Financial Accounting is the ideal introduction to this topical and dynamic subject. Successfully combining
a conceptual approach with an accessible, interactive style, the text tackles the very latest international
developments. Adopting a unique questioning attitude to the subject, the authors ask why accounting
practices exist and not simply how they work, without lingering on the technicalities.
The fourth edition has been fully updated in line with the transition to International Accounting Standards
(IASs) and International Financial Reporting Standards (IFRSs).
A Companion Website supports this book,
providing a full resource pack for both lecturers
and students, including further questions with
answers, a list of suggested web links and an
expanded bank of self-marking multiple-choice
questions for students.
Anne Britton is Associate Dean and Head of School of Accounting and Financial Services at Leeds
Metropolitan University, and Chris Waterston is a Principal Lecturer in the same school. They are both
experienced teachers and writers.
Financial Accounting is ideally suited for students
taking accounting courses at both undergraduate
and postgraduate level. This book will also be a
suitable introduction to the subject for those who
intend to continue studies in professional
accounting.
Key features for this new edition include:
• all material now based on International Accounting Standards;
• new material on accounts for non-profit organisations;
• expanded and revised IT chapter;
• clear coverage of the convergence programme between the US
and the IASB, as well as the roles of Enron and WorldCom;
• more company case studies and ‘real life’ examples;
• a greater emphasis on the relevance of the international
regulatory environment.
An imprint of
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Financial Accounting
FinancialAccounting
Fourth Edition
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ANNE BRITTON & CHRIS WATERSTON
BRITTON&WATERSTON
0273703609_COVER 19/9/05 3:20 PM Page 1
FINANCIAL ACCOUNTING
Visit the Financial accounting, fourth edition, Companion Website at
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We work with leading authors to develop the
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Fourth Edition
FINANCIAL ACCOUNTING
Anne Britton and Chris Waterston
Leeds Metropolitan University
FNAC_A01.QXD 12/10/05 11:01 am Page iii
Pearson Education Limited
Edinburgh Gate
Harlow
Essex CM20 2JE
England
and Associated Companies throughout the world
Visit us on the world wide web at:
www.pearsoned.co.uk
First published 1996
Second edition 1999
Third edition 2003
Fourth edition 2006
© Pearson Education Limited 1996, 2006
The rights of Anne Britton and Christopher Waterston to be identified
as authors of this Work have been asserted by them in accordance with
the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
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Microsoft product screenshots reprinted with permission from Microsoft Corporation
ISBN-13: 978-0-273-70360-0
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Typeset in 9.5/12.5pt by 30
Printed in Great Britain by Ashford Colour Press Ltd., Gosport
The publisher’s policy is to use paper manufactured from sustainable forests.
FNAC_A01.QXD 12/10/05 11:01 am Page iv
Contents
Preface x
1 What is accounting? 1
Introduction 1
Purposes of accounting 1
Types of accounting 3
Who cares anyway? The users 9
The future of financial accounting 11
Summary 13
Self-assessment questions 14
2 The balance sheet 17
Introduction 17
The sources and applications of funds 17
The format of the balance sheet 20
A few words about non-commercial organisations 23
What the balance sheet tells the user 23
The alternative valuation methods 25
Statement of changes in equity 26
Uncertainty 27
Summary 29
Self-assessment questions 30
3 The income statement 33
Introduction 33
The nature and content of the income statement 34
Operating costs 36
The appropriation account 37
Statement of changes in equity 38
Inventory valuation 40
Non-commercial organisations 44
Limited companies 46
Changes to the income statement 47
Information technology and accounting 47
Summary 48
Self-assessment questions 49
4 Concepts and characteristics 51
Introduction 51
Concepts and policies 53
Accounting estimation and measurement bases 60
FNAC_A01.QXD 12/10/05 11:01 am Page v
Revenue recognition 60
A true and fair view 61
The ‘Framework’ 62
Summary 66
Self-assessment questions 67
5 The double entry system 69
Introduction 69
The need for a double entry system 69
Double entry system – duality 71
Double entry system – account 71
Credit transactions 76
Worked example of double entry 77
Balancing off accounts 78
Trial balance 82
Income statement 84
Format of the income statement 86
Balances remaining in the books 87
Summary 88
Self-assessment questions 89
6 Adjustments, including entries in ledger accounts 92
Introduction 92
Accruals and repayments 92
Adjustment to ledger accounts 94
Adjustments for bad and doubtful debts 99
Depreciation 103
Sale of non-current assets 108
Summary 110
Self-assessment questions 110
7 Preparation of income statement and balance sheet from
trial balance and adjustments 115
Introduction 115
Extended example 116
Summary 123
Self-assessment questions 124
8 Accounts of limited companies 127
The need for companies 127
The company 128
Company capital 130
Other organisations 144
Summary 146
Self-assessment questions 147
9 Cash flow statements 154
Introduction 154
Cash flows within a business 154
vi Contents
FNAC_A01.QXD 12/10/05 11:01 am Page vi
Cash flow statement 157
Summary 167
Self-assessment questions 168
10 Regulatory framework in the UK compared with European
examples and the international framework 175
Introduction 175
UK legal framework 176
UK regulatory framework 178
International regulatory framework 181
Determinants of the accounting framework 183
Summary 187
Self-assessment questions 188
11 Interpretation, including ratio analysis and
consideration of additional information required 189
Accounting information and users 189
Needs and objectives of users 190
Standards 191
Technique of ratio analysis 193
Performance 195
Investment potential 200
Financial status 203
Limitations of ratio analysis 204
Additional information 206
Cash flow and ratio analysis 206
Overall 210
Summary 210
Self-assessment questions 211
12 Valuation and performance measurement 215
Introduction 215
Alternatives to historical cost 216
The time value of money 217
Putting the valuations together 218
Inflation accounting 220
Accounting for revaluations 227
Statement of changes in equity 231
Summary 231
Self-assessment questions 232
13 Control of accounting systems 234
Introduction 234
The need for controls 234
Audit 235
Bank reconciliations 240
Control accounts 244
Summary 248
Self-assessment questions 249
Contents vii
FNAC_A01.QXD 12/10/05 11:01 am Page vii
14 Information technology and accounting 252
Introduction 252
Control issues 253
Audit trails 256
Designing an accounting system 257
Implementation 258
Contingency planning 260
E-accounting 261
XML 263
The wider picture 265
Summary 266
Self-assessment questions 266
15 The finale 269
Introduction 269
Case study 269
Accounts for Kriton Manufacturers SA 270
Notes to the accounts 271
Note of retained earnings 273
Summary 281
Appendix: Answers to self-assessment questions 282
Glossary 336
Index 341
viii Contents
Supporting resources
Visit www.pearsoned.co.uk/britton to find valuable online resources
Companion Website for students
• Multiple choice questions to test your learning
• Annotated links to valuable resources on the web
• Glossary to explain key terms
For instructors
• Additional long exercises complete with solutions
• Solutions to all the questions posed in the text
• PowerPoint slides that can be downloaded and used as OHTs
• Glossary
Also: The Companion Website provides the following features:
• Search tool to help locate specific items of content
• E-mail results and profile tools to send results of quizzes to instructors
• Online help and support to assist with website usage and troubleshooting
For more information please contact your local Pearson Education sales
representative or visit www.pearsoned.co.uk/britton
FNAC_A01.QXD 12/10/05 11:01 am Page viii
1 · What is accounting ix
Preface
Welcome to your studies of financial accounting. Here we suggest how to
use this book to gain the maximum benefit from your studies.
This fourth edition has been revised to introduce new topic areas,
notably e-accounting and the increasingly important issue of revenue
recognition. All chapters now include a list of key terms to assist with gaining
an overview of the subjects to be covered in each chapter. Additional
self-assessment questions have been added to all chapters, with answers, to
provide for more practice in developing the skills of accounting. The whole
book is also now supported by a dedicated website, containing further
questions, with answers available to tutors, and self-marking multiplechoice
questions. The website also contains overhead transparency masters
of key topics, for use by tutors, and a list of suggested web links for use by
all users.
The book is divided into 15 chapters, each dealing with a separate area
of financial accounting. The sequence of chapters is important, and you
should normally work through the book following the chapter order. If you
try to jump ahead, you may find that the material doesn’t make much
sense because you haven’t yet picked up the necessary underpinning
knowledge and skills.
Each chapter starts with a brief list of its objectives. This is a checklist of
the things you should be able to do by the time you have worked through
that chapter. Check back to this list when you finish each chapter to
ensure that you have understood it all. If you are unsure about one or
more aspects, don’t leave the chapter, but have another look at the relevant
part. You may also find it helpful to review the list of key terms at
the head of each chapter. If you are still no more confident in your abilities,
you will find suggestions for alternative approaches to the topic at
the end of each chapter.
It is very tempting to forget this advice and to move on. However, we
also know that the next topic will be much easier if you have thoroughly
covered the previous one.
At a number of points in the book we suggest that you jot down your
own ideas about a question raised, or that you calculate a figure, prepare
an account, etc. You should therefore have at your side when you read
this book:
᭤ a pad of paper
᭤ a pen
᭤ a calculator.
FNAC_A01.QXD 12/10/05 11:01 am Page ix
Where an activity is designed to help you to learn the material, an
answer is given in the text immediately following. It can be difficult to discipline
yourself to make the effort to do the suggested activity instead of
just reading ahead to the answer, but it is well worth the effort. Where an
activity is designed to assess whether you have understood the topic, and
can apply the required skill, self-assessment questions are provided at the
end of the chapter. Answers are to be found at the end of this book.
Notice that in each case we have provided an answer, not necessarily the
answer. As you will see as you explore accountancy, it is not the exact science
that many people suppose it to be. Almost all the answers in
accountancy, at least in the UK, are contingent and dependent on ideas of
what is to be achieved – which is why Chapter 1 is concerned with such
fundamental issues. We must be clear about what we are trying to achieve
before we start on the mechanics of doing it.
Self-assessment questions can be found at the end of each chapter and
the relevant answers are at the end of the book. These are a selection
of questions providing practice in the topics covered in the chapters.
Don’t forget that there is also a website to support this book at www.
pearson.co.uk/britton/.
Remember, if you work through the issues for yourself, you will learn and
retain them much more effectively than if you just read about them.
Ultimately, it is your choice as to how much benefit you derive from studying
this book.
A few words about current changes in accounting
The general public have tended to view accounting as a traditional, neverchanging
subject. This is not true; despite common appearances, accounting
is a dynamic subject. The big change in 2005, and for the next few years, is
the move in the UK from domestic accounting rules to international rules.
Specifically, the rules that have been developed in the UK since 1970, known
as Statements of Standard Accounting Practice (SSAPs) and Financial
Reporting Standards (FRSs), are effectively being phased out. Coming in their
place are International Accounting Standards (IASs) and International
Financial Reporting Standards (IFRSs).
This change is being introduced gradually, with all companies across the
European Union, including the UK, that are listed on a stock exchange in
the EU, using the international set of standards from 2005. Other companies,
broadly the small and medium-sized ones, will continue to use the
old UK standards for the time being. However, it seems likely that all companies
will move to using the international standards in the medium term
and the UK standards will then presumably wither away. Indeed, the UK’s
standard setters are currently working on convergence of UK and international
rules.
This means that UK accounting is currently in the middle of a major
transition and this book reflects that. The book is based on the jargon and
rules in the new international standards. However, we have also made refx
Preface
FNAC_A01.QXD 12/10/05 11:01 am Page x
erence to the older jargon and rules at the appropriate points. For example,
what is now called the ‘income statement’ in the international standards
has traditionally been known as the ‘profit and loss account’ in the UK, but
we have used the new term. Again, when we explore the format of the cash
flow statement in chapter 9, we use the layout specified by the international
standard rather that the layout required by the UK standard. On the
other hand, some specimen international balance sheets use the terms
‘trade receivables’ for debtors and ‘trade payables’ for creditors. We think
the original terms are likely to remain in such wide currency that they are
still acceptable, so we haven’t changed these.
We know this is confusing (it is for all accountants during the current
transition!) but we believe that following the rules and jargon which will
increasingly become the norm over the next few years will best prepare
you for those years and beyond.
Preface xi
FNAC_A01.QXD 12/10/05 11:01 am Page xi
Guided tour – to comeGuided tour of the book
92 Financial Accounting
6
Adjustments, including entries in
ledger accounts
Introduction
Chapter 5 introduced you to the double entry system of bookkeeping. This
chapter intends to build on that knowledge and expertise gained and also
to further develop the concepts and conventions of accounting in relation
to this double entry system.
So far we have assumed, with the exception of the inventory adjustment
that we looked at in Chapter 5, that all entries made in the ledger for
assets, liabilities, expenses and income relate to the period for which you
wish to extract an income statement and balance sheet and that no items
are missing. This is an incorrect assumption!
Accruals and prepayments
In the previous chapter all the expenses for Mr Bean’s business entered the
ledger accounts via the cash or bank account and the assumption was
made that these related to sales, and were used up by Mr Bean in achieving
those sales.
By the end of this chapter you should be able to:
᭤ Identify the need for adjustments to ledger accounts.
᭤ Understand the nature of prepayments and accruals.
᭤ Describe the necessity for adjustments for bad and doubtful debts.
᭤ Define depreciation.
᭤ Carry out the required ledger entries for depreciation.
᭤ Balance off all ledger accounts after adjustments.
᭤ Understand the nature of any balance remaining.
Objectives
Answer Our list would include the following:
1 Money borrowed from an outsider, often a bank. Money borrowed is known as ‘debt
finance’.
2 Money invested by the owners. For a sole trader or a partnership this is known
simply as ‘capital’. For a limited company, such money is called ‘share capital’.
3 Once a business is up and running it will hopefully make profits. Profit is then another
source of funds, and can be used in the business as soon as it is received. The total
of capital or share capital, together with such profit, is then called ‘equity finance’.
4 More subtly, the credit allowed to an entity by a supplier is also a source of funds. If
I agree to supply you with goods and accept payment next month, what I am effectively
doing is lending you the goods for a month. Such a loan in kind is analogous
to the loan in money that we listed as point 1 above.
There are thus two broad classifications of funding sources: equity and
debt. These are both liabilities of the business because the business has an
obligation to repay them eventually. Loans will have to be repaid and even
the capital invested by the owners of the business will have to be repaid to
them if and when the business comes to an end. Similarly, the profits ultimately
belong not to the business, but to the owners, since the whole
business belongs to them. The profits will therefore have to be paid by the
business to the owners. In other words, the profits made in the past and
retained by the business are a liability of the business.
In the meantime, the business can spend the equity and debt funds on
buying a range of goods and services. Some of the things it buys will have a
transitory existence, such as the labour of the workforce. The immediate
benefit that comes from buying one hour of an employee’s time ends at
the end of that hour. Similarly, there will be nothing to show for money
applied to paying the electricity bill. Note that the labour and the electricity
may well have been used to produce the business’s product, and any
inventory of that product will have a continuing existence. The distinction
we are aiming for, however, is that the labour and the electricity no longer
exist as labour and electricity, but as part of the inventory value.
For comparison, some of the things the business applies its funds to will
have a continuing existence. We have already seen that one such example
could be inventory. Others could be, for example, buildings, vehicles or
machinery. Items like this which have a continuing existence in themselves,
and are of future benefit to the business, are called assets.
In Chapter 1 we defined assets as things we own and liabilities as things
we owe. We can now adopt more accurate definitions, namely:
᭤ The essence of an asset is the right to receive future economic benefit as
a result of past transactions or events.
᭤ A liability is the obligation to transfer economic benefits as a result of
past transactions or events.
18 Financial Accounting
List three sources of funds for a typical business. You may find it helpful to think
about your present or past employer, or another business you know of.
Activity 2.1
Objectives – Bullet points at the start of
each chapter show what you can expect to
learn from that chapter, and highlight the
core coverage.
Activities – Appearing throughout every
chapter, each activity is purposefully
designed to help you learn the material,
with the answer given in the text
immediately following. Try not to look at
the answer before trying the activity!
Key terms – The key concepts and
techniques in each chapter are highlighted
in colour where they are first introduced,
listed at the end of each chapter, and fully
explained in the comprehensive glossary.
FNAC_A01.QXD 12/10/05 11:01 am Page xii
Guided tour – to come
Summary
This chapter has:
᭤ introduced you to several adjustments that have to be made to the
ledger accounts at the end of a period in order to draw up the income
statement and balance sheet in accordance with accounting concepts
and conventions
᭤ identified for you that the concepts and conventions used were mainly
accruals (matching) and prudence
᭤ illustrated adjustments for accruals and prepayments both for expense
and revenue, bad debts and provision for bad debts and provision
for depreciation
᭤ identified that depreciation is perhaps the hardest adjustment to get to
grips with as it is an attempt to measure the use of the asset within the
business, not an attempt to reduce the asset to its realisable (sale) value at
any point in time. You must ensure that you are very clear on this fact.
This chapter concludes with several exercises involving these adjustments.
Self-assessment questions
Accruals and prepayments
1 The following adjustments are required to be made to the ledger accounts for Mr Cog
for the year ended 31.12.X5:
᭤ Stationery expenses paid in X5 £450, amount owing as at 31.12.X5 £50.
᭤ Building insurance paid in X5 £600 for the period 1.7.X5 to 30.6.X6 – note: the
building was purchased 1.7.X5.
᭤ Motor expenses paid in X5 £550, amount owing 31.12.X4 £70, amount owing
31.12.X5 £90.
᭤ Rents paid in X5 £1,500 for the period 1.7.X5 to 30.6.X6, £1,200 had been
paid last year for the period 1.7.X4 to 30.6.X5.
᭤ Rents receivable during the year should be £50 per month. Only £500 has been
received as at 31.12.X5.
110 Financial Accounting
prepayment (p. 93)
accrual (p. 93)
ledger adjustments (p. 94)
bad debts (p. 99)
provision for bad debts (p. 100)
depreciation (p. 104)
straight line method (p. 105)
reducing balance method (p. 105)
non-current asset (p. 108)
sale of a non-current asset account
(p. 108)
Key terms
Bullet point chapter summary – Each
chapter ends with a ‘bullet point’
summary. This highlights the material
covered in the chapter and can be used
as a quick reminder of the main issues.
Self-assessment questions – At the end
of each chapter you will encounter these
questions, allowing you to check your
understanding and progress. Solutions are
provided in the Appendix.
FNAC_A01.QXD 12/10/05 11:01 am Page xiii
Guided tour of the website
Multiple choice questions
Weblinks
Glossary
FNAC_A01.QXD 12/10/05 11:01 am Page xiv
1
What is accounting?
Introduction
This chapter aims to introduce the purposes and the types of accounting,
and to consider who might be interested in a knowledge of accounting.
Since you are reading this book, you presumably have some interest in
accounting, or at least a need to study it. Nevertheless, you may not be
aware of the range of activities that make up accounting, nor be quite sure
about what, and who, accounting is for. In this chapter we look at these
issues under three headings – the purposes, the types and the users.
If you have done some accounting before, you may be tempted to skip
over this chapter. Don’t. The last few years have seen a strong trend
towards accounting for the spirit of transactions, rather than the letter. If
you are to understand what the spirit of a transaction is, then you must be
clear about the fundamental issues dealt with in this chapter.
Purposes of accounting
Before we look at the purposes of accounting, it is helpful to review briefly
the contexts in which accounting occurs. In other words, we examine the
different types of organisation that need accounting.
By the end of this chapter you should be able to:
᭤ Discuss the need for, and purposes of, accounting.
᭤ Outline the nature and types of accounting.
᭤ Describe the major formats in which accounting information is
presented.
᭤ List the users of accounting and describe their particular
informational needs.
Objectives
FNAC_CO1.QXD 12/10/05 9:50 am Page 1
Answer The following list of organisations covers the main types. You may have included
others, or have expressed the same ones in different words.
᭤ Sole trader. This means one person who runs a business on their own, or perhaps
with a few employees. The main aim is to make a profit.
᭤ Partnership. This is two or more people who carry on a business in common, intending
to make a profit.
᭤ Limited company. In the UK, a limited company is a legal organisation set up under
the Companies Acts of 1985 and 1989. The owners are called the shareholders, and
it is run by directors, who are appointed by the shareholders. In small companies it is
common for the shareholders to appoint themselves as directors. Larger companies
are often public limited companies, or PLCs. You will find out more about limited
companies in Chapter 8.
᭤ Public sector bodies, such as local councils or the National Health Service.
Traditionally, these bodies have not existed to make a profit, but to provide a service.
᭤ Clubs and societies, such as a local cricket club. Again the intention is not to make
a profit, but to provide services for members.
All of these organisations require some form of accounting, however simple. Our next
task is to explore why this should be so.
Answer This is probably the most fundamental question in accountancy. Nevertheless, there
are no agreed, clear answers to it. In principle, therefore, your answers are as valid as
any others, but we would expect you to include some or all of the following.
1 To record what money has come into the organisation and what has gone out.
2 To help managers make decisions about how to run the organisation.
3 To tell other people about the activities and consequent profit or loss of the organisation
during the past year, or other period.
4 To tell other people about the present financial state of the organisation.
5 To provide a basis for taxation.
6 To help assess whether the organisation is beneficial to society as a whole.
7 To control the organisation, by controlling the finances.
8 To provide a basis for planning future activities.
9 To support legal relationships, for example how much one business owes another.
This not a comprehensive list: you may have listed other items, or have expressed similar
points in different ways. Points 2 and 8 in the list arguably overlap. However, if you
look at our list and your own, you should see that the purposes are broadly of two types.
First, there are purposes that relate to the running of the business, that is, those that
form a basis for decision making. In Chapter 10 you will see that part of the regulatory
2 Financial Accounting
What types of organisation can you think of? Jot them down and then put a cross
against any that you think have no need of accounting.Activity 1.1
Accounting is undertaken by organisations for a variety of reasons. What do you think
they are? Jot down at least three reasons before you read on.Activity 1.2
FNAC_CO1.QXD 12/10/05 9:50 am Page 2
framework of financial accounting is a document called the ‘Framework for the Preparation
and Presentation of Financial Statements’ (hereafter just called the Framework). This is a
publication by the International Accounting Standards Board (IASB), which is itself an
authoritative international group of accountants. The Framework is dealt with in more detail
in Chapter 4; briefly, it states that the prime objective of financial statements is to aid
decision making.
Second, there is a group of purposes that can be classified as ‘stewardship’. This
term means that accounting is used to keep track of what has been done with the
financial resources entrusted to its managers. Historically, this was the original purpose
of financial accounting, whereby managers (‘stewards’) had to account to the owners
for their stewardship of the owners’ money. The Framework is clear that stewardship is
now secondary to decision making as a general aim of financial accounting. This
means that accounting is now less a matter of keeping track of the money, and more a
matter of using the resulting information to actively manage the organisation, and for
outsiders to make decisions about the organisation.
If this is what accounting is for, what does that imply for the nature of
accounting? Well, for one thing, it means that accounting is not just a
matter of recording data, or even of processing it in an organised way. It is
both these things, but an increasingly large part of accounting is concerned
with subsequently presenting the resultant information to those who are
interested in the welfare of the organisation. The next section looks in
more detail at the consequent nature of today’s accounting.
Types of accounting
Accounting can be divided very roughly into two areas, financial accounting
and management accounting. Bear in mind that the division is a rather
arbitrary one, and many functions in the accountancy world spread across
both areas. Nevertheless, it is a distinction that is often made, and which
can help to make accountancy as a whole more manageable.
Financial accounting is concerned with the recording, processing and
presentation of economic information after the event to those people outside
the organisation who are interested in it. By contrast, management
accounting deals with similar activities, but is geared to providing information
about the organisation to its managers to help them run it. In other
words, the heart of the distinction is the purpose of the accounting, rather
than what is done. This may become clearer if we look at each of the three
functions of recording, processing and presentation.
Recording
All accounting requires the prior collection of raw data and its organisation
into some form of structured record. In principle, this could be as crude as
writing down each transaction in a single book, as it occurs. It should be
obvious, however, that it would not be easy to get information out of this
1 · What is accounting? 3
FNAC_CO1.QXD 12/10/05 9:50 am Page 3
book. You may be aware that, in fact, almost all accounting systems across
the world rely on ‘double entry’ recording in some form. This method has
been so successful over the past 500 years since it was codified precisely
because it is relatively easy to get information out of it. In Chapter 5 you
will start to learn about this system.
Before we can start on the practicalities of recording data, however, there
remains one major question to be answered.
Answer There are many kinds of transactions, and you may have noted others than those listed
below, or expressed similar items in different ways.
1 Sales made.
2 Money received for the sales – remember that you don’t always get paid as soon as
you sell something.
3 Production materials bought.
4 Expenses incurred, for example electricity used.
5 Production materials and expenses paid for – again we don’t always pay for something
as soon as we buy it.
6 Borrowing money from the bank.
7 Persuading other people to put money into our organisation.
8 Buying big items that we intend to keep, such as buildings or machinery.
Note that what accountants therefore record is almost always restricted to what can be
valued reasonably objectively in money terms. In other words, if you can’t attach a currency
symbol, such as a £ sign, to it, accountants ignore it. Furthermore, accountants
tend to focus on the organisation, rather than taking a broader societal view.
Answer As with most of the questions raised in this chapter, there is no single, correct answer.
Some of the things we consider to be currently important are:
1 The value added to the economy by the activities of the organisation.
2 The measurement and inclusion of human resources. Some football clubs, for
example, include a valuation of their players in their balance sheet, that is, the summary
of what the organisation owns and owes. Others claim that it is impossible to
say objectively what a player is worth, and so omit them from the balance sheet.
Which approach do you think gives the best picture of what the organisation owns?
We think this area of accounting is one of the more interesting ones, and it is dealt
with more fully in the next chapter and in Chapter 12.
4 Financial Accounting
What sorts of transaction does an accountant record? Note down at least four.Activity 1.3
List three things about an organisation that accountants might not record, but which
you would regard as useful things to be told about.
Activity 1.4
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3 Environmental accounting, which tries to report the impact of the organisation on
the environment, perhaps in terms of tonnes of pollutants emitted, compared with
previous years, other similar organisations, or standards of some sort.
4 Social accounting, which provides information about the social impact of the organisation.
This could include looking at, say, the employment of minority groups, or the
effect of purchasing policies, especially where supplies come from the Third World.
In the UK, The Body Shop plc is one of the more notable companies already moving
down this road.
The above possibilities are not part of generally accepted accounting practice
at the moment. However, there are signs that this is changing. Ethical
investment is a growing force in the UK, with over £4 billion invested by
investment funds which claim some ethical basis. An organisation trying to
attract such investment could find that providing some of the information
suggested above could help. Against this, there is a view that organisations
in the UK, especially limited companies, already have to provide so much
information that the costs of doing so prevent them from concentrating on
their core business. All we can do here is note that accounting is constantly
changing, and that there are signs that it is moving towards some of the
issues indicated above. This is discussed in more detail under ‘The future of
financial accounting’ later in this chapter.
Chapter 5 will start to explore exactly how organisations record data and
turn it into useful financial statements of various sorts. For the moment all
we need to consider is what data should be recorded and why. To consolidate
your knowledge so far, try putting a tick in the correct box in the table
shown in Activity 1.5.
Recorded Ignored
1 Selling one of the organisation’s cars
2 Paying the wages
3 Making the tea
4 Moving staff between jobs in the office
5 Incurring a fine for polluting a local river
6 Paying the fine
Answer You should have ticked the ‘recorded’ column for items 1, 2, 5 and 6, since all these
result in objectively measurable resources coming into or leaving the organisation. On
the other hand, items 3 and 4 do not change the economic relationship with the outside
world, and would therefore not be recorded in a financial accounting system. You
should therefore have ticked the ‘ignored’ column for these two.
1 · What is accounting? 5
In conventional accounting, which of the events listed in the table would usually be
recorded and which would be ignored?
Activity 1.5
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You might expect the law to specify what records are required. In fact, in
the UK the Companies Acts are quite vague about exactly what records
need be kept, and say only that they should be ‘sufficient to show and
explain’ the transactions and consequent position of the company. This
means that the records differ between companies, each organising the
recording as it thinks best. It need not be like this. In France, for example,
the ‘Plan Comptable’, that is, the government’s accounting plan, specifies
in exactly which ledger accounts must be kept, and exactly what can and
can’t be recorded in each. Ledger accounts are explained in Chapter 5.
Answer As usual, the answer depends on what you think accounting is for. The UK system has
the benefit of flexibility, in that it allows each organisation to set up an accounting system
that best suits its own circumstances and needs. If we are aiming to present information
for users to make decisions about that organisation, then gearing the system to the
peculiarities of the organisation is most likely to result in relevant information.
On the other hand, allowing each organisation to design a different system is unlikely
to result in information that is comparably prepared and presented between organisations.
Despite rules set down by the Companies Acts and by the ASB in accounting
standards, lack of comparability is a major problem in the UK. We leave it to you to judge
whether state control of accounting would be politically and culturally acceptable in the
UK. Nevertheless, as we’ve seen, it is becoming the case that UK accounting is increasingly
subject to international accounting standards published by the International
Accounting Standards Board. Ultimately, we get the accounting that reflects our society.
Processing
Processing means turning the raw data that we have recorded into useful
information that can be presented to those interested in knowing about
the organisation. As we have already seen, the processing will be determined
by what information we want from our accounting system, and by
the underlying method of recording that we have adopted. Given these
two, the processing is simply the way we turn the recorded data into the
required financial information.
Beginning in Chapter 5, you will see how we not only record data but
how we then process it so that we can produce the financial statements that
most users of the information require. Having looked at the essential features
of recording, it may help to appreciate what is involved in processing if we
now turn our attention to the end product. In other words, it is time to look
at the ways in which financial information is most usually presented.
6 Financial Accounting
Which approach, the UK or the French, do you think is best? Why?Activity 1.6
FNAC_CO1.QXD 12/10/05 9:50 am Page 6
Presenting
We saw above that there are very lax rules in the UK about what records
need be kept and how the data in them is then processed. However, as you
will see as we progress through this book, limited companies in the UK are
closely governed with respect to the presentation of information to the users
of the accounts. The Companies Acts require an income statement and a balance
sheet. Furthermore, accountants’ own rules, the accounting standards,
also require a cash flow statement and a ‘statement of changes in equity’.
Overall, what we have here is an accounting system, that is a series of
inter-connected entities, together making up the total system. It may be
best to present this idea as a diagram.
In the diagram above, the data we identified earlier as being appropriate
for accounting forms the input to our system. We then process this data,
usually using some form of double entry bookkeeping. In practice, of
course, this processing will normally be computer-based. Once we’ve put
the input data into a form that users can access to help them make decisions,
we call this organised data ‘information’. In financial accounting,
this information takes the form of the four financial statements we listed
above. We’ll look at them in much more detail later in the book – indeed,
you will learn to prepare them yourself – but they are so fundamental to
accounting that it is worth taking a brief look at them now.
The income statement
The income statement is a list of the expenses incurred by the organisation,
set against its revenues, the net result being a profit if revenues are
more than expenses, and a loss if the reverse is true. It covers a specific
period, usually one year. Note that, in the UK at least, this statement used
to be known as the ‘profit and loss account’ until the advent of the
International Accounting Standards in 2005. Many accountants will no
doubt continue to refer to the statement as a profit and loss account, especially
for smaller companies, for a few years yet. There’s more information
about this change in Chapter 10.
The balance sheet
The balance sheet is a summary of the assets and liabilities of the organisation
at a specific time. In simple terms, assets are what the organisation owns and
liabilities are what it owes. As you will see in the next chapter, these definitions
are not strictly true, but they are good enough for a basic understanding.
1 · What is accounting? 7
Input
Accounting
data to be
processed
Process
Processing of
input data, i.e.
classifying and
recording the
data
Output
Information
for use by
users, e.g. an
income
statement
FNAC_CO1.QXD 12/10/05 9:50 am Page 7
The cash flow statement
Like the income statement, the cash flow statement covers a specific
period, but it differs by listing the actual cash received and paid out. The
income statement, by contrast, lists the amounts incurred. For example, if
we sell goods for £10,000 but are paid only £8,000 immediately, with the
other £2,000 to be paid to us next month, the income statement would
record the sale of £10,000 but the cash flow statement would record only
the cash event of the receipt of £8,000. The difference will become clearer
when you look at the income statement adjustments in Chapters 6 and 7.
For the time being, however, we should note that the cash flow statement
is usually regarded as a more reliable statement of activity in that it
deals only with actual cash in and out, and those cash flows are normally
an objective fact. The sale recorded in the income statement, by contrast, is
less objective since it inherently contains an element of uncertainty. For
example, in the illustration above, it is possible that some goods, say
£1,000’s worth, will yet be returned to us as unsuitable and the final sale
could then be seen as only £9,000. This greater objectivity of cash flows,
and hence of the cash flow statement, has led some accountants to regard
the cash flow statement as a more useful and reliable statement than the
income statement. You will see these differences in more detail when we
look at the preparation of cash flow statements in Chapter 9.
Statement of changes in equity
As we saw above, the income statement lists revenues and expenses, that is,
amounts we are entitled to and have to pay, respectively, as a result of our
routine operations, usually from our trading. However, organisations can
also gain or lose wealth from causes other than trading.
For example, what if the value of our buildings rises – is that a gain? The
gain hasn’t arisen from anything we have done (except buy the building in
the first place and keep it), so it presumably can’t be seen as a trading gain.
Consequently, we wouldn’t report it as revenue in the income statement.
On the other hand, aren’t we richer because the value of our building has
risen, and shouldn’t we then report this increase in wealth? This is exactly
what a statement of changes in equity does – it reports gains and losses,
including those that have arisen other than from operations.
It may have occurred to you that all four of these statements are summaries
of different aspects of the organisation, prepared for those outside
the business. They therefore fall within the area of financial accounting. The
presentation of management accounting information is not governed by the
Companies Acts or the accounting standards. This means that management
accounting statements vary between organisations. Nevertheless, most
organisations of any size will produce some or all of the following, and
these would normally be regarded as management accounting statements.
᭤ A structured guess about what revenues and expenses will be in the
future. This is usually called a budget.
᭤ A comparison of the previously estimated revenues and costs with the
actual revenues and costs. Such a statement allows managers to see where
things have not gone according to plan, by highlighting the variances
8 Financial Accounting
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between estimated and actual figures. It is therefore sometimes known as
a variance report, or variance analysis report.
᭤ An analysis of the cost of a particular product or service provided by the
organisation, showing the cost of each item that has gone into that
product or service.
᭤ An estimate of what money will come into and flow out of the organisation
over the coming months. This is usually known as a cash flow forecast.
Answer A cash flow statement is a summary of what cash flow actually occurred during the
past accounting period. It is a record of what happened, prepared primarily for those
outside the business. It would therefore normally be regarded as part of financial
accounting. The cash flow forecast is an educated, structured guess about what we
think the cash flows will be in the next accounting period(s). It is mainly prepared for
managers, to help them plan the activities of the organisation in the future. It is thus
probably best classified as management accounting.
As you may have guessed from its title, this book is only about financial
accounting. We will therefore not be dealing with management accounting
topics any further.
Who cares anyway? The users
You should have noticed in our discussion above that what accounting is
ultimately depends largely on who we think the end users will be. If, for
example, you think that the information produced by the accounting
process is primarily for the managers of the organisation, you would probably
want to focus on recording and processing data about, say, the estimated
and actual costs of products, and estimates of future revenues and costs. You
could then present the resulting information to managers in the form of
comparisons of estimated and actual costs for making each product.
Alternatively, if you think those with the greatest need of information
about the organisation are those who work there, you might be more concerned
to record and process information about changes in rates of pay,
health and safety records, emission levels of toxic products, or employment
of minority groups. Think for a moment about how such a perspective
would change the nature of accounting.
1 · What is accounting? 9
Earlier in this chapter we referred to the cash flow statement. This is not the same
thing as a cash flow forecast. To ensure that you appreciate the difference, and
hence something of the difference between financial and management accounting,
state the difference in your own words.
Activity 1.7
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User group User needs
1 Investors Return on money invested. Growth in the
total value of the organisation.
2 Security of employment. Wage rates, and
the share of generated wealth going to the
employees, compared with owners and the
Inland Revenue.
3 Lenders
4 Suppliers and other trade creditors
5 Customers
6 Tax assessments and trade statistics.
7 Public
Answer At this point, we should admit that we have cheated a little here, and based the list of
users on the ‘Framework for Preparation and Presentation of Financial Statements’.
You may recall that we came across the Framework earlier, where it gave us an authoritative
statement about the purposes of financial accounting. The list is very similar to
other lists, notably that in the ‘Statement of Principles’, which was developed independently
in the UK through the 1990s. The suggested user needs are our own. The
completed table is as follows.
User group User needs
1 Investors Return on capital. Growth in the total value
of the organisation.
2 Employees Security of employment. Wage rates, and
the share of generated wealth going to the
employees, compared with owners and
the Inland Revenue.
3 Lenders Ability to make repayments of capital and
interest. Security, in the event of non
repayment.
4 Suppliers and other trade creditors Credit worthiness of the organisation. Time
typically taken to pay suppliers.
5 Customers Security of supply, i.e. will the organisation
still be in business next year?
6 Government and their agencies Tax assessments and trade statistics.
7 Public A ‘catch–all’ category covering local
communities, pressure groups and industry
watchers.
10 Financial Accounting
As a way of getting to grips with the various groups who are usually held to need
financial information, and why they need it, try completing the following table. To get
you started, we have already filled in some of the table. Don’t look ahead to the
completed table which follows until you have tried this for yourself.
Activity 1.8
FNAC_CO1.QXD 12/10/05 9:50 am Page 10
As a final point on users, note that they will not only be interested in commercial
businesses. You saw at the start of this chapter that accounting is
required by all organisations, not just commercial ones. We have therefore
used the term ‘organisations’ in this chapter to cover not only businesses,
but also charities, public sector organisations such as the NHS, voluntary
bodies and social clubs. Each will have a different weighting of users, and
different information needs.
The future of financial accounting
If nothing else, you should be finishing this chapter with the idea that
accounting is a dynamic subject. This means that it is constantly changing
to reflect changing practices and the requirements of competing user
groups. It may be helpful to conclude this first chapter with a brief exploration
of where financial accounting may be going over the next few years.
Notice what the table of users above is suggesting. A single set of financial
statements has to meet all the user needs in the list above. This is an
ambitious aim. Is it likely that it is achievable? If not, are we to try to satisfy
all users partially, or to put the needs of some users above the needs of
others? Who decides? Would it be acceptable to produce a number of
financial statements, each geared to the needs of a different user? If we did,
what would happen to comparability, and who would pay for all the extra
reports? You should be getting used to the idea that there are few definite
answers to many of the questions in accounting, and the questions we
have raised here are simply more examples of such questions. All we can
suggest is that you think about them in the light of what you have learned
in this chapter, and bear them in mind for later chapters.
For a specific example of how accounting is currently changing, we
could take the growing area of social and environmental accounting. We
touched on what is involved in this form of accounting earlier in the chapter.
All we want to emphasise here is that it constitutes an extension –
some would say an alternative – to existing generally accepted accounting
practice. It has arisen because of changing societal concerns over the environment
and over the impact of business on social issues. In turn, the
more responsible and responsive businesses have reacted to the changed
context by changes in their commercial practices. This is resulting in some,
so far limited, changes in accounting.
Nevertheless, social and environmental accounting is not only a good
example of the way financial accounting changes, but is also an increasingly
important topic in its own right. What follows is therefore a brief
summary of some of the main features of this new form of accounting.
It should be said to begin with that there are currently no legal or
accounting rules which require such accounting. Why, then, do some companies
do it? There is a complex range of views on this but we can
distinguish three broad categories.
1 · What is accounting? 11
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First, there are those companies, and other organisations, who do it
because their core values are tied up with social and environmental concerns.
They therefore regard it as important to gather and present information
about their activities in these areas. It must be said that there are not many
such companies in the UK, but The Body Shop and Traidcraft would perhaps
fall into this category.
Second, there is a fast-growing range of companies who are entering
social and environmental reporting because they foresee that such concerns
are becoming an increasingly significant issue in business. In other words,
while there may be some concern, as with the first group, the main motivation
is more probably commercial. This is a growing group in the UK and
elsewhere, and could be said to include such companies as BT, Scottish
Power, Shell and CIS. In Europe, environmental reporting is strongly supported
by Norsk Hydro, Daimler Benz and Volvo among others.
Third, there is a large group of companies who undertake little or nothing
in the way of social and environmental reporting.
In the UK, Pensions and Investment Research Consultants (PIRC), a
body monitoring corporate governance, published a report in 2000, the
main points of which were:
᭤ around half of the largest 100 quoted companies in the UK (the FTSE 100)
provide significant reporting on environmental targets and improvements;
᭤ the proportion of companies reporting falls rapidly as we look at smaller
companies;
᭤ there are significant variations between sectors, with some of the best performers
being utilities such as electricity companies, extraction industries
such as mining, gas and oil, and manufacturers of basics such as steel.
More recent evidence from Co-operative Insurance Services and PIRC
(‘Sustainability Pays’, 2002) suggests that, while the picture is mixed, there
does appear to be a positive link between reporting on social issues and
good financial performance.
You may have noticed that activity focuses on environmental reporting
rather than social. Why this should be is an interesting question, and we
can identify two possible causes. First, reporting on such environmental
matters as tonnes of sulphur dioxide emitted, or kilometres of copper cable
recycled, is a significant shift from traditional accounting. As we saw earlier
in this chapter, the traditional approach in financial accounting has been
to ignore an event unless it can be objectively measured in some unit of
currency, say a £ or €. Even so, with environmental reporting there is still a
reasonably objective unit of measurement. However, this is unlikely to be
the case if we are reporting on such social issues as the impact of making
500 employees redundant, or seconding 20 of our staff to work on local
community projects. In other words, environmental accounting is proving
technically easier than social accounting. Second, social reporting can be
seen as more politically charged than identifying our impact on the physical
environment – we are all green now.
12 Financial Accounting
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Answer This is another of those questions to which there is no unarguably correct answer.
Nevertheless, our answer is:
Investors
᭤ Environmental liabilities are becoming an ever-greater commercial issue. Unless they
are reported an investor is unable to fully assess the worth of the reporting company.
᭤ Environmental action can prove good business sense, for example where cutting
waste cuts costs.
Employees
᭤ Many environmental issues have a health and safety impact, of obvious concern to
an employee.
᭤ Many employees want to feel that they work for an environmentally responsible
employer.
Customers
᭤ As more well-respected companies undertake environmental accounting, environmental
responsibility can be taken as a measure of a well-run company, so helping
to ensure stability of supply.
᭤ Increasingly, firms are asking their suppliers to verify that what they supply comes, as
far as possible, from renewable sources.
Summary
This first chapter asked what accounting is all about. We saw that it is concerned
with:
᭤ the recording, processing and presentation of economically measurable
information
᭤ the law, especially the Companies Acts 1985 and 1989
᭤ the international accounting standards set by the IASB.
These issues are themselves a reflection of what users want to know about
the organisation. Where the users are primarily concerned about information
for the internal running of the organisation, the resultant accounting
systems and reporting would usually be classified as management accounting.
Otherwise, it will be the subject of this book, financial accounting.
Many textbooks simply describe accounting as it is, while this chapter
has tried also to suggest how accounting might be. After all, if you continue
with your studies of accountancy, you will one day be one of those
who will determine the nature and purposes of accountancy.
Before you can tackle such issues seriously, however, you should be competent
in the existing practice of financial accounting. The rest of this book will
help you achieve that competence, but always remember that all accounting
is ultimately determined by the issues we have covered in this chapter.
1 · What is accounting? 13
Look back at the user groups we identified earlier in this chapter. Which three groups
do you think would benefit most from environmental (not social) reporting? Give a
couple of reasons to justify each of your choices.
Activity 1.9
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Self-assessment questions
For each of the following questions, choose the single most appropriate answer.
1 The main purposes of financial accounting and reporting are:
(a) For stewardship and to aid decision making, in that order
(b) To aid decision making and to comply with company law, in that order
(c) To aid decision making and for stewardship, in that order
(d) For stewardship, and to comply with company law, in that order
2 The main purpose of management accounting and reporting is to:
(a) Provide information for internal decision making
(b) Determine costs of production processes
(c) Set budgets against which actual costs can be compared
(d) None of the above
3 Which two of the following events would not normally result in an immediate
accounting transaction?
(i) Buying goods, agreeing to pay next month
(ii) Selling goods for cash, payable immediately
(iii) Taking on a new employee
(iv) Announcing a new product line
(a) (i) and (iii)
(b) (iv) and (i)
(c) (ii) and (iv)
(d) (iii) and (iv)
4 The main purpose of a cash flow statement is to:
(a) Summarise short-term assets and liabilities at a point in time
(b) Summarise the cash in hand at a point in time
(c) Summarise cash paid and received over a period
(d) Summarise cash paid and payable, and received and receivable over a period
14 Financial Accounting
decision making (p. 2)
stewardship (p. 3)
recording (p. 4)
processing (p. 6)
presentation (p. 7)
income statement (p. 7)
profit and loss account (p. 7)
balance sheet (p. 7)
cash flow statement (p. 8)
statement of changes in equity (p. 8)
Key terms
FNAC_CO1.QXD 12/10/05 9:50 am Page 14
5 Which user group is likely to be most interested in the growth in wealth of the organisation,
and the profit relative to the money tied up in the organisation?
(a) lenders
(b) investors
(c) employees
(d) none of the above
6 Accounting standards are:
(a) Broad statements of guidance on accounting practice
(b) Effectively mandatory statements of acceptable accounting practice
(c) Rules set out in the Companies Acts governing accounting practice
(d) The same thing as the French ‘Plan Comptable’
7 Social and environmental accounting is:
(a) A mandatory part of UK financial accounting
(b) A possible extension to UK financial accounting
(c) A particular form of management accounting
(d) None of the above
8 The essential difference between the UK and French systems of financial accounting
is that:
(a) The UK system specifies more precisely the form of recording and presentation
(b) The French system specifies more precisely the form of recording and presentation
(c) There is no significant difference
(d) They are recorded in different units of currency
9 Match the statements listed in the left-hand column against the correct definition in
the right-hand column. Note that there will therefore be two definitions that are not
applicable.
Income Statement A summary of the environmental impacts of the
organisation
Balance Sheet A summary of liquid funds that flowed in and out of the
organisation in the past year
Cash Flow Statement A summary of why the organisation has become richer
or poorer during the past year
A summary of gains and losses realised by the
organisation during the past year
A summary of the assets, liabilities and capital applicable
to the organisation at the end of the year
1 · What is accounting? 15
᭤
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10 The IASB Framework outlines two rationales for financial accounting, namely decision
making and stewardship. It suggests that accounting is done to help users
make decisions (decision making) and to confirm what has happened (stewardship).
Which of these two purposes do you consider to be the more important? Give reasons
for your answer.
Your answer should be in the form of a short essay, of about 300 to 500 words,
or at least in the form of comprehensive notes for such an essay. There is no single
right answer, nor will you find the answer by looking it up in this chapter. You will
have to apply the ideas and facts introduced in this chapter to formulate your own
answer – indeed, requiring you to work through the issues like this is the point of this
self-check question. Our answer is at the back of the book, and is based on the
Framework, and lists the main points that you should have covered.
Answers to these questions can be found at the back of this book.
16 Financial Accounting
FNAC_CO1.QXD 12/10/05 9:50 am Page 16
2
The balance sheet
Introduction
In Chapter 1 we looked at the purposes of accounting, and saw how
accounting information is conventionally presented. One of the main
methods of presentation was the balance sheet. This is a statement of the
financial position of the undertaking at a specific point in time. In this
chapter we look at the balance sheet in more detail, and you will learn how
to prepare one.
Before we tackle the construction of a balance sheet, however, we need
to turn our attention to where the money typically comes from and where
it is spent. You discovered in the previous chapter that a balance sheet is
simply a list of the assets and liabilities of an entity. The entity must have
got the assets by spending money on them, and must have got that money
in the first place by incurring a liability to third parties. This should
become clearer if we now examine what are more formally known as the
sources and applications of funds.
The sources and applications of funds
The starting point is to consider where an entity gets its money from. Some
entities will have unusual sources. Charities, for example, receive donations,
whereas most other entities do not. Furthermore, public sector
bodies, such as local authorities and the police receive government funds.
Nevertheless, we can identify some sources of funds which will be widely
applicable, especially to commercial organisations.
By the end of this chapter you should be able to:
᭤ List and explain the major sources and applications of funds for a
commercial entity.
᭤ Construct a simple balance sheet.
᭤ Outline the alternative methods of valuing assets and liabilities.
Objectives
FNAC_CO2.QXD 12/10/05 9:51 am Page 17
Answer Our list would include the following:
1 Money borrowed from an outsider, often a bank. Money borrowed is known as ‘debt
finance’.
2 Money invested by the owners. For a sole trader or a partnership this is known
simply as ‘capital’. For a limited company, such money is called ‘share capital’.
3 Once a business is up and running it will hopefully make profits. Profit is then another
source of funds, and can be used in the business as soon as it is received. The total
of capital or share capital, together with such profit, is then called ‘equity finance’.
4 More subtly, the credit allowed to an entity by a supplier is also a source of funds. If
I agree to supply you with goods and accept payment next month, what I am effectively
doing is lending you the goods for a month. Such a loan in kind is analogous
to the loan in money that we listed as point 1 above.
There are thus two broad classifications of funding sources: equity and
debt. These are both liabilities of the business because the business has an
obligation to repay them eventually. Loans will have to be repaid and even
the capital invested by the owners of the business will have to be repaid to
them if and when the business comes to an end. Similarly, the profits ultimately
belong not to the business, but to the owners, since the whole
business belongs to them. The profits will therefore have to be paid by the
business to the owners. In other words, the profits made in the past and
retained by the business are a liability of the business.
In the meantime, the business can spend the equity and debt funds on
buying a range of goods and services. Some of the things it buys will have a
transitory existence, such as the labour of the workforce. The immediate
benefit that comes from buying one hour of an employee’s time ends at
the end of that hour. Similarly, there will be nothing to show for money
applied to paying the electricity bill. Note that the labour and the electricity
may well have been used to produce the business’s product, and any
inventory of that product will have a continuing existence. The distinction
we are aiming for, however, is that the labour and the electricity no longer
exist as labour and electricity, but as part of the inventory value.
For comparison, some of the things the business applies its funds to will
have a continuing existence. We have already seen that one such example
could be inventory. Others could be, for example, buildings, vehicles or
machinery. Items like this which have a continuing existence in themselves,
and are of future benefit to the business, are called assets.
In Chapter 1 we defined assets as things we own and liabilities as things
we owe. We can now adopt more accurate definitions, namely:
᭤ The essence of an asset is the right to receive future economic benefit as
a result of past transactions or events.
᭤ A liability is the obligation to transfer economic benefits as a result of
past transactions or events.
18 Financial Accounting
List three sources of funds for a typical business. You may find it helpful to think
about your present or past employer, or another business you know of.
Activity 2.1
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Both of these definitions are based on definitions in the International
Accounting Standards. In Chapter 10 we will look at the significance of
these standards and at how they are replacing the UK’s own Financial
Reporting Standards, but for the moment you only need to be aware that
they are very authoritative in the world of financial accounting.
The situation we have arrived at may become clearer if we look at
an activity.
Answer The asset would be a bank account with £10,000 in it, and the liability would be share
capital of £10,000. Remember that the share capital is a liability because it represents
money that has been contributed to the company by the shareholders. It is a liability of
the company to the owners, that is, the company is distinct from the owners.
Answer The list should have been fairly easy to construct, i.e.:
Assets: Delivery van £6,000
Bank account £4,000
Liability: Share capital £10,000
What you may not have noticed is that you have just constructed your first balance
sheet. In other words, a balance sheet is simply a listing of all assets and liabilities. As
we saw in Chapter 1, the actual layout of the balance sheet is presented in a specific,
detailed format, especially for limited companies, but its basic nature is no more than
you have just done.
Answer Our answer is shown below.
Assets: Delivery van £6,000
Inventory £3,000
Bank account £4,000
Liabilities: Share capital £10,000
Creditor £3,000
2 · The balance sheet 19
A new business starts up as a limited company called Sunrise Ltd by raising
£10,000 from its owners, i.e. its shareholders. It puts this money into a new bank
account. What would be the asset(s) and liability(ies)?
Activity 2.2
Sunrise Ltd then uses £6,000 of its bank account to buy a delivery van. List the
asset(s) and liability(ies) after this transaction.
Activity 2.3
Finally, Sunrise Ltd buys some inventory for £3,000 but does not yet pay for it. That is,
it buys on credit from Daytime Suppliers, agreeing to pay them the £3,000 next month.
List the asset(s) and liability(ies) after this transaction.
Activity 2.4
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Note one very important matter – the total assets equal the total liabilities.
This is not a coincidence, or just a feature of this example. It is inevitable
because the liabilities are providing the funds that we are then spending on
these assets. This equality is fundamental to all financial accounting, and is
often expressed as the balance sheet equation. This equation is usually set
out so as to make a distinction between the capital liability and all other liabilities.
This is done in order to maintain the distinction we saw earlier
between equity and debt. In the case of Sunrise Ltd, for example, the equity is
the share capital, while the debt is the creditor, After all, giving us goods with
only a promise to pay in return could be thought of as a loan in kind.
The balance sheet equation thus becomes:
ASSETS = CAPITAL + LIABILITIES
Note that the equation can be re-expressed in a number of different
ways, including:
CAPITAL = ASSETS – LIABILITIES
It is also worth noting here that this equality forms the basis of the
double entry bookkeeping which we will deal with in Chapter 5.
The format of the balance sheet
We have seen that a balance sheet is no more than a list of assets and liabilities
(including capital) at a particular point in time. However, we have also
noted that there is a specific format for the balance sheet. In the case of limited
companies in the UK, this format is specified by law, in Schedule 4 to the
Companies Act 1985. The next step in learning to construct a balance sheet is
therefore to apply the standard format to a list of assets and liabilities.
A few days later, on 30 June 20X6, Sunrise Ltd has the following assets
and liabilities (the use of dates such as ‘20X6’ is a standard way of expressing
a generic date, commonly used in textbooks):
Assets: Delivery van £6,000; Inventory (i.e. stock of goods for sale) £3,000;
Bank £500; Machinery £2,200; Debtors £700.
Liabilities: Share capital £10,000; Creditors £400; Loan repayable in five
years £2,000.
The first step is to divide the assets into ‘non-current assets’ and ‘current
assets’. Non-current assets are those where the expected life, i.e. how long
we think the asset will last in our business, is more than one year. (Note
that ‘non-current assets’ is the term for such assets under the new international
accounting standards; they used to be known as ‘fixed assets’ in the
UK, and many accountants will probably continue to use the latter term
for a while yet.) Current assets are then those that we do not expect to still
have one year from now. This is a rather crude pair of definitions, and we
will see in Chapter 8 that it will not always be valid, but is nevertheless
acceptable for our present purposes.
20 Financial Accounting
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Answer Your answer should look like the one below. There are a number of specific points
relating to our layout, which are explained below.
Non-current assets £ £
Machinery 2,200
Delivery van 6,000
–––––––
8,200
Current assets
Inventory 3,000
Debtors 700
Bank 500
–––––––
4,200
Note the following points about the layout above. These are not optional
issues, but matters you must normally comply with.
᭤ There are two columns of figures, with the current assets being inset.
The reason for this will become clear soon.
᭤ Both the non-current and current assets are listed in reverse order of liquidity.
This means that both lists start with the asset which is likely to be
hardest to turn into cash. We have assumed, for example, that a van is
easier and quicker to sell than machinery, and that debtors are more
liquid than inventory. The bank account is obviously the most liquid
asset and therefore comes last in the list of current assets.
᭤ There is a subtotal for each group of assets.
You might expect that the next step is to list and add up all the liabilities.
However, this is not the case. A typical format actually now proceeds by
deducting the current liabilities from the current assets. The net amount is
called ‘net current assets’ or, more commonly, working capital. This amount
is then carried out into the right-hand column and added to the non-current
assets subtotal. The non-current liabilities are then deducted from the
total of non-current assets and working capital.
2 · The balance sheet 21
List the non-current assets and total them. Then list the current assets beneath the
non-current assets, and total them separately.
Activity 2.5
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Answer Your completed balance sheet should now look as follows. As before, there are a
number of important points relating to the layout, which are explained below.
SUNRISE LTD
BALANCE SHEET AS AT 30 JUNE 20X6
Non-current assets
Machinery 2,200
Delivery van 6,000
–––––––––
8,200
Current assets
Inventory 3,000
Debtors 700
Bank 500
–––––––
4,200
Current liability
Creditors 400
–––––––
3,800
–––––––––
12,000
Non-current liability
Loan, repayable in five years 2,000
–––––––––
£10,000
––––––––––––––––––
Share capital £10,000
––––––––––––––––––
᭤ The completed balance sheet must be headed by the name of the reporting
entity and the date of the balance sheet. Remember that the balance
sheet only reports the entity’s state of affairs at a single moment.
᭤ The division of liabilities into current and non-current is done on the
same basis as the split of assets into non-current and current. That is,
current liabilities are those we expect to have cleared within a year,
while non-current liabilities are those we expect to still owe one year
from the date of the balance sheet.
᭤ The reason why we originally inset the current assets should now be clearer.
It was to provide a subtotal from which we could deduct the total of the
current liabilities, and so identify the working capital (£3,800). We will consider
the importance of working capital in more detail in Chapter 11. Note
that if we had had more than one current liability, we would have had to
inset those current liabilities into a third column, and carry the total out
below the current assets subtotal.
22 Financial Accounting
Extend your balance sheet to include the liabilities. Total your figures, and double
underline the total. Then list the share capital below the rest of the balance sheet.
Activity 2.6
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᭤ The net total of all assets less all liabilities (£10,000 in our case) is bold or
double underlined to denote that this is a final total. It marks the end of
the first side of the balance sheet, and is called the ‘net worth’. In principle,
this is what the company is worth, i.e. what we would be left with if
we sold all the assets and paid off the liabilities out of the proceeds.
A few words about non-commercial organisations
All we’ve said above has assumed that the organisation we’re accounting
for is commercial, i.e. it is owned by one or more people who aim to make
a profit from it. Where this isn’t true, for example government authorities,
the National Health Service, charities, or social organisations, then the
format of the balance sheet will be a little different.
The first half will often be the same as above, since most organisations
will have buildings, bank accounts, creditors, etc. even where the object of
their activities is not to make a profit. However, the second half of the balance
sheet will consist not of owners’ equity but of the stake in the
organisation held by government, trustees or members. These people don’t
own the organisation in the same way that shareholders own a company,
but they caretake the funds so that the organisation can provide the services
it was set up to provide.
In terms of the format of the balance sheet, the second half will consist
not of ‘owners’ equity’ but of ‘funds’. These may be divided into a number
of individual funds, depending on the nature and needs of the organisation,
but in total will constitute the funding for the net assets listed in the
first half of the balance sheet.
What the balance sheet tells the user
Having now prepared a balance sheet, it is worth considering what it tells
us. In other words, what does a balance sheet mean? We already know that
it provides a list of assets and liabilities at a particular point in time, and
you saw above that the total of the balance sheet represents, in principle,
what the entity is worth. Knowing the state of affairs of an entity would
obviously be a useful thing to know, but it is not necessarily true that this
is what the balance sheet tells us.
2 · The balance sheet 23
Look at the balance sheet for Sunrise Ltd, above.
1 We have included the delivery van at what we paid for it. List at least two other
ways we could have valued it.
2 Note down one reason why the debtors may not actually result in a benefit to the
business of £700.
Activity 2.7
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Answer Sorting out alternative valuations of assets, and indeed liabilities, is one of the major
difficulties in financial accounting and reporting. As you have seen in the balance sheet
above, the usual practice is to record assets at what the business paid for them. This
is known as the historical cost. Nevertheless, alternatives are possible, and you could
have listed any or all of the following:
᭤ Historical cost less an allowance for using up the asset to date. Such an allowance is
called depreciation, and is dealt with in more detail in Chapter 6. This valuation is, of
course, still simply a refinement of the historical cost valuation.
᭤ Selling price, i.e. what the van could be sold for. This is usually called the realisable
value. Normal practice when considering realisable value is to deduct any costs of
sale, such as advertising. In this case the net figure is known as the net realisable
value, or NRV.
᭤ Replacement cost, that is the cost of replacing the van if, for example, it were
stolen this afternoon. In a perfect market (i.e. one of zero transaction costs, perfect
competition and perfect knowledge of the market by all concerned) this should be
the same as the realisable value.
᭤ A refinement of the replacement cost approach would be to use the cost of replacing
the asset, not with another identical one, but with something that will do the
same job. This may be particularly relevant in times of rapidly changing technologies,
such as computing.
᭤ Finally, we could take a more complex view, and say that the van’s value is the economic
benefit that it will bring to the business. This is in line with the definition of an
asset that we looked at earlier in this chapter. Arriving at this valuation will involve
estimating the additional net revenues that the business will earn because of its use
of the van. Such additional net revenues will be difficult to determine, but might be
the profit on the orders that we only got because we were able to deliver directly
and quickly to the customer. This is conceptually and practically the most difficult
approach to valuation, and we will therefore examine it more thoroughly later in this
chapter and in Chapter 12.
As far as the debtors are concerned, their balance sheet valuation will not
turn out to be what they are worth if the debtor does not, in fact, pay us.
We have, after all, previously defined the essence of an asset as being control
of future economic benefit. If there is no payment, we will receive no
economic benefit, and the debtor will therefore not turn out to be an asset.
