 Sales 8,000 17/7/08 Bank 31/7/08 Bal. c/d 8,000 1/8/08 Balance b/d 2,000
GH 6,000 2,000 8,000
Stationery Account GH 20/7/08 Cash 1,150 1,150 1/8/08 Balance b/d 1,150 31/7/08 Balance c/d
GH 1,150 1,150
Stationery Account GH 20/7/08 Cash 1,150 1,150 1/8/08 Balance b/d 1,150 31/7/08 Balance c/d GH 1,150 1,150
Drawings Account GH 27/7/08 Cash 250 250 1/8/08 Balance b/d 250 31/7/08 Balance c/d
GH 250 250
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Electricity Account GH 31/7/08 Cash 25 25 1/8/08 Balance b/d 25 Insurance Account GH 31/7/08 Cash 30 30 1/8/08 Balance b/d 30 31/7/08 Balance c/d 31/7/08 Balance c/d
GH 25 25
GH 30 30
B. HANAN ENTERPRISE TRIAL BALANCE AT 31st July, 2008 PARTICULARS DEBIT CREDIT GH Capital Cash Purchases Creditor Lincoln Sales Bank Motor Van Debtor Saani Stationery Wages and Salaries Drawings Electricity Insurance 2,280 820 2,000 1,150 3,500 250 25 30 16,030 2,220 3,755 800 11,000 GH 4,230
16,030
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VALUE ADDED TAX

This is general tax on consumption expenditure. It is a type of indirect tax which a person may pay so long as the person has the ability to consume or venture into any economic activity. It is a charged on the final consumer and an addition to the price of supplies at all stages in the chain of production and distribution. However, because firms are dealing with other firms in the buying and selling of inputs (materials and products to be used in the production process) which are subject to VAT, the firms are allowed to 'claim' back VAT paid when purchasing inputs. Rather than having to collect VAT on any sales and also pay VAT on any purchases, firms can use the amount paid on purchases to offset (or reduce) the amount paid on any sales made. The final consumer of the product has no one to sell the product on to the final consumer will pay the full 15% VAT. VAT on invoice = 0.115 x Net invoice total Gross total for invoice = 1.115 x Net invoice total
The gross total will include the original net invoice amount plus the VAT due on that invoice. If you are given the net total for any invoice then the VAT on that invoice can be calculated by multiplying it by the following: It is collected by registered persons on value added that is created at the various stages in the production and distribution of the product. Value Added created is the addition made by the persons or firms through their own activities, to the value of inputs procured from other persons or firms to turn out the output. It is the difference between the sale value of the output and the costs of inputs relating to the output. It will be wrong to think that value added is created through manufacturing or conversion of raw materials (inputs) to goods (output). This will limit the incidence of value added. In a broader sense, value added tax according to Act 546, is chargeable on value added at; a. Importation b. Manufacturing c. Wholesale and Retail levels (Distribution) d. Provision of service The following is an illustration of the system of VAT; A wholesaler sells a product to a retailer for GH 5000.00 plus VAT of GH 400.00. The retailer will pay the wholesaler GH 5400.00 (5000 + 400) for the product. The VAT on that sale will be paid to the VAT Service by the wholesaler. Assume that the retailer sells the product for GH 6000.00 plus VAT of GH 550.00 to a customer. The customer will pay GH 6550.00 (6000+550) to the retailer for the product. The amount of VAT paid for the product by the retailer from the customer (GH 550.00) and the difference of GH 150.00 is then sent to the VAT service at the end of the month. To this end, the overall VAT of GH 550.00 is paid by the customer as tax on consumption.
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CHARACTERISTICS OF VAT
i. ii. It is a tax on consumption expenditure. Thus VAT is a tax on consumable products consumers who buy such products pay the VAT on them. It is a tax on the final consumer. VAT is ultimately paid by the final consumer of the product. The producer, wholesaler and retailer pass the VAT on the product to the final consumer of that product. It is a multi stage tax. VAT is paid by the wholesaler when he or she buys goods from the manufacturer, the retailer pays VAT on goods he buys from the wholesaler and ultimate VAT is passed to the final consumer when he or she buys from the retailer. It is collected by the registered persons. A business that is registered for VAT is essentially a collection agent for the government. VAT returns are paid monthly to the government. In Ghana, the VAT returns are submitted not later than the last working day of the month immediately following the month to which it relates. It is an indirect tax. Hence, it is not levied on personal income but rather on goods and services. Thus the consumer pays for tax when he or she buys goods and services.
iii.
iv. v. vi.
CALCULATION OF VALUE ADDED TAX

OUTPUT VAT; it is a category of VAT paid on goods sold and for services rendered by a firm. From the illustration above, GH 550.00 VAT paid by the consumer to the retailer is an output VAT to the retailer. INPUT VAT; It is a category VAT on goods purchased by a business. Input VAT is also levied on services received. From the example above, GH 400.00 VAT paid by the retailer to the wholesaler is termed as input VAT to the retailer. Example 1 A wholesaler buys goods from a manufacturer at GH 550.00 plus VAT at 155. Calculate the input VAT; Solution 1 Input VAT = 15% * GH 550.00 = GH 82.50 Example 2 The wholesaler sells goods to a retailer at GH 1050.00 plus VAT at 15%. Compute the output VAT. Solution 2 Output VAT = 15/115 * 1050 = GH 137.00
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VAT AND THE DOUBLE ENTRY SYSTEM

So far, all our double entry transactions have assumed that there is no VAT to be accounted for. However, we now need to adjust our adjustments to take VAT into account. When we buy or sell goods we know part of the selling price will include VAT (assuming that the firm is registered for VAT). This amount will need to be separated out from the actual net invoice total on both purchases and sales totals. VAT usually changes the accounting entries for purchases and sales. The following are the accounting entry for VAT; i. Where VAT is paid on purchases (input tax); Debit Purchases account, with cost excluding VAT Debit VAT account, with VAT on purchases. Credit creditors/Cash book, with cost including VAT. ii. Where VAT is change on sales (output VAT). Debit Debtor/Cash book, with sales price including VAT Credit VAT with the VAT. Credit sales account with sales price excluding VAT. iii. Where payment of VAT is done (thus if output VAT exceeds input VAT); Debit VAT Credit cash book, with the amount owing on VAT. iv. Where VAT is received (thus if input VAT exceeds output VAT) Debit cash book Credit VAT with the amount received on VAT. Example 3 Net GH Purchases (All On Credit) Sales (all on credit) 42,500.00 63,750.00 VAT GH 7,500.00 11,250.00 Total GH 50,000.00 75,000.00
You are required to prepare the relevant ledger accounts to record the above transaction. Solution
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Sales Accounts GH Balance carried down 63,500.00 Debtors GH 63,750.00
Purchases Account GH Creditors 42,500.00 Balance carried down GH 42,500.00
Debtors Accounts GH Sales VAT 63,750.00 11,250.00 75,000.00 Creditors Account GH Balance carried down 50,000.00 Purchases VAT 50,000.00 VAT Accounts GH Creditors Balance c/d 7,500.00 3.195.00 11,250.00 Balance b/d 11,250.00 3,195.00 Debtor GH 11,250.00 GH 42,500.00 7,500.00 50,000.00 75,000.00 Balance carried down GH 75,000.00
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As the VAT account has a credit balance, this will be shown on the B/S as a current liability. The VAT account and the cash book will have been debited and credited respectively.
PREPARATION OF VALUE ADDED TAX RETURNS

A VAT registered person is required to file monthly returns showing details of VAT transaction for each calendar month. VAT returns mostly shows details of the sales and purchases made during the month immediately preceding that in which the returns are being filed and the related VAT on these values.
FORMAT OF VAT RETURNS GH GH
Output VAT Less Input VAT Amount paid (received)
XXX (XX) XXX
11,250.00 (7,500.00) 3,195.00
EXERCISES WITH ANSWERS 1. Samuel Ltd sells the following goods; i. To Enoch at a VAT inclusive of GH 1150.00 ii. To Linda at a VAT exclusive of GH 1000.00 You are required to calculate the VAT to be collected by the government if the VAT rate is 15%. Soln; i. Enoch Sales = 15/115 * 1150 = GH 150.00 ii. Linda Sales = 15/100 * 1000 = GH 100.00
Hence, total VAT collected = GH 150.00 + GH 100.00 = GH 250.00. 2. Tilly purchases goods for GH 2000.00 (VAT inclusive) and sells them for GH 2500.00 (VAT inclusive). Given the VAT rate at 15%, you are required to compute; i. Soln Input VAT ii. Output VAT and iii. VAT payable to the tax authority.
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i. Input VAT = 15/115 * 2000.00 = GH 260.87 ii. Output VAT = 15/115 * 2500.00 = GH 326.09 iii. Amount payable to tax authority = Output-Input = GH 65.22 VAT and fixed assets VAT is payable on expenditure relating to fixed assets purchases as well as other expenses related to the running of the business. Some firms will be able to reclaim the VAT paid on fixed asset purchases by offsetting it against the VAT payable on sales, in the same way that VAT paid on purchases is used. For example, if a firm buys a machine for GH5,000 and the VAT included amounted to GH750, then the firm would only enter the net value of the machine in the assets account (i.e. Debit machinery GH4,250) and the VAT would be entered in the account (Debit VAT GH750). If a firm cannot reclaim VAT on these items that the full value of the purchase will be entered into the asset account. Ex. Construct VAT account from the following information: 1. Sales for the month were GH1,976 which included VAT of GH 296.25. 2. Purchases for the month were GH1,666 that included VAT of GH 249.90 3. Returns inwards for the month were GH800 including VAT of GH120. 4. Returns outwards for the month were GH588 including VAT of GH 88. 20
XYZ Ltd. Is a registered VAT organisation. During the month of August ending, it made the following transactions of which were subject to VAT of 15%; Use the information below to prepare a VAT account to record the transactions. SALES; GH 200,000.00 excluding VAT GH 149,500.00 including VAT GH 207,000.00 including VAT GH 264,500.00 including VAT PURCHASES; GH 140,000.00 excluding VAT GH 230,000.00 including VAT GH 172,500.00 including VAT GH 400,000.00 excluding VAT
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ACCOUNTING CONCEPTS AND CONVENTIONS

ACCOUNTING CONCEPTS
This may be defined as broad assumptions which underline the periodic financial accounts of business concern. The concepts are axioms which have developed to become accepted by the accountancy profession after a number of years of their application (use).
PURPOSE & IMPORTANCE

Accounts are prepared for internal and external use. Internally it forms the basis for an evaluation of past performance and is a guide for decision makers. External users include investors, taxation authorities etc. The task of regular measurement of position and profit of a firm is a difficult one and that there are conceptual as well as practical problems. It might be possible for each accountant to work out his own solution to those problems but this would clearly be unacceptable method of operating. There is a need for a set of assumptions and rules which provide a conceptual framework to be used as a guide to preparing accounting information. It seems sensible that there should be some degree of consistency about the way in which accounting information is prepared. This makes it easier for those preparing and interpreting the information. Also, it limits the area of discretion open to the accountant or to the firm to present information in a biased manner. The strength of this last comment depends of course on the sanctions provided against not working within the framework. Perhaps the most important reason for having a conceptual framework is that it is more likely to establish confidence in accounting information. This is very necessary when it is remembered that users are expected to use it as a basis, for example, for investment decisions, calculating taxation, or evaluating management performance or as a guide to government policy. Fundamental accounting concepts are the assumptions that underline the preparation of financial statements. These are usually not stated because their acceptance and use is assumed. If these are not followed, this fact and reasons for not following them must be given.
Going Concern Concept FAC:

This assumption implies that the business or entity will continue in operational existence for the foreseeable future. This means in particular that the income statement and the statement of financial position assume no intention or necessity to liquidate or curtail significantly the scale of operation. In line with this concept accounts are prepared in short; but regular intervals of equal lengths such as yearly intervals. The justification i. If this assumption is accepted then depreciation and provision for bad debts are reasonable otherwise there will be no need for them.
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ii.
The distinction between fixed and current assets will be unfounded as both items will be written off in the year of acquisition and are therefore current. iii. Liquidation values would need to be substituted for historical cost based figure had it not been his concept. Drawbacks It may mislead, because some firms do cease trading shortly after the publication of accounts drawn up on the going concern basis. Consequences i. Fixed assets are shown at cost less depreciation. ii. Current assets are valued at cost or net realisable value (market price) in the course of the business. iii. Liabilities that may arise in the event of liquidation are ignored e.g., redundancy pay. iv. Information about the consequences of liquidation is not given.
Accrual or the Matching Concept FAC:

The principle or concept states that in order to measure profit, the revenue for the period must be matched with the cost incurred in order to earn that revenue. This is to say that expenses, the benefits which have been used up in a given accounting year should be reported in the accounts of the period whether or not those expenses have been paid for. Also money paid in respect of expenses the benefits of which have not yet been used, should not be included in the accounts as expenses because the expenses do not relate to the given period. The justification is that the profits of the period are revenue from transactions less associated costs for the period. Any cost not connected with future revenue is written off as it occurs. Drawbacks; i. Difficulty in determining which costs are associated with particular revenue. The whole idea of depreciation, absorption cost, finished goods, work-in-progress (partly finished material) valuation are aspects of the matching concept. ii. The use of different matching methods (e.g. depreciation methods) by different accountants lend to the results of enterprises not being comparable with another. Consequences i. ii. Valuation of stock and work-in-progress on balance sheet which includes the related cost (e.g. rent) for expired periods. The inclusion on the balance sheet of assets with no tangible value, e.g., development costs.
Consistency Principle FAC:

It is the requirement that the same interpretation of accounting principle is applied from year to year within the same firm. When a firm has once fixed a method of the accounting treatment of an item, it
will enter all similar items that follow in exactly the same way e.g. stock valuation and method of providing for depreciation. This does not mean changes should not be made in methods or procedures, if there is sufficient reason to change from one method to another. However, there should not be habitual and frequent changes. This concept limits possibility of misinterpretation, since judgement and decision making depend to a large extent upon validity of comparison
Prudence/Conservatism Concept FAC:

Anticipate no profit, provide for all possible losses. This principle states that accountant will tend to understate rather than overstate profit. Where alternative treatments are available, the treatment that produces the less favourable result should be preferred. Prudence however does not justify the creation of secret or hidden reserves. The justification is that this concept prevents the eroding of the proprietors capital since large profit may tempt large drawings Drawbacks; i. It unnecessarily pessimistic. ii. The tendency to understate assets values tend to lower the appropriate price for shares on the stock exchange. Consequences; i. Profits are not anticipated. ii. Holding (Investment) gains are ignored. iii. Potential losses (even future) are fully reflected in accounts.
The Business Entity Concept:

This concept considers the business enterprise as a separate entity distinguishable from the owners and from all other enterprises. The items recorded in the books of the business are, therefore, restricted to the transactions of the business. The only attempt to show how the transactions affect the owner(s) of the business is when they introduce new capital into the business or take drawings out of it. The total drawings figure at the end of the given period will reduce the proprietors capital contribution. The justification for this convention is that proprietors and other interested parties are concerned to know the profit earned by the capital invested in the business The drawback is that the assumed entity is artificial because the assets are in law are those of proprietors and not of some artificial entity of the business Consequences i. The capital of a business is seen a liability of the business to its owners or proprietor.
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ii. Drawings and losses are regarded as a reduction of this liability (capital). iii. Profit and capital introduced are regarded as an increase in this liability (capital).
The Historical Cost Concept:

This principle states that assets and other items e.g. expenses incurred are to be shown in the books at the prices they are bought (historic cost). i. ii. iii. iv. Items having no value are left out of accounts. Serious problems may arise during changing price level. Actual information regarded by management and investors etc. may be current value. Stock valuation for balance sheet purposes flouts this concept when the value of selling price is less than the cost price, since lower of this is shown in the balance sheet.
Consequences i. ii. iii. iv. v. Assets are valued at cost. Revenues at current cost are matched against historical cost. Items which have no cost are ignored. Unrealised gains are ignored. Relevant information (e.g., real value of capital employed in the business) is not given.
The Money Measurement Concept:

This concept states that accounting statements must be quantified in terms of a monetary unit. This means that transactions are recorded in money terms. It therefore means that expenses, assets, liabilities, revenues, the values of which can be measured in monetary terms with a fair degree of objectivity are recorded in the accounts. Note that accounting does not record that the firm has a good or bad management team. It does not show that the poor morale prevalent among the staff is about to lead to a serious strike etc. The justification for this concept is that financial statements intend to summarise events of the year and the position of businesses. To do this well a common unit of measurement must be used and that common unit is money. Drawbacks; Transactions, events and facts that cannot be recorded in money terms are ignored, e.g. the quantity of orders on hand, existence of satisfied customers or competent management. ii. Statement is drawn from entries in books. As a result of transaction not derived from the monetary base are not recorded. iii. Money as a unit of measure is unstable. Consequences
i.
i. Non-transaction based facts are eliminated (excluded). ii. Relevant data that are not measurable in monetary terms are excluded.
Double Entry Principle or Dual Aspect Concept:

This principle or concept states that every transaction affects the business in two ways and therefore needs to be recorded in two accounts. That is the receiving account and giving account. The receiving account is debited with the value of benefit received, while the giving account is credited with the same value of benefit given at the same time. In other words, the concept states that every debit entry there is a corresponding credit entry and vice versa. This is the alternate form of the accounting equation: ASSETS=CAPITAL + LIABILITIES The justification of this concept is that it enables the position of the business to be known through the balance sheet and again facilitates in the preparation of the Trial Balance. Advantages i. ii. iii. It gives a complete record of each transaction. Control of business is facilitated as the entries affect all accounts concerned. This enables the ability of knowing the trend or changes that are taking place at all times. Preparation of final accounts and balance sheet. As the accounts contain full information, it is easy to prepare the accounts needed to assess the present position of the business and how it has changed. A check on arithmetical accuracy of clerical work. Since every debit has a corresponding credit entry, the total debits should be equal to the total credits. Whether this is or not a trial balance could easily verify this.
iv.
Realisation
Given the fact that revenue is matched with cost at the time it is earned. It is important to know exactly when revenue is earned (realised) to determine in which accounting period it will be matched with costs. Revenue is usually realised at the time of sale, i.e. when goods are passed to the customer. In some industries, especially, long-term contracts, production spans more than one accounting period. Therefore if revenue is realised is recognised only on time of its completion and the product is passed to the customer (probably after several years work), the profit earned by business each year will not give fair view. Instead, revenue is recognised for each period based on the amount of work complete during the period. This is disclosed in work in work certificate. The justification; i. Asset Transfer; on sale, the goods cease to be the property of the trader and become the property of the customer. At this point the trader ceases to own the goods; instead he has a debt due to him. The value of goods is the cost to the trader. Any other value (especially selling price) will be an estimate and accountants like to be objective.
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ii.
Critical event Principle; the trader as a businessman is in business to sell things. It is suggested that buying good and collecting debts are relatively easy. The hard bit is selling the goods and consequently it the point that profit is earned. iii. Certainty Principle; when goods are bought the profit that will be made is not certain. It is not certained that the goods will be sold and a profit made. When the goods are sold, there is a certainty that a profit has been made and how much profit is. Drawbacks i. Unrealised profits or holding gains are ignored. for example, an asset may have increased in value while it has been held by the business but, not recognition of this increase is made until the asset is sold. ii. Distortions can occur when the trading cycle is long. For example, the profit on long term contract accrues over the period of the contract does not occur suddenly on the completion of the contract. In practice, the realisation concept is modified in the case of long term contracts. iii. The convention is unnecessary caution in waiting until a sale before profit can be recognised. Consequence; i. Fixed and current assets are valued at cost or cost derived amount. ii. Holding gains and unrealised profits are ignored.
Periodicity
Although the accountant assumes that the business has a continuous life, most of financial information requires periodic reports of the firms financial condition. In this light, financial statements are prepared for regular intervals. The justification of this concept is that ongoing information about the business is required at regular intervals for all sorts of purposes; performance evaluation, tax assessment etc. Drawbacks; i. It is assumed that business transactions can be identified with particular periods.. in practice many transactions (e.g., buying fixed assets) have consequences for may periods. ii. Periodic computations lead to comparison of the results of successive periods. As the pattern of business activity change overtime, this comparison may be misleading. iii. A range of concepts have had to be developed (matching, realisation, prudence) to relate transactions to specific time period. iv. In very short period accounting (e.g., half-yearly, or shorter) seasonal variation may be misleading. Consequence i. Much effort is required to prepare periodic accounts. ii. Arbitrary allocation and apportionment methods are required.
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Materiality
There are some transactions or events that are not significant enough for accountants to record or disclose. Accounting is concerned with the measurement of profit and capital and the presentation of the results to interested parties. Insignificant items are merged with others with others and are not shown separately the problem is making a decision as to what is material and what is not a material. What is significant material in one instance to warrant full disclosure may not justify complete reporting in another circumstance because of practical considerations.
For example, a box of paper clips in the book-keepers desk as on the balance sheet date is an asset of the company although, it has been charged to expense. It is possible but not practicable to ascertain the asset value of the unused clips and make a corresponding entry. Because of this insignificance of unused paper clip, to make the adjustment will have no material effect on the financial statements and cannot mislead the user of financial statement. The treatment of an item depends on the size of business. Justification is that many outlays that are theoretically should be recorded as assets are immediately written off as expenses because of their lack of significance
Objectivity/Verifiability
Accountants normally insist that every financial event that is recorded should have a proof of documentation; such as invoices, receipts, time cards and other vouchers. Whenever possible undocumented opinions of management or others do not provide a good basis for accounting determinations. This practice provides a better assurance that any qualified accountant, whether or not employed by the company, viewing the same evidence will probably arrive at a similar treatment of financial event. The justification is that it prevents accountants from having his/her personal feelings cropping into the preparation of financial reports.
Full Disclosure
Financial reports should fully disclose all information which is in accordance with statutory requirements and which is material to presentation of a true and fair view. Information disclosed must be arranged to facilitate interpretation and care must taken to avoid misunderstanding by ensuring that they are not shown out of their correct context. This avoids misinterpretation. A change in method of accounting should, for example, be disclosed. Depreciation methods, price level adjustments etc., are shown in explanatory notes.
Substance Over Form

Transactions and other events be accounted for and presented in accordance with their substance and economic reality and not merely their legal form.
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FINANCIAL STATEMENT OF SOLE TRADER

Having proved the arithmetical accuracy of ledger by means of trial balance we should proceed to ascertain our profit or loss for a period, in order to determine the profit or loss of a business and its financial position, final accounts at the end of a particular period are prepared. The term "final accounts" means statements which are finally prepared to show the profit earned or loss suffered by the firm and financial state of affairs of the firm at the end of the period concerned. The basis of these statements is trial balance. The trial balance includes all the accounts from the ledger. The nature of which may be either, personal, real, or nominal. It should be noted that from the trial balance only nominal accounts are transferred to the profit and loss account. The real or personal accounts go to the balance sheet. INCOME STATEMENT (FINAL ACCOUNT) Income Statement is prepared to know the financial performance of an entity. In an Income Statement; expenses for the year are subtracted from the incomes earned during the year. Both incomes and expenses are measured according to the accrual concept, whereas, profit are measured according to the matching concept. According to the IAS 1 Income Statement can be prepared using ether: 1. Function of expenses method, or 2. Nature of expenses method a) Function of expenses method According to the functions of expenses method the expenses are divided into five groups according to their functions: Cost of sales Administrative Selling and marketing Financial Income Tax Incomes are also divided into two groups: Sales revenue (operating income) Other incomes (non-operating incomes)
ELEMENTS OF FINANCIAL STATEMENTS
Financial information of an entity are classified into five main heads, these main heads are elements of financial statements.
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Elements of financial statements
Measurement of financial Measurement of financial
Position through balance sheet performance through income statement
Assets Liabilities Equity
Incomes Expenses
ASSETS: These are the resources in control of the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Points to remember: 1. Resources in control 2. Past event 3. Future inflow LIABILITIES: These are the present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Points to remember: 1. Present obligation 2. Past event 3. Future outflow EQUITY (CAPITAL): It is the residual interest in the assets after deducting all its liabilities. In other words, equity is what is left when all liabilities have been settled. Points to remember: 1. Equity contributed 2. Reserves created INCOMES: Incomes establish increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity other than those relating to contributions from equity participants.
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Incomes include: 1. Revenue a. Sales of goods b. Sales of services c. Returns on investments 2. Gains a. Disposal of assets at a value higher than its carrying amount b. Discharge of liabilities at a value lesser than its carrying amount Expenses: Expense is decrease in economic benefits during the accounting period in the form of outflows or decrease in assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Expenses include: 1. Revenue Expenses a. Expenses that arise in the course of ordinary activities of an entity. 2. Losses a. Disposal of assets at a value lesser than its carrying amount b. Discharge of liabilities at a value higher than its carrying amount
TRADING ACCOUNT:
Learning Objectives: 1. 2. 3. 4. Define and explain trading account. What are the items of a trading account? Prepare the format of trading account. What are advantages of trading accounting?
Definition and Explanation: A trading account is an account which contains, in summarised form, all the transactions, occurring, throughout the trading period, in commodities in which one deals" and which gives the gross trading result. In short, trading account is the account which is prepared to determine the gross profit or the gross loss of a trader.
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Items of Trading Account: The following items usually appear in the debit and credit sides of the trading account. Debit Side Items: 1. The value of opening inventory of goods (i.e., the stock of goods with which the business was started). 2. Net purchase made during the year (i.e., purchases less returns). 3. Direct expenses, if any. Credit Side Items: 1. Total sales made during the period less the value of returns, i.e., net sales. 2. The value of closing stock of goods. The difference between the two sides of the trading account represents either gross profit or gross loss. Thus if the credit side is heavier that would mean that the trader has earned gross profit i.e., the excess of selling price of the goods sold over their purchase price. If the debit side is heavier it would mean that the trader has suffered gross loss i.e., purchase price of goods exceeds the selling price. The balance of trading account which represents either gross profit or gross loss is transferred to profit and loss account. Trading Accounts Items: Now we shall discuss the items of trading account one by one. Opening Inventory: In case of trading concerns it will consist of only finished goods or goods to be sold without alteration. In manufacturing concerns, the opening inventory will consist of three parts (a). Stock of raw materials. (b). Stock of partly completed goods or work-in-progress. (c). Stock of finished goods. In case of new business there will be no opening stock. Purchases:
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This item includes both cash and credit purchases of goods bought with the object of sales. Return Outwards or Purchases Returns: It means the goods returned by a trader to his suppliers from out of his purchases. Return outwards reduce the purchases. It is shown by way of deduction from purchases in the trading account. Discount on Purchases: It is also shown by way of deduction from purchases in the trading account. Sales: This item includes total of both cash and credit sales of goods in which businessman deals in. It is credited to trading account. Returns Inwards or Sales Returns: It means goods returned to a trader by his customers from out of goods sold to them. It is shown by way of deduction from sales on the credit side, of the trading account. Discount on Sales: This account has always a debit balance and is shown by deduction from sales in the trading account. Direct Expenses: Direct expenses are those expenses which are incurred to convert raw-materials into finished goods or which may be regarded as a part of the cost of purchasing the goods. e.g., wages paid by a manufacturer to construct furniture out of raw wood, the expenses incurred to bring goods from the place of purchase to the business place of the trader etc. All the direct expenses are charged to the trading account. The items usually included in the direct expenses are: 1. Wages: This item usually signifies some hourly, daily or piecework remuneration paid to labourers. It is direct expenditure and should be charged to trading account. 2. Manufacturing or Productive Wages: This item usually signifies the wages of factory workmen actually engaged in making or producing something. It is a direct charge on the cost of manufacturer. It is debited to manufacturing account or trading account. 3. Carriage Inward: Carriage means conveyance charges of goods by land. Carriages inward are the conveyance expenses incurred to bring the goods purchased in the shop. It is debited to trading account. In examination questions when the item only "carriage" is given and is not expressly stated
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4. 5. 6. 7.
8.
9.
to be inward or outward, it should be assumed to be inward and debited to trading account. The reason is that carriage on goods is usually paid by the purchaser.. Freight: Freight is the charge made for conveyance of goods by sea. Freight on goods purchased is charged to trading account. Customs Duty: When goods are purchased from a foreign country import duty will be payable. All duties on goods purchased should be debited to trading account. Excise Duty: It is a tax levied by the government. If the duty is levied on production it will be treated as manufacturing expenses and debited to trading account. Stores Consumed: This item stores denote lubricating oil, tallow, grease, cotton and jute waste, etc., required for running the machinery of manufacturing concern. The amount of stores consumed is a direct expense and should be charged to trading account. Royalty: Royalty is an amount paid to a person for exploiting rights possessed by him it is usually paid to patentee, author, or landlord for the right to use his patent, copyright or land. If they are productive expenses, they are debited to manufacturing account; but in the absence of a manufacturing account, they are debited to trading account. Manufacturing Expense: All other expenses such as factory rent, factory insurance, factory repair etc., are direct expenses and should be charged to trading account.
Closing Stock and its Valuation: Closing stock represents the value of goods lying unsold in the hands of a trader at the end of a trading period. The value of closing stock is ascertained by means of compilation of list of materials, stores and goods actually in possession at the close of the trading period. This work is known as taking the inventory. The inventory or lists of physical stock are then faired and valued. The total of the lists will be closing stock. The closing stock is valued at cost or market price whichever is lower. As this item materially affects the gross profit (or gross loss), it is essential that all possible care should be taken to calculate the closing stock at a proper value. The value of closing stock is taken into consideration only at the time of preparing the trading account and not before. The trial balance is prepared before the preparation of the trading account. Hence the closing stock does not appear in a trial balance. It is brought into account by means of a journal entry debiting stock account and crediting the trading account. Closing Entries for Trading Account: Closing entries are those which are passed at the end of each financial period for the purpose of transferring the various revenues items to the trading and profit and loss account and thus the nominal accounts are closed. I preparing a trading account, the opening stock, purchases, sales, returns both inwards and outwards, direct expenses and closing stock are transferred to it by means of journal entries as follows:
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1. Trading Account To Purchases Account To Returns Inwards Account To Direct Expenses Account (wages, carriage etc.) (Being the transfer of the latter accounts to the former.) 2. Sales Account Returns Outward Account To Trading Account (Sales etc., transferred to trading account) 3. Closing Stock Account To Trading Account (Being to record closing stock)
ADVANTAGES OF TRADING ACCOUNT:

The advantages of the trading account are as follows: 1. A trader can find out the gross profit and thereby can ascertain the percentage of profit he has earned on the cost of goods sold. This percentage of gross profit may serve as his ready guide for the adjustment of future sale price. 2. A trading account helps a trader to compare his stock at open with that at the close. He can further find out whether the purchases he has made during the period of account have been judicious. 3. Once can compare the figure of sales with similar figure of the previous year and can find out whether business is improving or declining. 4. If the gross profit disclosed by the trading account is less than expected, an enquiry can be made into the cause responsible for the decline. And if the gross profit is more than was expected, steps can be taken to maintain it.
PROFIT AND LOSS ACCOUNT:

Learning Objectives: 1. Define and explain profit and loss account. 2. Prepare the format of profit and loss account (account form and statement form). 3. Prepare closing journal entries profit and loss account. Definition and Explanation: Profit and loss account is the account whereby a trader determines the net result of his business transactions. It is the account which reveals the net profit (or net loss) of the trader.
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The profit and loss account is opened with gross profit transferred from the trading account (or with gross loss which will be debited to profit and loss account). After this all expenses and losses (which have not been dealt in the trading account) are transferred to the debit side of the profit and loss account. If there are any incomes or gains, these will be credited to the profit and loss account. The excess of the gain over the losses is called the net profit and that of the loss over the gain is called the net loss. The account is closed by transferring the net profit or loss to capital account of the trader. Closing Entries for Profit and Loss Account: The following usual entries are passed at the end of each trading period. 1. Transferring all expenses or losses: Profit and loss account To Each of the various expenses or losses (This entry will close the expenses accounts) 2. Transferring all items of gains etc: Various nominal accounts (representing gains) To Profit and loss account (This entry will close all the remaining nominal accounts) 3. Transferring net gain to capital account: Profit and loss account To Capital account (This entry closes the P & L account) 4. Transferring net loss to capital account: Capital account To Profit and loss account (This entry closes the P & L account) Trading Profit and Loss Account in Statement Form/Income Statement: Trading and profit and loss account/income statement may be prepared either in account form (T form) or in report form (statement form). Trading and profit and loss account in both the forms give the same information. The account or T form is traditional and is used widely but in recent years many business houses prefer to present the profit and loss account/income statement in the report form. Explanation of Certain Items of Income Statement: Income from sales: The total of all charges to customers for goods sold, both for cash and on credit, is reported in this section. Sales returns and allowances and sales discounts are deducted from the gross amount to yield net sales.
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Cost of Goods Sold: Cost of goods sold refers to the cost price of goods which have been sold during a given period of time. In order to calculate the cost of goods sold we should deduct from the total cost of goods purchased the cost of goods at the end of the year. This can be explained with the help of following formula/equation: (Opening stock + Net Cost of goods purchased) - Closing stock = Cost of goods sold Gross Profit: The excess of the net income from sales over the cost of goods sold is also called gross profit on sales, trading profit or gross margin. It is as gross because all other expenses for the period must be deducted from it to obtain the net profit or net income of the business. Operating Expenses: The operating expenses also called operating costs of a business may be classified under any desired number of headings and sub-headings. In small retail business it is usually satisfactory to classify operating expenses as selling or general. 1. Expenses that are incurred directly in connection with the sale of goods are known as selling expenses. Selling expenses include salaries or the salesmen, store supplies used depreciation of the store equipment, and advertising. 2. Expenses incurred in the general administration of the business are known as administrative expenses or general expenses. Examples of general expenses are office salaries, depreciation of equipment, and office supplied used. Net Profit from Operations: The excess of gross profit on sales over total operating expenses is called net profit or net profit from operations. If operating expenses should exceed gross profit, the excess is designated as net loss or net loss from operations. Other Income: Minor sources of income are classified as other income or non-operating income. In a merchandising business this category often includes income from interest, rent, dividends and gains from the sale of fixed assets. Other Expenses: Expenses that cannot be associated definitely with the operations are identified as other expenses or non-operating expenses. Interest expense that results from financing activities and losses incurred in the disposal of fixed assets are examples of items reported in this section. The two categories of non-operating items, other income and other expenses, are offset against each other on the profit and loss account. If the total of other income exceeds the total other expenses, the excess is added to net profit from operations; if the reverse is true, the difference is subtracted from net profit from operations. Net Profit: The final figure on the profit and loss account is labelled as net profit (or net loss) or net profit carried to balance sheet. It is the net increase in capital from profit making activities.
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DIFFERENCE BETWEEN TRADING ACCOUNT AND PROFIT AND LOSS ACCOUNT:

Learning Objectives: 1. What is the difference between account and profit and loss account?
The main difference between trading account and profit and loss account is that the gross profit or loss which is derived from the trading account shows the trend of the business and the profit and loss account reflects on the management of the business the final outcomes of the concern. Trading account deals with the cost price of the goods. All the expenses directly connected with the buying of goods are entered in it. It is credited with the sale proceeds of the goods. Profit and loss account deals with the expenses indirectly connected with the goods (expenses with the selling of the goods.)
BALANCE SHEET:
Learning Objectives: 1. Define and explain balance sheet. 2. How is a balance sheet prepared? 3. What are the objectives of preparing a balance sheet?
Definition and Explanation: A balance sheet is a statement drawn up at the end of each trading period stating therein all the assets and liabilities of a business arranged in the customary order to exhibit the true and correct state of affairs of the concern as on a given date. A balance sheet is prepared from a trial balance after the balances of nominal accounts are transferred to the trading account or to the profit and loss account. The remaining balances of personal or real accounts represent either assets or liabilities at the closing date. These assets and liabilities are shown in the balance sheet in a classified form - the assets being shown on the right side and the liabilities on the left hand side.
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Sales Less sales returns Net sales Less cost of sales: Opening stock Add purchases Add carriage inwards
Kofi Wayo Income Statement for the Year Ended 31- 12- 09 GH GH *** (**) ** *** *** *** *** (****) **** (***) (***) **** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** ***
Less return outwards Cost of goods available for sale Less closing stock Cost of goods sold Gross profit Add other incomes: Discount received Rent received Commission received Insurance rebate Decrease in provision for bad debts Less operating expenses: Wages and salaries Postages Bad debts Rent and rates Discount allowed Insurance payable Depreciation Stationary Repairs and maintenance Lighting and heating Motor expenses General expenses Net profit (Loss)
(***) *** (***)
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Kofi Wayo Balance sheet as at 31 December 2009 Noncurrent Assets: Cost *** *** *** *** *** **** Dep. (***) (***) (***) (***) (****) *** *** (***) *** *** *** *** **** NBV *** *** *** *** *** ****
Land and building Plant and Machinery Motor Vehicles Furniture and Fittings Fixtures Current Assets: Stock Debtors Less provision for bad debts Prepayments Bank Cash Less Current Liabilities: Creditors Accruals/Owings Bank overdraft WORKING CAPITAL NET ASSETS Financed by: Capital Add Net Profit (Loss) Less Drawings Noncurrent Liability: Loan
*** *** ***
(****) ***** **** *** *** (***) **** (***) *** *** ****
THE FOLLOWING POINTS MUST BE CAREFULLY NOTED: 1 The first point, in direct contrast with the balance sheet, is the income statement which summarizes the trading activities of the business over the period of time, usually twelve months.
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2. Secondly the figures for sales relate to goods sold during the year, whether or not the cash was actually received during the year. 3. Having arrived at a figure for sales, one must deduct the cost of buying these goods. It is quite likely that some of the goods sold at the beginning of the year were goods which were in stock at the previous year end. One must therefore add these onto goods, which were actually purchased during the year. However, some of the years purchases were unsold at the year end. These must be deducted from purchases, as they will be set off against next years sales. 4. Sales less cost of sales gives gross profit .Deducting expenses from the gross profit arrives at net profit. For convenience the profit and loss is divided into two parts. The parts dealing with sales and cost of sales may be referred to as the trading account, the remaining as the profit and loss account. 5. One must be very careful to distinguish between wages and drawings. Wages relate to payment to third parties (employees) and represent a deduction or charge in arriving at the net profit. Amount paid to the proprietor (even if he calls them salary) must be treated as drawings. It would be wrong to treat drawings as a business expense as the amount drawn is not used to further a sale. They represent an appropriation of profit earned by the business and are eventually deducted from the proprietors capital account.
OBJECTIVES OF THE BALANCE SHEET:

The function of the correctly prepared balance sheet is to exhibit the true and correct view of the state of affairs of any concern. In a balance sheet as the assets and liabilities are shown in details after being properly valued, a trader can judge the position of his business from it. Classification of assets in the balance sheet is on the base of permanency order. This is known as marshalling. In a company balance sheet grouping and marshalling is strictly followed. It is clearly presented in the balances sheet that assets are broadly classified into Non-Current Assets and Current Assets. Non-Current Assets are then grouped into fixed and other non-current assets. Fixed assets are further classified into fixed tangible and fixed intangible assets. a) Fixed Tangible Assets These are the property, plant and equipment that are held by the entity a) for production or selling of goods or services, b) for administrative purposes, or c) for rental to others. These are expected to be useful for the entity for more than one accounting year. Examples include: land & Building, Plant & Machinery, Furniture & fixtures, Motor Vehicles, Office equipments etc. b) Fixed Intangible Assets These are the identifiable, non monetary asset in control of the entity that have no physical existence and are expected to be useful for the entity for more than one accounting year. Examples include: Trademark, Copy right, Patents, Designs etc.
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c) Long term Investment These are the investments made by the company in other entities for more than one accounting year. Examples include: Investments in equity instruments or debt instruments of other entities. d)Long term loans These are the loans given to the third parties on long term basis, receivable after the expiry of more than one accounting year. e) Long term advances, deposits, and prepayments These are the security deposits, fixed deposits, advances given to the suppliers of assets, and prepayments on long term basis. f) Current Assets These are the assets recoverable and tradable within the normal operating cycle of an entity that is 12 months after the balance sheet date in normal circumstances. Cash and cash equivalents are also current assets. g) Current Liabilities These are the obligations that are payable within the normal operating cycle of an entity that is 12 months after the balance sheet date in normal circumstances. This also include bank overdraft.
Distinction/Difference Between Trial Balance and Balance Sheet:

The following are the points of distinction/difference between trial balance and balance sheet: Trial Balance Balance Sheet
It is a list of balance extracted from the ledger accounts. It contains the balance of all accounts - real, nominal and personal. It is prepared before the preparation of trading and profit and loss account.
It is a statement of assets and liabilities It contains the balance of only those accounts which represents assets and liabilities. It is prepared after the preparation of trading and profit and loss account.
It does not contain the value of the closing stock of goods.
It contains the value of closing stock, which appears on the assets side.
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Expenses due but not paid and incomes due but not received do not appear in the trial balance
Expenses due but not paid appear on the liability side and income due but not received appear on the asset side of the balance sheet.
ILLUSTRATION A: - CEMBA 560 ENTERPRISE TRIAL BALANCES AS AT 31ST DECEMBER, 2009. DEBIT CREDIT ACCOUNTS NAME GH GH
Cash in hand Furniture & Fitting Purchases Wages & Salaries Motor Vehicles Buildings Telephone & Postages Office expenses Insurance Returns inwards Carriage inwards Inventory Trade receivables Interest on loan Bank overdraft Sales Long term loan Rent received Returns outwards Accumulated depreciation: Motor Vehicles Buildings Furniture & Fitting Trade payables Capital 1,200.00 7,500.00 9,700.00 12,500.00 14,200.00 60,500.00 1,500.00 4,200.00 3,200.00 760.00 970.00 1,730.00 1,950.00 600.00 3,400.00 15,200.00 6,000.00 2,700.00 120.00 3,750.00 2,500.00 1,250.00 2,104.00 83,486.00 120,510.00
_________ 120,510.00
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B: - CEMBA 560 ENTERPRISE INCOME STATEMENT FOR THE YEAR ENDED 31ST DECEMBER, 2009. Revenue GH GH GH
Sales Less returns inwards Net sales Less Cost of Sales: Opening inventory Add net Purchases: Purchases Carriage inwards Gross purchases Less returns outwards Cost of Goods Available for Sale Less closing inventory Gross profit carried down Gross profit brought forward Add rent received Less Operating Expenses: Wages & Salaries
Telephone & postage Office expenses Interest on loan Insurance Less insurance prepaid Electricity bill owing Provision for doubtful debt Provision for depreciation: Motor van Buildings Furniture & fittings Net Loss
15,200.00 760.00 14,440.00 1,730.00 9,700.00 970.00 10,670.00 120.00
10,550.00 12,280.00 1,550.00
10,730.00 3,710.00 3,710.00 2,700.00 6,410.00
12,500.00 1,500.00 4,200.00 600.00 3,200.00 800.00 2,400.00 500.00 195.00 2,090.00 12,100.00 1,125.00 37,210.00 (30,800.00)
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C: - CEMBA 560 ENTERPRISE BALANCE SHEET AT 31ST DECEMBER, 2009.

Noncurrent Assets COST GH 14,200.00 60,500.00 7,500.00 82,200.00 Add Working Capital: Current Assets Inventory Trade receivables less provision for doubtful debt Insurance prepaid Cash in hand 1,550.00 1,950.00 195.00 1,755.00 800.00 1,200.00 5,305.00 Less Current Liabilities; Trade payables Electricity bill owing Bank overdraft Net Assets Financed by: Capital Less net loss Capital Invested Add Noncurrent Liabilities long-term loan Capital Employed 2,104.00 500.00 3,400.00 6,004.00 (699.00) 58,686.00 AC. DEP GH 5,840.00 14,600.00 2,375.00 22,815.00 NBV GH 8,360.00 45,900.00 5,125.00 59,385.00
Motor vehicle Building Furniture & fittings
83,486.00 30,800.00 52,686.00 6,000.00 58,686.00
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ADJUSTMENTS OF THE FINAL ACCOUNTS OF BUSINESS ORGANISATIONS

In this section we cover the following topics:

Capital and revenue expenditure Accounting for accruals and prepayments Bad debts, recovered bad debts and provision for doubtful debts o Bad debts o Provisions for doubtful debts o Bad debts recovered Depreciation o Meaning of depreciation o Calculation of straight-line and reducing balance methods of depreciation o Deprecation adjustments for profits and balance sheets o Calculation of profits and losses on asset disposal
CAPITAL AND REVENUE EXPENDITURE

Expenditure is a payment made for assets bought or for services enjoyed. Assets which are purchased not for the purpose of being sold but for use in the business over two or more years are classified as fixed assets. Payments made for the purchase of such an asset is called capital expenditure.
Capital Expenditure
Capital expenditures are those items the benefit of which is received over a number of accounting periods. It may be described as an outlay resulting in increase or acquisition of an asset or increase in the earning capacity of a business, or major alteration, improvement or extension in the asset operating capacity or any expense that was necessary for the asset to start operating properly or for the business to start its operations. It produces an asset comparatively permanent in character. Capital expenditure may also be defined as expenditure incurred: a. In the acquisition of fixed assets acquired for the use in the business and not for resale or b. In the alteration or improvement of assets for increasing their earning capacity in the business. If the purpose of expenditure is to improve the earning capacity of the business, it is considered as a capital expenditure. Capital expenditure is therefore made when a firm spends money either to: Buy fixed assets or Add to the value of an existing fixed asset. Included in such should be those spent on: Acquiring fixed assets;
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Bringing them into the firm; Legal cost of buying a building; Carriage inwards of machinery bought; Any other cost needed to get the fixed asset ready for use.
Since capital expenditure results in a long-term benefit to the business, it is written off in bits to profit and loss account. The proportion unexpired at the end of each accounting period is carried forward to continue to form part of the capital employed in the business. Examples of this form of expenditure are improvements to building; the purchase of additional machinery; legal cost incurred in the purchase of a building and of course the purchase price of the building.
Revenue Expenditure
Revenue expenditure is those items the full benefit of which is received in one accounting period. They are such outlay as is necessary for the maintenance of earning capacity including the upkeep of the fixed asset in a fully efficient state and the normal total cost involved in selling, including the cost of goods and services of the business. Revenue expenditure may also be defined as expenditure incurred: In the maintenance of fixed assets In the acquisition of assets required for conversion into cash or In selling and distributing goods and in administering the business. OR This is expenditure incurred by business for purposes of generating income for enhancing profitability. These expenses are therefore charged against the profit or loss account for the period or accounting year for which they have been incurred. Examples are carriage outwards, insurance of business premises, motor vehicle running cost, commission payable to agents, wages and salaries etc. In short revenue expenditure is that which does not add to the value of fixed assets but merely the costs incurred in running the business during a particular period. If the purpose of expenditure is to maintain the business, it is revenue. Revenue expenditure contributes only once to the profit earning of a firm and except where it is represented by unsold stock and payments in advance is wholly exhausted and written off against revenue (profit and loss account) in the period in which it is incurred.
Importance
Revenue expenditure constitutes a charge against profits that is they are debited to profit and loss account whereas capital expenditure is treated as capital charge, and is shown as an asset in the balance sheet. Such expenditure is not written off against the profit and loss account in one year but is
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maintained in the business permanently. Its permanence attracts regular annual depreciation charges in the revenue accounts (profits and loss accounts). The cost of a fixed asset is capital expenditure, however, the cost of the proportion used for a period or depreciation is revenue expenditure. If revenue expenditure is written in the balance sheet as a capital item, expenses would be understated thereby overstating profits. The assets in the balance sheet in this case would include an item that is not truly an asset. In the same way if capital expenditure is charged to revenue, future profits would be distorted due to undercharge or overcharge of depreciation for subsequent years. The classification is important because it ensures that the financial statement shows a true and fair view of profit or loss made by the business and the true financial state of the business affairs. In government budgets the term recurrent expenditure is used in place of revenue expenditure because these expenditures are repeated from year to year, while non-recurrent expenditure is used in place of capital expenditure.
Distinction between Capital Expenditure and Revenue Expenditure

1. Capital expenditure is incurred in acquiring or improving fixed assets whereas revenue expenditure is incurred on items other than those related to acquisition and improvement of fixed assets. 2. Capital expenditure seeks to improve the earning capacity of the business whereas the revenue expenditure is incurred in the normal course of the business. 3. Capital expenditure is normally a non-recurring expenditure whereas revenue expenditure is usually recurring expenditure. Expenditure is usually a recurring expenditure when incurred in the normal course of the business. 4. Revenue expenditure benefits current years only and, therefore, are charged to profit and loss account of the current year. On the other hand, capital expenditure benefits several years. As a result, only a part of capital expenditure is charged as expense to the profit and loss account of a particular year and the balance is shown in the asset side of the balance sheet. Summary The distinction between capital and revenue expenditure has a significant impact on the computation of business income since revenue expenditure is chargeable to the income statement, while capital expenditure concerns the acquisition of an asset which is to be carried forward in a balance sheet.
Capital and Revenue Receipts

The sale of any item of capital expenditure and the receipt of any monetary income is called a capital receipt. For example a motor vehicle which was bought for 50, 000 and sold five years later for 7500. The 50, 000 could be treated as capital expenditure while the 7500 should be treated as a capital receipt.
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Revenue receipts are sales or other revenue items, such as rent receivable or commission receivable. Treatment of Loan Interest An amount borrowed to finance the purchase of a fixed asset will attract an interest rate which has to be paid on the loan. The loan interest however not a cost of acquiring the asset is, but is simply a cost of financing it. This means that loan interest is revenue expenditure and not capital expenditure.
Incorrect Treatment of Expenditure If one of the following occurs: 1. Capital expenditure is incorrectly treated as revenue expenditure or Revenue expenditure is incorrectly treated as capital expenditure; then both the balance sheet figures and trading and profit and loss account figures will be incorrect The following table illustrates examples of capital and revenue expenditure: Capital expenditure Installation of heating system, Upgrades to computer system New premises Painting new premises Carriage inwards on new equipment Installation costs of machinery One-off license fee Revenue Expenditure Annual costs of heating system Power cost of computing system Repairs to premises Repainting existing premises Carriage inwards on stocks for resale Running costs of machinery Annual road tax
Exam tips - capital and revenue expenditure Examination questions do not normally focus solely on the distinction between capital and revenue expenditure. This topic is likely to be tested in the context of some other topic - such as the effect on profits of the purchase of a fixed asset. The distinction between capital and revenue expenditure (and incomes) may be tested in terms of their effect on cash flow and profits at the same time.
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PROVISION AND RESERVES

Provision
Is an amount written off to provide for depreciation or diminution in value of assets or retained to provide for a known liability. Provisions made for expected losses and contingencies are charges against profits. The liability should be a present obligation whether legal or constructive which has arisen as a result of a past event and where payment is probable (more likely than not) and the amount can be estimated reliably. It arises from the accrual and prudence principles. Examples of these liabilities appearing in the liabilities side of the balance sheet are: Provision for retirement benefits. Provisions for reorganisation or severance: this provision is recorded when a company announces a plan to change its organisation structure, which will incur significant costs, including termination of personnel However, take note that the provisions can also be classified on the asset side of the balance sheet which are then known as negative assets with the objective to decrease the value of other assets of the company. Examples of provision as negative assets: Bad debt provision provision decreasing the value of receivables, because their recoverability is doubtful. Mostly recorded based on aging of the receivables, older receivables are more doubtful that new ones. Provision for product returns / credit note provision provision decreasing the value of receivables due to expected sales returns. Normally recorded based on historical experience as a percentage of recent sales. Provision for excessive, obsolete or damaged inventory decreasing the value of inventory with uncertain marketability (due to its obsoleteness, damages or excessive volume on stock) Impairment provisions generally any provisions recorded when a book value of an asset is significantly higher than its fair value.
What Is Reserves?
Reserves are appropriations of profit namely when profits have been ascertained after deducting all expenses which includes provision and others. Reserves are residual earnings after all expenses and taxation which belongs to the owners namely the shareholders. There are essentially two(2) types of Reserves: Capital Reserves and Revenue Reserves
Capital Reserves:
Are appropriations from profits which cannot be distributed by way of cash dividends. These capital reserves arises mainly from (i) equity transactions between the enterprise and its shareholders; (ii) from adjustments arising in accounting for business combinations; (iii) from differences arising on translation of foreign currency operations; (iv) from surpluses arising from asset revaluation; (iv) any unrealized
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gain which has not been included in income. Examples of capital reserves includes: share premium, capital redemption reserves, capital reserves arising on merger and acquisition, statutory reserves, asset revaluation reserve and exchange fluctuation reserves.
Revenue Reserves are:

Are appropriations from profit which can be distributed by way of cash dividends although some may be set aside for other purposes. Examples like retained profits and general reserves.
Main Difference Between Provision And Reserve

Remember that provision is a charge to the profit whilst a reserve is an appropriation to the profit. Reserves belong to the owners equity side while provision can be on a liability side or on the assets side but as a negative asset. Distinction between provisions and reserves
Reserves
1. 2. It is created by debiting the profit and loss appropriation account. It is created to meet an unknown liability, or to strengthen the financial position of the company or for equalization of dividends etc. A reserve is created only when there is profit in the business. It can be distributed among shareholders as dividend. The reserve is created without taking into consideration the actual amount required except in the case of redemption of debentures when a definite sum is set aside. Creation of reserve depends upon the financial policy of the business and discretion of its management. It is usually shown on the liability side of the balance sheet as it is not a specific reserve.
3. 4. 5.
6.
7.
Provisions
1. 2. It is created by debiting the profit and loss account. It is created to meet a known liability or a specific contingency, e.g.. provision for bad and doubtful debts, or provision for depreciation etc. A provision is created irrespective of whether there is profit or loss in the business. It is not available for distribution as dividend among shareholders. A provision is made for a definite amount and, therefore, a definite sum is set aside every year to meet the known contingency.
3. 4. 5.
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6. 7.
Making of a provision is a must to meet known liability or contingency. The provision is generally shown on the assets side of the balance sheet.
Distinction between general reserve and specific reserve

General reserve 1. It is created for a specific purpose. 2. It is utilized for that specific purpose, for which it was created. 3. Whether profit or no profits, it must be created. 4. It is necessary to create in order to ascertain profit. 5. It is shown on the debit side of profit and loss account. 6. Net profits are reduced because of it. Specific Reserve
1. It is created not for any specific purpose but for meeting future contingencies. 2. It can be utilized for meeting any future loss. 3. It is created only when there are sufficient profit. 4. They are created only when there are profits i.e. they depend upon profits. 5. It is shown on the debit side of profit and loss appropriation account. 6. Only distributable profits are reduced because of it. Reserve Fund
Profit set aside and used in the business is a reserve. But profit set aside and invested outside the business is a reserve fund. Thus, the use of the term 'fund' indicates investment of reserve outside the business. Sinking Fund
A sinking fund is a fund built up by annual contributions. The contributions are invested outside the business in readily realizable securities. Interest received on investments is reinvested in the same securities. A sinking fund may be (i) for replacement of fixed assets or (ii) for the redemption of debentures or repayment of loan. A sinking fund for the replacement of a fixed asset is a provision. But a sinking fund
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for redemption of debentures or repayment of loan is an appropriation of profits. A sinking fund represents amount invested outside the business.
Distinction between reserve fund and sinking fund

Reserve fund 1. Investments are not for definite period. 2. It is created always out of divisible profits. 3. Interest received on investments representing reserve fund may not be re-invested. 1. 2. Sinking fund Investments are for a definite period. It is not always out of divisible profit e.g. sinking fund for replacement of asset is provision for depreciation, it must be created even if there are no profits. In case of sinking fund, interest is always re-invested
3.
ACCRUALS AND PREPAYMENTS

The profit and loss account for any firm should show the income and expenses belonging to the time period in which account claims to represent. In most cases, the profit and loss account is drawn up for a year - this means that it should show all the income earned and all the expenses incurred for that year even if they have not all been paid and received. This idea is contained within the accruals (or matching) concept - that we should account for income and expenses when they are incurred (i.e. used up), not when they are paid and received. In other words, if an item of income or an expense belongs to a period of time (e.g., car insurance for a year) then it would appear as an income or expense for that period - regardless of the amounts actually paid or received. So far, we have only applied this concept to sales and purchases - sales are included as income and purchases are included as an expense even though they are usually on credit terms and the money from these transactions may not be paid or received until the next accounting period. For example, credit sales made on 20th December 2001 would count towards the profits of the year ended 31 December 2001, but the cash generated by this sale is unlikely to be received until 2002. The accruals concept must also be applied for any expenses and any incomes. This leads to some new definitions:
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The implications of these for the profit and loss account is that this account should show the income that should have been received and the expenses that should have been paid when the transaction was originally made, even if this does not correspond with the money paid in or received. If expenses are paid immediately when they are incurred and income is received immediately when it is also earned, then we have no need for accrual and prepayments. For example, if we assume the annual electricity bill was GH750 and commission received for the year of 2001 was GH500, then the ledger accounts would appear as follows: Electricity
GH
GH
2001 Dec 31
Bank
750
2001 Dec 31 Profit & loss
750
Electricity appears on the debit side of the profit and loss account (as an expense).
Commission Received
GH GH
2001 Dec 31
Profit & loss
500 2001 Dec 31 Bank 500
Commission received appears on the credit side of the profit and loss account (as income). If you are not using bookkeeping, then you should be aware of the following: Expenses Incomes Debit balances Credit balances
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In the above example, Rent would appear as a debit (expense) and commission received would appear as a credit (income) in the profit and loss account. If we allow for accrued expenses and prepayments then this will involve discrepancies between the amount that appears in the profit and loss account and the amount that was actually paid or received. The following examples include situations taking this into account. Concepts covered 1. Accrued expenses (or accruals) are expenses incurred during a financial period but not yet paid for, i.e. expenses owing 2. Prepayments are expenses paid in advance of the current financial period (i.e. paid now for the next period). 3. Accrued revenue refers to income which is still owing to firm (similar to debtors) 4. Prepaid revenue refers to income which the firm has received in advance of when it was due
Adjustments without bookkeeping