It should therefore not be shown as an asset in the balance sheet, but as an
expense in the income statement, usually described as something like ‘Bad
Debt Written Off’. We will look at expenses in the income statement in
more detail in Chapter 3.
Alternatively, the debtor may only be expected to pay us part of what is
owed, perhaps £500 of the total £700. In this latter case it would seem to
be sensible, and consistent with the definition of an asset, to value the
debtor in the balance sheet at £500. The remaining £200 would then be
written off as an expense.
Valuation in the balance sheet, especially of assets, is thus a problematic
area of financial accounting and reporting. The final part of this chapter
therefore considers each of the suggested alternative methods of valuation
in the balance sheet more fully.
24 Financial Accounting
FNAC_CO2.QXD 12/10/05 9:51 am Page 24
The alternative valuation methods
We have seen that the obvious way to value an asset is at what we paid for
it, that is, at its historical cost. This is obviously simple and unambiguous as
a method. In other words, it has the advantage of objectivity.
Answer The most obvious problem with historical cost is that it will gradually become more and
more out of date. It will describe the value of an asset as it was several years ago. This
is inappropriate when we have already said that a balance sheet is supposed to give us
a picture of the entity today. Furthermore, the higher the level of inflation then the
more inappropriate the historical cost valuation will become, as the difference between
today’s cost and the historical cost gets wider.
Second, and more subtly, adding together assets in the balance sheet which were
bought at different dates is implicitly adding together items expressed in different £s,
since the real value of the £ will fall during times of inflation. The meaning of the
aggregate amount is then highly questionable.
If the deficiencies of historical cost stem from the fact that it becomes more
and more out of date, perhaps we should use a current method of valuation.
One possibility would be to value an asset at what it would cost
today, that is its current cost. One way of looking at this is to say that we
will value each asset at what it would cost if we were to buy it today, as a
replacement for the existing asset. This is known as the replacement cost.
Answer Our suggested answer is set out below. Note that some of our answers are debatable,
especially the last two. Whether historical cost is the more true and fair valuation or
not depends on what we mean by true and fair. There is no agreed definition of this key
phrase, which appears in the Companies Act as the over-riding requirement for financial
statements in the UK. Nevertheless, we think that replacement cost comes closer
to providing a true and fair valuation, if only because it is a better representation of the
position at the balance sheet date.
2 · The balance sheet 25
List at least two disadvantages that you can see with the use of historical cost as a
method of valuing an asset.
Activity 2.8
Which of the following statements about a method of valuing assets are true? Mark
each with a T for true, or an F for false.
1 Replacement cost represents a current valuation of what the entity is worth _____
2 Replacement cost is usually simpler to determine than historical cost _____
3 Replacement cost is more objective than historical cost _____
4 Historical cost is the more true and fair valuation _____
5 Historical cost is a more useful method of valuation than replacement cost _____
Activity 2.9
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Similarly, question 5 depends on your definition of useful – an issue that we looked
at in the previous chapter. This is a very contentious statement, and our answer
depends on seeing objectivity as a very important quality of accounting. We think it is
because it improves the comparability and the understandability of financial accounting,
as well as its reliability. We have therefore marked this question as true. However,
you could think that the more up-to-date nature of replacement cost makes that valuation
method the more useful.
1 Replacement cost represents a current valuation of what the entity is worth T
2 Replacement cost is usually simpler to determine than historical cost F
3 Replacement cost is more objective than historical cost F
4 Historical cost is the more true and fair valuation F
5 Historical cost is a more useful method of valuation than replacement cost T
Replacement cost is a current valuation, but it is not the only one. Net realisable
value is also a current valuation, one that values an asset at what it
could be sold for, rather than at what it could be bought for. You might
expect these two valuations to be the same, or certainly very similar. In perfect
market circumstances, that is, where all buyers and sellers have the same
information and competition is universal, you would be right. However, you
should note that buying and selling costs, and imperfections in the market,
for example through poor information being available to one party to the
deal, will often mean that what we could sell for, net of selling costs, is not
the same as what we could buy for.
Furthermore, you should note that using net realisable value could be
held to be inappropriate to a business which has no intention of selling
one or all of its assets. After all, selling all the assets would probably only
be the case if the entity were being wound up. For an entity which is a
going concern, replacement cost might be held to be more suitable as a
method of valuation, although not all accountants would agree with this
view. Going concern is a concept that we will return to in Chapter 4.
Finally, as we noted above, the economic value method is both conceptually
and practically the most difficult method, and we will therefore
leave a detailed exploration of that method until Chapter 12.
Statement of changes in equity
If we do decide to show a valuation other than the existing historical cost in
our balance sheet then the issue arises of reporting that change. In Chapter 1
we briefly considered the statement of changes in equity, and saw that it is,
indeed, largely a summary of any gains and/or losses we may make when the
value of our assets and liabilities changes. If we regard those changes as substantial
and for the long term, then we could reflect such a change in a
change in the valuation of the asset or liability in the balance sheet. This
would be one way to obtain a more up-to-date valuation.
26 Financial Accounting
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For example, if we decide to reflect a rise in the value of a building from
its historical cost of £300,000 to a current valuation of £400,000, then the
asset side of the balance sheet would rise by £100,000 to reflect this, and
the capital side must also rise so that the balance sheet still balances. The
rise on the capital side is shown in a ‘revaluation reserve’ of £100,000,
showing that the organisation is now richer by £100,000. This gain is not a
trading gain so would not appear in the income statement, but would
appear in the statement of changes in equity, so that the gain is reported
somewhere as an event of the year. We will look at the preparation of statements
of changes in equity in more detail in Chapter 12.
Uncertainty
At this point you may be beginning to feel that there are no clear answers
in accounting, and that it is not the straightforward process you thought it
was. We know that this may be unsettling, and that you may be asking
whether there is any point to accounting when the answer always seems to
be ‘it depends . . .’. Nevertheless, for better or worse, this is the position of
UK accounting.
At anything above a very basic level, accounting is not a mechanistic
exercise, because it has to reflect the uncertainties and complexities of the
transactions it describes. We have deliberately started this book with a consideration
of fundamental questions about the nature and purposes of
accounting for two reasons. First, you can only learn to do good accounting
if you understand why you are accounting in the way you are. Second,
we think that sorting out these issues is one of the more interesting aspects
of accounting.
To check your understanding of what we have covered in this chapter
you should now attempt the following question. It brings together many
of the points from Chapter 1 as well as from this chapter, so you will help
yourself if you attempt it seriously. We have provided an answer after the
question, but try not to simply read through our answer.
2 · The balance sheet 27
Dayspring Ltd undertakes the following activities in its first week of existence:
1 Starts its activities by raising £50,000 from the issue of 50,000 £1 shares, and
putting this money into a new bank account.
2 Buys a workshop for £30,000, paying by cheque.
3 Buys two delivery vans for £8,000 each, paying by cheque.
4 Interviews and appoints two employees, to start work next week.
5 Borrows £10,000, agreeing to repay it in one lump sum, with interest, in two
years’ time. Puts the money into the bank account.
6 Buys machinery for £15,000 on credit from Hartford Supplies.
7 Decides that it does not need two delivery vans, and sells one of them on credit
to Sunset Garages for £8,000.
Activity 2.10
᭤
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Answer Our suggested answers are set out below. Make sure you understand all parts of them
before you leave this chapter.
1 DAYSPRING LTD
BALANCE SHEET AT END OF FIRST WEEK
Non-current assets
Workshop 30,000
Machinery 15,000
Delivery van 8,000
–––––––––
53,000
Current assets
Debtors 8,000
Bank 14,000
––––––––
22,000
Current liability
Creditors 15,000
––––––––
7,000
–––––––––
60,000
Non-current liability
Loan, repayable in five years 10,000
–––––––––
£50,000
––––––––––––––––––
Share capital £50,000
––––––––––––––––––
2 There are a number of reasons why the appointment of two employees should not
be reflected in the balance sheet. If you have done some accounting before, you
may have mentioned the accruals, or matching concept. In terms of what we have
covered so far in this book, you could have justified the exclusion of transaction (4)
by reference to the definitions of assets and liabilities.
28 Financial Accounting
Required
There are three questions for you to deal with:
1 Prepare the balance sheet at the end of the week. You could do this by preparing
successive balance sheets after each relevant transaction, but this would be
rather clumsy and time-consuming. For a fairly small set of transactions like this,
it is probably better, therefore, to simply keep a rough record of the balance of
each item. The workshop, for example, starts at £30,000 and then does not
change, and so will appear in your balance sheet at £30,000. The bank account
will take more analysis.
You may find it helpful to use the Sunrise Ltd balance sheet (above) as a guide to
the correct layout.
2 Justify your treatment of transaction (4).
3 Suggest two groups who would probably be particularly interested in the balance
sheet you have prepared. Briefly note down why each would be interested.
FNAC_CO2.QXD 12/10/05 9:51 am Page 28
We know that only assets and liabilities (including capital) appear in a balance
sheet. Does the appointment of employees to start next week result in an asset or
liability as defined? An employee will normally result in future economic benefit to the
business, and will in principle, therefore, be an asset. However, quantifying this benefit
with reasonable objectivity will usually be impossible. In these circumstances, an
employee should therefore not be recognised as an asset in a balance sheet.
3 It is possible to make out a case for virtually any user group having some interest in
the financial statements of any organisation. However, it is likely that the shareholders
and the lender will be particularly interested in the balance sheet of Dayspring
Ltd, since they have substantial sums at stake in the company. Additionally, you
could have made out a good case for saying that Hartford Supplies would be especially
interested, given that they have effectively lent Dayspring Ltd £15,000.
Summary
This chapter has been about the balance sheet. We have seen that it is:
᭤ essentially just a listing of assets and liabilities
᭤ in a specified format.
You have also prepared a simple balance sheet for yourself. However, what
ultimately determines the nature and usefulness of the balance sheet are:
᭤ the definitions of the assets and liabilities. (These definitions are worth
learning and remembering.)
᭤ the different bases on which assets and liabilities can be valued; the
usual method – historical cost – is not necessarily the best basis.
In Chapter 3 we continue our review of the basic accounting statements
with an exploration of the income statement.
2 · The balance sheet 29
sources and applications of funds
(p. 17)
assets (p. 18)
liabilities (p. 18)
balance sheet equation (p. 20)
non-current assets (p. 20)
working capital (p. 21)
alternative methods of valuation
(p. 24)
replacement cost (p. 25)
net realisable value (p. 26)
Key terms
FNAC_CO2.QXD 12/10/05 9:51 am Page 29
Self-assessment questions
Select the most appropriate answer for each of the following multiple choice questions.
1 Non-current assets are:
(a) assets the organisation expects to keep for more than one year
(b) assets worth more than £1m
(c) assets that can’t normally be physically moved
(d) assets specified as fixed by the organisation
2 Liabilities are:
(a) the capital of an organisation
(b) the total of assets and capital
(c) the obligation to transfer economic resources
(d) the total an organisation would have to pay if it were wound up
3 The total of a balance sheet represents:
(a) what the organisation would sell for if someone took it over
(b) the original historical cost, amended by revaluations, net of liabilities
(c) the total replacement cost, net of liabilities
(d) what the directors believe the organisation should be valued at
4 The difference between debt and equity is that:
(a) debt is what the organisation owes its shareholders and equity is what it owes
government
(b) debt is what the organisation owes its lenders and equity is what it owes
government
(c) debt is what the organisation owes its lenders and equity is what it owes
shareholders
(d) debt is what the organisation owes its shareholders and equity is what it owes
lenders
5 ‘Working capital’ is the difference between:
(a) non-current assets and current liabilities
(b) share capital and non-current assets
(c) current assets and current liabilities
(d) non-current liabilities and current assets
6 ‘Historical cost valuation’ means valuing an asset at:
(a) what it was worth one year ago
(b) what it is worth at the balance sheet date
(c) what it would cost to replace
(d) what was paid for it
30 Financial Accounting
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7 Mortlake Ltd owned a building that had cost £42,000 just before the end of the current
accounting year on 31 December, and a vehicle bought for £13,000 at the
same time. A new access road was announced on the balance sheet date, perhaps
making the building worth about £50,000 on the open market. Inventory existing at
the balance sheet date had been bought for £7,000, but had deteriorated in storage
and was now valued at £6,000. Debtors and creditors at the balance sheet date
were £4,000 and £5,000 respectively.
You are required to prepare the balance sheet, including the equity figure as the
amount needed to make the balance sheet balance. For each item where there is a
choice of valuation, you should briefly note down why you have chosen the valuation
you have.
8 Hammerstein Ltd has a number of assets with the following details. For each asset
you are required to state the most true and fair valuation, and to justify your choice.
In all cases you should ignore depreciation. (Depreciation is a topic that we will deal
with in Chapter 6.)
(a) A building cost £300,000 four years ago. Since then the company has spent
£80,000 on an extension to the building and £45,000 on repairs. The current
market price of a similar building next door is £400,000.
(b) Two cars were bought last month for use by the company’s sales force. The first cost
£12,000 and the second £15,000. The first was written off in an accident just after
the balance sheet date and insurance proceeds are expected to be £10,000.
(c) Computing equipment was acquired for £19,000 one year ago. The same
equipment is no longer made, but could be bought for about £8,000 on the
second-hand market. Equipment that would do much the same job could be
bought new and would cost around £15,000.
(d) We have three debtors at the balance sheet date. The first owes £2,000 and
has always paid on time in full. The second owes £700 and has disappeared.
The third owes £800 and has been promising to pay for the last three months,
but has so far paid nothing.
9 Prepare the balance sheet at 31 December 20X9 for Yeovil Electronics, in each of
the following situations. The capital is not given, so you should calculate it as being
the figure needed to make the balance sheet balance, in accordance with the balance
sheet equation.
(a) First, the accountant has extracted the following balances from the books at 31
December, all balances being at the traditional historical cost valuation.
Premises 345,000
Plant and machinery 104,800
Inventory 67,250
Debtors 46,200
Bank overdraft 15,000
Creditors 56,780
Non-current loan 120,000
Prepare the historical cost balance sheet.
2 · The balance sheet 31
᭤
FNAC_CO2.QXD 12/10/05 9:51 am Page 31
(b) Second, the managers of Yeovil Electronics are concerned that the historical
cost figures do not represent the ‘true’ worth of the company and are accordingly
a poor basis for their decision making. They have therefore estimated the
replacement cost of the assets and liabilities. Specifically, the balances which
differ significantly from historical cost are:
Premises 480,000
Plant and machinery 95,000
Inventory 61,000
Creditors 53,600
All other figures may be assumed to be at historical cost. Prepare a replacement
cost balance sheet.
(c) Third, the major lender has expressed a wish to wind up the company, sell the
assets, and use the proceeds firstly to repay her loan of £120,000. Her estimates
of what the assets would sell for and what the liabilities could be settled
for are set out below. Draft a balance sheet using these net realisable values.
Premises 450,000
Plant and machinery 40,000
Inventory 83,650
Debtors 44,000
Bank overdraft 15,000
Creditors 56,780
(d) Which balance sheet gives the most true and fair view of the state of affairs of
Yeovil Electronics? Justify your decision.
Answers to these questions can be found at the back of this book.
32 Financial Accounting
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3
The income statement
Introduction
This chapter introduces the second of the main financial statements typically
used in the UK, that is, the income statement, along with the
associated statement of changes in equity. The advent of international
accounting standards to the UK has resulted in changes in jargon here as
well as in the balance sheet. Specifically, what is from 2005 properly called
the income statement used to be called the profit and loss account. It’s
likely that both terms will be used in the UK for the immediate future.
The balance sheet that we explored in the previous chapter tells us
something about the state of affairs at a point in time, usually the last day
of the accounting year. The income statement tells us something about
what happened during that year. In its simplest form, the income statement
is just a list of the revenues and expenses which arose during a
particular period. In practice, it can be complicated. This chapter looks first
at the basics of income statements, and then goes back to pick up some of
the complications. In this way you should be able to grasp the essentials
without being distracted by the intricacies.
It is important to be clear right from the start that the income statement
does not tell us about everything that happened during the year. First, it does
not tell us about events that cannot be objectively quantified. This exclusion
is one that we have already come across in relation to the balance sheet.
Second, as you will know from our brief consideration of the statement of
changes in equity, it does not report anything other than trading transactions.
By the end of this chapter you should be able to:
᭤ List the main trading transactions.
᭤ Prepare a simple income statement, including the treatment of
opening and closing inventory.
᭤ Explain and account for typical appropriations of profit.
Objectives
FNAC_CO3.QXD 12/10/05 9:53 am Page 33
Answer There are many examples that you could have chosen, but they should all be either events:
᭤ the effect of which cannot be quantified with reasonable certainty, such as the employment
of a new manager, or the introduction of a new manufacturing process, or
᭤ which do not relate to trading, such as the purchase of an asset, or the issue of new
shares (both of these would, however, be reflected in the balance sheet instead).
The nature and content of the income statement
So, what does go in the income statement? There are three distinct elements
to what is commonly called the income statement. We can then
deal with each of these elements in turn.
The first section of the income statement can be called the trading
account, and it details the core trading of an organisation. For example, for
a supermarket, this would deduct the cost of purchasing the goods sold
from the proceeds of the sales, to calculate the profit on trading. This profit
is more properly called the ‘gross profit’.
Answer
LOWPRICE SUPERMARKETS
TRADING ACCOUNT FOR THE MONTH ENDED 30 JUNE
Sales 300,000
Cost of goods sold 220,000
––––––––––––––––––––
Gross profit £80,000
––––––––––––––––––––
You should note that the trading account is headed by the name of the entity, just as
the balance sheet was in the previous chapter. It is also good practice to head the
trading account not only with the fact that it is a trading account, but also to specify
which period it covers.
It is unlikely, of course, that the supermarket sells all the inventory it has on
its shelves. (‘Inventory’ is accounting jargon for ‘stock’, introduced by the
advent of international accounting standards into the UK in 2005. We’ll no
doubt continue to talk about ‘stock’ alongside ‘inventory’ for a few years yet,
but note that ‘inventory’ is technically the correct term now.) There will
almost certainly be a closing inventory of goods left over at the end of the
month. This inventory represents goods that have been bought, but not sold.
34 Financial Accounting
Note down at least three specific events that will therefore not usually be included in
an income statement.
Activity 3.1
Mr Tate owns a supermarket, which trades as Lowprice Supermarkets. In June,
Lowprice Supermarkets buys goods from its suppliers costing £220,000, and makes
sales of £300,000. Prepare the trading account.
Activity 3.2
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If we are to compare the selling price of the goods sold with their cost, then we
should deduct the cost of any goods not sold from the purchases cost. This net
amount, which we then deduct from sales to calculate the gross profit, is
called the ‘cost of goods sold’ or the ‘cost of sales’. These are both good names,
because they accurately describe exactly what this net figure represents, i.e. the
cost to Lowprice of the goods it has sold to its customers.
If, for example, the supermarket staff do a stocktake at the end of June –
i.e. they physically count it – and find that there are goods left which cost
Lowprice £55,000, then the trading account will look like this:
LOWPRICE SUPERMARKETS
TRADING ACCOUNT FOR THE MONTH ENDED 30 JUNE
Sales 300,000
Purchases 220,000
Less: Closing inventory 55,000
––––––––––
Cost of sales 165,000
–––––––––––
Gross profit £135,000
––––––––––––––––––––––
Notice the technique we used above of insetting a subsidiary calculation
into a left-hand column, and carrying the total out into the main, righthand
column.
Before we move on to the income statement, we should look at how we
cope if there was inventory at the beginning of June as well as at the end.
If a stocktake at the start of June had shown an opening inventory for the
month of, say, £48,000, think what must have happened to this inventory.
Assuming it was neither lost nor stolen, then this inventory must have
been sold during the month. In other words, it is part of the cost of sales
for June, and should therefore be added to the purchases in the trading
account. True, some of it might still be inventory as part of the £55,000 at
the end of the month, but this does not change the fact that what has been
sold should be added to the purchases.
Answer
LOWPRICE SUPERMARKETS
TRADING ACCOUNT FOR THE MONTH ENDED 30 JUNE
Sales 300,000
Opening inventory 48,000
Add: Purchases 220,000
––––––––––
268,000
Less: Closing inventory 55,000
––––––––––
Cost of sales 213,000
––––––––––
Gross profit £87,000
––––––––––––––––––––
3 · The income statement 35
Use the opening inventory figure of £48,000 to revise the trading account above.Activity 3.3
FNAC_CO3.QXD 12/10/05 9:53 am Page 35
In our examples above we have put a double underline under the gross
profit to indicate that this is the end of the financial statement. This is correct
so long as we are only preparing a trading account. Usually, however,
the user of the financial statements will also want information about other
expenses, such as insurance, wages, rent and so on. Such information is
provided by the second section of the income statement.
Operating costs
The second section of the income statement starts where the trading
account left off, that is, with the gross profit. There will then be no need to
underline the gross profit, since we will construct what will effectively then
be a single financial statement. What is therefore happening is that the
trading account presents the ‘raw’ profit on direct trading, and the second
section shows what expenses are then paid out of the gross profit. The net
result is called the ‘net profit’.
Answer
LOWPRICE SUPERMARKETS
INCOME STATEMENT FOR THE MONTH ENDED 30 JUNE
Sales 300,000
Opening inventory 48,000
Add: Purchases 220,000
––––––––––
268,000
Less: Closing inventory 55,000
––––––––––
Cost of sales 213,000
––––––––––
Gross profit 87,000
Wages 32,000
Insurance 4,000
Heat and light 17,000
Telephone 2,000
––––––––––
55,000
––––––––––
Net profit £32,000
––––––––––––––––––––
As we noted at the beginning of this chapter, this first look at the income
statement will avoid complications. We will pick up some of the more
important ones later in this chapter, and others in later chapters, particularly
in Chapters 7 and 8. Nevertheless, the income statement above is
36 Financial Accounting
Assume that the other expenses for June were wages of £32,000, insurance of
£4,000, heat and light expenses amounting to £17,000, and telephone costs of
£2,000. Draft the trading and income statement for June. (You can use the same insetting
technique that we saw above to provide a subtotal of the overhead expenses.)
Activity 3.4
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valid for non-company accounting, where the net profit is simply added to
the owner’s capital account. For limited companies, it only remains to consider
what will happen to the £32,000 profit and to report those
happenings. Such a report is the third and final section of the full income
statement. This is traditionally referred to as the appropriation account,
which is complemented by the statement of changes in equity.
The appropriation account
As the name suggests, the appropriation account details the various appropriations
of profit. In simpler language, it lists what has happened to the
profit made by the entity in the past year. There are normally only three
things that can happen to the profit.
Answer You may have expressed your ideas in different ways, but your suggestions should have
fallen into the following groups:
1 Tax. The Inland Revenue, or equivalent authority in other countries, will want the first
slice of a limited company’s profit. We will look at tax in more detail in Chapter 8.
2 Owners’ share. In a limited company this share will be in the form of dividends –
again we will look at dividends in more detail in Chapter 8. More generically, this
slice of profit will more usually be called the distribution.
3 Retained profit. By default, this is the amount left over after the other appropriations.
In a sole trader or partnership business, this amount will simply be added to
the capital of the sole trader or shared out to the capitals of the partners. In a company
the procedure is more formal, and the retained profit will be transferred to one
or more ‘reserves’. Once again, Chapter 8 will examine this transfer in greater detail.
Traditionally each of these three appropriations was subtracted in turn
from the net profit. However, current practice under International
Accounting Standard 1 ‘Presentation of Financial Statements’ subtracts the
tax from net profit to leave the retained profit, but the dividends are seen
as what we do with the profit after tax, rather than part of the calculation
of profit, so we now show them in a separate statement, the ‘Statement of
Changes in Equity’.
The presentation of the appropriation account within the income statement
is relatively simple. All we need to do is subtract the tax from the net
profit, and we’ll worry about the dividends later in the Statement of
Changes in Equity.
3 · The income statement 37
Think about who is likely to be entitled to a share of a limited company’s profit, and
so suggest what these three appropriations will be.
Activity 3.5
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Answer
LOWPRICE SUPERMARKETS LTD
APPROPRIATION ACCOUNT
FOR THE MONTH ENDED 30 JUNE
Net profit before tax 32,000
Tax 11,000
–––––––––
Profit after tax 21,000
––––––––––––––––––
Statement of changes in equity
We have now seen all the elements of the income statement, but we have
still to look at the associated Statement of Changes in Equity. This is
simply a summary of why the equity, i.e. the shareholders’ stake, has
changed during the year. We know from the previous chapter that equity
may rise because we revise the value of our buildings upward. However, in
the absence of such capital gains, the change in equity will typically be due
to the profit after tax that we’ve just worked out, less any dividends paid
out to the shareholders, so it will look like this.
LOWPRICE SUPERMARKETS LTD
STATEMENT OF CHANGES IN EQUITY
FOR THE MONTH ENDED 30 JUNE
Retained earnings at 1 June 10,000
Profit after tax 21,000
Less: dividends (8,000)
––––––––
Retained earnings at 30 June 23,000
––––––––––––––––
Most of the rest of this chapter will now explore some of the complications
which typically arise in practice. Before we do this, however, you should
try the following activity. It brings together all we have covered in this
chapter, and is intended to consolidate your knowledge and understanding
of the basics, before we go on to tackle the difficult bits.
38 Financial Accounting
Assume that Lowprice Supermarkets is a limited company. It calculates its tax liability
on the profit for June at £11,000. Mr Tate, the managing director, paid a dividend
of £8,000 from the remaining profit after tax. Any retained profit is to be transferred
to the company’s reserves. At the start of June the retained earnings balance was
£10,000. Draft the appropriation account part of the income statement for June.
Activity 3.6
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Answer Your answer should look like the following. Check your answer against ours, noting not
just the numbers, but also the narration in the title and in how each number is
labelled. Accounting is about communication, and the words matter.
SURAYA LTD
INCOME STATEMENT
FOR THE YEAR ENDED 31 DECEMBER 20X7
Sales 296,483
Cost of sales:
Opening inventory 15,450
Purchases 175,962
––––––––––
191,412
Closing inventory 16,070
––––––––––
175,342
––––––––––
Gross profit 121,141
Heat and light 26,730
Insurance 11,978
Wages 36,389
Rent 6,397
––––––––––
81,494
––––––––––
Net profit before tax 39,647
Tax 7,360
––––––––––
Profit after tax 32,287
3 · The income statement 39
Suraya Ltd started in business on 1 January 20X7. On 31 December 20X7 the following
balances were taken from the company’s books, and from a final stocktake.
£
Sales 296,483
Heat and light 26,730
Insurance 11,978
Wages 36,389
Opening inventory 15,450
Closing inventory 16,070
Purchases 175,962
Dividend 18,400
Rent 6,397
Retained earnings balance at start of period 55,000
The tax liability on the profit for the year was estimated at £7,360. Any retained
profit is to be transferred to the company’s reserves.
Prepare the income statement and the statement of changes in equity for the
year ended 31 December 20X7. The income statement will incorporate the trading,
operating costs and appropriation sections, but the whole thing can be entitled
simply ‘Income Statement’.
Activity 3.7
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We can now draft the statement of changes in equity.
SURAYA LTD
STATEMENT OF CHANGES IN EQUITY
FOR THE YEAR ENDED 31 DECEMBER 20X7
Retained earnings balance at 31 December 20X6 55,000
Profit for the period 32,287
Less: Dividends (18,400)
––––––––––
Retained earnings balance at 31 December 20X7 68,887
––––––––––––––––––––
The rest of this chapter is now concerned with three refinements which
you need to be aware of before we leave the income statement. These are
inventory valuation, non-trading organisations, and the particular presentation
of income statements for limited companies.
Inventory valuation
We have seen how the purchases figure has to be adjusted by adding on the
opening inventory and deducting the closing inventory to arrive at the cost
of the sales figure. However, we have not yet given any thought to where the
inventory figure came from, other than to say it resulted from a stocktake.
A stocktake involves counting all the inventory items that we hold at a
particular time. While this will give us the number of each inventory line we
hold, it will not attach a value to that number. Counting the inventory of
bags of sugar held by Lowprice Supermarkets at the end of June, for example,
will tell us that we have, say, 60 bags in stock, but not what each is worth.
There are a number of different bases of inventory valuation that we could
use, such as:
᭤ Historical cost, that is, what Lowprice Supermarkets paid for each bag.
᭤ Replacement cost, that is, what it would cost Lowprice to buy the inventory
again today. This will often be more than the historical cost,
especially when prices are rising quickly.
᭤ Net realisable value, which is what Lowprice could sell each bag of sugar
for, less any immediate costs of sale. In these circumstances, this would
be the selling price on the shelf, and would normally be more than
either cost above.
We shall see in Chapter 12 that there are other bases of valuation, and we
will look at the relative merits of each in that chapter. For the moment
we can take a pragmatic approach, and all we need to know is what
International Accounting Standard 2 (IAS 2) ‘Inventories’ says. In Chapter 10
we shall examine the nature and purposes of such accounting standards, but
note for now that their regulations should be followed when preparing
financial statements. IAS 2 specifies that inventory should be valued at ‘the
lower of cost and net realisable value’.
40 Financial Accounting
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As with the bags of sugar in Lowprice Supermarkets, the lower of these
alternatives will normally be cost. Net realisable value will only be lower in
relatively rare cases, such as when the inventory has gone out of fashion,
or is close to its sell-by date. In such circumstances the owner might be prepared
to sell for less than he or she paid for it, in order to be able to sell it.
However, this is not the end of the matter, because identifying what we
paid for the inventory, that is, its historical cost, is not always straightforward.
Look, for example, at the following case.
Lowprice supermarkets had the following transactions in bags of sugar
during June.
1st Bought 300 bags from the supplier for 60p each
14th Sold 160 bags for 95p each
19th Bought 100 bags for 65p each
26th Sold 200 bags for 95p each
If we now try to work out the profit on our trading in sugar, we must
follow through the sales transactions. The first sale was of 160 bags at 95p,
i.e. £152, and the cost of this sale is clearly 160 bags at the 60p we paid for
them, i.e. £96. There was thus a gross profit of £56 on the first sale.
The sales value of the second batch of sales is also fairly easy to calculate,
that is, 200 bags at 95p, i.e. £190. However, the cost of these sales is problematic.
Have we now sold the remaining 140 bags from those we bought
on 1 June, and 60 from those bought on 19 June? If so, the cost of sales
will be 140 at 60p plus 60 at 65p, i.e. £123.
Alternatively, have we sold all the 100 bought on 19 June and thus 100
from those left from the batch bought on 1 June? In this case, the cost of
sales will be 100 at 65p plus 100 at 60p, i.e. £125. This is certainly not a large
difference from the other calculation of £123, but replicated over all product
lines in the supermarket it is clear that we potentially have a significantly
different cost of sales figure, and hence a different gross profit reported.
One way to decide which batch of purchases are being sold for any given
sale is to consider the physical reality. Normal supermarket practice would
be to sell the older inventory first, so that they are not left with inventory
past its sell-by date. In other words, the first inventory that came in is the
first to go out. This method is called ‘first in, first out’, usually abbreviated
to ‘FIFO’. In our example above, this is the first scenario, the one that
resulted in a cost of sales of £123. It is widely used in practice, largely
because it does reflect normal inventory rotation practice.
Some traders, however, do not deal in inventory which has a short sellby
date, but do have inventory which is difficult to handle. An example
would be a steel stockholder, dealing in girders, RSJs and so on. When a
new delivery arrives from the steel mill, the stockholder is unlikely to
move the existing inventory to store the new delivery underneath the old.
When he then sells to a customer, he will usually take the steel from the
top of the pile, and will thus be selling the newer inventory. In other
words, the last inventory that came in is the first to go out. An inventory
system that rests on this model is known as ‘last in, first out’, or ‘LIFO’.
3 · The income statement 41
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This is the approach implicitly adopted by the second alternative in our
example above, and resulted in a cost of sales of £125.
Notice that if we adopt a FIFO approach, any inventory left over is
assumed to be from the later delivery, while LIFO assumes that any such
closing inventory is drawn from the earlier delivery. This should become
clearer if you work through an example for yourself.
Answer We have used a tabular layout for our answer, which we think allows for a better comparison
of the methods.
FIFO LIFO
––––––––––––––––– –––––––––––––––––
Sales 3,825 3,825
Purchases 2,830 2,830
Closing inventory 320 280
–––––– ––––––
Cost of sales 2,510 2,550
–––––––– ––––––––
Gross profit £1,315 £1,275
–––––––– –––––––––––––––– ––––––––
Notice that the sales and purchases figures do not alter. What gives the different gross
profit figure is the different inventory valuation. Under FIFO the remaining ten items are
valued at £32, since the earlier inventory has been sold and what is left as the closing
inventory is priced at what came in last. Under LIFO, the same ten items are valued at
the earliest valuation, i.e. £28 each, since we assume that it is the latest inventory
which has been sold, so leaving the earliest.
There is one more possibility for our inventory valuation. Consider the position
of a garage that takes a new delivery of petrol into a tank already part
full from a previous delivery. When a customer draws off a few litres what
she takes will be a mixture of the old and new inventory. Neither FIFO nor
LIFO will now be wholly appropriate – what we need is a mixture, to reflect
the mixture that has been taken as the cost of sales. This third method is
called average cost, abbreviated to AVCO, and calculated as follows.
42 Financial Accounting
Anne, a trader, had the following dealings during August in her only item of inventory.
There was no opening inventory.
1st Bought 40 for £28 each
5th Bought 25 for £30 each
10th Sold 50 for £45 each
21st Bought 30 for £32 each
27th Sold 35 for £45 each
Draft the trading account for the month, assuming:
᭤ a FIFO basis of inventory valuation
᭤ a LIFO basis of inventory valuation.
Activity 3.8
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Suppose customers in Lowprice Supermarkets could help themselves to
sugar from the total inventory, and took some of the old delivery and some
of the new. The sales on 14 June must have been from the inventory
bought on 1 June for 60p, since we had no other inventory at that time.
The cost of sales must therefore have been 160 at 60p, i.e. £96 again.
However, the sale on 26 June of 200 is now deemed to come partly from
the 140 bags remaining from those delivered on 1 June (cost 60p), and
partly from the 100 delivered on 19 June (cost 65p). The way to work out
the average cost to Lowprice of the bags sold on 26 June is:
140 bags at 60p = 84
100 bags at 65p = 65
–––– –––––
240 £149
–––– –––––
The average cost of each bag sold on 26 June must therefore have been
149/240, i.e. 62p. This would then be the AVCO valuation of the remaining
inventory of 40 bags, so that the closing inventory under AVCO would
be shown in the trading account at 40 times 62p, i.e. £25, to the nearest £.
Answer Our answer is as follows:
Sales 3,825
Purchases 2,830
Closing inventory 309
–––––––
Cost of sales 2,521
––––––––
Gross profit £1,304
––––––––––––––––
The closing inventory is calculated like this:
Sale on 10 August
40 at £28 = 1,120
25 at £30 = 750
––– ––––––––
65 £1,870
––– ––––––––
Cost of sale = 50/65 × 1,870 = 1,438
Inventory remaining = 15/65 × 1,870 = 432
Sale on 27 August
15 at average cost, as above = 432
30 at £32 = 960
––– ––––––––
45 1,392
––– ––––––––
Cost of sale = 35/45 × 1,392 = 1,083
Inventory remaining = 10/45 × 1,392 = 309
Notice that AVCO occupies a mid-way position between FIFO and LIFO in terms of valuation,
and hence results in a mid-position report of gross profit.
3 · The income statement 43
Draft the trading account for Anne, using the same data as in the previous activity,
but this time assuming an AVCO valuation base for inventory.
Activity 3.9
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We thus have three bases on which we can arrive at a cost for our inventory,
and the question that should occur to you is which one is right? As you
may be beginning to suspect by now, the answer is that there is no single
right choice. It would seem reasonable to choose the method that best
reflects our inventory management in practice, using FIFO, for example,
where strict inventory rotation is a feature of our business. Many businesses
do, in fact, use FIFO. However, it is important to note that many accountants
would argue that the accounting treatment need not necessarily reflect
the physical reality – certainly, there is no obligation for it to do so, either in
law or in any accounting standard. Hence, there is no absolutely correct
method, but bear in mind that IAS 2 no longer allows the use of LIFO, as it
argues that the inventory value under this method is unlikely to bear a reasonable
relationship to actual costs incurred in the period.
Non-commercial organisations
So far in this chapter we have been looking at organisations whose aim is to
trade for a profit. While this will be true of the great majority of organisations
for whom accounts are prepared, it is not universal. Some organisations
exist for more fundamental purposes. Examples are charities, social clubs and
religious bodies.
Such organisations will not usually prepare an income statement,
because they typically do not trade, and because a financial statement that
reports on the profit or loss is inappropriate for bodies that do not aim at a
profit. There are two possible alternatives to the income statement for such
bodies. These are the ‘Receipts and Payments Account’ and the ‘Income
and Expenditure Account’.
The receipts and payments account is, in fact, sometimes also used for
reporting the activities of very small trading organisations, but is more
often found in non-trading bodies. As the name suggests, it is simply a list
of what money has been received and what has been paid out. In other
words, at its simplest, it is just a summary of the bank account. There will
thus be no inventory adjustment, such as we have just looked at above for
the trading account. Nor will there be any of the other adjustments that we
will come across in Chapter 6, and which are involved in the preparation
of a commercial income statement.
The receipts and payments account for an athletics club might look
like this:
44 Financial Accounting
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MOORTOWN ATHLETICS CLUB
RECEIPTS AND PAYMENTS ACCOUNT
FOR THE MONTH ENDED 31 JANUARY
Subscriptions from members 120
Life memberships 45
–––––
165
Rent of clubhouse 75
Publicity 10
Travel 20
Furnishings 40
––––
145
–––––
Excess of receipts over payments £20
––––––––––
The ‘subscriptions from members’ is a typical source of funds for a nonprofit-making
organisation. It will usually cover the whole of the
forthcoming year. ‘Life memberships’ may be a feature of some clubs. They
represent lump sums paid by members which entitle them to life membership
without paying any further subscriptions.
Notice also that the payments include a fixed asset, ‘furnishings’.
Everything, including capital expenditure (i.e. non-current assets) that
would normally be shown separately in the balance sheet, is included in
the receipts and payments account.
By contrast, an income and expenditure account is prepared using all the
adjustments, such as the inventory adjustment, that are used in preparing
the income statement. The difference between the income and expenditure
account and the income statement is one of terminology. The former title
seems more appropriate than the latter when the statement is reporting on
a non-profit-making organisation. In all other respects an income and
expenditure account is identical to a income statement.
If, for example, Moortown Athletics Club decides to prepare an income and
expenditure account instead of a receipts and payments account, it will use
exactly the same techniques that a commercial organisation would use to prepare
an income statement. It will therefore need to determine its debtors,
creditors and inventory, and to distinguish between capital and revenue items.
3 · The income statement 45
Suppose that the subscriptions from members of the Moortown Athletics Club (see
above) are for the year to 31 December, but were all received in January, and that
the rent of the clubhouse was paid in January for the first three months of the calendar
year. There is a stock of publicity materials left at the end of January valued at
£5. Amend the receipts and payments account above to turn it into an income and
expenditure account. To do this, you will need to adjust the cash flows by the
amounts outstanding in order to arrive at the amount which relates to January alone.
Life memberships are awkward because they relate to an uncertain future period, i.e.
the lives of the relevant members. It will therefore often be regarded as acceptable
for the club to account for these wholly in the period when they are received.
You may find this a difficult activity, but, as always, do try it before you look at
the answer.
Activity 3.10
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Answer
MOORTOWN ATHLETICS CLUB
INCOME AND EXPENDITURE ACCOUNT
FOR THE MONTH ENDED 31 JANUARY
Subscriptions from members (£120/12 months) 10
Life memberships 45
––––
55
Rent of clubhouse (75/3 months) 25
Publicity (10–5) 5
Travel 20
Furnishings 40
––––
90
––––
Excess of expenditure over income £35
––––––––
Our answer above includes calculations of the adjustments we have made.
Make sure you at least understand the answer before you move on. Notice
that the cash surplus reported by the receipts and payments account indicated
a positive view of the club’s finances, but the income and expenditure
account gives a very different view of its financial health. This is primarily
because the income and expenditure account allows for the fact that the subscriptions
received in January will have to last the club for the whole year.
Limited companies
This is a topic that we will deal with in more detail in Chapter 8. However, if
you have seen any income statements published by limited companies, you
may have noticed that they do not look exactly like the one you prepared
for Lowprice Supermarkets. This is because the Companies Act 1985 lays
down very detailed rules about the layout of both the income statement
(which it still calls the ‘Profit and Loss Account’) and the balance sheet.
The income statement that we prepared earlier will be acceptable for sole
trader and partnership businesses, but will only be acceptable for internal
use by a limited company. For external published use, Schedule 4 to the
Companies Act 1985 specifies that all expenses must be grouped, not by
‘purpose’ as we have done (cost of sales, heat and light, insurance, wages,
rent), but by ‘function’. The three broad functional areas that are specified
in the Companies Act are:
᭤ cost of sales
᭤ selling and distribution expenses
᭤ administration expenses.
There are other changes, as we will see in Chapter 8, but this regrouping of
expenses is perhaps the most striking. For now, all you need to be aware of
is the different presentation of the income statement imposed by the law.
Note that it is purely a matter of different presentation – the final net profit
will be exactly the same, whichever method of presentation is used.
46 Financial Accounting
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Changes to the income statement
What we have looked at in this chapter is the income statement as it is currently
used in the UK. However, it is possible that this will change in the
near future, specifically by combining the income statement with the statement
of changes in equity. After all, both report gains and losses, it’s just
that the income statement restricts itself to reporting realised gains and
losses from operations. (‘Realised’ here essentially means we have been paid
for sales, etc. or have paid for purchases, expenses, etc., that is, money has
changed hands or almost certainly soon will.) By contrast, the statement of
changes in equity reports all gains, including unrealised non-trading gains
and losses such as revaluations.
Briefly, the proposal is that non-trading gains and losses are added on to
the end of the income statement, so that the combined statement then
shows the trading profit or loss, as now, but then goes to append any nontrading
profit or loss, so resulting in a figure which represents the total
increase or decrease in the wealth of the organisation. This total would be
known as ‘comprehensive income’. The proposal has strong international
support, but note that it is only a proposal at the moment, and that, for
the time being, you should continue to prepare income statements in the
way you have learnt in this chapter.
Information technology and accounting
Before we leave the income statement and the balance sheet that we considered
in the previous chapter, it is worth briefly looking at the role of
information technology in all this accounting. It is a topic that we will
return to in more detail in Chapter 14, but has become so central to
accounting that we should introduce it before moving on.
All the accounting that you have done in the past couple of chapters has
been manual, that is, you used pen and paper to keep track of changes to
the bank account, summarise the expenses in the income statement, and
so on. In practice much or all of this work tends to be done using computers.
This should not be surprising given that you have seen that accounting
is largely concerned with recording and summarising routine transactions.
Since computers are good at dealing with large numbers of well-defined
routine events, accounting has used computers since the earliest days of
information technology.
Recording the purchase of inventory for £3,000 on credit from Daytime
Suppliers, as Sunrise Ltd did in Chapter 1, for example, would be a very typical
transaction. In a manual system, we would record the asset as inventory
and also record our liability towards Daytime. This implies two entries, and
we may forget one, or enter one twice, or enter both but for the wrong
amount. In Chapter 5 we will look at how this works in more detail and at
how we can control for such errors, but for now note that the possibility of
such errors is inherent in manual systems. If uncorrected, the inventory
and/or the creditor figure that we report in the balance sheet would be wrong.
3 · The income statement 47
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In a computer-based system the entry of the inventory purchase will
require us also to record the liability towards Daytime. In other words, the
software will not let us record the transaction at all unless we record both
aspects for the same amount. This is not fool-proof – we could record both
the inventory and the liability at £300 instead of £3,000, for example, but
it is an improvement.
Perhaps more importantly, information technology is able to sort and
extract the information we want from very large amounts of data
extremely quickly. This means that more, and more flexible, information
can be extracted from the data that we already hold.
These are all issues that we will return to in Chapter 14. For now, all you
need be aware of is that accounting usually relies heavily on information
technology, even though the exercises in this book inevitably require you
to use a manual approach.
Answer 1 Accounting software can impose a certain amount of control on the accuracy and
completeness of our accounting.
2 Information can be extracted both more quickly and in a wider variety of formats
than would usually be possible with a manual system.
3 Computer-based systems can reduce the overall level of understanding of accounting
required by staff, and so reduce training costs.
4 Business partners, including our auditors, expect to be able to exchange data with
us so that, for example, they can place orders with us through the internet.
Summary
This chapter has introduced you to what is usually just called the income
statement. You have seen that it is actually made up of three parts, that is:
᭤ the trading account
᭤ the operating costs account
᭤ the appropriation account.
Each of these parts has been examined in turn, and you have now covered
the essentials of financial reporting, specifically
᭤ a simple income statement, including an inventory adjustment
᭤ a simple balance sheet in the previous chapter
᭤ some of the problems surrounding the question of how to value inventory
᭤ distinguishing between, and calculating, the FIFO, LIFO and AVCO bases.
48 Financial Accounting
List three advantages for a business of having its accounting carried out using information
technology. (There are a couple inherent in what we have said above, but try
to come up with at least one other for yourself.)
Activity 3.11
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One of the points that has hopefully struck you is that each of these bases
results in a different profit figure. Furthermore, we saw in Chapter 2 that
there are a number of different ways to value assets, and each results in a
different balance sheet position being reported. There is obviously a problem
looming here, which is the range of possible accounting results from
given data. Before looking at any more of the techniques of accounting, we
will therefore look in some detail at what theory of accounting has been
developed to help us tackle this problem. The next chapter is therefore
concerned with the concepts and characteristics of accounting.
Self-assessment questions
1 The following details relate to the trading activities of Anarkhi Ltd for its first year of
trading, to 30 June:
£
Purchases 531,946
Sales 794,062
Wages 218,470
Transport 54,475
Rent and insurance 30,775
Tax 3,900
All purchases may be considered as part of cost of sales. All other costs should be
allocated 40% to cost of sales, 40% to selling and distribution expenses, and 20%
to administration expenses.
Anarkhi Ltd uses the FIFO method of inventory valuation. On 23 June there was
no trading inventory. During the last week of the year, inventory transactions were:
5,000 units delivered at £12 each
2,000 units delivered at £13 each
3,000 units sold at £19 each
3 · The income statement 49
trading account (p. 34)
closing inventory (p. 34)
opening inventory (p. 35)
appropriation account (p. 37)
inventory valuation (p. 40)
receipts and payments account
(p. 44)
income and expenditure account
(p. 45)
information technology (p. 47)
Key terms
᭤
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You are required to draft the income statement for the year, adopting the
Companies Act format as far as possible. You will need to calculate the value of the
closing inventory and to allocate the expenses as listed above to their Companies
Act categories before you can construct the income statement.
2 This question requires you to prepare an Income statement, but then also brings in
the preparation of the associated balance sheet. In this way it aims to integrate your
study of Chapters 2 and 3. Note that any retained profit that you calculate in the
Income Statement should appear in the Balance Sheet as ‘Reserves’, included
immediately after share capital.
Use the following balances of Tayside Glass Ltd to prepare an Income Statement
for its first year of trading, which ended on 31 March 20X9 and the associated balance
sheet at that date. You will first need to identify which items relate to the
income statement and which to the balance sheet.
Sales 80,007
Purchases 62,419
Debtors 1,215
Creditors 1,630
Rent 4,600
Telephone 627
Delivery van 4,000
Wages 9,650
Share capital 10,000
Light and heat 1,629
Office expenses 1,127
Bank – positive balance 370
Shop fittings 6,000
There was no opening inventory, since this was the first year of trading. The closing
inventory was valued at £4,200.
3 Marsden Computing buys end-of-range computers and sells them to the general
public at monthly auctions. Its transactions for the past three months have been as
follows. (On 1 January it held 20 computers which had cost £550 each.)
January Bought 300 computers at £550 each and sold 260 for £700 each
February Bought 240 computers at £650 each and sold 280 for £700 each
March Bought 300 computers at £600 each and sold 290 for £680 each.
Prepare the trading account for the three-month period, assuming
(a) a FIFO inventory valuation method.
(b) a LIFO inventory valuation method.
4 Hambleton Players is a cricket club which exists primarily to play cricket but incidentally
carries out some fund-raising activities. As accountant for the club, outline the arguments
for producing a receipts and payments account, compared with the arguments
for preparing an income statement, to report the activities of the club for the past year.
Answers to these questions can be found at the back of this book.
50 Financial Accounting
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4
Concepts and characteristics
Introduction
At this stage, it is worth taking stock of where we have got to. Chapter 1
explored the nature and uses of accounting, and then Chapters 2 and 3
looked at the two major statements conventionally used in financial
accounting, that is, the balance sheet and the income statement. One of
the points that should have struck you is that accounting is far from being
the exact science many people believe it to be.
In particular, we have already seen how both the balance sheet and the
income statement can vary according to the basic assumptions we make
about how and what we should measure. For example, balance sheets would
look very different if all companies did what some football clubs currently
do, and showed the value of their employees – the players, valued at their
transfer fees – on the balance sheet. Again, we saw in the previous chapter
that the gross profit will vary if we change our assumptions about inventory
rotation, and use FIFO instead of AVCO as a basis of inventory valuation. As
you will see as we work through this book, there are many other examples.
What we seem to have in accounting is a situation where the balance sheet
and the income statement, taken together, present a different picture of the
state of affairs and the performance of an entity, respectively, depending on
what fundamental assumptions we make. In other words, the economic
health of an entity can apparently vary not only with the reality of economic
changes, but also with how we choose to account for that reality. How, then,
can any user place any reliance on the financial statements?
The approach that accountants in many countries, including the UK,
have chosen as their way forward is a two-stage technique:
By the end of this chapter you should be able to:
᭤ Outline the generally accepted concepts and conventions of
financial accounting.
᭤ Explain the four major characteristics of financial reporting.
Objectives
FNAC_CO4.QXD 12/10/05 9:54 am Page 51
᭤ to agree on explicit underlying assumptions, and then
᭤ to develop accounting practices that are consistent with those generally
accepted assumptions, and hence lead towards ‘a true and fair view’.
We have come to accept this approach in the UK as being so obviously correct
that it can be hard to think of any alternative. However, it is instructive
to look at what, say, the French approach has been. The French approach is
to specify in great detail exactly what sort of transactions go under each
heading or account, and then to further specify how those accounts shall be
presented. The set of rules that specify these headings and presentations is
known as the plan comptable – the plan of accounts. There is thus, for example,
no choice about whether to use FIFO or AVCO, since the single, ‘correct’
method is laid down in the plan comptable.
The French equivalent of the UK idea of a true and fair view is the image
fidèle. A rough translation would be ‘faithful picture’, and it is notable that
the French first specified the ‘plan’, as the way to produce accounts, and only
subsequently imposed the aim of an image fidèle. In other words, the attainment
of an image fidèle is not central to French accounting in the same way
as the attainment of ‘a true and fair view’ is central to UK accounting.
Answer Any answers to this activity will be a matter of debate, but our views are that the UK
approach has advantages in terms of relevance. By allowing some choice of method, it
can be argued that UK accounts can be prepared according to methods which are
geared to the particular needs of the entity, rather than being geared to a mythical
‘national average’ entity. Furthermore, it may be that the need to consider the most
appropriate treatment of a given accounting issue, rather than to simply follow the
specified treatment, results in a more lively and participative accounting profession.
On the other hand, the French approach does have the key benefit of consistency.
All entities will, in principle at least, treat the same item in the same way, so improving
comparability between the accounts of different entities. In addition, the prescription of
practice should result in less debate and therefore in faster preparation, and faster will
mean cheaper.
You may have had your own, equally valid, ideas. We hope so, because, as you have
just seen, accounting in the UK is ultimately determined by some minimum agreement
on fundamental underlying assumptions. If you have no ideas then you can’t engage in
this fundamental debate. The rest of this chapter presents the current state of the
52 Financial Accounting
Complete the following table, by making at least one entry under each heading. You
may find it helpful to think in terms of the relative disadvantages of the UK system,
rather than of the relative advantages of the French system. You will be addressing
much the same issues.
UK approach French approach
Relative advantages
Activity 4.1
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more important parts of this debate. It is divided into two main sections. The first part,
concepts, covers fairly well-established ideas. The second part, characteristics, deals
with more recently developed thinking about what makes a set of financial statements
‘good’ – whatever that means.
Concepts and policies
To reiterate, concepts are the underlying ideas of accounting. They have
usually been implicit and understood as a common culture of accounting,
rather than being made explicit, even though we have seen above how
important they are. Given that such underlying theoretical principles can
radically change the view the financial statements give of an entity, it
should be obvious that preparers and users of those statements should be
very clear about the particular principles that have been applied to any
given set of statements. Requiring such an explicit declaration of the
accounting practices they result in for a given entity is a large part of the
purposes of International Accounting Standard 8 (IAS 8), ‘Accounting
Policies, Changes in Accounting Estimates and Errors’.
We will consider the nature and authority of accounting standards in
more detail in Chapter 10, but for the moment you need only be aware
that they are generally held to be effectively mandatory in almost all cases.
At the heart of IAS 8 is the assumption that all financial statements will be
consistent with a few basic, specified principles, known as the concepts.
Linked to this, International Accounting Standard 1 (IAS 1) ‘Presentation of
Financial Statements’ highlights two concepts, going concern and accruals,
as being pervasive. In other words, these two ideas are held to be so important
that they should underpin all accounting.
You should note that this is a change from the UK position before 2001,
when the standard in force was SSAP 2 ‘Disclosure of accounting policies’,
which specified four basic concepts, namely going concern and accruals
again, but also consistency and prudence. What has happened to the latter
two is an instructive story, and one that we will consider later in this chapter.
IAS 8 is concerned that the accounting policies it uses should be both
explicitly stated and appropriate for the organisation to achieve a true and
fair view. Policies are defined as ‘the specific principles, bases, conventions,
rules and practices applied by an entity in preparing and presenting financial
statements’. Put simply, policies are how an organisation chooses to account
for transactions and events given the range of different methods available to
it. We have already seen that an organisation has some choice in how it
accounts for inventory, for example. However, this is not an entirely free
choice, since IAS 8 requires that the accounting an organisation chooses
should be based on a few basic policies, principally, as we have seen, going
concern and accruals, but also realisation. It is therefore time to turn our
attention to a more detailed consideration of the ideas of accounting.
4 · Concepts and characteristics 53
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Going concern
There is an assumption that the business will continue to operate for the
foreseeable future. The application of this policy could make a difference,
for example when we consider asset valuations. We have seen that the
usual basis is historical cost, but if the entity is no longer a going concern
and will be wound up, it is arguably more appropriate to value the assets at
selling price, since they will soon be sold.
Accruals (or matching)
When preparing the income statement, revenue and profits are matched
with the associated costs and expenses incurred in earning them (known as
accruals or matching). This means that revenues and expenses are recognised
when they are incurred, rather than when the related cash is received
or paid. A sale will thus be accounted for when the contract is agreed, and
not when the goods or services are paid for.
Realisation
This is an idea that we touched upon in Chapter 3 when we explored the difference
between the income statement and the statement of changes in equity.
We saw then that one of the critical differences is that the income statement
deals only with transactions that are realised; that is, ones where the money
has changed hands, or is almost certain to do so in the near future, whereas
the statement of changes in equity deals with both realised and unrealised
transactions. This is an increasingly important issue in accounting, and we will
return to it later in this chapter under ‘Revenue Recognition’.
The characteristics of good accounting
The question which then arises is how do we select and apply these policies
in practice? If there are a range of possible accounting policies, how
can we judge which represent good accounting? Certainly, the policies we
choose should be in line with the three above, but that could still leave us
with a range of possible policies from which to choose. In other words,
what are the characteristics of good accounting? This question is dealt
with in the ‘Framework for the Preparation and Presentation of Financial
Statements’, which specifies four such characteristics, namely relevance,
reliability, comparability and understandability. We’ll explore the nature
and authority of this ‘Framework’ later in this chapter and in more detail
in Chapter 10; for now simply note that it is a formal codification, by the
International Accounting Standards Board, of the ideas we’ve been discussing
in this chapter.
Briefly, relevance asserts that good financial information is information
which is relevant to helping users to make decisions about the organisation
being reported on. Reliability is essentially a matter of freedom from bias
54 Financial Accounting
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and material error. Comparability simply means that accounting policies
should normally be the same from one year to the next, and ideally also
between organisations, so that comparisons aren’t distorted by different
methods of accounting. Finally, understandability makes the seemingly
obvious point that financial information should be understandable by
users. However, we shall see when we look at the Framework that it isn’t
always that simple.
Answer The correct answer is that A is an extract from the definition of accruals, and B from
that for going concern.
In addition to the well-established ideas outlined above, there are also a number of
implicit ideas that are generally accepted. You will find that these are referred to both
in books and, less commonly, in practice, so it is worth being aware of them.
Consistency concept
There should be consistency of treatment of like items within each
accounting period and from one period to the next. In other words, once
you have chosen an accounting treatment, you should stick with it from
one year to the next. The key reason for this is to promote comparability,
which we identified above as a key characteristic. That is, it helps the user
to make comparisons over time, and so to pick out useful trends. Having
decided, for example, to value our buildings at historical cost, rather than
at, say, replacement cost, consistency requires that we will normally continue
to adopt historical cost for the buildings.
Prudence concept
In the UK tradition of accounting, prudence was regarded as one of the
major ideas. In recent years it has been significantly downgraded, so that it
is now simply one approach to help achieve the characteristic of reliability.
When we have to choose between two or more accounting treatments of
an economic event, prudence dictates that we should always aim to show a
treatment free from bias and/or the result we would like to present. The
logic is that explicitly avoiding overstatement under conditions of uncertainty
results in more reliable accounting. For example, we saw in Chapter 3
that inventory is valued at the lower of cost and net realisable value, rather
4 · Concepts and characteristics 55
In the list below, two definitions are given. Identify which definition relates to which two
of the three policies we explored above, i.e. accruals, going concern and realisation.
A the non-cash effects of transactions and other events to be reflected, as far as is
possible, in the financial statements for the accounting period in which they occur
B The information provided by financial statements is usually most relevant if prepared
on the hypothesis that the entity is to continue in operational existence for
the foreseeable future.
Activity 4.2
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than at the normal selling price. The justification for this lower valuation
has been the prudence concept, but it is interesting to speculate that such a
treatment may not always be the case. Given the down-grading of prudence
we can presumably expect standard setters to give it less weight in future,
and one implication of this could be that inventory may not always be
valued according to an emphasis on prudence.
Separate valuation
Separate valuation is an important idea because it is specifically referred to
in the Companies Act 1985. This Act includes accounting rules, and requires
that all UK financial statements will normally be based on the concepts of
accruals, going concern, consistency and prudence, plus the concept of separate
valuation. This concept is best explained by an example:
Assume that A has sold goods on credit to B worth £600, so that, in A’s books, B
shows up as a debtor for £600. Meanwhile, B has sold goods on credit to A for £400.
In A’s books, B also therefore appears as a creditor for £400. No agreement has been
made about setting off one amount against another. What should we show in A’s balance
sheet in relation to B?
You could argue that we should simply show the net debtor of £200 as a
current asset. However, there is a counter-argument that holds that showing
just the net debtor does not give a full picture of the total situation,
and thus does not give a true and fair view. After all, in the absence of an
explicit agreement between A and B to legally set off the £400 against the
£600, the position is that B must pay the full £600. This being so, the correct
presentation in A’s balance sheet would be to show a debtor of £600
and a creditor of £400. In other words, the debtor and the creditor should
be separately valued, and disclosed as such.
Business entity
We have come across this concept already, in relation to capital in the balance
sheet. The business has an identity and existence distinct from the
owners, so that the business can and should record an amount owing to its
owner, i.e. the capital. Transactions of a business are recorded as they affect
the business, not as they affect the owner.
Duality
Again, we have already seen this concept in action, when we looked at
sources and applications of funds in Chapter 2. In relation to any one economic
event, two aspects are recorded in the accounts, that is, the source
of funds and the related applications. The balance sheet equation is an
application of the duality concept. In Chapter 5 we will see that it also
underpins double entry bookkeeping.
56 Financial Accounting
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Monetary measurement
Only those events and situations that can be reasonably objectively measured
in money terms are recorded. This means, for example, that ‘happy
and skilled workforce’ is not an asset that you will see on a balance sheet,
even though most managements routinely say that their workforce is the
company’s greatest asset, and it may even be true. It does not appear
because the value of this asset cannot normally be objectively quantified.
Objectivity
This concept is obviously closely linked to money measurement. More generally,
however, and more formally, it is a required attribute of accounting
that competent individuals working independently should arrive at the
same or very similar measures of given economic events or situations.
Historical cost
The usual method of arriving at an objectively agreeable quantification of
an event is to value it at what the item in question cost. This is known as
its historical cost. It has the huge advantage over any other system of being
simple and relatively objective, but we will see in Chapter 12 that it has its
own problems in times of significant inflation.
Materiality
A very small mistake in the financial statements of an entity will not invalidate
those statements. They should still be usable by anyone interested in
the entity. However, the key issue is obviously what we mean by ‘very
small’. The concept of materiality applies the test of whether the financial
statements still show a true and fair view. If the answer is yes, then the
error is not material, and we need not spend time and resources trying to
find and correct it. If, on the other hand, the mis-statement, or even the
total omission, of an item would result in the financial statements as a
whole not showing a true and fair view, then that item would be regarded
as material. Such an error would have to be corrected if the statements are
to comply with the Companies Act 1985 and show a true and fair view.
The materiality of an item is related to the size of the entity. The omission
or mis-statement of a £10,000 item would probably not be material in the
financial statements of ICI, but would almost certainly be very material in the
financial statements of a one-person business. Note that materiality can be
measured against size, as suggested above, but occasionally it may be more
appropriate to measure it against profits. If, for example, the profits of ICI were
only £20,000, then a £10,000 item could, perhaps, be considered material.
4 · Concepts and characteristics 57
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Answer Given that the ideas involved in any answer to this question are so open ended, what
follows should not be regarded as the definitive answer, but rather as a reasonable
response that covers all the main points that should be made.
Relevant ideas
Opening position
Asset
Cash 800 Money measurement
–––––
Liability
Capital 800 Business entity
–––––
Closing position
Assets
Van 500 Historical cost,
materiality, reliability,
prudence
Debtor 70 Accruals
Cash 350 Money measurement
–––––
920
Liabilities
Owing for bicycle 100 Accruals, reliability
–––––
820
–––––
Capital
Opening position 800 Business entity
Increase in wealth 20 Going concern
–––––
£820
––––––––––
What our answer sets out is both the opening and closing balance sheets. Notice how
the increase in wealth has been calculated by determining the difference between the
opening capital position and what the net result of the assets and liabilities tells us must
be the closing value of the business. Another way to view this increase in wealth is as
58 Financial Accounting
Sam and Louise had £800, out of which they purchased a second-hand van for
£500. All their other assets are to be ignored. They estimated that the van will have
a life of about another 20,000 miles. Sam and Louise started a light removals business,
but were involved in an accident on their first day, and damaged a bicycle.
Sam promised to pay for the damage and the rider said he thought the bike could be
repaired for between £60 and £100.
At the end of their first day, Sam and Louise were offered £600 for the van. They
were also paid £50 cash for a job they did in the morning and £70 for the afternoon’s
job, payable next week. During the day, they had travelled 50 miles.
List Sam and Louise’s assets and liabilities at the start and end of the first day and
hence say how much better, or worse, off they are since they started. More importantly,
in doing so, clearly indicate which accounting ideas justify your calculations.
This is an important activity, drawing together much of what we have covered so
far in this book, so try to do it, and do it conscientiously.
Activity 4.3
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the net income for the period. In other words, what we have done above is to calculate
the net profit without preparing an income statement. We do not have the detail about
revenues and expenses that the income statement provides, but it is an alternative way
to calculate profit. This is an idea that we will return to in Chapter 12.
In terms of the concepts that we have listed above, there are a number of points to
be made. First, both the opening and the closing cash positions depend on their validity
as measures of wealth on the basic assumption that we can measure anything by
attaching a number of £s to it. In other words, the whole exercise rests on the money
measurement concept.
Second, the valuation of the van is more of a problem. The usual basis would be to
value it according to what we paid for it, i.e. at its historical cost, but there are other possibilities.
We could, for example, decide that a more relevant and useful valuation would
be what we were offered for it, that is, £600. Would this value be any less logical or reasonable
than using the old cost? If not, the implication is that the conventional choice of
historical cost is at least partly arbitrary. If, on the other hand, the choice of historical
cost is more logical and reasonable than any other, we should be explicit about why we
believe this. As we saw before, a major advantage of historical cost is its relative objectivity,
and the inherent prudence arguably enhances the reliability of the measurement.
Third, this is not the only issue in relation to the valuation of the van, there is also
the question of depreciation. This a topic that we will cover in more detail in Chapter 6,
but note that if the van is going to be of benefit for 20,000 miles, the accruals concept
would suggest that we should allocate some of the cost of £500 against the day’s
profits. The question of how much benefit can be answered by saying that we have
presumably had 50/20,000ths of the benefit, since we have travelled 50 miles out of
a total usable mileage of 20,000. Using the historical cost value of £500, this works
out to a depreciation charge for the period of £1.25, which hardly seems worth bothering
with. In more formal terms, we can invoke the convention of materiality to justify
ignoring any charge for the using up of the value of the van, at least for one day.
Fourth, accruals and realisation could be used to justify the inclusion of the amount
due for the afternoon’s work, that is, the debtor of £70.
Fifth, the adoption of prudence would guide our valuation of the creditor, since showing
£100 as being outstanding is a more reliable treatment than only showing £60.
Showing £60 would result in a lower total for liabilities and would arguably therefore be
an overstatement of our position, contrary to prudence. Further, the amount has not yet
been paid, but we conventionally allow for it since it relates to this accounting period.
The formal justification for making such allowances is, of course, the accruals concept.
Sixth and finally, the net effect of applying all these concepts and conventions to the
opening and closing valuations of Sam and Louise’s business is to report an increase
in wealth of £20. Unless they withdraw this profit, it will be carried forward to finance
their business in future periods. The implication is that we are assuming that the business
is a going concern.
This has been a discursive answer to a fairly short activity. However, we
have been concerned to demonstrate how even simple accounting practice
rests explicitly on fundamental assumptions, usually known as the concepts
or principles, or just the ideas, of accounting. If we change the ideas,
we will get different accounting. To look in more detail at how the ideas
work through into practical accounting, we need to consider estimation
and measurement bases.
4 · Concepts and characteristics 59
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Accounting estimation and measurement bases
In the conventional understanding of the conceptual framework, estimation
builds on the policies, and measurement bases then build on the
estimation. Estimation is concerned with how the policies can be applied to
economic transactions and events in order to attach a number of £s to an
accounting item. For example, the accounting policy of accruals applied to
inventory implies that we should allow for opening and closing inventory
in the calculation of gross profit. However, this still leaves the question of
how to value that inventory, and estimation is the particular method that
we select. As we saw in the previous chapter this could be FIFO or AVCO,
and our particular choice is then our estimation technique.
To continue the example, we have decided to apply the policy of accruals
and so chosen to allow for inventory in the profit calculation, and have further
chosen, say, FIFO as the estimation technique for inventory. There
remains just one final step before we have an amount to enter into the
income statement for the inventory adjustment, and that is to measure the
value on our FIFO basis. The final step is thus to select the measurement basis.
We already know that there are alternative measurement basis such as
historical cost, replacement cost and net realisable value. We choose one of
these, and then stick with it to provide consistency and hence comparability,
and this choice is our measurement basis.
Accounting practice is thus determined by the policies the entity
chooses. If it had chosen different policies then the practices would have
been different, and the income statement and balance sheet would present
a different view of the entity. If users are to be able to make allowances for
differing policies between entities they are looking at, then they must at
least know what the policies are. Finally, therefore, IAS 8 requires that the
accounting policies and associated estimation techniques should be disclosed
as a note to the financial statements. If we change the estimation
basis then the figures will change, of course, so IAS 8 also requires explicit
disclosure of any such change.
Revenue recognition
This is a topic that we have touched on earlier, especially in relation to the
realisation concept. That introduced the idea that we should only take
account of revenues and expenses when the associated cash flow has happened,
or at least become reasonably certain. However, this is not always
easy to apply in practice and the idea has recently been developed into the
broader area of revenue recognition.
There has been an international accounting standard, IAS 18 ‘Revenue
Recognition’, in the area for a number of years. The standard starts with a
consideration of what we mean by revenue, and assert that it is an inflow of
economic benefits arising from ordinary activities. This seems like an obvious
definition, but note two points about it. First, the reference to economic
60 Financial Accounting
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benefits is an echo of the definition of an asset, that is, ‘revenue’ is what
makes an asset worth something. Second, revenue only arises from ordinary
activities, so selling a major asset, for example, is not revenue.
This leads on to the next major issue which is how we measure the amount
of the revenue. The approach adopted is to take the fair value of the consideration
received. In other words, the value of revenue is not the value to us of
what we gave up, but the value of what we received from our customer.
So far this all appears to be fairly obvious and you may be wondering
why we need an accounting standard on such a simple topic. However, the
recognition and measurement of revenue is not always so simple. For
example, consider the following activity.
Answer The approach adopted by the standard setters is that one of two accounting policies
will be appropriate, depending on the circumstances. (The fact that there is no right
way to deal with this situation is an indication that revenue recognition is not as simple
a topic as it first appears.) One policy would be to recognise £180,000, being the
books sold that are likely to stay sold, that is, to allow for returns as best we can given
the inherent uncertainty.
The other policy put forward by the standard setters is to only recognise the sale
after the possibility of any returns has expired. This would imply not recognising any
revenue until two years have passed. This latter approach might be considered inappropriate
in the circumstances, and the decision about which policy to adopt would
rest on a consideration of the policies and characteristics set out in IAS 8 and which
we explored earlier in this chapter. Ultimately, we would have to decide, as always,
which of the alternatives produces the most true and fair view.
A true and fair view
As a final element in our survey of the ideas of accounting we should consider
a true and fair view. This phrase comes from the Companies Act, and is the
over-riding legal requirement for financial statements in the UK, that is, they
must show ‘a true and fair view’. The phrase is not then defined in the Act so
is implicitly left to accountants to define in practice. It is held to be achieved
primarily through adherence to the accounting standards, which implies that
the ideas we have considered in this chapter do have legal impact.
4 · Concepts and characteristics 61
Markham Publishing plc sells books to bookshops worth £200,000 just before the
accounting year end. The agreement is that any book not sold may be returned to
the publisher. None are returned in this accounting year, but past experience is that
about 10% will be returned next year. The right of return expires after two years. Is
the revenue to be entered in this year’s Markham income statement £200,000 or
£180,000 or something else?
Activity 4.4
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The ‘Framework’
To give it its full title the ‘Framework’ is properly called The Framework for the
Preparation and Presentation of Financial Statements. We introduced it earlier
in this chapter, where we noted that it is a codification of many of the ideas of
accounting that we’ve been considering. It can be seen as the International
Accounting Standard Board’s attempt at a conceptual framework for accounting.
Alternatively, we could regard it as a standard for setting standards, in that
it provides guidance on what constitutes good accounting.
It is divided into a number of sections, each dealing with a specific theoretical
topic. The next page or so explores each of these sections in some detail.
First, the Framework deals with who are the users of financial information.
This is a topic that we consider back in Chapter 1, so we needn’t consider it
again here. Second, the Framework goes on to address the question of why
we do accounting. Again, this is something we explored back in Chapter 1,
where we decided that it’s primarily ‘decision usefulness’ – the main purpose
of accounting is to help users make decisions about the organisation.
The Framework then goes on to consider the characteristics of good
accounting. We’ve already touched on these, but they’re such an important
issue that we’ll leave them for now and explore them as a separate topic
later in this chapter, under the ‘Characteristics’ heading.
The next part of the Framework identifies and defines the basic building
blocks of financial accounting. These are identified as being assets, liabilities,
equity, gains and losses, and contributions from, and distributions to, owners.
These classifications will be familiar to you from our exploration of the balance
sheet in Chapter 2. The significance of their formal declaration in the
Framework is that they now define the scope of financial accounting. All
items that appear in financial statements must fall into one of the specified
categories. The question of whether a key employee should be shown as an
asset of the company in the balance sheet, for example, should be answered,
at least partly, by reference to the definition of an asset in this part of the
Framework. In such a case, the issue would be whether the employee represents
‘future economic benefit’ controlled by the company, since that phrase
is the heart of the definition of an asset. Presumably, the answer would be
yes, given that it is likely that the net revenues generated by such a key
employee would exceed the cost of his or her wages. However, the question
does not rest there, because the material in the framework on elements has to
be seen alongside the issue of recognition.
Accordingly, the framework goes on to deal with the circumstances in
which these elements should be recognised in the financial statements. It
should come as no surprise to find that it requires items to be recognised
only if they are elements as defined. We have already accepted that our key
employee probably fits the definition of an asset. However, the framework
also imposes the further condition that the element must also be capable
of being objectively quantified. In other words, we need to be able to
objectively quantify the ‘future economic benefit’ that our employee represents.
One approach could be to sum the net revenues after wages costs
that the employee will bring in during his or her time with the company.
62 Financial Accounting
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Answer Our view is that the main problem is the uncertainty inherent in any estimate of future
revenues and expenses. It would be highly questionable, for example, whether our
guesses about the net revenues or the number of years the employee will stay with us
will turn out to be accurate. If we cannot objectively quantify an element, then the
Framework requires that we do not recognise it, that is, we should not include it in the
financial statements.
More subtly, such an approach to valuation is not historical cost, and we have
already seen that historical cost is the most widely used and accepted method of valuation.
If we use some estimate of future value for an employee, and historical cost for
another asset, such as a building, it is hard to see what the total of the two assets represents
or means. We looked at valuation problems in Chapter 2, and will return to the
topic in greater depth in Chapter 12. In the meantime, the Framework goes on to
address the issue of valuation.
Specifically, the next section of the Framework deals with the alternative
bases on which we could quantify. So far we have only looked seriously at
historical cost, but we will explore other possibilities in Chapter 12. As you
may be beginning to realise from the brief discussion above, valuation is a
complex topic.
Finally, the last main topic dealt with by the Framework is an exploration
of capital maintenance. This means looking at what we understand by the
‘wealth’ or ‘net worth’ of an organisation. It’s something we touched on
back in Chapter 2, and something that we’ll return to in Chapter 12.
In the rest of this chapter we will consider the characteristics in more
detail, that is, the conventional wisdom on what constitutes good accounting.
This topic therefore represents guidelines for everything else we do in
this book.
The characteristics
As we briefly saw earlier in this chapter, the Framework identifies the qualitative
characteristics of good financial reporting relevance, reliability,
comparability and understandability.
Answer Our answer is based closely on the Framework, which says that the relevance of financial
information is primarily related to its predictive role, that is the extent to which the
information helps users to predict the organisation’s future and so to make decisions
4 · Concepts and characteristics 63
Briefly, note down at least one practical problem that you foresee with such an
approach to valuation. As always, you will learn more and faster if you think about
the issue raised in the activity than if you simply skip ahead to the answer.
Activity 4.5
Write two sentences of your own to define each of the characteristics, ‘relevance’ and
‘reliability’. In other words, what do you think these words mean in accounting terms?
Activity 4.6
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about it. For example, the attempt by a potential investor to predict future profitability
and dividend levels will be at least partly based on the financial statements. Relevance
also relates to the use of financial information to confirm past predictions, e.g. about
returns on a particular capital project.
In relation to reliability, the Framework asserts that reliability of financial information
is deemed to be achieved by producing information that has a series of characteristics.
There are four of these, but most should already be familiar from your studies earlier in
this book.
1 Faithful representation. This consists of valid description, free from error, although it
should be taken together with a suitable ‘choice of aspect’, i.e. a decision of which
properties of a transaction we should disclose. Achievement of faithful representation
also depends on the idea of ‘substance over form’. This is a very important idea in UK
accounting, and so we’ll consider it as a topic in its own right later in this chapter.
2 Neutrality. The information presented must be free from bias. There is a very close
link here to the prior characteristic of objectivity.
3 Prudence. This principle is restated. While we should aim to reflect an unbiased
view of an event or transaction, in accordance with neutrality, under conditions of
uncertainty it will be helpful to select a prudent view of the possible outcomes.
4 Completeness. The more complete the information is the better, but the benefits of
completeness should be weighed against the costs of the time and money needed
to prepare full information.
Answer Once again, our answer draws heavily on the points made in the Framework.
Specifically, the achievement of comparability implies the presentation of financial
information in a consistent way from one year to the next, and between enterprises.
One important feature of this will be the disclosure of and adherence to accounting
policies. The presentation of comparative figures for the previous year will also help to
achieve this characteristic.
Understandability requires a prior consideration of who the users of the information
are held to be. The presentation of the information should then be such that those
users will normally be able to make substantial use of that information. It will, however,
be acceptable to assume that users are reasonably well-informed about basic accounting
and economic matters.
Finally, the Framework insists that all the above characteristics are subject
to a minimum threshold of quality. The main consideration here is materiality,
which provides a cut-off point for the disclosure or non-disclosure of
particular events. Furthermore, you should bear in mind that in the UK
everything in the Framework is subject to the over-riding legal requirement
to show a true and fair view.
64 Financial Accounting
The other characteristics are comparability and understandability. Repeat the previous
activity, this time jotting down a couple of your own sentences to define each of
these terms.
Activity 4.7
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Answer As with many of the questions in this fundamental area of accounting, there is no
single correct answer. However, we think the following suggested answer covers most
of the main points.
Reliability
The Framework says that relevance rests on whether the financial statements are of
significant use for predicting or confirming economic events. Whether the proposal
improves relevance depends on who the users are, and what they want to predict or
confirm. A lender, for example, would probably find a summary of cash movements relevant,
since he or she would be concerned about the ability of Global Trading to make
repayments. A shareholder, on the other hand, would probably be most concerned
about the profit made, and would accordingly find the income statement more relevant,
and the proposal would therefore not be as sound.
Reliability
This characteristic is to be judged according to faithful representation, substance over
form, neutrality, prudence and completeness. These points seem to be as valid for
either approach to accounting, but they at least do not suggest that the proposal
should be rejected on the grounds of reliability. Indeed, in terms of neutrality (objectivity)
the proposal could be seen as positive, in that the amounts passing through the
bank account are a more objective measure of events than, say, the measure of profit.
In terms of completeness, the provision of the suggested statement in addition to
existing statements is likely to be positive. Note, however, that provision of an extra
statement will take time, so delaying the publication of the statements and so making
them more out of date.
Reliability
A summary of monies in and out of the bank account will probably be understandable
to a wider group of users than will a conventionally complex set of financial statements.
On these grounds the proposal seems sound. However, we need to balance
this against the difficulties we have already noted in relation to relevance and reliability.
If there is a conflict between, say, reliability and understandability, then the Framework
requires that we prefer reliability. In other words, it is more important that the accounts
be ‘right’ than that they be understandable.
4 · Concepts and characteristics 65
Global Trading is currently preparing its annual report and accounts. As its name suggests,
it is a very big enterprise, with very complex accounting procedures and
reports. Currently, it publishes an income statement and a balance sheet. The directors
are considering a proposal to produce a more simplified set of financial
statements, either in addition to, or even instead of, the usual, more complex statements.
One possibility, for example, would be to produce simply a summary of
monies in and out of the bank account.
Taking each of the four characteristics in turn, assess whether the proposal is
sound. You may ignore any legal requirements.
Activity 4.8
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Comparability
This refers to a user’s ability to make comparisons both with Global Trading’s own
accounts in previous years, and with the accounts of other similar companies.
Comparability with previous years will be poor, unless the company retrospectively prepares
a similar cash summary for those years. This is possible, but would be expensive.
Comparability with other companies will only be possible if other companies produce a
similar statement.
Overall, it is not possible to make a clear recommendation to the directors, without
knowing more about the circumstances. What we can say is that the four characteristics
seem to provide criteria by which we can start to judge the validity of both current
and proposed accounting practices.
Substance over form
You’ll remember that the idea of ‘substance over form’ is part of how we
achieve reliability. It’s a fundamental part of the conceptual framework so
we’ve separated it out here to deal with it as a topic in its own right.
In essence, the idea says that there can be a difference between the economic
substance of a transaction – what’s really happening – and the strict
legal form. An example is probably the best way to explain how the idea
works. If we buy a car and use it in our business then there’s no difference.
The economic substance is that the car is our asset, since we receive any
economic benefits associated with its use. Similarly, since we bought the
car the legal form is also that its our car. However, compare this with the
situation where we lease the car for most or all of its expected life.
We will again physically have the car, we’ll use it to earn economic benefits
for our business, we’ll control who can drive it, and we’ll pay for the running
costs. In substance, it appears to be our asset, and so we’ll presumably show it
in our balance sheet. However, legally the car doesn’t belong to us, it belongs
to the lease company. Accordingly we shouldn’t show it in our balance sheet.
There’s a conflict between what the economic substance of the lease suggests
we do and what the legal form suggests is the correct accounting. The concept
of substance over form says that in those situations where we have such
a conflict then we account according to the economic substance rather than
the legal form. In this case we would therefore show the car in our balance
sheet, and then depreciate it, even though it belongs to someone else. Note
that the idea of substance over form applies to all accounting, not just to
leases. It’s therefore a very powerful idea in accounting.
Summary
This chapter has dealt with three topics
᭤ the concepts of accounting, the most important of which are set out in
the Framework, complemented by IAS 1 and IAS 8
᭤ IAS 8, which sets up a structure of policies – estimation – measurement
bases for determining accounting practice in a reasonably coherent way
66 Financial Accounting
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᭤ the Framework, which attempts a definition of what constitutes good
accounting. In other words, it provides a target for all our accounting to
aim at.
This chapter concludes the first part of this book. So far, we have explored
the nature of accounting, looked at the two main statements by which
accounting reports to the outside world, and started to look at some of the
theoretical underpinning to accounting. We will return to the theory in
Chapter 12. In the meantime, however, we should turn our attention to
the everyday practicalities of accounting. Chapter 5 therefore starts our
study of double entry bookkeeping.
Self-assessment questions
Select the most appropriate answer for each of the following multiple choice questions.
1 The assumption that an organisation will continue to operate indefinitely is a fair
description of which concept?
(a) accruals
(b) going concern
(c) consistency
(d) prudence
2 The concept of materiality implies that an organisation will:
(a) only account for items which don’t affect the overall view gained from its accounts
(b) not account for fixed assets which are due to be sold in the next accounting year
(c) only account for fixed assets and those current assets costing more than £1,000
(d) not account for items which don’t affect the overall view gained from its accounts
3 The concept of money measurement means:
(a) accounts cost a material amount of money to prepare
(b) only items that can be objectively measured in money terms are accounted for
(c) accounts are only ever prepared in one currency
(d) items in accounts are recorded at the amount of money they originally cost
4 · Concepts and characteristics 67
concepts (p. 53)
going concern (p. 54)
accruals (p. 54)
matching (p. 54)
realisation (p. 54)
characteristics (p. 54)
measurement bases (p. 60)
revenue recognition (p. 60)
a true and fair view (p. 61)
Key terms
᭤
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4 The recognition that an organisation is distinct from its owners is a fair description of
which concept?
(a) duality
(b) separate valuation
(c) business entity
(d) objectivity
5 The concept of realisation means that:
(a) items are accounted for in the period in which the associated cash flow occurs
(b) items are recognised when the directors realise that a cost has been incurred
(c) items are accounted for when only they can be objectively measured
(d) items are recognised when the associated cash becomes reasonably certain of
being received
6 ‘The International Accounting Standards Board (IASB) should spend less time on
developing a vague set of principles and more time on specifying clear accounting
practices.’ To what extent do you agree with this statement?
As in the self-assessment question for Chapter 1, you should justify your response
and construct your answer as an essay of 300 to 500 words, or as comprehensive
notes for such an essay. Again, we have provided feedback as a list of points that
you should have covered.
7 Back in Chapter 1 we asked you to identify the relative merits of the UK and French
approaches to financial reporting. To recap, the French system is based on the ‘plan
comptable’, a specification of exactly which accounts must be kept to record which
transactions and how those details are then to be presented in the income statement
and in the balance sheet. This can be contrasted with the less directed
approach used in the UK and outlined in this chapter.
For each of the characteristics of good accounting that you have now explored
(relevance, reliability, comparability and understandability), suggest one reason to
prefer the UK system and one reason to prefer the French system. You may like to
set out your answer as a table – we have.
8 Outline the purposes and main features of the Framework for the Preparation and
Presentation of Financial Statements. Your answer should be in the form of an essay
of around 500 words, briefly covering the content of each of the chapters in turn,
but also focusing clearly on the purpose of each chapter.
Answers to these questions can be found at the back of this book.
68 Financial Accounting
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5
The double entry system
Introduction
This chapter is intended to introduce you to the basics of the double entry
bookkeeping system that was codified by Luca Pacioli in the fifteenth century.
As an accountant you may not be involved in the actual recording
within the double entry bookkeeping system as this is carried out by bookkeepers
or indeed a computer. You must, however, understand the system as
you, as an accountant, will be called on to ensure the system is operating
effectively and to complete year-end entries to enable relevant and reliable
financial statements to be prepared for an organisation.
The need for a double entry system
You have seen in previous chapters that it is possible to construct a balance
sheet, to show the position of a business at a point in time, and an income
statement to identify the profitability of a business for a period of time.
How did you do this? Refresh your memory with the following activity.
By the end of this chapter you should be able to:
᭤ Identify the need for a system of double entry.
᭤ Relate the duality concept to this system.
᭤ Prepare ledger accounts.
᭤ Balance off ledger accounts.
᭤ Extract a trial balance and understand its importance within the
system.
᭤ Prepare simple income statements and balance sheets from a trial
balance.
Objectives
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Answer
MR BEAN
BALANCE SHEET AS AT END OF FIRST MONTH
Non current assets
Van 5,000
Current assets
Inventory 9,500
Bank 7,000 16,500
–––––––– –––––––––
£21,500
––––––––––––––––––
Capital
Opening 20,000
Profit 1,500 £21,500
–––––––– ––––––––––––––––––
MR BEAN
INCOME STATEMENT FOR THE
PERIOD ENDED FIRST MONTH
Sales 4,300
Cost of sales 2,500
––––––––
Gross profit 1,800
Rent 300
––––––––
Net profit £1,500
––––––––––––––––
How did you construct the above? Probably by doing calculations on a
piece of paper to arrive at sales, cost of sales, inventory and bank figures.
Would the above have been as simple though if Mr Bean had made 100
sales during the month? Obviously the answer is no. Thus you have identified
that there is a need for a record of all Mr Bean’s transactions that will
enable a balance sheet and an income statement to be drawn up at the end
of any given period.
70 Financial Accounting
Mr Bean intends to set up in business as an antiques dealer. He places £20,000 of
his own money into a business bank account then purchases items for resale for
£12,000 and a van for £5,000. He rents a shop for £3,600 per annum paying the
first monthly instalment of rent. At the end of his first month of trading he is able to
identify the fact that he has sold for cash two items, one costing £2,000 for
£3,500, and one costing £500 for £800.
Draw up the balance sheet for Mr Bean as at the end of the first month’s trading
and an income statement for the period.
Activity 5.1
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Double entry system – duality
You learnt in Chapter 4 about the concept of duality.
Answer This was fairly straightforward. In the first case you created a liability of capital and the
asset of bank, in the second you reduced the asset of bank and created an asset of
van. There was a dual effect of each transaction to maintain the accounting equation:
ASSETS = CAPITAL + LIABILITIES
Double entry system – account
When you calculated the bank figure in Activity 5.1 you made a list of additions
to and subtractions from the bank probably similar to the following:
Additions Subtractions
Capital 20,000 Van 5,000
Sale 1 3,500 Purchases 12,000
Sale 2 800 Rent 300
––––––––– –––––––––
£24,300 £17,300
––––––––– –––––––––––––––––– –––––––––
Additions were sources of funds to the business and subtractions applications
of those funds from the business.
The above can be represented as an account in a double entry system
as follows:
BANK ACCOUNT
Capital 20,000 Van 5,000
Sale 1 3,500 Purchases 12,000
Sale 2 800 Rent 300
The left-hand side of this account is referred to as the debit side (debit
means ‘to give’ – I give (place) £20,000 to the bank account); the righthand
side as the credit side (credit means to receive – I receive £5,000 from
the bank to buy a van).
This bank account has enabled you to make a very neat recording of Mr
Bean’s dealings with the bank but has not recorded the duality of the above
transactions. Looking at the transaction of purchasing the van, you have credited
the bank account with £5,000, so to comply with duality it would seem
reasonable to suggest that you should debit another account with £5,000.
5 · The double entry system 71
Identify for Mr Bean the duality involved in the introduction of his capital into the
business and the purchase of his van.
Activity 5.2
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Thus:
VAN ACCOUNT
Bank 5,000
Answer PURCHASES ACCOUNT
Bank 12,000
RENT ACCOUNT
Bank 300
SALES ACCOUNT
Bank sale 1 3,500
Bank sale 2 800
CAPITAL ACCOUNT
Bank 20,000
The pattern of the above accounts is that of double entry. For each transaction
we have made a debit and a credit entry for the same amount, the
description (narrative) referring always to the other double entry account.
Using your knowledge of the duality concept, the accounting equation
and with reference to the double entry accounts used above you should be
able to complete the following activity without too much trouble.
72 Financial Accounting
Complete the duality for the other transactions in the bank account.Activity 5.3
Complete the following table:
Account Transaction Entry to account
Asset Addition Debit
Asset Subtraction (a)________
Liability Addition (b)________
Liability (c)________ Debit
Capital (d)________ Credit
Capital Subtraction (e)________
Expense Addition (f)________
Expense Subtraction (g)________
Income Addition (h)________
Income (i)________ Debit
Activity 5.4
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Answer The missing entries are as follows:
(a) Credit, (b) Credit, (c) Subtraction, (d) Addition, (e) Debit, (f) Debit, (g) Credit, (h)
Credit, (i) Subtraction.
Fairly easy we know, but we hope you thought about the activity rather than just following
the pattern.
Answer MISS COFFEE
BALANCE SHEET AS AT END OF FIRST MONTH
£ £
Non current assets
Car 8,000
Current assets
Inventory 23,000
Bank 10,500 33,500
–––––––– ––––––––
41,500
––––––––––––––––
Capital
Opening 40,000
Profit 1,500
––––––––
41,500
––––––––––––––––
MISS COFFEE
INCOME STATEMENT FOR THE PERIOD ENDED FIRST MONTH
£ £
Sales 5,000
Cost of sales 2,000
–––––––
Gross profit 3,000
Rent 1,000
Sundry expenses 500 1,500
––––––– –––––––
Net profit 1,500
––––––––––––––
5 · The double entry system 73
The following question is similar to Activities 5.1 and 5.3 and completing the question
will ensure that you have understood the concepts so far.
Miss Coffee intends to set up in business as a retailer of ladies’ high-class fashion.
She places £40,000 of her own money into a business bank account and then
purchases a car for £8,000 and inventory for £25,000. She rents property at
£12,000 per annum paying the first month’s rental. At the end of the first month of
trading she is able to identify that she has sold inventory worth £2,000 for £5,000
and paid sundry expenses of £500.
Draw up the balance sheet for Miss Coffee as at the end of the first month’s trading
and an income statement for the period together with the double entry accounts
for the period.
Activity 5.5
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BANK ACCOUNT
Capital 40,000 Car 8,000
Sales 5,000 Rent 1,000
Purch. 25,000
Sundry 500
RENT ACCOUNT
Bank 1,000
SUNDRY ACCOUNT
Bank 500
SALES ACCOUNT
Bank 5,000
CAR ACCOUNT
Bank 8,000
CAPITAL ACCOUNT
Capital 40,000
PURCHASES ACCOUNT
Bank 25,000
74 Financial Accounting
This question is provided for extra practice. Mr Pickup sets up in business as a website
designer. He places £25,000 of his own money into a business bank account
and then purchases a computer for £2,500 and a car for £10,000. He rents a small
office for £6,000 per annum and buys some furniture and other equipment for the
office costing £2,200. At the end of the second month of trading Mr Pickup is able
to identify that he has sold several website designs for a total of £7,500, he has
paid two months’ rent on the office and he has paid other expenses of £850.
Draw up the balance sheet for Mr Pickup as at the end of the second month of
trading and an income statement for the period together with the double entry
accounts for the period.
Activity 5.6
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Answer
MR PICKUP
BALANCE SHEET AS AT END OF SECOND MONTH
£ £
Non current assets
Car 10,000
Computer 2,500
Furniture and equipment 2,200 14,700
––––––––
Current assets
Bank 15,950
––––––––
30,650
––––––––––––––––
Capital
Opening 25,000
Profit 5,650
––––––––
30,650
––––––––––––––––
MR PICKUP
INCOME STATEMENT FOR THE PERIOD ENDED SECOND MONTH
£ £
Sales 7,500
Cost of sales 0
––––––
Gross profit 7,500
Rent 1,000
Sundry expenses 850 1,850
–––––– ––––––
Net profit 5,650
––––––––––––
BANK ACCOUNT
Capital 25,000 Car 10,000
Sales 7,500 Rent 1,000
Computer 2,500
Equipment 2,200
Sundry 850
RENT ACCOUNT
Bank 1,000
SUNDRY ACCOUNT
Bank 850
SALES ACCOUNT
Bank 7,500
5 · The double entry system 75
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CAR ACCOUNT
Bank 10,000
CAPITAL ACCOUNT
Capital 25,000
COMPUTER ACCOUNT
Bank 2,500
EQUIPMENT ACCOUNT
Bank 2,200
Credit transactions
So far the transactions you have dealt with for Mr Bean have all involved
cash as one side of the double entry.
A lot of business is carried out on credit. For example Mr Bean, when he
acquired £12,000 of goods, could well have paid only £5,000 immediately
and bought the rest on credit.
We account for this in the double entry system as follows:
PURCHASES ACCOUNT
Cash 5,000
Creditor 7,000
CASH ACCOUNT
Purchases 5,000
CREDITOR ACCOUNT
Purchases 7,000
Similarly sales may be made on credit so a debtor account would be created.
Note the creditor is a liability of the business and the debtor an asset.
It is also customary to maintain separate accounts for each debtor and each
creditor in the double entry system.
To help reinforce your understanding of the double entry system a full
example is provided below for you to work through as a self-check of
understanding. The suggested answer is provided at Activity 5.9 so if you
feel fairly confident in respect of your understanding so far you could wait
and complete Activities 5.7 and 5.9 together. By the way, it is normal in the
double entry system to enter the date against each entry made. The place
76 Financial Accounting
FNAC_CO5.QXD 12/10/05 10:23 am Page 76
where double entry accounts are recorded is generally known as a ledger.
This ledger is divided into sub-ledgers:
᭤ Creditors ledger – where we record the suppliers accounts (from whom
we have purchased supplies)
᭤ Debtors ledger – where we record the customers accounts (to whom we
have made sales)
᭤ Nominal ledger or impersonal ledger – where everything else is recorded.
We will return to this division of the ledger in Chapter 14.
Worked example of double entry
Answer The answer to the above is contained in the answer to Activity 5.9 but we suggest you
carry out the exercise now and check your answer later.
5 · The double entry system 77
Enter the following transactions in the ledgers of A. Bate, maintaining separate bank
and cash accounts.
£
March 3 Bate placed £20,000 in a business account
3 Bought car for £8,000, paying by cheque 8,000
4 Bought goods on credit from Hall 6,350
5 Paid cheque for office expenses 340
5 Paid cheque for car insurance 195
8 Cashed a cheque for cash 600
9 Cash received for sales 2,345
12 Sold goods on credit to White 1,645
14 Paid wages in cash 250
18 Cash received for sales 300
20 Banked excess cash
24 Bought goods on credit from Dunn 1,895
25 Cheque received from White 850
26 Cash sales 400
27 Paid wages in cash 250
28 Sold goods on credit: White 600
Black 750
29 Cash sales 250
30 Cheque sent: Hall 5,500
Dunn 1,500
31 Paid all cash into bank
Activity 5.7
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Balancing off accounts
You have now learnt how to record business transactions in the books but
you also need to know the following data at the end of a period:
᭤ what the cash balance is
᭤ what the total value of sales is that has been made
᭤ how much is owed to the creditors
᭤ how much debtors owe the business
᭤ what the total of expenses is.
To do this we need to balance off the accounts. Looking back at the bank
account we derived for you after Activity 5.2 we had:
BANK ACCOUNT
Capital 20,000 Van 5,000
Sale 1 3,500 Purchases 12,000
Sale 2 800 Rent 300
The left-hand side of this account (the debit) totals £24,300 and the credit
side (the right) £17,300. The difference is £7,000, the balance at the bank you
identified at Activity 5.1, an asset. You should also have noticed that the van,
another asset of the business, appeared in its double entry account as a debit
which implies that the asset of £7,000 at the bank has to appear as a debit.
The ‘balancing off’ takes place as follows:
BANK ACCOUNT
Capital 20,000 Van 5,000
Sale 1 3,500 Purchases 12,000
Sale 2 800 Rent 300
Balance carried down 7,000
––––––––– –––––––––
£24,300 £24,300
––––––––– –––––––––––––––––– –––––––––
Balance brought down 7,000
To check whether you understand what we did to balance the bank
account try the next activity.
Answer You should have identified a sequence similar to the following:
1 Add up both sides and identify the difference.
2 Enter the difference on the side with the smaller total (the credit side here).
3 Enter the totals for both sides – which are now identical.
4 Complete the double entry in respect of (2) by entering the same figure on the
opposite side (in this case the debit side) below the totals.
78 Financial Accounting
Identify the sequence that occurred to balance off the above bank account.Activity 5.8
FNAC_CO5.QXD 12/10/05 10:23 am Page 78
This balance brought down of £7,000 debit is the balance of cash at bank, an
asset of the business. Again it is normal to enter the date in the accounts
when balancing off the accounts, the carried-down date being that of the end
of the period and the brought-down date that of the start of the next period.
The rest of the accounts for Mr Bean are balanced as follows:
VAN ACCOUNT
Bank 5,000 Balance carried down 5,000
–––––– –––––––––––– ––––––
Balance brought down 5,000
PURCHASES ACCOUNT
Bank 12,000 Balance carried down 12,000
–––––––– –––––––––––––––– ––––––––
Balance brought down 12,000
RENT ACCOUNT
Bank 300 Balance carried down 300
–––– –––––––– ––––
Balance brought down 300
SALES ACCOUNT
Bank 3,500
Balance carried down 4,300 Bank 800
–––––––– ––––––––
£4,300 £4,300
–––––––– –––––––––––––––– ––––––––
Balance brought down 4,300
CAPITAL ACCOUNT
Balance carried down 20,000 Bank 20,000
–––––––– ––––––––
Balance brought down 20,000
Notice that when there is only one entry in an account there is no need to
enter the total for each side. It is also customary to abbreviate brought
down and carried down to b/d and c/d respectively. ‘Balance’ can also be
abbreviated to ‘bal’.
Answer The answer below is that for Activities 5.7 and 5.9.
CAPITAL ACCOUNT
Bal c/d 20,000 Bank 20,000
–––––––– –––––––––––––––– ––––––––
Bal b/d 20,000
5 · The double entry system 79
Balance off all the accounts for Activity 5.7.Activity 5.9
FNAC_CO5.QXD 12/10/05 10:23 am Page 79
OFFICE EXPENSE ACCOUNT
Bank 340 Bal c/d 340
––––– –––––––––– –––––
Bal b/d 340
CAR ACCOUNT
Bank/loan 8,000 Bal c/d 8,000
–––––– –––––––––––– ––––––
Bal b/d 8,000
INSURANCE ACCOUNT
Bank 195 Bal c/d 195
–––– –––––––– ––––
Bal b/d 195
LOAN ACCOUNT (note 2)
Balance c/d 5,000 Car 5,000
–––––– –––––––––––– ––––––
Bal b/d 5,000
WAGES ACCOUNT
Cash 250
Cash 250 Bal c/d 500
––––– –––––
£500 £500
––––– –––––––––– –––––
Bal b/d 500
PURCHASES ACCOUNT
Hall 6,350
Dunn 1,895 Bal c/d 8,245
–––––––– ––––––––
£8,245 £8,245
–––––––– –––––––––––––––– ––––––––
Bal b/d 8,245
SALES ACCOUNT
Cash 2,345
White 1,645
Cash 300
Cash 400
White 600
Black 750
Bal c/d 6,290 Cash 250
–––––––– ––––––––
£6,290 £6,290
–––––––– –––––––––––––––– ––––––––
Bal b/d 6,290
80 Financial Accounting
FNAC_CO5.QXD 12/10/05 10:23 am Page 80
DEBTOR – WHITE
Sales 1,645 Bank 850
Sales 600 Bal c/d 1,395
–––––––– ––––––––
£2,245 £2,245
–––––––– –––––––––––––––– ––––––––
Bal b/d 1,395
DEBTOR – BLACK
Sales 750 Bal c/d 750
–––– –––––––– ––––
Bal b/d 750
CREDITOR – HALL
Bank 5,500 Purchases 6,350
Bal c/d 850
–––––––– ––––––––
£6,350 £6,350
–––––––– –––––––––––––––– ––––––––
Bal b/d 850
CREDITOR – DUNN
Bank 1,500 Purchases 1,895
Bal c/d 395
–––––––– ––––––––
£1,895 £1,895
–––––––– –––––––––––––––– ––––––––
Bal b/d 395
BANK ACCOUNT
Capital 20,000 Car 3,000
Cash 2,995 Office 340
White 850 Insurance 195
Cash 400 Cash 600
Hall 5,500
Dunn 1,500
Bal c/d 13,110
––––––––– –––––––––
£24,245 £24,245
––––––––– –––––––––––––––––– –––––––––
Bal b/d 13,110
CASH ACCOUNT
Bank 600 Wages 250
Sales 2,345 Bank (note 1) 2,995
Sales 300 Wages 250
Sales 400 Bank (note 1) 400
Sales 250
–––––––– ––––––––
£3,895 £3,895
–––––––– –––––––––––––––– ––––––––
5 · The double entry system 81
FNAC_CO5.QXD 12/10/05 2:09 pm Page 81
Note 1 At this point the cash account had to be totalled to identify the balance that
was then paid into the bank.
Note 2 As the cost of the car was £8,000 but only £3,000 was paid in cash the
remaining £5,000 is identified as a loan.
The example we have given above consists of very few sales and purchases
but in an actual business there are likely to be many sales and purchases in a
day. For most businesses it is impossible to write up every sale as we have
here into the sales ledger but for now, in our simple examples, we will continue
to use the method above. You will see at Chapter 13 how we deal with
multiple sales and purchases to minimise the entries in the ledgers.
Trial balance
The double entry system follows the duality concept – for every debit there
is an equal credit – thus if the system has been carried out correctly the
total debit balances should equal the total credit balances. This check on the
operation of the system is known as a trial balance.
TRIAL BALANCE FOR MR BEAN AS AT (PERIOD END DATE)
Dr Cr
Sales 4,300
Capital 20,000
Van 5,000
Purchases 12,000
Rent 300
Bank 7,000
––––––––– –––––––––
£24,300 £24,300
––––––––– –––––––––––––––––– –––––––––
Answer TRIAL BALANCE AS AT 31 MARCH (A BATE)
Dr Cr
Capital 20,000
Bank 13,110
Office expenses 340
Car insurance 195
Car 8,000
Wages 500
Loan 5,000
Purchases 8,245
Sales 6,290
Creditors: Hall 850
Dunn 395
Debtors: White 1,395
Black 750
––––––––– –––––––––
£32,535 £32,535
––––––––– –––––––––––––––––– –––––––––
82 Financial Accounting
Construct the trial balances in respect of Activity 5.7.Activity 5.10
FNAC_CO5.QXD 12/10/05 10:23 am Page 82
Use of trial balance
If the totals of the trial balance agree, it does not necessarily prove that the
books are correct. What it will prove is that you have entered an equal
debit for every credit and that the accounts have been added correctly, but
there are several errors that could have been made that the trial balance
will not identify. It is also worth remembering that the trial balance is not
part of the double entry system itself.
Answer A little thought and you should have been able to identify that the trial balance will
reveal the following types of error:
᭤ Incorrect additions in an account as per item 1.
᭤ Posting (entering) one side only of the double entry as per item 2.
᭤ Entering a different amount in the debit side than the credit side, for example debit
£92 credit £29 as per item 3.
but will not reveal the following:
᭤ An entry completely missed as per item 4.
᭤ An entry in a wrong account but the double entry still maintained as per item 5.
᭤ Where errors cancel each other as per item 6.
᭤ Entries where the double entry is completely the wrong way round as per item 7.
5 · The double entry system 83
The following errors have been made in the books of Mr Bean. Identify those errors
that the use of a trial balance will reveal and those it will not.
1 The sales account has been incorrectly added.
2 The purchase of goods on credit was entered in the relevant creditor account but
not the purchases account.
3 Wages paid of £92 was debited as £92 to the wages account but as £29 credit
to the bank account.
4 The sale of goods for £100 on credit was not entered in the books at all.
5 An electricity bill was correctly credited to the bank account but the debit entry
was made to the office expenses account not the electricity account.
6 Goods for £50 were bought on credit and entered in the books as purchases
account debit £5 creditor account credit £50. Sales made of £50 cash were entered
in the cash account as debit £50 but as £5 to the credit of the sales account.
7 A loan made to Mr Bean of £1,000 from Mr Atkinson was debited to the loan
account and credited to the bank account.
Activity 5.11
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Income statement
At the very beginning of this chapter you were able to construct an income
statement and a balance sheet for Mr Bean (see Activity 5.1).
You did this by identifying the expenses to match with the income in
the income statement and identifying the assets and liabilities at the end of
the period and recording these in the balance sheet. In effect you made use
of the accounting equations:
PROFIT = INCOME – EXPENSES USED UP
ASSETS = CAPITAL + LIABILITIES + PROFIT
It is possible to treat the income statement as part of the double entry
system and transfer expenses and income to it maintaining the principles
of double entry. This would result in an income statement in what is
known as ‘horizontal format’. This is not the normal format that is used.
The normal format is ‘vertical format’. We identified this vertical format for
you in Chapter 3 and we will return to it again later in this chapter. We
must be careful though that we only transfer that expense used up in generating
the income – the accruals or matching concept. Refer back to
Chapter 4 here to refresh your memory on the accruals concept. In particular
we must be careful how much of the purchase expense we transfer.
Mr Bean, at Activity 5.1, had not sold all of the goods he bought, in fact
he has only sold goods costing £2,500. He therefore has goods remaining
of £9,500 which is not recorded as yet in the double entry system. This
figure of inventory could have been ascertained in one of two ways:
1 By counting the goods remaining in the shop and valuing them at the
cost Mr Bean paid.
2 By reducing the figure of purchases, each time a sale is made, by the purchase
price of that item sold.
When a business has several sales within a period the easiest method is to
count inventory at the end of the period (refer back to Chapter 3 for how
we did this).
This inventory figure is then entered in the books by the means of a
closing inventory account and the income statement is used to calculate
the cost of goods sold. The following demonstrates this.
SALES ACCOUNT
Income statement 4,300 Balance b/d 4,300
PURCHASES ACCOUNT
Balance b/d 12,000 Income statement 12,000
84 Financial Accounting
FNAC_CO5.QXD 12/10/05 10:23 am Page 84
RENT ACCOUNT
Balance b/d 300 Income statement 300
CLOSING INVENTORY ACCOUNT
Income statement 9,500
INCOME STATEMENT
Purchases 12,000 Sales 4,300
Gross profit c/d 1,800 Closing inventory 9,500
––––––––– –––––––––
£13,800 £13,800
––––––––– –––––––––––––––––– –––––––––
Rent 300 Gross profit b/d 1,800
Net profit c/d 1,500
––––––––– –––––––––
£1,800 £1,800
––––––––– –––––––––––––––––– –––––––––
Net profit b/d 1,500
Did you understand what we did here?
Answer Your sequence should have been similar to the following:
᭤ Transfer balance on sales account to income statement by debiting sales account
and crediting income statement.
᭤ Transfer balance on purchases by crediting this account and debiting income statement.
᭤ Enter closing inventory in the ledgers by debiting closing inventory account and crediting
income statement.
᭤ Balance off the income statement but call the balance Gross Profit, i.e. difference
between sales and cost of goods sold.
᭤ Transfer balance on rent account to income statement.
᭤ Balance off the income statement again calling balance Net Profit.
Let us see if you can do all this now.
5 · The double entry system 85
Identify the sequence carried out above to arrive at the net profit figure of £1,500.
For example the sequence will start:
᭤ Transfer balance on sales account to income statement by debiting sales account
and crediting income statement.
Activity 5.12
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Answer INCOME STATEMENT
FOR THE MONTH ENDED 31 MARCH
Purchases 8,245 Sales 6,290
Gross profit c/d 2,545 Closing inventory 4,500
––––––––– –––––––––
£10,790 £10,790
––––––––– –––––––––––––––––– –––––––––
Office expenses 340 Gross profit b/d 2,545
Car insurance 195
Wages 500
Net profit c/d 1,510
––––––––– –––––––––
£2,545 £2,545
––––––––– –––––––––––––––––– –––––––––
Net profit b/d 1,510
Format of the income statement
In Chapter 3 we discussed the format of the income statement. The above
income statement would normally be written as follows:
£ £
Sales 6,290
Purchases 8,245
Less closing inventory 4,500 3,745
––––––– ––––––––
Gross profit 2,545
Office expenses 340
Car insurance 195
Wages 500 1,035
––––––– ––––––––
Net profit £1,510
––––––––––––––––
This is known as a vertical income statement. It is perceived as being easier
for users to understand, and avoids the need to insert ‘carried down’ and
‘brought down’ figures.
86 Financial Accounting
Given that the closing inventory as at 31 March in Activity 5.9 for A. Bate is £4,500
draw up an income statement for the month ended 31 March.
Activity 5.13
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Balances remaining in the books
Having constructed an income statement for Mr Bean it is possible at this
point to extract another trial balance as follows:
Dr Cr
Capital 20,000
Inventory 9,500
Van 5,000
Bank 7,000
Net profit 1,500
––––––––– –––––––––
£21,500 £21,500
––––––––– –––––––––––––––––– –––––––––
Again just a minor leap in imagination and the above could be written as
follows:
BALANCE SHEET AS AT 31 MARCH
Non current assets
Van 5,000
Current assets
Inventory 9,500
Bank 7,000 16,500
––––––– –––––––––
£21,500
––––––––––––––––––
Capital 20,000
Profit 1,500
–––––––––
£21,500
––––––––––––––––––
Thus the balances remaining in the books, after having extracted an
income statement, form a balance sheet. The balance sheet records the
position of the business at a specific point in time.
5 · The double entry system 87
Draw up the balance sheet for the information contained in Activities relating to A.
Bate after the extraction of the income statement as at 31 March.
Activity 5.14
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Answer The balance sheet should look as follows:
BALANCE SHEET AS AT 31 MARCH
Non current assets £ £ £
Car 8,000
Current assets
Inventory 4,500
Debtors: White 1,395
Black 750 2,145
––––––
Bank 13,110
––––––––
19,755
Creditors: Hall 850
Dunn 395 1,245 18,510
–––––– –––––––– –––––––––
26,510
Loan 5,000
–––––––––
£21,510
––––––––––––––––––
Capital 20,000
Profit 1,510
–––––––––
£21,510
––––––––––––––––––
Summary
This chapter has introduced you to the double entry system of accounting.
Within it we:
᭤ have identified the need for the system when a business has several
transactions to account for
᭤ saw that it was based upon the concept of duality
᭤ have taken you through the workings of the ledgers
᭤ have balanced them off
᭤ have extracted a trial balance
᭤ have learnt that the income statement was in fact part of the double
entry system and that income and expense accounts were cleared by
being transferred to the income statement, recognising that the concept
of matching must be applied and
᭤ have illustrated the matching concept within the context of cost of sales.
The remaining balances in the ledgers then formed a balance sheet at the
end of the financial period. The two main statements extracted from all this
double entry, the income statement and the balance sheet, have also been
written in what is regarded as a ‘user friendly’ manner, i.e. vertical format.
All this has been rather ‘long winded’ and the accounts take time to
enter up. However, practice makes perfect, so we have provided several
questions below.
88 Financial Accounting
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Self-assessment questions
1 On 1.4.20X1 H Britton commenced a business dealing in subaqua equipment. He
paid £20,000 into the business bank account and the following transactions took
place during the month of April.
1st From previous owner bought shop £8,000, fixtures and fittings
£5,000 and stock £4,000 paying by cheque £17,000
£
2nd Withdrew cash from bank for shop use 500
Paid for stationery and other incidentals 175
3rd Sold goods for cash 450
4th Sold goods on credit to A Britton 650
5th Cash sales 250
Wages paid in cash 160
8th Bought goods for resale on credit from R Sevier 950
A Britton returned faulty goods 100
9th Cash sales 340
Paid sundry expenses in cash 80
10th Sold goods on credit to R Sewell 440
11th Returned goods to R Sevier 230
12th Cash sales 340
Wages paid in cash 160
Paid excess cash into bank
15th Sold goods on credit to S Boatman 260
16th Bought goods for resale from P Ocean 1,500
17th Paid cheque on account to R Sevier 500
Received cheque on account from A Britton 400
18th Cash sales 550
Office expenses paid in cash 60
19th Paid wages in cash 160
22nd S Boatman paid on account by cheque 50
Paid P Ocean by cheque 900
Cash sales 850
24th Wages paid in cash 160
Office expenses paid in cash 50
Withdrew cash for personal use 400
25th Paid excess cash into bank account
Inventory on hand 30 April cost £3,500
5 · The double entry system 89
double entry (p. 71)
account (p. 71)
credit transactions (p. 76)
ledger (p. 77)
balance off (p. 78)
trial balance (p. 82)
closing inventory account (p. 84)
Key terms
FNAC_CO5.QXD 12/10/05 10:23 am Page 89
Required
(a) Record the above transactions in the ledger accounts of H Britton maintaining
separate cash and bank accounts and separate accounts for returned goods.
(b) Balance off the ledger accounts as at 30 April and extract a trial balance.
(c) Prepare the income statement for the month ended 30 April and close off all
revenue and expense accounts.
(d) Prepare a balance sheet as at 30 April.
2 On 1.6.X1 D Alex commenced a business dealing in IT software. He paid £50,000
into the business bank account and the following transactions took place during the
first week of June.
1 June Purchased premises for £25,000 from previous owner
including £6,000 for furniture and fittings.
Purchased inventory for £10,000 and further furniture and
fittings £2,000.
All transactions above were completed by cheque.
£
2 June Withdrew cash from bank for shop use 400
Paid for sundry incidentals 90
Sold goods for cash 300
Sold goods on credit to Roberts 100
3 June Bought goods for resale on credit from Davids 600
Sold goods for cash 550
4 June Sold goods for cash 400
Sold goods on credit to Richards 350
Paid office expenses in cash 70
5 June Received cheque from Roberts 60
Paid cheque on account Davids 250
Sold goods for cash 200
Sold goods on credit Martin 480
Bought goods for cash 250
Paid all excess cash into bank
6 June Stock on hand at cost 9,500
Required
(a) Record the above transactions in the ledger accounts of D. Alex maintaining
separate cash and bank accounts.
(b) Balance off the ledger accounts as at 5 June X1 and extract a trial balance.
(c) Prepare the income statement for the week ended 5 June X1 and close off all
revenue and expense accounts.
(d) Prepare the balance sheet as at 5 June X1.
3 Explain why businesses have a need for a system of double entry accounting/
bookkeeping.
4 Complete the following:
The double entry system of accounting is based on the concept of ……
90 Financial Accounting
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5 What is the accounting equation?
6 A debit balance b/d on a double entry account is:
(a) an asset or expense
(b) a liability or income?
7 Explain the need for a trial balance.
8 What types of errors will the trial balance not reveal?
9 The following trial balance has been extracted from the ledgers of Narn as at
31 March 200X.
£ £
Sales 79,000
Purchases 32,000
Inventory 1st April 200W 2,700
Salaries and wages 15,600
Heating and lighting 3,600
Rent 10,400
Other expenses 2,300
Fixtures and fittings 5,600
Vehicles 10,900
Motor expenses 4,500
Debtors 6,600
Creditors 5,700
Capital injection by Narn 15,000
Bank and cash 5,500
–––––––– ––––––––
99,700 99,700
–––––––– –––––––––––––––– ––––––––
Required
Prepare the income statement and the balance sheet for Narn as at 31 March 200X
given that inventory at 31 March 200X was £4,200.
10 In the trial balance given at question 9 the following issues were discovered.
᭤ An item of sale had been correctly entered in the cash ledger but had been
entered in the sales account as at £4,500 instead of £5,400.
᭤ A debtor had been entered on the ledgers as owing £2,300 instead of £3,200.
The sale had been correctly entered in the ledgers.
᭤ The book-keeper had failed to record an office expense of £450 in the ledger
although the item had been entered in the cash account.
᭤ The book-keeper had debited £225 to the bank account instead of crediting it.
Required
Correct the trial balance of Narn as at 31 March 200X and redraw the income statement
and balance sheet.
Answers to these questions can be found at the back of this book.
5 · The double entry system 91
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92 Financial Accounting
6
Adjustments, including entries in
ledger accounts
Introduction
Chapter 5 introduced you to the double entry system of bookkeeping. This
chapter intends to build on that knowledge and expertise gained and also
to further develop the concepts and conventions of accounting in relation
to this double entry system.
So far we have assumed, with the exception of the inventory adjustment
that we looked at in Chapter 5, that all entries made in the ledger for
assets, liabilities, expenses and income relate to the period for which you
wish to extract an income statement and balance sheet and that no items
are missing. This is an incorrect assumption!
Accruals and prepayments
In the previous chapter all the expenses for Mr Bean’s business entered the
ledger accounts via the cash or bank account and the assumption was
made that these related to sales, and were used up by Mr Bean in achieving
those sales.
By the end of this chapter you should be able to:
᭤ Identify the need for adjustments to ledger accounts.
᭤ Understand the nature of prepayments and accruals.
᭤ Describe the necessity for adjustments for bad and doubtful debts.
᭤ Define depreciation.
᭤ Carry out the required ledger entries for depreciation.
᭤ Balance off all ledger accounts after adjustments.
᭤ Understand the nature of any balance remaining.
Objectives
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However, many expenses may be recorded as they are paid but may not
relate, match, to the period in question. This was true in the case of purchases.
Mr Bean may have purchased £12,000 of goods during a period but
he did not use up all those purchases in achieving his sales. He had some
purchases left, i.e. inventory. We accounted for this by making an adjustment
to the accounts. An inventory account was debited with the amount
of inventory in the warehouse and the same figure was credited to the
income statement. The closing inventory also appeared on the balance
sheet as it was a balance remaining after extracting the income statement at
the period end. Closing inventory is an example of a prepayment. We have
acquired the inventory but not yet used it up in generating revenues.
Answer This was quite tricky if you gave a full answer to the question.
᭤ The rent payment related to the year from 1.7.X5 so some of this needs matching
to the period in question – six months of it, i.e. £100. The other £100 will need
matching to the income of the next year. Mr Bean has in fact prepaid his rent.
᭤ The electricity amount paid does need matching to the period in question. A very
interesting question is what about the electricity expense that was presumably used
up in December. Mr Bean will not pay for this until after he receives his next quarterly
bill – presumably in March X6 – so there is no reference to this expense within
the ledgers as yet. There should be if expenses are to be correctly matched. An
accrual of one month’s electricity charge is required.
᭤ Only nine months of the insurance premium needs matching to the income for the
period ended 31.12.X5. The other three months will relate to next year’s accounts.
Again Mr Bean has prepaid part of his insurance.
The prepayments identified above, for insurance and rent, will need adjusting
for in the ledger accounts of Mr Bean in order to correctly match expense
with income achieved. The electricity account will also need an adjustment
otherwise the 12-month expense for electricity will not be matched, only 11
months. For the electricity an accrual is required. Adjustments for accruals
and prepayments are necessary to ensure compliance with the matching
concept. The adjustments for accruals and prepayments within the ledger
accounts can at first sight appear rather confusing but as long as you think
very carefully about the period an expense relates to rather than its payment
date you should find no difficulty with it.
6 · Adjustments, including entries in ledger accounts 93
Identify whether the following payments made by Mr Bean during the period 1.1.X5
to 31.12.X5 actually relate (need to be matched) to any income achieved in that
period and, if so, how much?
᭤ Rent of £200 paid on 1.7.X5 relating to the period 1.7.X5 – 30.6.X6.
᭤ Electricity paid 14.12.X5 relating to the period 1.9.X5 – 30.11.X5.
᭤ Car insurance paid 1.4.X5 relating to the annual premium for the car purchased
on that date.
Activity 6.1
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Adjustment to ledger accounts
The following example shows the necessary ledger adjustments for accruals
and prepayments. An activity then follows asking you to carry out some
adjustments. Work through the example and activity carefully.
Mr Carn has set up in business as a florist and the annual rental for shop premises is
£2,000. This rental is paid by Mr Carn as follows:
᭤ £500 5.4.X5
᭤ £500 10.7.X5
᭤ £500 11.10.X5
The remaining £500 Mr Carn expects to pay sometime in January X6.
The three rental payments above will have been entered into the ledger accounts
when they are paid, by crediting the bank account and debiting the rent expense
account. (See Chapter 5 if you need to refresh your memory on double entry.)
The rent account will appear as follows:
RENT ACCOUNT
5.4. Bank 500
10.7. Bank 500
11.10. Bank 500
Mr Carn wishes to draw up an income statement for the year ended 31.12.X5. To
do this you saw in Chapter 5 that the expense accounts were balanced off and the balance
transferred to the income statement – a double entry account.
If the rent account as above is balanced off then the balance will be £1,500 and
this will be transferred to the income statement. However, this would not be the
matched expense for rent for the year. An accrual of £500 needs to be made, i.e. the
remainder of the rent that is due for the period but will not be paid until January X6.
RENT ACCOUNT
5.4. Bank 500
10.7. Bank 500
11.10. Bank 500
31.12. Accrual c/d 500 31.12. Income statement 2,000
–––––––– ––––––––
£2,000 £2,000
–––––––– –––––––––––––––– ––––––––
1.1. Accrual b/d 500
This account now shows that the expense transferred to the income statement is the
matched expense of £2,000 and that there is a balance on the account on the credit
side of £500 as at 1 January. This arose because duality had to be maintained. An entry
was made on the debit side of the account for the accrual of £500 and duality demands
that an equal and opposite entry also be made – this is the credit entry below the balance
on the account. This credit balance of £500 will appear in the balance sheet as at
31.12.X5 as a liability, as it is an amount that is owed in respect of the period.