The same examples as above are now explained without the use of bookkeeping. Remember the profit and loss account has to deal with the amounts that were due to be either paid or received. Therefore the adjustments needed for accruals and prepayments in expenses will be as follows: Profit and loss entry = amount paid + accrued expenses still owing Profit and loss entry = amount paid - prepayment for next period For incomes and revenues received by the firm, the treatment will be as follows: Profit and loss entry = amount received + accrued revenue (amount still owing to us) Profit and loss entry = amount received - prepaid revenue (received in advance for next period) Dealing with more than one year So far we have considered examples where the outstanding balance only occurs at the end of the year. It is perfectly possible to carry these forward and to have outstanding balances at the start and at the end of the year. We can use our knowledge to determine how much should actually be entered in the profit and loss account for the particular period. Consider the following examples (as before, follow the links to the examples):
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Balance sheets On the balance sheet, only the amount that is either an accrual or a prepayment should be included in current assets and current liabilities. Normally, prepayments should appear in current assets after bank and cash. Accruals should appear in current liabilities after creditors and bank overdrafts. Accrued expenses or prepaid revenue Credit balances Current liabilities Prepaid expenses or accrued revenue Debit balances Current assets
In questions where the data is presented in the form of a trial balance, the amount actually paid or received will appear within the trial balance. Information relating to accruals and prepayments will be given at the bottom of the trial balance with the closing stock and other information Exam tips - accruals and prepayments To calculate the amount to be included in the profit and loss account, think about the amounts that belong to that period - irrespective of whether they have been paid or not. Be careful in case there are outstanding balances from both the start and the end of the period - the amounts will need adjusting for both. Accruals and prepayments will always generate an item for the balance sheets
Bad debts
Credit sales and credit purchases are normal business transactions, where goods are exchanged between supplier and customer, but the money for the transaction is exchanged at a later date. These credit terms offered gives firms valuable 'breathing space' where they can pay for the goods at a time when the firm may have more money available (most credit terms expect payment within one month). The business offering credit terms is taking the risk that some customers may never pay for the goods sold to them on credit. Any debtor's balances that remain unpaid (after a specified period of time has elapsed) are classified as a bad debt.. The process of cancelling a debt because payment is not expected to be received is known as 'writing off' the bad debt. Bad debts are an unfortunate, but not unusual business expense, and must be charged as an expense to the profit and loss account in the period when the firm decides to cancel the debt from ledger accounts
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Bad debts are a profit and loss expense in the period in which they are written off Firms would not offer credit to any firm they know would not pay, but many firms will experience financial difficulty - and may have to close down - thus making bad debts an inevitable part of the business world. When a debt is found to be bad, the balance on the debtor's account ceases to have any real value and must be closed down as an asset account (here we are trying to show a realistic value of the assets of the firm - the prudence concept - covered in 3.2). This is done by crediting the debtor's account to cancel the asset and increasing the expenses account of bad debts by debiting it there. Sometimes the debtor will have paid part of the debt, leaving the remainder to be written off as a bad debt. Alternatively, the firm may receive part of the outstanding debt in full settlement. At the end of the accounting period, the total of the bad debts account is later transferred to the profit and loss account as an expense. The double entry for bad debts is as follows: Debit Bad debts Credit Debtor
During 2005, the following sales were made all on a credit basis. January 15, sales of GH750 were made to G Flitcroft March 11, sales of GH490 were made to G Elliot April 27, sales of GH160 were made to P Krugman The entries for these sales would appear as follows: G Flitcroft
2005 Jan 15 Sales
GH 750
2005
GH
81
G Elliot
2005 Mar 11 Sales
GH 490
2005
GH
P Krugman
2005 Apr 27 Sales
GH 160
2005
GH
(N.B. The sales account would receive the credit entry for each of these sales) On the 31 December of that year it was decided that the following accounts would be written off as bad debts: G Flitcroft G Elliot At 31 December, P Krugman had been declared bankrupt during the year and a payment of 25p in the GH was received by cheque in full settlement of this account. The debtor's account would now appear as: G Flitcroft
2005 Jan 15 Sales
GH 750
2005 Dec 31 Bad debts
GH 750
82
G Elliot
2005 Mar 11 Sales
GH 490
2005 Dec 31 Bad debts
GH 490
P Krugman
2005 Apr 27 Sales
GH 160
2005 Dec 31 Dec 31 Bank Bad debts
GH 40 120 160
160
With the P Krugman account, a settlement of 25p in the means that we have received 25p for every GH1 owing to us - the other 75p in the is rewritten off as a bad debt. To complete the entries, the amounts are transferred to the debit side of the bad debts account. This account is then transferred to the debit side of the profit and loss account - as an expense. Bad debts
2005 Dec 31 Dec 31 Dec 31 G Flitcroft G Elliot P Krugman
GH
2005 Dec 31 Profit and loss
GH 1360
750 490 120 1360
1360
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In a trial balance, the entries for bad debts will always be in the debit column. This means that the bad debts have already been deducted from the debtors figure in the trial balance and therefore you should not deduct the bad debt from he debtors figure. Only if the bad debt has not been recorded in the books would the debtors figure need to be reduced because of bad debts.
Provisions for doubtful debts

The profit and loss account and the balance sheet are the final accounts of the firm. One of the main aims of producing these statements is to show a true and fair view of the firm's financial position. One way in which we achieve this is by showing realistic values for any assets that the firm has. Any debtor balance which is unlikely to be collected should be written off as a bad debt and the overall total for debtors will therefore not contain amounts that we have given up hope of collecting. However there is a problem with the debtors figure as it appears on the balance sheet. Although the debtors figure contains the total amount that we aim to collect from our customers, the firm will probably recognise that, over the course of the next year, some of these debtors will become bad debts and have to be written off. The firm will have no idea (although it may suspect) which of the firm's debtors will become bad debts (surely it would not have given credit terms to any customer who is unlikely to pay), but it will have to face up the fact that bad debts are a common business occurrence. In most cases, the debtors would be willing to pay, but simply cannot (maybe because the customer's firm has had to close). As a result, the debtors figure on the balance sheet does not show a 'true and fair view' of the actual amounts that will be collected by the firm from the customers. Therefore to be prudent, the firm should try to aim to show a more realistic figure for the amounts likely to be collected over the near future - in other words, it should try to estimate the size of any future bad debts, before they actually occur. This can be done by creating a provision for doubtful debts. This provision is supposed to reflect the likely size of the future bad debts which means that this can be deducted from the debtors figure on the balance sheet so to give a more realistic figure for the amounts likely to be collected. The provision for doubtful debts is not the same as the amount of bad debts. Bad debts are actual sums of money that have been written off. The provision for doubtful debts is an estimate of the size of future bad debts - it has not happened. The firm may actually over or underestimate the size of the future bad debts when creating this provision. This does not matter, as long as the estimate is a reasonably realistic prediction of what will happen then it does not matter if the actual bad debts in the future are not exactly the same as the provision for doubtful debts.
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Calculating the size of the provision for doubtful debts When trying to estimate a figure for doubtful debts, a firm would want to take into account the following: 1. The amounts of debts outstanding from each customer 2. How long each debt has been outstanding 3. Economic climate - incidences of business failure Firms will have different experience when it comes to bad debts. Some firms will operate in industries where bad debts are more frequent than others. Therefore the estimates will differ between firms. Generally, the longer a debt is owing the more likely it is that it will become a bad debt. This can be seen in an aged debtors schedule which ranks and classify amounts owing to the firm by the length of time that they have been outstanding. Example: Ageing Schedule for Doubtful Debts
Period debt owing
Amount
Estimated percentage doubtful % 1 2 5 10 50
Provision for doubtful debts
GH 30 days or less 1 month to 2 months 2 months to 6 months 6 months to 1 year Over 1 year Total debtors amounts 10,000 6,000 800 300 180 17,280
GH 100 120 40 30 90 380
This balance of GH 380 for the provision would then be deducted from the value of the debtors figure on the balance sheet - giving us a more realistic value of the amount that we will collect from the debtors. As far, as most examination questions go, the provision for doubtful debts is likely to be a
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percentage of the overall debtors figure. For example, some firms may always maintain a provision for doubtful debts of 2 or 3% of their outstanding debtors totals. Accounting for provisions A provision is an amount charged against profit (i.e. treated as an expense) to record a reduction in the value of an asset - even if the exact fall in value is uncertain. Whether you have studied bookkeeping or not, the accounting entries for provisions are unlike any other types of entries that you will make in terms of their effect on the profit and loss account, as well as on the balance sheet. There are three main types of provisions that are studied: 1. Provisions for doubtful debts 2. Provisions for depreciation 3. Provision for unrealised profit on stock If a firm's asset has lost, or is expected to lose value, then we would want to show this loss in the accounts. The balance sheet value can be reduced, but we also want to show the effect of this loss on the profits as well. Therefore a provision will appear in the profit and loss account as an expense - even though no money has been spent. If you imagine that you'd lost some money - you would treat this as a loss for yourself, even though you haven't actually spent any money. Although a provision will appear as an expense in the profit and loss account, it is only the adjustment to the provision that appears as an expense. Therefore, if the provision is kept at the same level over a few years then, apart from when the provision is created, there will be no further expense in the profit and loss account - only when it was first created. It may help if you think of it as money you put aside. If last year you had put aside GH 200 out of profits, and this year you want the same amount to be 'aside' then you don't need to deduct anything from this years profits. The GH200 is still there - it was on last years balance sheet and it will be on this years' too, unless it is adjusted. Provisions are always credit balances and they are kept in the firm's books until the firm decides to eliminate them from the entries. If a provision is to be increased then a further credit entry will need to be 'added' on the existing balance. If the provision were to be reduced then there would need to be a debit entry to reduce the overall balance. If the provision were actually reduced between one year and the next, then this reduction in the provision would actually be treated as income and would be added on the year's gross profit. The rules for provisions are as follows:
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Profit & loss account Show change in provision only Increases = expenses Decreases = revenues
Balance sheet Deduct full provision from relevant asset
Accounting entries for provisions for doubtful debts When the decision has been taken as to the amount of the provision to be made, then the accounting entries needed for the provision are: Debit Profit & loss Increasing the provision This provision that was created will be kept on the firm's books and can be adjusted both upwards and downwards to meet changing circumstances. If we assume that as at 31 December 2002 the debtors figure had risen to GH16,000 (see example 1 link above) then the provision may well be adjusted upwards to take into account the increased likelihood of bad debts. If we maintain the provisions at 3% of debtors, then the provision would be increased to 3% x GH16,000 = GH480. However, because there is already a provision in existence of the GH450, we simply need to add on another GH30 to the credit side of the provision for doubtful debts account. Provision for doubtful debts Credit Provision for bad debts
2001 Dec 31 2002 Dec 31 Balance c/d Balance c/d
GH 450
2001 Dec 31 2002 Profit & loss
GH 450
480
Jan 1 Dec 31
Balance b/d Profit & loss
450 30
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480
480
Therefore the rule for increasing the provision is as follows: Debit Profit & loss with the increase in the provision Credit Provision for bad debts with the increase in the provision
Profit and Loss Account (extract) for the year ended 31 December 2002 GH Gross profit Less Expenses: Provision for doubtful debts 30 xxx
Balance sheet (extract) as at 31 December 2002 Current assets Debtors Less Provision for doubtful debts Reducing the provision The provision is always shown as a credit balance. Therefore, to reduce it we would need a debit entry in the provision account. If the firm's debtors figure was lower than in the provision year, or the firm had decided that there was a reduced risk of bad debts then the firm may wish to reduce the overall provision. GH 16,000 480 15,520 GH
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In our example, on 31 December 2003, the debtors figure was GH 14,000 and the provision were to be maintained at 3% of debtors. This means that the provision would be reduced down to GH14,000 x 3% = GH420. As the outstanding credit balance on the provision for doubtful debts account is GH480, we will need to debit that account in order to reduce the provision. This is completed as follows: Provision for doubtful debts
GH 450
GH 450
480
Jan 1 Dec 31
450 30 480
480 2003 Dec 31 Dec 31 Profit & loss Balance c/d 60 420 480 2004 Jan 1 Balance b/d 2003 Jan 1 Balance b/d
480
480
420
The entries needed for when the provision is to be reduced are as follows: Debit Provision for bad debts Credit Profit & loss
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with the decrease in the provision
with the decrease in the provision
Profit and Loss Account (extract) for the year ended 31 December 2003 GH Gross profit Add Reduction in provision for doubtful debts 60 xxx
Balance sheet (extract) as at 31 December 2002 Current assets Debtors Less Provision for doubtful debts GH 14,000 420 13,580 GH
For non-bookkeeping students... Even if you are not using the bookkeeping entries in this module, the rules for accounting for the provisions for doubtful debts can still confuse. As long as you remember then distinction between the entries in the profit & loss account and the entry for the balance sheet than you should be alright. Profit & loss account Show change in provision for doubtful debts only: Increases = expense Decreases = revenue Balance sheet Deduct full provision from debtors figure - show workings in current assets
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Bad debts recovered It is not uncommon for a debt written off in previous years to be recovered in later years. The entries needed to record this can be split into two stages: 1. First reinstate the balance on the debtors account in the sales ledger This may appear odd, but the main reason for restoring the balance on the debtor's account is to give a more detailed record of the debtor's 'history'. The fact that the bad debt has been recovered may influence the decision in the future as to whether the firm offers credit terms to this same customer again. Entry to reinstate the balance on the debtor's account Debit Debtor's account Credit Bad debts recovered account
2. Show the effect of the payment being received in the cashbook and in the debtors account Payment received from debtors Debit Cash/bank Credit Debtor's account
At the end of the financial year, the credit balance in the bad debts recovered account will normally be transferred to the credit side of the profit and loss account (as income)- it would be added on to the gross profit Normally, we try to match income to the period in which it was generated, or the expense to when it was incurred. However, with bad debts recovered this procedure is ignored. Rather than add the bad debt recovered as income for the period in which the sale was made, we include the income in the period in when it was recovered instead. To summarise: Bad debts recovered Trial balance entry Credit Effect on net profit Added as income
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Exam tips - bad debts and provision for bad debts

Remember, it is the change in the provision that will appear in the profit and loss account. The full provision will be deducted on the balance sheet. Although related, it will be easier if you treat the bad debts and the provision for any bad debts as completely separate items when making calculations. This topic can be integrated into the construction of the final accounts.
DEPRECIATION OF TANGIBLE NON-CURRENT ASSETS (FIXED ASSETS)

Definition of depreciation
Depreciation as a process is the systematic allocation of the depreciable amount of an asset over its useful life. The amount of depreciation charged to the income statement as an expense is part of the depreciable amount deemed to have been consumed during the period being reported.
Definitions Depreciable amount: the term means carrying value minus residual value The residual value: is the net realizable value of an asset at the end of its useful life The useful life: of an asset is the period over which the entity expects to use the asset Carrying amount- is the amount at which an asset is included in the balance sheet after deducting any accumulated depreciation Depreciation is all about recognizing in the income statement the cost associated with the use of the non-current asset. Consequently depreciation must still be charged even where the asset is worth more than its carrying amount. Depreciation should be allocated so as to charge a fair proportion of cost or valuation of the asset to each accounting period expected to benefit from its use in line with the matching concept
Causes of Depreciation
a) Physical deterioration Wear and tear e.g. Motor Van, Erosion, rust, rot and decay e.g. Land b) Economic factors Obsolescence (changes in technology) e.g. Software Inadequacy c) Time factor e.g. patent, copyright d) Depletion e.g. Mine, quarries, oil well
Methods of Calculating Depreciation

Four main methods
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a) b) c) d)
Straight line or fixed instalment Reducing balance Sum of the years digit Revaluation STRAIGHT LINE OR FIXED INSTALMENT METHOD
Fixed instalment method is also known as straight line method or original cost method. Under this method the expected life of the asset or the period during which a particular asset will render service is the calculated. The cost of the asset less scrap value, if any, at the end f its expected life is divided by the number of years of its expected life and each year a fixed amount is charged in accounts as depreciation. The amount chargeable in respect of depreciation under this method remains constant from year to year. This method is also known as straight line method because if a graph of the amounts of annual depreciation is drawn, it would be a straight line. Formula: The following formula or equation is used to calculate depreciation under this method: Annual Depreciation = [(Cost of Assets - Scrap Value)/Estimated Life of Machinery] Journal Entries: The journal entries that will have to be made under this method are very simple. The journal entries will be as under: 1. Depreciation account To Asset account (Being the depreciation of the asset) Profit and loss account To Depreciation account (Being the amount of depreciation charged to Profit and Loss account)
2.
These entries will be passed at the end of each year so long as the asset lasts. In the last year, the scrap will be sold and with the amount that realised by the sale the following entry will be passed: 3. Cash account To Asset account (Being the sale price of scrap realised.)
Advantages: 1. Fixed instalment method of depreciation is simple and easy to work out 2. The book value of the asset can be reduced to zero.
Disadvantages: 1. This method, in spite of its being simplest is not very popular because of the fact that whereas each year's depreciation charge is equal, the charge for repairs and renewals goes on increasing as the asset becomes older. The result is that the profit and loss account has to bear a light burden in the initial years of the asset but later on this burden becomes heavier. 2. Interest on money is locked up in the asset is not taken into account as is done in some other methods. 3. No provision for the replacement of the asset is made. 4. Difficulty is faced in calculation of depreciation on additions made during the year. Scope of Application: On account of the above mentioned advantages and disadvantages of fixed instalment method, it is generally applied in case of those assets which have small value or which do not require many repairs and renewals for example copyright, patents, short leases etc. Example: On 1st January 1991 X purchased a machinery for GH 21,000. The estimated life of the machine is 10 years. After it its break up value will be GH1,000 only. Calculate the amount of annual depreciation according to fixed installment method (straight line method or original cost method) and prepare the machinery account for the first three years. Machinery Account Debit Side GH 1991 Jan. To Bank account 1 1991 21,000 By Depreciation account Dec. 31 1991 By Balance c/d Dec. 31 21,000 1992 Jan. To Balance b/d 1 19,000 1991 By Depreciation account Dec. 31 1991 Dec. 31 Credit Side GH 2,000 19,000 21,000 2,000 17,000 15,000 1991 By Depreciation account Dec. 31 1991 By Balance c/d Dec. 31 2,000 15,000 17,000
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15,000 1993 Jan. To Balance b/d 1 17,000
17,000
rexmay2003@yahoo.com Tutorial | DEPRECIATION OF TANGIBLE NON-CURRENT ASSETS (FIXED ASSETS)
Exercise: Wahala Ltd bought a motor vehicle for GH22,000. The vehicle is estimated to have a useful life of five years and could be sold for GH2,000 after its life. Required: Calculate the annual depreciation charge for each of the five years. REDUCING BALANCE METHOD: With this method you apply a fixed percentage (given to you), to the net book value of the non-current asset at the beginning of each year as depreciation. The method is also called diminishing balance method. Diminishing balance method is also known as written down value method or reducing instalment method. Under this method the asset is depreciated at fixed percentage calculated on the debit balance of the asset which is diminished year after year on account of depreciation. Journal Entries: The entries in this case will be identical to those discussed in the case of the fixed instalment method. Only the amount will be differently calculated. Advantages of Diminishing Balance Method: 1. The strongest point in favour of this method is that under it the total burden imposed on profit and loss account due to depreciation and repairs remains more or less equal year after year since the amount after depreciation goes on diminishing with the passage of time whereas the amount of repairs goes on increasing an asset grow older. 2. Separate calculations are unnecessary for additions and extensions, though in the first year some complications usually arise on account of the fact that additions are generally made in the middle of the year. Disadvantages of Diminishing Balance method: 1. This method ignores the question of interest on capital invested in the asset and the replacement of the asset. 2. This method cannot reduce the book value of an asset to zero if it is desired. 3. Very high rate of depreciation would have to be adopted otherwise it will take a very long time to write an asset down to its residual value Scope of Application: Diminishing balance method of depreciation is most suited to plant and machinery where additions and extensions take place so often and where the question of repairs is also very important. Written down value method or reducing instalment method does not suit the case of lease, whose value has to be reduced to zero.
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Example: On 1st January, 1994, a merchant purchased plant and machinery costing GH25,000. It has been decided to depreciate it at the rate if 20 percent p.a. on the diminishing balance method (written down value method). Show the plant and machinery account in the first three years. Plant and Machinery Account Debit Side Date 1994 Jan. To Cash 1 GH 25,000 Date 1994 By Depreciation Dec. 31 " By Balance c/d Credit Side GH 5,000* 20,000
25,000
25,000
1995 Jan. To Balance b/d 1
20,000
1995 By Depreciation Dec. 31 " By Balance c/d
4,000** 16,000
20,000
20,000
1996 Jan. To Balance b/d 1
16,000
1996 By Depreciation Dec. 31 By Balance c/d
3,200*** 12,800
16,000
16,000
Formula or equation for the depreciation calculation may be written as follows:

*First year: 25,000 20% = 5000 **Second Year: (25000 - 5000) 20% = 4,000 ***Third Year: [25000 - (5,000 + 4,000)] 20% = 3,200
Formula; R = ( N=Life of Asset (Years) R=Rate S=Scrap value C=Original cost
)*100%
An assets cost 5000 with an estimated life of 4years. Scrap value was estimated at 200. R=
*100 =
*100% =(1-0.45)* 100 =55%
Illustration: A business acquires a fixed asset for $10,000 which he will use for 3 years at which time he will sell for GH2,160. Using the reducing balance method and a rate of 40%, show the annual depreciation charges. SUM OF THE YEARS DIGIT METHOD: A fast method of depreciation which is also based on the assumption that the loss in the value of the fixed asset will be greater during the earlier years and will go on decreasing gradually with the decrease in the life of such asset. The SYD is found by estimating an asset's useful life in years, then assessing consecutive numbers to each year, and totalling these numbers. For n years: SYD = 1 + 2 + 3 + 4 + ...... + n For example if the useful life of an asset is 5 years, the SYD would be 1 + 2 + 3 + 4 + 5 = 15. Determining the SYD factor by simple addition can be somewhat laborious for long-lived assets. For these assets the formula n (n + 1) / 2 where n = the number of periods in the asset's useful life can be applied to derive the SYD. In our example, we have: The yearly depreciation is then calculated by multiplying the total depreciable amount for the life of the asset by a fraction whose numerator is the remaining useful life and whose denominator is the SYD. Thus in our example the calculation would: The formula for depreciation for this method is:
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Depreciation =
Depreciation cost (Remaining useful life/SYD) Example:
ABC Ltd. purchased a truck for GH65,000 on 1st January 1991. The expected life was 5 years and salvage value GH5,000. Calculate the annual depreciation expense by applying sum-of-the-years' digits (SYD) method. Solution: Amount to be written off = GH65,000 - 5,000 = 60,000 SYD = 1 + 2 + 3 + 4 + 5 = 15 The annual depreciation is: First year depreciation Second year depreciation Third year depreciation Fourth year depreciation Fifth year depreciation Total = = = = = 5/15 4/15 3/15 2/15 1/15 60,000 60,000 60,000 60,000 60,000 = = = = = GH 20,000 16,000 12,000 8,000 4,000 60,000
When the asset is acquired during the year, the depreciation expense may be determined by dividing the fractional multipliers between the current and succeeding year. Using the data in the above example suppose the truck is purchased on 30thJune 1991, the depreciation is computed as follows:
End of theDepreciable Years' fraction year cost
Years' depreciation
Accumulated Cost depreciation
Book value
1. 2.
60,000 60,000 60,000 60,000 60,000
5/15 (1/2) ]5/15 4/15 (1/2) ]4/15 3/15 (1/2)
10,000 (1/2)10,000 8,000 (1/2)8,000 6,000
1,000
65,000
55,000
28,000
65,000
37,000
3.
42,000
65,000
23,000
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4.
60,000 60,000 60,000 60,000 60,000
3/15 2/15 (1/2) ]2/15 1/15 (1/2) 1/15 (1/2)
(1/2)6,000 4,000 (1/2)4,000 2,000 2,000
52,000
65,000
13,000
5.
58,000 60,000
65,000 65,000
7,000 5,000
6.
Scope of the Sum of Years' Digits Method (SYD): As an accelerated depreciation method, the SYD approach is most appropriate for those situations in which the asset is judged to render greater utility during its earlier life and less in its later life. Illustration: Koosoko Bro purchased a machine for GH 35,000. It has a useful life of 4 years and salvage value of GH 5,000. REVALUATION METHOD As the name implies under revaluation method, the assets are valued at the end of each period so that the difference between the old value and the new value, which represents the actual depreciation can be charged against the profit and loss account. This method is mostly used in case of assets like bottles, horses, packages, loose tools, casks etc. On rare occasions when on revaluation the value of an asset is found to have increased, it being of temporary nature not taken into account. Revaluation method is open to various objections. Firstly, the method do not specify as to which is the value that the experts are to estimate at the end of each year. It however appears that this is the market value. If so, to assess depreciation with reference to market value is against the basic principles and theory of depreciation. A fixed asset has nothing to do with market value. Secondly, the charge against profit and loss account on account of depreciation will vary year to year through the asset renders the same service throughout of its life time. Thirdly, this method is unscientific, because there is great chance of manoeuvring.
INTEXT EXERCISE Theoretical:
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1. What is depreciation and how is it brought about? 2. Name the different methods of providing for depreciation, and discuss any one of them in detail? 3. Explain the difference between (i) depreciation and fluctuation (ii) depreciation and obsolescence. How obsolescence should be provided for. 4. What are the objects of making provision for depreciation of the fixed assets of a business. 5. Why depreciation on fixed assets should be brought into account. Discuss in detail the several methods of providing for depreciation. 6. What is depreciation? Does it depend on the market value of the asset? Why is it necessary to provide for depreciation of assets while preparing the balance sheet? 7. Explain briefly the nature and use of the "revaluation process" of depreciation. Answers: To find the answers of all the questions above, please read our accounting for depreciation chapter in detail. Click here to start now. Objectives: A. State whether each of the following statements are true or false: 1. The objective of charging profit and loss account with the amount of depreciation is to spread the cost of an asset over its useful life for the purpose of income determination. 2. The amount of depreciation is credited to depreciation fund account in case of annuity method. 3. The charge for use of the asset remains uniform each year in case of straight line method. 4. Depreciation is charged on the book value of the asset each year in case of diminishing balance method. 5. Depletion method is suitable for charging depreciation in case of stock or loose tools. 6. Net charge to the profit and loss account is the same under both annuity method and depreciation fund method. 7. The amount of depreciation is credited to the depreciation fund account in the depreciation fund method. 8. The asset appears always at original cost in case depreciation is credited to provision for depreciation account. 9. In case of insurance policy method, the depreciation is credited to the asset account. Answers: 1 True 2 False 3 False 4 True 5 False 6 True 7 True 8 True 9 False
B. Fill in the blanks 1. The total amount of depreciation to be written off over the life of an asset is equal to the cost of the asset less its ________. 2. Obsolescence and inadequacy are called the ________ factors causing depreciation. 3. Over or under provision of ________ is taken to profit and loss account as profit or loss at the time of termination or sale of assets.
4. The useful life of depreciable asset for an enterprise may be ________ than its physical life. This is usually because of such factors as _________ and ________. 5. In the case of wasting assets the amount of charge determined on the basis of exhaustion of the asset is known as ________.
DEPRECIATION ADJUSTMENTS FOR PROFITS AND BALANCE SHEETS Once you have mastered the ability to calculate depreciation, you will then need to enter this into the double entry accounts. As with other provisions, depreciation will always be a credit balance. All provisions are credit balances Unlike the provision for doubtful debts, the total depreciation provision is never reduced (unless a mistake has been made) and therefore, we will only credit the depreciation account, while we have the asset. The double entry record for annual depreciation is as follows: Debit Profit & loss Credit Provision for depreciation
No entry is ever made in the actual asset account - unless we decide to purchase more of the same type of asset, or decide the sell some of this type of asset. The double entry tells us that the depreciation charge will appear on the debit side of the profit and loss account as though we were paying an expense. However, the credit balance on the provision for depreciation account will be kept and maintained, and added to, as long as the firm still has the relevant asset. Example 1 On 1 January 2001, a firm purchases a machine for GH10,000, paying by cheque. It chooses to depreciate the machine at 25% on cost using the straight-line method. Show the asset, the provision for depreciation account and the extracts from the balance sheet for each of the four years, the firm has the asset for.
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Answer The annual depreciation will be 25% x GH10,000 = GH2,500 (i.e. the machine is expected to last for four years). The entry in the asset account is easy, it will look as follows: Machinery
2001 Jan 1 Bank
GH 10,000
2001 Dec 31 Balance c/d
GH 10,000
This balance will be carried forward in this account until the firm either sells the machine or buys more machinery. The first entry in the provision for depreciation account would appear as follows:
Provision for depreciation
2001 Dec 31 Balance c/d
GH 2,500
2001 Dec 31 Profit & loss
GH 2,500
The profit and loss account is therefore 'charged' with GH2,500. We know it is a 'charge' because given the credit entry in the provision for depreciation account; the other half of the entry will be on the debit side of the profit and loss account. The balance on this account is carried forward (unlike expense accounts which are normally 'emptied' at the end of each year and transferred in full to the profit and loss account) and added to in each of the next three years. The full account for the four-year period would appear as follows:
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Provision for depreciation - machinery
GH 2,500
GH 2,500
5,000
Jan 1 Dec 31
2,500 2,500 5,000
5,000 2003 Dec 31 Balance c/d 7,500 2003 Jan 1 Dec 31 7,500 2004 Dec 31 Balance c/d 10,000 2004 Jan 1 Dec 31 10,000 Balance b/d Profit & loss Balance b/d Profit & loss
5,000 2,500 7,500
7,500 2,500 10,000
Although the charge to the profit and loss account stays the same at GH2,500, the accumulated total on the above 'provision' account will increase each year. This is illustrated on the balance sheet where the closing balance is deducted from the cost of the asset to give the net book value of the asset at that moment in time.
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Balance sheet (extract) as at 31 December 2001 Fixed assets Machinery Less Provision for depreciation GH 10,000 2,500 7,500 GH
Balance sheet (extract) as at 31 December 2004 Fixed assets Machinery Less Provision for depreciation GH 10,000 10,000 0 GH
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Calculation of profits and losses on asset disposal Purchases of fixed assets do not appear as expenses in the profit and loss account because they are items of capital expenditure. The 'cost' of the asset will appear over a number of years as provisions made for the depreciation of the fixed assets. Similarly, when a fixed asset is sold, we do not include the income from the sale of the asset in the profit and loss account because it is capital income. What we do include is the profit or loss on the sale of the fixed asset. The profit or loss on the sale of any fixed asset is calculated as follows; Profit on disposal = selling price of asset - net book value of the asset The net book value represents what the asset is 'worth' at the moment of the sale and it is calculated as follows: Net book value = cost of asset - accumulated depreciation The accumulated depreciation is all the depreciation that has been 'charged' on the asset right up until the moment of the sale. If an asset is sold during a financial year then calculating the accumulated depreciation can be completed. Some firms will use a fractional depreciation policy which means they would charge depreciation for each portion of a year. For example, if the asset was sold after three months of a financial year's starting date, then one quarter of a full years (3 months is a quarter of one year) depreciation would be charged for. This is sometimes referred to as deprecation being charged on 'a monthly basis'. Some firms prefer to keep it simple and only charge a full year's depreciation regardless of when the sale actually occurs. Any examination question will guide you as to what method will be used. Therefore, if the net book value is higher than the selling price of the asset, a loss will be made on the sale. The sale of fixed assets is referred to as the disposal of assets. This will include situations where the asset is part of a 'trade in' deal, where a new asset is acquired in part exchange for the old asset. The treatment of the profit or loss on the asset disposal will be as follows: Profit & loss entry Profit on disposal Loss on disposal Credit Debit Treated as: Income - added on to profits Expense - deducted from profits
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There are three main steps in the calculation of the profits and loss on the disposal of the asset. These are as follows: 1. Calculate the annual deprecation for the asset. 2. Calculate the accumulated depreciation on the asset 3. Calculate the net book value of the asset. 4. The profit or loss on the disposal can be calculated by comparing the net book value with the selling price of the asset. Example 1 A machine was bought on 1 January 2001 for GH9,000. Depreciation was to be provided for at 20% on cost (straight line method) on a monthly basis. On 30 June 2003 the machine was sold for GH5,000 cash. Answer The profit on the disposal is calculated as follows: 1. The annual deprecation provided on this machine is 20% of GH9,000 = GH1,800 2. The accumulated depreciation is the annual deprecation over a 2 1/2 year period = GH 1,800 x 1/2 =GH4,500 3. The net book value will be: cost - accumulated depreciation, i.e. GH9,000 - GH4,500 = GH4,500. 4. The profit on the asset disposal will therefore be: GH5,000 - GH4,500 = GH500 profit. This GH500 profit would appear as income in the profit and loss account for this period.
BOOKKEEPING ENTRIES FOR ASSET DISPOSAL