94 Financial Accounting
Example 6.1
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Mr Carn has also made a payment of £600 on 1.4.X5 for his annual car insurance
premium.
This again will be entered into the ledger via the bank account and the car insurance
account will appear as follows:
CAR INSURANCE ACCOUNT
1.4. Bank 600
However, only part of this premium relates to the period for which we wish to draw
up the income statement. There is a prepayment of £150. This is reflected in the
ledger accounts as follows:
CAR INSURANCE ACCOUNT
1.4. Bank 600 31.12. Prepaid c/d 150
31.12. Income statement 450
–––––– ––––––
£600 £600
–––––– –––––––––––– ––––––
1.1. Prepaid b/d 150
The duality concept again gives rise to a balance on the account but this time it is a
debit balance b/d as £150 has been paid in advance. This prepayment will form an
expense of the next period and will appear on the balance sheet at 31.12.X5 under
current assets.
6 · Adjustments, including entries in ledger accounts 95
Example 6.1
continued
Tom, a greengrocer, wishes to prepare his income statement for the year ended
31.10.X5 and balance sheet as at that date.
During the year he has made the following payments:
᭤ Rent £1,200 for the period 1.1.X5 to 31.12.X5.
᭤ Wages £1,020, £20 owing as at 31.10.X5.
᭤ General expenses £470, £50 owing as at 31.10.X5.
᭤ Electricity for three quarters £900.
᭤ Telephone rental, quarterly in advance, £18 paid 1.11.X4, 1.2.X5, 1.5.X5, 1.8.X5
and 28.10.X5.
᭤ Telephone calls, quarterly in arrears, £55 1.2.X5, £65 1.5.X5, £60 1.8.X5.
Show the ledger accounts for all these payments and balance them off at the year
end, 31.10.X5. Clearly show the matched transfer to the income statement for the
period and identify where balances, if any, on these ledger accounts will appear in
the balance sheet.
Activity 6.2
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Answer RENT ACCOUNT
31.10.X5 Bank 1,200 31.10.X5 Income statement 1,000
31.10.X5 Bal c/d 200
–––––––– ––––––––
£1,200 £1,200
–––––––– –––––––––––––––– ––––––––
1.11.X5 Bal b/d 200
WAGES ACCOUNT
31.10.X5 Bank 1,020 31.10.X5 Income statement 1,040
31.10.X5 Bal c/d 20
–––––––– ––––––––
£1,040 £1,040
–––––––– –––––––––––––––– ––––––––
1.11.X5 Bal b/d 20
GENERAL EXPENSES ACCOUNT
31.10.X5 Bank 470
31.10.X5 Bal c/d 50 31.10.X5 Income statement 520
–––––– ––––––
£520 £520
–––––– –––––––––––– ––––––
1.11.X5 Bal b/d 50
TELEPHONE RENTAL ACCOUNT
1.11.X4 Bank 18
1.2.X5 Bank 18
1.5.X5 Bank 18
1.8.X5 Bank 18 31.10.X5 Income statement 72
28.10.X5 Bank 18 31.10.X5 Bal c/d 18
––––– –––––
£90 £90
––––– –––––––––– –––––
1.11.X5 Bal b/d 18
TELEPHONE CALLS ACCOUNT
1.2.X5 Bank 55
1.5.X5 Bank 65
1.8.X5 Bank 60
31.10.X5 Bal c/d 60 31.10.X5 Income statement 240
–––––––– ––––––––
£240 £240
–––––––– –––––––––––––––– ––––––––
1.11.X5 Bal b/d 60
96 Financial Accounting
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BALANCE SHEET EXTRACT AS AT 31.10.X5
£
Current assets
Prepayments: Rent 200
Telephone rentals 18
––––––––––
218
Current liabilities
Accruals: Wages 20
General 50
Telephone calls 60
––––––––––
130
Note that the accruals and prepayments b/d will appear as the first item on
the ledger account for the next period and will automatically adjust the
accounts for the next period. These accrual and prepayment balances must
never be ignored! They exist as a liability or asset in the books in the same
way as a creditor or a non-current asset. If you ignore them your trial balance
will not balance nor will your balance sheet. The final activity within
this section involves providing definitions in your own words for accruals
and prepayments.
Answer Your definitions should have been similar to the following:
᭤ Accrual – the addition necessary to the cash paid to ensure that all expense used
up in generating revenue is matched with that revenue. The accrual will be a liability,
an amount owing at the end of the period.
᭤ Prepayment – the reduction necessary to the cash paid when payments have been
made in advance but the expense has not been used up in generating revenue. The
prepayment will appear as an asset at the end of the period.
You must also note at this point that accruals and prepayments can also occur in
respect of items of income. For example, a business may own some property, an asset,
which it rents to another business. This rent receivable will be income to the business
owner but could be cash paid in arrears or in advance. If in arrears then at the end of
the period an adjustment will be made to accrue the rent receivable, if in advance an
adjustment of a prepayment will be required.
A simple example follows to illustrate this.
6 · Adjustments, including entries in ledger accounts 97
In your own words provide a definition for an ‘accrual’ and a ‘prepayment’.Activity 6.3
FNAC_CO6.QXD 12/10/05 10:24 am Page 97
A Flower rents part of his business premises, which he owns, to A Carn at an annual
rental of £2,400. This rental is payable quarterly in arrears commencing 1.4.X5.
Show the ledger account for rents receivable in A Flower’s books with the year-end
adjustments necessary for the year ended 31.12.X5 assuming all payments are
received on their due dates.
RENTS RECEIVABLE ACCOUNT
1.4.X5 Bank 600
1.7.X5 Bank 600
1.10.X5 Bank 600
31.12.X5 Income statement 2,400 31.12.X5 Accrued c/d 600
–––––––– ––––––––
£2,400 £2,400
–––––––– –––––––––––––––– ––––––––
1.1.X6 Accrued b/d 600
One further point to note is that the main item of revenue for a business, sales
income, has already had any revenue owing accrued in the books by the introduction
of debtors into the system. So neither accruals nor prepayment adjustments are usually
necessary for sales income.
However, other adjustments are required in respect of debtors, but before dealing
with this we provide a practice question incorporating accruals and prepayments in
respect of both expenses and income.
Answer RENTS PAID
10.1.X1 Bank 5,000 1.1.X1 Balance b/d 2,500
15.12X1 Bank 6,000 31.12.X1 Balance c/d 3,000
31.12.X1 Income statement 5,500
–––––––– ––––––––
11,000 11,000
–––––––– –––––––––––––––– ––––––––
1.1.X2 Balance b/d 3,000
98 Financial Accounting
Example 6.2
Mr Wong a sole trader with a year end of 31.12.X1 has the following items of cash
paid and received in his ledgers:
᭤ Rent paid 10.1.X1 £5,000 relating to the year 1.7.X0 to 30.6.X1 and rent paid
15.12.X1 £6,000 relating to year from 1.7.X1.
᭤ Rent received of £12,000 on 1.6.X1 relating to the year from 1.3.X1.
᭤ Electricity paid quarterly in arrears: 7.1.X1 £320, 5.4.X1 £300, 3.7.X1 £280,
4.10.X1 £260, and 28.12.X1 £310.
Show the ledger accounts for the above in Wong’s ledgers with the year-end adjustments
necessary for the year ended 31.12.X1. Note you may also need to make
some pre-year adjustments as at 1.1.X1.
Activity 6.4
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RENTS RECEIVED
31.12.X1 Income statement 10,000 1.6.X1 Bank 12,000
31.12.X1 Balance c/d 2,000
–––––––– ––––––––
12,000 12,000
–––––––– –––––––––––––––– ––––––––
1.1.X2 Balance b/d 2,000
ELECTRICITY ACCOUNT
7.1.X1 Bank 320 1.1.X1 Balance b/d 320
5.4.X1 Bank 300 31.12.X1 Income statement 1,150
3.7.X1 Bank 280
4.10.X1 Bank 260
28.12.X1 Bank 310
–––––– ––––––
1,470 1,470
–––––– –––––––––––– ––––––
Adjustments for bad and doubtful debts
The point at which you have recognised sales in the business books, generally
at the point of delivery or invoicing of the goods, rather than the
point at which cash is received gives rise to the next lot of adjustments to
the year end accounts.
Recognising sales before cash has been received has introduced debtors
into the books but there may be a possibility that some of these debtors may
not pay the amounts due. Under the concept of prudence an allowance for
this possibility must be made, but how much does this allowance need to
be? This problem can be broken down into two parts.
Bad debts
Some debts can be identified as bad debts, that is, the debtor will never pay
what he owes as he has been declared bankrupt or cannot be traced. These
bad debts are a normal part of business today and like all other expenses of
a business must be charged as an expense to the income statement.
See if you can complete the following activity without an example first.
6 · Adjustments, including entries in ledger accounts 99
A Flower has several debtor accounts within his books. Two of these debtors, A Carn
and P Rose, who owe respectively £250 and £130, have both been declared bankrupt
and there is no possibility that these debts will be paid. Show the adjustments
necessary in the accounts of A Flower as at the year end, 31.12.X5, to deal with
these bad debts.
A hint – use a ledger account entitled bad debt account to make the required
adjustments.
Activity 6.5
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Answer A CARN ACCOUNT
31.12.X5 Balance £250 31.12.X5 Bad debts £250
–––––– –––––––––––– ––––––
P ROSE ACCOUNT
31.12.X5 Balance £130 31.12.X5 Bad debts £130
–––––– –––––––––––– ––––––
BAD DEBTS ACCOUNT
31.12.X5 A Carn 250
31.12.X5 P Rose 130 31.12.X5 Income statement 380
–––––– ––––––
£380 £380
–––––– –––––––––––– ––––––
As you can see, a bad debt account is set up to which the bad debts are transferred
at the year end. This bad debt account is then cleared to the income statement as it is
an expense of trading.
Sometimes it is possible to find a situation where part of a debt will be paid
and the remainder will be declared bad. This quite often occurs in bankruptcy
situations where creditors receive a proportion of what they are
owed. For example, it could have been the case that P Rose was able to pay
50p in the pound in respect of his debts, in which case P Rose’s account
would have been adjusted as follows:
P ROSE ACCOUNT
31.12.X5 Balance 130 31.12.X5 Bad debts 65
31.12.X5 Balance c/d 65
–––––– ––––––
£130 £130
–––––– –––––––––––– ––––––
1.1.X6 Balance b/d 65
The balance of £65 will remain as a collectable debt on P Rose’s account
as it is expected he will pay this amount in the future.
Provision for bad debts
In addition to adjusting for debts that you know are bad, a provision in
respect of amounts owing that may turn out to be bad is also required. This
provision for bad debts is to accord with prudence and ensure that assets
are not overstated in the balance sheet. The problem is, how does the business
assess the amount of debts that may turn out to be bad; how much
provision do they need to make?
Businesses generally assess the amount of debts that may turn out to be
bad by looking at the length of time a debt has been outstanding and making
an estimate based on past experience of the probability of a debt turning bad.
100 Financial Accounting
FNAC_CO6.QXD 12/10/05 10:24 am Page 100
By doing this a trader could arrive at the conclusion that of the balance of
debtors at the year end there is a probability that 2% could turn out bad. A
provision will then be made for this amount of 2%, but the debtors’ balances
will not be reduced as the trader still hopes to recover the debts. He is just
being prudent by making a provision for any bad debts that could occur.
Let’s see how this works in the books.
A Flower has a total debtors balance of £11,600 at the year end after writing off the
bad debts. From past experience he estimates that 2% of these debtors may be bad.
He therefore needs to make a provision for bad debts of £232. Note that the provision
is calculated after taking account of bad debts! To make this provision the accounting
entries necessary are:
᭤ Credit provision for bad debts account.
᭤ Debit income statement.
PROVISION FOR BAD DEBTS ACCOUNT
31.12.X5 Balance c/d 232 31.12.X5 Income statement 232
–––––– ––––––
£232 £232
–––––– –––––––––––– ––––––
1.1.X6 Balance b/d 232
You must note that this provision for bad debts account will have a balance on it at the
year end and this must be shown, as all other balances, on the balance sheet. It is
customary to show this provision together with the debtors balance as follows:
A FLOWER BALANCE SHEET EXTRACT AS AT 31.12.X5
Current assets £ £
Debtors 11,600
Less provision for bad debts 232 11,368
––––––– –––––––
Provision for bad debts after the first year
This provision for bad debts of £232 will form part of the ledgers for the
following year of A Flower, and at the end of the next year a further estimate
for bad debts will be made.
Suppose that at 31.12.X6 A Flower has a debtors balance of £12,400 after
writing off bad debts, and estimates that 2% of these debtors may not pay,
i.e. £248.
In the ledgers there is already a provision for £232 from the previous
year and therefore the only adjustment necessary at 31.12.X6 is to increase
this provision to £248 by crediting the provision account and debiting
profit and loss with £16.
6 · Adjustments, including entries in ledger accounts 101
Example 6.3
FNAC_CO6.QXD 12/10/05 10:24 am Page 101
PROVISION FOR BAD DEBTS ACCOUNT
1.1.X6 Balance b/d 232
31.12.X6 Balance c/d 248 31.12.X6 Income statement 16
––––– –––––
£248 £248
––––– –––––––––– –––––
1.1.X7 Balance b/d 248
Again a practice question for you with the answers below. This practice
question incorporates adjustments in respect of bad debts and provision
for bad debts.
Answer DEBTORS
30.6.X1 Balance b/d 7,900 30.6.X1 Bad debt 250
30.6.X1 Bad debt 90
30.6.X1 Balance c/d 7,560
––––––– –––––––
7,900 7,900
––––––– –––––––––––––– –––––––
1.7.X1 Balance b/d 7,560
PROVISION FOR BAD DEBTS
1.7.X0 Balance b/d 145
30.6.X1 Balance c/d 151 30.6.X1 Income statement 6
––––– –––––
151 151
––––– –––––––––– –––––
1.7.X1 Balance b/d 151
BAD DEBTS
30.6.X1 Wong 250 30.6.X1 Income statement 340
30.6.X1 Hue 90
––––– –––––
340 340
––––– –––––––––– –––––
102 Financial Accounting
As at 30.6.X1 Mr Wong’s debtor balance was £7,900. Within this amount he notes
that Lee, who owes £250, has recently been declared bankrupt as has Hue who
owes £90. Wong currently estimates his provision for bad debts at 2% of debtors
after writing off bad debts. The provision for bad debts in the books at 1.7.X0 was
£145. Show the ledger accounts in relation to the above with the necessary yearend
adjustments.
Activity 6.6
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Answer DEBTORS
31.12.X1 Balance b/d 43,900 31.12.X1 Bad debt 2,500
31.12.X1 Bad debt 900
31.12.X1 Balance c/d 40,500
–––––––– ––––––––
43,900 43,900
–––––––– –––––––––––––––– ––––––––
1.7.X1 Balance b/d 40,500
PROVISION FOR BAD DEBTS
31.12.X1 Income statement 585 1.1.X1 Balance b/d 1,800
31.12.X1 Balance c/d 1,215
––––––– –––––––
1,800 1,800
––––––– –––––––––––––– –––––––
1.7.X1 Balance b/d 1,215
BAD DEBTS
31.12.X1 Orchard 2,500 31.12.X1 Income statement 3,400
31.12.X1 Lea 900
––––––– –––––––
3,400 3,400
––––––– –––––––––––––– –––––––
This activity was slightly different from Activity 6.6 as instead of the provision
for bad debts being increased this year it is in fact reduced. This
required a credit to the income statement for £585. Note the income statement
is also debited with the bad debts that have materialised of £3,400 so
that the net charge to the income statement for the year is £2,815.
Depreciation
Another adjustment that is required at the year end is depreciation. But
what is depreciation?
In Chapter 5, Mr Bean purchased a van for £5,000 for use in his business.
This van was regarded as an asset of the business and was shown on
the balance sheet as a non-current asset at the amount it was purchased
for. If this van is not sold by Mr Bean, then after several years, unless an
adjustment is made in the accounts, it will still be shown on the balance
sheet as an asset of £5,000, but it may in fact be quite useless if it has come
6 · Adjustments, including entries in ledger accounts 103
As at 31.12.X1 Mr Martin’s debtor balance was £43,900. Within this amount he
notes that Orchard, who owes £2,500, has recently been declared bankrupt as has
Lea who owes £900. Martin currently estimates his provision for bad debts at 3% of
debtors after writing off bad debts. The provision for bad debts in the books at
1.1.X1 was £1,800. Show the ledger accounts in relation to the above with the necessary
year-end adjustments.
Activity 6.7
FNAC_CO6.QXD 12/10/05 10:24 am Page 103
to the end of its useful life. In other words non-current assets generally
have a finite life and are therefore used up in the business. An estimate of
the amount of this use in each year must be made and charged to the
income statement for the year in the same way as all other expenses that
are used up are matched to the revenue they generate. This estimate of
usage of fixed assets is known as depreciation.
Answer Depreciation is an assessment of the amount of a non-current asset used up in a
period by a business as it earns revenue.
Depreciation estimate
How is the estimate of depreciation arrived at?
Answer There are several factors that you could have chosen from:
᭤ Original cost of asset – the amount used up will obviously depend on the amount
originally paid for the asset. The expense of depreciation will be greater for a more
expensive van.
᭤ Life of the asset – the longer the use of the asset in the business then the lower the
depreciation charge in each period.
᭤ Residual value of asset at the end of its useful life – the total amount of the asset
used up in the business will be the original cost less any resale value at the end of
its useful life.
᭤ Method of use of the asset – the charge for each period will depend upon how the
asset is used in each period. For example, the asset may be used up more in the
first period than in the second. This will need reflecting in the depreciation charge.
The business has to combine all these factors in order to arrive at the depreciation
charge. The method of combination may well be different for each
business as each business will use the asset in a unique way. Thus there are no
rules that state how each type of asset should be depreciated. Within accounting
practice there are two methods of combining these factors which are
quite popular: straight line and reducing balance, but there are others.
104 Financial Accounting
Provide a definition for the term ‘depreciation’ as it is used in accounting.Activity 6.8
Identify two factors that you think will influence the estimate of depreciation to be
charged in a period.
Activity 6.9
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Straight line method
The straight line method assumes that the asset is used evenly throughout its
useful life and allocates cost less residual value over the useful life of the asset
providing an estimate of depreciation that is the same for each period of use.
Answer Depreciation = £(10,000 – 1,500)/5
= £1,700 per annum
Reducing balance method
The reducing balance method assumes that more of the asset is used up in
the first period than the next and so on. It is calculated by applying a fixed
percentage to the reducing balance of the asset. This is easiest to explain by
the use of an example.
An asset is purchased for £8,000 and is estimated to have a residual value of £2,000
at the end of its useful life of four years. The percentage charge for depreciation will be
30% applied to the reducing balance of the asset as follows:
Cost at beginning of Year 1 8,000
Depreciation charge Year 1, 30% × 8,000, 2,400
––––––––
Reducing balance Year 2, 8,000 – 2,400, 5,600
Depreciation charge Year 2, 30% × 5,600, 1,680
––––––––
Reducing balance Year 3 3,920
Depreciation charge Year 3, 30% × 3,920, 1,176
––––––––
Reducing balance Year 4 2,744
Depreciation charge Year 4, 30% × 2,744, 823
––––––––
Reducing balance end of Year 4 £1,921
––––––––––––––––
The reducing balance at the end of Year 4 should have equated to the residual
value of £2,000. It didn’t as the percentage depreciation figure used was rounded for
ease of calculation. The percentage charge for reducing balance depreciation is calculated
from the following formula:
r = 1 –
n
s / c
where:
r = percentage; r = 1 –
4
2,000 / 8,000
n = useful life; r = 1 –
4
0.25
s = residual value; r = 1 – 0.707107
c = original cost r = 29.2893%
There are other methods of calculating depreciation but the two identified above will
suffice for your studies at this stage.
6 · Adjustments, including entries in ledger accounts 105
An asset was purchased for £10,000 on 1.1.X0 and has an estimated residual value
of £1,500 at the end of its useful life of five years. Calculate the depreciation charge
for each year assuming the straight line method.
Activity 6.10
Example 6.4
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Ledger entries for depreciation
Having identified a figure for depreciation this must now be entered in the
ledger accounts as a period end adjustment so as to charge depreciation as
an expense to the income statement for the period.
Answer You need to identify another provision account here as you did for provision for bad
debts. A provision for depreciation account is created and credited with the provision.
ASSET ACCOUNT
1.1.X0 Bank £10,000 31.12.X0 Balance c/d £10,000
––––––––– –––––––––
1.1.X1 Balance b/d £10,000 31.12.X1 Balance c/d £10,000
––––––––– –––––––––––––––––– –––––––––
1.1.X2 Balance b/d £10,000
PROVISION FOR DEPRECIATION ACCOUNT
31.12.X0 Balance c/d £1,700 31.12.X0 Income statement £1,700
–––––––– –––––––––––––––– ––––––––
1.1.X1 Balance b/d 1,700
31.12.X1 Balance c/d 3,400 31.12.X1 Income statement 1,700
–––––––– ––––––––
£3,400 £3,400
–––––––– –––––––––––––––– ––––––––
1.1.X2 Balance b/d £3,400
Note how the asset account remains at its original amount in the ledgers and that the
provision for depreciation account increases each period as further charges are made
to the income statements.
These two accounts will be reflected in the balance sheet as at 31.12.X0 and
31.12.X1 as follows:
BALANCE SHEET EXTRACT AS AT 31.12.X0
£
Asset 10,000
Depreciation 1,700
––––––––
Net book value 8,300
––––––––––––––––
BALANCE SHEET EXTRACT AS AT 31.12.X1
£
Asset 10,000
Depreciation 3,400
––––––––
Net book value 6,600
––––––––––––––––
106 Financial Accounting
If the depreciation estimate is debited to the income statement in a period identify
where the equal and opposite credit entry will be made. Show the entries in the
accounts for the period ending 31.12.X0 and 31.12.X1 for the straight line example
used in Activity 6.10.
Activity 6.11
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The above is quite often written in columnar form as follows:
Cost Depreciation Net book value
£ £ £
Non-current asset 10,000 3,400 6,600
Answer PREMISES
Yr 1 Bank 40,000 Balance c/d 40,000
–––––––– –––––––––––––––– ––––––––
Yr 2 Balance b/d 40,000 Balance c/d 40,000
–––––––– –––––––––––––––– ––––––––
Yr 3 Balance b/d 40,000
EQUIPMENT
Yr 1 Bank 10,000 Balance c/d 10,000
–––––––– –––––––––––––––– ––––––––
Yr 2 Balance b/d 10,000 Balance c/d 10,000
–––––––– –––––––––––––––– ––––––––
Yr 3 Balance b/d 10,000
VEHICLES
Yr 1 Bank 12,000 Balance c/d 12,000
–––––––– –––––––––––––––– ––––––––
Yr 2 Balance b/d 12,000 Balance c/d 12,000
–––––––– –––––––––––––––– ––––––––
Yr 3 Balance b/d 12,000
DEPRECIATION PREMISES
Yr 1 Balance c/d 700 Income statement 700
––––––– –––––––––––––– –––––––
Yr 2 Balance c/d 1,400 Balance b/d 700
Income statement 700
––––––– –––––––
1,400 1,400
––––––– –––––––––––––– –––––––
Balance b/d 1,400
6 · Adjustments, including entries in ledger accounts 107
C Charm purchases assets at the commencement of his business as follows:
Cost Useful life Residual value
£ Years £
Premises 40,000 50 5,000
Equipment 10,000 10 400
Vehicles 12,000 7 800
Depreciation is to be charged on a straight line basis for all assets. Show the ledger
accounts for all fixed assets and provision for depreciation together with the balance
sheet extracts in columnar form for the first two years of business.
Activity 6.12
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DEPRECIATION EQUIPMENT
Yr 1 Balance c/d 960 Income statement 960
––––––– –––––––––––––– –––––––
Yr 2 Balance c/d 1,920 Balance b/d 960
Income statement 960
––––––– –––––––
1,920 1,920
––––––– –––––––––––––– –––––––
Balance b/d 1,920
DEPRECIATION VEHICLES
Yr 1 Balance c/d 1,600 Income statement 1,600
––––––– –––––––––––––– –––––––
Yr 2 Balance c/d 3,200 Income statement 1,600
Balance b/d 1,600
––––––– –––––––
3,200 3,200
––––––– –––––––––––––– –––––––
Balance b/d 3,200
BALANCE SHEET EXTRACT YEAR 1
Net book
Cost Depreciation value
£ £ £
Premises 40,000 700 39,300
Equipment 10,000 960 9,040
Vehicles 12,000 1,600 10,400
–––––––– ––––––– ––––––––
62,000 3,260 58,740
–––––––– ––––––– –––––––––––––––– ––––––– ––––––––
BALANCE SHEET EXTRACT YEAR 2
Net book
Cost Depreciation value
£ £ £
Premises 40,000 1,400 38,600
Equipment 10,000 1,920 8,080
Vehicles 12,000 3,200 8,800
–––––––– ––––––– ––––––––
62,000 6,520 55,480
–––––––– ––––––– –––––––––––––––– ––––––– ––––––––
Sale of non-current assets
The last adjustment to be considered in this chapter is that for the sale of a
non-current asset.
When a non-current asset is sold the proceeds will, of course, be debited
to the bank account as would all other income received. But where will the
corresponding credit appear? The accounting answer is to credit a sale of
non-current asset account. At this stage though, the ledger accounts will
still include the asset account showing the original cost of the asset and a
provision for depreciation account which has been built up over the period
108 Financial Accounting
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of use of the asset before its sale. These accounts need deleting from the
books otherwise an asset will be recorded in the balance sheet which no
longer belongs to nor is controlled by the business. These ledger accounts
are deleted through the sale of asset account. We will return to this again
in Chapter 12 when we look at the sale of revalued assets.
Answer ASSET ACCOUNT
1.1.X0 Bank £12,000 31.12.X0 Balance c/d £12,000
––––––––– –––––––––––––––––– –––––––––
1.1.X1 Balance b/d £12,000 31.12.X1 Balance c/d £12,000
––––––––– –––––––––––––––––– –––––––––
1.1.X2 Balance b/d £12,000 31.12.X2 Sale of asset £12,000
––––––––– –––––––––––––––––– –––––––––
PROVISION FOR DEPRECIATION ACCOUNT
31.12.X0 Balance c/d £2,500 31.12.X0 Income statement £25,000
––––––––– –––––––––––––––––– –––––––––
1.1.X1 Balance b/d 2,500
31.12.X1 Balance c/d 5,000 31.12.X1 Income statement 2,500
––––––––– –––––––––
£5,000 £5,000
––––––––– –––––––––––––––––– –––––––––
31.12.X2 Sale of asset £5,000 1.1.X2 Balance b/d £5,000
––––––––– –––––––––––––––––– –––––––––
SALE OF ASSET ACCOUNT
31.12.X2 Asset 12,000 1.5.X2 Bank 5,400
31.12.X2 Depreciation 5,000
31.12.X2 Balance c/d 1,600
––––––––– –––––––––
£12,000 £12,000
––––––––– –––––––––––––––––– –––––––––
31.12.X2 Balance b/d 1,600
Note how the asset account and the depreciation account have been cleared to the
sale of asset account. The balance on the sale account is the difference between what
was paid for the asset, the amount of the asset estimated to have been used up in the
business and the amount received on its sale. It is a loss on sale and will be charged
to the income statement as are all other expenses of the business.
SALE OF ASSET ACCOUNT
31.12.X2 Bal b/d £1,600 31.12.X2 Income statement £1,600
–––––––– –––––––––––––––– ––––––––
6 · Adjustments, including entries in ledger accounts 109
An asset is purchased for £12,000 on 1.1.X0 and is estimated to have a useful life
of four years with a residual value at the end of its useful life of £2,000. Its method
of use is assumed to be straight line. On 1.5.X2 the asset is sold for £5,400.
Assume a charge for depreciation is made in the year of purchase but not in the year
of sale. Show the ledger entries required for all three years and identify what the balance
is on the sale of asset account at 31.12.X2.
Activity 6.13
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Summary
This chapter has:
᭤ introduced you to several adjustments that have to be made to the
ledger accounts at the end of a period in order to draw up the income
statement and balance sheet in accordance with accounting concepts
and conventions
᭤ identified for you that the concepts and conventions used were mainly
accruals (matching) and prudence
᭤ illustrated adjustments for accruals and prepayments both for expense
and revenue, bad debts and provision for bad debts and provision
for depreciation
᭤ identified that depreciation is perhaps the hardest adjustment to get to
grips with as it is an attempt to measure the use of the asset within the
business, not an attempt to reduce the asset to its realisable (sale) value at
any point in time. You must ensure that you are very clear on this fact.
This chapter concludes with several exercises involving these adjustments.
Self-assessment questions
Accruals and prepayments
1 The following adjustments are required to be made to the ledger accounts for Mr Cog
for the year ended 31.12.X5:
᭤ Stationery expenses paid in X5 £450, amount owing as at 31.12.X5 £50.
᭤ Building insurance paid in X5 £600 for the period 1.7.X5 to 30.6.X6 – note: the
building was purchased 1.7.X5.
᭤ Motor expenses paid in X5 £550, amount owing 31.12.X4 £70, amount owing
31.12.X5 £90.
᭤ Rents paid in X5 £1,500 for the period 1.7.X5 to 30.6.X6, £1,200 had been
paid last year for the period 1.7.X4 to 30.6.X5.
᭤ Rents receivable during the year should be £50 per month. Only £500 has been
received as at 31.12.X5.
110 Financial Accounting
prepayment (p. 93)
accrual (p. 93)
ledger adjustments (p. 94)
bad debts (p. 99)
provision for bad debts (p. 100)
depreciation (p. 104)
straight line method (p. 105)
reducing balance method (p. 105)
non-current asset (p. 108)
sale of a non-current asset account
(p. 108)
Key terms
FNAC_CO6.QXD 12/10/05 10:24 am Page 110
Show the ledger accounts for the above, the amounts transferred to the income
statement and any balances carried down.
2 Answer TRUE or FALSE in respect of the following and fully explain your choice:
(a) If an accrued expense is ignored at the year end the profit will be understated.
(b) If an accrued expense from the previous period is not carried forward into the
current year the profit for the current year will be understated.
(c) An accrued expense is an expense that has been paid but not used up in generating
revenue.
(d) A prepayment is an expense that has been paid but not used up in generating
revenue.
(e) When adjusting a ledger account for an accrued expense, you debit the account
with the accrual before balancing and bring down a credit balance.
(f) An accrued expense is an asset.
(g) An accrued revenue item is an asset.
3 Complete the following:
Adjustments for accruals and prepayments are made in the accounts in accordance
with the concept of —.
4 The following adjustments are required to the ledger accounts for Mr Black for the
year ended 31 December 20X5:
᭤ office expenses paid in 20X5 £1,425, amount owing £75
᭤ rents paid £4,800 relating to the period 1 April 20X5 to 31 March 20X6
᭤ goods sold and delivered on credit no entry made in the books £2,500
᭤ insurance paid £3,600 relating to the period 1 October 20X4 to 30 September
20X5, insurance is likely to increase by 10% per annum thereafter.
Identify all accruals and prepayments for the period in question and the amounts to
be transferred to the income statement.
Bad debts and provision for bad debts
5 Creating a provision for bad debts uses which accounting concept? Explain your
choice.
6 When bad debts are eliminated from accounts a provision for bad debts is no longer
necessary. Discuss.
7 As at the year end 31.12.X5 the following debts out of a total debtors’ figure of
£54,500 are found to be bad:
A Bloggs £780
B Swift £320
P Trent £1,500 – 50p in the £ is payable.
6 · Adjustments, including entries in ledger accounts 111
᭤
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The balance sheet as at 31.12.X4 showed a provision for bad debts for the business
of £2,100. The provision for bad debts as at 31.12.X5 is estimated to be 5% of
debtors’ balances. Show the bad debts account, provision for bad debts account and
the balance sheet as at 31.12.X5.
8 At the year end the following debts, out of a total debt figure of £45,680, are found
to be bad:
᭤ David £450
᭤ Alex £650
᭤ Sand £240 but 10p in the pound payable.
It is also estimated that a further provision for bad debts of 4% of debtors is
required.
Show the amount of bad debts to be written-off, the provision for bad debts and
the balance for debtors to be shown in the balance sheet of the business.
Depreciation
9 Identify the factors involved in the calculation of depreciation for a non-current asset.
10 Are the following statements TRUE or FALSE? Explain your answer fully.
(a) Depreciation is the amount necessary to reduce the asset to its net realisable
value at the year end.
(b) Depreciation is the assessment of the amount of an asset used up in generating
revenue for a period.
(c) The amount of depreciation charged by two businesses using an identical asset
will be the same.
(d) Motor vehicles are always depreciated using the reducing balance method and
buildings using the straight line method.
(e) The straight line method of depreciation allocates an equal charge for depreciation
to each period of use.
(f) If depreciation is omitted from the accounts, profit for the year will be overstated.
11 The following non-current assets are bought by C Brewer for use in his business on
1.1.X0.
Cost Estimated Estimated residual
useful life value at end of
useful life
£ Years £
Building 60,000 50 10,000
Vehicle 12,000 10 300
Equipment 9,000 10 800
Buildings and equipment are to be depreciated using the straight line method,
vehicles reducing balance of 25%.
112 Financial Accounting
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The vehicle is sold for £6,500 on 1.12.X2 and an item of equipment costing
£1,500 for £1,200 on the same date. Assume that the residual value of the item of
equipment sold was estimated to be £100 at its date of purchase. Assume a full
year’s depreciation in the year of purchase and none in the year of sale.
Show the asset accounts, provision for depreciation accounts, sale of asset
accounts and extracts from the income statement and balance sheet in respect of
these assets for the years ended 31.12.X0, 31.12.X1, 31.12.X2.
12 Currant commenced business on 1.10.X2 purchasing fixtures and fittings for
£25,000 and a van for £16,000. The fixtures and fittings were estimated to have a
useful life of 8 years and a residual value of £1,800. Further fittings were purchased
on 1.11.X5 for £15,200 with nil residual value.
During December 20X6 the van was involved in an accident and the insurance
assessors considered it a write-off. A cheque for £3,200 was received in December
from the insurers in full settlement. Another van was purchased on 5 January 20X7
at a cost of £18,500. Depreciation policy of Currant is to charge a full year in the
year of purchase and none in the year of sale, and to depreciate fixtures and fittings
on a straight line basis and vehicles by 25% reducing balance.
Prepare the ledger accounts for the two years ending 30.9.X6 and 30.9.X7 for each
non-current asset together with related provision for depreciation and the sale of asset
accounts. Show the balance sheet extract for fixed assets as at the two year ends.
13 Provide a definition of depreciation as it is used in accounting.
14 What information is needed in respect of an asset in order in order to make an
assessment of depreciation for that asset.
15 The following non-current assets are owned by Black for use in his business:
Cost Estimated Estimated residual
useful life value at end of
useful life
£ Years £
Building 400,000 40 250,000
Vehicle 110,000 6 6,000
Equipment 80,000 8 1,000
All assets were bought on 1 January 20X0 and the depreciation policy of Black is as
follows:
Buildings 1% straight line
Equipment and vehicles 10% reducing balance
Show the depreciation charges for the year ended 31 December 20X0 and
31 December 20X1 and comment on the depreciation policy of Black.
6 · Adjustments, including entries in ledger accounts 113
᭤
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16 The income statement or Tosuso shows a profit of £10,870 for the period ended
31 December 200X. However this income statement has been drawn up before
adjustments have been made for the following:
᭤ Non-current assets of £54,000 are to be depreciated on a straight line basis over
10 years. Residual value is assumed to be £5,400.
᭤ Bad debts of £6,700 have been identified for the period.
᭤ The provision for bad debts, which is set at 5% of debtors balance, is shown in
the balance sheet as £3,000. Debtors at the year end amount to £63,000
before the bad debt of £6,700 is written off.
᭤ Accruals of £1,500 for electricity and prepayments of £4,500 for rent of office
space.
Required
Show the adjustments to be made to the income statement to account for the
above and recalculate the profit for the period.
Answers to these questions can be found at the back of this book.
114 Financial Accounting
FNAC_CO6.QXD 12/10/05 10:24 am Page 114
7
Preparation of income statement
and balance sheet from trial
balance and adjustments
Introduction
This chapter aims to bring together your knowledge of Chapters 5 and 6 so
that you can prepare income statements and balance sheets at the period
end of a business after taking account of all the period-end adjustments necessary
to the ledger accounts. These period-end adjustments will ensure that
the final statements prepared will be in accordance with concepts and conventions
of accounting that were identified in Chapter 4. Use will be made
of the extended trial balance technique in compiling these final statements.
First, though, a recap on Chapters 5 and 6:
᭤ Ledger accounts are required for all assets, liabilities, expenses and
income within a business.
᭤ These ledger accounts are written up using double entry – the duality
concept.
᭤ At a period end, ledger accounts are balanced.
᭤ Expense and income accounts are transferred to the income statement
which is a double entry account.
᭤ Any other balances remaining in the ledgers are shown on a balance sheet.
᭤ To prepare accounts in accordance with accounting concepts and conventions
several adjustments need to be made to the ledger accounts
before transfers are made to the income statement.
By the end of this chapter you should be able to:
᭤ Prepare an income statement from a trial balance after taking
account of several adjustments.
᭤ Prepare a balance sheet from a trial balance after several
adjustments.
Objectives
FNAC_CO7.QXD 12/10/05 10:25 am Page 115
᭤ These adjustments take account of accruals and prepayments so that
expenses used up are matched to the revenue they generate.
᭤ Adjustments are required for bad debts and provision for bad debts to
comply with prudence.
᭤ A depreciation adjustment for non-current assets that are used up in
generating revenue is also required.
This chapter will consist of an example that will demonstrate adjustments
required to the ledgers at the period end, the extraction of a trial
balance at this stage, and the preparation of an income statement and balance
sheet for the period. Work through this example carefully as you will
then be expected to complete a similar activity yourself. Our example will
conclude with a technique called an extended trial balance, which is a
working paper from which the adjustments to the double entry accounts
will be made. This speeds up the process of producing an income statement
and balance sheet without having to wait for all the ledger accounts to be
adjusted. This can be a useful technique for students in examinations. Note
that the ledgers will eventually have to be amended for the period-end
adjustments whether or not we use an extended trial balance.
Extended example
The following trial balance was extracted from the ledgers of a sole trader, Mai Wong,
as at 31.12.X5:
Dr Cr
Sales 45,000
Purchases 15,000
Inventory 1.1.X5 2,300
Wages 5,200
Office expenses 900
Heating and lighting 850
Telephone 450
Rent 2,200
Fixtures and fittings 7,550
Vehicles 8,500
Provision for depreciation 1.1.X5:
Fixtures and fittings 755
Capital 8,805
Debtors 1,300
Creditors 1,150
Insurance 650
Motor expenses 210
Drawings 10,400
Bank and cash 200
––––––––– –––––––––
£55,710 £55,710
––––––––– –––––––––––––––––– –––––––––
116 Financial Accounting
Example 7.1
FNAC_CO7.QXD 12/10/05 10:25 am Page 116
The following period-end adjustments are required:
᭤ Office expenses to be accrued, £50.
᭤ Heating and lighting to be accrued, £150.
᭤ Rent paid in advance, £200.
᭤ Insurance paid in advance, £80.
᭤ Fixtures and fittings to be depreciated at 10% of cost and vehicles 20% of cost.
᭤ An item of fixtures was sold during the year for £90. The item had been bought on
1.1.X3 for £120. The sale proceeds were credited to the sales account.
᭤ Closing inventory is valued at £1,950.
᭤ £90 of the motor expenses relates to items for Mai Wong’s own use.
Show the adjustments necessary to the ledger accounts to account for the above and
the transfers to the income statement for the year.
OFFICE EXPENSES ACCOUNT
31.12.X5 Balance b/d 900
31.12.X5 Balance c/d (1) 50 31.12.X5 Income statemement (2) 950
–––––– ––––––
£950 £950
–––––– –––––––––––– ––––––
1.1.X6 Balance b/d (1) 50
Entry 1 is the accrual of £50 for the year and the corresponding carry-down of the
balance to the following year.
Entry 2 shows the charge to the income statement for the year which is the £900
cash paid plus £50 accrual. This accrual is to ensure matching of expenses used up to
the revenue generated.
HEATING AND LIGHTING ACCOUNT
31.12.X5 Balance b/d 850
31.12.X5 Balance c/d (1) 150 31.12.X5 Income statement 1,000
–––––––– ––––––––
£1,000 £1,000
–––––––– –––––––––––––––– ––––––––
11.X6 Balance b/d 150
RENT ACCOUNT
31.12.X5 Balance b/d 2,200 31.12.X5 Income statement 2,000
31.12.X5 Balance c/d 200
–––––––– ––––––––
£2,200 £2,200
–––––––– –––––––––––––––– ––––––––
1.1.X6 Balance b/d 200
INSURANCE ACCOUNT
31.12.X5 Balance b/d 650 31.12.X5 Income statement 570
31.12.X5 Balance c/d 80
–––––––– ––––––––
£650 £650
–––––––– –––––––––––––––– ––––––––
1.1.X6 Balance b/d 80
7 · Preparation of income statement and balance sheet from trial balance and adjustments 117
Example 7.1
continued
FNAC_CO7.QXD 12/10/05 10:25 am Page 117
The above three accounts show similar entries to those for office expenses.
FIXTURES AND FITTINGS ACCOUNT
31.12.X5 Balance b/d 7,550 31.12.X5 Sale 120
31.12.X5 Balance c/d 7,430
–––––––– ––––––––
£7,550 £7,550
–––––––– –––––––––––––––– ––––––––
1.1.X6 Balance b/d 7,430
Here we have shown the ‘write-out’ from the asset account of the fixtures sold. The
corresponding debit entry will be shown in the sale of fixtures account. A similar writeout
needs to be made in the provision for depreciation account for fixtures and fittings.
The depreciation previously provided on the fixtures sold will have been £120 × 10%
for two years, that is, £24.
PROVISION FOR DEPRECIATION OF FIXTURES ACCOUNT
31.12.X5 Sale 24 31.12.X5 Balance c/d 755
31.12.X5 Balance c/d 1,474 31.12.X5 Income statement (1) 743
–––––––– ––––––––
£1,498 £1,498
–––––––– –––––––––––––––– ––––––––
1.1.X6 Balance b/d 1,474
Entry 1 is the depreciation for the current year calculated on the remaining assets
of £7,430 after the sale of £120. A corresponding entry will be made in the income
statement.
The sale of fixtures account will appear as follows.
SALE OF FIXTURES ACCOUNT
31.12.X5 Fixtures 120 31.12.X5 Depreciation 24
31.12.X5 Sales (1) 90
31.12.X5 Income statement 6
–––––– ––––––
£120 £120
–––––– –––––––––––– ––––––
Entry 1 is the transfer of the sale proceeds of the fixtures which had been included
in the sales account. The transfer of £6 to the income statement represents a loss on
sale of the asset. The sales account will need amending as follows:
SALES ACCOUNT
31.12.X5 Sale of fixtures 90 31.12.X5 Balance b/d 45,000
31.12.X5 Income statement 44,910
––––––––– –––––––––
£45,000 £45,000
––––––––– –––––––––––––––––– –––––––––
118 Financial Accounting
Example 7.1
continued
FNAC_CO7.QXD 12/10/05 10:25 am Page 118
The charge for depreciation on the vehicles also needs calculating and entering into
the accounts: depreciation for the year 20% × £8,500 = £1,700.
PROVISION FOR DEPRECIATION OF VEHICLES ACCOUNT
31.12.X5 Balance c/d 1,700 31.12.X5 Income statement 1,700
–––––––– ––––––––
£1,700 1.1.X6 Balance b/d £1,700
–––––––– –––––––––––––––– ––––––––
The motor expenses account also needs amending as £90 of these expenses
related to Mai Wong’s own use. This £90 is treated as drawings of Mai Wong.
MOTOR EXPENSES ACCOUNT
31.12.X5 Balance b/d 210 31.12.X5 Drawings 90
31.12.X5 Income statement 120
–––––– ––––––
£210 £210
–––––– –––––––––––– ––––––
The accounts for purchases, inventory 1.1.X5, wages and telephone will all be transferred
to the income statement and an account for closing inventory opened as follows:
CLOSING INVENTORY ACCOUNT
31.12.X5 Income statement £1,950
The income statement will now appear as follows:
INCOME STATEMENT FOR THE YEAR ENDED 31.12.X5
Sales 44,910
Opening inventory 2,300
Add purchases 15,000
––––––––
17,300
Less closing inventory 1,950 15,350
–––––––– –––––––––
Gross profit 29,560
Wages 5,200
Office expenses 950
Heating and lighting 1,000
Rent 2,000
Insurance 570
Depreciation: Fixtures 743
Vehicles 1,700
Telephone 450
Motor expenses 120
Loss on sale 6 12,739
–––––––– –––––––––
Net profit £16,821
––––––––––––––––––
7 · Preparation of income statement and balance sheet from trial balance and adjustments 119
Example 7.1
continued
FNAC_CO7.QXD 12/10/05 2:11 pm Page 119
All balances now remaining in the ledgers are entered in the balance sheet as follows:
BALANCE SHEET AS AT 31.12.X5
Cost Depreciation Net book
value
Non-current assets
Fixtures and fittings 7,430 1,474 5,956
Vehicles 8,500 1,700 6,800
––––––– –––––––– –––––––––
15,930 3,174 12,756
––––––– ––––––––––––––– ––––––––
Current assets
Inventory 1,950
Debtors 1,300
Rent prepaid 200
Insurance prepaid 80
Bank and cash 200
––––––––
3,730
Current liabilities
Creditors 1,150
Office expenses accrued 50
Heat and light accrued 150 1,350 2,380
––––––– –––––––– –––––––––
£15,136
––––––––––––––––––
Capital 8,805
Add profit 16,821
Less drawings 10,490 6,331
–––––––– –––––––––
£15,136
––––––––––––––––––
Adjusting the ledger accounts as shown above is very time consuming but has to be
done by a business if it keeps double entry records. Many businesses will use computerised
ledgers. We will look at these in Chapter 14. The process of adjusting the ledgers for
both computerised and manual systems can be controlled by the use of an extended trial
balance – a worksheet. The worksheet for the example above would appear as follows:
Trial balance Adjustments Income statement Balance sheet
Dr Cr Dr Cr Dr Cr Dr Cr
Sales 45,000 90 44,910
Purchases 15,000 15,000
Inventory 2,300 2,300
Wages 5,200 5,200
Office 900 50 950
Heating and
lighting 850 150 1,000
Telephone 450 450
Rent 2,200 200 2,000
Fixtures and
fittings 7,550 120 7.430
Vehicles 8,500 8,500
Depreciation,
furniture
and fittings 755 24 743 1,474
120 Financial Accounting
Example 7.1
continued
FNAC_CO7.QXD 12/10/05 10:25 am Page 120
Trial balance Adjustments Income statement Balance sheet
Dr Cr Dr Cr Dr Cr Dr Cr
Capital 8,805 8,805
Debtors 1,300 1,300
Creditors 1,150 1,150
Insurance 650 80 570
Motor 210 90 120
Drawings 10,400 90 10,490
Bank 200 200
––––––––– –––––––––
£55,710 £55,710
––––––––– –––––––––––––––––– –––––––––
Accruals 200 200
Prepayments 280 280
Depreciation,
furniture
and fittings 743 743
Depreciation,
vehicle 1,700 1,700
Profit on sale 6 6
Provision for
depreciation,
vehicle 1,700 1,700
Closing
inventory 1,950 1,950
Income
statement 1,950 1,950
Net profit 16,821 16,821
–––––––– –––––––– ––––––––– ––––––––– ––––––––– –––––––––
£5,083 £5,083 £46,860 £46,860 £30,150 £30,150
–––––––– –––––––– ––––––––– ––––––––– ––––––––– ––––––––––––––––– –––––––– ––––––––– ––––––––– ––––––––– –––––––––
This work sheet has been constructed as follows:
᭤ the first two columns, headed trial balance, are simply a listing of the income,
expenses, assets and liabilities from the question trial balance
᭤ the third and fourth columns, headed adjustments, take account of all the period
end adjustments
Office expenses – debit 50 credit accruals 50
Heating and lighting – debit 150, credit accruals 150; accruals balance is now 200
Rent – credit rent 200, debit prepayments 200
Insurance – credit insurance 80, debit prepayments 80; prepayments balance now 280
Fixtures and fittings sale – debit sales 90, credit sales account 90. Write out the
cost of the fixtures sold by crediting fixtures asset account 120, debiting sale account
120. Write out depreciation accrued on the item sold by debiting provision for depreciation
24 (2 years depreciation at 12 per year), crediting sale account 24. Now balance
the sale account and you are left with a debit balance b/d of 6 which is profit on sale.
Depreciation on fixtures and fittings – the extended trial balance now shows a debit
of 7,550 and a credit of 120. The overall debit is 7,430. Depreciation is provided on
this at 10% by crediting provision for depreciation 743 and debiting depreciation
charge 743.
Vehicles only has a debit balance showing in the extended trial balance so far of
8,500, so the depreciation charge is 20% × 8,500 = 1,700 which is credited to provision
for depreciation and debited to provision charge.
7 · Preparation of income statement and balance sheet from trial balance and adjustments 121
Example 7.1
continued
FNAC_CO7.QXD 12/10/05 10:25 am Page 121
Closing inventory needs entering, so debit closing inventory account, 1,950. Credit
income statement.
The last adjustment is to account for the personal drawings of Mai Wong by crediting
motor expenses 90, then crediting drawings 90.
᭤ Columns five and six show the transfers of balances on income and expense ledgers
after the adjustments have been made to the income statement.
᭤ Columns seven and eight show the assets and liabilities and capital and reserves
tranferred to the balance sheet.
᭤ As each pair of columns is completed we check the extended worksheet by totalling
the columns and the pairs should be equal. If they are not, then a mistake will have
been made somewhere in the worksheet and this must be corrected.
Look at this extended trial balance carefully and follow all the adjustments made
and the entries into the income statement and balance sheet. You may find this
method of drawing up the final accounts useful for examinations. The extended trial
balance technique lends itself to computer spreadsheet applications.
So far we have dealt with year end account preparation for a sole trader,
but the same process applies when preparing an income statement and balance
sheet from a trial balance and making adjustments for any type of
business or organisation. Try the following activity which deals with the
transactions of a club.
122 Financial Accounting
Example 7.1
continued
From the following trial balance relating to the position of a tennis club as at
31 March 200X, draw up the income and expenditure account (similar to the
income statement) and the balance sheet as at that date.
Debit Credit
£ £
Clubhouse at cost 54,700
Creditors 3,300
Debtors 2,200
Inventory 31 March 200X 1,080
Gross profit on bars etc 1,240
Furniture and fittings 7,600
Bank and cash 5,600
General expenses 760
Insurance 1,200
Heating and lighting 780
Subscriptions to the club 10,100
Accumulated fund 1 April 200W
(similar to capital) 19,470
Provision for depreciation:
Clubhouse 38,290
Furniture and fittings 1,520
–––––––– ––––––––
73,920 73,920
–––––––– –––––––––––––––– ––––––––
Activity 7.1
FNAC_CO7.QXD 12/10/05 10:25 am Page 122
Answer Income and expenditure account for the period ended 31 March 200X
£ £
Subscriptions 10,100
Gross profit 1,240
––––––––
11,340
Insurance (1,200 + 1,200) 2,400
Heating and lighting (780 + 230) 1,010
General expenses 760
Depreciation: Clubhouse 5,470
Furniture and fittings 1,520 11,160
––––––– ––––––––
Surplus 180
––––––––
Balance sheet as at 31 March 200X
Non-current assets
Clubhouse (54,700 – 5,470 – 38,290) 10,940
Furniture and fittings (7,600 – 1,520 – 1,520) 4,560 15,500
–––––––
Current assets
Inventory 1,080
Debtors 2,200
Bank and cash 5,600 8,880
–––––––
Liabilities less than one year
Creditors 3,300
Accruals (1,200 + 230) 1,430 4,730
––––––– ––––––––
19,650
––––––––––––––––
Accumulated fund 1 April 200X 19,470
Surplus 180
––––––––
19,650
––––––––––––––––
Summary
This chapter has combined your learning from Chapters 5 and 6. You
should now be able to:
᭤ prepare an income statement and balance sheet from a trial balance after
making several adjustments at the period end to this trial balance for a
business and a club.
7 · Preparation of income statement and balance sheet from trial balance and adjustments 123
The following information is also available:
᭤ The insurance paid for the year only relates to the first 6 months of the period
᭤ Heating and lighting of £230 needs to be accrued
᭤ Clubhouse is depreciated 10% on cost and furniture and fittings 20% on cost
FNAC_CO7.QXD 12/10/05 10:25 am Page 123
We also illustrated the technique of an extended trial balance which is, in
fact, a work sheet to control the adjustments within the ledger accounts. It
can, however, be a useful tool to use in an examination.
We have only provided two self-assessment questions in this chapter as
you will find plenty of practice in preparing income statements and balance
sheets in Chapter 8. You may like to attempt to do the exercises at the
end of the chapter using an extended trial balance but note that we have
not provided the answers in that way.
Self-assessment questions
1 The following trial balance was extracted from the books of Rodney, a sole trader, as
at 31.12.X5:
Dr Cr
Capital 1.1.X5 15,500
Drawings 4,660
Debtors and creditors 6,530 5,210
Sales 71,230
Purchases 29,760
Inventory 1.1.X5 4,340
Rates 800
Heat and light 2,650
Wages 8,250
Bad debts 230
Provision for bad debts 280
General expenses 2,340
Motor expenses 3,240
Premises at cost 30,000
Fixtures and fittings 8,000
Vehicles 12,000
Provision for depreciation 1.1.X5:
Premises 2,400
Fixtures and fittings 1,600
Vehicles 5,400
Bank 820
Loan 12,000
–––––––––– ––––––––––
£113,620 £113,620
–––––––––– –––––––––––––––––––– ––––––––––
124 Financial Accounting
extended trial balance (p. 116) period-end adjustments (p. 117)Key terms
FNAC_CO7.QXD 12/10/05 10:25 am Page 124
The following matters have not been taken into account in the preparation of the
above trial balance:
᭤ Inventory 31.12.X5 £4,870.
᭤ Light and heat due 31.12.X5 £120, general expenses due £80.
᭤ Depreciation is to be provided for the year as follows:
Premises – 2% on cost
Fixtures and fittings – 10% on cost
Vehicles – 20% reducing balance.
᭤ A further bad debt of £130 is to be written off and the bad debts provision is to
be at 5% of debtors after the write-off.
᭤ The loan interest of £600 has not been paid for the year.
You are required to prepare an income statement for the year ended 31.12.X5 and a
balance sheet as at that date.
2 The following trial balance was extracted from the books of ATEC as at 31.12.X9
Dr Cr
Sales 53,500
Purchases 29,200
Inventory 1.1.X9 5,400
Office expenses 150
Electricity 700
Salaries and wages 12,100
Rates 600
Telephone 280
Other expenses 120
Premises 30,000
Rents received 550
Equipment 12,000
Vehicles 12,000
Provisions for depreciation:
Premises 4,200
Equipment 8,400
Vehicles 3,000
Drawings 16,000
Debtors and creditors 4,800 5,200
Provision for bad debts 90
Capital 1.1.X9 46,500
Bank 2,000
Cash 90
––––––––– –––––––––
123,440 123,440
––––––––– –––––––––––––––––– –––––––––
7 · Preparation of income statement and balance sheet from trial balance and adjustments 125
᭤
FNAC_CO7.QXD 12/10/05 10:25 am Page 125
The following matters have not been taken into account in the preparation of the
above trial balance:
᭤ inventory as at 31.12.X9 £6,200
᭤ accruals required as at 31.12.X9 – electricity £230
salaries and wages £230
telephone £90
᭤ rents receivable are £50 per month as from 1.1.X9
᭤ the business commenced 1.1.X2 and depreciation has been provided on a
straight line basis for premises and equipment since that date except for the current
year for which no depreciation charge has yet been made
᭤ vehicles are depreciated at 25% reducing balance and were purchased 1.1.X8
᭤ no sales of non-current assets have been made prior to 1.1.X9. On 1.7.X9 part of
the premises, cost £15,000, was sold for £25,000. These sale proceeds have
been credited to the capital account
᭤ drawings includes the purchase of a second-hand van for £5,000 on 1.2.X9. This
van is used solely for business purposes
᭤ bad debts to be written off as at 31.12.X9 amount to £120 and bad debts provision
is to be set at 25% of debtors after writing off bad debts
᭤ depreciation is to be provided on the basis of a full year’s charge in the year of
purchase of the asset but none in the year of sale of the asset.
You are required to prepare an income statement for the year ended 31.12.X9 and a
balance sheet as at that date for ATEC.
Answers to these questions can be found at the back of this book.
126 Financial Accounting
FNAC_CO7.QXD 12/10/05 10:25 am Page 126
8
Accounts of limited companies
The need for companies
In previous chapters we have assumed that the business is that of a sole
trader. This is where an individual invests his capital in a business and
trades with the intention of earning profit that will belong to him to do
with as he chooses. However, this type of business has several drawbacks.
Answer You should have chosen two from the following list. However, this list is not exhaustive
and you may have come up with drawbacks that we have not mentioned. You should
be able to explain whether your drawbacks are reasonable.
᭤ A sole trader has limited resources available – the capital he is able to invest in the
business – limited specialist and management skills.
᭤ For a business to grow, more resources are required in terms of capital and expertise.
᭤ The sole trader is personally liable for all debts of the business – creditors can claim
on the personal assets of the sole trader.
᭤ The sole trader business is dependent upon the owner.
By the end of this chapter you should be able to:
᭤ Explain what is meant by corporate entity.
᭤ Identify the nature of capital invested in companies and the returns
available on this capital.
᭤ Identify the main changes to company law from the company law
review.
᭤ Describe the term ‘reserves’.
᭤ Identify and account for the taxation charge within company accounts.
᭤ Prepare the income statement and balance sheet for companies.
Objectives
Identify two drawbacks of sole trader businesses.Activity 8.1
FNAC_CO8.QXD 12/10/05 10:28 am Page 127
Establishing the business as a limited company can overcome all the above
drawbacks. Capital resources are available from more than one person, and
the company also has easier access to loan funds. Specialist and management
skills can be brought into the business by widening the number of owners.
A company provides what is known as limited liability to the owners.
Ownership can change without there being any effect on the business.
The company
A company has two notions as its basis:
᭤ Corporate entity
᭤ Limited liability.
The notion of corporate entity means that several people can band together
as owners of a business by investing capital. The business will be a legal entity
separate from the owners. It also means that the owners, the investors of capital,
can change without the need to change the legal entity of the company.
The notion of limited liability limits the claim on the owners of the business
from any of its creditors to the capital these owners invested. It also
means that a creditor has to sue the company, not the owners, for payment
of any debts due to him, and these creditors could indeed force the winding
up, or liquidation, of the company. There are several hundred thousand
companies in the United Kingdom and mainland Europe, many of them
large conglomerates such as British Telecom, Guinness, Shell and ICI.
The law in relation to companies in the UK was established by the first
Companies Act of 1844, which fused these two notions of corporate entity
and limited liability. Any confusion in respect of the two notions was put
to rest by the judgment in the case of Salomon v Salomon & Co Ltd (1897).
The judgment handed down by the House of Lords stated that the company
was a separate legal entity distinct from the owners and that creditors
could not claim on the personal assets of the owners, only on the assets of
the company. Creditors trade with a limited company at their own risk. It
is advisable for creditors to investigate the financial stability of a company
before they trade with it.
Formation of a company
Further detail in respect of the formation of a company will be found in a
company law course, but it is worthwhile identifying the main points here.
᭤ All companies must be registered with the Registrar of Companies by the
submission of a number of legal documents. This marks the legal birth
of a company.
᭤ The two most important documents to be filed are the Memorandum of
Association and the Articles of Association.
128 Financial Accounting
FNAC_CO8.QXD 12/10/05 10:28 am Page 128
᭤ The Memorandum of Association defines the relationship between the
company and any external parties and states the objectives of the company,
that is what sort of trade it will undertake. It also identifies the
maximum capital to be invested in the company by the owners, known
as the Share Capital. All companies must have at least two shareholders
whose names and addresses appear in the memorandum.
᭤ The Articles of Association define the rights of shareholders, the rules of
operation of the company and the rights and duties of owners and
employees of the company.
᭤ Companies are registered as either public limited companies (plcs) or private
companies. Essentially the distinction is that plcs can, if they wish,
raise capital by selling shares to the general public. They must have a minimum
allotted (i.e. issued to shareholders) share capital of £50,000. Many
plcs are quoted on the London Stock Exchange, thus anyone who wants
to can become an owner of the company as long as they have the necessary
capital to invest. Private companies have restricted ownership. The
following diagram illustrates the type of companies in general that exist.
᭤ There must be at least two shareholders in any company but there is no
maximum number.
᭤ The day-to-day business of the company is generally not carried out by the
owners but by directors who are appointed by the owners. The directors
report to the owners through the facility of an Annual General Meeting
and an Annual Report that incorporates the financial statements.
8 · Accounts of limited companies 129
Listed
on Stock
Exchange
Not listed
on Stock
Exchange
Private
company
Public
company
Company registered
under Companies Act
FNAC_CO8.QXD 12/10/05 10:28 am Page 129
Company law review in the UK
A review of company law is currently underway. This is the most extensive
reform of Company Law for nearly 150 years in the UK. As a result of Enron
and other corporate scandals across the world there has been a significant
push to require companies to report clearly about their business actions
through new legislation. Much of the detail of the review was produced in a
steering group report in July 2001 and then in a Government White Paper,
Modernising Company Law, in July 2002. The objective of the review is to
streamline procedures for all companies, especially smaller companies, to
make the law clearer, more accessible and responsive to developments.
According to the Department of Trade and Industry website on modernising
company law, the Company Law Review will:
᭤ enable better shareholder engagement,
᭤ modernise and de-regulate the law,
᭤ give greater clarity to directors on their duties and responsibilities, so
that they do not inadvertently fall foul of the law,
᭤ facilitate better communications with shareholders,
᭤ help speed up decision making, and
᭤ deregulate aspects of current law.
All of this should help maintain the UK’s position as the best place to set
up and run a business. The detailed work of updating company law in
respect of detailed requirements for accounting and other company disclosures
is to be handled by a non-governmental business-led body based
on the Accounting Standards Board (ASB). We deal with the ASB in
Chapter 10. The review of company law is a major task that the current
government has set itself. It is not envisaged that this will change the form
of a company, but it might well bring about changes to the reporting of a
company’s financial position and performance.
At the current rate of progress, the Company Law Review Act is not
expected to receive full parliamentary approval in the UK until Autumn 2005.
Company capital
The capital of a company is divided into shares. Investors purchase as many
of these as they are able, and want, to buy. For example, a company could be
registered with a maximum share capital of 100,000 £1 shares. The maximum
capital of the company would therefore be £100,000 and this would be
termed its Authorised Share Capital. A company, not the same one, could
also be registered with a share capital of say 50,000 £3 shares – a maximum
capital of £150,000. The pound value attached to a share is known as its
nominal (or par) value and a company can decide on the nominal value and
total number of shares it wishes to issue. The decision will depend on how
much capital the company needs to commence its operations. Note that the
company does not have to issue all its authorised share capital.
130 Financial Accounting
FNAC_CO8.QXD 12/10/05 10:28 am Page 130
Once a company has made the initial issue of the shares, further trading
in these shares can take place in what is known as the share market – for
many plcs this is the Stock Exchange. Company shares may well be bought
and sold every day on the Stock Exchange, but the company will make no
reference to this in the ledger accounts as it is not a transaction between
the corporate entity and the buyer, but between the separate shareholder
and the buyer. Thus we are differentiating again between the entity of a
company and the individual. The company will need to keep a list of who
owns shares in it so that it can pay over any return from the trading of the
company due to the shareholders. This return paid over to shareholders is
known as the dividend.
Companies are also able to vary the rights of shareholders within a company
by issuing different types of shares. The following activity is concerned
with share issues and share transactions.
Answer Your company almost certainly has in issue ordinary shares. These are the most important
type of share and are those most commonly traded on the stock exchange. They
generally carry voting rights in proportion to the number of shares held. These voting
rights give control over the operations of the company to the shareholders through the
right to appoint the directors. You should also have been able to identify the dividends
paid to ordinary shareholders.
Preference shares may also have been issued by the company. The main feature of
preference shares is that they usually carry a specific rate of return to the holder from
the company’s profits. For example, 5% £1 preference shares would require a payment
to the shareholders every year of 5p for every share held. A holder of £10,000 of these
preference shares would receive £500.
Preference shares can also be termed cumulative. This means that if the company
does not make enough profit in any one year to pay out the amount due to the preference
shareholders, it carries over to the next year and accumulates until the company
does have enough profit to pay out the amount due – the dividend.
The preference shares may also be redeemable, giving the company the right to
repay the capital to the preference shareholders at a determined future date.
Shares can also be issued by a company at a value above the nominal value declared
in the Memorandum of Association. This is known as issuing shares at a premium.
8 · Accounts of limited companies 131
Obtain a set of company financial statements. This can be done by accessing library
facilities, using company websites or by using the Annual Reports Service offered in
the Financial Times – read the small print at the end of the daily stock exchange listings
to see how this is done. Identify the types of shares in issue for your chosen
company from the financial statements and notes.
Activity 8.2
FNAC_CO8.QXD 12/10/05 10:28 am Page 131
Answer A company may wish to raise additional capital. To issue £1 ordinary shares at a price
of £1 to new investors would be unfair to the initial investors in the company. The following
example illustrates this point.
A company was initially formed by the issue of 100 £1 ordinary shares. The balance
sheet of the company at its formation can be summarised as follows:
£
Bank 100
––––––––
Capital 100 £1 ordinary shares 100
––––––––
The company trades for a number of years, earning profits of £250 in total. Its balance
sheet will then appear as follows:
Assets £350
––––––––––––
Capital 100 £1 ordinary shares 100
Profit 250
––––––
£350
––––––––––––
From this balance sheet we can conclude that each share now has a book value of
£3.50. It is also feasible that if these ordinary shares were traded on the stock
exchange they would probably sell at a price in excess of £1. The company at this
stage now wishes to raise more capital, £140, so that it can expand by the purchase
of further assets. If it issues more £1 ordinary shares at their nominal value then this
will be unfair to the original shareholders as the balance sheet would now be:
Assets £490
––––––––––––
Capital 240 £1 ordinary shares 240
Profit 250
––––––
£490
––––––––––––
Now each share has a book value of £2.04. The original shareholders have lost £1.46
on each share!
To ensure equity (fairness) between old and new shareholders the new shares will
be issued at a premium. In this case the shares of £1 nominal value will be issued at
£3.50 and the number issued will be 40.
The balance sheet will now be:
Assets £490
––––––––––––
Capital 140 £1 ordinary shares 140
Share premium 100
Profit 250
––––––
£490
––––––––––––
Now each share has a book value of £3.50.
Note that the premium paid on the shares is entered in a separate ledger account
known as share premium.
132 Financial Accounting
Explain why a company may wish to issue shares at a premium.Activity 8.3
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Answer 1 300,000 £1 ordinary shares and 50,000 £2 5% preference shares. Preference dividend
payment £5,000.
2 300,000 £1 ordinary shares at £1.25 raises £375,000, the further £25,000
required is raised by issuing 10,000 £2 5% preference shares at £2.50. Preference
dividend payment £1,000. Issuing the minimum number of preference shares in
each case ensures that the preference dividend payment will be minimised. Note
that the preference dividend is only calculated on the nominal value of shares
issued not the premium.
Rights issues and bonus issues
Companies often make what is termed a rights issue of shares. This is an offer
of shares to the existing shareholders that they have a right to purchase at a
price below the current market value of the shares. The amount the existing
shareholders are allowed to purchase is pro-rata to their existing share holding.
Alpha plc has in issue one million £1 (nominal value) shares. The current market value
of the shares is £3.50. The company proposes a rights issue of one share for every
four held at a price of £2.
If all of this rights issue is taken up by the shareholders then the company will issue
a further 250,000 shares and will receive £500,000 from the shareholders. The company
has benefited in this transaction, as it is a very inexpensive way to raise further
capital. It does not have to go through all the formalities associated with a full share
issue to the public, such as producing what is known as a prospectus. The shareholders
benefit, as they are able to buy more shares in the company at a beneficial price
and, of course, control of the company remains in their hands. Under a normal issue of
shares the existing shareholders could have their control diluted if they did not buy all
of the shares issued.
A company can also make a ‘bonus issue’ of shares to its existing shareholders. As
is the case with a sole trader, a company will build up its retained profits over the years
and these will appear as a reserve on the balance sheet. We will talk further about
reserves after Activity 8.8.
8 · Accounts of limited companies 133
A company is formed with a total authorised (authorised by its inclusion in the
Memorandum of Association) share capital of £500,000, consisting of 300,000 £1
ordinary shares and 100,000 5% £2 preference shares. The company wishes to
raise £400,000 in capital to start the business. Identify the number of shares of
each type it should issue to minimise the preference dividend payment in each of
the following circumstances:
1 All shares are to be issued at par.
2 Ordinary shares are to be issued at a premium of 25p and preference shares at a
premium of 50p.
Activity 8.4
Example 8.1
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Alpha plc’s balance sheet as at 31 March 20X5 shows the following:
£
Share capital – £1 ordinary shares 500
Retained profits 1,000
––––––
1,500
––––––––––––
The company makes a bonus issue of two shares for every one held by the existing
shareholders. This means every shareholder receives two free shares for every one
held. Note no money changes hands and the cash of the company will not be
increased. The balance sheet after the bonus issue will appear as follows:
£
Share capital – £1 ordinary shares 1,500
Retained profits 0
––––––
1,500
––––––––––––
Once a bonus issue of shares is made, the market value of the shares will fall to reflect
the extra number of shares in issue.
Other forms of capital
When considering the business of a sole trader you saw that the owner
could increase the funds available in the business not only by investing
more money himself, but also perhaps by acquiring a loan from a bank.
Companies can also raise extra finance in a similar way. However, they are
also able to raise loan capital by the issue of debentures that can be traded
in the market in the same way as a share.
The debenture document sets out the capital value, the interest rate
payable, the date the loan is redeemable and any security for the loan. The
capital value of the debenture is expressed in nominal value terms, usually
in multiples of £100. The interest rate payable on the debenture is set at a
fixed percentage of this nominal value. It is important to remember that
debentures are loans to the company, not part of its share capital. Because
of this, debenture interest is shown as a charge against profits within the
income statement, rather than an appropriation of profits. The only difficulty
with debentures is that they are often issued at a value above or
below nominal value. Thus a £100 debenture could be issued at £99. This
means that on issue the cash received by the company will only be £99;
that is, the debenture has been issued at a discount of £1. Note, though,
that the amount payable by the company on redemption, repayment, of
the loan will be £100. In the same way that shares are entered into the
company’s ledger accounts at nominal value so are the debentures. The
question to answer is ‘How do we account for the £1 discount on issue?’
134 Financial Accounting
Example 8.2
A company makes an issue of £10,000 6% debentures at £99. Show the entries in
the ledger accounts, including cash, to account for this issue.
Activity 8.5
FNAC_CO8.QXD 12/10/05 2:12 pm Page 134
Answer The debenture account is used to record the nominal value of the debentures issued
as for share capital.
6% DEBENTURES ACCOUNT
Issue 10,000
CASH ACCOUNT
Debentures 9,900
The above entries do not maintain duality. A debit of £100 is required to be made
somewhere in the ledgers.
This £100 discount on issue can be considered as an expense of making the
debenture issue. Therefore we have:
DEBENTURE DISCOUNT ACCOUNT
Issue 100
Like all other expenses this debenture discount should be written off to the income
statement by debiting the income statement.
DEBENTURE DISCOUNT ACCOUNT
Issue 100 Income statement 100
There is also another possibility for the write-off of this discount on issue which is permitted
by the Companies Act in the UK and that is to charge it against the share
premium account if there is one.
Return on shares and debentures
Any investment is made with the expectation of some form of return. For
the sole trader this return was in the form of profits that he was free to
withdraw from the business. In the same way the profits of a company
belong to the shareholders and they will expect some return on their capital
invested. This return is made in the form of a dividend payment. These
dividend payments are usually made in two instalments, the interim dividend
and the final dividend.
Answer The dividends identified were probably expressed as so many pence per share. For
example, if the dividend was declared as 6p per share and there were 100,000
£1 shares in issue, then the total dividend payment made would be £6,000. Note the
dividend is calculated by reference to the nominal value of shares issued.
8 · Accounts of limited companies 135
From your set of company accounts identify the interim and final dividend payments
made.
Activity 8.6
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The interim dividend is generally paid halfway through the financial period
and the final dividend, an additional payment, is proposed at the year end.
This means that the shareholders will vote at the annual general meeting on
the payment of this final dividend as proposed by the directors and after a vote
in favour, the dividend will be paid. Note that this means that all final, proposed,
dividends are unpaid at the year end. It has long been UK accounting
practice to include this proposed dividend as a current liability in the balance
sheet. However International Accounting Standards now explicitly state that
dividends declared after the balance sheet date, i.e. proposed dividends should
not be recognised as a liability at the balance sheet date. This will be a change
of accounting practice for all UK companies who report under IASs.
The return made to the debenture holder is in the form of interest at the
rate specified on the debenture. In the example at Activity 8.5, the interest
payable was 6% on a nominal debenture value of £10,000. Thus the company
will be required to pay £600 in interest.
Answer For the debenture interest the answer is yes. This interest is treated in exactly the
same way as the interest on a loan for a sole trader, as an expense of trading.
The dividend payable, though, is not an expense. Remember the drawings of a sole
trader were not an expense but an extraction of capital invested.
For a company, the dividend payment is shown as a change in equity, as the following
example demonstrates.
Alpha Ltd made a net profit before the payment of interest and dividends of £35,000
in year X. There were £10,000 6% debentures in issue and 100,000 £1 ordinary
shares in issue at the beginning of year X and retained profits were £20,000. No further
issues of shares or debentures were made during the year. The interim dividend
declared was 3p per share and the final proposed dividend 4p per share. The interest
and dividend payments are shown in the income statement, as follows.
INCOME STATEMENT FOR ALPHA LTD
Profit 35,000
Interest on debentures 6% 600
––––––––
Net profit 34,400
––––––––––––––––
Statement of changes in equity
Share Retained Total
capital profits
Balance at beginning of year 100,000 20,000 120,000
Net profit for the year 34,400 34,400
Interim dividend 3p = 3,000
Final dividend 4p = 4,000 (7,000) (7,000)
––––––––– –––––––– –––––––––
Balance at end of year 100,000 47,400 147,400
––––––––– –––––––– –––––––––––––––––– –––––––– –––––––––
136 Financial Accounting
Is the interest payable on the debenture an expense of trading for the company?
Is the dividend payable to the shareholders an expense of trading for the company?
Activity 8.7
Example 8.3
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Financing a company
This chapter has shown us so far that a company can raise capital by issuing
ordinary shares, preference shares and debentures. There are many different
forms of these instruments, e.g. options, warrants, deep discounted bonds,
interest rate swaps, but we leave these to later, more detailed, studies of
finance and financial management. However, in addition to companies
using these various instruments to raise finance they also use bank overdraft
facilities and their own earnings, in the form of non-distributed profit, to
provide finance. We look at the non-distributed profit under the next section
on reserves.
Answer INCOME STATEMENT FOR PUMP LTD
Year 1 Year 2
£ £
Profit 100,000 102,000
Interest on debentures 3% 3,300 3,300
––––––––– –––––––––
Net profit 96,700 98,700
––––––––– –––––––––––––––––– –––––––––
Statement of changes in equity
Share Share Accounting Total
capital premium profits
Balance as at 1.1.Year 1 690,000 200,000 890,000
Profit for Year 1 96,700 96,700
Preference dividend (17,600)
Interim dividend 2p (10,000)
Final dividend 3p (15,000) (42,600)
––––––––– ––––––––– –––––––––
Balance as at 31.12. Year 1 690,000 200,000 54,100 944,100
––––––––– –––––––––
Profit for Year 2 98,700 98,700
Preference dividend (17,600)
Interim dividend 4p (20,000)
Final dividend 5p (25,000) (62,600)
––––––––– ––––––––– ––––––––– –––––––––
Balance as at 31.12. Year 2 690,000 200,000 90,200 980,200
––––––––– ––––––––– ––––––––– –––––––––––––––––– ––––––––– ––––––––– –––––––––
8 · Accounts of limited companies 137
Pump Ltd, a newly forming company, estimates it will need capital of £1m so that it
can remain in business. It estimates its profits per annum before interest payments and
dividends as £100,000 in the first year with an estimated 2% increase year on year. It
proposes to issue 500,000 50p ordinary shares at a premium of 40p, 220,000 4% £2
preference shares and to raise the remaining capital it needs from an issue of 3%
debentures. Show the capital section of the balance sheet and the non-current liabilities
assuming estimated profit is realised, the statement of changes in equity and the
income statement as far as the information provided permits for the first two years of
trading. The interim and final dividends for Year 1 are expected to be 2p and 3p and for
Year 2 4p and 5p. Assume the final dividend is paid before the year end.
Activity 8.8
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CAPITAL BALANCE SHEET SECTION PUMP LTD
Year 1 Year 2
Capital 500,000 50p ordinary shares 250,000 250,000
220,000 £2 4% preference shares 440,000 440,000
Share premium account 200,000 200,000
Profit 54,100 90,200
––––––––– –––––––––
944,100 980,200
––––––––– –––––––––––––––––– –––––––––
Non-current liabilities
3% debentures 110,000 110,000
There are several issues to note in the above activity. First, you needed to
calculate the amount of debentures issued. Ordinary share raised £450,000
(including the share premium remember thus 500,000 × 90p), preference
shares raised £440,000 (220,000 × £2) and therefore the remaining amount
(£1m – 890,000 = £110,000) was required from the debenture issue.
In Year 2, the profit after dividends of £36,100 is in addition to that
already accumulated at Year 1, £54,100.
The percentage payable on the preference shares and debentures is
applied to the monetary amount whereas the dividend payable is calculated
by reference to the number of shares.
Taxation in company accounts
If you look at the income statement in your set of company accounts you
will notice that there is another item that did not appear in the income
statement of a sole trader, and that is taxation.
Companies are separate legal entities, unlike a sole trader’s business, and
are subject to taxation, corporation tax, which will be shown in the
income statement. A sole trader does not show taxation in his accounts as
the taxation authorities view the earnings of the business of the sole trader
as his personal income and tax accordingly. The calculation of corporation
tax is complicated and based on taxable profits, which are not the same as
accounting profits. At this level of study you will be given a figure to use as
the taxation charge for the year. This tax will not be payable until nine
months after the end of the accounting year, so it will be shown as a liability
in the year-end accounts, and an expense in the income statement.
Reserves
If you look at the balance sheet in your set of company accounts you will
notice that the share capital is entered under the heading, Capital and
Reserves. Reserves that you have met so far consist of accumulated profits
of the business, that is, profits that have not been extracted from the business
by the shareholders but have been left as further investment, and
share premium that was an initial investment by shareholders. These
reserves are further classified into capital or revenue reserves. Share
premium is an example of a capital reserve, initial capital invested by
138 Financial Accounting
FNAC_CO8.QXD 12/10/05 10:28 am Page 138
shareholders. Accumulated profit is an example of a revenue reserve, capital
earned from the trading of the business. Another distinction between
capital and revenue reserves is that revenue reserves can be distributed in
the form of dividends; capital reserves must be retained within the business
and cannot be distributed in the form of dividends. This is to protect creditors.
Share capital and capital reserves are sometimes known as the
creditors’ buffer, i.e. the base capital of the company that must not be
repaid to shareholders except in very exceptional circumstances.
Another reserve that you might see in your set of accounts is a revaluation
reserve. When we considered the non-current assets of a business in
our double entry system we tended to record them at historical cost or what
the purchaser had paid for them. Look back to Chapter 5 and the details in
the Mr Bean examples to revise this. However, there might be circumstances
when recording the historical cost or purchase price of the non-current asset
does not provide very relevant information to the user of the accounts.
Answer When the asset has increased in value as the owner has held it due to circumstances
outside his control. For example, business assets such as land and buildings tend to
increase in value in the same way as your house price does. Providing the information
on this increase in value is highly relevant, as the owner could if he wished sell the
asset and increase the business worth. Knowledge of this unrealised, until actual sale,
worth is useful both to owners and those who wish to invest in the business as well as
other users of accounts.
Common practice has arisen and company law permits us to carry assets at their
revalued amount, but we need to know how to account for this increase in value.
Answer The land would have been originally recorded in the books at its original purchase price of
£10,000. The increase in value the company wishes to reflect is £40,000. This is the
amount of the revaluation. Quite simply the fixed asset account of land is shown at £50,000
and the uplift in value, the revaluation, is credited to a revaluation reserve as follows:
LAND ACCOUNT
1.1.X5 Balance b/d 10,000
31.12.X5 Revaluation reserve 40,000 31.12.X5 Balance c/d 50,000
–––––––– ––––––––
50,000 50,000
–––––––– –––––––––––––––– ––––––––
1.1.X6 Balance b/d 50,000
8 · Accounts of limited companies 139
Identify a circumstance when recording a non-current asset at historical cost might
not be the most relevant to the user.
Activity 8.9
Company A purchased land in 20X1 for £10,000 for cash. As at 31.12.X5 the company
estimates that the land could be sold for £50,000. Identify how this increase in
value could be recorded in the company’s books (ledgers).
Activity 8.10
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REVALUATION ACCOUNT
31.12.X5 Balance c/d 40,000 31.12.X5 Land 40,000
–––––––– ––––––––
40,000 40,000
–––––––– –––––––––––––––– ––––––––
1.1.X6 Balance b/d 40,000
The revaluation reserve, the £40,000 in the activity above, is shown in the
balance sheet under the capital and reserves section and is a capital unrealised
reserve. We will consider revaluation reserves again in Chapter 12.
The following activity brings together various issues that you have come
across in your studies so far.
140 Financial Accounting
The trial balance of Beta Ltd as at 31.12.X5, before adjustment for any of the items
listed in the notes, is as follows:
Dr Cr
Issued £1 ordinary shares 50,000
Share premium 5,000
Buildings (cost) 55,000
Fixtures and fittings (cost) 27,000
Vehicles (cost) 15,000
Depreciation as at 1.1 X5
Buildings 3,300
Fixtures and fittings 6,750
Vehicles 5,400
Sales 111,000
Purchases 75,000
Wages and salaries 12,000
Other expenses 8,000
Stock 1.1.X5 2,500
6% debentures 30,000
Debenture interest paid 900
Interim dividend paid 2,000
Debtors and creditors 28,000 15,000
Accumulated profits 1.1.X5 9,500
Cash 10,550
–––––––––– ––––––––––
£235,950 £235,950
–––––––––– –––––––––––––––––––– ––––––––––
The following notes are to be taken into account:
1 Stock as at 31.12.X5 is £3,400 valued at cost.
2 Depreciation is to be provided for as follows:
– Buildings 2% per annum straight line
– Fixtures and fittings 25% straight line
– Vehicles 20% reducing balance.
3 Corporation tax for the year is estimated at £3,500.
Activity 8.11
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Answer BETA LTD
INCOME STATEMENT FOR THE YEAR ENDED 31.12.X5
Sales 111,000
Opening inventory 2,500
Purchases 75,000
––––––––
77,500
Closing stock 3,400 74,100
–––––––– ––––––––
Gross profit 36,900
Wages and salaries 12,000
Office expenses 8,000
Debenture interest 1,800
Depreciation:
Buildings 1,100
Fixtures and fittings 6,150
Vehicles 1,920 9,170
–––––––
Loss on sale 250 31,220
–––––––– ––––––––
Profit before tax 5,680
Taxation 3,500
––––––––
Profit after tax 2,180
––––––––––––––––
BETA LTD
STATEMENT OF CHANGES IN EQUITY
Share Share Accumulated Total
capital premium profits
Balance as at 1.1.X5 50,000 5,000 9,500 64,500
Profit for the year 2,180 2,180
Dividends (2,000) (2,000)
–––––––– –––––– –––––– –––––––
Balance as at 31.12.X5 50,000 5,000 9,680 64,680
–––––––– –––––– –––––– –––––––
8 · Accounts of limited companies 141
4 Fittings originally costing £2,400 on which depreciation of £1,200 had been provided
were sold on 31.12.X5 for £950. No entries have been made in the
accounts for the sale nor has any cash been received.
Prepare the income statement, statement of changes in equity and balance sheet
for Beta Ltd for the year ended 31.12.X5.
FNAC_CO8.QXD 12/10/05 10:28 am Page 141
BETA LTD
BALANCE SHEET AS AT 31.12.X5
Cost Depreciation Net book value
Non-current assets
Buildings 55,000 4,400 50,600
Fixtures and fittings 24,600 11,700 12,900
Vehicles 15,000 7,320 7,680
–––––––– –––––––– –––––––––
94,600 23,420 71,180
–––––––– –––––––––––––––– ––––––––
Current assets
Inventory 3,400
Debtors 28,000
Debtors (fixtures) 950
Cash 10,550
––––––––
42,900
Current liabilities
Creditors 15,000
Taxation 3,500
Debenture interest 900 19,400 23,500
–––––––– –––––––– –––––––––
94,680
Non-current liabilities
6% Debentures 30,000
–––––––––
£64,680
––––––––––––––––––
Capital and reserves
Ordinary shares of £1 50,000
Share premium 5,000
Accumulated profits 9,680
–––––––––
£64,680
––––––––––––––––––
Format presentation
As you have been looking at your set of company accounts you may have
noticed that the presentation of the income statement and balance sheet is
slightly different from the one we have used so far. The Companies Act UK
and the EU Fourth Directive actually specifies four formats that can be
used for the presentation of the income statement of a company and two
for the balance sheet. However the IASs are not as specific as UK law or the
EU directives on the format for the income statement and balance sheet.
We will use for our purposes at this level of study simplified versions of the
Fourth Directive formats, which also take account of the IAS regulations.
142 Financial Accounting
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INCOME STATEMENT FOR THE YEAR ENDED 20YZ
Turnover/Revenue X
Cost of sales (X)
––––
Gross profit X
Distribution costs X
Administration costs X (X)
–––– ––––
Operating profit X
Income from investments X
Interest paid and similar charges (X)
––––
Profit on ordinary activities before tax X
Tax on ordinary activities (X)
––––
Profit on ordinary activities after tax X
Extraordinary charges X
Tax (X) (X)
–––– ––––
Profit for year X
––––––––
This presentation of the income statement requires the analysis of
expenses under three headings: cost of sales, distribution and administration.
Wages and salaries will have to be analysed across these three
headings as will depreciation.
BALANCE SHEET AS AT 20YZ
Non-current assets
Intangible assets X
Property, plant and equipment X
Investments X
––––
X
Current assets
Inventory X
Debtors X
Cash at bank and in hand X
––––
X
Current liabilities due within one year
Creditors (X)
Other (X) (X)
–––– ––––
Net current assets X
––––
Total assets less current liabilities X
Non-current liabilities due after one year (X)
––––
£X
––––––––
Capital and reserves
Called up share capital X
Share premium account X
Revaluation reserve X
Other reserves X
Accumulated profit X
––––
£X
––––––––
8 · Accounts of limited companies 143
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You might also have noticed in your set of accounts two more statements
in addition to the income statement and balance sheet, the cash
flow statement and the statement of changes in equity. The cash flow statement
we will deal with in Chapter 9 and we will look further at the
statement of changes in equity in Chapter 12.
Other organisations
We have looked in some detail in this chapter at accounts for companies.
There are many other types of organisations that have a need to keep
records and prepare information similar to that of companies. We have
referred to clubs and societies in Chapter 7, but charities and public sector
organisations also need similar information. Income statements and balance
sheets for these types of organisations are prepared using the same
principles and concepts as for companies but of course the Companies Act
does not apply to them. Charity accounts have to be prepared in accordance
with the Charities Acts and the government provides detailed
requirements for the public sector. Below, we provide a fully worked example
for the preparation of a set of accounts for a club. We advise you to
work through this example diligently, then you will be able to answer the
question on clubs at the end of chapter. You will remember we initially
looked at these in Chapter 3.
The following information is extracted from the records of Mudby
Rugby Club for the year ended 31.12.X5.
1.1.X5 31.12.X5
£ £
Bar inventory 16,200 17,860
Creditors for bar purchases 8,600 8,100
Creditors for other expenses 230 1,240
Summary of bank account for the year ended 31.12.X5
£ £
Balance 1.1.X5 16,290 Bar purchases 120,650
Subscriptions received 24,530 Bar wages 15,230
Bar sales 146,320 Other salaries and wages 5,340
Interest on investments 1,230 Rent and rates of club premises 5,670
General expenses 8,760
Cost of fittings and furniture 7,680
Balance 31.12.X5 25,040
––––––––– –––––––––
188,370 188,370
––––––––– –––––––––––––––––– –––––––––
144 Financial Accounting
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Other information available at the year end is as follows:
᭤ Rent and rates have only been paid for three quarters of the year
᭤ Investments held by the club at 1.1.X5 had several years ago cost £30,750
᭤ Fixtures and fittings held at 1.1.X5 had cost £42,500 on 1.1.X2 and all
fixtures and fittings are to be depreciated at 10% on original cost
Prepare a bar trading account and an income and expenditure account for
year ended 31.12.X5 and a balance sheet as at that date in good form.
A bar trading account simply groups together all the income and expenditure
relating to the bar to see if it has been operating at a profit.
Bar trading account for Mudby Rugby Club for the year ended 31.12.X5
£ £
Bar sales 146,320
Opening inventory 16,200
Bar purchases (120,650 – 8,600 + 8,100) 120,150
––––––––––
136,350
Closing inventory 17,860 118,490
–––––––––– –––––––––
Gross profit on bar 27,830
Bar wages 15,230
–––––––––
Net profit on bar 12,600
––––––––––––––––––
Income and expenditure account for the year ended 3.12.X5
Subscriptions 24,530
Bar net profit 12,600
Interest on investments 1,230
––––––––
38,360
Other salaries and wages 5,340
Rent and rates (5,670 + 1,890 for last quarter) 7,560
General expenses (8,760 – 230 + 1,240) 9,770
Depreciation of fixtures and fittings
(10% × 42,500 + 7,680) 5,018 27,688
––––––– ––––––––
10,672
––––––––––––––––
8 · Accounts of limited companies 145
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Balance sheet as at 31.12.X5
£ £ £
Cost Depreciation Net book value
Non-current assets
Fixtures and fittings 50,180 17,768 (W1) 32,412
Investments 30,750
––––––––
63,162
Current assets – inventory bar 17,860
Cash at bank 25,040 42,900
––––––––
Current liabilities – rent and rates 1,890
Creditors other expenses 1,240
Bar purchases 8,100 11,230 31,670
–––––––– –––––––– ––––––––
94,832
––––––––
Accumulated fund 1.1.X5 84,160 (W2)
Surplus 10,672
––––––––
94,832
––––––––––––––––
W1 total cost value of fixtures and fittings £42,500 + £7,680 = £50,180
Depreciation 10% on £50,180 = £5,018 for Year 31.12.X5
Depreciation at 10% for 3 years on £42,500 = £12,750
Total depreciation £12,750 + £5,018 = £17,768
W2 Net book value 1.1.X5 fixtures and fittings
(£42,500 – £12,750 depreciation) £29,750
Investments 30,750
Inventory 16,200
Bank 16,290
Creditors (£8,600 + £230) (8,830)
––––––––
84,160
––––––––––––––––
Summary
This chapter has:
᭤ introduced you to the accounts of a limited company
᭤ identified the concept of legal entity of a company and the differences
between a company and a sole trader
᭤ noted that the capital of a company was issued in the form of shares
᭤ noted that companies were subject to taxation, which was accounted for
as a deduction from the profit of the company
᭤ identified the fact that companies are required to publish their final
accounts in a specified format. However, the preparation of the income
statement and balance sheet of the company required the same techniques
as those used for a sole trader.
146 Financial Accounting
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At the end of this chapter there are several exercises for you that will test
your knowledge and understanding of accounting for companies and also
the preparation of final accounts in accordance with the specified formats.
Chapter 9 looks at several other statements that a company is required
to publish in its final accounts (or annual report as it is known).
Self-assessment questions
1 Answer the following questions for both sole traders and companies:
(a) Is there any statutory regulation governing them?
(b) Who owns the business?
(c) Who manages the business?
(d) Is the business a separate legal entity?
(e) Does the business end when its owners change?
(f) Is taxation an expense of the business?
(g) How do owners extract profits from the business for their own use?
(h) Is the business quoted on the stock exchange?
2 The directors of Britton plc wish to raise additional capital. They currently have in
issue one million £1 ordinary shares and no long-term loans. What options do they
have available to raise extra capital and which would you advise them to choose?
3 The following is an extract from the balance sheet of Comp plc as at 31.3.X6:
£m
Ordinary shares £1 20
Share premium account 5
Accumulated profits 12
5% debentures £1 8
(a) What is the par value of each share?
(b) What is the book value of each share?
(c) What is the interest payable per annum on the debentures?
(d) If the interest rate in the market for debentures similar to those of Comp plc was
higher than 5% would the market price of Comp’s debentures in the market place
be higher or lower than £1?
8 · Accounts of limited companies 147
limited company (p. 128)
limited liability (p. 128)
corporate entity (p. 128)
Memorandum of Association (p. 128)
Articles of Association (p. 128)
shares (share capital) (p. 130)
dividend (p. 131)
premium (p. 131)
debentures (p. 134)
taxation (p. 138)
reserves (p. 138)
format presentation (p. 142)
annual report (p. 147)
Key terms
᭤
FNAC_CO8.QXD 12/10/05 10:28 am Page 147
4 The following trial balance was extracted from the books of Cuddly Toy Ltd as at
31.12.X5
Dr Cr
£000 £000
Sales 1,562
Inventory 1.1.X5 660
Purchases 885
Land 1,010
Buildings 980
Equipment 55
Vehicles 72
Depreciation: Buildings 390
Equipment 18
Vehicles 25
Debtors and creditors 180 235
Bank 121
£1 ordinary shares 900
Share premium 350
Distribution expenses 98
Administration expenses 24
Accumulated profits 1.1.X5 185
5% debentures 420
–––––––– ––––––––
£4,085 £4,085
–––––––– –––––––––––––––– ––––––––
The following information has not yet been accounted for:
᭤ Closing inventory 31.12.X5 is valued at £560,000.
᭤ Depreciation is to be charged as follows:
– 2% straight line on buildings
– 20% straight line on equipment
– 25% reducing balance on vehicles.
᭤ Assets are used as follows:
– buildings: 50% cost of sales, 25% distribution and 25% administration
– equipment: all cost of sales
– vehicles: all distribution.
᭤ Taxation to be charged for the year is estimated at £200,000.
᭤ An interim dividend has been declared but not yet paid of 6p per share.
Prepare the published income statement, statement of changes in equity and balance
sheet for the company as at 31.12.X5.
148 Financial Accounting
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5 You are required to prepare the income statement for the year ended 31.3.X6 and
the balance sheet as at that date for internal purposes for the following company:
TRIAL BALANCE OF GERRY LTD AS AT 31.3.X6
Dr Cr
Ordinary shares £1 100,000
6% preference shares £1 20,000
8% debentures 30,000
Share premium 9,500
Revaluation reserve 10,000
General reserve 12,000
Accumulated profit b/f 1.4.X5 976
Non-current assets (cost £210,000) 191,000
Inventory 1.4.X5 14,167
Debtors and creditors 11,000 7,500
Provision for doubtful debts 324
Bank 9,731
Purchases and sales 186,000 271,700
Wages and salaries 31,862
General expenses 15,840
Debenture interest 1,200
Preference dividend 1,200
–––––––––– ––––––––––
£462,000 £462,000
–––––––––– –––––––––––––––––––– ––––––––––
You are also given the following information:
᭤ Inventory 31.3.X6 £23,483.
᭤ Depreciation of non-current assets is to be provided at the rate of 10% per
annum on cost.
᭤ The provision for doubtful debts is to be at 5% of debtors.
᭤ £1,200 of debenture interest and £1,437 of general expenses are to be accrued.
᭤ £925 of general expenses have been paid in advance.
᭤ Provision is to be made for taxation on this year’s profits of £9,700.
᭤ The directors have decided to increase the general reserve by a further £3,000.
8 · Accounts of limited companies 149
᭤
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6 The trial balance of Hobo Ltd as at 30.9.X6 was as follows:
Dr Cr
Audit fee 1,200
Bad debts 5,320
Debtors and creditors 92,360 111,450
Delivery expenses 22,060
Productive wages 32,300
Warehouse wages 30,200
Administrative salaries 15,200
Purchases and sales 426,500 623,300
Administration expenses 5,600
Rents administration 12,600
Inventory 1.10.X5 18,950
Ordinary 50p shares 100,000
Share premium account 50,000
Accumulated profits 1.10.X5 26,000
Premises 275,000
Vehicles 18,500
Equipment 12,000
Depreciation as at 1.10.X5
Premises 3,750
Equipment 3,600
Vehicles 6,500
7% debentures 95,000
Bank 51,810
–––––––––––– ––––––––––––
£1,019,600 £1,019,600
–––––––––––– –––––––––––––––––––––––– ––––––––––––
The following additional information is available:
᭤ Inventory as at 30.9.X6 was valued at £20,650.
᭤ Premises and equipment are used at 50% production and 50% distribution, and
are to be depreciated at the rate of 1% and 10% straight line respectively.
᭤ Vehicles are only used for distribution, and are depreciated at 20% reducing balance.
᭤ A provision for bad debts of 5% is to be allowed for.
᭤ £500 was prepaid for rent and £600 is owing for production wages as at 30.9.X6.
᭤ Taxation for the year is estimated at £22,680.
Prepare the income statement and balance sheet for Hobo Ltd as at 30.9.X6 in a
form suitable for publication.
150 Financial Accounting
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7 The trial balance of Burn Ltd. as at 31.12.X9 was as follows:
Dr Cr
£ £
Purchases and sales 15,260 83,460
Inventory 1.1.X9 6,230
Debtors and creditors 8,240 7,210
Production salaries and wages 12,320
Production expenses 7,210
Warehouse expenses 950
Warehouse wages 10,100
Administration salaries 14,200
Administration expenses 950
Ordinary £1 shares 100,000
Share premium account 20,000
Accumulated profits 1.1.X9 62,000
Premises 200,000
Equipment 50,000
Vehicles 15,000
Provision for depreciation: Premises 20,000
Equipment 15,000
Vehicles 6,560
6% Debentures 50,000
Bank 103,520
Cash 250
New capital 80,000
––––––––– –––––––––
444,230 444,230
––––––––– –––––––––––––––––– –––––––––
The following additional information is available none of which has been accounted
for in the trial balance:
᭤ Inventory 31.12.X9 £4,560.
᭤ Premises and equipment are used 50% production, 25% distribution and 25%
administration and are depreciated at the rate of 2% and 10% respectively.
᭤ Vehicles are only used by distribution and are depreciated at 25% reducing balance.
᭤ A provision for bad debts of 5% is to be made.
᭤ The new capital consists of the issue on 1.12.X9 of 40,000 £1 shares; the ledger
clerk did not know how to treat this item in the ledgers.
᭤ Tax for the year is estimated at £1,200.
᭤ A vehicle, purchased 1.1.X7 for £7,000 was sold on 1.8.X9 for £3,750. The proceeds
had been credited to sales.
᭤ 5% Debentures were issued on 1.1.X9, par value £10,000, for £9,500. The
£9,500 has been credited to accumulated profits 1.1.X9 account.
Prepare the income statement and the balance sheet for Burn Ltd. as at 31.12.X9
in a form suitable for publication.
8 · Accounts of limited companies 151
᭤
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8 The trial balance of Black Ltd as at 31 December 20X5 was as follows:
Dr Cr
Debtors and creditors 46,800 34,200
Returns inwards 2,450
Productive wages 74,000
Distribution expenses 32,870
Administrative salaries 61,230
Purchases and sales 321,700 552,600
Office expenses 5,630
Returns outwards 4,670
Inventory 1.1.X5 22,300
Ordinary £1 shares 150,000
Debentures 6% 50,000
Accumulated profits 1.1.X5 9,870
Premises 150,000
Vehicles 85,000
Equipment 70,000
Depreciation as at 1.1.X5
Premises 11,600
Equipment 27,500
Vehicles 29,250
Bank 2,290
–––––––––– ––––––––––
£871,980 £871,980
–––––––––– –––––––––––––––––––– ––––––––––
The following information is available none of which has been taken account of in
the preparation of the trial balance above:
(a) Inventory as at 31 December 20X5 is valued at £22,000.
(b) Vehicles are primarily used for distribution, buildings equally between production,
distribution and administration and equipment equally between production
and administration.
(c) Buildings are to be depreciated 1% straight line, equipment 20% straight line
and vehicles 25% reducing balance.
(d) Equipment was sold on the 31 December 20X5 for £15,000. This had been
credited to sales. The original cost was £20,000 and it had been purchased on
31 December 20X2. No further entries than cash and sales had been made in
the books.
(e) Bad debts of £2,600 need writing off and a provision for bad debts at the rate
of 5% is to be introduced.
(f) Taxation for the year is estimated at £9,860.
(g) Accruals of £3,500 for administration expense are required and prepayments of
£5,600 have been identified within distribution expenses.
(h) The interest on the debentures has not yet been paid.
Prepare the income statement for the year ended 31 December 20X5 and the balance
sheet as at that date in a form suitable for publication.
152 Financial Accounting
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9 Explain the terms rights issue and bonus issue of shares
10 Gamma plc has issued share capital of £1,000,000, nominal value of ordinary
shares is £2 and accumulated profits of £456,000 as at 31.12.X6. The company
proposes to make a rights issue of 2 for 5 existing shares held at a price of £4.25
and a bonus issue of 200,000 ordinary shares. The market value of the shares as at
31.12.X5 is £6.70. Show the capital section of the balance sheet after the two
share issues and also identify how many shares a holder of 1,000 shares before the
issues will have afterwards.
Answers to these questions can be found at the back of this book.
8 · Accounts of limited companies 153
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154 Financial Accounting
9
Cash flow statements
Introduction
In previous chapters we have concentrated on preparing financial information
for a business based on the concept of profit. You should have already
realised that profit does not equal cash and therefore it is quite possible for a
business to be making reasonable profits but have very little cash. However,
cash is vital to a business. Without it the business cannot purchase inventory,
pay creditors, wages or any other expenses. Cash is quite often referred
to as the ‘lifeblood’ of a business – without it it will not survive!
A business therefore must pay attention to both its profit and cash position.
Cash flows within a business
At this point in your studies you should be able to complete the following
activity quite quickly. If you do have problems return to Chapter 5 and
consider the cash transactions that Mr Bean made.
By the end of this chapter you should be able to:
᭤ Explain the importance of cash flow within the business.
᭤ Identify cash flows within a business.
᭤ Prepare a cash flow statement.
᭤ Explain the relationship between the cash flow statement, income
statement and balance sheet within a business.
᭤ Identify the difference between the indirect and direct method of
preparing a cash flow statement.
᭤ Identify and calculate a simple cash flow ratio.
᭤ Explain the word ‘fund’ as used in accounting.
Objectives
FNAC_CO9.QXD 12/10/05 10:29 am Page 154
Answer CASH FLOWS
Into the business Out of the business
᭤ Capital contributed in cash ᭤ Wages paid in cash
᭤ Cash sales ᭤ Cash purchases
᭤ Receipts from debtors ᭤ Payments to creditors
᭤ Cash loans and debentures ᭤ Purchase of non-current assets
᭤ Sale of fixed assets ᭤ Cash paid for rent, heat, etc.
᭤ Rents or other income received ᭤ Dividends paid
᭤ Interest and dividends received ᭤ Interest paid
᭤ Taxation paid
You have, in fact, just constructed a cash account and this is essentially what a cash
flow statement is about.
Remember what we said in Chapter 1 about a cash flow statement, which
was that:
᭤ Many accountants regard it as more objective and reliable than an
income statement.
᭤ Cash flows are generally hard fact whereas assessment of profit requires
estimation and subjective judgement.
᭤ It is much easier to manipulate profit figures than cash figures.
The above factors are demonstrated in the following activity.
9 · Cash flow statements 155
Identify as many cash flows as you can for a business. Enter them in the table
below. Two are already entered for you.
CASH FLOWS
Into the business Out of the business
᭤ Capital contributed in the form of cash ᭤ Wages paid in cash
Activity 9.1
Alex Ltd has drawn up the following income statement for the first year of trading:
£
Sales 60,000
Cost of sales 35,000
––––––––
Gross profit 25,000
Depreciation 5,000
Expenses 10,000
––––––––
Net profit 10,000
––––––––––––––––
The following information is also available:
᭤ The company started the year with £20,000 cash in the bank.
᭤ Sales for cash throughout the year were £58,000 and cost of sales for cash
£38,000. No debtors or creditors existed at the beginning of the year.
Activity 9.2
᭤
FNAC_CO9.QXD 12/10/05 10:29 am Page 155
Answer £
Opening cash 20,000
Add cash sales 58,000
––––––––
78,000
Deduct: cash cost of sales 38,000
Cash expenses 8,500
Non-current assets paid for 15,000
Closing cash 16,500
––––––––––––––––
Cash inflows were sales of £58,000
Cash outflows were cost of sales of £38,000, expenses of £8,500 and purchase of
assets of £15,000, a total of £61,500.
A net outflow of £3,500 has occurred. This is mainly due to the purchase of non-current
assets, which, remember, is not recorded in the income statement in the year of acquisition,
but is spread over the useful life of the asset by means of a depreciation charge.
The profit figure above of £10,000 can be changed if different assumptions are made
about the depreciation charge.
In the above activity Alex Ltd is profitable but if, to remain in business, it
had to purchase £50,000 of non-current assets, or if it had to repay a loan
of £50,000 immediately after the end of the year then it would not have
enough cash to do this and would need to organise an overdraft facility.
The future of the business depends, to a large extent, on its cash position
and its ability to generate cash to pay off the overdraft. As cash is so important
to businesses they are required to prepare a cash flow statement which
identifies the cash position of the business at a point in time and the
inflows and outflows of cash for the users of the financial statements.
Using the above activity we can also calculate a very simple cash flow
ratio. You will learn more about ratios and ratio analysis in Chapter 11, but
it is useful to deal with this one ratio at this stage. Ratios can help us to
interpret/analyse the information in a set of financial statements. From the
above activity we can calculate a ratio of total cash inflows divided by total
cash outflows; 58,000/61,500 = 0.94. This is close to 1, indicating that our
inflows have almost matched our outflows and we have been able to purchase
some non-current assets.
156 Financial Accounting
᭤ Of the expenses figure of £10,000, £1,500 has not yet been paid.
᭤ The company acquired £15,000 of non-current assets during the year paying in cash.
Identify:
᭤ The cash figure at the end of the year and explain why this is different from the
profit figure.
᭤ Cash inflows and outflows during the year.
᭤ Any figures in the income statement that could be manipulated.
FNAC_CO9.QXD 12/10/05 10:29 am Page 156
Cash flow statement
Accountants prepare cash flow statements to a given format prescribed by
the International Accounting Standards Board in IAS 7. This format incorporates
all the items you have listed in Activity 9.1 above, but identifies
cash flows under specific headings as follows:
CASH FLOW STATEMENT FOR THE YEAR ENDED XX
Net cash inflow/outflow from operating activities X
Interest paid (X)
Taxation paid (X) X
–––
Net cash used in investing activities
Acquisition of subsidiary less cash acquired X
Purchase of non-current assets X
Proceeds from sale of non-current assets X
Interest received X
Dividends received X X
–––
Net cash used in financing activities
Proceeds from issuing shares X
Proceeds from long-term borrowing X
Dividends paid (x) X
––– –––
Increase/Decrease in cash and cash equivalents £X
––––––
One item on this cash flow statement, the net cash inflow/outflow from
operating activities, does not equate directly to an item on the cash account.
We will explain how this figure is derived later in this chapter. To familiarise
yourself with the cash flow format, work through the following activity.
9 · Cash flow statements 157
The following information is available in respect of White Rose Ltd for the year end
31.12.X5:
᭤ Net cash inflow from operating activities was £120,000.
᭤ The company received dividends during the year of £45,000, paid an interim dividend
of £30,000 and proposed a dividend of £20,000 at the year end. Last
year’s proposed dividend was £25,000.
᭤ The taxation charge for the year was estimated at £55,000 which was £3,000
less than that estimated for the year ended 31.12.X4.
᭤ Interest was payable during the year on £200,000 of 5% debentures. All interest
due had been paid at the year end.
᭤ White Rose Ltd had purchased £120,000 of fixed assets during the year to
31.12.X5 and fixed assets sold had produced a profit on sale of £10,000. The
net book value of fixed assets sold was £50,000.
Activity 9.3
᭤
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Answer CASH FLOW STATEMENT FOR THE YEAR ENDED 31.12.X5
£ £
Net cash inflow/outflow from operating activities 120
Interest paid (10)
Taxation paid (58) 52
–––––
Net cash used in investing activities
Acquisition of subsidiary less cash acquired
Purchase of non-current assets (120)
Proceeds from sale of non-current assets 60
Interest received
Dividends received 45 (15)
–––––
Net cash used in financing activities
Proceeds from issuing shares 75
Proceeds from long-term borrowing 40
Repayment of debentures (20)
Dividends paid (55) 40
––––– –––––
Increase/Decrease in cash and cash equivalents £77
––––––––––
In completing this activity care was required when dealing with the following items to
ensure that the cash flow was identified:
᭤ Dividends proposed at the year end 31.12.X5 were not paid but the proposed dividend
from the previous year was.
᭤ Tax is not due until nine months after the end of the year so the tax paid is last
year’s liability.
᭤ The actual receipt from the sale of assets was the cash flow not the profit on sale
which is the figure included in the income statement.
᭤ The cash flow from the issue of shares included the share premium.
Net cash flow from operating activities
This item refers to cash flows in respect of buying and selling goods and
expenses incurred. It can, of course, be derived from the cash book by identifying
all cash receipts from trading and all cash payments such as
payments to trade creditors, payments for wages, rent, rates, electricity and
so on. This would be the direct method of arriving at the net cash flow
from operating activities. However, it can also be derived from the income
statement for the year.
158 Financial Accounting
᭤ White Rose Ltd had also issued 50,000 £1 ordinary shares at a premium of 50p.
All shares were fully paid at the year end. A loan of £40,000 had also been raised
by the company at the same time as redeeming loans of £20,000 at par.
Prepare the cash flow statement for the year ended 31.12.X5 (NB: There were
no acquisitions or disposals of subsidiaries.
FNAC_CO9.QXD 12/10/05 10:29 am Page 158
9 · Cash flow statements 159
Answer ᭤ Depreciation – a book entry not a flow of cash.
᭤ Profit or loss on sale of assets – the cash receipt of sale price is the cash flow.
᭤ Accruals and prepayments – income and expense within the income statement is recognised
in accordance with accounting concepts. It is not the cash receipt and payment.
᭤ Sales (cash sales and sales on credit) – the cash flow is cash sales and receipts
from debtors.
᭤ Cost of sales (cash and credit purchases adjusted for opening and closing inventory) –
the cash flow is the cash spent during the year on purchases and payments to creditors.
Another method, in contrast to the direct method, of arriving at the net
cash flow from operating activities would be to adjust the operating profit
before taxation, interest and dividends for all the items listed in the answer
to Activity 9.4. This is known as the indirect method. IAS 7 actually prefers
the direct method as it provides information which may be useful in estimating
future cash flows which is not available under the indirect method.
It does however permit the use of the indirect method as it can be easily
derived from the income statement.
The reconciliation of operating profit and net cash flows from operating
activities is required as a note to the cash flow statement. The note is formatted
as follows:
Reconciliation of operating profit and net cash flows from
operating activities:
Operating profit (as per income statement) X
Adjustment for items not involving the
movement of funds
Depreciation X
(Profit)/loss on sale of assets (X)
Amortisation X X
––––
(Increase)/decrease in inventory X
(Increase)/decrease in debtors X
(Decrease)/increase in creditors X
––––
Net cash inflows from operating activities £X
––––––––
Note in the above that:
᭤ Depreciation and amortisation charges are added back to the operating
profit as these were deducted in arriving at the profit figure. Amortisation
is the term used to describe the depreciation of leases.
᭤ Profit on sale is deducted.
Identify as many items as you can that appear in the income statement before interest,
taxation and dividends that do not involve a flow of cash.
Activity 9.4
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160 Financial Accounting
᭤ Decrease in inventory and debtors from last year to this is added to the
operating profit as this means less cash has been tied up in inventories and
debtors. Conversely an increase would mean more cash had been tied up.
᭤ An increase in creditors is also added back to the profit figure as this
means cash has been kept in the business not paid out to reduce the liability
to creditors.
The direct method of arriving at net cash flows from operating activities is
formatted as follows:
Cash received from customers X
Cash paid to suppliers (X)
Cash paid to and on behalf of employees (X)
Other cash payments (X)
––––
Net cash inflow from operating activities £X
––––––––
The following information is available in respect of Red Rose Ltd for the year ended
31.12.X5.
INCOME STATEMENT EXTRACT FOR THE YEAR ENDED 31.12.X5
Net profit 120
Net interest charges 30
–––––
Net profit before taxation 90
Taxation 15
–––––
Net profit after taxation 75
Dividends paid and proposed 40
–––––
Retained profit £35
––––––––––
Net profit of £120 is after charging depreciation of £25 and including loss on sale of
assets of £15.
BALANCE SHEET EXTRACTS
31.12.X4 31.12.X5
£ £
Inventory 8 6
Debtors 5 2
Cash 2 3
–––– ––––
15 13
Creditors 7 8
Prepare the reconciliation of operating profit to net cash flow from operating activities.
Activity 9.5
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9 · Cash flow statements 161
Answer Net profit before interest and taxation 120
Adjustments for items not involving the movements
of funds
Depreciation 25
Loss on sale 15 40
––– –––––
160
Decrease in inventory 2
Decrease in debtors 1
Increase in creditors 1 4
––– –––––
£164
––––––––––
Purpose of cash flow statement
The cash flow statement provides information in addition to that provided
by an income statement and balance sheet. It identifies the cash flows in a
business which are not apparent from the other two statements. It also
identifies whether cash has increased or decreased from one year to the
next. It does, however, have several drawbacks, some of which it shares
with the other statements.
Answer Several clues have already been given to you to answer this question. You should have
identified two from the following:
᭤ Cash is the ‘lifeblood’ of an organisation but the cash flow statement is historical. If
we are concerned over the liquidity of a business, the ability to pay its debts, then a
cash flow forecast would be more useful.
᭤ Cash flow from operating activities is derived by either the direct or indirect method.
The indirect method uses information from the accruals-based accounting system. If
cash flow is what we are interested in then there should only be one alternative –
the direct method. This would also avoid confusion for users who may have difficulty
in understanding the reconciliation between operating profit and cash flow.
᭤ What is cash? Is it cash in the shop till, cash in the bank, short-term investments?
Just what do we mean by cash?
Funds flow
This section will provide you with an answer to the last question raised in
the answer to Activity 9.6.
We have already looked at the idea of funds in Chapter 2, which identified
the concept of funds coming into and out of the business – sources
and applications. Sources of funds were such items as profit from trading,
Identify two drawbacks of a cash flow statement.Activity 9.6
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162 Financial Accounting
capital invested and loans taken out. Applications were the purchase of
non-current assets and investments. Funds were not necessarily cash funds.
In Chapter 11 you will meet the phrase ‘return on shareholders’ funds’.
These funds are the total of share capital and reserves, which are certainly not
represented solely by cash. Shareholder funds are represented by the business’s
net assets, that is, non-current assets and current assets less current liabilities.
In general, in accounting the word ‘funds’ is used in connection with the
accruals-based accounting system. It is possible to prepare a statement of
sources and applications of funds for every business. In fact, prior to the
introduction of the cash flow statement requirement businesses did prepare
such a statement. The statement, instead of arriving at a figure showing the
increase/decrease in cash balances, showed the change in working capital –
the funds flow. Working capital is the difference between current assets and
current liabilities including accruals and prepayments. It is quite feasible for
a business to have a net inflow of funds, as defined in terms of working capital,
but an actual net outflow of cash. This is demonstrated by the
following example.
BALANCE SHEET EXTRACTS
31.12.X4 31.12.X5
£ £
Inventory 12 14
Debtors 8 9
Cash 6 5
–––– ––––
26 28
Creditors 12 9
–––– ––––
14 19
–––– –––––––– ––––
Increase in working capital (19 – 14) 5
Decrease in cash (6 – 5) 1
The move away from preparing source and application of funds statements
to that of preparing cash flow statements is regarded by many as being an
important step forward in the provision of useful information.
Answer You should have identified two of the following:
᭤ Cash is more objective and verifiable. It is not blurred by estimates of accruals and
prepayments.
᭤ Cash is more easily understood by users.
᭤ Cash flow is a better guide to a business’s ability to pay its liabilities than a funds flow.
᭤ Working capital is not an indication of the solvency of a business.
Identify two reasons why cash flow statements may be regarded as more useful than
funds flow (working capital) statements.
Activity 9.7
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9 · Cash flow statements 163
Cash and cash equivalents, for our cash flow, still needs to be defined. In general,
cash is determined as cash on hand and all deposits payable on demand. Deposits
payable on demand are defined as those that are easily convertible into cash and can
be withdrawn at any time without notice and without penalty. Don’t forget that overdrafts
repayable on demand will also have to be taken into account. Cash equivalents
refers to short-term investments. Investments are viewed as short term if the maturity
date is within three months or less from the date of acquisition.
Answer 1 This can be viewed as short term and therefore cash equivalent
2 This is really a long-term investment as far as cash flows are concerned and therefore
part of investing activities
3 This is cash
4 This is financing activities as a loan for a specific purpose cannot be viewed as
everyday cash management
5 There is a significant risk with this investment and therefore it should be viewed as
part of investing activities
Relationship between the cash flow statement, income statement
and balance sheet
In the preparation of cash flow statements so far in this chapter, you have
been given the information required. However, some of this information
can be deduced from the income statement and the opening and closing
balance sheets. For example, you should be able to identify the increase in
share capital from the opening and closing balance sheets. The following
example illustrates the connections between the three statements and
demonstrates the preparation of a cash flow statement by using information
from the other two plus additional information.
Determine whether the following items are cash, cash equivalents, investing activities
or financing activities;
1 An account held with a bank where a withdrawal requires 80 days’ notice
2 An account held with a bank where a withdrawal requires 150 days’ notice
3 An overdraft with the bank which is seen as short term and part of everyday cash
flows of the business
4 A loan from a bank for 75 days for a specific purpose
5 An investment with the bank which has 60 days to maturity but its final value
payable fluctuates in accordance with stock market values
Activity 9.8
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164 Financial Accounting
The following information is available in respect of Yellow Rose Ltd.
INCOME STATEMENT FOR THE YEAR ENDED 31.12.X5
£ £ £
Gross profit 140
Depreciation 30
Interest receivable (5)
Interest payable 8 3
–––
Profit on sale of asset (8)
Amortisation of intangibles 20 45
––– ––––
Net profit before taxation 95
Taxation 40
––––
Net profit after taxation 55
Dividends paid and proposed 40
––––
Retained profit after dividends £15
––––––––
BALANCE SHEETS AS AT
£ £
31.12.X4 31.12.X5
Non-current assets
Intangibles 120 140
Property, plant and equipment 320 389
––––– –––––
440 529
Current assets
Inventory 30 34
Debtors 24 22
Cash and bank 64 72
118 128
Current liabilities
Creditors 32 36
Dividends 15 20
Taxation 45 40
92 96
Net current assets 26 32
––––– –––––
466 561
Non-current liabilities 100 120
––––– –––––
£366 £441
––––– –––––––––– –––––
Ordinary share capital 250 280
Share premium 20 30
Retained profits 96 111
––––– –––––
£366 £441
––––– –––––––––– –––––
Example 9.1
FNAC_CO9.QXD 12/10/05 10:29 am Page 164
The sale proceeds from the sale of non-current assets was £36. All interest due has
been received and the interest payable has been paid. The first task to carry out to
prepare the cash flow statement is to identify all changes from last year’s balance
sheet to this year’s. Note that in the above example the current year figures are on the
right. It is advisable when you are given several columns in a table referring to different
years to take great care in identifying the appropriate year’s figures.
Intangible fixed assets have increased by £20. Amortisation of intangibles for the
year was £20, therefore cash of £40 must have been spent.
Property, plant and equipment has changed according to the balance sheets from
£320 to £389. However, assets have been bought, sold and depreciated throughout
the year. If assets sold produced a profit of £8 and proceeds of £36 then the net book
value of assets sold was £28. We can now identify how the assets have changed:
1.1.X4 balance 320
Sale of assets 28
–––––
292
Depreciation year 31.12.X5 30
–––––
262
31.12.X5 balance 389
–––––
Therefore purchase £127
––––––––––
However, a revaluation reserve of £20 has been created during the year. If we assume
this is in respect of non-current assets, then the figure for the purchase of assets
reduces to £107. Current asset changes are easy to identify as inventory increases £4,
debtors decrease £2 and cash increase £8. Similarly, creditors increase £4.
We need to be more careful when identifying the changes in respect of taxation and
dividends. The balance sheet as at 31.12.X5 shows the liability remaining in respect of
these items, the income statement shows the matched charge for the year.
Thus dividends paid during the year will be:
Balance 1.1.X5 15
Charge for year 40
–––––
55
Balance 31.12.X5 20
–––––
Paid £35
––––––––––
and taxation:
Balance 1.1.X5 45
Charge for year 40
–––––
85
Balance 31.12.X5 40
–––––
Paid £45
––––––––––
The change in non-current liabilities indicates a further loan of £20 raised and the
changes in respect of ordinary share capital and share premium, issue of shares for
cash of £40.
9 · Cash flow statements 165
Example 9.1
continued
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166 Financial Accounting
We can now prepare the reconciliation of operating profit to net cash flow from
operating.