As far as any examination goes, whether you use the non-bookkeeping method or the bookkeeping method it does not matter. It is the final answer, and the workings that support that answer which will gain marks. The profit or loss on disposal can be calculated thorough the use of an asset disposal account. This uses double-entry transactions to work out if a profit or loss has been made on the disposal.
Example 1 A machine was bought on 1 January 2001 for GH9,000. Depreciation was to be provided for at 20% on cost (straight line method) on a monthly basis. On 30 June 2003 the machine was sold for GH5,000 cash. If we use bookkeeping, then we would need to see the state of the relevant accounts at the moment of sale. These would be as follows: Machinery
2003 Jan 1 Balance b/d
GH 9,000
2003
GH
2003
GH
2003 Jun 30 Balance b/d
GH 4,500
To record the disposal of a fixed asset, we need to eliminate all the entries relating to this asset in the ledger accounts. This can be achieved as follows: 1. Credit the relevant asset account
2. Debit the depreciation account (with the amount provided on this asset) In our example, the ledger accounts would appear as follows: Machinery
2003 Jan 1 Balance b/d
GH 9,000
2003 Jun 30 Machinery disposal
GH 9,000
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2003 Jun 30 Machinery disposal
GH 4,500
2003 Jun 30 Balance b/d
GH 4,500
Notice how each entry will also appear in a new account - machinery disposal. This asset disposal account is opened to deal with the disposal of any fixed asset. Once the profit or loss on the disposal has been calculated then this account is closed off. Machinery disposal 2003 Jun 30 Machinery GH 9,000 2003 Jun 30 Machinery deprecation GH 4,500
Notice that the disposal account is taking the other half of the double entry for the entries made in the cost and provision accounts. The cash received from the sale is also entered into the disposal account. This is debited to the cashbook and therefore is credited to the disposal account. This is shown below: Machinery disposal
2003 Jun 30 Machinery
GH 9,000
2003 Jun 30 Machinery deprecation Cash
GH 4,500
Jun 30
5,000
This account is now closed off. If there were no outstanding balance then this would mean that the asset has been sold for exactly the same amount as its net book value. This means there is no profit or loss on this sale and no further entries are required.
However, in our example, there is an outstanding balance on the account. This amount represents the profit or loss on the disposal. We finish off the disposal account as follows: Machinery disposal
2003 Jun 30 Machinery
GH 9,000
2003 Jun 30 Machinery deprecation Cash
GH 4,500
Jun 30
Profit & loss
500 9.500
Jun 30
5,000 9,500
The GH500 'balancing figure' represents the profit made on the sale
How do we know it is a profit? Well, this is because if it is on the debit side of the disposal account, then it must be on the credit side of the profit and loss account - which means it is added on to the profit.
FACTORS TO BE CONSIDERED IN DETERMINING THE CHOICE OF DEPRECIATION METHOD

Easy calculation A method which will help the business to benefit from the new fixed asset more than an older fixed asset A method which can create room for whether the wearing out of the asset is a function of time such as patent right, or use, such as a motor van A method which meets legal requirements A method which is recommended by the management as a policy. A method which will be suitable for convention in the industry
DOUBLE ENTRY RECORDING OF DEPRECIATION AND DISPOSAL OF FIXED ASSETS

Each year when depreciation is computed, the following entries are made: Debit the depreciation expense account and credit provision for depreciation account with the charge for each year. Transfer the depreciation expense to the income statement by debiting the income statement and crediting the depreciation expense account
Balance off the provision for depreciation account and deduct this balance from the cost of the asset in the statement of financial position Where an asset has been disposed off, the following entries are made: Transfer the cost of the asset from the pool of assets by debiting the asset disposal account and crediting the asset account. This entry is made at cost Transfer the amount of accumulated depreciation charged so far on the asset from the provision for depreciation account by debiting it and crediting the asset disposal account Receive the proceeds from the sale of the asset, if any, by debiting the bank/cash account and crediting the asset disposal account. Balance off the asset disposal account and any difference is either a gain on disposal or a loss on disposal. This should be taken to the income statement either as income or loss as the case may be. ILLUSTRATIONS: Q1 A business has a financial year end of 31 December. A computer is bought for $20,000 on 1 January 2005. It is to be depreciated at the rate of 20% using the reducing balance method. Required: a. Computer account b. Accumulated provision for depreciation account c. Income statement (extract) d. Statement of financial position (extract) Q2. Beverly bought a van for making deliveries for her florist business 3 years ago when she first set up in business. She makes up annual accounts and has a year end of 31 December. The van cost $8,000. She had estimated a life of 4 years with nil residual value. She provides depreciation on a straight line basis. She sells the van on 31 December of her current accounting period for $2,900, receiving a cheque from the buyer Required: write up the ledger accounts below Motor van Provision for depreciation Disposal Q3. Buster is preparing accounts for year end 31 Dec 2006. At 1 January 2006 balance on machinery account is $110,000. Depreciation is charged at 20% straight line. Accumulated depreciation at 1 January 2006 stands at $50,000. On 1 May 2006 Buster sold one machine for $19,000, which cost $30,000 when acquired on 1 April 2004. A full years depreciation is made in the year of acquisition and none in the year of disposal. Required: write up the ledger accounts below Machinery Provision for depreciation Disposal
ERRORS NOT AFFECTING THE BALANCING OF THE TRIAL BALANCE

Do the following errors affect the trial balance or do not affect the trial balance? Write Yes if it affects and No if does not affect. 1. Sold goods of GH3200 to Nayar, but it is not entered in the Sales Book. 2. Purchased goods of GH2400 from Simon and is correctly entered in the Purchases Book but posted to the credit of her account in the ledger as . GH3400. 3. Total of the Purchases Book is incorrect. 4. An amount of repair to building is debited to Building Account. Again suppose we correctly entered cash sales of GH 70 to the debit of the cash book, but did not enter the GH 70 to the credit of sales account. If this were the only error in the books, the trial balance total would differ by GH 70. However, there are certain kinds of errors which would not affect the agreement of the totals, and would now consider them: CLASSIFICATION OF ACCOUNTING ERRORS Errors Of Omission
Occurs when a transaction is being COMPLETELY OMITTED from the books Example: A cash receipt of GH 500.00 from a trade debtor, Mr.ABC has been omitted from the books. The correcting entry should be: Debit: Bank GH 500.00 Credit: Mr. ABC GH 500.00 Being omission of aforesaid entry now adjusted Errors Of Commission
An entry has been posted to the correct side of the Ledger but to the wrong account. Example: Billing to Mr. A of GH 00.00 was wrongly posted to Mr. Bs a/c [Both are trade debtors in the books of account] Debit: Mr. A GH 500.00 Credit: Mr. B GH 500.00 Being correction of error, sales to Mr. A wrongly debited to Mr. Bs account. Errors Of Principle
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A transaction which is incorrectly dealt with like should be taken up into expenses a/c (income statement) but now wrongly taken up into the balance sheet a/c Example: Office maintenance of GH 1,000.00 wrongly posted into Machinery a/c. Compensating Errors
An error on the debit side being compensated by an error of equal amount on the credit side. Example: Purchases a/c was overcast by GH 1,000.00 and so is Sales a/c Debit: Sales A/c GH 1,000.000 Credit: Purchases a/c GH 1,000.00 Being correction of overcasts of GH 1,000 each in the Sales a/c and Purchases a/c which compensated for each other. Errors Of Original Entry
A wrong amount is recorded in the subsidiary book and posted to the accounts Example: A sales to Mr. A GH 560.00 was entered in the books as GH 650.00 Debit: Sales GH 90.00 Credit: Mr. As a/c GH 90.00 Being correction of error, sales overstated by GH 90.00 Complete Reversal Of Entry
This is where the correct accounts are used but each item is shown on the wrong side of the account. Example: Payment of GH 100.00 to trade creditor Mr. X was entered on the debit side of the Cash book in error and credited to Mr. Xs a/c. This type of error requires an adjustment to cancel the error and the actual entry itself. Normally, this is done by one journal adjustment by doubling the actual amount first recorded. Debit: Mr Xs a/c GH 100.00 x 2 = GH 200.00 Credit: Bank a/c GH 200.00 Being correction of error, payment of cash to Mr. X GH 100.00 debited to cash and credited to Mr. X incorrectly. Errors of Transposition
This where the wrong sequence of the individual characters within a number was entered. For example; GH 142 entered as GH 124. This is a common type of error and is very difficult to spot when the error
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has occurred in both debit and credit entries. A credit purchase from Emmanuel costing GH 56 was entered in books as GH 65. The error need to be removed by Debit; Emmanuel a/c by GH 9 and Credit; Purchases a/c by GH 9 INTEXT QUESTIONS Following are the accounting errors. Write against each error the type i.e. error of omission, error of principle, compensatory error, and error of commission as per the nature of error: (i) Purchase of Furniture is entered in the Purchase Book (Error of ............) (ii) Repairs of building is debited to Building A/c. (Error of ............) (iii) Sales Book is totalled GH15000 instead of its GH 14600. (Error of ............) (iv) Mohans A/c was to be debited by GH4500 and Sohan A/c was to be debited by GH 5500 while Mohons A/c was debited by GH 5500 and that of Sohans A/c by GH 4500. (Error of ............)
CORRECTION OF ACCOUNTING ERRORS

BALANCE SHEET ERRORS These include classification errors among the real accounts in the balance sheet. They have no effect on the income statement and therefore do not require any restatement of retained earnings. When comparative financial statements are prepared the classification errors of prior periods should be corrected for each year presented. INCOME STATEMENT ERRORS These include classification errors among the nominal accounts in the income statement. They have no effect on net income and therefore do not require any restatement of retained earnings. When comparative financial statements are prepared the classification errors of prior periods should be corrected for each year presented. BALANCE SHEET AND INCOME STATEMENT EFFECTS There are two types of errors involving both the income statement and the balance sheet. Counterbalancing errors will be offset over two accounting periods. Non counterbalancing errors take more than two periods to offset. A. (1) a) b) (2) a) b) Counterbalancing Errors We first need to determine if the books are closed for the current year. If the books are closed for the current year: No entry is necessary if the error has already counterbalanced. An entry must be made to retained earnings if the error has not counterbalanced. If the books are not closed for the current year: If the company is in the second year and the error has already counterbalanced, an entry is necessary to correct the current period and adjusted beginning retained earnings. If the error has not counterbalanced, an entry is necessary to adjusted beginning retained earnings and correct the current period.
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Restatement of the financial statements is necessary under all conditions. Example: Spencer Company forgot to accrue payroll at the end of 2001. The amount of accrued payroll at December 31, 2001 was GH 25,000. Assuming that the books for 2002 have NOT been closed the correcting journal entry would be as follows:
DATE 12/31/02
ACCOUNT DEBIT CREDIT Retained earnings 25,000 Salary and wages expense 25,000 To correct error at the end of 12/31/01, failure to accrue payroll If the books have been closed the error has already counterbalanced and no journal entry is necessary. The comparative financial statements for Spencer Company for the two years ended December 31, 2001 and 2002 must reflect the correct amounts of payroll. B. Non counterbalancing Errors It makes no difference whether the books are closed or still open, a correcting journal entry is necessary. Correction of Accounting Errors Example: Spencer Company purchased a machine on January 1, 2000 for GH100,000. The machine had an estimated salvage value of GH10,000 and a service live of 9 years. Spencer Company uses the straight-line method to depreciate all of its assets. The company incorrectly expensed the equipment as an expense in the year of purchase. The error was discovered in 2002. Assuming that the books for 2002 are still open the following journal entry would be required to correct this error. DATE 12/31/02 ACCOUNT Equipment Depreciation expense Retained earnings Accumulated depreciation DEBIT 100,000 10,000 CREDIT
80,000 30,000
To correct for error made in 2000 when the equipment was purchased and expensed Analysis of error: Cost of equipment Salvage value Depreciable base Service life Annual deprecation Years to December 31, 2001 Accumulated depreciation Book value at December 31, 2001 Depreciation expense for 2002 Accumulated depreciation
100,000 10,000 90,000 9 10,000 2 20,000 10,000 30,000
100,000
20,000 80,000
If the 2002 books are closed the following journal entry would be made to correct the error made in 2000.
DATE 12/31/02
ACCOUNT DEBIT CREDIT Equipment 100,000 Retained earnings 70,000 Accumulated depreciation 30,000 To correct for error made in 2000 when the equipment was purchased and expensed Again, it is important to note that if comparative financial statements are prepared the correct amounts for equipment, accumulated depreciation and depreciation expense are to be reported for each year presented. RECTIFICATION OF ACCOUNTING ERRORS By now you must have understood well that every business enterprise prepares its financial statements to provide information of profit earned or loss incurred by it during an accounting period and its financial position on the relevant date. This information will be most useful only if the information is accurate. How can the business concern achieve this objective if there are number of errors in the accounting? Your immediate response will be that errors in accounts should be detected at the earliest and be corrected before preparing the financial statements. It should be clear in your mind that the errors should never be rectified by erasing or overwriting because it will encourage manipulations and frauds in accounts. In accounting practice there are some definite methods to rectify the accounting errors. These are based on accounting practices and procedures. Rectification of errors using these methods is called rectification of accounting errors. So it is a process of rectification. It is generally done by passing an entry to nullify the effect of error. (a) One sided errors Accounting errors that affect only one side of an account which may be either its debit side or credit side, is called one sided error. The reason of such error is that while posting a recorded transaction one account is correctly posted while the corresponding account is not correctly posted. For example, Sales Book is overcast by GH1000. In this case only Sales A/c is wrongly credited by excess amount of GH 1000 while the corresponding account of the various debtors have been correctly debited. Another example of one sided error is Rs 2500 received from Ishita is wrongly debited to her account. In this case, only Ishitas account is affected, amount in the cash-book is correctly written. This type of mistake does affect the trial balance. (b) Two sided errors. The error that affects two separate accounts, debit side of the one and credit side of the other is called two sided error. Example of such error is purchase of machinery for GH1000 has been entered in the Purchases Book. In this case, Purchases A/c is wrongly debited while Machinery A/c has been omitted to be debited. So two accounts i.e. Purchases A/c and the Machinery A/c are affected. Methods of rectification of accounting errors Before preparing Trial Balance (i) Instant correction (ii) Correction in the affected account
After preparing Trial Balance Before preparing Trial Balance (i) Instant correction If the error is detected immediately after making an accounting entry, it may be corrected by neatly crossing out the wrong entry and making the correct entry and the accountant should put his initials. For example, an amount of GH3500 is written as GH5300. This can be corrected as GH3500. Correction in the affected accounts. In case error is detected on a date later than the date on which the transaction was recorded but before the Trial Balance, the rectification will be made by making a correction in the affected account. A few Illustrations of accounting errors corrected by this method are as follows:
(ii)
Illustration Purchases book is overcast for the month of July, 2006 by GH8000. Solution. Accounts Affected The total of the Purchase Book is posted to the debit of Purchase A/c. Therefore Purchase A/c is affected. Rectification: To cancel out the effect of the error, the entry of GH8000 will be made on the credit side of the Purchase A/c. With the words written as. The amount of Purchase Book is overcast for the month of July 2006. PURCHASE A/C Amount Date Particulars GH
Amount as per Purchase Book, for the month of July, 2006
Date
Particulars
Amount GH 8000
NOTE: Casting is the adding up. Overcastting means incorrectly adding up a column of figures to give an answer which is greater than it should be. Undercasting means incorrectly adding up a column of figures to give an answer which is less than it should be. SUSPENSE ACCOUNTS AND ERRORS Many errors will mean the trial balance total will not be equal. These include: Incorrect addition in any account; Making an entry on only one side of the accounts, e.g., a debit but no credit; a credit but no debit;
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Entering a different amount on the debit side from the amount on the credit side.
SUSPENSE ACCOUNT
You have learnt that the Trial Balance prepared at the end of a period by the business concern must agree. It means the sum of its debit column and sum of credit column should agree. But if the totals do not agree the difference amount is written in a new account. This account is called Suspense Account. If the total of the debit side of the Trial Balance is more than the total of its credit side, the difference amount will be written in Suspense A/c on its credit side i.e. Suspense A/c is credited and vice-versa. You have also learnt that the two sides of the Trial Balance do not agree because there is some error or errors in the accounts, which is reflected in the Suspense Account. Thus, Suspense A/c is a summarised account of errors. Opening of a Suspense Account is a temporary arrangement. As soon as the error that has led to Suspense Account is rectified, this account will disappear. One point needs to be noted that Suspense A/c is the result of one sided errors. So one sided errors are corrected through Suspense A/c. Completing the double entry when an error is corrected by placing the correct amount on the debit of the proper account, the credit is placed in Suspense Account or vice-a-versa. For example, Gopals Account was debited short by GH100. The error will be rectified through Suspense A/c by debiting Gopal A/c and crediting Suspense A/c by GH100. Journal entry for the same is as follows: DEBIT Gopal 100 To Suspense A/c (Gopals A/c debited short is now corrected)
CREDIT 100
Similarly, while correcting as one sided error the proper account is credited with the correct amount, the debit is placed in the Suspense A/c. For example, Sales Book for December, 2006 is undercast by GH 500. The error will be rectified by debiting Suspense A/c and crediting Sales A/c. Journal Entry for the same will be as follows: DEBIT
CREDIT
Suspense A/c 500 To Sales A/c 500 (Sales Book undercast is rectified) Illustration 1 Following are some accounting errors. Rectify the same through Suspense A/c. (i) Purchases Book has been overcast by GH.200 (ii) Goods purchased from Manohar of GH.2500 has been posted to the debit of his account. (iii) Cash of GH 4500 paid to Munish was credited to Manish. (iv) Discount GH100 allowed to Anthony was not debited to discount account. Solution. (i) Accounting effect Purchase A/c has been debited in excess by GH200 Rectification: Purchase A/c is credited by GH 200 and Suspense A/c is debited by GH200. Journal entry DEBIT CREDIT
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Suspense A/c To Purchases A/c (Purchase Book overcast is now corrected) (ii)
200 200
Accounting effect Manohar A/c has been debited by GH2500 instead of it being credited by the same amount. Rectification Manohar A/c is credited by GH5000
Journal Entry DEBIT CREDIT Suspense A/c 5000 To Manohar A/c 5000 (Goods purchased from Manohar debited to his account is now corrected) (iii) Accounting effect Manish A/c is credited by GH4500 while Manish A/c was to be debited by the same amount. Rectification. Manish A/c is to be debited by GH4500 and Manish A/c is also be debited by GH 4500 and Suspense A/c to be credited by GH 9000
Journal Entry: DEBIT Manish 4500 Munish 4500 To Suspense A/c (Cash paid to Munish was wrongly credited to Manish, now corrected)
CREDIT
9000
(iv)
Accounting effect Discount A/c is omitted to be debited by GH100. This account is debited and Suspense A/c is credited.
Journal Entry Discount A/c To Suspense A/c (Discount allowed is not debited to discount A/c.)
DEBIT 100
CREDIT 100
Summary Accounting errors are the errors committed by persons responsible for recording and maintaining accounts of a business firm in the course of accounting process. Errors can be in the form of omission of recording of transaction in various books or posting in ledger or mistake in totalling or recording wrong amount or in wrong account. There can be accounting errors which affect the agreement of trial balance and errors which do not affect the agreement of Trial Balance. Errors should never be rectified by erasing or overwriting. Methods of rectification of errors are
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(a) (b)
Before preparing trial balance, instant correction and correction in the affected account. After preparing trial balance through suspense Account
Illustration 2 Rectify the following accounting errors through Suspense Account by making journal entries: 1. Purchase of goods from Mohit for GH2500 was entered in the Sales Book; however Mohits Account was correctly credited. 2. Cash received from Anil a debtor GH3200 was correctly entered in the Cash Book but was omitted to be posted to his account. 3. Sales Book was overcast by GH1500. 4. Cash of GH 4000 paid to Hanif was credited to Rafique A/c as GH1400. 5. The total of Purchase Returns Book of Rs3150 was carried forward as GH1530. 6. Namita was paid cash GH6500 but Sumita was debited by GH 6000. DETAILS 1. Purchase A/c Sales A/c Dr To Suspense A/c (Purchase of good was entered in the sale book now corrected) 2. Suspense A/c To Anil A/c (Anils account omitted to be credited now rectified Sales A/c To Suspense A/c (Sales Book overcast is corrected) 4. Hanif A/c Rafique A/c To Suspense A/c (Cash paid to Hanif was wrongly credited to Rafique the error is now rectified) 5. Suspense A/c To Purchase Returns A/c (Purchase Return Book is undercast is now rectified) 6. Namita A/c To Sumita A/c To Suspense A/c (Cash paid to Namita GH 6500 was debited to Sumita by GH6000 is the error is rectified) DEBIT GH 2500 2500 CREDIT GH
5000
3200 3200 1500 1500
4000 1400 5400
1620
1620
6500 6000 500
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EX The Book keeper of a firm found that his trial balance did not agree. Its credit total exceeded the debit total by GH2850. He placed the amount in Suspense A/c and subsequently found the following errors. (i) A credit item of GH.3490 has been debited to his personal Account as GH4390. (ii) A sum of GH2650 written off as depreciation on machine has not been posted to Depreciation A/c. (iii) Goods of GH5300 sold were returned by the customer and were taken into stock before closing the books but were not entered in the books. (iv) GH4800 due from Lakhan Pal which had been written off as bad debt in a previous year was unexpected recorded and had been posted to the personal account of Lakhan Pal. (v) Sales Book is undercast by GH1500. (vi) GH4000 withdrawn for domestic use by the proprietor was debited to General Expenses A/c. (vii) Machine Purchased from Machine Mart for GH18000 were entered in the Purchases Book. (viii) Cash paid GH1200 to Lakshman was credited to Ram as GH2100.
BANK RECONCILIATION STATEMENT:

Definition and Explanation: From time to time the balance shown by the bank and cash column of the cash book required to be checked. The balance shown by the cash column of the cash book must agree with amount of cash in hand on that date. Thus reconciliation of the cash column is simple matter. If it does not agree it means that either some cash transactions have been omitted from the cash book or an amount of cash has been stolen or lost. The reason for the difference is ascertained and cash book can be corrected. So for as bank balance is concerned, its reconciliation is not so simple. The balance shown by the bank column of the cash book should always agree with the balance shown by the bank statement, because the bank statement is a copy of the customer's account in the banks ledger. But the bank balances as shown by the cash book and bank balances as shown by the bank statement seldom agree. Periodically, therefore, a statement is prepared called bank reconciliation statement to find out the reasons for disagreement between the bank statement balance and the cash book balance of the bank, and to test whether the apparently conflicting balance do really agree. Causes of Disagreement Between Bank statement and Cash book: Usually the reasons for the disagreement are: 1. That our banker might have allowed interest which has not yet been entered in our cash book. 2. That our banker might have debited our account for any such item as interest on overdraft, commission for collecting cheque, incidental charges etc., which we have not entered in the cash book. 3. That some of the cheque which we drew and for which we credited our bank account prior to the date of closing, were not presented at the bank and therefore, not debited in the bank statement.
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4. That some cheques or drafts which we have paid into bank for collection and for which we debited our bank account, were not realised within the due date of closing and therefore, not credited by the bank. 5. The banker might have credited our account with amount of a bill of exchange or any other direct payment into bank and the same may not have been entered in the cash book. 6. That cheques dishonoured might have been debited in the bank statement but have not been given effect to in our books. How to Prepare a Bank Reconciliation Statement: To prepare the bank reconciliation statement, the following rules may be useful for the students: 1. Check the cash book receipts and payments against the bank statement. 2. Items not ticked on either side of the cash book will represent those which have not yet passed through the bank statement. 3. Make a list of these items. 4. Items not ticked on either side of the bank statement will represent those which have not yet been passed through the cash book. 5. Make a list of these items. 6. Adjust the cash book by recording therein those items which do not appear in it but which are found in the bank statement, thus computing the correct balance of the cash book. 7. Prepare the bank reconciliation statement reconciling the bank statement balance with the correct cash book balance in either of the following two ways: (i) First method (Starting with the cash book balance) (ii) Second method (Starting with the bank statement balance) First Method (Starting With the Cash Book Balance): (a) If the cash balance is a debit balance, deduct from it all cheques, drafts etc., paid into the bank but not collected and credited by the bank and added to it all cheques drawn on the bank but not yet presented for payment. The new balance will agree with bank statement. If the bank balance of the cash book is a credit balance (overdraft), add to it all cheques, drafts, etc., paid into the bank but not collected by the bank and deduct from it all cheques drawn on the bank but not yet presented for payment. The new balance will then agree with the balance of the bank statement.
(b)
Second Method (Starting With the Bank Statement Balance): (a) If the bank statement balance is a debit balance (an overdraft), deduct from it all cheques, drafts, etc., paid into bank but not collected and credited by the bank and add to it all cheques drawn on the bank but not yet presented for payment. The new balance will then be agreed with the balance
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of the cash book. (b) If the bank statement balance is a credit balance (in favour of the depositor), add to it all cheques, drafts, etc., paid into the bank but not collected and credited by the bank and deduct from it all cheques drawn on the bank but not yet presented for payment. The new balance will agree with the balance of the cash book.
Alternatively: Cash book shows debit balance Cash book shows credit balance i.e., bank statement shows credit i.e., bank statement shows debit balance balance CB to BS Cheques issued but not presented in Add the bank Cheques paid into bank but not Less collected and credited by the bank Credit, if any in the bank statement Debit, if any in the bank statement Add less BS to CB Less CB to BS Less BS to CB Add
Information
Add Less Add
Add Less Add
Less Add Less
TERMINOLOGY USED When dealing with bank reconciliation statements we will use new terms to refer to items appearing in the cashbook and on the bank statement. Terms will be used to describe cheques that we have both received and have paid out of our cashbook that have not yet appeared on the bank statement. When we receive a cheque, or when we write out a cheque, we would normally enter this into the cashbook straight away. Therefore, from the firm's view, the money has already been paid or received. However in reality, this does not happen. Cheques will normally take a few days (assuming the cheque was deposited in the bank immediately - which may not happen thus further delaying the process) before they are cleared. Only when the cheque is cleared will the money be paid into the bank account (or paid out in the case of us writing cheques). The ways in describing cheques in the clearing process are as follows: Unpresented cheques These cheques have been paid out by us (i.e. credited to the cashbook) but have not yet been deducted by the bank from the firm's account (they have not yet been 'presented' for payment).
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Uncredited (Undeposited) cheques These cheques have been received by the firm (i.e. debited to the cashbook) but they have not yet been entered by the bank into the firm's account. It may also be that we have not yet physically taken the cheques to the bank and deposited them. These are also sometimes known as 'banking lodgements not yet cleared' or 'uncleared cheques'. Dishonoured cheques Sometimes the firm will receive a cheque from a customer that the bank will not give us money for. It will not honour the cheque and therefore the money will not be received as it stands. The reasons for this could be as simple as that a mistake appeared on the cheque (wrong date, not signed, discrepancies in amounts written, etc.) or it could be that the customer has insufficient funds in their account and the bank will not allow more to be paid out of their account. Any cheque more than 6 months old will not be honoured as it considered being 'stale'. Bank accounts and direct transfers In addition to the types of cheques that will appear on a bank reconciliation statement, there will also be items that will appear on the bank statement that are not yet in the cashbook. These will normally refer to items automatically paid into and out of our account without us first having entered into our cashbook. These items could include: Standing orders This occurs when a firm sets up a process for a regular amount to be paid out of bank account. The amount does not change and is used by many firms making payments to either a firm or an individual. Direct debits Similar to standing orders, these involve amounts paid out of the firm's bank accounts. However, the amount paid out is not fixed and can be different. A firm normally will give another firm permission for it deducted amounts from the firm's accounts. Many bills are paid by direct debit arrangements. Credit transfers These involve amounts being paid directly into our bank account. They are normally from other customers, or other people who owe the firm money. Technically they could actually involve payments out of an account, but normally a credit transfer is used to refer to money paid into the account. Bank charges
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Firms may be charged money buy their bank for services they have used. This may be a one-off fee, or it could be a regular amount. A common example would be a charge for allowing the firm to go overdrawn on its account. These will be directly deducted from the firm's balance and will appear on the bank statement. Interest Interest may be both paid and received directly into the firm's bank account. If it is being paid out then it will normally be the charge for the firm being overdrawn on its account. As long as the firm keeps a positive balance of money in the account then any interest is likely to be received (most current accounts now give interest on positive balances).
BANK STATEMENTS
A bank statement is a summary of recent transactions (usually one month) that have taken place in the firm's bank account. The balance on the account is normally displayed as a running total (i.e. the balance is adjusted as each transaction occurs). A sample bank statement may look as follows: Bank statement
2003 April 1 April 3 April 8 April 16 April 23 April 29 April 30 Balance b/f Cheque Cheque - 1145 Credit transfer: K Smith Cheque - 1146 Bank charges Balance c/f
(Dr) GH
(Cr) GH
Balance GH 1,970 Cr.
80 270 35 560 25
2,050 Cr. 1,780 Cr. 1,815 Cr. 1,255 Cr. 1,230 Cr. 1,230 Cr.
The statement is always drawn up from the bank's point of view. This means that if we have money in the bank then from the bank's viewpoint, the bank owes us money. This is why the account is presented as a credit balance. If we were overdrawn (taken out more than we have in the account) then the balance would be a debit balance - i.e. we now owe the bank money. This can be confusing, because the cashbook will still be drawn up on the principles of double entry - debits involves money paid into the account, and credits involve money paid out of the account.
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Notice how each cheque paid out of this account has a number attached to it - this refers to the actual number of the cheque - the person or firm it is paid to will not appear into the cheque. Now we can compare the above bank statement with the firm's own cashbook. In this example we will only concern ourselves with the bank column of the cashbook, as this is the amount we are trying to reconcile with the bank statement. Cashbook
2003 Apr 1 Apr 6 Apr 28 Balance b/d L Preston J Mason
GH 1,970 80 140 2190
2003 Apr 11 Apr 26 Apr 29 Apr 30 T Lawton C Groves J Cowens Balance c/d
GH 270 560 195 1165 2190
May 1
Balance b/d
1165
So we have a discrepancy. According to the bank statement we have GH1,230 in the bank. According to our cashbook we only have GH1,165. To see if this can be explained, we will draw up a bank reconciliation statement.
Procedure for bank reconciliation

1. We need to eliminate items that appear in both the cashbook and on the bank statement, as these will not be the reason for the discrepancy. 2. The cashbook will need to be brought up to date by entering items found only on the banks statement and not in the cashbook. 3. Draw up a reconciliation statement using the updated cashbook balance and items appearing in the cashbook that were not on the bank statement. A bank statement was received by M Sim on 31 July 2002. It appeared as follows:
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Bank statement
2003 July 1 July 3 July 6 July 8 July 12 July 22 July 27 July 31 Balance b/f Cheque Standing order: A May Cheque - 011654 Interest Cheque - 011655 Cheque Balance c/f
(Dr) GH
(Cr) GH
Balance GH 650 Cr.
45 300 290 5 250 560
695 Cr. 395 Cr. 105 Cr. 110 Cr. 140 Dr. 420 Cr. 420 Cr.
The cashbook for July 2003 appeared as follows: Cashbook
2003 Jul 1 Jul 6 Jul 21 Balance b/d L Wosko J Thompson
GH 650 45 230 925
2003 Jul 11 Jul 25 Jul 29 Jul 30 P Willmott M Goulding S Davey Balance c/d
GH 290 250 75 310 925
May 1
Balance b/d
310
Bank statement balance = GH 420 Cashbook balance = GH 310 The procedure is always to add unpresented cheques and to subtract undeposited cheques from the updated cashbook balance. It is possible to start with the balance on the bank statement, in this case, undeposited cheques would be added and unpresented cheques would be subtracted.
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The reconciliation has worked. This means that no errors have been made. If the two balances could not be reconciled then errors would have been present. The differences in the balances on the cashbook and banks attempt can be explained and reconciled by firstly, updating he cashbook and secondly, by adjusting for cheques that have not yet shown up on our bank statement.
Bank reconciliation without updating the cashbook

It is possible to prepare a bank reconciliation statement without bothering to update the cashbook first. In this case, all the items that do not appear in both the cashbook and on the banks statement would go on the reconciliation statement. If we use our previous example, then the reconciliation statement would appear as follows: M Sim - bank reconciliation statement as at 31 July 2003
GH Balance as per cashbook Add S Davey (Unpresented cheque) 75 Interest received Credit transfer Less J Thompson Standing order Balance as per bank statement 230 300 5 560
GH 310
640 950 530 420
Other than for Unpresented and undeposited cheques, there is no actual method of working out whether items found on the banks statement but not in the cashbook should be added or subtracted. It has to be worked out intuitively. Consider the following explanations for the above example: 1. Interest received - is not in the cashbook so if added on to cashbook figure then we will be closer to the bank statement. 2. Credit transfer - is not in the cashbook so if added on to cashbook figure then we will be closer to the bank statement. 3. Standing order has been deducted in bank, so if deducted from the cashbook figure we are more likely to get a closer approximation to the bank statement balance.
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CONTROL ACCOUNTS (SELF-BALANCING ACCOUNTS)

For a small firm, the trial balance alone may prove sufficient in providing a check on the numerical accuracy of the ledger accounts. Whilst still useful, the trial balance will not necessarily speed up the location of errors. If a firm operates ledgers for sales, purchases and general accounts then control accounts can be used as a further check on the accuracy of the ledgers. In effect, a control account is like a trial balance for each of the sales and the purchases ledger. If the control account does not tally with the accounts in each ledger, then an error will exist in that ledger. Two control accounts Sales ledger control account (also known as the total debtors account) Purchases ledger control account (also known as the total creditors account) Each control is a summary total of the respective ledger. It has the totals for all balances and all entries as found in the sales or the purchases ledger. It is easier to imagine them as an overall debtor account (for the sales ledger account) or an overall creditor account (for the purchases ledger account). Construction of control accounts The information for constructing each control accounts are taken from both the personal accounts of debtors and creditors, as well as information from the main daybooks (e.g. sales daybook for total of credit sales). The main sources of information are found in the following locations: Information for sales ledger control account
Information needed: Opening balance of debtors Credit sales Returns inwards Money received from customers Discounts allowed Closing balance of debtors
Information located: Debtor accounts in sales ledger Sales daybook Returns inwards daybook Cashbook General ledger or cashbook (3rd column) Debtor accounts n sales ledger
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Information for purchases ledger control account
Information needed: Opening balance of creditors Credit purchases Returns outwards Money received from customers Discounts received Closing balance of creditors
Information located: Creditor accounts in purchases ledger Sales daybook Returns outwards daybook Cashbook General ledger or cashbook (3rd column) Creditor accounts in purchases ledger
A control account will appear as if it is a personal account - with amounts relating to purchases and sales, returns, discounts as well as payments made and received. The examples below are to remind you of what a debtor and what a creditor account looks like:
Debtor accounts
Balance owing to us at start Credit sales made during period
Cash/cheques received Returns inwards Discounts allowed Balance owing to us at end (*1)
(*1 this is a debit balance but it is initially carried down from the credit side when the account is balanced off)
Creditor accounts
Cash/Cheques paid Returns outwards Discounts received Balance owing to by at end (*2)
Balance owing by us at start Credit purchases made during period
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(*2 this is a credit balance but it is initially carried down from the debit side when the account is balanced off)
Set-offs
Some firms may find that they have customers who are also suppliers. In this case, there will be an account for this firm or person both in the sales ledger (as a customer) and in the purchases ledger (as a supplier). It could appear to be common sense that rather than both parties send a cheque to each other, the amounts owing (both to and by the firm) should be partly offset against each other. If you owe someone 5 who also owes you 10, then it would be sensible for you to offset the debt and accept 5 in full settlement of both debts. This can also be achieved with firms and are known as set-offs. As a general rule, set-offs will appear in both control accounts and on the following sides: In the sales ledger control account - on the credit side In the purchases ledger control account - on the debit side
Memorandum records
For some firms, the control account will be used as a check on the numerical accuracy of the sales and purchases ledger. The control account in this case is not part of the double-entry system. In this case, the control accounts would be known as memorandum records - they are simply there as a back up to the normal double entry system. However in some larger firms, all the control accounts are kept as an integral part of the double-entry system of bookkeeping. The personal accounts as found in the sales and purchases ledger would then become the memorandum records and would be used for information only. Here, the control accounts, as found in the general ledger, would be used for the trial balance and so on.
Benefits of maintaining control accounts

If the control accounts are kept purely as memorandum records then they are not necessary for the double entry system to function fully. However the control accounts will still have some uses for the firm and these are as follows: 1. If the control accounts do not balance then it is obvious that a mistake has taken place in the respective ledger. This will save time in the locating of the error. If we relied on the trial balance alone then we would have to check all the three main ledgers as well as the cashbook. 2. Control accounts can be kept by a person who is not the same person who maintains the personal accounts of debtors and creditors. In this case, fraud is less likely to occur (unless both the ledger clerks and the person maintaining the control accounts are in collaboration together!).
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3. The debtors and creditor figures can be ascertained more speedily for construction of the trial balance, than having to balance off each individual personal account in the sales and purchases ledgers. NOTE; only credit purchases and sales are recorded in a purchases and sales ledger control account. Again, cash allowances for doubtful debt are excluded from sales ledger control account.
RECONCILIATION OF CONTROL ACCOUNTS