Profit before interest and taxation (95 + 3) 98
Depreciation 30
Amortisation 20
Profit on sale (8) 42
––––– –––––
140
Increase in inventory (4)
Decrease in debtors 2
Increase in creditors 4 2
––––– –––––
Net cash inflow from operating activities £142
––––––––––
CASH FLOW STATEMENT FOR THE YEAR ENDED 31.12.X5
Net cash inflow from operating activities 142
Taxation paid (45)
Interest paid (8) 89
––––––
Net cash used in investing activities
Payments to acquire intangible non-current assets (40)
Payments to acquire property, plant and equipment (107)
Sale of non-current assets 36
Dividends received
Interest received 5 (106)
–––––– ––––––
Net cash used in financing activities
Dividends paid (35)
Issue of shares 40
Loans raised 20 25
–––––– ––––––
Increase in cash balances £8
––––––––––––
Note: The figure derived from the cash flow statement for the increase in cash equates
to the increase we identified from the balance sheet 1.1.X5 to 31.12.X5.
Interpretation of cash flow statements
It is possible to gain an insight into the activities of a business by reviewing
the cash flow statement. For example, the cash flow in respect of Yellow
Rose Ltd identifies the following facts:
᭤ Interest, dividend and taxation payments are more than covered by the
cash generated from operating activities.
᭤ Acquisition of non-current assets has been financed partly from internal
resources and partly from new capital raised in the form of shares
and loans.
Example 9.1
continued
FNAC_CO9.QXD 12/10/05 10:29 am Page 166
9 · Cash flow statements 167
᭤ Working capital displays no significant changes during the year, the
small increase in inventory being matched by an increase in creditors.
᭤ The company could either be expanding or just replacing worn out assets.
Answer ᭤ Interest, dividend and taxation payments are slightly more than the cash generated
from operating activities. The business has gained a benefit from its investments in
the form of dividends received.
᭤ Acquisition of non-current assets has been partly financed by sale of old assets and
partly from issue of new capital in the form of shares and loans.
᭤ New debentures were issued in part to finance the redemption of older debenture stock.
᭤ The remainder of the cash raised from the issue of shares and loans still remains in
the cash balances.
᭤ It is possible that from these cash balances the business intends to purchase more
non-current assets.
Summary
This chapter has
᭤ introduced you to the cash flow statement
᭤ reiterated the fact that profit does not equal cash and that for a business to
survive it must have cash – it is its ‘lifeblood’. A cash flow statement is historical
in nature but identifies cash inflows and outflows within a business
᭤ presented cash flow statements in a prescribed format which also
includes a reconciliation of operating profit to net cash inflow
᭤ derived cash flows from operating activities by using either the direct or
indirect method. The direct method is more appropriate and is the
method preferred by the IASB as this identifies cash from customers and
cash paid to customers and others, whereas the indirect method arrives
at the cash flow by adjusting profit for movements in working capital
and items not involving the movement of funds. The majority of businesses,
though, prepare their cash flow using the indirect method as it
demonstrates the link between the three required financial statements
and does not require the business to adapt their information systems to
extract additional information
᭤ continued the discussion in respect of the definition of funds, which we
began at Chapter 2.
The self-assessment exercises at the end of this chapter provide you with
practice in preparing cash flow statements.
Review the cash flow for White Rose Ltd. and identify any facts you can about the
business from it.
Activity 9.9
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168 Financial Accounting
Self-assessment questions
1 Identify information provided by a cash flow statement to users that is not provided
by an income statement and balance sheet.
2 From the following information in respect of Sparrow Ltd prepare the cash flow statement
for the year ended 31.12.X5.
BALANCE SHEETS AS AT
31.12.X4 31.12.X5
£000 £000
Non-current assets
Intangible 237 222
Property, plant and equipment 637 738
Investments 100 120
–––––––– ––––––––
974 1,080
Current assets
Inventory 230 256
Debtors 136 194
Bank – 26
–––– ––––
366 476
Current liabilities
Creditors 97 103
Taxation 64 61
Dividends 60 66
Bank overdraft 24 –
–––– ––––
245 230
Net current assets 121 246
–––––––– ––––––––
Total assets less current liabilities £1,095 £1,326
–––––––– –––––––––––––––– ––––––––
Ordinary shares of £2 500 520
Share premium – 130
Retained profits 545 576
Debentures 50 100
–––––––– ––––––––
£1,095 £1,326
–––––––– –––––––––––––––– ––––––––
cash flows (p. 155)
cash flow statement (p. 155)
net cash flow from operating activities
(p. 158)
direct method (p. 158)
indirect method (p. 159)
funds flow (p. 162)
Key terms
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9 · Cash flow statements 169
INCOME STATEMENT FOR THE YEARS ENDED
31.12.X4 31.12.X5
£000 £000
Net profit for the year before tax 151 158
Taxation 64 61
–––––– ––––––
Net profit after tax 87 97
Dividends 60 66
–––––– ––––––
Retained profit for the year 27 31
Retained profit b/f 518 545
–––––– ––––––
£545 £576
–––––– –––––––––––– ––––––
Depreciation charged during the year was £187,000 and assets sold during the year
produced a profit of £45,000. The net book value of the assets sold was £88,000.
No intangible non-current assets have been acquired or sold during the year. Interest
charged in the income statement for the year was £12,000 and all of this was paid.
3 Review the cash flow statement prepared in answer to question 2 and summarise
any conclusions which may be drawn from it in respect of the financial operations
and position of Sparrow Ltd for the year ended 31.12.X5.
4 On 1 September 200Y CIP Ltd. issues 21 million £1 ordinary shares at a premium of
100%. The financial statements for the year to 30 September 200Y were as follows:
INCOME STATEMENT FOR THE YEAR ENDED 30 SEPTEMBER 200Y
£m £m
Turnover 587
Cost of sales 260
–––––
Gross profit 327
Distribution costs 51
Administration costs 38 89
–––– –––––
Operating profit 238
Interest payable 12
Interest receivable 5 7
–––– –––––
Profit before tax 231
Taxation 53
–––––
Profit after tax 178
Dividends 33
–––––
Retained profit for the year 145
––––––––––
᭤
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170 Financial Accounting
BALANCE SHEET AS AT
30.9.0Y 30.9.0X
£m £m £m £m
Property plant and equipment 587 331
Current assets:
Inventory 232 256
Debtors 215 182
Interest receivable 2 3
Investments 25 0
Cash 18 35
––––– –––––
492 476
Current liabilities falling due within one year: 382 292
––––– –––––
Net current assets 110 184
––––– –––––
Total assets less current liabilities 697 515
Non-current liabilities due after one year:
Debentures 124 141
––––– –––––
Net assets 573 374
––––– –––––––––– –––––
Capital reserves
Ordinary shares 170 149
10% £1 preference shares 35 35
Share premium account 79 58
Revaluation reserve 12 0
Retained profits 277 132
––––– –––––
573 374
––––– –––––––––– –––––
Additional information:
᭤ The current assets investment is a 30-day government bond.
᭤ Property, plant and equipment include certain properties which were revalued in
the year.
᭤ Depreciation charged in the year is £38 million.
᭤ Debentures were redeemed at par on 30 September 200Y.
᭤ Assets with a net book value of £31 million were disposed of during the year for
£35 million.
᭤ Creditors falling due within one year are further analysed as follows:
30.9.0Y 30.9.0X
£m £m
Bank overdraft 13 33
Trade creditors 309 210
Taxation 48 33
Dividends 7 13
Interest payable 5 3
––––– –––––
382 292
––––– –––––––––– –––––
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9 · Cash flow statements 171
Prepare a cash flow statement for the year ended 30.9.0Y in accordance with IAS 7
showing clearly the reconciliation of operating profit to net cash flows from operating
activities.
5 Prepare a cash flow statement in acceptable form for Peak Ltd for the year ended 31
December 20X5.
BALANCE SHEET AS AT
31.12.X4 31.12.X5
Property, plant and equipment nbv
Buildings 543,100 624,500
Other 93,450 102,300
Investments 56,000 692,550 142,000 868,800
––––––––– –––––––––
Current assets:
Inventory 82,400 83,400
Debtors 54,300 48,750
Bank 1,100
––––––––– –––––––––
137,800 132,150
Current liabilities falling due within one year:
Trade creditors 63,470 35,480
Taxation 10,500 12,500
Dividends 35,000 38,000
Bank 10,500
––––––––– –––––––––
108,970 96,480
––––––––– –––––––––––––––––– –––––––––
Net current assets 28,830 35,670
––––––––– –––––––––
Total assets less current liabilities 721,380 904,470
Non-current liabilities due after one year:
5% Debentures 45,000 150,000
––––––––– –––––––––
Net assets 676,380 754,470
––––––––– –––––––––––––––––– –––––––––
Capital reserves
Ordinary £1 shares 600,000 620,000
Share premium account 40,000
Revaluation reserve 50,000 70,000
Retained profits 26,380 24,470
––––––––– –––––––––
676,380 754,470
––––––––– –––––––––––––––––– –––––––––
᭤
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172 Financial Accounting
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER
£ £
20X4 20X5
Profit before tax 65,600 48,590
Taxation 10,500 12,500
––––––– –––––––
Profit after tax 55,100 36,090
Dividends 35,000 38,000
––––––– –––––––
Retained profit for the year 20,100 (1,910)
Retained profit b/f 1 January 6,280 26,380
––––––– –––––––
Retained profit at 31 December 26,380 24,470
––––––– –––––––––––––– –––––––
The following additional information is available:
᭤ A market issue of shares was made on 1 January 20X5.
᭤ During 20X5 equipment originally purchased at £65,200 was sold for £17,900,
accumulated depreciation being £37,700. The difference on disposal had been
taken to the income statement.
᭤ Buildings costing £100,000 had been purchased during 20X5 and the depreciation
charged for the year 20X5 on other assets was £25,000. The only assets
revalued during the year were the buildings.
᭤ Dividends received amounted to £7,500 and interest received £15,000 during
20X5 both of which had been credited to the income statement.
᭤ The debentures were issued on 1 January 20X5 and all interest due had been paid.
Required
(a) Prepare the cash flow statement for the year ended 31 December 20X5 in a
form suitable for publication.
(b) Summarise the main conclusions arising from the cash flow produced for Peak
Ltd.
(c) Comment on the usefulness of the cash flow statement to users of financial
statements.
(d) Support your answer by relevant articles.
FNAC_CO9.QXD 12/10/05 10:29 am Page 172
9 · Cash flow statements 173
6 Prepare a cash flow statement in acceptable form for Campus Ltd for the year ended
31 December 20X5.
BALANCE SHEET AS AT
31.12.X4 31.12.X5
Property, plant and equipment nbv
Buildings 324,100 624,500
Other 76,450 102,300
Investments 36,000 436,550 142,000 868,800
––––––––– –––––––––
Current assets:
Inventory 72,400 83,400
Debtors 64,300 48,750
Bank 100
––––––––– –––––––––
136,800 132,150
Current liabilities:
Trade creditors 42,470 35,480
Taxation 18,500 12,500
Dividends 25,000 38,000
Bank 16,500
––––––––– –––––––––
85,970 102,480
––––––––– –––––––––
Net current assets 50,830 29,670
––––––––– –––––––––
Total assets less current liabilities 487,380 898,470
Non-current liabilities:
5% Debentures 45,000 150,000
––––––––– –––––––––
Net assets 442,380 748,470
––––––––– –––––––––
Capital reserves
Ordinary £1 shares 350,000 620,000
Share premium account 40,000
Revaluation reserve 50,000 70,000
Retained profits 42,380 24,470
––––––––– –––––––––
442,380 748,470
––––––––– –––––––––––––––––– –––––––––
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER
£ £
20X4 20X5
Profit before tax 83,600 32,590
Taxation 18,500 12,500
–––––––– ––––––––
Profit after tax 65,100 20,090
Dividends 25,000 38,000
–––––––– ––––––––
Retained profit for the year 40,100 (17,910)
Retained profit b/f 1 January 2,280 42,380
–––––––– ––––––––
Retained profit at 31 December 42,380 24,470
–––––––– –––––––––––––––– –––––––– ᭤
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174 Financial Accounting
The following additional information is available:
᭤ A market issue of shares was made on 1 January 20X5.
᭤ During 20X5 equipment originally purchased at £55,200 was sold for £21,900,
accumulated depreciation being £27,700. The difference on disposal had been
taken to the income statement.
᭤ Buildings costing £400,000 had been purchased during 20X5 and the depreciation
charged for the year 20X5 on other assets was £25,000. The only assets
revalued during the year were the buildings.
᭤ Dividends received amounted to £8,500 and interest received £12,000 during
20X5 both of which had been credited to the income statement.
᭤ The debentures were issued on 1 January 20X5 and all interest due had been paid.
Required
(a) Prepare the cash flow statement for the year ended 31 December 20X5 in a
form suitable for publication.
(b) Summarise the main conclusions arising from the cash flow produced for
Campus Ltd.
(c) Comment on the usefulness of the cash flow statement to users of financial
statements
Answers to these questions can be found at the end of this book.
FNAC_CO9.QXD 12/10/05 10:29 am Page 174
10
Regulatory framework in the
UK compared with European
examples and the international
framework
Introduction
The regulatory framework of accounting in the UK has been shaped by various
factors, many of which are historical. The same is true of other
European countries. Several countries have a framework similar to that of
the UK due to the influence of the UK in these countries at some point in
history. Others have a very different framework. Attempts have been made
to harmonise accounting across the EU, the initial steps in this being taken
by the issue of EU Directives. The Fourth Directive issued by the EU
requires all EU members to prepare their financial statements in accordance
with a true and fair view. In fact, the Fourth Directive can be said to
have exported the true and fair view from the UK to the rest of Europe and
imported formatted presentation of accounts to the UK.
In addition we also look at the framework identified by the International
Accounting Standards Board (IASB) and note that all listed companies in
Europe are required to prepare their accounts in accordance with International
By the end of this chapter you should be able to:
᭤ Describe the regulatory framework of accounting in the UK.
᭤ Describe the regulatory framework of accounting in other European
countries.
᭤ Describe the international regulatory framework of accounting.
᭤ Compare and contrast the regulatory framework of accounting in the
UK with those of other European countries and the international
framework.
Objectives
FNAC_C10.QXD 12/10/05 10:30 am Page 175
Accounting Standards as from January 2005. Remember small and mediumsized
companies will still be able to use the national standards of the country
they operate in. This means you will find companies from the same country
using two different sets of standards in their reporting;
᭤ National standards for unlisted companies
᭤ International standards for listed companies
This chapter is intended to provide you with a brief introduction to, and
flavour of, European accounting, as well as identifying the framework of
accounting within the UK and that of the IASB.
We hope it will encourage you to develop your studies in the area of
European accounting at a later stage. Remember, the world is getting ever
smaller due to the improvements in communication networks, and it is
essential to know something about how the rest of the world operates, particularly
mainland Europe.
UK legal framework
In Chapter 8 we referred to the legal framework in respect of limited companies.
This legal framework consists of case law and the Companies Acts.
Answer A simple bit of revision here for you.
The case law was Salomon v Salomon & Co Ltd (1897). This case, after a ruling
handed down by the House of Lords, clearly identified the fact that a limited company
is a separate legal entity from its shareholders.
The Companies Acts detail numerous requirements for the preparation of
published accounts. We have touched on the main requirements at various
points within this text. A summary of these is provided below:
᭤ Directors must prepare a balance sheet and profit and loss account for
each financial year.
᭤ Notes, as prescribed, to the accounts must also be provided.
᭤ The balance sheet and profit and loss account must be prepared to a prescribed
format.
᭤ The balance sheet and profit and loss account must give a true and fair
view of the state of affairs of the company.
᭤ Accounting rules and principles are identified. These are consistent with
those identified in Chapters 1 and 4.
This, then, identifies the legal framework within which accountants
must work in the UK. However, there was and is a need for more than just
a legal framework.
176 Financial Accounting
Identify the case law that is at the base of corporate organisations in the UK.Activity 10.1
FNAC_C10.QXD 12/10/05 10:30 am Page 176
The need for a regulatory framework
The accounting concepts and conventions were identified in Chapter 4.
The five principal accounting concepts as detailed in the Companies Acts
in the UK are
᭤ Going concern.
᭤ Consistency.
᭤ Prudence.
᭤ Accruals/matching.
᭤ Separate valuation of asset and liability.
However, the faithful application of these principles can still result in different
judgements being made which will lead to different profit and loss
and balance sheet figures. For example:
᭤ Does the prudence concept require us to account for all possible liabilities
even those we believe have only a remote chance of occurring?
᭤ Does the matching concept require us to delay charging advertising and
research expenditure within the profit and loss account until we account
for the income it has generated, if any?
Answer ᭤ The concept of prudence would suggest that we should take account of this potential
liability for damages of £200,000. If a provision is made for all of the liability
then the profit for the year will be reduced to a £90,000 loss!
Does prudence require us to provide for this liability no matter how remote the possibility
of the damages becoming payable? Prudence should be about making judgements
with a degree of caution, not about the deliberate overstatement of liabilities, which
may not result in a true and fair view being presented. Perhaps a more reliable view to
take would be to obtain an assessment of the likelihood of the damages becoming a
liability. Therefore the profit for the company could be declared as anywhere from a
£90,000 loss to a £110,000 profit.
᭤ Accounting concepts require us to charge all expenses in the year of payment – prudence
– unless they can be matched with the generation of future revenue, and if there
is a conflict between prudence and matching, then prudence should prevail. Note that
10 · Regulatory framework in the UK compared with European examples and the international framework 177
Boss Ltd identifies a profit of £110,000 for the year before accounting for the following
items:
᭤ There is a law suit pending against Boss Ltd for which the amount of damages
could be £200,000 if the case is lost.
᭤ Expenditure on research for the year was £150,000. This was in respect of the
development of new products. It is probable that a half of this expenditure will
lead to a viable product in two years.
Identify two different accounting treatments for each of the above items both of
which are in accordance with accounting concepts and conventions.
Activity 10.2
FNAC_C10.QXD 12/10/05 10:30 am Page 177
we use this idea of prudence and matching in accounting for prepayments and depreciation.
The research expenditure of £75,000 will be charged against the profit for the
year as there is no possibility of future matching – the profit is therefore £35,000. The
other £75,000 could either be written off in the year under prudence or carried forward
to be matched with future income which looks very probable as it is stated there is a
viable product. Therefore the profit is either £35,000 or a loss of £40,000.
Accounting for these two transactions together gives a profit figure of either
£240,000 loss or a profit of £35,000, or indeed any figure in between.
The above activity clearly demonstrates the effects on profits of applying
different judgements permitted within the faithful application of accounting
principles as identified within the Companies Acts. These differences
were highlighted in the 1960s and led to the introduction of a regulatory
framework for accounting, as well as a legal framework.
One publicised case in the 1960s, demonstrating the above, was that of
the takeover of Associated Electrical Industries Ltd (AEI) by General Electric
Company Ltd (GEC). Before the takeover AEI published forecast profits of
£10 million for 1967; after the bid the actual results showed a loss of £4.5
million. The majority of this difference of nearly £15 million was attributed
to the difference in application of accounting concepts and conventions by
the two companies.
UK regulatory framework
The regulatory framework in the UK has its roots in the 1940s, when the
Institute of Chartered Accountants in England and Wales (ICAEW) issued a
series of Recommendations on Accounting Principles. These were little more
than general summaries of existing practice and by the late 1960s, as we have
seen above, something more was required. In 1971 the Accounting Standards
Steering Committee was established by the ICAEW. In 1976 this became the
Accounting Standards Committee (ASC), which was responsible for preparing
standards of accounting under the auspices of the Consultative Committee of
Accounting Bodies (CCAB). The CCAB comprises the six accounting bodies
ICAEW, ICAS, ICAI, ACCA, CIMA and CIPFA.
The aims of the ASC were to narrow the areas of difference in accounting
practice and to require full disclosure of all accounting bases. It attempted
to achieve these aims by issuing Statements of Standard Accounting Practice
(SSAPs), for example SSAP 12 Accounting for Depreciation.
By the middle of the 1980s the ASC was facing a barrage of criticism
because:
᭤ it had no legal power to force companies to follow the standards
᭤ the standards issued by the ASC allowed alternative treatments and were
essentially of a general, rather than detailed nature
᭤ the time taken to issue a standard was often several years.
178 Financial Accounting
FNAC_C10.QXD 12/10/05 10:30 am Page 178
Answer The ASC was a function of the professional accounting bodies. Directors are responsible
for accounts and may or may not be accountants. The ASC had no power to force
directors to follow SSAPs, which were not legal requirements. It was possible to view
them as an interpretation of the true and fair view, though.
As a result of the criticism of the ASC another committee was established
in 1987 – the Dearing Committee – with the task of reviewing the accounting
standard-setting process within the UK. Dearing reported in 1988,
proposing several radical changes to the process which resulted in the current
regulatory framework.
Current regulatory framework UK
This is now a two-tier structure. First, the Financial Reporting Council (FRC)
was established as the body responsible for overseeing accounting policy
and direction.
Second, the Accounting Standards Board (ASB) was established under the
auspices of the FRC with the power to issue accounting standards without
the prior approval of the CCAB. To date, the ASB has issued 27 Financial
Reporting Standards (FRSs), covering issues such as cash flow, FRS1, reporting
financial performance, FRS3, and has also adopted all of the statements
issued by the ASC. It has also issued in its lifetime 30 Financial Reporting
Exposure Drafts (FREDs) the latest of which is concerned with Financial
Instruments. These FREDs are issued by the ASB for consultation prior to the
issue of the definitive FRS.
Answer Summary of the main requirements of the standard:
᭤ Objectives of the standard.
᭤ Definitions of terms used.
᭤ Statement of standard accounting practice covering scope, detailed requirements
and the date from which effective.
᭤ Reference to compliance with International Accounting Standards.
᭤ Explanation of why the standard was needed.
᭤ Illustrative examples.
᭤ History of the development of the standard.
10 · Regulatory framework in the UK compared with European examples and the international framework 179
Why did the ASC have no legal power to enforce standards?Activity 10.3
Find a copy of any FRS. These should be available in your library in a text of accounting
standards, or may even be available on your computer network. Identify the main
sections of an accounting standard.
Activity 10.4
FNAC_C10.QXD 12/10/05 10:30 am Page 179
As you can see from the above activity the FRSs are detailed and comprehensive,
covering in addition to the actual accounting practice required,
the logic and reasoning behind the issue of the standard.
In addition to this two-tier structure the Financial Reporting Review
Panel (FRRP) was formed under the FRC with the remit to review compliance
with accounting standards by individual companies. The panel
advises companies when their accounts do not appear to be in accordance
with standards and/or a true and fair view, and can request the company to
re-draft their accounts. In addition the panel has the facility to apply to the
law courts for a declaration that the annual accounts do not comply with
standards, and if this is given the company will be legally required to
change its accounts. The Review Panel reviews on average about 50 plcs
each year. This then provides some legal backing for accounting standards,
although just applying to the courts does not guarantee a judgment in the
Review Panel’s favour. A QC has issued a statement to the effect that compliance
with accounting standards would constitute a true and fair view.
Court cases are also a very expensive activity and for this reason the FRRP
is provided with a ‘fighting fund’. To date, no court cases have occurred so
the FRRP seems to have been successful in persuading companies to alter
their accounts where they did not agree with standards.
Answer ᭤ Companies may be preparing accounts in accordance with accounting concepts and
conventions. However, this may still lead to the possibility of different profit figures
being declared from the same set of information.
᭤ Differences in profit figures may be allowed/permitted by the ASB. This is actually
the case. The ASB was only established in 1990, has only issued 27 FRSs and has
not completed the review of all other standards that it took over from the old ASC.
The ASB has another body to assist it in meeting its objectives, the Urgent
Issues Task Force (UITF). The UITF deals very quickly with emerging issues
that require an immediate method of treatment. For example, the UITF has
issued advice on revenue recognition.
180 Financial Accounting
Identify any other reasons that you can think of why no court cases have occurred.Activity 10.5
Draw a diagram to show the relationships between the bodies governing the regulatory
framework.
Activity 10.6
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Answer FRC
ASB FRRP
UITF
The ASB has issued FRS 18 Accounting Policies which updates our Activity 9.2 and
hopefully the company law review will update the Companies Act in relation to the principal
accounting concepts. FRS 18 sets out the principles to be followed in selecting
accounting policies which are defined as ‘those principles, bases, conventions, rules
and practices applied by an entity’. The standard states that two concepts are pervasive,
going concern and accruals and that accounting policies should be judged against
the following objectives: relevance, reliability, comparability and understandability. Note
that the objective of relevance can lead us to provide information on a different cost
base to historical cost. In other words we can revalue assets if that would provide more
relevant information to users provided we balanced the information with objectivity.
Interestingly, prudence is only referred to in FRS 18 where conditions of uncertainty
exist. Prudence is not a pervasive accounting concept.
International regulatory framework
Like the UK, several countries have their own regulatory framework for
accounting and the preparation of annual accounts such as profit and loss
account, balance sheet, etc. However, there is also an international regulatory
framework. This international framework is gaining in importance as
investors seek to invest in global markets and therefore require more comparable
information between companies.
International regulation first began in 1973 with the creation of the
International Accounting Standards Committee which was an independent
private sector body and therefore had no formal authority. Many countries
adopted international accounting standards (IASs) to avoid developing
their own or amended IASs to suit their needs. The IASs were, because the
committee had no formal authority, fairly flexible and in many cases
allowed alternative treatments. During the 1980s the IASC moved to minimise
this flexible approach by clearly stating its preference for a particular
method but its formal authority was not increased.
In 1995 the IASC achieved a breakthrough in terms of authority when it
entered into an agreement with the International Organisation of Securities
Commissions (IOSCO) to complete a core set of standards by 1999. These core
standards would then be endorsed by IOSCO as an appropriate reporting
regime for business entities in the global marketplace for the raising of
finance, i.e. worldwide stock exchanges. This deal was to give the IASC its
authority but in order to achieve the deal the IASC had to agree to a restructuring
which occurred in 2000, becoming the International Accounting Standards
Board, and the core standards were accepted by IOSCO in May 2000.
10 · Regulatory framework in the UK compared with European examples and the international framework 181
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European regulation
The European Union has also entered the arena of international regulation
in terms of the Directives on company law that it has issued, Fourth and
Seventh Directives, and also in terms of its latest statement requiring all
listed companies in the EU to prepare their accounts in accordance with
international standards.
Structure of IASB
The IASB is governed by a group of 19 individual trustees with diverse geographical
and functional backgrounds and its current Chair is Paul A.
Volcker, the former Chairman of the US Federal Reserve Board. The trustees
form the IASC Foundation and they are responsible for governance,
fundraising and public awareness of the IASB. The IASB is solely responsible
for setting International Financial Reporting Standards and has 12
full-time members and two part-time. Its members are chosen for their
technical expertise and experience and its Chair is Sir David Tweedie who
was the Chair of the UK ASB. It’s also interesting to note that the IASC
Foundation and the IASB are based in London.
The structure also includes a Standards Interpretation Committee (SIC)
and a Standards Advisory Council both of which sit alongside the IASB.
Trustees
Standards Advisory Council ASB SIC
The IASB is at the forefront of harmonisation as it pushes for acceptance
of its accounting standards around the world. In addition the requirement
that all listed companies prepare their financial statements in accordance
with IASs will increase the pressure for national standards to harmonise
with those of the IASB. This process has already begun in the UK as the UK
ASB issues new standards that converge with those of the IASB. The UK
convergence programme takes as its starting point the principle that there
can be no case in the medium term for two sets of different accounting
standards in the UK. The UK ASB publishes a convergence handbook and it
would be useful for you to look at this on the website.
Answer We provide no answer for you here as it will depend upon what date you visit the site.
As you can see, the IASB is a key mover in establishing global harmonisation
of accounting but whether this can be achieved perhaps depends on what
determines accounting practices in any country.
182 Financial Accounting
Visit the UK ASB website at www.asb.co.uk and review the progress on the convergence
programme with international accounting standards.
Activity 10.7
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Determinants of the accounting framework
Many factors have determined the legal and regulatory framework of accounting
in the UK. Accounts are prepared ostensibly for their usefulness to users,
therefore the first of the determinants of the accounting framework should be
users’ needs. Looking back over the history of accounting in the UK we can
see that providers of finance, shareholders, have influenced the framework,
notably the establishment of the ASC and then the ASB. Looking further back
in history we can see that as companies were established, and owners passed
the running of the company to directors, owners required information on
stewardship (i.e. the management of the company’s assets) which led to the
establishment of the legal framework. The accounting profession is a determinant
of the framework: the ICAEW was successful in promoting the idea of
the true and fair view in the 1940s. The economic environment also has an
effect on the framework. For example, the high levels of inflation suffered in
the UK in the 1970s led to a consideration of alternatives to historical cost
accounts, to reflect changing values.
The tradition of law within a country also has an effect on the framework.
The UK has a common law system, that is, our laws are about broad
principles, for example Companies Acts, with the detail being left to case
law or other forms of regulation, for example FRSs. Countries with a tradition
of Roman law, that is, detailed rules and regulations, will probably
have a more codified set of rules for accounting regulation.
The framework of accounting in one country can also be influenced by
another country. For example, many British Commonwealth countries
have a system of regulation derived from the UK.
Answer ᭤ Providers of finance.
᭤ Accounting profession.
᭤ Economic environment.
᭤ System of law.
᭤ Other country influences.
These are not the only determinants, but they are the main ones and will
help in understanding why the framework of accounting in other European
countries is different from that of the UK. We cannot look at all countries in
Europe so we have chosen three: Germany, France and the Netherlands. We
will also very briefly look at China. The consideration of these four countries
will be brief but we hope it stimulates your interest to study international
accounting further.
10 · Regulatory framework in the UK compared with European examples and the international framework 183
List five possible determinants of a country’s regulatory framework of accounting.Activity 10.8
FNAC_C10.QXD 12/10/05 10:30 am Page 183
Accounting framework in Germany – the determinants
The providers of finance in Germany were traditionally not so much individual
shareholders but large banks. These banks were able to force companies
to provide financial information to their requirements, thus there was no
pressure for full public disclosure. Germany has a tradition of Roman law
and a strong tradition of central authority imposed by the government. One
interesting element within German law is in relation to taxation; benefits
given under tax law can only be claimed if reflected in the accounts. This is
known in Germany as Massgeblichkeitsprinzip – principle of bindingness – it
binds tax and accounting rules together. In the UK tax laws are, by and large,
separate from accounting legislation. The strength of Germany as a world
power has enabled it to resist influences from other countries so far.
Answer Law and government prescription are prevalent in Germany, therefore one might expect
a system of detailed instruction dominated by tax law.
Germany’s accounting framework is indeed dominated by legislation.
Companies Acts and tax law identify the legal framework and a uniform
chart of accounts is also prescribed. There is no official institution for the
setting of binding accounting standards as they are all prescribed by law,
particularly tax law. There is a strong accounting profession but it is one
geared towards carrying out the letter of the law, not developing Generally
Accepted Accounting Principles (GAAP). The majority of accounting decisions
are formulated by the Supreme Tax Court.
However, Germany as a member of the EU is subject to EU Directives
and has had to introduce into its law the concept of a true and fair view,
but this is not treated as an override as in the UK. Accounts are still prepared
in accordance with law, which according to German law will provide
a true and fair view. An interesting way of interpreting true and fair!
German law also identifies the concepts of going concern, consistency,
accruals, prudence and individual determination (separate valuation of assets).
Accounting framework in France – the determinants
Providers of finance in France have traditionally been the government or
banks. The accounting profession is government controlled as is the economic
environment. The law is Roman law and one of the main influences
on accounting in modern times has come from Germany. During the occupation
of France in the Second World War, Germany introduced a General
Accounting Plan which was an accounting guide detailing valuation and
measurement rules, definitions of accounting terms and structured financial
184 Financial Accounting
Given the information above suggest in one sentence what type of accounting framework
Germany may have.
Activity 10.9
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statements. This plan was retained by France after the liberation as it provided
the government with a means of control when rebuilding French
industry. This plan – plan comptable – was referred to in Chapter 4.
Answer Government control is at the centre of these determinants, therefore the accounting
framework will be one of detailed prescription by law.
The accounting framework is dominated by legislation. Accounting regulations
and Charts of Accounts are drawn up by the Conseil National de la
Comptabilité (CNC), a body closely linked to the Finance Ministry.
The legal framework is dominated by the General Accounting Plan which
identifies the accounting concepts of accruals, consistency, individual determination,
prudence and going concern. The EU Fourth Directive also introduced
the principle of Image Fidèle – true and fair view – to French accounting.
Accounting framework in the Netherlands – the determinants
Providers of finance are traditionally shareholders and the Netherlands is
also home to some of the world’s major multinational enterprises. There is
a strong independent accounting profession founded in 1895 which
focused attention on the development of accounting theory, particularly
replacement value theory.
Economic environment is one dominated by the concept of economic
value, that is, businesses must ensure availability of resources to replace
used inputs. Law is Roman but a distinction is made between accounting
and tax law.
Answer The Netherlands law is Roman but not dominant and as providers of finance are shareholders
and there is a strong accounting profession, then the accounting framework
could well be similar to that in the UK.
The Netherlands system is basically similar to that of the UK but there are
notable differences. One is that the Netherlands places emphasis on economic
value not historical cost. Legal provisions tend to identify the general
rules of accounting and the concept of true and fair was incorporated into
Dutch law in 1970 prior to the EU Fourth Directive. Generally Accepted
Accounting Principles (GAAP) is in the hands of the accounting profession,
10 · Regulatory framework in the UK compared with European examples and the international framework 185
Suggest in one sentence what type of accounting framework France may have.Activity 10.10
Suggest in one sentence what type of accounting the Netherlands may have.Activity 10.11
FNAC_C10.QXD 12/10/05 10:30 am Page 185
the Council for Annual Reporting, which has representatives from employers,
employees and professional accountants. Standards produced by the
council tend to be flexible and are not legally binding although they would
provide evidence as to the true and fair view. In 1970 a law was enacted to
establish an Enterprise Chamber – a court of law – to consider cases where
companies failed to comply with accounting standards. This chamber can
order the issue of revised accounts. The general concepts of accounting are
going concern, consistency, accruals and prudence.
Accounting framework in China
China is becoming a major economic force globally and its economic
growth is being controlled quite carefully to ensure it does not overheat. By
2020 it is expected that China will be the largest economy in the world.
International trade with China is increasing and investment in the country
is undergoing massive change. However, all of this investment and growth
is still subject to substantial control from the government. The Chinese
accounting system is also undergoing massive change and new accounting
laws substantially based on IASs are being introduced. When considering
accounting in China you must however always keep in mind the size of
the country and the size of its population – around 1.3 billion. Remember,
some of its smaller cities have a population greater than that of London.
China has a long history of communism and as it moves forward with
economic reform this history will have an impact. Market-orientated principles
are being taken on board but a socialist theme is still maintained.
Many institutions will still remain under state control. The legal system in
China can be regarded as unique. It has only recently developed contract
and commercial law, but this is still tightly controlled by the government
and the whole process is quite bureaucratic. Tax is collected from all enterprises,
including state enterprises, but the accounting rules and tax rules
are decoupled as in the UK. Stock markets operate in China but they only
started in the early 1990s. The accounting profession prior to 1980 was
almost non-existent, as recording of economic information was simply a
case of following prescribed systems rather than providing information
which would be useful to users. The accounting profession in a modern
form was only set up in 1980 and although the government is now issuing
standards similar to those of the IASB, they are simpler and more rigid
allowing less choice and judgement.
Answer Government control is still dominant in China and thus the accounting system will display
characteristics of uniformity and rigidity.
186 Financial Accounting
Suggest in one sentence what type of accounting China has.Activity 10.12
FNAC_C10.QXD 12/10/05 10:30 am Page 186
Answer UK Germany France Netherlands China
Type of law Common Roman Roman Roman Roman state
controlled
Role of profession Forceful Compliance Minor Forceful Minor
Providers of finance Shareholders Banks Banks Shareholders Government
Government limited
shareholder
and foreign
investment
Source of accounting Companies Legal Tax Legal plans Companies Government
regulation Acts, Binding Acts and
professional standards
standards
Summary
This chapter has:
᭤ identified the accounting framework within the UK, both legally and
regulatory
᭤ given you a flavour of accounting in three other European countries and
also China, and compared and contrasted those to that of the UK.
᭤ introduced you to the international work on financial accounting/
reporting driven by the IASB.
The work of the IASB is very important as we move towards more global markets
for both products and financial instruments. Investors now need to be
able to compare companies in terms of their financial position and performance
from all countries and without an harmonised reporting framework this
will not be easy. The EU has declared that it requires all companies listed on an
EU stock exchange to report under IAS regulation as from 2005. This means
that large British plcs will need to convert their reporting from UK GAAP to
IAS GAAP. This will not be easy as the standards issued by the UK Board and
10 · Regulatory framework in the UK compared with European examples and the international framework 187
Complete the following table – the UK entries have already been made for you.
UK Germany France Netherlands China
Type of law Common
Role of profession Forceful
Providers of finance Shareholders
Source of accounting Companies
regulation Acts,
professional
standards
Activity 10.13
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International Board are not always directly comparable. The UK ASB is currently
working on a convergence programme between UK and IAS GAAP.
The study of accounting in the international arena is, we believe, both
interesting and essential as we move into the twenty-first century. Indeed
the international expansion of the UK accounting profession during the
twentieth century saw the development of what are now among the world’s
largest accounting, auditing and management consultancy firms, including
PricewaterhouseCoopers and KPMG. We hope this chapter has stimulated
your interest in this area.
Self-assessment questions
1 Identify the reasons for differences in financial accounting practices within Europe.
2 Do all European countries adopt the principle of the true and fair view?
3 The IASB can establish worldwide influence over financial reports even if China does
not adopt the IASs. Discuss.
Answers to these questions can be found at the back of this book.
No further questions are provided in respect of this chapter as we feel students will
benefit more from open discussion in seminars on the following topics:
(a) ‘The regulatory framework in the UK and other European countries is identical.’
Discuss.
(b) ‘The only influences on the regulatory framework of a country are the legal system
and the language of a country.’ Discuss with particular reference to China.
(c) ‘Any moves towards European harmonisation of regulatory frameworks are
doomed to failure.’ Discuss.
We would suggest that students are given the discussion topics before the seminar
and asked to present information to support their arguments. Such information can
be obtained by library and CD-ROM search and will aid students in the development
of their information search skills. These discussion topics can also be given as summative
assessment.
188 Financial Accounting
regulatory framework (p. 178)
Dearing Committee (p. 179)
Financial Reporting Council (p. 179)
Accounting Standards Board (p. 179)
International Accounting Standards
Board (IASB) (p. 181)
Fourth and Seventh Directives (p. 182)
determinants of the accounting
framework (p. 183)
harmonised reporting framework
(p. 187)
Key terms
FNAC_C10.QXD 12/10/05 10:30 am Page 188
11
Interpretation, including ratio
analysis and consideration of
additional information required
Accounting information and users
Throughout the previous chapters you have learnt how to collect information
about a company and how that culminates in its published financial
statements. For a sole trader you have also seen that the production of an
income statement and balance sheet in respect of his business is very
important even though it is not required to be published.
These financial statements therefore provide valuable information for
both the owners of the business and for any potential owners/investors. It
is therefore important that we learn how to analyse the information provided
and make informed decisions by interpreting this analysis.
In Chapter 1 you identified the users of accounting information.
By the end of this chapter you should be able to:
᭤ Identify the needs and objectives of users of accounting
information.
᭤ Explain the standards by which a particular set of accounts can be
judged.
᭤ Understand the technique of ratio analysis and calculate ratios.
᭤ Explain what the ratios mean and their limitations.
᭤ Identify additional information that users may require.
Objectives
Identify the users of accounting information. Note that your list could be wider than that
identified in Chapter 1 if you refer to your studies in other areas such as economics.
Activity 11.1
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Answer You should have included the following in your list:
᭤ Trade debtors – customers.
᭤ Trade creditors – suppliers.
᭤ Employees and their representatives.
᭤ Taxation authorities.
᭤ Financial analysts and stockbrokers.
᭤ Other government departments – those concerned with the economy and environ-
ment.
᭤ Those considering investing in the business – potential investors or purchasers of
the business.
᭤ The public, particularly environmental pressure groups and those who live close to
the location of the business.
The above is not an exhaustive list and you may have thought of others. A list of users
is also provided in the IASB’s ‘Framework for Preparation and Presentation of Financial
Statements’ and you will find our list is similar.
Needs and objectives of users
Each of the users we have listed may well want to know different things
about the business; they will have different needs and objectives. We must
identify these needs and objectives so that the correct information is
abstracted for them.
Answer ᭤ Investors/owners – could their resources earn more if invested elsewhere, should they
invest even more money in the business? Is the business likely to become insolvent,
i.e. bankrupt, and thus the owners may not receive their investment back?
᭤ Suppliers – is the business able to pay for the goods bought on credit? Will the
business wish to purchase more goods from the supplier?
᭤ Customers – do the customers receive the goods they want when they want them?
Will the business continue in operation so that guarantees on goods purchased will
be met?
190 Financial Accounting
Complete the following table:
User Needs/objectives
Investors/owners
Suppliers
Customers
Lenders
Employees
Activity 11.2
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᭤ Lenders – is there adequate security for the loan made? Is the business able to
make the interest payments on the loan when they fall due? Can the business
redeem the loan on its due date?
᭤ Employees – Does the business make sufficient profit and have enough cash available
to make the necessary payments to employees? Will the business continue in
operation at its current level so that employees have secure employment?
From the above answer to Activity 11.2 you should be able to identify
three general areas of interest in which users’ needs and objectives may lie.
Answer 1 Performance – how successful is the business? Is it making a reasonable profit? Is
it utilising its assets to the fullest? Is it, in fact, profitable and efficient?
2 Investment – is the business a suitable investment for shareholders or would returns
be greater if they invested elsewhere? Is it a good investment?
3 Financial status – can the business pay its way? Is it in fact liquid?
Standards
The three questions posed above are subjective not objective. For instance,
how do we define a ‘reasonable profit’? We have to do so by comparing
current profit to profit made in previous years and to profit made by other
businesses. We need benchmarks against which we can compare current
performance, financial status and investment potential. However, we need
to take care with this comparison against benchmarks otherwise our comparison
will not be valid.
Consider, for example, your opinion of a movie you recently watched.
You may think it was the best movie you have seen; your friend may think
it was the worst movie he or she has seen. This is because the experiences/
benchmarks you each have are different and you are making a subjective
judgement on how the movie compares with those you have previously
seen. Thus, in setting benchmarks against which we can compare a company,
we must be aware of the subjectivity that could be involved in these
benchmarks.
First we need to identify benchmarks/indicators we can use, then we can
consider their limitations.
Four possible benchmarks are:
᭤ Past period achievements.
᭤ Budgeted achievements.
᭤ Other businesses’ achievements.
᭤ Averages of business achievements in the same area.
11 · Interpretation, including ratio analysis and consideration of additional information required 191
Identify the three general areas of interest for users of financial statements.Activity 11.3
FNAC_C11.QXD 12/10/05 10:32 am Page 191
Answer
Indicator Uses of indicators Limitations of indicator
Past periods Is current activity better or External factors may have
worse than previous periods? influenced activity levels,
e.g. public awareness of
environmental issues may
have necessitated a change
in manufacturing process
leading to increased costs
Budgets Has current activity matched The budget may not have
that planned? been a valid standard of
performance, e.g. underlying
assumptions may have been
unrealistic or set at too high
a level
Other business Is our business performing Businesses may not be truly
as well as another? comparable with regard to
size and type, e.g. grocer
sole trader compared to
hairdresser, grocer sole trader
compared to supermarket.
External factors may affect
one business, e.g. a lengthy
strike. Accounting policies,
bases on which accounting
information is prepared, may
be different, e.g. inventory
valuations, depreciation
Industry averages As other business As other business
192 Financial Accounting
Complete the following table:
Indicator Uses of indicator Limitations of indicator
Past periods
Budgets
Other business
Industry averages
Activity 11.4
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Technique of ratio analysis
From the study of previous chapters you now have enough knowledge to
be able to pick out certain figures such as profit before tax, gross profit,
total of non-current assets, net current assets, etc. from a set of financial
statements. But what do these figures mean? For example, the financial
statements for a record company may show profit before tax is £8m but is
this a good profit? It may, for example, be more than a computer company’s
profit, but does it mean the record company is performing better?
Consider the following example:
You have £5,600 to invest, and discover that Type 1 investment will provide interest of
£315 per annum and Type 2 investment, £1,500 after five years. Which investment would
you choose assuming no compound interest and no change in the value of the pound?
The return on Type 1 investment is 315/5,600 = 5.625% per annum. The return on
Type 2 investment is 300/5,600 = 5.36% per annum. Thus Type 1 investment provides
the highest return. To reach this conclusion we compared the return with the
amount invested and expressed the figures in the same units – interest per annum.
In evaluating the financial status, performance, and investment potential of a business
we first need to identify which figures in a set of financial statements we need to
have regard to and which other figures to compare these with. We will use the financial
statements of Rodann Ltd, which are reproduced below to demonstrate this process.
RODANN LTD INCOME STATEMENTS
Year ended (£000s) 31.12.20X4 31.12.20X5
Sales 150 250
Opening Inventory 8 12
Purchases 104 180
––––– –––––
112 192
Closing inventory 12 16
––––– –––––
100 176
––––– –––––
Gross profit 50 74
Wages and salaries 20 26
Depreciation 4 8
Debenture interest – 2
Other expenses 14 16
––––– –––––
38 52
––––– –––––
Net profit before tax 12 22
Taxation 4 10
––––– –––––
Net profit after tax 8 12
Proposed dividend 4 6
––––– –––––
Retained profit for year £4 £6
––––– –––––––––– –––––
11 · Interpretation, including ratio analysis and consideration of additional information required 193
Example 11.1
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RODANN LTD BALANCE SHEET AS AT
(£000s) 31.12.20X4 31.12.20X5
Non-current assets 72 110
Current assets
Inventory 12 16
Debtors 18 40
Bank 10 4
–––– ––––
40 60
Current liabilities due for payment within one year
Creditors 10 28
Taxation 4 10
Proposed dividends 4 6
–––– ––––
18 44
–––– ––––
Net current assets 22 16
–––– ––––––
94 126
Non-current liabilities due for payment after more than one year
10% debentures – 20
–––– ––––––
£94 £106
–––– –––––––––– ––––––
Share capital and reserves
Ordinary share capital 70 76
Retained profits 24 30
–––– ––––––
£94 £106
–––– –––––––––– ––––––
Answer The points of interest were as follows:
᭤ Sales increased in 20X5.
᭤ Cost of sales has increased.
᭤ Expenses have increased.
᭤ Profit after tax has increased by 50%.
᭤ Non-current assets have increased by 50%.
᭤ Net current assets have reduced.
᭤ Shares and debentures have increased in 20X5.
Having gained a ‘pen picture’ of what has occurred in the company from
one year to the next we can now carry out a ratio analysis which will help
us to ‘fill in’ this pen picture with more detail.
194 Financial Accounting
Example 11.1
continued
Compare and contrast each item on the balance sheet and income statement
of Rodann with the figure for the previous year. Note seven points of interest from
this comparison.
Activity 11.5
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Performance
Performance is generally assessed by the return on capital employed
ratio, ROCE.
profit before taxation and long-term loan interest
ROCE = –––––––––––––––––––––––––––––––––––––––––––––––––––––––––
net assets (capital employed including long-term loans)
This ratio identifies how much profit the business has made from the
capital invested in it. It will also identify whether the owners would be
better off placing their money in a bank deposit account rather than leaving
it invested in the company.
Answer ROCE 20X4 20X5
12/94 = 12.77% 24/126 = 19.05%
This ratio has increased from 20X4 to 20X5 indicating an increase in profitability
of the business from the increased investment. But where has this increased
profitability come from? Is it because the business has increased sale prices or
reduced expenses, that is, increased net profit margins, or is it because the business
has increased the volume of trade compared to the capital employed?
These two questions can be expressed as ratios as follows:
Profit before tax and long-term interest
Net profit margin = ––––––––––––––––––––––––––––––––––––––––
Sales
Sales
Volume of trade = –––––––––––––––––
Capital employed
Calculating these two ratios for Rodann Ltd:
Net profit margin 20X4 20X5
12/150 = 8% 24/250 = 9.6%
The net profit margin has increased indicating benefit gained from control
of expenses or increased sale prices:
Volume of trade 20X4 20X5
150/94 = 1.6 times 250/126 = 1.98 times
indicating that Rodann Ltd is earning more sales per £ of net assets or capital
employed in 20X5 than 20X4.
These three ratios have the following relationship:
ROCE = Margin × Volume
NP/CE = NP/S × S/CE
where NP = Profit before interest and tax, CE = Capital employed, and S = Sales
11 · Interpretation, including ratio analysis and consideration of additional information required 195
Calculate the ROCE for Rodann Ltd for 20X4 and 20X5.Activity 11.6
FNAC_C11.QXD 12/10/05 10:32 am Page 195
This relationship can be shown as a family tree as follows:
ROCE
NP/S S/CE
This family tree can be expanded and will provide a framework for ratio
analysis. For example:
NP/S = GP/S – E/S
where GP = Gross Profit and E = Expenses
If we invert S/CE first to CE/S, this can then be expanded as:
FA/S + NCA/S
Where FA = Non-current assets and NCA = Net Current Assets
We invert again and calculate S/FA and S/NCA.
Answer Gross profit margin 20X4 20X5
50/150 = 33.3% 74/250 = 29.6%
This shows a reduction in gross profit probably due to a decrease in sale prices which
has generated more sales or an increase in the cost of goods sold.
Expenses/sales 20X4 20X5
38/150 = 25.3% 50/250 = 20%
This has decreased from 20X4 to 20X5 indicating a better control of expenses.
20X4 20X5
S/FA 50/72 = 2.08 250/110 = 2.27
Non-current assets have generated 2.08 times their value in sales in 20X4 and 2.27
times their value in sales in 20X5. Non-current assets are earning more sales in 20X5
than 20X4.
20X4 20X5
S/NCA 50/22 = 6.82 250/16 = 15.6
Net current assets are also earning more sales in 20X5 than 20X4.
The family tree of ratios now looks like this:
ROCE
NP/S S/CE
GP/S E/S S/FA S/NCA
196 Financial Accounting
Calculate these four ratios for Rodann Ltd and interpret them.Activity 11.7
Level 1
Level 2
Level 3
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The pyramid can be extended to a fourth level by comparing individual
expenses to sales and breaking down the non-current assets and net current
assets into their constituent parts:
E/S
E1/S E2/S E3/S E4/S E5/S
S/FA
S/land and buildings S/equipment S/vehicles
S/NCA
S/CA S/CL
S/stock S/debtors S/creditors
However, as inventory is recorded at cost not selling price then a
more appropriate ratio than sales/inventory would be, cost of goods sold/
inventory, and as creditors relates to goods purchased on credit, credit purchases/creditors.
Lastly S/debtors would be more appropriate as credit
sales/debtors. Example 11.2 demonstrates the calculation and interpretation
of these Level 4 ratios.
The following information is provided for Anne Ltd as at 31.12.20X4:
£000
Cost of goods sold 110
Average inventory 25
Trade creditors 43
Credit purchases 108
Trade debtors 48
Credit sales 142
Cost of goods sold/inventory = 110/25 = 4.4, that is 4.4 times the average inventory
level has been used in the cost of goods for the year. This could be written much
simpler as inventory is turned over every 83 days, i.e. 365/4.4 = 83 days.
The ratio is therefore:
Average stock
––––––––––––––––––– × 365
Cost of goods sold
The debtors and creditors ratio is written as:
Trade debtors
–––––––––––––– × 365
Credit sales
which will tell us on average how long it takes debtors to pay:
Trade creditors
–––––––––––––––––– × 365
Credit purchases
which will tell us how long on average it takes the business to pay its creditors.
11 · Interpretation, including ratio analysis and consideration of additional information required 197
Example 11.2
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Total sales and total purchases will have to be used in lieu of credit sales and credit
purchases in this example.
Debtors period = 48 × 365/142 = 123 days
Creditors period = 43 × 365/108 = 145 days
Whether or not these Level 4 ratios should be calculated when carrying out
a ratio analysis will depend upon the information produced at previous
levels. For example, when considering Rodann Ltd we noted a marked
improvement in the efficiency of net current assets, therefore calculating
the Level 4 ratios may tell us where this improvement came from.
Answer 20X4 20X5
Inventory turnover = (8 + 12)/2 × 365/100 (16 + 12)/2 × 365/176
= 36.5 days 29 days
Thus inventory is being turned over quicker in 20X5, demonstrating greater efficiency.
20X4 20X5
Debtors turnover period 18/150 × 365 40/250 × 365
= 44 days = 58 days
Thus debtors have been allowed 14 more days in 20X5 than 20X4 in which to pay
their debts to the business. This could possibly indicate that Rodann Ltd is losing control
of its debtor collection or that it has purposely allowed debtors more time to pay so
as to encourage more sales.
20X4 20X5
Creditors turnover period 10/104 × 365 28/180 × 365
= 35 days = 57 days
(Note that cost of goods sold could be used as a substitute for purchases if the financial
statements do not provide a figure for purchases.) This indicates Rodann Ltd is
taking longer to pay its suppliers – 22 days longer. This may damage relations with
suppliers if Rodann does not take care, but also shows how Rodann is using creditors
to finance its business operations. A balance has to be struck within this dichotomy.
Within the analysis of Rodann Ltd at Level 3 there was also a benefit gained
from control of expenses. Therefore Level 4 analysis is required here.
198 Financial Accounting
Example 11.2
continued
Calculate inventory, debtor and creditor turnover periods for Rodann Ltd and interpret
them.
Activity 11.8
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Answer 20X4 20X5
Wages/sales 20/150 = 13.3% 26/250 = 10.4%
indicating that the amount of wages expended to generate one £ of sales has been
reduced.
Depreciation/sales 4/150 = 2.7% 8/250 = 3.2%
Depreciation has marginally increased as a proportion of sales, which may be due to
an increase in assets.
Other expenses/sales 14/150 = 9.3% 16/250 = 6.4%
Other expenses have also been controlled as a percentage of sales.
These three ratios, as we saw earlier, when combined gave an increase in
profit margin – increased profitability. The pyramid also demonstrates that
the ratios on the left-hand side show profitability and those on the right
efficiency in the use of assets.
Let us look again at the first ratio on the pyramid – ROCE. Capital
employed consists of shareholder funds, that is, share capital and reserves,
and long-term debt, for example debentures. In the example of Rodann Ltd
ROCE was:
20X4 12.77%
20X5 19.05%
The debentures in 20X5 only required a return to be paid to the holders
of 10% even though the capital invested, £10,000, earned 19.05%. The
earnings over and above the 10% will therefore accrue to the shareholders
and their return will be increased beyond the 19.05% that the total capital
earned. If we calculate another ratio, return on shareholders’ funds (ROSHF),
we can demonstrate the above quite easily. Return on shareholders’ funds or
owners’ equity (ROOE) =
Profit before tax but after long-term debt interest
–––––––––––––––––––––––––––––––––––––––––––––––––––
Shareholder’s capital
20X4 20X5
12/94 = 12.77% 22/106 = 20.75%
The shareholders have increased their earnings in the business partly
due to the benefit gained by borrowing at a lower rate of return than the
business is earning. However, the converse can also occur! Note that ROCE
and ROSHF were exactly the same in 20X4 as there was no long-term debt.
11 · Interpretation, including ratio analysis and consideration of additional information required 199
Calculate ratios of wages, depreciation and other expenses to sales and interpret
them for Rodann Ltd.
Activity 11.9
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Answer 20X4 20X5
ROCE 90/1250 = 7.2% 95/1280 = 7.4%
20X4 20X5
ROOE 80/1150 = 7% 85/1180 = 7.2%
The return made in each year is 7.2% and 7.4% but the return payable to the long-term
debt holders is 10% in both years, therefore the return available to the shareholders
reduces to 7% and 7.2%.
Investment potential
Before looking in detail at investment ratios it is useful to carry out some
practical research.
Answer Your list possibly included the following:
᭤ Book value per share compared with market value per share.
᭤ Net dividend.
᭤ Dividend cover.
᭤ Earnings per share.
᭤ Gross dividend yield.
᭤ Price/earnings ratio.
We will look at each of these ratios in turn.
200 Financial Accounting
Given the following information calculate ROCE and ROOE for Ricmar Ltd for 20X4
and 20X5:
20X4 20X5
£ £
Profit before tax 80 85
Interest charged 10 10
Capital employed 1,250 1,280
Long-term debt 100 100
Activity 11.10
Obtain a fairly recent copy of the Financial Times. Look up the London share information
service found in the FT and make a note of the data provided for each
company. Also read the ‘UK company news’ either in the FT or any other quality
newspaper and note down any ratios or indicators used to evaluate the companies.
Activity 11.11
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Book value per share
This is:
Ordinary shareholders’ funds
––––––––––––––––––––––––––––––
Number of shares
This book value is the value each share would have if the company’s
assets and liabilities were sold at their balance sheet (book) value. The
market value is the price a potential shareholder is willing to pay to acquire
a share in the company. Comparing these two values identifies whether the
market values the company at more or less than its book value.
Net dividend
This is the amount of dividend declared in any one year per share:
Paid and proposed dividends
––––––––––––––––––––––––––––––
Number of shares
People invest in shares either:
᭤ to earn dividends or
᭤ to gain capital growth in the value of the share, or both.
The level of dividend and its comparison with previous years is generally
regarded as an important indicator of future expectations. However, one
danger with this comparison is that dividends are not necessarily just paid
out of the current year’s earnings but can be paid out of retained earnings.
It is therefore important to look at dividend cover in any one year.
Dividend cover
Net profit available to ordinary shareholders
–––––––––––––––––––––––––––––––––––––––––––––––
Total ordinary dividend
11 · Interpretation, including ratio analysis and consideration of additional information required 201
The following information is available in respect of Shamar Ltd.
20X4 20X5
£ £
Ordinary shares issued £1 2,500,000 2,500,000
8% preference shares £1 500,000 500,000
Dividend ordinary shares 300,000 250,000
Net profit after tax 287,500 271,900
Calculate dividend per share in pence for both preference and ordinary shares, and
dividend cover.
Activity 11.12
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Answer 20X4 20X5
Dividend per share in 8p 8p
pence preference
Dividend per 12p 10p
share ordinary 287,500/340,000 271,900/290,000
Dividend cover = 0.85 = 0.94
The dividend has reduced per share from 20X4 to 20X5 but the dividend
cover has improved. However, this dividend cover is less than one which
indicates that the company is not earning enough in either year to pay the
dividend and is therefore using past earnings retained to fund the dividend
payment. This may be a danger sign for potential investors.
Earnings per share
This is another indicator used widely by the investment community. It represents
the amount of profit, in pence, the company has earned during the
year for each ordinary share.
For the example of Shamar above the earnings per share in 20X4 is:
247,500/2,500,000 = 9.9p
and 20X5 is:
231,900/2,500,000 = 9.3p
Earnings per share is:
Net profit available to ordinary shareholders
––––––––––––––––––––––––––––––––––––––––––––––
Number of ordinary shares in issue
Gross dividend yield
This is calculated from the formula:
Gross dividend
––––––––––––––––––––––––––––––––
Market price of ordinary share
Shareholders may be willing to accept a low gross dividend yield if there
is a greater than average capital growth in share value expected or if the
company is a safe investment. Gross dividend is calculated by grossing up
the dividend declared in the accounts for basic rate taxation as dividends
are always declared and paid net of basic income tax at least in the UK.
For example, in the case of Shamar Ltd if the basic rate of tax is 20%
then the gross dividend is:
20X4 20X5
£ £
300,000/80% 250,000/80%
375,000 312,500
or per share 15p 12.5p
202 Financial Accounting
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If the market value per share for Shamar was £1.75 in 20X4 and £1.82 in
20X5 then the gross dividend yield is:
20X4 20X5
15/175 12.5/182
= 8.6% = 6.9%
Price/earnings ratio (P/E ratio)
The formula for the P/E ratio is:
Market price per share
––––––––––––––––––––––––
Earnings per share
For Shamar this is:
20X4 20X5
175/9.9 182/9.3
= 17.7 = 19.6
Like the dividend yield the P/E ratio will change as the market price per
share changes. It represents the market’s view of the growth potential of
the company, its dividend policy and the degree of risk involved in the
investment. In general a high P/E indicates the market has a high/good
opinion of these factors, a low P/E a low/poor opinion of these factors.
Another way of looking at the P/E is that it represents the number of years’
earnings it is necessary to have at the current rate to recover the price paid
for the share. For Shamar this was 19.6 years at the 20X5 rate of earnings.
Financial status
It is vital for a business to be able to pay its debts as and when they fall due
otherwise its chances of remaining in operation become remote. There is a
need to analyse the assets available to meet liabilities. This can be done in
the short, medium and long term.
For the short term we use the quick assets ratio or acid test:
Current assets less stock
––––––––––––––––––––––––––
Current liabilities
Inventory is excluded from current assets as it is regarded as less liquid
than other assets within that category.
For the medium term the current ratio is:
Current assets
––––––––––––––––––
Current liabilities
If current liabilities exceed current assets this is not necessarily a sign of
weakness. For example, major supermarket chains usually have a negative
ratio as they have few debtors and yet take as much credit as possible from
suppliers. Their strong cash flow ensures that creditors will be paid when due.
11 · Interpretation, including ratio analysis and consideration of additional information required 203
FNAC_C11.QXD 12/10/05 10:32 am Page 203
For the long term the gearing ratio is:
Long-term debt
–––––––––––––––––––––
Shareholders’ funds
Another ratio, interest cover, can also be used:
Net profit before interest and tax
––––––––––––––––––––––––––––––––––
Total interest charges
Answer 20X4 20X5
Acid test 40 – 12 28 60 – 16 44
–––––––– = ––– –––––––– = –––
18 18 44 44
expressed as 1.6:1 1:1
The ratio has decreased from 20X4 to 20X5 quite considerably but there are still plenty
of liquid assets. The ratio will need careful monitoring to control this downward trend.
20X4 20X5
Current ratio 40/18 = 2.2:1 60/44 = 1.4:1
Again this ratio has been substantially reduced but still appears adequate. Monitoring
of this downward trend is again required.
20X4 20X5
Gearing ratio not relevant 20/106 = 18.9%
This is low and we would consider this company low geared. If a company is high
geared then it may have difficulty meeting the required interest payments.
20X4 20X5
Interest cover not relevant (22 + 2)/2 = 12
In 20X5 the profit covered the required interest payment 12 times indicating no immediate
problem for Rodann Ltd.
Notice how consideration of all four ratios helped to build up a picture of the financial
status of Rodann Ltd.
Limitations of ratio analysis
There are seven principal limitations of ratio analysis:
᭤ Differences in accounting policies.
᭤ The historical nature of accounts.
᭤ Absence of suitable comparable data.
᭤ Differences in the environments of periods compared.
204 Financial Accounting
Calculate the four liquidity ratios for Rodann Ltd and explain what the figures calculated
mean.
Activity 11.13
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᭤ Hidden short-term fluctuations.
᭤ Changes in the value of money.
᭤ Other non-monetary factors.
Three of these were examined in Activity 11.4: accounting policies, absence
of suitable comparable data and changes in environment. Non-monetary
factors relates to the fact that nowhere in the analysis is the quality of the
product or service considered, whether labour relations are good or bad. In
fact, no regard is had to the goodwill of the business.
The historical nature of accounts must always be borne in mind as our
interpretation of the business is based on this historical information.
However, it may not be the best guide as to the future performance, financial
status and investment potential.
Short-term fluctuations are also hidden in ratio analysis as our appraisal
is based on a balance sheet that provides values of assets and liabilities as at
a point in time. For example, consider the following information relating
to a company whose year end is 31 December:
September October November December
£ £ £ £
Debtors 2,000 2,100 2,500 5,000
Other current assets 4,000 4,000 3,950 3,900
Current liabilities 5,500 5,600 5,550 5,500
The current ratio for
each month is 1.09:1 1.09:1 1.16:1 1.62:1
However, calculating the current ratio by reference to the balance sheet
would show a figure of 1.6:1 in December which represents a better view of
liquidity than has been the case over the past four months. It is important
to remember that the balance sheet only provides a ‘snap-shot’ of a company
at a particular point in time and that considerable changes can occur
to that picture in a short period of time. Shamar may well have increased
its debtors, and therefore its liquidity position, due to an increased level of
sales for the Christmas period or other festival period.
Changes in the value of money
We all know how inflation affects the value of the pound in our pocket and
this is no different for a business. In fact the effects of inflation on our ratio
analysis could make the whole analysis invalid. To demonstrate this, consider
a company with sales last year of £350,000 and sales this year of £400,000.
Would you interpret this as an increase in volume of trade of 14%?
If you were informed that the price of the goods sold had been subject
to an increase of 10% (inflation) then the increase in volume would only
be approximately 4%.
11 · Interpretation, including ratio analysis and consideration of additional information required 205
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Additional information
From the work you have already completed in this chapter you should be
able to identify additional information that may help you in assessing the
performance, financial status and investment potential of a business.
Answer You should have identified several of the following:
᭤ Inflation effects on the company.
᭤ Does the balance sheet represent the position of the business throughout the year
or just at the year end?
᭤ Cash flow throughout the year.
᭤ Forecast business plans in the form of budgets and cash flows.
᭤ Information in respect of the quality of goods and services and other factors affecting
the assessment of goodwill in the business.
᭤ Industrial averages of ratios.
᭤ Differences in accounting policies between businesses.
However, you must be aware that several items in this list may not be available
to you as a potential investor as they will not be public information in
respect of the business. For example, it would be very difficult, probably
impossible, for a potential investor to obtain detailed information in
respect of future plans of the business apart from that disclosed in the
Chairman’s Report in the financial statements.
Cash flow and ratio analysis
In Chapter 10 we showed you how to construct a cash flow statement and
we also made reference to using this in analysing the performance and
financial position of a business. The following activity consists of interpretation
using ratios and information derived from the income statement,
balance sheet and cash flow.
206 Financial Accounting
Make a list of additional information that you would like when undertaking a ratio
analysis of a company.
Activity 11.14
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11 · Interpretation, including ratio analysis and consideration of additional information required 207
From the following information assess, as far as the information permits, the financial
position and performance of the business.
INCOME STATEMENT FOR THE YEARS ENDED
31.12.X5 31.12.X6
£m £m
Turnover 2,516 2,203
Cost of sales 1,762 1,548
––––––– –––––––
Gross profit 754 655
Distribution costs 159 145
Administration costs 226 211
––––––– –––––––
Operating profit 369 299
Net interest payable 16 (2)
––––––– –––––––
Profit before tax 353 301
Taxation 108 91
––––––– –––––––
Profit after tax 245 210
––––––– –––––––––––––– –––––––
BALANCE SHEET AS AT
31.12.X5 31.12.X6
Non-current assets 1,392 1,354
Investments 67 47
–––––– ––––––
1,459 1,401
––––––– –––––––
Current assets
Inventory 270 244
Debtors 379 318
Bank and cash 62 33
––––––– –––––––
711 595
Current liabilities
Creditors 577 665
––––––– –––––––
134 (70)
––––––– –––––––
Non-current liabilities
Debentures 5% 160 56
––––––– –––––––
Net assets 1,433 1,275
––––––– –––––––
Share capital 1,027 1,029
Revaluation reserve 15 15
Retained profits 391 231
––––––– –––––––
1,433 1,275
––––––– –––––––––––––– –––––––
CASH FLOW STATEMENT FOR THE YEAR ENDED
31.12.X5 31.12.X6
Net cash inflow from operating activities 402 315
Interest paid (10) (1)
Taxation paid (96) (90)
Net cash used in investing activities (120) (126)
Net cash used in financing activities (12) (182)
Dividends paid (132) (88)
––––––– –––––––
Increase/decrease in cash and cash equivalents 32 (172)
––––––– –––––––––––––– –––––––
Activity 11.15
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Answer The first task in this activity is to review the statements you are given and identify the
changes that have taken place from one year to the next.
From the income statement we can see that:
᭤ gross profit has increased by 15%
᭤ expenses have also increased but only by 8.1%
᭤ profit after tax has increased by 16.7%
From the balance sheet we can see that:
᭤ investment has been made in non-current assets – a net increase of £38m so the
actual investment will have been much higher that this to offset any sales and the
depreciation/amortisation of the year
᭤ more funds are tied up in current assets particularly stock but current liabilities have
been greatly reduced
᭤ further loans in the forms of debentures have been acquired during the year.
From the cash flow it is evident that the operating activities for the year
have financed interest, taxation, dividends, purchase of non-current assets
and that dividends have increased by 50% from last year to this.
We can then calculate several ratios for the information:
ROCE 20X5 20X6
369/1433 +160 = 23.2% 299/1275+56 = 22.5%
Slightly more return has been made this year.
ROSHE 20X5 20X6
353/1433 = 24.6% 301/1275 = 23.6%
A gearing up has occurred in both years and the increase in ROCE is also
shown in ROSHE from last year to this.
GP/S 20X5 20X6
754/2516 = 30% 655/2203 = 29.7%
The company has made a slight increase here
NP/S 20X5 20X6
369/2516 = 14.7% 299/2203 = 13.6%
This shows a bigger increase than at gross profit level so the company has controlled
its expenses during the year which is also demonstrated by looking at
Expenses/sales 20X5 20X6
385/2516 = 15.3% 356/2203 = 16.2%
The volume of trade is demonstrated by
S/CE 20X5 20X6
2516/1593 = 1.58 2203/1331 = 1.66
208 Financial Accounting
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Thus volume has fallen but margins have increased resulting in a greater
return on capital employed. However the company must ensure capital
employed continues to generate a good volume of trade. We can extend
the volume indicator by looking at volume generated by non-current assets
and current assets as follows:
S/NCA 20X5 20X6
2516/1392 = 1.81 2203/1354 = 1.63
This shows that the volume of trade generated from NCA is much higher
than last year so the problem must lie with net current assets
S/net current assets 20X5 20X6
2516/134 = 18.78 2203/(70) and thus the reduction
in current liabilities from £665m
to £577m is the problem for
the company.
The liquidity ratios further demonstrate this
CA/CL 20X5 20X6
711/577 = 1.23 595/665 = 0.89
The company is much more liquid and therefore could be keeping excess
funds tied up in working capital; but remember the balance sheet is a
snapshot at a point in time so this will require further investigation within
the company.
20X5 20X6
CA-inventory /CL 441/577 = 0.76 351/665 = 0.53
Inventory turnover 270*365/1762 = 56 days 244*365/1548 = 57.5 days
Debtors turnover 379*365/2516 = 55 days 318*365/2203 = 52.7 days
Creditors turnover 577*365/1762 = 119.5 days 665*365/1548 = 156.8 days
Thus the company has made a great change in the time it takes them to
pay creditors. This has been speeded up considerably.
We noticed earlier that the dividend had been increased and this can be
further demonstrated by calculating the net dividend if we assume £1 shares:
Dividends/number of share 20X5 20X6
132/1027 = 12.8p 88/1029 = 8.55p
Earnings per share can also be calculated:
E/Number of shares 20X5 20X6
245/1027 = 23.86p 210/1029 = 20.4p
11 · Interpretation, including ratio analysis and consideration of additional information required 209
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Overall
The company has increased its return by controlling expenses and has had a
slight drop in volume of trade. It has also increased the dividend payment to
the shareholders but this is greatly in excess of the increased earnings.
Creditors’ period has been reduced and the company is much more liquid.
This liquidity and the increased dividend payment must be kept under review.
Summary
This chapter has
᭤ introduced you to the technique of ratio analysis
᭤ demonstrated the calculation of such ratios
᭤ identified ratio analysis as a tool that users of accounts can make use of
in order to meet their needs and objectives
᭤ noted that there were several limitations in the use of ratio analysis and
that these must be borne in mind when making an assessment as to the
performance, financial status and investment potential of a business; and
᭤ shown you how to calculate and interpret the ratios referred to in this
chapter.
The interpretation is the most difficult part of ratio analysis and requires a
great deal of practice and use of common sense! This interpretation is also
not definitive – there is no right or wrong answer – as much of the analysis
requires subjective judgements to be made by the analyst. The chapter concludes
with a few exercises for you to complete in this area.
210 Financial Accounting
needs and objectives of users (p. 190)
benchmarks/indicators (p. 191)
return on capital employed (ROCE)
(p. 195)
net profit margins (p. 195)
volume of trade (p. 195)
return on shareholders’ funds
(ROSHF) (or owners’ equity
(ROOE)) (p. 199)
earnings per share (p. 202)
P/E ratio (price/earnings ratio) (p. 203)
gearing ratio (p. 203)
Key terms
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Self-assessment questions
1 Obtain a set of accounts for a supermarket and a manufacturer. You can do this by
accessing your university library or using the service provided by the Financial Times
(www.ft.com).
Compare and contrast the nature of the current assets and liabilities of your two
companies.
2 You are given the following information in relation to Olivet Ltd:
INCOME STATEMENTS FOR 20X4 AND 20X5
20X4 20X5
£ £
Sales 100,000 100,000
Cost of sales 50,000 60,000
––––––––– –––––––––
50,000 40,000
Expenses 30,000 30,000
––––––––– –––––––––
20,000 10,000
Dividends 10,000 10,000
––––––––– –––––––––
10,000
Retained profits b/f 2,500 12,500
––––––––– –––––––––
£12,500 £12,500
––––––––– –––––––––––––––––– –––––––––
BALANCE SHEETS AS AT 20X4 AND 20X5
20X4 20X5
£ £
Land 21,500 31,500
Buildings 20,000 39,500
Equipment 3,000 3,000
–––––––––– ––––––––––
44,500 74,000
Investments at cost 25,000 40,000
Inventory 27,500 32,500
Debtors 20,000 25,000
Bank 1,500
–––––––––– ––––––––––
£118,500 £171,500
–––––––––– –––––––––––––––––––– ––––––––––
Ordinary £1 shares 20,000 25,000
Share premium 6,000 7,000
Revaluation reserve 10,000
Retained profits 12,500 12,500
Debentures 10% 50,000 75,000
Creditors 20,000 30,000
Proposed dividend 10,000 10,000
Bank 2,000
–––––––––– ––––––––––
£118,500 £171,500
–––––––––– –––––––––––––––––––– ––––––––––
11 · Interpretation, including ratio analysis and consideration of additional information required 211
᭤
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You are required to comment on the financial position of Olivet Ltd as at 20X5.
Calculate any ratios you feel necessary.
3 A Ltd and B Ltd, two separate companies, manufacture IT equipment. Their financial
statements at 31.12.X9 are as follows:
INCOME STATEMENTS FOR THE YEAR ENDED 31.12.X9
A Ltd B Ltd
£000 £000
Sales 2,150 1,512
Cost of sales 1,430 1,148
–––––– ––––––
Gross profit 720 364
Other expenses 250 190
–––––– ––––––
Operating profit 470 174
Interest on debentures 20 60
–––––– ––––––
Net profit before tax 450 114
Taxation 100 30
–––––– ––––––
Net profit after tax 350 84
Dividends 200 80
–––––– ––––––
Retained profit 150 4
–––––– –––––––––––– ––––––
BALANCE SHEETS AS AT 31.12.X9
£000 £000
Property, plant and equipment cost 2,750 3,420
Depreciation 980 2,524
––––––– –––––––
1,770 896
Current assets
Inventory 420 340
Debtors 900 680
Cash 40
––––––– –––––––
1,360 1,020
Current liabilities due within one year
Creditors 360 400
Dividends 200 80
Overdraft 200 560
––––––– –––––––
760 1,040
––––––– –––––––
Net current assets 600 (20)
––––––– –––––––
2,370 876
Debentures 10% 200 600
––––––– –––––––
2,170 276
––––––– –––––––––––––– –––––––
Capital and reserves
Ordinary share capital 1,200 200
Retained profits 970 76
––––––– –––––––
2,170 276
––––––– –––––––––––––– –––––––
212 Financial Accounting
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Comment on the profitability, liquidity and risk of the above companies. Calculation of
relevant ratios for the above two companies is essential in answering this question.
4 From the financial statements of Ocean Ltd, a retailer, identify:
(a) Five points of interest from comparing this year’s results with those of the previous
year.
(b) Calculate relevant ratios for Ocean Ltd to enable you to assess the performance
of the company in the current year.
(c) Identify any further information you might find useful.
INCOME STATEMENTS FOR THE YEARS ENDED
31.12.20X0 31.12.20X1
£000 £000
Sales 1,168 1,944
Cost of sales 778 1,370
–––––– ––––––
Gross profit 390 574
Wages and salaries 156 202
Depreciation 32 62
Other expenses 108 124
–––––– ––––––
Operating profit 94 186
Interest on debentures 16
–––––– ––––––
Net profit before tax 94 170
Taxation 32 78
–––––– ––––––
Net profit after tax 62 92
Dividends 32 46
–––––– ––––––
Retained profit 30 46
–––––– –––––––––––– ––––––
BALANCE SHEETS AS AT
£000 £000
31.12.20 31.12.20 31.12.20 31.12.20
X0 X0 X1 X1
Property, plant and equipment cost 560 856
Current assets
Inventory 94 124
Debtors 140 312
Cash 78 32
––––– –––––
312 468
––––– –––––––––– –––––
Current liabilities due within one year
Creditors 78 218
Taxation 32 78
Dividends 32 46
––––– –––––
142 342
––––– –––––
11 · Interpretation, including ratio analysis and consideration of additional information required 213
᭤
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Net current assets 170 126
–––––
Non-current liabilities greater than one year
Debentures 10% 160
–––––
730 822
––––– –––––––––– –––––
Capital and reserves
Ordinary share capital 544 590
Retained profits 186 232
––––– –––––
730 822
––––– –––––––––– –––––
Note inventory, debtors and creditors figures at 1.1.20X0 were £102,000, £100,000
and £60,000 respectively.
5 Many plc financial reports now include information on ratios or these can be found
on such systems as Extel or Datastream. A useful exercise for you would be to obtain
a set of financial statements of a plc, and to calculate some ratios and compare
them with any published information available. You could also attempt an analysis of
the company in simplistic terms or using a published analysis (e.g. from the
Financial Times or elsewhere) comment on it. These sorts of exercises lend themselves
to group work by students and group presentations so if you are studying with
others try doing this exercise as a group.
Answers to these questions can be found at the back of this book.
214 Financial Accounting
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12
Valuation and performance
measurement
Introduction
You have now reached a point in your studies where you should be reasonably
confident in your ability to account for fairly complex economic events,
and to present the outcomes using an income statement, balance sheet and
cash flow statement. You may remember from Chapter 4 that there is a
fourth statement required by IAS 1, and that is the statement of changes in
equity. We will deal with that in some detail towards the end of this chapter.
Before doing so, however, we should take a more rigorous look at some of
the implicit assumptions we have made in preparing all these statements.
Specifically, we need to reconsider the validity of the historical cost concept.
There are two aspects to this. First, historical cost may be the simplest
and most objective basis for valuing our assets, but it may not be the most
relevant and reliable, especially if prices are changing significantly. What,
after all, is the use of quantifying a building at what it cost 20 years ago, if,
during that time, prices have doubled or trebled? Is it still a relevant and
reliable figure to help users make decisions about the entity?
Second, we will take a brief look at attempts that have been made to
explicitly allow for the effects of changing prices, and at why they have so
far failed. It could be argued that restating our assets at a more current valuation
than historical cost is one way of making at least some such
allowance, so we will also study the accounting for this process.
By the end of this chapter you should be able to:
᭤ Review valuation theory, including economic value.
᭤ Explain why Constant Purchasing Power and Current Cost
Accounting failed.
᭤ Outline the revaluation accounting approach.
᭤ Prepare a simple statement changes in equity.
Objectives
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Alternatives to historical cost
In Chapter 2 we considered replacement cost, net realisable value (NRV),
and touched on economic value. To recap, replacement cost is what an asset
would cost if we were to replace it today. Strictly, this should be the cost of a
similarly part-worn asset. In times of rising prices this will usually be higher
than the historical cost. Note, however, that, even when prices generally are
rising, the prices of some assets may be rising at a different rate, or even
falling. Think, for example, about what has happened to the prices of computers
in recent years. Net realisable value is what we could sell the asset for,
after allowing for any direct selling costs.
In this chapter we concentrate on the conceptually most difficult of the
three alternatives, that is, economic value. Having done that, we can consider
all the alternatives, together with historical cost, and arrive at a single
coherent approach to asset valuation.
Economic value rests on the definition of an asset given in the Framework
for the Preparation and Presentation of Financial Statements, that is, ‘a
resource controlled by the enterprise as a result of past events and from
which future economic benefits are expected to flow to the enterprise’. The
essence of an asset is thus the stream of benefits that will flow in to us in the
future, because we control that asset. It therefore seems reasonable to value
the asset by adding up all those future economic benefits. This is sometimes
called the value in use of the asset.
If, for example, an asset is expected to last three years, the products we
make using it can be sold for £25,000 per year, and the direct costs of making
those products are £10,000 per year, then the net economic benefit is £15,000
for each of three years. We could then simply add up the benefits, i.e.
£45,000, and use that as the valuation of the asset. We would then show the
asset in our balance sheet at £45,000, rather than at its historical cost.
Answer In the advantages box, you should have noted such points as its consistency with the
formal definition of an asset, and the fact that it is an up-to-date valuation. The disadvantages
include its uncertainty, in that the method assumes that we can predict
future incomes and costs with reasonable certainty. This is unlikely. More subtly, the
method in its crude form above simply adds together net inflows from different years.
This is highly questionable, because of the time value of money.
216 Financial Accounting
Comparing economic value with historical cost, what are its advantages and disad-
vantages?
Complete this table by making at least one entry in each box.
Advantages Disadvantages
Activity 12.1
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The time value of money
The time value of money is a concept that states that money has a value,
not just in terms of its absolute amount, but also in terms of when that
amount is received. If you are offered £100 today, or £100 in a year’s time,
which would you take? The answer is almost certainly that you would
want the money now, perhaps because there is something you urgently
want to spend it on, and perhaps because you have realised that, given
inflation, that same amount will be worth less in real terms in a year from
now. Even without these two reasons, however, you may have realised that
if you get the money now, you could invest it for a year, so that the total
sum would be £110, if we assume a 10% rate of interest.
Looking at this situation from a slightly different angle, there must be
some sum of money which you could receive now, instead of getting £100
a year from now, and be indifferent about which one you got. If we again
assume interest at 10%, this amount would be £90.91. It is the amount
which you could invest now, at 10%, and expect to receive £100 a year
from now (£90.91 + £9.09 = £100.00). The £90.91 is called the Present
Value of £100 received in one year, at a 10% discount rate.
Returning to our example of the machine that will yield a net £15,000
for three years, we should now note that simply adding the three lots of
£15,000 is not actually adding like to like, because it is expressed in £s at a
different point in time, and the time value of money concept tells us that
these three amounts are therefore not expressed in the same terms. In a
theoretically pure world, we should add the present value of each of the
three inflows, since they would then, by definition, all be expressed in £s
at the same point in time – the present.
The key to this technique is applying the correct discount factor to each
inflow. Fortunately, there is a fairly simple formula for working out what
this factor should be,
1
––––––––
(1 + r)n
where r is the rate of interest applicable to the entity – often, slightly inaccurately,
called the cost of capital, and n is the number of years before we
receive the inflow. The cost of capital is the rate of interest that the organisation
or individual would have to pay if they wanted to borrow money. In
the case of an individual, it is often called their ‘personal cost of capital’.
Note that we will be making a simplifying assumption, namely that the
net inflow associated with each year is actually received at the end of that
year. If we assume a cost of capital of 10%, then we are finally in a position
to work out the economic value of our asset, as follows:
End of year Inflow Discount factor Present value
1 15,000 0.90909 13,636
2 15,000 0.82645 12,397
3 15,000 0.75131 11,270
–––––––––
£37,303
––––––––––––––––––
12 · Valuation and performance measurement 217
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The base value of this asset that should go in our balance sheet is therefore
£37,303. Note that what we paid for the asset, its historical cost, has not
figured anywhere in the calculation.
Answer Your calculation should look like this:
Year Inflow Discount factor Present value
1 20,000 0.90909 18,182
2 20,000 0.82645 16,529
––––––––––
£34,711
––––––––––––––––––––
Putting the valuations together
We now have three alternatives to historical cost as bases for asset valuation.
These are:
᭤ Replacement cost.
᭤ Net realisable value.
᭤ Economic value.
In terms of practical accounting, this is not a satisfactory position, because
we are faced with trying to determine which is the most relevant, reliable,
comparable and understandable basis for any given entity. Not only may
opinions vary, but the answer may change as circumstances in the real
world change. There are two ways out of this problem. First, we could
decide on one as being the most appropriate most of the time, although this
would inevitably be a rather arbitrary decision. Second, we could use the
more rigorous approach known as the deprival value model. It is usually
summarised by the diagram in Figure 12.1.
Deprival value
lower of
Replacement cost Recoverable amount
higher of
Economic value NRV
Figure 12.1 Deprival value model
218 Financial Accounting
Ms Lee’s entire wealth consists of one investment which cost her £30,000, and
which will yield £20,000 for each of the next two years, with no further returns. If her
personal cost of capital is 10%, calculate the present value of the inflows today, and
hence value her asset.
Activity 12.2
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This approach rests on asking two questions, which we then use to work
upwards through the model. In other words we start at the bottom of the
diagram and compare economic value and net realisable value. Once we’ve
chosen one of these as the recoverable amount we then continue to work
upwards to compare this recoverable amount with the replacement to
arrive at the deprival value. The two questions are:
1 Assuming we have an asset, what should we do with it – keep it and use it, or
sell it?
The answer to this question will depend on what would result in the
most money for the entity. If we keep it and use it, the benefit is best
measured by the economic value method, since this measures the value
in use. If we sell, the most appropriate valuation will be the NRV. The
higher of these two represents the greatest benefit we could derive from
the asset, and is called the recoverable amount.
2 Assuming we were deprived of the asset, would we replace it?
The answer to this second question depends on whether the cost of
replacement is more or less than the recoverable amount. If it is less,
then it is economically logical to replace the asset, since we can recover
more from either using it or selling it than it costs to acquire in the first
place. In this case, the most appropriate valuation will be replacement
cost. Otherwise, the best valuation will be the recoverable amount,
because the consequent non-replacement leaves us with recoverable
amount as the best we can do with the asset we are attempting to value.
12 · Valuation and performance measurement 219
A property company owns two plots of land, in Leeds and Bradford, with the following
values. It is aware that property prices bear little resemblance to historical costs and
therefore wishes to value its property on a deprival value basis.
Leeds Bradford
Original cost £730,000 £185,000
Replacement cost £815,000 £170,000
Net realisable value £775,000 £165,000
Estimated economic value (value in use) £800,000 £180,000
Select the best answer from the list below of respective deprival values for the plots
in Leeds and Bradford:
1 £730,000 and £180,000.
2 £800,000 and £170,000.
3 £815,000 and £170,000.
4 £775,000 and £185,000.
5 None of the above.
Activity 12.3
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Answer Deprival value is the lower of replacement cost and recoverable amount, where the
recoverable amount is the higher of net realisable value and economic value. For
Leeds, recoverable amount is therefore the higher of £775,000 and £800,000, i.e.
£800,000, and this is lower than the replacement cost of £815,000. The deprival
value for Leeds is therefore £800,000. For Bradford, the recoverable amount is the
higher of £165,000 and £180,000, i.e. £180,000. Deprival value is then the lower of
this and the replacement cost of £170,000, i.e. £170,000. The correct answer is
therefore (2) ‘£800,000 and £170,000’.
Finally, note that, in nearly all cases, the economic value will be greater than
the NRV – if it were not then no enterprise would be using any asset, since
they could derive more from it by selling it second-hand, and this is obviously
not the case. In other words, the recoverable amount will usually be
economic value. Furthermore, when this economic value is then compared
with the replacement cost, the outcome will usually be that the replacement
cost is lower. If this were not so, then no entity would be buying any asset,
and this is again patently not so. In the great majority of cases, therefore,
deprival value can be equated with replacement cost.
We therefore have a single, logically coherent alternative to historical cost.
This alternative has so far been used in accounting for two things. First, it
has been used to help clarify general thinking on asset valuation. Second,
and more practically, it has been applied to help address the distortions
caused to historical cost accounting by changing prices. The next section of
this chapter is thus concerned with a brief look at inflation accounting.
Inflation accounting
Inflation accounting is accounting that makes specific allowances for the
effects of inflation. As we will see, it actually includes allowances for
changes in prices which are specific to a particular entity. To be pedantic,
such accounting is not strictly ‘inflation accounting’ because inflation is
defined as a persistent and general rise in prices. Nevertheless, any accounting
that makes some explicit allowance for changes in prices, whether
general or not, is commonly referred to as inflation accounting.
The need for inflation accounting arises out of the distortions caused
within historical cost accounting. Specifically, there are two accounting
effects. First, if we buy an asset and record it at historical cost, then its
reported value will be increasingly out of date, and often materially lower
than a current valuation such as deprival value. Similarly, a liability such as a
loan will be recorded in our accounts at its original historical value. A loan of
£20,000, for example, is the amount we will show in our balance sheet and it
is also the amount we will repay, despite the fact that each of the £s we repay
will in real terms be worth less than each of the £s that we borrowed.
Second, inflation will also have an effect on our real profits. Revenues
will be in current terms, i.e. we will sell at today’s prices, but the cost of
sales will be based on historical cost. We are therefore not comparing like
220 Financial Accounting
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with like, and the effect will be to relatively understate the cost of sales,
and so to overstate reported profit. Further, the depreciation charge will be
based on a historical asset cost, and thus understated in current terms.
Again, the net effect will be to overstate the reported profit. To understand
these points more fully, try the next two activities one after the other.
Answer This should have been a fairly easy exercise, and your answer should be the same as
ours, that is:
REALIA LTD
HISTORICAL COST INCOME STATEMENT FOR THE YEAR
Sales 480,000
Cost of sales:
Opening inventory 30,000
Purchases 360,000
–––––––––
390,000
Closing inventory 35,000
–––––––––
355,000
–––––––––
Gross profit 125,000
Depreciation (10% × 160,000) 16,000
Other expenses 72,000
–––––––––
88,000
–––––––––
Historical cost net profit £37,000
––––––––––––––––––
Now we take some account of inflation. It seems reasonable to assume that
sales, purchases and other expenses took place fairly steadily through the
year. Some sales, purchases and expenses will then have taken place early
in the year, when prices were relatively low, and some towards the end of
the year, when prices were high. Assuming that prices rose fairly steadily
throughout the year, and given our first assumption, we can then also
assume that the typical transaction took place half-way through the year,
at an average price level. In other words, the sales, purchases and other
expenses shown in our income statement are stated at average prices.
However, the opening inventory would be stated at its cost when
bought, some time before the beginning of the year, and the closing inventory
at a cost that reflects the price level towards the end of the year, when
the closing inventory was probably bought. Furthermore, the underlying
12 · Valuation and performance measurement 221
Realia Ltd recorded sales of £480,000, and purchases of £360,000. Its opening
inventory cost £30,000 and its closing inventory was valued at £35,000. Depreciation
was to be provided at 10% straight line on assets which cost £160,000, and other
expenses totalled £72,000. Use these figures to prepare a historical cost income
statement for the year.
Activity 12.4
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price level for the depreciation would be that when the non-current assets
were bought, which could well have been many years ago. The traditional
historical cost income statement ignores these differences in price levels,
and so does not actually compare like with like.
If we want a more meaningful income statement, then one answer
would be to restate the opening and closing inventory and the depreciation
so that they reflect average, mid-year prices, in the same way that the
sales, purchases and other expenses implicitly do.
Answer REALIA LTD
PRICE ADJUSTED INCOME STATEMENT FOR THE YEAR
Sales 480,000
Cost of sales:
Opening inventory 33,000
Purchases 360,000
–––––––––
393,000
Closing inventory 32,000
–––––––––
361,000
–––––––––
Gross profit 119,000
Depreciation (10% × 250,000) 25,000
Other expenses 72,000
–––––––––
97,000
–––––––––
Price adjusted net profit £22,000
––––––––––––––––––
It is our view that the price-adjusted statement presents a more true and fair
view, simply because it makes at least some allowance for the fact that the
accountant’s unit of measurement, the £, changes in size from year to year,
because of inflation. The historical cost income statement is presented for
all UK companies, and most other entities, but it is distorted whenever
inflation is material.
Accountants in the UK have had two major attempts to address this distortion.
The first was an approach known as current purchasing power (CPP). If
the root problem is that the real value of a £ falls with inflation, then an obvious
way to counteract the effects of this would seem to be to develop a
system of accounting that uses a unit of currency that is, by definition, current.
Monetary items, that is, items whose values are expressed and fixed in
222 Financial Accounting
Realia Ltd knows that if it had bought its opening inventory at mid-year prices, it
would have cost £33,000, and the closing inventory at mid-year prices would have
cost £32,000. Finally, it also knows that the cost of its non-current assets at midyear
prices would have been £250,000. Use these figures to redraft the income
statement for Realia Ltd. When you have done that, compare it with the original historical
cost statement. Which gives the more true and fair view?
Activity 12.5
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nominal money terms, such as the £20,000 loan we considered above, always
have the same nominal and real value, so need no adjustment. By contrast,
non-monetary items, such as non-current assets and inventory whose value is
not given by the number of £s attached to them, should be index-linked
using a general index of inflation. In the UK the obvious index to use is the
Retail Price Index (RPI). This index linking then compensates for the fall in
the value of each £ by attaching a correspondingly greater number of them to
each non-monetary item.
The following example provides a further illustration of the points we
have been covering in the last two activities. In particular, it provides a
good overview of the alternative approaches that have been taken to
accounting under changing prices.
A company begins the year with share capital of £100 and £100 worth of
newly purchased inventory. Inflation during the year is 5%. The company
sells the inventory at the end of the year for £200. Replacement cost of the
inventory is £150.
OPENING BALANCE SHEET
Newly purchased inventory £100
––––––
Share capital £100
––––––––––––
Traditional historical cost accounting
INCOME STATEMENT
Sales 200
Less: cost of sales 100
––––––
Nominal money profit £100
––––––––––––
Current purchasing power
INCOME STATEMENT
Sales 200
Less: cost of sales 105
–––––
Current purchasing power profit £95
––––––––––
What the CPP method thus does is uplift the cost of sales by the rate of
inflation, so that it is expressed in something like current terms, i.e. the same
terms as the sales. Notice that the effect, when compared with the traditional
historical cost accounting approach is to reduce the reported profit by £5. The
policy prescription here is that this company should pay a maximum dividend
of only £95, not £100. Paying out all the historical cost profit of £100
would, in fact, amount to a distribution of capital. In other words, £5 of the
profit would not be a return on capital but a return of capital.
12 · Valuation and performance measurement 223
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Notice that paying out a dividend of £100 would leave the balance sheet
total at £100, which is what we started the business with, and it would
seem that we have therefore maintained capital. In a historical cost world
this is true. However, CPP takes the view that true capital maintenance
should maintain the original £100 adjusted by 5% inflation, i.e. £105. The
CPP profit calculated above is therefore the most we should distribute if we
are to maintain CPP capital.
CPP formed the basis of Statement of Standard Accounting Practice 7
(SSAP 7), but was short lived. The main reasons for its lack of acceptance by
accounts preparers and users were:
᭤ The use of a general index, such as the RPI, is strictly only relevant to a
mythical average entity. No business or individual actually experiences
average inflation – it always depends on what you buy in a particular
period. SSAP 7, however, explicitly required the use of the RPI.
᭤ It is not directly relevant to the needs of the specific business, since CPP
does not aim to maintain the capital of each particular business, but
only of the mythical average business. Organisations in the information
technology market tend to experience falling prices, even when inflation
is positive. CPP accounting would require even these organisations to
account for rising prices.
᭤ The process is not easy to understand, takes time to implement, and is
therefore expensive.
The issue of the non-specific nature of CPP was addressed by the second
attempt at inflation accounting, namely current cost accounting (CCA). This
was implemented by SSAP 16 in 1980, and was longer lasting. The essential
difference between CPP and CCA is that the latter has a very different view of
the capital it is trying to maintain. CCA assumes that the issue is less to maintain
the purchasing power of the entity (and hence its owners), than to
maintain the ability of the entity to physically do the same things this year as
it could last year. If our physical infrastructure allowed us to produce 10,000
tables last year, then the point is to ensure that we can produce the same
number again this year, and the money capital needed to do that is incidental.
This ‘operating capability’ approach implies a basis of valuation which
rests on ‘value to the business’, i.e. what an asset can do, rather than what it
cost. SSAP 16 took the view that this means deprival value. We saw earlier in
this chapter that deprival value tends, in practice, to equate with replacement
cost. CCA therefore uses replacement cost as a basis for valuing both
assets and expenses. Using the same example as before, we can again calculate
the reported profit, this time using CCA.
224 Financial Accounting
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Physical capital maintenance
INCOME STATEMENT
Sales 200
Less: cost of sales 150
–––––
Current cost operating profit £50
––––––––––
The policy prescription in this case is even more stark. The entity should
only distribute a maximum dividend of £50 if it is to maintain the real
value of its net assets. SSAP 16 set out a number of adjustments to profit to
ensure that funds are retained to allow for:
᭤ replacing inventory despite the fact that its price has risen – as above
᭤ replacing non-current assets, despite the fact that their prices have risen
᭤ funding working capital, despite the fact that the absolute amount will
have risen in terms of nominal £s.
It also uplifted the value of non-current assets and inventory in the balance
sheet to ensure that they are fairly represented at something close to their
current values, rather than their historical values. All these adjustments
will, in principle, make the inflation-adjusted accounts more reliable, and
perhaps more relevant. However, the increased complexity does also make
them less understandable. This was not the only problem with CCA
accounting as implemented by SSAP 16. In summary the problems were:
᭤ Complexity and hence lower understandability, as above.
᭤ The provision of both the traditional, historical cost profit and an
inflation-adjusted profit, as above. The provision of two profits in the
same set of accounts did not improve either the credibility or the understandability
of those accounts.
᭤ The fact that tax continued to be levied on the historical cost profit.
᭤ The conceptual difficulty of much of the process.
᭤ The consequent time and expense involved in the production of inflation-adjusted
accounts.
As a result of these problems, many companies stopped producing inflationadjusted
accounts around 1983 and 1984. The fact that inflation began to fall
probably helped their decision. They were, of course, still producing historical
cost accounts, so users had what they were used to. Finally, the Accounting
Standards Committee accepted the demise of the standard, and it was formally
withdrawn in 1988. Nevertheless, that was not the end of inflation
accounting. IAS 29 ‘Financial Accounting in Hyperinflationary Economies’
requires companies to use what is essentially CPP accounting where inflation
is significant. ‘Significant’ is primarily defined as a rate of inflation of more
than 100% over three years. In other words, inflation and inflation accounting
are continuing issues.
12 · Valuation and performance measurement 225
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This section on inflation accounting has only scratched the surface of an
extensive and difficult topic. Nevertheless, you may have had trouble following
the arguments. If so, you are not alone, but a broad understanding of the
issues that were tackled will help you in any further studies of accounting. As
a final brief check on your understanding, try the following activity.
Answer SSAP 16 ‘Current Cost Accounting’ was based on the idea of maintaining the operating
capability, and suggested that assets should be valued at their value to the business.
This is then defined as net current replacement cost, or, if lower, recoverable amount.
In other words, value to the business is based on the deprival value model, and answer
(3) is therefore correct. Deprival value will usually turn out to be replacement cost, so
choice (2) is reasonable, but not strictly correct.
The Accounting Standards Board (ASB) thinking on the future of inflation
accounting currently appears to be that a return to something like SSAP 7
or 16 is unlikely, because of the complexity and widespread scepticism
among accountants over the value of the consequent financial statements.
Nevertheless, as we saw above, when inflation again becomes significant
there will be a need to allow in some form for the distortions that we have
seen occur under historical cost accounting. One possible, albeit partial,
answer would be to regularly revalue all non-current assets to some current
value, probably replacement cost.
The rationale for this is that non-current assets tend to cost a lot in the
first place, and then inflation impacts on them for their relatively long lives.
Allowing for the effects of inflation on non-current assets would therefore
address a large part of the distortion. It would ensure that the non-current
assets are presented at an up-to-date figure in the balance sheet, and that
the depreciation charge reflects this more current amount. The next part of
this chapter therefore deals with the accounting for such revaluations.
226 Financial Accounting
Choose the most appropriate response from those listed below. The method of asset
valuation which best measures the operating capability of a business is:
1 Net realisable value
2 Replacement cost
3 Deprival value
4 Recoverable amount
5 None of the above.
Activity 12.6
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Accounting for revaluations
When we revalue an asset our aim is primarily to restate the asset in the
balance sheet at a current value. In times of rising prices, this will mean an
adjustment upwards. An incidental issue is that the same depreciation
policy will then be applied to the higher amount and will itself be a larger
charge in the income statement, so resulting in a smaller reported profit.
The best way to see all this is to follow an example.
Asif owns a building which cost £400,000 on 1 January 20X0. The depreciation
policy has always been to write off the building over 40 years on a straight
line basis. In the ledger accounts for the year ended 31 December 20X6, the
following amounts will therefore appear, before any year-end adjustments.
BUILDING AT COST
1.1.X0 Cost 400,000
PROVISION FOR DEPRECIATION
1.1.X6 Balance b/f (*) 60,000
* Six years’ depreciation at £10,000 per year (400,000/40)
As part of the year-end accounting, Asif values the building at £540,000,
and considers that the remaining useful life is another 30 years including
20X6. The first matter is to revalue the buildings in the books. The key to
doing this is to open a revaluation account, which will hold the uplift in
value from the present net book value (NBV) to the new valuation. Note
that this uplift is therefore not £140,000 (540,000 – 400,000), but £200,000
(540,000 – 340,000 (NBV)). The necessary entries will be:
BUILDING AT VALUATION
1.1.X0 Cost 400,000
31.12.X6 Revaluation account 140,000
––––––––––
£540,000
PROVISION FOR DEPRECIATION
31.12.X6 Revaluation account £60,000 1.1.X6 Balance b/f £60,000
–––––––––– ––––––––––––––––––– –––––––––
31.12.X6 Income statement 18,000
REVALUATION ACCOUNT
31.12.X6 Buildings 140,000
31.12.X6 Depreciation 60,000
––––––––––
£200,000
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You should be able to follow what is going on here. The building account is
uplifted to the value we want, with the corresponding credit going to the
revaluation account. Notice also, however, that the provision for depreciation
account is cleared out, with another credit going to the revaluation account,
giving the total uplift on that account of £200,000. Finally, since we have benefited
from the building during 20X6, we must match some charge against
that benefit. In other words, we must make a depreciation charge for 20X6.
You may object that we have only just got the value up to where we
wanted it and this seems to be immediately reducing it. True, but remember
that the purpose of depreciation is not to get the right value in the
balance sheet, but to match a cost in the income statement to reflect the
using up of the asset in earning the benefits that appear in the income
statement. This depreciation charge will be based on the revised estimate of
a 30-year life, and will therefore be £18,000, i.e. 540,000/30. This is shown
in the provision for depreciation account above.
It may be that we subsequently sell the building. The way to deal with this
is to open one final account, namely the sale of assets account. Assuming
Asif sells the building on 1 September 20X7 for £500,000, the accounting
will be:
BUILDING AT VALUATION
1.1.X0 Cost 400,000
31.12.X6 Revaluation account 140,000
–––––––––
540,000 1.9.9X6 Sale of assets £540,000
––––––––– ––––––––––––––––––– ––––––––––
PROVISION FOR DEPRECIATION
31.12.X6 Revaluation account £60,000 1.1.X6 Balance b/f £60,000
––––––––– –––––––––
1.9.X7 Sale of assets 18,000 31.12.X6 Income statement £18,000
––––––––– –––––––––––––––––– –––––––––
REVALUATION ACCOUNT
1.9.X7 Revenue reserve £200,000 31.12.X6 Buildings 140,000
31.12.X6 Depreciation 60,000
–––––––––– ––––––––––
£200,000 £200,000
–––––––––– –––––––––––––––––––– ––––––––––
SALE OF ASSETS
1.9.X7 Building 540,000 1.9.X7 Bank 500,000
1.9.X7 Depreciation 18,000
1.9.X7 Loss to Income
statement 22,000
–––––––––– ––––––––––
£540,000 £540,000
–––––––––– –––––––––––––––––––– ––––––––––
228 Financial Accounting
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The additional entries are mostly straightforward. The balances on the
building account and on the provision for depreciation account are transferred
to the sale of assets account. The proceeds are debited in the bank
account and credited in the sale of assets account. In common with generally
accepted practice, no depreciation is charged in the year of disposal.
The resulting balance on the sale of assets account then represents the
profit or loss on the sale of the building, and is shown in the income statement
for the year. In this case it is a loss of £22,000.
The treatment of the balance of £200,000 on the revaluation account is
contentious. There are two possibilities.
1 Clear it by transfer to the sale of assets account. Note that this would
make the balance on the sale of assets account a credit of £178,000, so
that we would report a profit of this amount in the income statement
for the year. This is the difference between the cost of £400,000, less the
total depreciation charged over the years of £78,000 (60,000 + 18,000),
i.e. £322,000, and the proceeds of £500,000. You might think there is
some logic to this.
2 Clear it by transfer direct to the revenue reserve. In this way it will not
pass through the income statement for the year, and will not be reported
as part of the profit for the year. This is what we have done above. The
logic of this approach is that the building is now considered to be worth
£540,000 (less depreciation) to Asif, and it is this amount that should be
compared with the proceeds. The £540,000, less depreciation, is known
as the ‘carrying value’.
The treatment of the balance on the revaluation reserve obviously makes a
material difference to the profit for the year, and most businesses would probably
want to use method 1 above. However, the IASB prefers the logic of
method 2, and IAS 16 ‘Property, Plant and Equipment’ requires that approach.
Nevertheless, in order to disclose what the situation would have been if we
had used historical cost, IAS 16 also requires that the historical cost figures
must be shown as a note to the accounts. In Asif’s case, this would allow for
showing a loss of £22,000 in the income statement and a profit of £178,000 as
a note of historical cost profit. Notice that the difference between the two
results is, of course, the balance of the revaluation account.
12 · Valuation and performance measurement 229
Faraday Ltd has always prepared its final accounts to 31 March. The company
bought a building on 1 April 20X3 for £72,000. Its depreciation policy on buildings
has always been to depreciate at 10% p.a. on a reducing balance basis, but no
depreciation is ever charged in the year of a disposal.
When preparing the final accounts for the year ended 31 March 20X6, before any
depreciation had been charged for that year, it was decided to revalue the building to
£100,000. On 1 September 20X6, the company sold the building for £95,000.
Write up the ledger accounts for all years up to and including the year ended
31 March 20X7, including all opening and closing balances, for:
Activity 12.7
᭤
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Answer You will learn more easily and more effectively if you try this activity before you look at
the answer. It’s your choice!
BUILDING
1.4.X3 Cost 72,000
31.3.X6 Revaluation account 28,000 1.9.X6 Sale of asset 100,000
–––––––––– ––––––––––
£100,000 £100,000
–––––––––– –––––––––––––––––––– ––––––––––
PROVISION FOR DEPRECIATION
31.3.X4 Income statement 7,200
31.3.X6 Revaluation account 13,680 31.3.X5 Income statement 6,480
––––––––– –––––––––
£13,680 £13,680
––––––––– –––––––––––––––––– –––––––––
1.9.X6 Sale of asset £10,000 31.3.X6 Income statement £10,000
REVALUATION
31.3.X6 Cost 28,000
1.9.X6 Revenue reserve 41,680 31.3.X6 Depreciation 13,680
––––––––– –––––––––
£41,680 £41,680
––––––––– –––––––––––––––––– –––––––––
SALE OF ASSET
1.9.X6 Building 100,000 1.9.X6 Depreciation 10,000
1.9.X6 Profit – Income
statement 5,000 1.9.X6 Bank 95,000
–––––––––– ––––––––––
£105,000 £105,000
–––––––––– –––––––––––––––––––– ––––––––––
You should be able to follow our answer, since the logic is the same as in the Asif
example. Remember that reducing balance depreciation takes a fixed percentage of
the net book value every year.
In the balance sheet at 31 March 20X6, the building and depreciation will be shown
under non-current assets as usual, except that it will be described as being ‘at valuation’,
rather than as ‘at cost’. The revaluation account is a capital reserve (i.e. not available for
dividend payments), and will be shown with shareholders’ funds.
230 Financial Accounting
᭤ Building account.
᭤ Provision for depreciation account.
᭤ Revaluation account.
᭤ Sale of asset account.
Indicate how the balances would be dealt with in the final accounts at 31 March 20X6.
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There is just one matter remaining to be dealt with in this chapter, and that
is the further reporting of revaluation gains, and similar gains and losses. We
have already seen that any balance on the revaluation account is a capital
reserve, and is taken directly to the revenue reserve when realised on a sale.
Pending such a sale, we have recognised an uplift in the value of the building,
but hold it as a capital reserve because it is unrealised (i.e. the asset has
not been sold). Nevertheless, we have recognised that a gain has occurred
during the year, and it is arguable that such a gain should be explicitly
reported in its own statement, rather than left implicit within the note of
reserves. Such a statement is called the statement of changes in equity.
Statement of changes in equity
You may recall from Chapter 4 that this statement is identified as one of
the four primary statements in IAS 1, along with the balance sheet, income
statement and cash flow statement. It differs from the income statement by
including not just the realised profit for the year but also all unrealised
gains and losses.
If, for example, Asif had reported a profit of £145,000 for the year ended
31 December 20X6, then his statement of changes in equity for the year
ended 31 December 20X6 would be:
Profit for the year 145,000
Surplus on revaluation of buildings 200,000
––––––––––
Total gains recognised since the last annual report £345,000
––––––––––––––––––––
Such a short and simple statement will often be all that is needed. Indeed,
if there are no unrealised gains or losses, the company will simply report
this fact, instead of producing the statement. In more complex enterprises,
you may come across gains and losses on foreign exchange, and even prior
year adjustments. These are beyond the scope of this book.
Summary
This has been a wide-ranging chapter, covering some difficult ideas. We
have followed a train of argument covering:
᭤ an introduction to the theory of valuation and concentrated on the new
ideas of economic value and deprival value
᭤ a major application of these ideas, namely inflation accounting
᭤ the need for some allowance for changing prices in our accounting, and
the main efforts that have so far been made to tackle the problems
᭤ a look at the uses and mechanics of revaluations needed if our assets and
profits are to reflect at least some changing values
᭤ the statement of changes in equity.
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In Chapter 13 we shift the emphasis of study, and consider the need for
and techniques of control in accounting.
Self-assessment questions
1 It is conceivable that UK accounting and reporting for non-current assets could be
changed to a system based on one of the valuation methods dealt with in this chapter,
perhaps deprival value. List three reasons for such a change, and three reasons
for retaining historical cost as the base method of valuation.
2 Jerome plc bought a large plot of freehold land for £3,600,000 on which Jerome
intends to build a storage depot. The land was bought just before news was released
of a new road link, and the neighbouring plot, which is very similar, is now on the
market at £4,700,000. Indeed, Jerome has been offered £4,200,000 for its own
plot. However, Jerome intends to build on the new plot because it is believed that the
present value of future inflows just from the land will amount to at least £5,000,000.
Jerome’s only other major asset at the moment is a fleet of delivery lorries, for
which a total of £1,300,000 was paid at various times over the past year. Prices of
new lorries have not moved significantly since then, but the transport manager estimates
that the second-hand value of the existing fleet is only about £800,000.
More positively, she has estimated the net benefit of the fleet at £1,100,000 in
present value terms. The lorries have a useful life of about four years.
(a) Draft the historical cost and deprival value balance sheets for Jerome, including
depreciation where appropriate.
(b) Assuming Jerome originally recorded all assets on a historical cost basis, but,
after preparing the balance sheet, wishes to revalue them on an undepreciated
deprival value basis, show the Revaluation Account.
3 Holderness Ltd prepares its final accounts to 31 December. The company bought a
building on 1 January 20X7 for £520,000. Its depreciation policy on buildings has
always been to depreciate at 5% p.a. on a straight line basis, but no depreciation is
charged in the year of a disposal.
When preparing the Final Accounts for the year ended 31 December 20X8, before
any depreciation had been charged for that year, it was decided to revalue the building
to its estimated replacement cost of £800,000. On 1 September 20X9, the
company sold the building for £750,000.
232 Financial Accounting
economic value (p. 216)
value in use (p. 216)
time value of money (p. 217)
deprival value (p. 218)
current purchasing power (p. 222)
current cost accounting (p. 224)
statement of changes in equity
(p. 231)
Key terms
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Required
(a) Write up the ledger accounts for the years ended 31 December 20X7 to 20X9,
including all opening and closing balances, for:
᭤ asset cost account
᭤ provision for depreciation account
᭤ revaluation account
᭤ sale of asset account.
(b) Indicate how the balances would be dealt with in the Final Accounts at 31
December 20X9.
(c) Briefly outline the alternative bases of valuation that Holderness could have
used at 31 December 20X8, instead of replacement cost.
4 (a) Outline the problems with historical cost accounting. (You may find it helpful to
refer back to Chapter 4 as well as Chapter 12.)
(b) Mystron Products has prepared its Trading Account for its first year of trading in
traditional historical cost terms, and this is set out below.
Sales 400,000
Purchases 340,000
Closing inventory 80,000
–––––––––
260,000
–––––––––
Gross profit 140,000
––––––––––––––––––
Sales and purchases were made steadily throughout the year. General inflation
ran at 10% through the year. The closing inventory consisted of the same physical
amount of inventory, and could have been bought for about £65,000 in
average price terms.
Restate the Trading account on a current cost accounting (CCA) basis.
(c) Which of the profits, the historical cost figure of £140,000 or the CCA figure you
have calculated, gives the most true and fair view of Mystron Products’ trading
activities for the year? Justify your decision.
Answers to these questions can be found at the back of this book.
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234 Financial Accounting
13
Control of accounting systems
Introduction
So far in this book, we have tended to assume that bookkeeping procedures
and the preparation of final accounts will be carried out by competent
people of integrity, who never make mistakes. This is obviously unlikely.
This chapter therefore deals with the issue of the controls in accounting systems,
which enable us to address the effects of any failings.
Many of the techniques that we examine in this chapter have their roots
in traditional manual accounting systems. Such systems are becoming
increasingly rare, in any but the smallest organisations, because of the growing
cost-effectiveness of computer-based systems. Nevertheless, the principles
of control remain, although they may be implemented very differently in a
computer system. This chapter looks at the basic principles and at how they
have traditionally been applied, and Chapter 14 explores the impact on such
controls of the introduction of computers to accounting.
The need for controls
We identified above three requirements of those involved in the accounting
function if financial statements are to show a true and fair view. These
are requirements in terms of:
᭤ avoidance of mistakes
᭤ competence
᭤ integrity.
By the end of this chapter you should be able to:
᭤ Outline the main features of control in a financial accounting system.
᭤ Explain the function of internal and external audit.
᭤ Prepare a bank reconciliation statement.
᭤ Prepare control accounts.
Objectives
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It is worth considering a response to each of these requirements in turn.
First, it is as common for accountants to make mistakes as for anyone else.
Arithmetic errors are probably less common since the advent of computers,
but errors of principle are still possible. Errors of principle include, for
example, entering a transaction twice, or omitting it entirely, or making an
entry in the wrong account. It would be quite possible, for instance, to
record a purchase invoice from J. Smith as a purchase invoice from a supplier
called L. Smith.
Some errors, such as a one-legged entry, i.e. entering only the debit or
only the credit, will be shown up by a trial balance that does not balance.
The trial balance is thus a basic, but very effective, control on the accuracy of
bookkeeping. If you are unsure exactly what a trial balance looks like and
how it is constructed, you can, and should, revise it now from Chapter 5.
There are two other widely-used controls, the bank reconciliation and control
accounts, which we study later in this chapter. We noted back in
Chapter 3 that information technology can help us to reduce such errors,
and we will look at this topic in more detail in Chapter 14.
Second, financial statements can fail to show a true and fair view because
of a lack of technical ability on the part of those involved in their preparation.
Mistakes can be made even if you know what you are supposed to be
doing, but they are more likely if you are unsure about appropriate techniques
of accounting and the rules concerning the presentation of financial
information. Third, those involved in the preparation of financial statements
may be tempted to bend those rules in order to present a more favourable
picture of the entity. If your annual bonus is linked to the reported profit of
your organisation, you may occasionally be tempted to adopt an accounting
treatment that results in a higher profit, rather than one that you objectively
believe to show a more true and fair view. Both of these possibilities are, in
principle, addressed by the existence of audit. However, not only do company
employees occasionally bend the rules, but auditors have also been
known to bend the rules for their personal advantage. Accordingly, it is
worth being clear about what audit is supposed to achieve.
Audit
There are two types of audit, external and internal. External audit is carried
out by persons from outside the organisation, who should be both expert and
independent. They investigate the accounting systems and transactions and
then ensure that the financial statements have been prepared in accordance
with the underlying books, and with the law and accounting standards. The
purpose of an external audit is for the auditor to be in a position to express an
opinion on whether the financial statements being reported on show a true
and fair view or not. A satisfactory ‘clean’ audit report provides considerable
reassurance to the users of the accounts that those accounts are reliable. This
is so obviously fundamental to the purpose of financial statements that an
external audit is required by the Companies Act 1985. This Act requires all
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limited companies, except the smallest, to have, and to pay for, an external
audit. The Act then requires the auditors to report to the shareholders of the
company on whether, in their opinion, the financial statements do actually
show a true and fair view.
The above is the position as it currently operates in the UK. However,
this should be seen in the context of auditing world-wide. For example, if
we audit a company in the UK which has a subsidiary in Australia, the
group accounts will combine the UK company’s accounts with those of the
Australian company and we will want to audit both so that the combined
group accounts have credibility. We could fly out to Australia to do this or
we could use Australian auditors to do the work on our behalf. This means
that we need to be sure that audit practices in Australia, and in any other
country where we may be involved, are consistent with UK auditing practices.
To this end, just as international accounting standards set rules for
international accounting, so International Standards of Auditing, published
by the International Auditing and Assurance Standards Board, set
rules for international auditing.
Notice what the purpose of an external audit is not. It is not an attempt
to find fraud, and it is not a management control. Fraud may be discovered
during an audit, and the auditor will usually be well placed to give advice
to management about potential improvements in the internal control systems,
but these benefits are incidental. The auditor’s report is addressed,
not to the management, but to the members (shareholders). Nevertheless,
the reassurance as to the truth and fairness of the statements will usually
also be of value to all the other users of those statements, that is all the
users we considered back in Chapter 1.
However, as you may know, such reassurance is not always given by an
audit. Recent failures of the audit process to detect and report poor accounting
have damaged users’ confidence in the validity of financial statements.
In particular, recent failures at Enron and WorldCom in the USA have led
many to question whether such failures could happen in the UK.
Internal audit is a management tool, which aims to verify that accounting
procedures are being carried out as they should be. It often has the incidental
benefit of recommending improvements to those systems. Internal auditors
tend to be found only in larger organisations, where the cost is justified by
the benefits of monitoring relatively complex accounting systems. Standards
and procedures in internal audit are thus a matter for the management of
individual organisations to determine, whereas external audit is governed by
extensive regulation. A detailed exposition of audit regulation would fill this
book, and would probably not thrill you. What follows is a brief summary of
the major issues that you should appreciate in relation to external audit,
arranged under three headings, Who are external auditors? Procedures of
external audit, and Reporting of external audit.
236 Financial Accounting
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Who are external auditors?
The essential point is that external auditors should be both expert and
independent. The Companies Act 1985 empowers the Secretary of State to
nominate ‘Authorised Bodies’, whose members can audit UK companies,
provided they are registered as auditors with those bodies. The relevant
bodies at the moment are:
᭤ Institute of Chartered Accountants in England and Wales (ICAEW).
᭤ Institute of Chartered Accountants of Scotland (ICAS).
᭤ Institute of Chartered Accountants in Ireland (ICAI).
᭤ Association of Chartered Certified Accountants (ACCA).
᭤ Association of International Accountants (AIA).
Independence should be ensured by the requirement in the Companies Act
that an ‘officer or servant’ (i.e. an employee) of the company, or their partner
or employee, is ineligible for appointment as auditor of a company.
Furthermore, they should not normally be reliant on the one company for
more than 15% of their total income.
It has been proposed by the EU that preparing the accounting records of
audit clients should be prohibited, although it is currently permitted by
statements on ethics by the professional bodies. The objective of the proposal
is to prevent accountants from suppressing information, or failing to
notice their own errors, by insisting that audits should be carried out by
someone independent of the preparer of the accounts. It is supported by
most other EU countries.
Auditors are notionally appointed by, and report to, the shareholders of
the company. A simple majority vote at the company’s AGM is sufficient to
appoint, or remove, them. In practice, the choice of auditors is often delegated
to the directors. Indeed, the Companies Act allows directors to
appoint auditors if a vacancy occurs between general meetings. Such
vacancies usually occur because the auditor has resigned. They may do this
at any time, provided they confirm to the shareholders that there are no
matters connected with the resignation that the shareholders should be
aware of. This language can be interpreted to mean that auditors should
tell the shareholders if the directors are pressurising the auditors to resign,
perhaps because they are finding evidence of a lack of total integrity.
Procedures of external audit
The Auditing Practices Board is to auditing what the Accounting Standards
Board is to accounting. It has published mandatory ‘Auditing Standards’,
on a wide range of audit topics and practices. From December 2004 it has
been working with ‘International Standards on Auditing’ (ISAs), which are
more in line with international practice on auditing, albeit contextualised
for the UK and Ireland. The detail of these standards is beyond the scope of
this book, but note that the practice of auditing is increasingly becoming
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as tightly regulated as the practice of accounting. Of particular importance
is ISA 700 ‘The Auditor’s Report on Financial Statements’, which details the
procedures for the audit report.
Reporting of external audit
The audit report is the auditor’s opinion, addressed to the shareholders, on
whether the financial statements show a true and fair view. According to
ISA 700, the audit report should state:
᭤ which financial statements have been audited
᭤ an emphasis that it is the management’s responsibility to prepare the
financial statements and the auditors’ purely to audit them
᭤ the fact of compliance with auditing standards in doing the audit
᭤ a brief overview of the work done to provide the auditor with the evidence
for the opinion
᭤ the audit opinion
᭤ the identity of the auditor, and the date of the report.
Where an issue arises during the audit which does not affect the opinion but
the auditor believes that it needs to be brought to the attention of readers,
then the audit report will include an ‘emphasis of matter’, which outlines
the issue.