When a ledger control account is not in balance, it indicates that something has gone wrong with the entries made to accounting records. This leads to investigation that reveals the cause(s). Then, in order to verify whether the identified item(s) caused the failure to balance the control account, reconciliation is carried out. Illustration; An example of a purchases Ledger Control Account Reconciliation GH Original purchases ledger control account balance Add Invoice omitted from control account, but entered in purchases ledger Suppliers balance excluded from purchases ledger total because the account had been included in the sales ledger by mistake. credit sales posted in error to the debit of purchases ledger account instead of debit of an account in the sales ledger. Undercasting error in calculation of total end of period creditors balance . xxx xxx xxx xxx Less; Customer account with a credit balance included in the purchases ledger That should have been included in the sales ledger. Return inwards posted in error to the credit of a purchases ledger instead of the credit of an in the sales ledger. Credit note entered in error in the returns outwards Day Book as xxx xxx xxx xxx GH xxx
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GH233 instead of GH 332.
xxx
(xxx) xxx
Revised purchases ledger control account balance obtained from revised source amounts
PARTNERSHIP ACCOUNTS
The association of two or more individuals carrying on business jointly for the purpose of making a profit (IPP Act 1952, Act152). A firm in which two or more persons are working together as owners is known as a partnership. The individuals working in a partnership firm are known as Partners. The law governing partnership is contained in the Partnership Act, 1932. Section 4 of the Act defines partnership as the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. The following are the essential elements of partnership: 1. 2. 3. There must be an agreement entered into by all the persons concerned. The agreement must be to share the profits of a business. The business must be carried on by all or any of them acting for all.
All these elements must be present before a partnership can come into existence. If any of them is not present, there cannot be formed a partnership.
REASONS FOR THE FORMATION OF PARTNERSHIP 1. The capital requirement is high and therefore requires more than one person can provide. 2. The use of special skills 3. The need to share of risks. 4. Goodwill attached to certain people.
NATURE AND FORMATION OF A PARTNERSHIP Partnership Agreement It is desirable that there should be a written agreement between the partners to avoid any dispute that may arise in future. The document which contains the terms and conditions regarding the conduct of partnership business is known as Partnership Agreement. Contents of Partnership Agreement: The usual contents of a partnership agreement are: 1. 2. 3. 4. 5. 6. The capital to be contributed by the each partner. The maximum amount of drawings which a partner can make during a year. The rate of interest, if any, to be paid on capital before the profits are shared. The rate of interest on capital and partners drawings made by the partners during the year. Salaries, Commission, Remuneration, if any, to be allowed to any partner. The rate of interest on loan by a partner to the business.
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7. (a) (b) (c) 7. 8.
The ratio in which the profits and losses shall be shared among the partners. Profits and losses are generally shared either Equally; or In the ratio of capital contributed by each partner (Capital ratio); or In any other ratio to which the partners may agree. Arrangements on retirement, death or dissolution. Procedures to be carried out for admission of a new partner.
Partnership is the result of an agreement. The agreement among the partners that sets out the terms on which they have agreed to form a partnership is called partnership agreement. It may be in writing or by words of mouth or be implied from the course of conduct of the parties. It is desirable to have the partnership agreement in writing to avoid future disputes. The document in writing containing the various terms and conditions as to the relationship of the partners to each other is called the partnership deed. The following clauses are normally included in partnership agreement. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Name under which business of the firm is to be carried on. Nature of partnership business. The capital of the firm and the proportion in which it is to be contributed by each partner. Ratio in which profits and losses are to be shared by partners. Rate at which interest is to be allowed on the capital and charged on the drawings. Amount, which each partner is allowed to withdraw in anticipation of, profits from the business for private expenses and the timing of such drawings. Amount of salaries and other allowances if any payable to partners. Commencement and duration of partnership. Whether the capital accounts are to be fixed or fluctuating. Valuation of goodwill at the time of retirement or death of a partner. The method of ascertaining the amount due to the retiring partner or the representative of a deceased partner at the time of retirement or death and the manner in which the amount due will be paid. Keeping of proper books of accounts and preparation of balance sheet. Audit of the accounts of the firm and the manner of appointment of auditor. Right and duties of partners. Arbitration clause, laying down the procedure to be followed for the settlement of disputes among the partners. RULES IN ABSENCE OF PARTNERSHIP AGREEMENT The Incorporated Private Partnership (IPP) Act 1962 (Act 152) which governs a partnership in the absence of an agreement states that there should be; 1. Equal contribution of capital 2. Equal share of profit of profits and losses
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12. 13. 14. 15.
3. No interest on capital and drawings 4. 5% interest on any amount in excess of agreed capital contribution.
FINAL ACCOUNTS OF PARTNERSHIP Profit And Loss Appropriation Account: This is the account to show the various appropriations of the profit among the partners. This is an extension of profit and loss account. GH Net profit during the year Add: interest on drawings: A B xxx xxx xxxx xxxx Less: appropriations Interest on capital: A B Salary or commission allowed to partners: A B Balance of profit shared by A (xxxx in profit sharing ratio) B (xxxx in profit sharing ratio) xxx xxx xxxx nil CAPITAL ACCOUNTS IN PARTNERSHIP: The capital accounts in partnership may be maintained under: A. Fixed capital method
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GH xxxx
xxx xxx
xxx xxx xxxx xxxx
B. Fluctuating capital method A. Fixed Capital Method: Under this method two accounts are kept for each partner viz. Capital account and Current account. In the capital account the original capital investment only will be shown every year. The current account is kept for recording Interest on capital allowed, salary allowed, share of profit, drawings, interest on drawings etc. This account may show either a debit balance or a credit balance. Debit balance represents drawings in excess of profits to which a partner was entitled. Credit balance means profits undrawn. Format of accounts under fixed capital method CAPITAL ACCOUNT Bank (capital withdrawal) if any xxxx Balance c/d xxxx xxxx balance b/d xxxx Balance b/d Bank (additional capital) if any xxxx xxxx xxxx
PARTNERS CURRENT ACCOUNTS Drawings: Cash drawings Goods drawings Interest on drawings balance c/d xxxx xxxx xxxx xxxx xxxx balance b/d xxxx xxxx balance b/d interest on capital salary allowed share of profit xxxx xxxx xxxx xxxx
B. Fluctuating Capital Method: Under this method, only one account is kept in the name of each partner i.e. Capital account. The partners capital contribution, share of profit, interest on capital, salaries allowed, drawings and interest on drawings are recorded in one same capital account itself so that the balance in this account changes or fluctuates each year.
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CAPITAL ACCOUNT Drawings: cash Goods Interest on drawings share of loss (if any) Balance c/d xxxx xxxx xxxx xxxx xxxx xxxx Balance b/d xxxx xxxx balance b/d interest on capital salary allowed share of profit xxxx xxxx xxxx xxxx
Key points In the absence of a partnership agreement: The partners shall share the profits & losses equally. 5% interest shall be allowed on amount advanced by partners as loan. No salary or commission will be allowed. Interest on partners drawings is debited in the partners current account and credited in the profit & loss appropriation account. All appropriations are to be shown on the debit side of the profit & loss appropriation account. Share of loss is transferred to the partners current account debiting current account and crediting profit & loss appropriation account. Salary allowed to partners is credited in their current account. Debit balance in the current account means profit overdrawn and credit balance in the current account means profit undrawn. Under fluctuating capital method only one capital account is maintained. But under fixed capital method, one capital account and one current account are maintained. Both cash and goods drawings are shown on the debit side of the current account. If the salary allowed to the partner is given on monthly basis, then multiply by 12 to get annual salary. Interest on partners loan is debited to profit & loss account as an expense.
INTEXT QUESTIONS AND ANSWERS Q1. A. B. C. Where will you show interest on capital in the books of a partnership? Debit side of partners fixed capital account. Credit side of partners current account. Debit side of partners current account.
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D.
Credit side of partners fixed capital account.
Q2. A. B. C. D.
Interest on partners drawings in case of fluctuating capitals should be shown in credit side of partners current account. credit side of Partners capital account. debit side of partners current account. debit side of partners capital account.
Q3. B. C. D.
In the absence of a partnership agreement how profits should be shared? Equally Equally after interest on capital Equally after interest on partners loan Equally after interest on partners capital and partners salaries
Q4. A. B. C. D.
Salary allowed to partner will come in the profit and loss appropriation account only. the partners capital account only both the profit and loss appropriation account and partners current account. the partners current account only.
Q5.
How will interest on capital and share of profit appear in a partners current a/c? Interest on capital on the debit side and share of profit on the credit side Both interest on capital and share of profit on the credit side Both interest on capital and share of profit on the debit side Interest on capital on the credit side and share of profit on the debit side.
Q6.
What is the double entry to record salary to a partner if he maintains fluctuating capital? Salary debit and partners capital account credit Salary debit and profit and loss account credit Salary debit and partners current account credit
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Q7.
Partners current account credit salary account debit A and B are partners in a firm. They supply the following information at the end of a year:- Net trading profit $ 3 000, Interest on capitals $ 500, Interest on drawings $ 300. What amount will finally be transferred to their current accounts? A. $ 3 000 B. $ 2 500 C. $ 3 300 D. $ 2 800
Q8.
What is the meaning of credit balance in partners current account? A. Cash at bank C. Balance of profit undrawn B. Balance of profit overdrawn D. None of these
QUESTIONS:Q1. T. Terry and S. Shell are in partnership for the last 10 years. Their partnership agreement provides for the following:
Interest on capital shall be allowed @ 8% p.a. Interest shall be charged on cash drawings @4% p.a. T. Terry shall be allowed a salary of $ 12 000 p.a. and S. Shell shall be allowed a salary of $ 6000p.a. The remaining profits or losses shall be shared in the ratio of 3:2 between the partners. The following information is available relating to the year ended 31st, December, 2003 T. Terry ($) Capital accounts (1-1-03) Current accounts (1-1-03) Partners drawings Cash Goods 5 000 3 000 3 000 1 500 60 000 1 000 Cr. S. Shell ($) 40 000 1 500 Cr.
The net profit before appropriation was $ 45 650. Prepare the profit and loss appropriation account and the partners accounts under fluctuating capital method and fixed capital methods.
Q 2. Sunny and Thomas are in partnership. Their partnership agreement provides for the following: a. Sunny to receive a salary of $ 12 000 p.a.
b c. d.
Interest on capital is allowed @ 6% p.a. Interest on drawings shall be charged @ 5% p.a. Any remaining profits are to be shared between Sunny and Thomas in the ratio of 2:1
On 1st January, 2003 the following balances appeared in their books: Sunny ($) Capital accounts Current accounts 20,000 400 Cr. Thomas ($) 25,000 300 Cr.
During the year Sunny and Thomas have withdrawn $ 6 000 and $ 5 000 respectively. The net profit before the adjustments for the year ended 31st December, 2003 was $ 12 000. Prepare the partners accounts under fluctuating capital method and fixed capital methods.
Q 3. Anees and Ameer are in partnership for the last 5 years. Their partnership agreement provides for the following: a. b. c. d. Anees to receive a salary of $ 1 000 p.m. Interest on capital shall be allowed @ 10% p.a. Interest on drawings shall be charged @ 5% p.a. Any remaining profits are to be shared between Anees and Ameer in the ratio of 2:1
On 1-1- 2003, the balances in the partnership books were as follows: Anees ($) Ameer ($)
Capital accounts Current accounts
24 000 300 Cr.
30 000 150 Cr.
During the year ended 31st December, 2003 partners drawings were: Anees $ 16 000 and Ameer $ 8 000. The net profit for the year ended 31st December, 2003 was $ 27 600 Prepare the profit and loss appropriation account and the partners current accounts.
Q 4. Allen and Susan are in partnership. Their partnership agreement provides for the following:
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a. b. c. d.
Allen to receive a salary of $ 14 000 p.a. Interest on capital to be paid @ 10 % p.a. Interest on drawings to be charged @ 5% p.a. Any remaining profits are to be shared between Allen and Susan in the ratio of 4:2
During the year ended 31st December, 2003:Allen $ Capital accounts Current accounts (1-1-2003) 30 000 400 (Cr) Susan $ 40 000 300 (Dr)
The net profit for the year ended 31st December, 2003 was $ 33 100. You are required to prepare the profit and loss appropriation account for the year ended 31st December, 2003 and the partners current account.
Q 5. Graeme and Mendez are in partnership for several years. The terms of their partnership includes: a. b. c. Interest on capital to be paid @ 10% p.a. The profits are to be shared in the ratio of 2:1. Mendez to receive an annual salary of $ 8 000.
The following information is available relating to their business during the year 2003: Graeme ($) Capital accounts Current accounts Drawings: Cash Goods 5 750 400 8 580 1 000 10 000 (150) Mendez ($) 12 000 230
The net profits during the year ended 31st December, 2003 amounted to $ 19 350(before appropriation) Required to: a. b. Prepare the profit and loss appropriation account for the year ended 31st December, 2003 Partners current accounts.
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Q 6. Kate and Mate are partners sharing profits in the ratio of 3:2. Their partnership agreement provides for the following: a. b. Interest on capital is allowed on their fixed capitals @ 10%p.a. Interest on cash drawings is charged @ 3%p.a.
The following information is available from their books for the year ended 31st December, 2003: Kate ($) Capital account Current account Cash drawings Goods drawings 60 000 1 000 Cr. 10 000 2 100 Mate ($) 40 000 1 200 Cr. 8 000 1 500 8 000 p.a. 1 500
Salary allowed during the year 1 000 p.m. Commission on sales 2 000
The net profit for the year ended 31st December, 2003 was $ 50 360. You are required to prepare the profit and loss appropriation account and the partners current accounts.
Q 7. Ash and Dash are in partnership for many years. Their partnership agreement provides for the following: a. b. c. d. Interest on capital to be allowed @ 10% p.a. A salary of $ 12 000 p.a. is to be allowed to Ash. The balance of profits is to be shared between Ash and Dash equally. Interest is charged on cash drawings @ 5% p.a.
The following information is available from the books of their firm for the year ended 31st December, 2003: Ash ($) Capital account Current account Drawings: Cash 5 000 7 000 25 000 1 200 Cr. Dash ($) 30 000 1 000 Cr.
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Goods
700
500
The net profit for the year ended 31st December, 2003 before appropriation was $ 35 000. Prepare the profit and loss appropriation account and partners current account.
Q 8. Albin and Robbin are in partnership business sharing profits & losses in the ratio of 2:1. Their partnership agreement provides for the following: a) b) c) Albin will get a monthly salary of $ 1 000 and Robbin, an annual salary of $ 10 000. 5% interest is charged on partners cash drawings 10% interest is allowed on partners fixed capitals On 01.01.2000 the balances were:Capital account Current account On 31.12.2000 the balances were:Capital account Current account 30 000 12 100 Cr 20 000 6 800 Cr Albin $ 30 000 1 000 Cr Robbin $ 20 000 800 Dr
Cash drawings Goods drawings You are required to prepare:
8 000 500
6 000 600
The partners current accounts to calculate the share of profit and the profit & loss appropriation a/c, clearly showing the net profit before appropriation.
Q 9. Blue & Yellow are partners in business for several years and their partnership agreement includes the following: Interest on fixed capital to be paid @ 10% p.a. Profits & losses to be shared between Blue & Yellow in the ratio of 2:1. Yellow shall receive an annual salary of $ 10 000. Blue $ 20 000 Yellow $ 15 000
Balances on 01.01.1999:Capital accounts
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Current accounts Balances on 31.12.1999:Capital accounts Current accounts Cash drawings Goods drawings Interest on drawings
500 Cr
800 Dr
20 000 1 250 Cr 4 900 350 1 000
15 000 1 700 Cr 9 700 1 300 500
You are required to prepare: The partners current accounts to calculate the share of profit and The profit & loss appropriation a/c , clearly showing the net profit before appropriation.
Q 10. The following information is obtained from the partnership business f Kate and Rita for the year ended 31st Dec 2002. Kate Rita Current account balances on 1-1-2002 Current account balances on 31-12 2002 Salary allowed during the year Drawings during the year $ 400(Cr) $ 8 650(Cr) $ 500 p.m $ 4 000 $ 200(Cr) $ 6 450(Cr) $ 4 000 p.a $ 3 500
Interest on capital allowed 10% on $ 30 000 fixed capital 10% on $ 25 000 fixed capital A total commission of, 2% on total sales during the year $ 7 500, was allowed to both the partners according to their profit sharing ratio. Required to:1. Calculate the partners share of profit for the year ended 31st Dec 2002. 2. Calculate the profit before appropriation.
Q 11. Anderson, Baker and Copeland are in partnership. Their partnership agreement provides that interest on capital shall be allowed to the partners at the rate of 8% per year, and that Baker and Copeland shall be entitles to salaries of $ 15 000 each. After charging the interest and salaries, the remaining profit or loss is to be shared as follows.
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Anderson one half: Baker one third: Copeland one sixth. The details given below relate to their accounting year ending 31st march 1998. Anderson $ 1st April 2001 Capital Accounts Current Accounts 1st January 2002 Additional capital brought in 1st April 2002 t0 31st March 2002Cash drawings 20 000 5 000 18 200 2 500 16 000 40 000 1200(Cr) 1 500(Cr) 8 000 16 000 500(Dr) Baker $ Copeland $
(Including for Baker &Copeland their salaries) The profit for the year 31st march 2002, before allowing interests and salaries, was $ 82,004.
Prepare for the partnership, for the year ended 31st March 2002: The profit and loss appropriation account the current accounts of the partners Note Capital accounts are NOT required.
Q 12. Ananth and Marry have been partners in a business since 1st Jan 2002 The partnership agreement provides for: Profits and losses to be shared in the ratio of 3:1 Partners to receive 10 % p.a on fixed capital Ananth to receive a salary of $ 6000 p.a which is to be credited in her current account
On 31st December 2003 the balances remaining in their books at the ends of their trading year were as follows:CAPITAL ACCOUNTS (01-01-2003) $ Ananth $ Marry
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60,000 CURRENT ACCOUNTS (01.01.2003) DRAWINGS Net profit for the year Good will Fixed assets at cost Current Assets Current liabilities 56,000 64,000 112,000 93,000 32,000 11,200 56,000 3,600 24,000
100,000 1,400 20,000
Provision for depreciation on fixed assets Loan from Anthoo Required to prepare:-
1. Profit & loss appropriation account for the year ended 31st December 2003 2. Partners current accounts for the year ended 31st December 2003. 3. A balance sheet as at 31st December 2003 for the partnership business.
Q 13. King and Queen are in partnership sharing profits and losses in the ratio of 3:2. Their partnership deed provides for the following: a) b) c) Interest on drawings is charged on partners drawings @ 5% p.a. Interest on capital is allowed on partners fixed capitals @ 10% p.a. King is allowed to get a monthly salary of $ 250 and Queen is entitled to get an annual salary of $ 6 000.
The following trial balance had been extracted from the books of the partnership for the year ended 31st December, 2003, after the preparation of their Trading and Profit and Loss account. Account Balances Debit $ Credit $ Capital accounts: King Queen Current accounts: King 1 000
60000 40 000
Queen Drawings during the year: King Queen Plant and Machinery at cost Land and Buildings at cost Furniture and Fixtures at cost Debtors and Creditors Cash-in-hand 2 500 Stock of goods on 31-12-2003 Bank Overdraft Salaries to staff owing Commission received in advance Insurance prepaid Provision for bad debt Provision for depreciation: Plant and Machinery Land and Building Furniture and Fixtures Bank loan (payable after 5 years) Net profit during the year Stock of stationery on 31-12-2003 Total
400
8 000 7 000 60 000 40 000 30 000 18 000 9 000
24 000 3 500 1 000 500 300 1 500
3 000 2 000 1 500 20 000 48500 100 1 90 900 1 90 900
Prepare the profit and loss appropriation account; the partners current accounts and the balance sheet of the firm.
Q 14. Alim & Salim are partners in a business sharing profits and losses in the ratio of 10:7.
The following trial balance was available from their books for the year ended 31st December, 2003 after the preparation of their Trading and Profit and Loss account:Account Balances Capital accounts: Alim Salim Current accounts: Alim Salim Drawings during the year: Alim Salim Debtors and Creditors Salaries to office staff owing Cash in hand Bank balance Plant and Machinery at cost Land and Buildings at cost Furniture and Fittings at cost Motor car at cost Stock on 31st March, 2003 Provision for bad debts Provision for depreciation on: Plant and Machinery Land and Building Furniture and Fittings Motor car Net profit during the year 2 000 2 500 1 000 1 000 37 900
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Debit $
Credit $
45 000 40 000
2 000 1500
10 000 8 000 16 000 9 500 1 800 2 100 3 000 40 000 50 000 10 000 20 000 7 400 1 000
Insurance prepaid Bank loan Total
700 20 000 166 200 166 200
Their partnership deed provides the following: a. b. c. a. Both partners are entitled to get interest on their fixed capital @ 15% p.a. Interest @! 4% is charged on partners drawings every year. Salim is entitled to get a monthly salary of $ 300 every year. No salary is allowed to Alim.
Required to prepare: a) b) c) The Profit and Loss Appropriation account The partners current accounts. The Balance Sheet of the firm.
Q 15. King and Strong are partners sharing profits and losses equally. Their partnership agreement provides the following: a) b) c) Interest on capital to be paid @ 5% p.a. King to be paid an annual salary of $ 12 000 and an annual bonus of 1% of sales. Strong, who is part-time partner, to be paid a salary of $ 3 000 p.a.
The following trial balance was extracted from their books on 31.12.2003Account Balances Debit $ Credit $ Capital on 01.01.2003 King Strong Current account on 01.01.2003 King Strong Purchases and Sales 1 000 700 130 000 2 00 000 60 000 48 000
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Debtors & Creditors Drawings during the year: King Strong Stock on 01.01.2003 Premises Delivery Van Provision for depreciation on Delivery Van Repairs to Premises Cash in hand $ bank Insurance Delivery van expenses General expenses Total b. c. d. e.
1 500
7 000
16 000 10 000 14 000 90 000 20 000 8000 15 600 7 600 3 200 2 400 12 400 3 23 700 3 23 700
Additional information: Stock was valued at $ 10 000 on 31.12.2003 The delivery van is to be depreciated by 20% of cost During the year the goods drawings made by King was valued at $ 850. No entry had been made in the books of accounts f. On 31.12.2003, the delivery van expense owing amounted to $ 200. An addition to the premises costing $ 12 000 has been wrongly posted to repairs to premises account. From the above information prepare the trading, profit & loss and appropriation account for the year ended 31.12.2003 and a balance sheet as on that date. (The adjustments for current account should be shown in the balance sheet itself). No separate current a/c is required.
Q 16. Beauty and Sweety are in partnership sharing profits and losses in the ratio of 3:2. Their Partnership agreement provides for the following: a) b) c) Interest on Capital is allowed @ 10% p.a. Interest on cash drawings is charged @ 5% p.a. Salary allowed to each partner is $ 7 000 p.a.
The following trial balance was extracted from their books on 31.03.2003.Account balances Debit $ Credit $ Capital accounts on 1-4-02 Beauty Sweety Drawings during the year: Beauty Sweety Current accounts on 1-4-02 Beauty Sweety Wages to staff Carriage Inwards Furniture & Fixtures at cost Delivery van at cost Machinery at cost Purchases & Sales Rent paid Delivery van expenses Discount received Lighting & heating General Expenses Insurance paid Returns Opening Stock Debtors & Creditors Cash in hand Cash at bank 100 380 4 500 1 200 10 000 14 000 25 000 63 000 3 000 1 380 1 000 800 1 000 1 200 500 4 250 8 300 1 020 2 500
20 000 25 000
5 000 6 000
99 770
400
6 200
Total Additional Information:
1 52 750
1 52 750
The fixed assets are to be depreciated @ 10% on cost Bad debts written off from the debtors $ 300 Rent owing was $ 290 Prepaid insurance was $ 200 Closing stock is valued at $ 6 200 Goods drawings by Sweety $ 1 200
You are required to prepare the trading, profit & loss appropriation account for the year ended 31.03.2003 and a balance sheet as at that date, showing the current account adjustments in the balance sheet itself. TREATMENT OF GOODWILL Conditions under which goodwill is valued are; Introduction of a new partner Changes in profit or loss sharing ratio Retirement of a partner and Death of a partner.
Goodwill may arise from such attributes of a business as good reputation, good customer relationship, strategic location, skill of its employees, dynamic management, durability of its products, effective advertisement, patented manufacturing process, outstanding credit rating, training program of the employees, and good relationship with suppliers and employees, etc. Goodwill may be described as the aggregate of those intangible attributes of a business that contribute to the superior earning capacity of the business. Goodwill is the outcome of an impression created in the mind of each customer and related persons. Valuation of Goodwill Methods to be adopted in valuing goodwill will depend upon the circumstances of each particular case. At the time of valuation of goodwill, the partnership deed should be examined and valuation should be done in such a manner as must have been agreed upon by the partners. Goodwill Calculation methods 1. Average profit method
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2. 3.
Super profit method Market capitalization method
Average Profit Method Under this method, at first, average profit is calculated on the basis of the past few years profits. At the time of calculating average profit, precaution must be taken in respect of any abnormal items of profit or loss which may affect future profit. It should be mentioned that average profit is based on simple average method. After calculating average profit, it is multiplied by a number (times) 3, or 4, or 5, whatever, as agreed. The product will be the value of the goodwill. For example: Goodwill is three times of the average profit of previous five years. Lets suppose: Average profit = 100 / 5 = 20 Goodwill = 20 x 3 = 60 Solved Problem No 1: Years Profit 1st year 20,000 2nd year 40,000 3rd year 50,000 4th year 70,000 Total 180,000 Goodwill of the firm is equal to the three years purchase of the last four years average profits: Average profit = 180,000 / 4 = GH 450,000 Goodwill = 45,000 x 3 = 135,000 Super Profit Method Super profit is the excess of actual profit (average profit) over the normal profit of an entity. A common method of valuation of goodwill is the super profit method. A business unit may possess some advantages which enable it to make extra profits over and above the amount that would be earned if the capital of the business was invested elsewhere with similar risks. These extra profits, generally expressed as super profits, can be valued, and goodwill is the value of the few years purchase of super profit. In this method, super profits are taken as the basis for calculating goodwill in place of average profit. Certain steps are followed in calculating goodwill under super profit method, these are as under: 1. 2. 3. 4. 5. 6. Calculate Capital of the firm Calculate normal profit by multiplying firms capital with normal rate of return Calculate average profit of the firm Calculate super profit by subtracting normal profit from the average profit Multiply the super profit by the number of years purchase (number of times) The product will be called goodwill.
Lets suppose: Normal profit = 200,000 x 18% = 36,000 Super profit = Average profit Normal profit = 45,000 36,000 = 9,000
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Goodwill = 9,000 x 3 = 27,000 Market Capitalization Method Under this method the value of the firm is first determined based on the market capitalisation rate using the following formula: Average profit of the firm x 100 % of market rate of return The above formula will give an estimate of the firms value in the market. By subtracting the book value of the net assets (owners equity/capital) of the firm from the above calculated value we shall get the amount of goodwill. Suppose average profit of the firm is GH 45,000 and the market rate of return is 18% and the capital (net assets) of the firm is GH 200,000. Then the good will of the firm will be calculated as under: Goodwill = 45,000 / 18 x 100 = 250,000 = 250,000 -200,000 = 50,000 Accounting treatment of goodwill Since the goodwill of a partnership firm belongs to the old partners and no one else, it is apparent that some adjustments must be made to the Capital accounts of the old partners upon the admission of a new partner so that the incoming partner will not take a share of the goodwill belonging to old partners without payment. The amount that the incoming partner pays for goodwill is known as premium for goodwill. This goodwill can be treated in the books of account in any of the following manner: Goodwill Raised Scenario-1 When the incoming partner cannot bring cash as premium for goodwill Here, the capital accounts of the old partners are artificially inflated towards the right of the goodwill, without any cash contribution. The idea is that if the business were sold immediately after the admission of the new partner and the goodwill and other assets realized their book value, the old partners would automatically receive cash for their share of the goodwill since the amounts attributable to them in respects of the goodwill are now included in their respective capital accounts. In this case, goodwill account is to be raised in the books of account at its full value by debiting the goodwill account and crediting the old partners capital accounts in old ratio. Journal Entry Debit Goodwill A/c 135,000 As capital A/c Bs capital A/c Working As share = 135,000 x 3/5 = 81,000 Bs share = 135,000 x 2/5 = 54,000 Credit 81,000 45,000
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Important Note Following should be taken in to account when doing the above treatment for goodwill: If goodwill already appears in the Balance Sheet which is equal to full value of goodwill so calculated, then no entry is required to be passed. If goodwill already appears in the Balance Sheet which is less than the full value of goodwill then goodwill is to be raised for the balance (full value of goodwill calculated less goodwill already appearing in the Balance sheet) If goodwill already appears in the Balance sheet which is more than the full value of goodwill, then excess goodwill is to be written off. The journal entry will be as under: Old partners capital accounts Dr Goodwill accounts Cr (Being the value of the goodwill written down to its calculated value) Goodwill Raised & Written-Off Scenario-2 When the incoming partner cannot bring anything as premium for goodwill but no goodwill is to appear in the books: Since the value of the goodwill constantly changes and partners may not wish that an account should remain in the books, goodwill is raised in the books first and, thereafter it is written off. Journal Entry (Goodwill raised) Goodwill A/c As capital A/c Bs capital A/c
135,000 81,000 45,000
Journal Entry (Goodwill raised & written off) As capital A/c Bs capital A/c Cs capital A/c Goodwill A/c As benefit Old ratio (Cr) New ratio (Dr) (Cr) Bs benefit Old ratio (Cr) New ratio (Dr) (Cr) As benefit + Bs benefit 13,500 + 9,000 =
67,500 45,000 22,500 135,000
81,000 67,500 13,500
54,000 45,000 9,000
22,500
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Cs share = 22,500 Cs share = 135,000 x 1/6 = 22,500 Goodwill Brought in Cash Scenario-3 When the required amount of premium for goodwill is brought in by the incoming partner and the money is retained in the business to increase the cash resources: In this situation, premium for goodwill is to be shared by the old partners in the sacrificing ratio. The sacrificing ratio is to be calculated by deducting the new ratio from the old ratio for each partner. It should be noted that when the profit sharing ratio between the old partners does not change as between themselves, this old profit sharing ratio is their sacrificing ratio. Goodwill brought in cash Bank A/c Cs premium for goodwill A/c
22,500 22,500
Distribution of goodwill (sacrifice ratio) Cs premium for goodwill A/c As capital A/c Bs capital A/c As share = 22,500 x 3/5 = Bs share = 22,500 x 2/5 = 13,500 9,000
22,500 13,500 9,000
Goodwill Brought in Cash & Withdrawn Scenario-4 When the required amount of premium for goodwill is brought in by the new partners and this amount is immediately withdrawn by the old partners: Goodwill brought in cash Bank A/c Cs premium for goodwill A/c
22,500 22,500
Distribution of goodwill (sacrifice ratio) Cs premium for goodwill A/c As capital A/c Bs capital A/c Goodwill withdrawn As capital A/c Bs capital A/c Bank A/c
22,500 13,500 9,000
13,500 9,000 22,500
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REVALUATION OF ASSETS & LIABILITIES When a new partner is admitted into the partnership firm, he acquires the ownership rights of the assets and also makes himself responsible for the liabilities of the firm. It is, therefore, desirable both from the point of view the incoming partner as well as the existing partners that the assets and the liabilities appearing in the balance sheet on the date of admission of a new partner should be properly valued. Revaluation journal entries Debit Increase in assets Assets A/c Revaluation A/c Decrease in assets Revaluation A/c Assets A/c Increase in liabilities Revaluation A/c Liabilities A/c Decrease in liabilities Liabilities A/c Revaluation A/c Expenses incurred Revaluation A/c Cash, expenses etc A/c Bad debts provision Revaluation A/c Provision for bad debts A/c xxx xxx xxx xxx GH xxx Credit GH xxx
xxx xxx
xxx xxx
xxx xxx
Any profit or loss on revaluation should be shared among the pre-change partners in their pre-change (old) profit or loss sharing ratio. ILLUSTRATION A and B are partners who share the profits in the ratio of 3/5 and 2/5 respectively they admit C into partnership and the profit sharing ratio is agreed at 3/8 : 3/8: 2/8 respectively. What is the new profit or loss sharing ratio?
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If; Increase in assets GH10, 000 Decrease in assets GH 2,000 Increase in liabilities GH 3,000 Increase in liabilities GH500 Pass the necessary journal entries for the above information and prepare the revaluation account Solution: Increase in assets Assets A/c Revaluation A/c Decrease in assets Revaluation A/c Assets A/c xxx Increase in liabilities Revaluation A/c Liabilities A/c Decrease in liabilities Liabilities A/c Revaluation A/c Debit GH 10,000 Credit GH 10,000 2,000 2,000 3,000 3,000 500 500 Revaluation Account Amount Particulars GH Assets (Dec.) Liabilities (Inc.) Balance 2,000 3,000 5,500 10,500 Assets (Inc.) Liabilities(Dec.) Particulars GH 10,000 5,00 Amount
10,500
A & B old ratio = 3:2 As share = 5,500 x 3/5 = 3,300 Bs share = 5,500 x 2/5 = 2,200 Revaluation A/c Debit 5,500 Credit
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Old partners capital A/c (Old sharing ratio) ILLUSTRATION 11
5,500
Sam, Emma and Eben were in partnership sharing profit or loss in the ratio 3:5:2. Their balance sheet at 31/12/10 was as follows; BALANCE SHEET GH Capital: Sam Emma Eben Creditors 6000 8000 4000 2700 Building Equipment Motor Van Inventory Debtors Bank 20700 GH 5400 2130 3970 5100 3750 350 20700
Boakye was admitted into the partnership at 1/1/11. The profit or loss sharing ratio is now 4:3:3 respectively. Boakye brought in GH5000 for his share of goodwill and capital. The assets were revalued as follows; Building GH10000, Equipment GH1950, Van GH3500, Inventory GH4800, and a bad debt allowance was GH350. Goodwill was agreed to be worth GH12000, and goodwill account was to be opened and closed immediately after the admission of the new partner. You are required to prepare; 1. Revaluation account 2. Capital a/c for each partner 3. Balance sheet after Boakye is admitted.
SOLUTION
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(a) Revaluation account GH Eqipment Motor Vehicle Inventory Prov. For bad debt Provision; Sam Emma Eben 180 470 300 350 4590 7650 3060 16.600 Capital Accounts Sam Emma Eben Boakye GH GH GH GH Goodwill Balance c/d 4000 2000 5000 6590 13650 4060 3000 Balance b/f 2000 Revaluation Bank 10590 15650 7060 5000 Sam Emma Eben GH Boakye 16.600 Building Goodwill GH 4,600 12,000
GH GH GH 5000
6000 8000 4000 14590 7650 3060 -
10590 15650 7060 5000
(b) Balance sheet after Boakye is admitted. GH Capital; Sam Emma Eben Boakye Creditors 6590 13650 4060 2000 2700 Building Equipment Motor Van Inventory Debtors 3750 Less Prov. 350 Bank (5000+350) 29000 3400 5350 29000 GH 10000 1950 3500 4800
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DISSOLUTION OF A PARTNERSHIP The term dissolution means coming to an end or discontinuation. The dissolution of the firm implies a complete breakdown of the partnership relation among all the partners. Dissolution of the partnership (owing to retirement, death or insolvency of a partner), merely involves change in the relation of the partners but it does not end the firm; the partnership would certainly come to an end but the firm, the reconstituted one might continue under the same name. So the dissoluton of the partnership may or may not include the dissolution of the firm but the dissoluton of the firm necessarily means the dissoluton of the partnership. On dissolution of the firm, the business of the firm ceases to exist since its affairs are would up by selling the assets and by paying the liabilities and discharging the claims of the partners. The dissolution of partnership among all partners of a firm is called dissolution of the firm. (i) (ii) (a) (b) (iii) Dissolution by Agreement : A firm is dissolved in case; all the partners give consent or as per the terms partnership agreement . Compulsory dissolution : A firm is dissolved compulsorily in the following cases; When all the partners or all excepting one partner becomes insolvent or of unsound mind. When the business becomes unlawful. When all the partners excepting one decide to retire from the firm. When all the partners or all excepting one partner die. A firm is also dissolved compulsorily if the partnership deed includes any provision regarding the happening of the following events expiry of the period for which the firm was formed, Completion of the specific venture or project for which the firm was formed. Dissolution by notice: In case of a partnership at will, the firm may be dissolved if any one of # the partner gives a notice in writing to the other partners. Dissolution by Court: A court may order a partnership firm to be dissolved in the following cases: When a partner becomes of unsound mind When a partner becomes permanently incapable of performing his/her duties as a partner,
(iv) (a) (b)
When a partnership is dissolved all the accounts need to be balanced off and any cash surplus distributed to the partners. The following sequence may be followed: 1 The current account for each partner is cleared to their capital accounts, because it is no longer necessary to keep a distinction between the two types of accounts. 2 A realisation account is established and all assets (except cash) and liabilities are transferred to it at their net book value (NBV). 3 When the assets are sold and the liabilities settled, a double entry is made between the realisation account and the cash account. Any expenses incurred during realisation are debited to the realisation account. During some dissolutions, partners may decide to take some of the assets for themselves. In these circumstances it is recorded in their accounts.
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4 Once all the assets are disposed of, and all the liabilities met, the balance on the realisation account is transferred to the partners account in their profit sharing ratio. A credit balance on the realisation account represents a profit on dissolution; a debit represents a loss. 5 The total amount due to the partners should equal the cash balance. The cash is distributed to the partners and the partnership is dissolved DISTINCTION BETWEEN DISSOLUTION OF PARTNERSHIP AND DISSOLUTION OF PARTNERSHIP FIRM You have already studied that on the occasion of admission, retirement and death existing partnership comes to an end, but the business of the firm continues under a new agreement. When a firm decides to wind up its business operations under any of the circumstances mentioned, it stands dissolved. Dissolution of a partnership firm is different from the dissolution of a partnership. Dissolution of a firm means that the firm closes its business and comes to an end. While dissolution of a partnership means termination of old partnership agreement and a reconstitution of firm due to admission, retirement and death of a partner. In dissolution of a partnership the remaining partners may agree to carry on the business under a new agreement. TREATMENT OF ASSETS AND LIABILITIES When the partners decide to discontinue the business of the firm, it becomes necessary to settle its accounts. For this purpose, it disposes off all its assets (except cash and bank balances) for satisfying all the claims against it. For this purpose a separate account called Realisation Account is opened. Realisaiton is an account in which assets excluding cash in hand and bank are transferred at their book value and all external liabilities are transferred at their book It also shows what amount were realised on the sale of assets and which liabilities were discharged at what amount. In order to record the disposal of assets and discharge of liabilities, the following journal entries are recorded: 1. For Transfer of Assets Assets account is closed by transferring it to the Realisation Account at its Book Value. Realisation A/c Dr. To Assets A/c (Individually) (Transfer of assets) It is to be noted that the following items on the assets side of the Balance Sheet are not transferred to the Realisation Account: (a) (i) Undistributed loss (i.e. Debit Balance of Profits and Loss account) (ii) Fictitious assets or deferred revenue expenditures such as preliminary expenses. All the above items are closed by transferring them to the partners Capital Account in their profit sharing ratio. The Journal entry is made: Partners capital A/c Dr. (Individually) To Profit & Loss A/c To Fictitious Assets A/c (Transfer of loss and fictitious Assets) (b) Cash in hand, and Cash at Bank, will be the opening balance of the
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Cash/Bank account; (c) Provisions and reserves against assets should be closed by crediting the Realisation Account. The Journal entry is made: Provision for Doubtful Debts A/c Provision for Depreciation A/c Any other Provision A/c To Realisation A/c (Transfer of provision on assets)
Dr. Dr. Dr.
2. For Transfer of Liabilities The accounts of various external liabilities are closed by transferring them to the Realisation Account. The loan given to the firm by a partners wife treated as an external liability and is transferred to the credit of Realisation Account. The relevant Journal entry is as under: External Liabilities A/c Dr. (Individually) To Realisation A/c (Transfer of external liability) Capital and Loan account of the partners are treated separately and so are not transferred to the Realisation Account. 3. Treatment of accumulated reserves and profit/loss Any balance of accumulated reserves (e.g. general reserves), Profit and Loss Account (Cr.), Reserve Fund and other reserves on the date of dissolution will be credited to the Partners Capital accounts on the basis of profit sharing ratio. The following journal entry will be recorded: Profit and Loss A/c Dr. General Reserve A/c Dr. Any Other Fund Dr. To Partners Capital A/c (Individually) (Transfer of profit and reserve) 4. For Sale of Assets (for cash) Bank/ Cash A/c To Realisation A/c (Sale of assets) 5. For Assets taken over by the partner Partners Capital A/c To Realisation A/c (Assets taken over by partner) Bank/Cash/Partners capital A/c To Partners Loan A/c (Settlement of loan to a partner)
Dr. (Realised Value)
Dr. (Agreed Price) Dr.
6. Settlement of loans given by the Partner
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Partners Loan A/c To Bank/Cash/Partners capital A/c (Settlement of loan given by the partner) 7. Payment of Liabilities in Cash Realisation A/c To Cash A/c (Payment of liabilities)
Dr.
Dr.
8. Payment of Liabilities by the partner(s) Realisation A/c Dr. To Partner Capital A/c (Liabilities taken over by partner) TREATMENT OF UNRECORDED ASSETS AND LIABILITIES Sometimes, there may be some assets that have already been written off completely in previous years and thus, do not appear in the Balance Sheet but physically they still exist for operational purposes. For example, there is an old computer, which is still in working condition though its book value is zero. Similarly, there may be some liabilities, which do not appear in the Balance Sheet, but actually they are still there. For example, a bill discounted with bank, on dissolution it was dishonored and had to be taken up by the firm for payment purposes. It is to be kept in mind that an unrecorded asset would never be transferred to the debit of the Realisation Account, because the amount realised from its sale is in nature of a gain and the Realization Account is only credited accordingly. Similarly, an unrecorded liability need not be transferred to Realisation. The Reason being that its payment is a loss and Realisation Account is only debited with the actual payment. In such cases, the following journal entries are made : (a) When the amount realised from the sale of an unrecorded asset. Cash/Bank A/c Dr. To Realisation A/c (Sale of unrecorded assets) When an unrecorded asset is taken over by a partner at an agreed value. Partners Capital A/c Dr. To Realisation A/c (Unrecorded assets taken by partner) When unrecorded liability has been discharged by the firm. Realisation A/c Dr. To Bank/Cash A/c (Payment of unrecorded liabilities) When an unrecorded liability is discharged by a partner on behalf of the firm. Realisation A/c Dr. To Partners Capital A/c (Unrecorded Liabilities payment by partner)
(b)
(c)
(d)
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Payment of Realisation Expenses (a) When realisation expenses are paid by the firm (i.e. borne by the firm).The following journal entry will be recorded: Realisation A/c Dr. To Bank/ Cash A/c (Payment of realisation expenses) (b) When Realisation expenses are paid by the partner on behalf of the firm (i.e. realisation expenses paid by the partner but borne by the firm). The following journal entry is made: Realisation A/c Dr. To Partners Capital A/c (Payment of realisation expenses by partner on behalf of firm) (c) Realisation expenses paid by the partner and borne by the partner; Partners Capital A/c Dr. To Cash/Bank A/c (Realisation expenses paid and borne by partner) Closing of Realisation Account The balance in the realisation account would show either profit or loss on dissolution. If the total of the credit side is more than the debit side, then there is a profit and following journal entry is made: Realisation A/c Dr. (Individually) To Partners Capital/ Current A/c (Individually) (Profit on realisation transferred to capital accounts) If, the debit side is more than credit side, then there is a loss on dissolution and following journal entry is made: Partners Capital/Current A/c Dr. (Individually) To Realisation A/c (Loss on realisation transferred to capital account) FORMAT OF REALISATION ACCOUNT . All Assets A/c (Book Value) (Except Cash/Bank) Cash/Bank A/c (Payment of external (liabilities) Partners Capital A/c (if any liability paid by partner) Cash/Bank A/c Partners (Expenses on realisation) Partners capital A/c (Expenses on realisation paid by a partner) Partners capital A/c (For transferring profit on realisation) GH xxx xxx xxx xxx xxx All External liabilities A/c(Book Value) Cash/Bank A/c Amount realised on sale of various assets) Partners capital A/c (If any asset is taken over) Capital A/c (For transferring loss on realisation) GH xxx xxx xxx xxx
xxx xxx
xxx
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PARTNERS CAPITAL ACCOUNT AND CASH/BANK ACCOUNT Settlement of Partners Capital Accounts After all the adjustments related to partners capital accounts and transfer of profit or loss on realisation to the partners capital accounts, the capital accounts are closed in the following manner: (a) If the Partners Capital Account shows a debit balance, the partner is to bring the necessary amount of cash. The following journal entry is made: Bank/Cash A/c Dr. To Partners Capital A/c (Cash brought by the partner) (b) If the Partners Capital Account shows a credit balance, he/she is to be paid off the necessary amount of money. The following journal entry will be made : Partners Capital A/c Dr. To Bank/Cash A/c (Cash paid to partner) Preparation of Cash/Bank account After closing the partners capital accounts, bank account is prepared and all entries pertaining to the bank/cash are posted in it including any cash brought in by the partner on the dissolution of firm. Partners capital accounts are closed by making payment from the bank account and thereby bank account stands closed by making/receiving payment. In this way all the accounts stand closed. If cash/bank account does not show any balance, it implies that all the accounts of the dissolved firm are closed properly. ILLUSTRATIONS Harley and his son David have been in partnership for a number of years and share profits (and losses) in the ratio 2:1. However, on 1 June 2006 they decide to dissolve their partnership to pursue other interests. The balance sheet of the partnership at 31 May 2006 is given below:
HARLEY AND DAVID PARTNERSHIP BALANCE SHEET AS AT 31 MAY 2006 $ $ $ $ Capital accounts Non-current (fixed) Assets at net book value; Harley 10,000 Equipment 4,000 David 7,000 Motor vehicles 6,000 10,000 17,000 Current accounts current assets Harley 4,000 Investments 10,000 David 2,500 6,500 Receivables - (debtors) 14,000 Bank 500 24,500 Payables (creditors) 11,000 34,500 34,500
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At dissolution, it was agreed by the partners that David could take some equipment, which had a net book value of $500, at a valuation of $750. Other equipment was sold for $3,300. All vehicles were sold for a total of $5,500. The receivables (debtors) only realised $11,300, and the payables (creditors) were settled for $10,000. The partners investments realised $13,400 and there were dissolution expenses of $800. You are required to show the relevant accounts and the final distribution between partners. APPROACH AND SOLUTION Students need to work carefully through a question like this. A good approach would be to follow the structure of events described above. The key steps are demonstrated below. Step 1 Combine the current and capital accounts: Partnership capital accounts Harley $ 10,000 4,000 David $ 7,000 2,500
Capital accounts Bal b/f Current accounts Bal b/f
Step 2 Establish a realisation account and transfer the balances on all the assets (except the cash balance) and on liabilities at their book value. The assets will then be shown as debit entries and the liabilities as credit entries in the realisation account. In this example the realisation account will be as follows: Realisation account $ 4,000 6,000 10,000 14,000 $ 11,000
Equipment (NBV) Motor vehicles (NBV) Investments Receivables debtors
Payables (creditors)
Step 3 Now record what happens on the sale of the assets and the settlement of any debts. The key journals are: a In selling assets (for cash) Debit Cash and bank account Credit Realisation account b Costs incurred during dissolution Debit Realisation account Credit Cash and bank account c In paying payables (creditors) and redeeming loans (if taken) Debit Realisation account Credit Cash and bank account d Assets taken out by partners Debit Partners account with agreed valuation of the asset
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Credit Realisation account with agreed valuation of the asset. In this example the accounts will now appear as follows; Realisation account $ 4,000 6,000 14,000 10,000 800 450 45,250 Partnership capital accounts Harley $ Realisation a/c (equip) Balance as at step 3 14,000 14,000 David $ 750 8,750 9,500 David $ 10,000 4,000 14,000 Harley $ 7,000 2,500 9,500 $ 11,000 10,000 3,300 5,500 11,300 13,400 750 45,250
Equipment (NBV) Motor vehicles (NBV) (debtors) payments: Payables (creditors) settled Dissolution expenses Balance
Payables (creditors) Cash and bank proceeds: Investments Equipment ReceivablesMotorvehicles Receivables (debtors) Cash and bank Investments Davids account(equipment)
Capital accounts Bal b/f Current accounts Bal b/f
Cash and bank $ 500 3,300 5,500 11,300 13,400 34,000 $ Realisation account: Payables (creditors) settled Dissolution expenses Balance as at step 3 10,000 800 23,200 34,000
Balance b/f Equipment Motor vehicles Receivables (debtors) Investments
Step 4 It is helpful at this point to check that the accounts balance. In this example the balance on the accounts is as follows: $ Credit Partners accounts: Harley David Credit Realisation account Debit Cash and bank $ 14,000 8,750 450
23,200 23,200 23,200 The balance on the realisation account is the profit (or loss) that has been achieved on realisation. In this example, a profit of $450 has been achieved.
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Step 5 The next step is to share the profit or loss between the partners in the profit sharing ratio. The partners are then paid and the partnership accounts closed by debiting the partners capital accounts and crediting the bank account. The final accounts for Harley and David on dissolution are as follows: Realisation account $ 4,000 6,000 14,000 10,000 800 300 150 45,250 $ 11,000 10,000 3,300 5,500 11,300 13,400 750 45,250
Equipment (NBV) Motor vehicles (NBV) (debtors) payments: Payables (creditors) settled Dissolution expenses Profit on realisation; Harley: 2/3 David: 1/3
Payables (creditors) Cash and bank proceeds: Investments Equipment ReceivablesMotorvehicles Receivables (debtors) Cash and bank Investments Davids account(equipment)
Partnership capital accounts Harley $ Realisation a/c (equip) Cash (i) 14,300 14,300 9 David $ 750 8,900 9,500 ,650 David $ 10,000 4,000 300 14,300 Harley $ 7,000 2,500 150 9,650
Capital accounts Bal b/f Current accounts Bal b/f Realisation account
Cash and bank $ 500 3,300 5,500 11,300 13,400 34,000 $ Realisation account: Payables (creditors) settled Dissolution expenses Partners accounts: Harley David 10,000 800 14,300 8,900 34,000
Balance b/f Equipment Motor vehicles Receivables (debtors) Investments
Key Points; When a firm decides to close its business and no business activity is carried out by the firm, it is said to be dissolved. Dissolution of a firm is different from the dissolution of a partnership.
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Dissolution of a firm means that the firm closes its business and comes to an end. While dissolution of a partnership means termination of old partnership agreement and a reconstitution of firm due to admission, retirement and death of a partner. On dissolution of the firm the books of accounts are closed. All assets and liabilities are transferred to an account is called Realisation Account. This account records the realisation of assets and the payment of liabilities. When the partners decide to discontinue the business of the firm, it becomes necessary for to settle its accounts. For this purpose, it disposes off all its assets (except cash and bank balances) for satisfying all the claims against it. An unrecorded asset would never be transferred to Realisation Account, because the amount realised from its sale is in the form of a gain and the Realization Account is only credited accordingly. After all the adjustments related to partners capital account and transfer of profit or loss on realisation to the partners capital accounts, the capital accounts are closed. Partners capital accounts are closed through making payment from the bank account and thereby bank account stands closed by making/ receiving payment.
JOINT VENTURE ACCOUNTS

Definition: A joint venture is a temporary partnership of two or more persons engaged in any particular business adventure of enterprise of short or seasonal duration. Examples of Joint Venture: It may be in connection with speculation in shares, underwriting of shares or debentures of new companies, or any other similar temporary or seasonal business enterprise. As the parties to a joint venture do business in union with others, they also share profit or loss between themselves in some agreed proportion. Advantages and Disadvantages of Joint Venture: Smart entrepreneurs and business owners know that Joint Ventures are the fastest and most effective way to radically increase sales and profits with virtually no money and no risk, as long as its done correctly. Advantages of joint venture enterprise are that perhaps one party may buy goods at a much cheaper rate, but he has no capital; a second person may perhaps advance the requisite capital, but has no business acumen; while a third individual is a good salesman and can sell the goods readily at a good margin. In a case like this, it is advantageous for all the three to combine their energy and work for mutual gain.
Disadvantages of Joint Ventures are the possibility of being ripped off or disappointed by unscrupulous and unprofessional JV partners, and hurting your reputation and/or customers and associates by associating with the wrong people, even unknowingly. There are two methods in which joint venture accounts can be kept. These are:
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1. Where no separate books are kept to record joint venture transactions. 2. Whereas separate set of books is kept to record the transactions. When Separate Books Are Not Kept: When it is not possible to maintain a separate set of books for joint venture transactions, each party will use his ordinary business books for recording such transactions. Each party will open a joint venture account and the accounts of other parties in his books. Suppose A and B enter into a joint venture. Then A will open a joint venture account and also an account of B in his books. Similarly, B will open in his books, a joint venture account and the account of A. The following journal entries are made: 1. When goods are purchased and money is spent on joint venture by any partner: Joint venture account To Cash or seller's account
2.
When goods are purchased by the fellow - partners and report is received from them or money is spent by them on joint venture: Joint venture account To Partner's personal account Thus the joint venture account in the books of one partner tallies with the same as it stands in the books of other partner: 3. When expenses are incurred by the other party: Joint venture account To Cash account When expenses are incurred by the other party: Joint venture account To Other party's account If any advance is received by the other party, say in the form of bill of exchange: Bills receivable account To Other party's account If any advance is given to the other party, say in the form of promissory note: Other party's account To Bills payable account If the bill receivable is discounted, the usual entry for discounting the bill is passed. The discount should be transferred to the joint venture account. The entry is: Joint venture account To Discount account If the bill payable was issued in favour of the other party and that party has got it discounted, the discount will have to be debited to the joint venture account, the credit will be in the other party's account:
4.
5.
6.
7.
8.
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9.
When the goods bought on the joint venture account are old: Cash or purchaser's account To Joint venture account
10. When the goods are sold by the co-partners and on being informed of the sale: Other party's account To Joint venture account 11. When money is received on joint venture: Bank or cash To Joint venture account 12. If money is received by the other party on account of joint venture: Other party's account To Joint venture account 13. If any special commission is received on account of joint venture: Joint venture account To Commission account 14. If any commission is payable to other party: Joint venture account To Other party's account (Commission may have to be paid for making sales or even for making purchase) 15. Sometimes some goods are left unsold and one of the parties takes them. The entry is: Purchases account To Joint venture account 16. If the goods are taken by the other party: Other party's account To Joint venture account 17. Now the joint venture account will show a profit or loss. The profit will be divided in the agreed proportions. The entry is: Joint venture account To Other party's account To Profit and loss account (In case of loss the entry will be reversed.) When Separate Books Are Kept: Under this method a separate joint bank account is opened. The amount contributed by each partner as his share of investment is deposited into a joint bank account. Accounts of the parties concerned are also opened. The system of accounting then is as follows:
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1. The amount contributed by each partner is debited to a joint bank account and credited to the personal account of each partner. 2. Goods bought on joint venture as well as expenses incurred in connection with the business are debited to the joint venture account and credited to the seller's account or the joint bank account. 3. When the goods are sold, the amount thereof is debited to the partner's account or the joint bank account and credited to the joint venture account. 4. If the parties have taken over plant or materials etc., the value will be debited to the account of the party concerned and credited to the joint venture account. 5. The joint venture account will now show profit or loss which will be transferred to the personal accounts of the respective parties in their profit sharing ratio. 6. The joint bank account will then be closed by making payment to each partner of what is due to him in respect of his personal account. Joint Venture Memorandum Account - An Alternative Method: This is another method to record the transactions in the books of the various parties. Under this method the joint venture account is prepared on memorandum basis, just to find out the profit or loss but not as a part of financial books. The name of such account is memorandum joint venture account. I books only one account is opened styled as "joint venture with.....account". Suppose A and B have entered into a joint venture. The A will open an account named, joint venture with B account. Similarly, B will open, in his books, joint venture with A account. This account is prepared in the following manner:1. Goods sent or expenses incurred on joint venture are debited to the account. 2. No account is taken of goods supplied or expenses incurred on joint venture by the other party. 3. If any cash or acceptance is received on account of joint venture or from other party, this account is credited. 4. The account is debited with own share of profit (ascertained by the memorandum joint venture account) the credit being given to profit and loss account. If there is a loss the profit and loss account is debited and this account is credited. The balance of this account will show either the amount owing to the other party or amount owned by the other party. Example: Following example will make the concept more clear: Memorandum Joint Venture Account Debit Side $ To A (Cost of goods & Exp.) To B (Cost of goods & Exp.) 5,400, 4,300 By B - sales Credit Side $ 12,000
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To B (Commission) To Profit: A 4/5 B 1/5 1,360 340
600
1,700 12,000 12,000
In the Books of A Joint Venture with B Account
Debit Side
Credit Side $ $ By Cash 4,300 1,360 6,760 6,760 6,760
To Cash (goods) To Cash (Expenses) To Profit and loss (4/5 of profit)
5,400,
In the Books of B Joint Venture With A Account
Debit Side $ To Cash (goods) To Cash (Expenses) To Commission To Profit and loss (1/5 of profit) To Cash 4,000 300 600 340 6,760
Credit Side $ By Cash 12,000
12,000
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12,000
Joint Venture Accounting Questions and Answers:. Theoretical Questions: 1. Define a "joint venture". What are the different methods of recording transactions relating to joint venture? 2. Differentiate between "joint venture" and "consignment". 3. What is memorandum joint venture account? How is it prepared? Objective: 1. State whether each of the following statements is true or false: (i) (ii) (iii) (iv) (v) (iv) (iiv) Joint venture and partnership are synonymous terms. Joint venture has very long life. Parties of joint venture are known as co-venturers Co-venturers work for commission. Principle of mutual agency is applicable to joint venture. Co-ventures and co-partners are interchangeable terms. Joint venture must have a permanent and distinct name to be a legal form of organization.
Answers: [i. False ii. False iii. True iv. False v. True vi. False vii. False] 2. Select the most appropriate answer: (i) Joint venture account is: (a) a nominal account; (b) a personal account; (c) a real account (ii) Joint bank account is opened: (a) when no separate books for the venture are maintained; (b) when separate books for the venture are maintained (c) under no circumstances (iii) When goods are purchased for the joint venture, the amount is debited to: (a) Purchase account; (b) Joint venture account; (c) Venturer's capital account. (iv) In case of memorandum method when there are three co-venturers, each co-venturer opens in its books for the venture: (a) one account; (b) two accounts; (c) three accounts. (v) When a venturer recording the transactions brings goods to the joint venture from his own stock, the amount is credited to: (a) joint venture account; (b) purchases account; (c) capital account. Answers: [i. a ii. b iii. b iv. a v. b]
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Short Answer Questions: 1. (i) A has spent $20,000 on account of a joint venture. What journal entry will you pass? (a). When separate set of books are kept. (b). When records are kept by A only. (c). When records are kept by B (a co-venturer) only, and (d). When records are kept by all parties (ii) Is it necessary to pass a journal entry for the above transaction in the books of B when memorandum method is adopted? [Answer: No] 2. B, a co-venturer, took away goods worth $9,000 at the end of a venture. What entries will you make when:
(a). There is a separate set of books. (b). Records are kept by B only (c). Records are kept by A only. (d) There is a memorandum, method of recording transactions
3. A and B completed a venture and earned $30,000. They shared profits in the ratio of 2:1. What journal entry will be passed when: (a). There is a separate set of books. (b). Records are kept by A only (c). Records are kept by B only. (d) There is a memorandum, method of recording transactions. 4. A purchases goods worth $20,000 for the joint venture and spend $2,000 on packing, insurance, freight, etc. He sends it to B, who receives goods and spends $1800. What journal entry will be passed when memorandum joint venture method is adopted? Joint Venture Accounting Exercises and Problems: Learning Objectives: 1. Prepare journal entries and joint venture accounts in the books of parties doing joint venture business. 2. How to solve a joint venture problem.
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Problem 1 - Journal Entries, Joint Venture Account Co-venturer Accounts: A and B were partners in a joint venture sharing profits and losses in the proportion of four-fifth and one-fifth respectively. A supplies goods to the value of $5,000 and inures expenses amounting to $400. B supplies goods to the value of $4,000 and his expenses amounting to $300. B sells goods on behalf of the joint venture and realizes $12,000. B is entitled to a commission of 5 percent on sales. B settles his accounts by bank draft. Required: Give journal entries and necessary ledger accounts in the books of both the parties. Solution: Books of A Journal Entries joint venture account To Cash account (Goods sent to B) 5,000 5,000
joint venture account To Cash account (Expenses incurred on goods sent to B)
400 400
joint venture account To B (Goods supplied by B)
4,000 4,000
Joint venture account To B (Expenses incurred by B on joint venture)
300 300
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B To Joint venture account (Sales proceeds received by B)
12,000 12,000
Joint venture account To B (Commission due to B on sales at the rate of 5%)
600 600
Joint venture account To B To Profit and loss account (Profit $1,700 divided as 1/5 to B and 4/5 to self)
1,700 340 1360
Cash account To B (The draft received from B in settlement)
6,760 6,760
Joint Venture Account Debit Side Credit Side
To Cash - Goods To Cash - Expenses To B - Goods To B - Expenses
5,000 400 4,000 300
By B - Sales
12,000
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To B - Commission To B - Share of profit To Profit and loss account
600 340 1,360 12,000 12,000
B Account
Debit Side
Credit Side
To Joint venture account
12,000
By Joint venture - Goods By Joint venture - Expenses By Joint venture - Commission By Joint venture - Profit By Cash
4,000 300 600 340 6,760 12,000
12,000 Books of B Journal Entries
joint venture account To Cash account (The value of goods supplied)
4,000 4,000
joint venture account To Cash account (Expenses incurred on joint venture)
300 300
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joint venture account To A (Goods supplied by A)
5,000 5,000
Joint venture account To A (Expenses incurred by B on joint venture)
400 400
Cash account To Joint venture account (Sales proceeds received in cash)
12,000 12,000
Joint venture account To Commission account (Commission due on sales at the rate of 5%)
600 600
Joint venture account To A To Profit and loss account (Profit $1,700 divided as 1/5 to B and 4/5 to A)
1,700 340 1360
A To Cash account (The draft sent to A in settlement)
6,760 6,760
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Joint Venture Account Debit Side Credit Side
To Cash - Goods To Cash - Expenses To A - Goods To A - Expenses To Commission To A - Share of profit To Profit and loss account
4,000 300 5,000 400 600 1,360 340 12,000
By Cash account - Sales
12,000
12,000
A Account Debit Side To Cash account 6,760 Credit Side By Joint venture account By Joint venture - Expense By Joint venture - profit 6,760 5,000 400 1,360 6,760
Problem 2 - Joint Venture Account and Co-venturer Accounts: Salim & Sons bought goods of the value of $7,500 and consigned them to Tahir and Co. to be sold to them on a joint venture, profit being divided in 2/3 : 1/3. They also paid $550 for freight, insurance and cartage and drew on Tahir and Co. for $3,000 on account. The bill was discounted by Salim & Sons for
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$2,900. Tahir and Co. paid $300 for dock dues, storage, rent etc. The sales realised $12,500 and the sales expenses $250 were defrayed by Tahir and Co. The later forwarded a sight draft for the balance due to Salim & Sons after charging their sales commission at 5 percent on the gross proceeds.
Required: Write up the accounts in the books of both the parties. No interest needs to be brought into account.
Solution: Salim & Sons Books Joint Venture Account Debit Side $ To cash - cost of goods To cash - expenses To Discount on bill To Tahir and Co. Dock, dues & storage Sales expenses Commission 300 250 625 1,175 7,500 550 100 By Tahir & Co.-sales proceeds Credit Side $ 12,500
To Profit and loss - 2/3 share To Tahir & Co. - share of profit
2,116.67 1,058.33 12,500 12,500
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Tahir & Co. Debit Side $ To Joint venture a/c - sales1 12500 By Bill receivable account By Joint venture account Dock & Storage Sales expenses Commission 300 250 625 1,175 Debit Side $ 3,000
By Joint venture account By Cash - sight draft 12,500 Tahir & Co. Books Joint Venture Account
1,058.33 7,266.67 12,500
Debit Side $ To Salim & Co. - cost of goods To Salim & Co. - expenses To Salim & Co. - Discount on bill To Cash. Dock, dues & storage 300 Sales expenses 250 1,175 7,500 550 100
Credit Side $ By Cash - sales proceeds 12,500
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Commission To Profit and loss - 1/3 share To Salim & Co. - share of profit
625 1,058.33 2,116.67 12,500 12,500
Salim & Sons Debit Side $ To Bills payable a/c To Cash - sight draft 3,000 7,266.67 By Joint venture account By Joint venture account By Discount account By Joint venture account - 2/3 10,266.67 Credit Side $ 7,500 550 100 2,116.67 10,266.67
SINGLE ENTRY AND INCOMPLETE RECORDS

Incomplete records is the term used for any system of bookkeeping which does not use full double entry. Generally applies to small business whether incorporated as Sole Proprietorship or Partnership. For them, generally a simple cash book to record receipts and payments may be enough instead of the proper accounting system complete with day books and ledgers. Using incomplete records cannot give an accurate period end financial statements as they do not tell the whole story. There is no record of outstanding debtors or creditors, nor of stock, nor, without analysis, of for what receipts and payments have been received and paid, or, in some cases, of the split between revenue and capital items. As a result, in an incomplete record system:the figures must be calculated, extrapolated, or extracted in the case of creditors and debtors to arrive at the year-end profit and loss account and balance sheet will rely heavily on application of the concept of
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the accounting equation which is Assets A = Proprietors capital + liabilities. Thus the value of capital can be determined at any point in time. However, questions on incomplete records are quite popular with examiners to test the understanding of candidates on Double Entry Methodology.
1. Learn to master Incomplete Record By: Ensuring you have a SOUND knowledge of DOUBLE ENTRY for Sales (Cash & Credit),Purchase (Cash & Credit), Cash transactions for expenses & other cash received ( usually capital being introduced) 2. Learn how to prepare: an opening Statement of Affairs; main control accounts; Bank Account; calculating gross profit; draft the Profit and Loss Account; and draft the Balance Sheet. Solving incomplete records problems is a matter of working through each of these steps tabulated below. If you use standard workings for each, and insert the figures which are given in the question, the problem becomes one of finding the missing figures.
Steps To Follow Inc Completing Incomplete Records: complete the opening statement of affairs; set out the standard workings; insert the figures from the question; calculate the missing figures; draft the required accounting statements.
Lets consider each of the steps and the relevant workings. (1) Prepare Opening Statement Of Account When a Balance Sheet has to be prepared using estimated values, we refer to it as a Statement of Affairs. The first step is to set out the main headings which are used in a Balance Sheet. We can then use the available information to obtain the relevant values. The main headings which are needed are: Noncurrent Assets,
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Current Assets; Stock, Debtors, Cash and Bank, Current Liabilities; Creditors, Bank overdraft, Noncurrent Liabilities Capital
Salient points: Remember these headings before your exam. Review the question for the relevant information so that you can insert the values for as many figures as possible. Usually there will be two values missing Fixed assets and capital As capital is the balancing figure, it is usually necessary to work out the value for fixed assets. A methodical approach is important here. The question will usually tell you when the various assets where acquired, as well as the depreciation policy. Your task is to calculate the net book value at the date of the Statement of Affairs by starting with the year of acquisition and applying the depreciation policy to obtain the net book value at the end of that year. Repeat that process for each year until you have reached the date of the Statement of Affairs. Once you have the value for fixed assets, the capital balance can be calculated: Fixed assets + current assets current liabilities = capital (2) Learn How to prepare the respective Control Account -Debtors, Creditors Understand how to construct the following Debtors And Creditors Control A/c and Bank Account:
DEBTORS CONTROL GH Opening balance b/d Sales xxxxx xxxxx Cash received from debtors Discount allowed Closing balance c/d xxxxx Balance b/d xxxxx GH xxxxx xxxxx xxxxx xxxxx
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CREDITORS CONTROL GH Payment to suppliers Discount received Closing balance c/d xxxxx xxxxx xxxxx xxxxx Balance b/d Opening balance b/d Purchases GH xxxxx xxxxx xxxxx xxxxx
Salient points: The opening balance for the Bank Account will also be obtained from the Statement of Affairs. You need to take care however as the balance may be either a debit (cash at bank) or a credit (overdrawn). The value of cash lodged will be a debit entry, and the value of cheques issued will be a credit entry. The closing balance will be the balancing figure. Make sure whether the balance is cash on hand or an overdraft. The layout for the bank account is as follows:
BANK ACCOUNT GH Opening balance b/d(if cash at bank) Lodgements Closing balance c/d (if overdrawn) xxxxx xxxxx xxxxx xxxxx Balance b/d (if cash at bank) xxxxx Balance b/d (if overdrawn) Opening balance (if overdrawn) Cheques issued Closing balance c/d (if cash at bank) GH xxxxx xxxxx xxxxx xxxxx xxxxx
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Calculating Gross profit

Salient points: Gross profit is calculated by deducting cost of sales from the value of sales. Questions often require the calculation of either margin or mark up. Understand Margin If margin is to be used, the value of sales will already have been calculated as the total of credit sales (derived from the Debtors Control Account) and cash sales (derived from the Cash Account). The gross profit is found by applying the % margin to the value of sales. For example, if sales are 80,000 and the margin is 20%, the gross profit will be 80,000 x 20% = 16,000. In questions which involve this calculation, you may have to derive the closing stock value from the resulting cost of sales. The opening value of stock will be taken from the Statement of Affairs. The value of purchases will be the total of credit purchases (derived from the Creditors Control Account) and cash purchases (derived from the Cash Account). Closing stock will be the balancing figure in the calculation: Sales -cost of sales = gross profit Cost of sales = opening stock + purchases-closing stock
Understand Mark Up First of all remember that mark up is gross profit expressed as a percentage of cost of sales. Questions requiring a mark up calculation will have provided all the figures to calculate cost of sales. The problem will be that the Debtors Control Account cannot be completed as two figures are missing -one of which is sales. In this case calculate the gross profit as follows: Cost of sales x mark up % = gross profit Therefore, total sales = cost of sales + gross profit and credit sales = total sales- cash sales. Profit and Loss Account Salient points: Remember that expenses must include both cash expenses and expenses paid by cheque. Depreciation must be included- but remember to include any assets acquired during the year! Balance Sheet
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Salient points: Fixed assets = Value from the statement of affairs + new assets -depreciation for period Current assets:Stock = Closing stock as calculated in cost of sales Debtors = Closing balance on the Debtors Control Account Cash = Closing balance on the Cash Account Bank = Closing balance on the Bank Account (if cash on hand)
Current Liabilities Creditors = Closing balance on the Creditors Control Account Bank = Closing balance on the Bank Account (if overdrawn) Capital = Balancing figure which can be confirmed as: Opening balance from the Statement of Affairs + profit from the Profit and Loss Account- drawings+ capital introduced Activity 1 The opening capital of Ivor Pain at 1 Jan 2005 was 32,000. During the year he withdrew 1,000 a month. At 31 December 2005 the capital figure was 18,000. How much profit or loss has been earned or suffered during the year? Opening capital Withdrawals 32,000 -12,000 20,000 Closing capital Loss 18,000 2,000
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Activity 2 Eileen Dover has not kept proper bookkeeping records but has kept notes in diary form of the transactions of her business. She is able to give you details of her assets and liabilities as at 31 December 2004 and 31 December 2005: Dec 2004 Van Fixtures Stock Debtors Bank Cash Creditors Loan Drawings 2,000 1,400 1,700 1,900 2,200 200 400 1,200 1,600 (after depreciation) 1,260 (after depreciation) 1,980 2,880 3,400 400 600 800 1,800 Dec 2005
Draw up a Statement of Affairs at each balance sheet date. December 2004 Van Fixtures 2000 1400 3400 Stock Debtors Bank Cash 1700 1900 2200 200 6000 1980 2880 3400 400 8660
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December 2005 1600 1260 2860
rexmay2003@yahoo.com Tutorial | How much profit or loss has been earned or suffered during the year?
Creditors Loan
(400)
5600 (1200) 7800
(600)
8060 (800) 10120 7800 4120 (1800) 10120
Capital Profit Drawings
7800 7800
This method of calculating profit is unsatisfactory and should only be done in exceptional circumstances. Construction of a cash or bank summary financial statements should be drawn up If we know the opening and closing bank account balances we might be able to calculate a missing figure for sales receipts or purchases. Example;
Donald does not keep proper accounting records. His bank statements show that his opening bank balance was 100 and his closing bank balance was 400. He knows that his payments to suppliers were 1,200 and he took drawings of 700 (paid by cheque) but he has no idea of his receipts from debtors? Construction of an opening cash or bank summary example
Date Detail Bal b/d Debtors 100 2200 Date Detail Creditors Drawings Bal c/d 2300 1200 700 400 2300
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CONSTRUCTION OF SALES AND PURCHASES
Construction of sales and purchase figures.usually done via control 0accounts. Construct a control account Control accounts essentially contain 4 items.. 1. Opening debtors 2. Closing debtors 3. Credit sales 4. Receipts from debtors If we know 3 items, we can calculate the fourth!! Construction of sales and purchases; Donald does not keep proper accounting records. He knows that his opening debtors were 500 and his Closing debtors were 400. He has already reconstructed his bank account and knows that receipts from Debtors were 2,200. He needs to calculate his sales. Debtors control Detail Bal b/d Sales 500 2100 Bal c/d 2600 400 2600 Detail Bank receipts 2200
rexmay2003@yahoo.com Tutorial | If we know the opening and closing bank account balances we might be able to calculate a missing figure for sales receipts or purchases. Example;
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Ex. 1: K Wong is a sole trader who does not keep his business transactions under a double-entry system but he keeps accurate ( ) records. From his records the following information has been obtained: 1 January 2011 GH Premises 50,000 Furniture and Fittings 7,500 Stock 9,100 Debtors 6,700 Cash at Bank 3,100 Creditors 5,800 His financial year ends on 31 December each year. REQUIRED: Calculate K Wongs Capital as at 1 January 2011.
EXX: The facts are the same as in Example 1. From his records, the following Information has been obtained: 31 December 2011 GH Premises 52,000 Furniture and Fittings 7,200 Motor Vehicle 5,500 Stock 10,200 Debtors 6,200 Bank Overdraft 2,800 Creditors 6,300 His financial year ends on 31 December each year.
INCOME AND EXPENDITURE ACCOUNT:

ACCOUNTING FOR NON-PROFIT ORGANIZATIONS
Introduction Accounting is a language to communicate and understand financial information, every organization, whether involve in business or non business activities, needs accounting to get financial reports. Non
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profit organizations are not involved in complex transactions like trading of goods or services and manufacturing activities therefore a very simple accounting system can work. Mainly these organizations are engaged in welfare activities or the activities that will entertain its members specifically and others in general. A very commonly understood example of such organizations is mosque or church. Almost all of us use to visit our worship place frequently and can understand very easily that it is an organization where we can have examples of assets, liabilities, incomes and expenses as well. But remember non profit organizations do not have owners equity because these are not owned by any one rather a managing committee looks after all affairs of the organization. Therefore there is no question of owners equity in the financial information of non profit organizations.
TERMINOLOGY Subscription: The members of the associations, as per rules, are generally required to make annual subscription to enable it to serve the purpose for which it was created. It appears on the receipts side of the receipt and payment account and is usually credited to income. Care must be exercised to take credit for only those subscriptions which are relevant. Life Membership Fees: Generally the members are required to make the payment in a lump sum only once which enables them the members for whole of life. Life members are not required to pay the annual membership fees. As life membership fees is substitute for annual membership fees therefore, it is desirable that life membership fees should be credited to separate fund and fair portion be credited to income in subsequent years. In the examination question if there is no instruction as to what portion be treated as income then whole of it should be treated as capital. Entrance Fees: Entrance fees are also an item to be found on the receipt side of receipts and payments account. There are arguments that it should be treated as capital receipt because entrance fees is to be paid by every member only once (i.e., when enrolled as member) hence it is non-recurring in nature. But another argument is that since members to be enrolled every year and receipt of entrance fees is a regular item, therefore, it should be credited to income. In the absence of the instructions any one of the above treatment may be followed but students should append a note justifying their treatment. Sale of News Papers, Periodicals etc.
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As the old newspapers, magazines, and periodicals etc. are to be disposed of every year, the receipts on account of such sales should be treated as income, and therefore to be credited to income and expenditure account. Sales of Sports Material: Sale of support materials (used) is also a regular feature of the clubs. Sales proceeds should be treated as income, and therefore to be credited to income and expenditure account. Honorarium: Persons may be invited to deliver lectures or artists may be invited to give their performance by a club (for its members). Any money so paid is termed as honorarium and not salary. Such honorarium represents expenditure and will be debited to income and expenditure account. Special Fund: Legacies and donations may be received for specified purchases. As discussed above these should be credited to special fund and all expenses related to such fund are shown by way of deduction from the respective fund and not as expenditure in income and expenditure account.
Capital Fund: Any concern - whether profit seeking or non profit seeking - requires money for conducting day to day functions. In the case of profit seeking concerns such money is called "capital", while in the case of non - profit seeking concerns it is called "capital fund". The excess of total assets over total external liabilities of a concern is called capital fund. Capital fund is created with surplus revenue and capital receipts and incomes. It is shown on liabilities side of balance sheet.
ACCOUNTING RECORDS
Cash book is prepared in a chronological sequence; it is the only book of original entry that is maintained by the accountant of a non profit organization. At the end of the accounting year a summary of total cash receipts and total cash payments is made under different heads, such summary is known as Receipt and Payment Account. Cash book will contain subscription received on different dates during the year where as the Receipt and Payment Account will contain a single amount of total subscription received during the year. Similarly cash book contains payment of salaries made on different dates of the year, whereas, the Receipt and Payment Account will show the total salaries paid during the year as a single information.
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Memorandum Records
A non profit organization that has a large number of members will also maintain a memorandum record of members, and if that organization is running activities like providing medicines or providing library facilities or running a sports club then it will also be maintaining memorandum record for the inventory items.
Financial Statements
Non profit organizations prepare Income and Expenditure Account that replaces Income Statement of a business concerns to obtain surplus (excess of incomes over the expenses) or deficit (excess of expenses over the incomes). Incomes of a non profit organization. Incomes of a non profit organization mainly include the following: o Subscription o Donation o Entrance fee o Lockers rent o Membership fee etc. etc. All these incomes are measured according to the accrual concept. Actual receipts of these incomes are recorded in the Cash Book and ultimately become part of the Receipt and Payment account. Such receipts are then adjusted with the opening and closing owing/advance income to get the balance of income that belongs to the current accounting period.
For example: GH 55,000 subscription received during the year ending on December 31 20x7 of which GH 5,000 relate to the subscription due in the year 20x6 and GH 2,000 was received in advance that was relating to the year 20x8. GH 3,000 subscription of few members was received in advance during the year 20x6 and GH 4,000 subscription relating to the year 20x7 is still due to be received. GH 55,000 (7,000) 48,000 10,000 58,000
Cash received during the year 20x7 Less Cash received not related to year 20x7 (5,000 + 2,000) Add Income relating to the year 20x7 (3,000 + 7,000) Subscription income for the year 20x7 SUBSCRIPTION (INCOME) ACCOUNT Debit Opening Due GH 5,000 Credit Opening Advance
GH 3,000
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Closing Advance Income (balancing figure)
2,000 58,000
Cash Received Closing Due
55,000 7,000
Expenses of a non profit organization

Expenses are also measured according to the accrual concept. All revenue expenditures appearing in the payment side of the Cash Book (Receipt and Payment Account) are adjusted with the opening and closing balances of outstanding and prepaid expenses. This process of adjustment converts the revenue payments in expenses. Such expenses are ultimately matched with the Incomes to calculate surplus/deficit. Balance Sheet is prepared to know the financial position in the same way as we already have studied for business entities. The only difference in the balance sheet of a non profit organization comparing with the balance sheet of a business entity is that there will be no owners equity instead there will be a balance of accumulated fund also known as capital fund in the balance sheet of a non profit organization as a main source of finance.
Accumulated Fund
Like owners equity, accumulated fund is also a difference of Assets and Liabilities. Accumulated Fund = Assets Liabilities Accumulated fund represents the funds that are the source of the Assets obtained or constructed for the organization. These funds consist of grants, donations, legacies, entry fees, life membership fees etc. Often in the examination questions Statement of Affairs is prepared to find the opening balance of accumulated fund 31.12 2007 GH 3,000 400 22,000 ? 23,400 2,000 1,000 31.12.2008 GH 19,100 850 25,000 35,000 18,500
Cash at Bank Cash in hand Stocks Debtors Creditors Fixtures and fittings Motor Car
Cash Book analysis showed following figures amongst others: GH Receipts from customers 135,000 Discount allowed 1,400 Fresh capital on 1.7.2008 2,000 Salaries up to 30.11.2008 11,000 Office rent up to 30.11.2008 2,200 Advertising 900 General expenses 600 GH Motor car repair 1,350 Printing and stationery Drawings 6,600 Payments to creditors 112,000 Discount received 1,200 Electricity charges 1,000
800
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No ready figures are available for total sales but Ali Shah maintains a steady gross profit rate of 25% on sales. There were outstanding bills for electricity GH 250, Advertising GH150, and printing GH 450. Provide for doubtful debts up to 5% of the debtors. Motor car and fixtures are to be depreciated by 20% and 10% respectively.
Prepare Income Statement for the year ended 31-12-2008 and Balance Sheet as on that date.
Hints: 1. Calculate purchases as balancing figure in creditors account 2. Calculate cash sales as balancing figure in the cash book 3. Calculate total sales with the help of cost structure 4. Calculate credit sales by subtracting cash sales from the total sales 5. Calculate opening debtors balance as balancing figure in debtors account 6. Calculate opening capital from the statement of affairs
ACCOUNTING SYSTEM IN NON-PROFIT ORGANIZATIONS

Non profit organizations like business entities are also large, medium and small in size. A large organization will be having a complete accounting system along with a full fledge accounts department where the double entry accounting will be followed. Whereas, medium or small sized non profit organization will be maintaining few books of accounts and will not be having proper accounting system. Small size non-profit organization We can observe so many examples of a small size non-profit organizations around us, the very commonly understood example will be of a street library where cash book would have been maintained as the only book of account and finally a summary of that cash book is prepared at the end of the year just to have an overview of the total receipts and payment made during the year. Because of the very simple and few transactions, its members do not need to know its financial position at the end of each accounting period therefore Income & Expenditure Account and Balance Sheet is not prepared. Large size non-profit organization On the contrary, member of the large size organization will be interested in all financial results of the entity and a proper book-keeping system is developed over there. The outcome of which is production of a Trial Balance which is used to prepare Income & Expenditure Account and Balance Sheet. Medium size non-profit organization Medium size non-profit organizations although do not prepare proper books of accounts but need to know the financial status in terms of surplus income and financial position of the organization. From this purpose; rules of conversion of single entry into the double entry are followed and finally Income & Expenditure Account and Balance Sheet is prepared. Practice Question
197
(This is not difficult at your level to understand what appears in debit and credit sides of a trial balance and which information is put in the income & expenditure and with information relates to the balance sheet. For practicing purposes a solved problem is shown hereunder) From the following Trial Balance of a club prepare an Income & Expenditure Account for the year ended on 31st March 2008 and Balance Sheet as on that date: Particulars Dr. GH Cr. GH 30,000
General fund Cash in hand 2,000 Cash at bank 3,000 Sundry debtors 2,400 Sundry creditors 1,500 Loan @ 15% (1-07-2007) 20,000 Furniture & Fixture 10,000 Building 40,000 Stock of cold drink 500 Rent 6,000 Rate, Taxes & Insurance 600 Secretary Honorarium 1,200 Entrance fee 1,000 Subscription received in advance 1,500 Salaries & Wages 5,800 Extension of building 10,000 Printing & Stationary 1,000 Legal charges 500 Annual subscription 30,000 Card & Billiard room receipts 4,000 Sundry expenses 1,600 Cold drink sales 5,000 Repair of building and furniture 400 Utility expenses 1,000 Purchase of cold drink 4,000 Interest on Loan 1,000 Total 92,000 92,000 Additional Information 1. Subscription for the year end outstanding GH 2,000 2. Write off depreciation @10% per annum on furniture and 2% on building including the extension. 3. Stock of cold drinks GH 1,000
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Soln; Club Income and Expenditure Account For the year ended 31.03.2008 GH Consumption of cold drink Rent Rates, taxes & insurance Secretarys honorarium Entrance fees Salaries & wages Printing and Stationary Legal charges Sundry expenses Repairs to building and furniture Utility Bills interest on loan 1,000 Add: Outstanding 1,250 Depreciation Excess of income over Expenditure GH 3,500 6,000 600 1,200 1,000 5,800 1,000 500 1,600 400 1,000 2,250 2,000 14,150 41,000 GH By Subscriptions 30,000 Add: Outstanding 2,000 Card & Billiard Room Receipts Cold Drinks sales GH
32,000 4,000 5,000
41,000
Accumulated Capital Capital Fund Add: Surplus Noncurrent Lib 15% Loan
Club Balance Sheet As at 31.03.2008 GH GH Noncurrent Assets 30,000 14,150 Club House Add: Extension Less: Depreciation Furniture & Fixture Less : Depreciation Current Assets Stock in hand: Cigars 400 Wine 600 Sundry Debtors Subscription due Cash at Bank Cash in hand
GH 40,000 10,000 50,000 1,000 10,000 1,000
GH
44,150
49,000 9,000 58,000
20,000
Current Liabilities Sundry Creditors 1,500 Interest on Loan (Outstanding) 1,250 Subscriptions received in adv 1,500
4,250
1,000 2,400 2,000 3,000 2,000
68,400
10,400 68,400
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ACCOUNTING SYSTEM IN NON-PROFIT ORGANIZATIONS

Preparing financial statements with incomplete records Most of the non-profit organizations operate in medium scale and do not prepare proper books of accounts. The only accounting record that is maintained in such sized organizations is cash book along with year end adjustments. The management also keeps Statement of Affairs as on opening date to maintain during the year movements in the balance sheet items. Cash Book (Receipt and Payment Account) Statement of Affairs (as on opening date) Year end Adjustments Accrued incomes and expenses Advance receipts and payments Depreciation rate
Like business entities, these few accounting records are used to convert the information into double entry system and to produce Income & Expenditure Account and Balance Sheet. The technique of preparing financial statements of a non-profit organization is similar to that used for preparing financial statements of a business entity. While preparing Income & Expenditure Account following shall be assumed to calculate expenses and incomes Calculation of incomes For non-profit organizations the incomes are picked up from the cash books and amended with the year end adjustment: Cash based incomes Cash based incomes are the revenue receipts that are picked up from its origin cash book and are processed into the filter of accruals, like this: GH. Cash received during the year Less Opening balance of accrued income Add Closing balance of accrued income Add Opening balance of advance receipts Less Closing balance of advance receipts *** *** *** *** *** ***
Fixed Assets based incomes Profit/gain on disposal of Assets are calculated with the help of sales proceeds appearing in receipts side of Cash Book and some relevant information appearing in the year-end adjustments like cost and accumulated depreciation of the asset disposed off. Calculation of expenses For non-profit organizations the expenses are picked up from the cash books and amended with the year end adjustment: Cash based expenses Cash based expenses are the revenue payments that are picked up from its origin cash book and are processed into the filter of accruals, like this:
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Expenses paid in cash during the year Less Opening balance of accrued expenses Add Closing balance of accrued expenses Add Opening balance of prepaid expenses Less Closing balance of prepaid expenses Expense for the year to be shown in the Income Statement
GH. *** *** *** *** *** ***
Fixed Assets based expenses 1. Depreciation is calculated based on the depreciation rate mentioned in the Year-end Adjustments 2. Loss on disposal of an asset are calculated with the help of sales proceeds appearing in receipts side of Cash Book and some relevant information appearing in the year-end adjustments like cost and accumulated depreciation of the asset disposed off.
Balance Sheet of a non-profit organization is prepared in the usual way and contains particulars of all assets and liabilities of the organization on the date on which it is prepared. Net assets of non-profit organization are represented by Capital Fund in the balance sheet. This Capital Fund replaces the owners equity. The opening balance of Capital Fund is calculated through the Statement of Affairs as on the opening date. Such opening Capital Fund is then adjusted with the surplus or deficit in the Balance Sheet. Capital receipt like; specific donations, funds, grants etc. for purchase/acquisition or construction of assets are also included in the Capital Fund of the organization.
Calculating Subscription Income

Although calculating subscription income is not a separate issue apart from the calculation of incomes for the year originating from the cash book, but even then its calculations are being shown over here just to give confidence through practice. Subscription is cash based income and like other revenue receipts it appears in receipts side of the cash book summary. It is picked up from there and then amended with the opening and closing balances of subscriptions accrued and received in advance. Solved Problem Subscription received during the year 2007 Subscription outstanding at the beginning of 2007 Subscription outstanding at the closing of 2007 Calculate the amount of subscription income for the year 2007. Working: Subscription received during the year Less Opening due Add Closing due Income for the year GH. GH. 7,000 1,400 5,600 1,600 7,200 GH. 7,000 1,400 1,600
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Subscription Income Account Date Particulars Amount Date GH 1/1/07 Subscription opening due 1,400 31/12/2007 31/12/07 Subscription income 7,200 31/12/07 8,600
Particulars Cash Subscription closing due
Amount GH 7,000 1,600 8,600
PREPARATION OF FINANCIAL STATEMENTS OF NON-PROFIT ORGANIZATIONS FROM INCOMPLETE RECORDS

Questions often require candidates to prepare an Income & Expenditure Account and Balance Sheet from incomplete records. Generally, a summary of bank and cash transactions is provided along with information relating to opening and closing assets and liabilities. To solve these types of problems, the following steps are followed: 1. Prepare a receipt and payment account (if not given in the question). 2. Prepare statement of affairs as on opening date. 3. Post the balances of assets and liabilities from the statement of affairs into the relevant ledger a/c as opening balance b/f or put these in the working for further calculation of closing balance. 4. Pick up the revenue receipts and payment and pass these from the filter of accruals to calculate incomes and expenses for the year. 5. Prepare such ledger accounts as are deemed necessary (like subscription a/c). 6. Work out depreciation charge for the fixed assets and treat them accordingly. 7. Prepare trading account for supporting trading activities undertaken by the non-trading organization. 8. Draft the income and expenditure account and balance sheet. Solved Problem1 Karachi Golf Club prepared the following Receipts and Payments Account for the year ended December 31, 2007 Receipts Amount Payments Amount GH GH Opening balance b/f 3,800 Sports Equipments (purchased on Subscription 1.9.2007) 10,000 2006 2,000 Tournament expenses 4,000 2007 18,500 Electricity 500 2008 900 Printing 300 Entrance fees (capital receipts) 800 Salaries and wages 3,400 Interest on Investment 1500 Expenses for exhibition 2,100 Closing Balance c/f 7,200
27,500
Additional information: 1. Non-current assets of the club on January 1, 2007 include the following: GH Club Ground 50,000
27,500
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Sports Equipment Furniture Investment 2. 3. 4.
15,500 2,000 12,000
Subscription for 2007 collected in 2006 GH500 Unpaid subscriptions for 2007 GH 300 Depreciation to be provided @ 5% p.a. on furniture and @ 20% p.a. on sports equipment.
Required: prepare Income statement and balance sheet for the year 2007.
Assets Club ground Sports equipment Furniture Investments Subscription due Cash balance
Statement of Affairs as on January 1, 2007 GH 50,000 15,500 2,000 12,000 2,000 3,800 85,300 500 84,800
Less Liability Subscription received in advance Capital fund
Date 2007 1 Jan 1 Sep
Sports Equipment Account Particulars Amount Date Particulars GH 2007 Opening balance 15,500 31 Dec Depreciation Addition During the year 10,000 31 Dec Balance 25,500
Amount GH 3,767 21,733 25,500
Sports Equipment Opening balance Add Addition 1.9.2007 Less Depreciation 15,500 x 20% 10,000 x 20% x 4/12 667 Net book value Furniture Opening balance Add Addition 1.9.2007 Less Depreciation 2,000 x 5% Net book value 3,100 3,767
GH 15,500 10,000 25,500 (6,867) 21,733
2,000 0 2,000 100 1,900

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Subscription Income Subscriptions received during the year Less Opening due Add Closing due Add Opening advance Less Closing advance
21,400 2,000 300 500 900 19,300
Income & Expenditure Account For the year ended December 31, 2007 GH 19,300 Incomes Subscription 1,500 20,800 Interest on Investment 4,000 Expenses Tournament expenses 500 Electricity 300 Printing 3,400 Salaries and wages 2,100 Exhibition expenses Depreciation; 100 Furniture 3,767 14,167 Sports equipment 6,633
Owners Equity Opening capital Add Net profit Add Fresh capital Less Drawings Closing capital Capital Fund Opening capital fund Add Surplus Add Capital receipts during the year Closing capital fund Capital fund as on December 31, 2007 Opening capital Add Surplus Add Capital receipts Closing capital fund
GH xxx xxx xxx xxx xxx
xxx xxx xxx xxx GH 84,800 6,633 800 92,233
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Assets Club building Sports equipment Furniture Investments Subscription due Cash
Balance Sheet As on December 31, 2007 Amount Capital and Liabilities GH 50,000 Capital fund 21,733 Subscription received in Advance 1,900 12,000 300 7,200 93,133
Amount GH 92,233 900
93,133
MANUFACTURING ACCOUNTS In this section we cover the following topics:

Manufacturing accounts - sections and construction Factory profits and provision for unrealised profits on stocks
Manufacturing accounts So far, we have considered the final accounts of sole traders who do not make the goods that they sell. In all prior examples, the firms generate profits by purchasing stock and then selling this stock for a price higher than the cost meaning a profit has been earned - i.e. the difference between sales and the cost of those goods that were sold. In reality, most firms do not act in this way. Even if a firm does not make its own products, it is likely to add something to the products themselves. If a firm actually produces the goods that they sell then there will be no obvious 'purchases' figure to include in the trading account. The costs incurred in the production of goods will appear instead and these will be calculated in a manufacturing account. A manufacturing account shows the cost of producing the goods that are sold during an accounting period. It is split into the following sections: Prime cost Direct costs of physically making the products (e.g. raw materials) Other indirect costs associated with production but not in a direct manner
Overhead cost
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The cost of manufacturing the products will be the total of the prime cost and the overhead cost added together. This total factory cost (or production cost) will then be transferred to the trading account where it will appear instead of the 'normal' purchases figure. Prime cost The prime cost covers all the costs involved in physically making the products and other costs that are directly related to the level of output. These are usually known as direct costs and common examples would include: 1. Direct materials 2. Direct labour/wages 3. Other direct costs (e.g. packaging, royalties) Cost of raw materials consumed. Within the prime cost adjustments will have to be made for opening and closing stocks of raw materials. There may also be carriage inwards charged on the raw materials and returns outwards of materials sent back to their original supplier. The overall charge for materials is referred to as cost of raw materials consumed, this should be highlighted when drawing up a manufacturing account and it is calculated as follows: Opening stock of raw materials Purchases of raw materials Add Less Less Equals Carriage inwards on raw materials Returns outwards of raw materials Closing stock of raw materials Cost of raw materials consumed
A true direct cost will vary directly with the level of output. If the output level doubles, then we would expect a direct cost to also double. If the cost does not behave in this manner then it may be an indirect cost and not a direct cost. Royalties Royalties is sometimes included within the prime cost. These are a cost that is paid to the owner of a copyrighted process. Usually a fee is paid for each product that uses this process and therefore the total royalty cost will be directly proportional to the level of output.
206
Follow the link below to see an example of a prime cost calculation. Overhead cost This section includes all other expenses concerned with the production of output but not in a direct manner. This means that if the level of production increased, then these expenses may also increase but not by the same proportion. These are sometimes known as indirect costs, factory overheadsor indirect manufacturing costs. Common examples of overhead costs would include: 1. Factory rent 2. Indirect labour 3. Depreciation of factory plant and equipment Depreciation of fixed assets should be included in this section only if it is depreciation on assets included for production. For example, depreciation of machinery would appear as an overhead cost but depreciation of office equipment would appear in the profit and loss account as an expense as would be expected in a non-manufacturing organisation. Once the overhead costs have been calculated they will need adding to the total of the prime cost. This will give us the production cost of the goods. However, the production cost will need adjusting for goods which are not yet finished. Make sure you add the total for factory overheads to the prime cost and don't subtract! Allocation of expenses Some expenses may be split between two areas of the financial statements. For example, an expense may be split between the prime cost and the overhead costs. Similarly, expenses may be split between the manufacturing account and the profit and loss account. The term office expense is often used to illustrate an expense that will be allocated to the profit and loss account. If there are prepayments or accruals to adjust for then this should be completed before any split between the sections of the financial statements. Follow the link below to see an example of the allocation of expenses. Work-in-progress Goods which are not finished are known as work-in-progress. The opening balance of work-in-progress is added on to the production cost and the work-in-progress left at the end of the year will need subtracting to give us the cost of the goods completed during the period we are dealing with. Stocks in manufacturing organisations There are three types of stock that we deal with in manufacturing accounts. These are as follows:
207
1. Raw materials - the purchases of these will be adjusted for opening stock and closing stock in the prime cost. 2. Work-in-progress - partly completed goods will be dealt with at the end of the manufacturing account. 3. Finished goods - opening and closing stocks will be dealt with, as is normal, in the trading account All three types of closing stocks will appear as current assets on the balance sheet. Notice that for all three types, the principle is the same as ever: add on the opening stock and deduct the closing stock. The difference lies in the stage at which you do this for each type of stock. Factory profits and unrealised profit One of the main reasons why firms manufacture their own goods, rather than purchasing them from another firm, is that the goods can be manufactured at a lower cost than the purchase price from elsewhere. The difference between the cost of manufacture and the cost of 'bought in' goods is known as factory profit, or profit on manufacturing. Any factory profit will boost the overall profits for the firm but is kept separate from the gross profit until the net profit has been calculated, when they would be added together. Any factory loss incurred should also be kept separate until the net profit is calculated. By keeping the profits separate, this allows the managers of a firm to see how profit had been earned - did it arise out of efficiency in manufacturing, or other areas of the firm? It is hard to estimate how much a firm would 'save' by manufacturing its own products rather than purchasing them from elsewhere. As a result, factory profit is usually calculated by simply adding on an additional percentage of the production cost to give us the 'transfer price' which will replace the purchases figure in the trading account. This procedure is known as marking-up the production cost. However, if we mark-up the production cost then the value for the cost of goods sold in the trading account will be higher. This means that the final gross and net profits for the firm would be lower. To cancel out this effect, the factory profit is added on again at the end of the profit and loss account. This time it is added on to the net profit. Account Manufacturing Action Add factory profit to cost of production Deduct factory loss from cost of production Profit & loss Add factory profit to net profit Deduct factory loss from net profit
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Example 1 The following data has been extracted from the books of D Scaife Ltd. At 31 December 2001: Dr GH Stocks at 1 January 2001: Raw materials Work in progress Finished goods Purchases of raw materials Sales Direct labour Rent and rates Electricity Office salaries Depreciation for the year: Factory Office 7,000 3,000 32,000 18,000 8,000 43,000 89,000 215,000 12,500 7,650 18,900 Cr GH
Additional information 1. Stocks at 31.12.01: GH Raw materials 11,250
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Work in progress Finished goods
8,420 21,530
2. Rent, rates and electricity are to be apportioned: Factory 75%, Office 25% 3. Finished goods are to be transferred to the trading account at a profit of 20% on factory cost. Have a go at producing a manufacturing, trading and profit and loss account for D.Scaife for the year ended 31 December 2001. Follow the link below once you have had a go to compare your answer with ours. Unrealised manufacturing profit from unsold stock If we allow for factory profit then this will mean that the value of any closing stock would actually include an amount of factory profit in its valuation. The prudence concept disallows any anticipation of future profits - how can we say that the value of stock includes profits when we have yet to sell the stock? - and therefore we would need to deduct this profit by making a provision for any profits on unsold stock. This provision for unrealised profit on unsold stock should be treated in the same way as any other provision. This means that the change in the provision should appear in the profit and loss account as a debit (if it is increased) or as a credit (if it is decreased) which means this would be added on to the gross profit. Increasing the provision Debit Profit & loss with the increase Decreasing the provision Increasing the provision Credit Provision account with the increase Decreasing the provision
Debit Provision account with the decrease Credit Profit & loss with the decrease
The adjustment for unrealised profit on stock should only be made if implied in the question. Balance sheet Once the factory profit on the closing stock has been calculated then the adjustment would have to be made on the balance sheet. In our previous example, the stock would appear as follows:
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Current assets Stock Less provision for unrealised profit Example 3
GH 30000 6000
GH
24000
The following balances have been extracted from the books of Bohanna Company Ltd as at 30 June 2003. Stocks at 1 July 2002: Raw materials Work in progress Finished goods Factory wages: Direct Indirect Royalties Electricity and power General factory expenses Maintenance expenses General office expenses Purchases of raw materials Sales Depreciation of plant and machinery Provision for unrealised profit 143,000 54,600 1,290 13,000 27,000 17,540 28,950 124,000 565,000 9,000 4,500 GH 6,500 7,900 18,430
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Additional information 1. At 30 June 2003 stocks were as follows: GH Raw materials Work in progress Finished goods 4,980 6,950 21,500
2. Electricity and power and Maintenance expenses are to be apportioned 80% to the factory and 20% to the company's offices. 3. At 30 June 2003 an electricity bill of GH 800 remained unpaid and maintenance costs paid in advance amounted to GH 760. 4. The company always transfers finished goods from the factory to the warehouse at factory cost plus 25%. Exam tips - manufacturing accounts

It is vital that you learn the correct sections of the final accounts of the manufacturing organisation - prime cost, factory overheads, and trading and profit and loss account. Only items directly linked to the level of output will appear in the prime cost calculations. Items related to production but not directly will appear in the factory overheads section of the manufacturing account. When considering depreciation, only depreciation of productive assets (such as machinery) will appear in the manufacturing account. Show all your workings for adjustments (e.g. show the calculations for cost of raw materials consumed). Look out for any factory profits which will be 'marked-up' at the end of the manufacturing account. If factory profit has been added then make sure you add it again at the end of the profit and loss account - to cancel out of the effect of increasing production cost. It is the change in the provision of unrealised profits that will appear in the profit and loss account! The full provision for unrealised profits will be deducted from finished goods on the balance sheet. Show all kinds of (closing) stocks on the balance sheet. Never put items in twice - you will automatically get no marks for this item - if you don't know then take an (educated) guess.
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Meridian Pre-University College

Course: financial Accounting Part 1
Lecturer: Rexford Atta-Boakye Jnr. MBA (Accounting)
Course objectives: The course aims at; giving the student a detailed understanding of principles and the role of accounting recording business transactions, appreciate of the rules and functions of accounting as they apply to organisation, and ability for further studies in accounting.
COURSE OUTLINE/CONTENTS INTRODUCTION
Assessment: There will be at least one class tests/quizzes (30%) and a comprehensive end of semester examination (70%). Students will be informed a week before each test/quiz is due. READING LIST 1 2 Frank Wood/Alan Sangster (2008), Business Accounting (Eleventh Edition), FT Prentice Hall Accounting Foundations 1.1 The Institute of Chartered Accountants (Ghana)
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Public Sector Accounting

rexmay2003@yahoo.com Tutorial | BRANCHES OF ACCOUNTING

USERS OF ACCOUNTING INFORMATION AND THEIR INFORMATION NEEDS

MAIN USERS OF FINANCIAL INFORMATION RELATING TO A BUSINESS

Employees and their representatives

Government Suppliers Investment analysts Community representative

Government Investment/Financial analysts Suppliers Lenders (Banks)

rexmay2003@yahoo.com Tutorial | USERS OF ACCOUNTING INFORMATION AND THEIR INFORMATION NEEDS

CHARACTERISTICS (DESIRABLE QUALITIES) OF GOOD ACCOUNTING INFORMATION

rexmay2003@yahoo.com Tutorial | CHARACTERISTICS (DESIRABLE QUALITIES) OF GOOD ACCOUNTING INFORMATION

The Characteristics Which Influence the Usefulness of Accounting Information

Useful accounting information

Which will be limited by

Constraints/Problems on Relevant and Reliable Information

THE ROLE OF THE ACCOUNTANT IN AN ORGANIZATION

rexmay2003@yahoo.com Tutorial | ACCOUNTING STANDARDS

The role of the accountant

Accountants in public practice

Accountants in government and non-governmental institutions

rexmay2003@yahoo.com Tutorial | THE ROLE OF THE ACCOUNTANT IN AN ORGANIZATION

INTRODUCTION TO DOUBLE ENTRY

CAPITAL Capital 25,000

Old bal. 25,000 + 0 Effects (15,000) + 15,000 10,000 c) + 15,000

Old bal. 10,000 + 15,000 + 0 Effect New 0 + 0 + 5,500

rexmay2003@yahoo.com Tutorial | INTRODUCTION TO DOUBLE ENTRY

0 + 10,000 +5,500 + 10,000

Old bal. 10,000 + 8,000 + 5,500 Effects 0 10,000 +

+ 10,000 + 0 0 + 3,000 3,000

= 8,500 + 25,000 = +0 + 500 25,500

0 + (2,500) + 8,000 3,000

0 + 25,500 + 4,000 + 4,000 0

rexmay2003@yahoo.com Tutorial | INTRODUCTION TO DOUBLE ENTRY

3,000 = 8,500 + 0 8,500

+ 4,000 + (500) 4,000 25.000

Capital Long term Liabilities: Loan Current Liabilities: Creditors

rexmay2003@yahoo.com Tutorial | INTRODUCTION TO DOUBLE ENTRY

NBV *** *** *** *** *** ****

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THE RECORDING PROCESS

THE DOUBLE ENTRY SYSTEM

DOUBLE ENTRY RULES ARE:

rexmay2003@yahoo.com Tutorial | INTRODUCTION TO DOUBLE ENTRY

ELEMENTS OF BALANCE SHEET STATEMENTS 1. 2. 3. Assets Liabilities Equity/Capital

rexmay2003@yahoo.com Tutorial | INTRODUCTION TO DOUBLE ENTRY

Personal Accounts Debtors Accounts Creditors Account

rexmay2003@yahoo.com Tutorial | AN ACCOUNT

ACCOUNTING CYCLE (PROCESS)

BALANCING OFF ACCOUNTS

rexmay2003@yahoo.com Tutorial | BALANCING OFF ACCOUNTS

THE TRIAL BALANCE

rexmay2003@yahoo.com Tutorial | THE TRIAL BALANCE

DAY BOOKS AND LEDGERS

DAYBOOKS - BOOKS OF ORIGINAL ENTRY

rexmay2003@yahoo.com Tutorial | DAY BOOKS AND LEDGERS

ADVANTAGES OF KEEPING BOOKS OF ORIGINAL ENTRY

TYPES OF BOOKS OF ORIGINAL ENTRY

rexmay2003@yahoo.com Tutorial | DAY BOOKS AND LEDGERS

rexmay2003@yahoo.com Tutorial | DAY BOOKS AND LEDGERS

NBV * * * * * **

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