More seriously, a modified audit report is one in which the auditor has
reservations that have a material effect on the financial statements. The circumstances
giving rise to a qualification will typically be where:
᭤ there is a limitation on the scope of the audit, and hence an unresolvable
uncertainty, which prevents the auditor from forming an opinion, or
᭤ where the auditor is able to form an opinion, but, even after negotiation
with the directors, disagrees with the financial statements.
In such cases the audit report will be modified in one of the following ways:
᭤ where the issue is so serious as to affect the audit opinion then the audit
report should be modified to say ‘except for’ the issue the financial statements
provide a true and fair view,
᭤ where the auditor believes that the issue is so fundamental that its misstatement
invalidates the whole financial statements, then the opinion
should say that the financial statements do not give a true and fair view,
᭤ where there were significant restrictions on the scope of the audit the
report should say that the auditor was unable to form an opinion.
238 Financial Accounting
FNAC_C13.QXD 12/10/05 10:35 am Page 238
Answer First, we should say that making a judgement about the correct form of audit report is
a highly skilled activity, requiring extensive knowledge and experience. In particular, any
judgement needs to be made in the light of the overall impact on the accounts, and
particularly of the materiality of each issue. In the absence of such fuller information,
our answers can be no more than good indications of what an auditor would probably
decide. Furthermore, we have only attempted to cover the main features of an audit
report, and you should be aware that more complex audit opinions are possible. These,
however, would be the subject of a specialist book or course in auditing.
Nevertheless, we would write an ‘except for’ opinion for situations 1 and 3. The
inclusion of what is almost certainly a bad debt will result in materially incorrect
debtors and profit figures, and the accounts are therefore unlikely to show a true and
fair view. However, the rest of the accounts will be unaffected, and it should not be
necessary to give an adverse opinion. In situation 3, the cash sales figure may well be
right, but we have been unable to determine this, so our report should explain this
problem of a limitation on the scope of our audit, and again report that ‘except for’ this
issue, the accounts show a true and fair view.
Situation 2 is easier, in that a mis-statement of £1,800 will almost certainly not
have a material effect on the truth and fairness of the accounts of a large public company.
In this case, the audit report should make no mention of the issue, and a clean
report can be given.
Finally, situation 4 is an example of a fundamental mis-statement. Stock will be a
very large item in the accounts of a supermarket, and a treatment that conflicts with
IAS 2 ‘Inventories’ will almost certainly have such a pervasive impact on the accounts
as to mean that they do not show a true and fair view. The report should therefore be
adverse, i.e. ‘the accounts do not give a true and fair view’.
A qualified audit report is usually regarded as a serious matter, because it
significantly reduces the reliability of the financial statements. This may
then mean, for example, that a potential lender will not lend.
13 · Control of accounting systems 239
For each of the following situations, decide which audit report you, as auditor, would
give. Following on from the explanation above, your choices are:
᭤ a clean report
᭤ an ‘except for’ report
᭤ a ‘the accounts do not show a true and fair view’ report.
1 The inclusion of a material debt from a company that is known to be in liquidation.
2 A fraud involving £1,800 is discovered in a large public company.
3 Controls over the cash accounting system were found to be non-existent, and
records incompletely kept, so that there was no way of verifying the amount of
cash sales included in the accounts.
4 In a supermarket chain, stock has been valued at selling price, which is very much
higher than cost.
Activity 13.1
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Finally, you should be aware that there is a continuing debate over
whether an audit is of real benefit to very small companies. The shareholders,
to whom the audit report is nominally addressed, tend to also be the
directors, managers and much of the workforce. What then is the benefit of
using the traditional financial statements to tell them about their business?
They already know. If the financial statements are of little value, so must the
related audit report be. The counter-argument is that outsiders, such as
lenders and the Inland Revenue, are also interested in the business and
would benefit from the financial statements, and hence from an audit report
that enabled them to rely on the truth and fairness of those statements.
Before we move on from this introduction to auditing, use the following
activity to test your basic knowledge.
Answers The correct answers are (a), (b) and (d) for question 1, and (a) and (c) for question 2.
If this doesn’t make sense, go back and re-read the material above on the audit.
Audit, particularly external audit, can thus have a valuable function in
ensuring that financial statements are prepared competently and objectively.
As we noted earlier, control to guard against mistakes feeding through the
accounting system undetected can be helped through the use of bank reconciliations
and control accounts.
Bank reconciliations
Activity 13.2 demonstrated the fundamental importance of the cash book,
that is, our own record of amounts in and out of our bank account. It is
possible that deliberate or accidental mistakes will be made in writing it up,
but fortunately there is an independent record of exactly the same transactions.
That independent record is, of course, the bank statement.
240 Financial Accounting
Select the best answer or answers in each of the following cases.
1 Which of the following cannot be appointed as a company auditor?
(a) A director
(b) An employee
(c) An ex-employee
(d) A member of the Chartered Institute of Management Accountants.
2 Which of the following circumstances would probably result in a qualified audit report?
(a) The loss of the cash book
(b) Gross inaccuracies in the register of shareholders
(c) The omission of a cash flow statement
(d) Discovery of the theft of £200 petty cash.
Activity 13.2
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The balance in the cash book should be the same as the balance on the
bank statement. This independent record can therefore provide an excellent
check on the accuracy and completeness of our cash book. In practice,
however, the two balances may not be the same. There may, for example,
be amounts we have received and paid into our bank, and which we have
therefore entered in the cash book, but which have not yet cleared through
the banking system. The two balances will therefore differ by the amount
of the ‘uncredited lodgement’. However, if we can identify all such items in
transit, we can allow for them and so still reconcile the two balances. Such
a summary of items in transit, which reconciles the bank statement balance
with the cash book balance, is called a bank reconciliation statement.
Its purpose is to verify the cash book balance, and, by inference, all entries
in that cash book.
Answer The items we have identified are as follows:
1 A very common transit item is an unpresented cheque. This is a cheque that you
have entered in the cash book but which has not yet been presented to the bank.
2 The opposite item is the uncredited lodgement that we have already seen. This is an
amount you have paid in to the bank, and entered in your cash book, but which has
not yet been received by the bank and entered on the bank statement.
3 The bank may have charged interest or bank charges, or have given you interest on
your account, but you will usually only find out about these when you receive the
bank statement. Until you then enter them in the cash book they will also be sources
of difference.
4 You may have made a mistake in writing up your cash book, or the bank statement
may be wrong.
There are two broad reasons why these differences occur, and the distinction
is crucial. First, there are legitimate reasons, such as items 1, 2 and 3 above.
Second, there are mistakes, either by you or by the bank. The purpose of a
bank reconciliation statement is to allow for all such legitimate differences.
Any residual difference must then have been caused by an error.
Items 1 and 2 in the list above are items that we have entered in our cash
book but which the bank has not yet entered on the bank statement. All we
can do is list them as part of the reason why the two balances disagree, i.e.
they will form part of the bank reconciliation statement. Conversely, item 3
is an item that the bank has entered up but we haven’t. We can therefore
eliminate this source of difference before we prepare the bank reconciliation
statement. In other words, we should complete the writing up of the cash
book to take account of items that are so far only on the bank statement.
Such items will then no longer be a source of difference.
13 · Control of accounting systems 241
List four items which might cause the cash book balance not to immediately agree
with the balance per the bank statement.
Activity 13.3
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Answer CASH BOOK
1st Balance b/f 200 1st Garside Books 86
4th Darley Building 490 4th Fletcher Cars 480
15th Cash sale 38 13th Harker Ltd 300
20th Darley Building 780 27th Fletcher Cars 430
30th Cash sale 75 30th Plant Supplies 182
30th Balance c/f 105
–––––––– ––––––––
£1,583 £1,583
–––––––– –––––––––––––––– ––––––––
242 Financial Accounting
Gloria started business with £200 in her account at the bank. During June she
issued the following cheques:
1st £86 to Garside Books
4th £480 to Fletcher Cars
13th £300 to Harker Ltd
27th £430 to Fletcher Cars
30th £182 to Plant Supplies
She also recorded the following amounts paid into the bank:
4th £490 from Darley Building
15th £38 from a cash sale
20th £780 from Darley Building
30th £75 from a cash sale
Write up the cash book for the above transactions, remembering to include the
opening £200, and to show the closing balance. You should be able to do this by
thinking back to what you learnt about the writing up of ledger accounts earlier in
this book. Write up the cash book as simply another ledger account.
Activity 13.4
At the end of the month, Gloria receives the following bank statement. Note that it is
in overdraft (O/D) at some points during the month, i.e. there is a negative balance.
Check each item against the cash book and identify which items are not common.
BANK STATEMENT
Date Detail Payments Receipts Balance
£
1 Balance b/f 200
4 Cheque 86 114
6 Cheque 480 366 O/D
8 Counter credit 490 124
16 Cheque 300 176 O/D
17 Counter credit 38 138 O/D
22 Counter credit 780 642
30 Cheque 430 212
30 Charges for June 20 192
Activity 13.5
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Answer The items you should have identified are:
᭤ The cheque paid out on 30 June to Plant Supplies for £182 is not on the bank
statement.
᭤ The cash sale of £75 on 30 June similarly does not appear on the bank statement.
᭤ The bank statement shows charges of £20, which have not been entered in the cash
book, because Gloria did not know about them until she received the bank statement.
Answer The revised balance will be the existing balance of £105, less the bank charges of £20,
i.e. the cash book balance, written up as far as Gloria is able, will be £85. It is this
amount which we must reconcile to the balance per the bank statement of £192.
Hopefully, we know the reasons for the whole of the difference. It should
be attributable to the cheque paid on 30 June and the cash sale paid in on
the same date. All that remains is to set these items out formally to prove
that this is the case. In order to do so, you need to be aware of how the
bank balance is affected by the items in transit. A cheque drawn on our
bank account will be deducted from our account balance by our bank. In
other words, the balance will go down. Conversely, an uncredited lodgement
will increase the bank balance when it reaches the bank. Providing
we start with the balance per the bank statement, unpresented cheques
should therefore be deducted, and uncredited lodgements should be added.
Answer As always, you will learn faster and more easily if you discipline yourself to trying the
activity before you look at the answer.
GLORIA
BANK RECONCILIATION STATEMENT AT 30 JUNE
Balance per bank statement 192
Less: unpresented cheque; 30 June, Plant Supplies 182
––––
10
Add: uncredited lodgement; 30 June, cash sale 75
––––
Balance per cash book, as adjusted £85
––––––––
13 · Control of accounting systems 243
Recalculate the cash book balance after the bank charges have been entered, i.e.
complete the writing up of the cash book.
Activity 13.6
Bearing the above in mind, about the direction of adjustments, draft a bank reconciliation
statement for Gloria at 30 June. It should start with the balance per the bank
statement, then adjust for the unpresented cheque, and the uncredited lodgement,
and so arrive at the balance per the cash book.
Activity 13.7
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Answer Our suggested list would include these points:
᭤ The bank reconciliation statement constitutes a comparison between the cash book
and the independent bank statement, allowing for items in transit.
᭤ It thus provides a check on the completeness and accuracy of the cash book.
᭤ Agreement of the two adjusted balances provides a high level of assurance of the
accuracy and completeness of the cash book.
᭤ Non-agreement of the two adjusted balances indicates an error, probably in the
cash book, since errors on bank statements are less frequent.
᭤ A trial balance difference may have indicated an error somewhere in the accounting
system; the same amount showing up as a bank reconciliation difference indicates
that any search for an error can be restricted to the bank accounting system.
We thus have a way of verifying the bank account in our books. However,
it is still possible that we will make mistakes in the writing up of our other
accounts. Fortunately, control accounts provide a way of checking the
accuracy of our sales and purchase ledgers.
Control accounts
Think back to your earlier studies about how sales and purchase ledgers are
written up. Back in Chapter 5 we saw that the sales ledger is the collecting
together of the ledger accounts for our customers, the purchase ledger is
the set of ledger accounts for our suppliers, and the nominal ledger is made
up of all the remaining accounts.
You should recall that individual accounts in the sales ledger are written
up by posting sales invoices and cash receipts from customers. In practice,
the sales invoices would not be entered up one by one directly in the sales
account and individual customer accounts, but would usually first be listed
and summarised. This listing is called a ‘sales journal’ or ‘sales day book’. It
does not form part of the double entry system, and so was not covered in
the earlier chapters on double entry bookkeeping. Nevertheless, it becomes
significant once we turn our attention to control accounts.
This sales journal is no more than a listing of sales invoices as they are
sent out, but it does offer the opportunity to total all the invoices, usually
monthly, and to post just the total to the sales account, instead of having
to post the sales one by one from the individual invoices. Entries into individual
customers’ accounts would, however, still have to be posted
individually, in order to record sales to each customer. Receipts from each
customer would, of course, be entered from the cash book, but note that
such receipts could also be totalled in the cash book for the month.
244 Financial Accounting
Consolidate your knowledge now by outlining the purposes of a bank reconciliation
statement. You may find it most helpful to do this by creating a list of the purposes.
Activity 13.8
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In a computer-based system, of course, we would not have to prepare
such a separate listing of invoices and cash movements, since the act of
entering them into the ledgers would be tracked by the accounting software
and such listings would implicitly be created. Control in a computer-based
system is something we will explore further in Chapter 14.
Now imagine that, as well as doing all that, for the same month we also
posted the total amount of sales invoices from the sales journal and the
total amount of receipts from debtors in the cash book. In other words, we
would make just one total entry from the sales journal, and one total entry
from the cash book, to a new account, created for the purpose. This new
account is called either a total account or a control account. In this case it
would be the sales control account, but you could create a purchases control
account in exactly the same way. The total postings would be from the
purchases journal (a listing of purchase invoices) and from the total of payments
to creditors in the cash book.
Notice that we now have two sales ledgers (and two purchase ledgers),
one made up of individual accounts, and one made up of the control
account. Both of these sales ledgers should record the same transactions,
one customer by customer, and one in total, but both for the same month.
The implication is that the total of the balances on the individual ledger
accounts should add up to the same as the balance on the single control
account. This is the point of the control account. What we have created is
a check on the accuracy of the individual sales ledger accounts. If the total
of the balances on the individual accounts is the same as the balance on
the control account, then we can be reasonably confident that the individual
accounts have been written up correctly.
This can be invaluable if the trial balance does not agree, and we are
therefore faced with looking for one or more mistakes somewhere in the
accounting system. If, however, we prepare a sales control account and the
balance agrees with the total of individual sales ledger balances, then we
can be reasonably confident that the mistakes are not in the sales ledger.
This dramatically reduces the search we have to undertake. If we prepare a
purchase control and that also agrees with the total of the individual purchase
ledger accounts, then we can also eliminate the purchases sub-system
as a source of error. We now know the trial balance difference must be
somewhere in the nominal ledger, and we can focus our search there. What
we have achieved is a way of checking the accuracy of the sales and purchases
ledgers in isolation.
It is, of course, always possible that we make the same mistake in preparing
the control account as we did in writing up the individual accounts. In
this case the control account would agree with the total of the individual
accounts, and we would have failed to detect the error. Control accounts
are not as effective as bank reconciliations because they check against an
internally produced source, rather than against an independent source,
such as a bank statement.
13 · Control of accounting systems 245
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You may have wondered what happens to the integrity of the double
entry system if there are two sales ledgers in existence. The answer is that
either the total of the individual accounts or the control account forms part
of the double entry. There is no absolute rule about which forms part of
the double entry system, although it is obviously easier to list a control
account in a trial balance, rather than hundreds of individual accounts.
Understanding that only one of the control account, or the individual
accounts goes into the double entry system is fundamental to understanding
control accounts.
If the individual accounts are put into the trial balance then the control
account is known as a memorandum account. On the other hand, if the
control account balance is included in the trial balance, then the individual
ledger accounts form the memorandum. A memorandum is just that, a
working note of detail which is outside the double entry system.
Answer You should have answered yes in the boxes against errors A and B, and no against the
others. Error A will result in the same difference in the sales control and in the purchases
control – a good indication of what has happened. It is worth noting that three errors will
not be shown up by the control account technique. Nevertheless, it is a fairly easy and
cheap technique, and typically found in all but the most basic accounting systems.
246 Financial Accounting
Identify which of these errors can affect the agreement of the sales control account:
Error Affects agreement?
A Posting the total of the sales journal to the purchase
ledger control account
B Omission of entry from control account only
C Making the same mistake in the individual account as
in the control account
D Posting the correct amount to the wrong account in
the individual accounts
E Omission of entry from individual and control account
Activity 13.9
The following information has been taken from the records of Garside Books. Prepare
the sales ledger account for the year to 31 December 20X6. It can be written up in
exactly the same way as an individual sales ledger account.
£
Debtor balances at 1 January 20X6, per control
account and per list of balances 14,890
Sales for the year to 31 December 20X6, per sales journal 203,680
Cash received from debtors, per cash book 205,905
Bad debts written off 400
Activity 13.10
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Answer SALES LEDGER CONTROL
1.1.X6 Balance b/f 14,890 31.12.X6 Cash book 205,905
31.12.X6 Sales journal 203,680 31.12.X6 Bad debt 400
31.12.X6 Balance c/f 12,265
–––––––––– ––––––––––
£218,570 £218,570
–––––––––– –––––––––––––––––––– ––––––––––
Answer Our approach is to consider whether Item 1 will result in a control difference. It
appears to have been entered twice both in the individual account and in the control
account. It will be included twice in the control account because that is, of course,
written up from the sales journal, where it has been entered twice. While this is a mistake
which needs correction, it will not help us to agree the control account to the total
of individual balances.
We then consider Item 2. The sales journal treatment, and hence the control
account, is correct. However, the individual account for S Patel will be understated by
the omission of the invoice for £485. This must therefore be added to the total of the
individual balances. Note that it will also need to be corrected in I Patel’s account in
the purchase ledger, but that is not our immediate concern.
Item 3 is also correct in the control account, but the individual account for Foster
will have been credited with £9 too much. This therefore needs to be added back, so
increasing the balance on Foster’s individual account.
The net effect of all this can be summarised as follows:
Existing total of individual balances 11,771
Add: Omission of sales invoice to S Patel 485
Correction of over credit to Foster 9
–––––––––
Balance per sales control account £12,265
––––––––––––––––––
13 · Control of accounting systems 247
A list of the balances on the individual debtors’ accounts in Garside Books’ sales
ledger at 31 December 20X5 totalled £11,771. Investigation reveals:
1 An invoice for £263 to Sandringham was entered twice in the sales journal and
subsequently posted twice to the customer’s account.
2 An invoice for £485 to S Patel was correctly entered in the sales journal but was
subsequently posted to I Patel’s account in the purchase ledger.
3 A receipt of £78 from Foster was correctly entered in the control account, but
entered as £87 in the individual debtor’s account.
Correct the control account and/or the list of individual debtor balances as necessary
and so reconcile the total with the balance on the sales control account. You may
find it helpful to deal with each item in both the control account and the individual
account, before considering the next.
Activity 13.11
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If we now make correcting entries in the accounts of S Patel and Foster, the total of
the individual accounts will then agree with the balance on the control account. Notice
what the construction and use of the control account has done for us. It has enabled
us to detect a problem with two accounts in our sales ledger, which it is quite possible
we would not otherwise have found until the mistakes had damaged our relationship
with those customers.
Summary
This chapter has introduced a key issue in accounting – that of control. We
have seen:
᭤ how a lack of control can open up an entity to both mistakes and deliberate
fraud
᭤ how the achievement of a true and fair view may be consequently com-
promised
᭤ the use of audit, both internal and external
᭤ the use of bookkeeping controls, notably the bank reconciliation and
the control account.
None of these controls will ensure the integrity of our accounting records
and financial statements, either individually or together. However, what
they will do is significantly increase the likelihood of achieving something
close to such integrity. In the case of external audit, we have seen that the
benefits of the control are considered so important that an audit is
required by the Companies Act 1985.
Chapter 14 examines the role of the computer in accounting systems,
and includes a look at the control features involved in such systems.
248 Financial Accounting
audit (p. 235)
external auditors (p. 237)
bank reconciliation (p. 241)
control accounts (p. 244)
Key terms
FNAC_C13.QXD 12/10/05 10:35 am Page 248
Self-assessment questions
For each of the following issues, select the single most appropriate answer. Our answers
are at the end of this book. If you get any wrong, then re-read the relevant part of this
chapter.
1 Which of the following is an error of principle?
(a) Entering a sales invoice for £89 as £98 in the customer’s account.
(b) Not using a control account.
(c) Entering a sales invoice twice.
(d) Adding up the cash book incorrectly.
2 A main purpose of an external audit is:
(a) To enable the auditors to detect fraud.
(b) To enable the directors to use correct accounting policies.
(c) To enable auditors to report on the truth and fairness of the accounts.
(d) To enable the shareholders to monitor the managers.
3 A clean audit report implies that:
(a) The auditors believe that the accounts show a true and fair view.
(b) The directors believe that the accounts show a true and fair view.
(c) The shareholders believe that the accounts are reliable.
(d) The auditors have not detected any fraud or error.
4 Which of the following are required by law to have an external audit?
(a) Small limited companies.
(b) Sole traders.
(c) All limited companies.
(d) Larger limited companies.
5 The purpose of a bank reconciliation statement is to:
(a) Detect cash book errors.
(b) Make sure the cash book includes all bank interest and charges.
(c) Highlight items in transit within the banking system.
(d) None of the above.
6 If a bank reconciliation statement starts with the balance per the bank statement,
and that balance is in overdraft, then, in the reconciliation statement, any unpresented
cheques should be:
(a) Added to the balance per the bank statement.
(b) Subtracted from the balance per the bank statement.
(c) Omitted from the statement.
(d) Added back and then subtracted once the bank balance is positive.
13 · Control of accounting systems 249
᭤
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7 The balance on a sales control account should agree with:
(a) The total of both individual sales ledger and individual purchase ledger balances.
(b) The total of individual sales ledger balances.
(c) The trial balance total.
(d) The balance on the purchase ledger control account.
8 The purpose of a purchase ledger control account is to ensure that:
(a) All errors in the writing up of the purchases system are detected.
(b) Most errors in the writing up of the purchases system are detected.
(c) The purchases figure in the financial statements is correct.
(d) The creditors figure in the financial statements is correct.
9 (a) Julia has written up her cash book in double entry form for September as follows:
CASH BOOK
Date Detail Amount Date Detail Amount
1 Opening balance 500.00 1 Bradley Software Ltd 106.78
4 Cash sales 390.00 4 Clee & Co 690.00
10 Weelsby Partners 504.80 8 Halton Supplies 45.07
15 Cash sale 80.00 16 Tetney Merchandising 230.70
20 Atlantis Publishing plc 680.50 18 Bradley Software Ltd 305.75
27 Weelsby Partners 218.00 24 Vehicle rentals plc 530.00
30 Cash sale 50.00 28 Corner Newsagency 12.43
30 Halton Supplies 182.85
A few days later, Julia receives the following bank statement, dated 30 September,
showing a balance of £733.32. By checking each item against her cash book, identify
which items are not common to both records, and complete writing up the cash
book as far as possible.
BANK STATEMENT
Date Detail Payments Receipts Balance
1 Balance b/f 500.00
4 Cheque 568 106.78 393.22
8 Counter credit 390.00 783.22
9 Cheque 569 690.00 93.22
10 Cheque 570 45.07 48.15
12 Counter credit 504.80 552.95
15 Charges for Sept. 25.00 527.95
19 Counter credit 80.00 607.95
20 Cheque 571 230.70 377.25
23 Counter credit 680.50 1057.75
27 Cheque 573 530.00 527.75
29 Counter credit 218.00 745.75
30 Cheque 574 12.43 733.32
(b) Prepare the bank reconciliation statement at 30 September.
250 Financial Accounting
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10 (a) Peter Lee started business with £500 in his current account at Midclay Bank
plc. He issued cheques totalling £3,638 during July, his first month of trading.
He also banked cheques received totalling £4,003. Calculate the balance in
Peter Lee’s cash book at 31 July.
(b) A few days later, Peter receives a bank statement dated 31 July which shows a
balance of £622. By checking each item against his cash book he is able to
determine that;
᭤ Bank charges of £232 entered on the bank statement had not been entered
in the cash book.
᭤ A cheque received for £240 and paid into the bank account during July had
been returned by the bank marked ‘No funds available’. The original receipt
had been entered in the cash book, and is accordingly included in the total
amount shown above, but no adjustment had been made in the cash book
for the fact that the cheque has turned out to be worthless.
᭤ A cheque paid for £87 had been incorrectly entered in the cash book as
£78. The total for the month shown above therefore includes £78 in respect
of this transaction.
Calculate the new balance shown by the cash book.
(c) Checking of the bank statement against the cash book also revealed some outstanding
items, namely,
᭤ Cheques written and sent to suppliers amounting to £843 had been entered
in the cash book in July, and so are included in the totals for the month given
above, but were not presented to the bank for payment until August.
᭤ Cheques received totalling £605 had been entered in the cash book and paid
into the bank, but had not been credited by the bank until 2 August.
Draft the Bank Reconciliation Statement at 31 July.
11 (a) Briefly explain the difference between the nature and purposes of internal and
external audit.
(b) What is a qualified audit report? Outline the likely effect on the company of such
a report.
Answers to these questions can be found at the back of this book.
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14
Information technology and
accounting
Introduction
We noted in the previous chapter that accounting has become ever more
reliant on the use of computers. In all but the smallest entities, it has now
become most unusual to find an accounting system that is not computerbased
to some degree. The purpose of this chapter is to consider the
control issues in such systems, the design and use of those systems, and the
development of e-accounting.
There is a danger that the role of information technology can be seen as
something of an afterthought in the study of financial accounting. This is
because your studies have focused on the traditional principles of accounting,
such as double entry, the layout and role of the balance sheet, the
meaning of ratios, and so on, and it is not always obvious where information
technology fits in. Nevertheless, it is important that you have some
awareness of how information technology has changed, and is changing
accounting, both to understand accounting at this level and as a basis for
any further study you may undertake.
The principles of double entry that you have learnt and applied in previous
chapters underpin almost all current commercial accounting software.
Increasingly, this may not be obvious on the surface as developers move
towards greater ease of use, and away from requiring users to implement
double entry bookkeeping. After all, if one of the advantages of accounting
By the end of this chapter you should be able to:
᭤ explain the control issues applicable to accounting within an IT
environment
᭤ describe how accounting systems can be designed and
implemented
᭤ outline the main features of e-accounting
Objectives
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software that we identified in Chapter 3 is the automation of the double
entry discipline, then it may well be helpful for such mechanics to be hidden
behind simpler data entry screens. However, such a discipline still exists and
provides a strong control against error within the accounting application.
To illustrate, we’ve constructed a typical screen below from a hypothetical
accounting software application for a company called Newbolt
Engineering Ltd. You’ll notice that it presents a screen by function, that is
it allows the user to select an area of the accounting system, whether sending
an invoice to customers, processing an invoice from a supplier, or
whatever. At this stage there’s no need for the user to know anything about
double-entry bookkeeping, only to know the job they want to do.
We saw back in Chapter 3 how information technology can help to make
accounting both more reliable and richer in the information it provides.
Chapter 13 gave us some further insight into how control techniques can
enhance financial accounting, and this is especially true once we are operating
within an information technology environment. The first section in this
chapter expands this exploration of control and information technology.
Control issues
Chapter 13 outlined how controls within an accounting system can help to
guard against fraud, mistakes and incompetence. This is no less true in a
computer-based system. Think about what we need to achieve. We need an
accounting system that at least minimises error and fraud, and certainly a
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system that detects it. One of the great benefits of a computer-based system
is that arithmetic error should normally be eliminated, and the software
should not allow entries which do not balance.
What this means in practice is that, as we saw in Chapter 3, the entry of,
say, the debit for the purchase of stock will always require a corresponding
credit for the same amount. We know from the logic of the double entry
system that such a correspondence is required, but we also know that it is
easy to make a mistake in a manual system and forget to make a credit
entry, to make an entry for the wrong amount, or to make a second debit
entry, and so on. However, the use of accounting software, inserts a check
into the accounting system so that we at least enter the same total debit as
credit, even where the transaction may be made up of more than one debit
and/or more than one credit. Consider the screenshot below.
Having selected ‘Suppliers’ from the first screen we now want to enter
details of a purchase invoice. We start by entering the name of the supplier.
We won’t have to type this in since we should be able to select it from a
drop-down box in the ‘Supplier’ column. Note that, in double-entry terms,
what this does is credit Hammond in our purchase ledger. The debit is a
matter of where we record the asset or expense, and this is the purpose of
the ‘Code’ column. Clicking in this column will pop up the box we can see
above, listing all our nominal ledgers (scrolling up and down in this box
will take you to other nominal ledger accounts). All we have to do now is
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click on one line in this pop up box to tell the software which account
should be debited with the £120. The essential point to notice here is that
the software has made the debit and credit entries, and ensured that both
entries are for £120. We could, of course, have used the software in this
way without a knowledge of the double-entry bookkeeping that we first
met back in Chapter 3. However, it should be obvious to you that doubleentry
bookkeeping underpins such software.
While this is a significant improvement, it will still be possible to make
errors of principle, such as posting a repair invoice to an electricity
account, or crediting the wrong customer with a receipt. Some of these
errors may be deliberate.
Answer At its simplest we would expect the computer-based accounting system to detect and
prevent any error that violates the principles of double entry. This will be the case for
event (b) where Clark’s account will only be credited with £40, leaving the software to
query the remaining £360. It will also be the case for event (c) since a payment to Clark
cannot normally be dealt with through a cash receipt module.
Events (a), (d) and (e) will not be prevented by a simple software check on the validity
of the double entry. However, it may be that other checks will detect a problem. For example,
while we may enter the receipt as being from Clarkson, as in (a), this does mean that
both Clark’s and Clarkson’s ledger accounts will be wrong and periodic inspection of the
accounts would highlight a problem to be investigated. This could be the case, for example,
if we periodically review payments to detect bad debts and for credit control purposes.
A similar technique may help us to pick up error (d). Error (e), on the other hand, may only
be detected if and when we try to agree our physical computers with book records.
The lesson to be drawn is that no single control can be relied on to
detect and prevent all types of errors. What is required is a range of controls,
and information technology can provide some of them. In other
words, what we need is a coherent system which relies on much more than
simply the blind logic of double entry. One element in such a broader
system is the audit trail.
14 · Information technology and accounting 255
Assume that you have used the cash receipt module of an accounting software package
to record the receipt of £400 from Clark into the bank account, and the software
then presents you with a screen asking where the money has come from, i.e. which
account to credit. Which of the following separate errors would you normally expect to
be detected and prevented by the computer-based accounting system?
(a) Entering the receipt as being from Clarkson
(b) Entering the receipt as being £40
(c) Entering the receipt as being a payment to Clark
(d) Entering the receipt correctly and then entering it again correctly
(e) Entering the receipt as being for sales of trading goods when it was for the sale
of our old office computer.
Activity 14.1
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Audit trails
An audit trail is simply a listing of transactions, including a note of who
entered the transaction. This enables both the organisation and its auditors
to trace the accounting treatment of a transaction, to ensure that it has
been dealt with correctly. Alternatively, it allows the identification of an
error, and who made it. For routine transactions, this may mean no more
than the software attaching a number to each transaction and keeping a
record of who logged in to make that transaction. This, of course, implies
that there must be some way of ensuring that only the correct person is
able to log in with their personal identification.
The usual answer to this control problem is to use a password. This has
the additional benefit of preventing anyone other than the nominated
person from writing up the accounts. It is possible to set various levels of
password protection so that, for example, the sales ledger clerk can only
access the sales ledger and cash book receipts, the assistant accountant can
access any ledger, but only the chief accountant can access the software
which allows the preparation of final accounts. Passwords cannot be relied
on by themselves, since people tend to forget their passwords, tell them to
those helping them ‘temporarily’, use easy-to-guess words, or leave their
PC unattended after logging in.
A second benefit of an audit trail is then to at least trace what entries
have been made. As we’ve seen, accounting software takes care of one leg
of the double entry. Recording the cash book receipt of £100 from a customer
called Jack, for example, would automatically also credit Jack’s
account in the sales ledger. Nevertheless, a mistake, such as entering the
receipt as being from Jill, would still require an explicit double entry to correct
the error, in this case debiting Jill’s account and crediting Jack’s. In
other words, it would not be possible to simply go back to Jill’s account
and cross out the entry and then make it in Jack’s instead. This has ensured
that the audit trail was always very clear, if rather laboured.
However, some accounting software for smaller businesses has adopted a
more intuitive approach, where such adjustments are exactly what is done.
Jill’s account would therefore retain no record of the mis-posting. The
audit trail would include correcting the error, but it is still questionable
whether the lack of any record in Jill’s account maintains a full and obvious
audit trail for control purposes.
Answer The use of nominated persons, passwords and an audit trail should protect reasonably well
against accidental or deliberate fraud. However, an audit trail is only of use if someone
reads it, and picks up any anomalies. In a larger organisation, this will usually be included
within the internal audit function. In a smaller organisation, it may only be done by exception,
when a problem becomes apparent for other reasons. The point is that an audit trail
is of no value unless it is reviewed, at least by exception, and preferably routinely.
256 Financial Accounting
Assuming we have kept a good audit trail of transactions, what else is required for
the audit trail system to be effective?
Activity 14.2
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It should be obvious from all of the above that controls in an accounting
system are something that should be considered when designing that
system, rather than something that is bolted on afterwards. Indeed, designing
a system which copes with all the inputs we throw at it and still
produces the useful information we require, while building in appropriate
controls, is a significant part of accounting, and accordingly we now turn
our attention to a brief review of design.
Designing an accounting system
You will probably be aware of the current pace of change in computing, in
terms of the power of hardware, the sophistication of software, and the
spectacular growth in the ability to interconnect with other computing systems.
This implies that any description of current practices would be
seriously out of date before you came to read this. We will therefore deal
less with the current practicalities and more with the principles of designing
an accounting system.
The basic principles of designing an accounting system will be the same
whether we intend that system to be implemented using computers or not.
The starting point should be to be very clear about exactly what we want
from that system. This means making our accounting needs and wants
explicit in terms of:
᭤ Sources of and types of data to be dealt with.
᭤ The information to be extracted from the system by way of management
information, financial statements (e.g. a balance sheet), statutory returns
(e.g. a VAT return), and anything else we think might be useful to any of
the people we might regard as having a right to such information.
᭤ An acceptable level of costs for running this accounting system.
Hence, two of the key influences on how we plan and implement an
accounting system are the type of raw data and the requirements of the
end users. There will be many types of raw data, ranging from delivery
notes to bank statements and from time sheets to petty cash vouchers.
Answer This is a deliberately open-ended activity, since any answer will be dependent on the
particular organisation. Nevertheless, you could have suggested, among other things,
that source documents would include:
14 · Information technology and accounting 257
(a) List five source documents for accounting information that you think would be
relevant to a trading company. You may find it helpful to think about an organisation
you are familiar with, and the types of documentation it has to deal with.
(b) Identify three separate reports or statements that you would want to extract from
the accounting system, other than final accounts such as the balance sheet.
Activity 14.3
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᭤ sales invoices, giving details of amounts charged to customers;
᭤ sales credit notes, showing amounts due to customers because of goods returned,
overcharges, etc.;
᭤ purchase invoices and credit notes, giving the same details as the equivalent sales
documents, but in respect of our purchases from suppliers;
᭤ bank statements, showing bank charges, interest received, etc.;
᭤ cheque stubs, recording details of amounts paid;
᭤ paying-in slips, detailing amounts received into our bank account.
The information statements that we might want could include, for example:
᭤ a list of outstanding debtors;
᭤ a list of outstanding creditors;
᭤ a forecast of cash flows in and out of our bank account over the next few months;
᭤ a statement of inventory in hand;
᭤ a summary of actual expenditure, compared with budgeted expenditure.
Once we are clear about the need for a comprehensive system, have clarified
the data to be dealt with, and have decided on the information
statements we want from our accounting system, then we can move on to
consider implementation.
The options at this point are to have a system custom-written for us or
to buy a general system ‘off the peg’. The latter will obviously be much
cheaper and is, therefore, the usual approach. Occasionally, a specialist
software supplier will be able to customise a standard package marginally,
and this may achieve the best of both worlds.
Many accounting systems were designed originally as modular systems.
This means that they were divided into separate, self-contained programs
for different parts of the total accounting system. Thus there was one
module available for dealing with the sales ledger, and other, separate,
modules for purchases, nominal, inventory, etc. This had advantages in
that users only had to buy those parts of the system that they needed. A
business which only sells for cash would therefore not need to acquire the
sales ledger module. This approach also had the incidental benefit of
reducing the demands on the hardware.
As hardware power has risen and prices have fallen, however, the rationale
for modular systems has become less obvious. It is now more common
to find that accounting software is integrated, so that all functions are, in
principle at least, part of a whole. This is obviously a simpler approach and
ought to make the software easier to use.
Implementation
Once we have decided on the general approach, it only remains to successfully
implement such a package. This will require not only suitable hardware
and software, but also an organised approach to the implementation. In particular,
we must consider how the data can be accurately transferred from
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any old system to the new, and contingency plans in case the new system
fails in any unforeseen way. Data loss is a serious problem and could result in
the collapse of the organisation.
A typical process for the transfer of an accounting system from an old
system, whether manual or an older computer-based system, to our newly
specified system would include:
1 Ensuring that the old system is up to date.
2 Installing hardware and software as determined by the issues considered
above. This might include spare hardware and back-up software, preferably
on a separate site, to be used in case of damage to, or failure of, the main
hardware. These issues are considered in more detail later in this chapter.
3 Entering all existing data on to the software. Given the importance of
this step, it should preferably be verified, even though this is an expensive
process. This could be done, for example, by re-entering all data
and comparing the two sets. Where we are transferring data from an
older computer-based system, this step should be relatively straightforward,
given common formats between accounting packages, but should
still be verified.
4 Running both the old system and the new system for a period. Again,
this is expensive, but it is essential to be sure that the new system works
adequately before ending the old system. This process is known as parallel
running.
5 Once the new system is running reliably, the old system can be discontinued.
Note that the new system must include suitable control procedures,
analogous to control accounts, etc. before it can be considered to be
satisfactory.
Answer Our suggested answer summarises much of what has been covered earlier in this
chapter. For more detail on any of these points you should therefore refer back.
᭤ Identify the data sources and required outputs, and so clarify the required system.
This should help to ensure that the system will be sufficiently comprehensive to
accurately deal with all data.
᭤ Similarly, suitable software, i.e. that with a data format common with the old system
(or at least a proven data transfer program), and the necessary hardware will
improve the chances of avoiding data loss, especially in the transfer period.
᭤ Parallel running will provide some reassurance about the reliability of the Windowsbased
system before the DOS system is discontinued.
14 · Information technology and accounting 259
Arturo Ltd is considering changing from its existing DOS-based accounting system to a
newer Windows-based system. Outline the procedures that you will implement in order
to ensure that there is no loss of data, and no subsequent failure of the new system.
You may find it most effective to organise your answer as a list of points – we have.
Activity 14.4
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᭤ Once the new system is running, it is essential that frequent and regular back-up
copies are taken of the data. If done conscientiously, this should ensure that any
data loss is restricted to only whatever data have been input since the last back-up.
᭤ Contingency plans for back-up hardware and software will guard against the effects
of a disaster, such as a major fire. This is covered in more detail in the next section.
Contingency planning
There remains the major control problem of what to do if the computer
system breaks down. The usual method used to control for this possibility
is the use of back-ups. This means that there must always be at least two
sets of the same data, and many organisations will use three sets of data. At
the start of the day, there will thus be, say, two sets of data, A and B. Set A
will be used as a starting point for that day’s transactions, so that by the
end of the day it will not only include the transactions that are on B, but
will also have had that day’s transactions added on to it. If there is any disaster
during the day and data set A is lost, set B can be used, and all that
will have been lost will be the transactions for the day up to the time of
the disaster. It would not be a major issue to re-enter these on set B. If all
goes well, then set B can be backed up from set A at the end of the day so
that we again start the next day with two sets of data. It will improve the
level of control if set B is kept off-site until needed. There is obviously a
danger from, for example, fire if set B is located on the same site as set A, as
both sets could then be lost. This is why some organisations work with
three sets of data, thus allowing the third set to always be off-site. Sets B
and C can then be backed up in rotation, and the worst that could happen
is that we would lose one day’s entry of transactions.
A further back-up issue is the use of parallel hardware, so that there is
something to run the software on in the case of a major disaster. It will
obviously be expensive to keep otherwise redundant hardware, so one
alternative would be to come to a mutual arrangement with another organisation
running the same software, so that each could use the other’s
facilities, perhaps overnight, and so maintain processing of accounts pending
replacement of its own facilities. This may, of course, not be possible,
but there are a number of commercial firms which offer such facilities to a
number of companies in exchange for a fee.
The next part of this chapter deals briefly with e-accounting. Although
the focus is on the impact of communications and information technology
on accounting, bear in mind that any changes to accounting systems to
incorporate the benefits of e-accounting are an extension of what we have
covered so far, not a replacement. In other words, e-accounting offers new
opportunities for accounting systems to process data in order to provide
and disseminate useful information, but the basic principles of design and
control remain the same.
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E-accounting
Electronic accounting, or just e-accounting, can be defined as the application
of communications and information technology to accounting. This
covers many of the issues we have already dealt with, but the focus is usually
on the transmission and sharing of data and information, and
especially on the use of the internet in accounting.
The increasing power of the PC has gradually shifted computing towards
processing by the end user, so that individuals can carry out much of their
work locally. This has advantages in terms of flexibility, but can cause difficulties
in terms of shared data. In the days when there was only a single
computer, it was implicit that everyone used their terminals to access the
same data. Once PCs acquired the power to process data locally, the question
arose of how to ensure that many different versions of the same data
were not created. The answer usually adopted is the network.
A network is a number of computers connected together. Their inter-connection
allows for a single set of data to be maintained, since all will use and
update the one set of data. This single data set will be held on one of the
computers in the network. This means, for example, that the organisation’s
list of employees for payroll purposes – name, rate of pay, method of payment,
etc. – should always be up to date and correct. Contrast this with what
could happen if a number of payroll clerks all started with the same set of
data, but then each amended it as they processed the payroll over the weeks
and months. The organisation would be generating multiple sets of data for
the same employee, with no assurance over which was the most reliable.
The technology of how the network is constructed, and how the accounting
software and operating system software ensures that only one set of data
is maintained, is beyond the scope of this brief description. All we need to
note for our purposes is that there is a significant control issue here. From
the point of view of design and implementation of an accounting system
we can normally rely on the software controls to ensure that only one set of
data is maintained and used by all users. However, we also need to consider
controls over such issues as: who is authorised to be a user? whether some
users only need to be able to read the data and not be allowed to change it;
the distribution of reports around the organisation, and so on.
Sharing of data has become a more high-profile issue with the development
of the internet. In concept this is simply a network of networks.
Connection to any one network allows access to all other computers connected
to any of the other networks. In this regard, one notable development
is the use of ‘internet-enabled’ accounting packages. Potentially this means
packages which use ordinary browsers to interface with the accounting software.
A browser is itself software which allows the user to look at pages on
the world wide web, and has the advantage of being widely available and
probably already familiar to users. A saleswoman, for example, could use a
laptop and modem to dial into the main company system to check customer
details such as credit limits. The browser could then be used to run a small
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application program, known as an ‘applet’ from within the browser, using
the applet to, for example, enter details of the day’s orders from those customers.
The applet would link to the main accounting software, without the
saleswoman having to learn how to use the main accounting package or to
have it loaded on her laptop. Training and software costs should therefore
both be reduced.
Of potentially greater value to the accountant is the use of the internet
to allow for transmission of accounting data and information between an
organisation and any other. To appreciate the importance of this consider
the following activity.
Answer Company A will prepare the invoice from a record of the goods sold. This could be, for
example, a copy of a delivery note. This assumes that the delivery note has been correctly
prepared as a record of the goods delivered. Preparation of the invoice will then
involve copying data from the delivery note to the sales invoice. Company A will then
usually post the paper invoice to company B.
When company B receives the invoice it will enter it into the accounting system as a
purchase invoice. At its simplest this will involve copying the details from the invoice
into the purchase ledger. When company B eventually pays the invoice the payment
details will follow the reverse route with a similar number of points at which the same
details must be manually entered into the two accounting systems.
When the process is highlighted in this way it should be apparent that it is
wasteful to process the same data not only more than once within a company
but also across companies. We have already seen how computers can
reduce the need to enter more than once within a company’s accounting
system. This is a major step, but shouldn’t it be possible to take the data
that has already been entered within company A and use it to write up the
ledgers in company B as well? What is required is the transmission of data
from the accounting system of company A to that of company B, and vice
versa when we deal with the payment.
Answer The problems that occur to us are that the two accounting systems may well not produce
data in the same format, and that there are surely problems of security. Allowing
a third party access to your accounting system must have implications for control
within that system.
262 Financial Accounting
Company A sends a sales invoice for goods to company B. List the steps that would
typically be taken within company A and company B to process this invoice. Highlight
the points at which the same data is copied.
Activity 14.5
Outline two problems that you can foresee with such an approach.Activity 14.6
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On the question of security, bear in mind what we said above, that the basic
principles of control will still apply in the world of e-accounting. This
implies that the techniques we explored, such as passwords and audit trails,
should still help us to maintain controls over our systems. In this case, for
example, company B could give company A a password which allows access
only to the company A account in company B’s purchase ledger.
The question of compatibility of data formats is more difficult. Each
writer of accounting software has historically tended to store data in their
own format, and building in the facility to import and export data from
and to other software packages has been laborious and expensive. This is
unfortunate because the potential gains if accounting systems were compatible
are very significant.
To illustrate this point, consider the above activity again. If company A
could send its invoice to company B, either over the internet or as an e-mail
attachment, in a format that was understandable by the accounting system of
company B there would be no need for re-entering of the details in company
B. Similarly, the payments details could be sent direct from the accounting
system of company B to that of company A. The savings in time, error correction,
and hence in cost, should be obvious. Such a single format is being
developed within accounting systems, and is known as XML.
XML
XML stands for eXtensible Mark-up Language, and an understanding of XML
can be gained by looking at this name. A mark-up language is a set of labels
(‘tags’) which can be attached to content to describe that content. The current
language of the web is a mark-up language known as the hypertext
mark-up language, or HTML. This allows the content of a web page, that is,
the words and pictures you see on screen, to be described by attaching a tag
to each picture, word, or group of words such as a paragraph. This description
may be of the paragraph’s meaning, such as the CITE tag which marks
that paragraph as a citation. More usually within HTML the tag is a description
of the formatting of the paragraph, such as the BGCOLOR tag which
sets the background colour behind the paragraph.
XML takes a more rigorous approach to marking up with tags, in that it
is strict about only using tags which describe the meaning of the content –
formatting is dealt with separately. This means that each piece of content is
marked with a description of what it is. For example, a figure of £10,000
could be tagged as being the share capital for the current year, or as the
sales ledger balance for company B, or as anything else we want. What this
implies, of course, is that we must have a large set of tags, one for every
item we might ever deal with in an accounting system. Whereas the tags
for HTML are centrally defined, for our XML accounting to work we must
be able to define our own tags. In other words, the mark-up language must
be eXtensible, hence XML.
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Two things follow. First, if the accounting software of both company A
and company B can read a common set of XML tags then the data is interchangeable
and we have the possibility of integrating our accounting
systems with those of our customers, supplier, lenders etc. in the way we
explored above.
Second, financial reporting is about producing financial statements for a
variety of purposes. Certainly, this will include the production of a cash
flow statement for publication, but we might also want a revised format of
the cash flow information as part of an application for a loan. Once all the
underlying data has been tagged with its XML tag this revision becomes an
easy process. We can set up a template, perhaps in our accounting software,
perhaps in a spreadsheet or word-processor, so that the necessary figures
are extracted from the accounting system and placed in the correct place in
the template. The template will know which piece of data is the right one
because, of course, each piece of data carries its own unique tag. This might
seem laborious but next time we need the same report we have only to run
the template again and it will extract the corresponding data from the
updated accounting system.
Answer The potential advantages are principally the ability to exchange accounting data with other
organisations, leading to faster, less error-prone and therefore cheaper routine accounting,
and the ‘re-purposing’ of accounting information. This second point means that
information, such as the net profit will, of course, appear in the income statement, but
could also be useful in a loan application, a report to employees, a tax return, a marketing
web page, etc. Without XML tags, re-using the profit figure implies manually extracting
it from the income statement and entering it into each of the other documents. Not only
is there potential for error each time this is done, but it is time-consuming. Multiplied over
every figure we report to any user this is a significant cost. With XML tags a template can
be prepared once for each purpose and re-used indefinitely.
The advantages that we have considered above have resulted in a major
effort to implement XML as the key data format within accounting. In particular,
software companies and firms of accountants and professional bodies
have combined to develop an agreed set of tags for use within accounting.
Such a common set is, of course, essential if there is to be the required commonality
of tags to describe each item of accounting data and to allow for
the interchange of that data. For example, it is essential that we all agree to
tag the inventory figure as, say INVENTORY, and not as, say, STOCK.
This common effort has resulted in a set of tags specific to the world of
accounting, known as the eXtensible Business Reporting Language, or
XBRL. XBRL can be thought of as a sub-set of XML, and it is actually XBRL
which will almost certainly form the basis of data formats in accounting in
the future.
264 Financial Accounting
List at least two advantages for a company of having its accounting data held in XML
format.
Activity 14.7
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The wider picture
The final part of this chapter is concerned with uses of information technology
other than accounting software that may still be of relevance to the
accountant. Much of this is likely to deal with applications that are familiar
to you, but what we are focusing on here is the use of those applications
in accounting.
The first area to look at is other applications software, especially spreadsheets
and databases. Spreadsheets are an electronic version of the
accountant’s traditional working paper with many columns and rows. You
have already seen one major example of such a working paper in the use of
the extended trial balance in Chapter 7. A spreadsheet not only allows text
and numbers to be placed in the cells of the spreadsheets, but then also
enables formulae to be included, which refer to that text and, more usually,
to those numbers. This then means that totals and other calculated figures
can be automatically computed, and then recomputed if any underlying
figure changes. This ability to very quickly recalculate enables the user to
try out ‘what if’ scenarios, i.e. changing figures, perhaps as a result of
changing underlying assumptions, so that alternative courses of action can
be tested. Most of the more modern spreadsheets allow calculations to
include references to more than one spreadsheet.
A database is a collection of data stored on a computer system. However,
constructing a useful database is a much more complex matter than constructing
a spreadsheet to automatically add up a budget, or using a word
processor to write the notes to the accounts. Accordingly, it is far less
common to find databases being seriously used by end users. Note that the
maintenance of supplementary accounting records, such as a register of all
our non-current assets, or our inventory records may well be implemented
using a database package.
The other significant area of the common use of information technology
by accountants is the acquisition and communication of information. First,
e-mail is the transfer of messages between computers, either over a permanent
network or over a dial-up phone line. There is usually the facility to
attach files to the message, and this allows the easy transmission of financial
data on an ad-hoc basis, or more routinely, as we saw above.
Second, there are the on-line sources. Some of these are commercial and
concerned specifically with data about UK companies, usually including
the full annual report and accounts. Saving such data in spreadsheet
format would, for example, enable the user to calculate ratios for a number
of companies, and so make the sort of inter-firm comparisons we covered
earlier in this book. More simply, it is an effective method of acquiring
names of directors, addresses of registered offices, discovering who the
auditors are, and so on. They may also provide ready calculated ratios,
share prices, etc. and often present that information graphically. Being
commercial, there is usually a substantial charge for using such services.
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Summary
This chapter has been concerned with computer-based accounting and particularly
with
᭤ the control issues in an IT environment
᭤ the design of an accounting system
᭤ the use of a computer-based accounting system
This has been the last chapter that introduces new material. Chapter 15
attempts to pull together much of what this book has been about, through
the use of one large case study. Accounting is about synthesising data and
communicating it in a way meaningful to the users. The case study is one
way of synthesising your knowledge and understanding acquired so far,
and then using it to produce useful information. We strongly recommend
that you try it.
Self-assessment questions
For each of the following questions, choose the single most appropriate answer.
1 The main advantage of a networked computer system is that it allows for
(a) Maintenance of a single set of data
(b) Sharing of scarce or expensive hardware
(c) Exchange of data
(d) All of the above
2 Operating system software is primarily software to
(a) Network computers in a wide area network
(b) Give commands to the hardware
(c) Record and extract accounting data
(d) Allow computer hardware to be designed efficiently
266 Financial Accounting
audit trail (p. 256)
designing an accounting system
(p. 257)
implementation (p. 258)
back-ups (p. 260)
e-accounting (p. 261)
XML (p. 263)
Key terms
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3 Customised application software is
(a) Software to record our customers’ details and accounting transactions
(b) Software that can be applied to any computer
(c) Software developed to suit a particular organisation’s needs
(d) Software used to develop products and services for our customers
4 Errors in a computer-based accounting system can be eliminated by the use of
(a) An audit trail
(b) Passwords used by nominated staff
(c) Software that checks that all entries balance
(d) None of the above
5 The main advantage of keeping one set of data off-site at all times is
(a) To minimise deliberate error and fraud
(b) To ensure one set of data survives in case of a major disaster on-site
(c) To allow for parallel running of two independent accounting systems
(d) Effective compliance with any software licence agreement
6 The importance of the internet to accountants is that it allows relatively easy access to
(a) Different types of spreadsheet
(b) Operating systems software
(c) A wide range of information
(d) Parallel running of accounting systems
7 Which of the following are usually regarded as outputs from a computer-based
accounting system?
(i) list of debtors
(ii) purchase invoices
(iii) summary of stock in hand
(iv) balance sheet
(v) audit trail
(a) (i), (iii) and (v)
(b) (ii), (iii), (iv) and (v)
(c) (iii), (iv) and (v)
(d) None of the above
8 The transfer of accounting data from a manual system to a computer-based system
can be verified by
(a) Parallel running of both systems
(b) Frequent back-ups, with one set of data always kept off-site
(c) Ensuring that the accounting software includes the facility to check that all
entries balance
(d) Re-entering all transferred data and comparing with the first-entered set
14 · Information technology and accounting 267
᭤
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9 Are you familiar with accounting software? You may have used such software at work,
but many of you are likely to be studying accounting before starting full-time work.
Nevertheless, most higher educational establishments have some sort of accounting
software for use by students. While it is often older versions of popular commercial
packages such as Sage or Pegasus, it is still useful to try setting up accounts, entering
a few transactions and extracting the results. Only in this way will you properly grasp
many of the issues raised in this chapter, especially in relation to control.
When you use the package, try entering deliberate mistakes, and see which the
software will pick up, and which it will not. Think about how your wider accounting
system could prevent or detect the latter errors. Would a bank reconciliation help, for
example? Wider still, what would you do now if the disk on which you have just
saved your transactions were to be lost or corrupted?
Even if you cannot get access to such a package, try to get hold of one of the
newer generation of accounting packages, such as Quicken or Money, which are
aimed at use in the small business, or for domestic accounting. Restricted or evaluation
editions of such packages are occasionally given away with computing magazines.
At the very least, browse such magazines looking for reviews of accounting packages.
Your overall aim is to get a feel for what accounting software can do, and how it typically
does it. It is only through getting as close to the use of accounting software as
your circumstances permit that you will be able to relate the practicalities of accounting
to the inevitably rather general points that have been covered in this chapter.
10 Hyperion Landscaping Ltd currently keeps its accounting records in a manual system,
but now intends to move to a computer-based system. Put the following items in the
correct chronological order in which Hyperion should deal with them.
᭤ Investigate suitable software
᭤ Get the manual system up to date
᭤ Monitor the audit trail for the computer system
᭤ Determine the information required from the system, e.g. budgets, income statement
᭤ Transfer the account balances from the manual system to the computer system
᭤ Back up the computer records
᭤ Determine the source documents and other data to be processed by the system
᭤ Investigate suitable hardware
᭤ Move wholly to the computer system
᭤ Decide on back-up and security arrangements
᭤ Run both systems in parallel
Answers to these questions can be found at the back of this book.
268 Financial Accounting
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15
The finale
Introduction
The style of this chapter is somewhat different from previous chapters in
that there is no new information to learn. If you work through this chapter
diligently it will identify for you those items that you have not thoroughly
understood.
This chapter also has something of an international flavour and is in
essence a case study.
Case study
Bairstow Holdings plc is investigating the possibility of investing in one of
two companies. The first, Hamilton Engineering Ltd, is a UK company, and
the accounts for the year ended 31 December 20X7 are available. In line
with developing UK practice, these accounts have been prepared in line with
international accounting standards (IASs). The second is an overseas competitor
to Hamilton Engineering, called Kriton Manufacturers SA. Kriton is
incorporated in the central European country of Ecudia. Bairstow Holdings
has also obtained the annual report and accounts for Kriton, but has found
that the accounts are significantly different from those of Hamilton.
In particular, the accounting regulations in Ecudia do not require the
publication of an income statement. However, they do require a cash flow
statement, although in a non-IAS format, and a balance sheet. As assistant
By the end of this chapter you should be able to:
᭤ Prepare an income statement from cash flows and appropriate
balance sheet information for a company.
᭤ Redraft financial statements prepared using non-UK accounting
practices.
᭤ Prepare a report to users analysing and comparing a non-UK and UK
company.
Objectives
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accountant for Bairstow Holdings, you have been asked to use the available
information about Kriton to redraft the Kriton accounts in a format consistent
with generally accepted accounting practice according to international
accounting standards. Having thus prepared accounts for Kriton which are
comparable to those of Hamilton, you are also required to analyse their
respective positions and prospects, and so to recommend which company,
if either, Bairstow should invest in.
Accounts for Kriton Manufacturers SA
All amounts are expressed in the local currency, the euro (€).
CASH FLOW STATEMENT
FOR THE YEAR ENDED 31 DECEMBER 20X7
Receipts €
From customers 654,836
Interest received 12,900
Non-current assets sold 105,040
Debentures issued 150,000
–––––––––––
€922,776
––––––––––––––––––––––
Payments
To suppliers for goods purchased 362,573
To suppliers for other expenses 151,353
Purchases of non-current assets 278,200
Costs of debenture issue 2,150
Tax paid 63,045
Dividends paid 40,257
Interest paid 5,238
–––––––––––
€902,816
––––––––––––––––––––––
Increase in bank balance €19,960
––––––––––––––––––––––
BALANCE SHEETS
20X7 20X6
€ €
Non-current assets
Land and buildings 588,933 465,287
Machinery 659,314 590,721
Vehicles 34,941 54,020
–––––––––––– ––––––––––––
1,283,188 1,110,028
Current assets
Inventory 90,200 86,582
Trade debtors 44,877 43,084
Bank 39,532 19,572
–––––––––– ––––––––––
174,609 149,238
270 Financial Accounting
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Current liabilities
Trade creditors (31,613) (33,365)
Other creditors (5,045) (4,502)
Tax (42,919) (63,045)
Dividends (42,300) (40,257)
Contingencies (56,000) –
––––––––––– ––––––––––
(3,268) 8,069
–––––––––––– ––––––––––––
1,279,920 1,118,097
Debentures 450,000 300,000
–––––––––––– ––––––––––––
€829,920 €818,097
–––––––––––– –––––––––––––––––––––––– ––––––––––––
Share capital 500,000 500,000
General reserve 329,920 318,097
–––––––––––– ––––––––––––
€829,920 €818,097
–––––––––––– –––––––––––––––––––––––– ––––––––––––
Notes to the accounts
Non-current assets
You discover that the non-current assets of Kriton are depreciated in accordance
with the fiscal policy in operation in Ecudia. Thus depreciation for
the year to 31 December 20X7 of €85,343 has been reflected in the Kriton
accounts. If the depreciation charge had been based on the same policy as
in Hamilton, then the depreciation charge would have been €103,445 for
the year, i.e. an additional €18,102.
The non-current asset figures in the balance sheet of Kriton reflect the
depreciation charged over the years, that is, they are at net book value, in
accordance with Ecudian generally accepted accounting practices. If the
total provision for depreciation brought forward at the beginning of 20X7
had been calculated on the same basis as for Hamilton, it would have been
an extra €46,578. In other words, the net book value as at 1 January 20X7
would have been reduced by that amount.
Other expenses
Research and development costs of Kriton are written off to the income
statement as and when they are incurred. They form part of the other
expenses on the cash flow statement.
All contingencies, no matter how remote, are also included in this
income statement. You estimate that €56,000 in expenses has been accrued
for. It is very unlikely to ever become due. You also note that this type of
contingency would not normally be accrued for in the UK, i.e. according to
international accounting standards.
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Dividends
These are declared at the year end and the company is committed to pay
them on 7 January.
Inventory
Standard accounting practice in Ecudia is to value inventory at selling
price. The valuations at historical cost for Kriton would be €65,900 at
31 December 20X6 and €67,250 at 31 December 20X7.
Issue costs
Debenture issue costs are written off in the year in Ecudia.
HAMILTON ENGINEERING LTD FINANCIAL STATEMENTS
BALANCE SHEETS AS AT 31 DECEMBER
20X7 20X6
£ £
Non-current assets 850,976 793,465
Current assets
Inventory 23,472 26,574
Debtors 36,457 38,563
Bank 6,453 –
–––––––––– –––––––––
66,382 65,137
Current liabilities
Creditors (29,756) (27,463)
Tax (37,465) (29,465)
Bank – (350)
–––––––––
(839) 7,859
–––––––––––– –––––––––––
851,815 801,324
Non-current liabilities
Debentures 150,000 200,000
–––––––––––– –––––––––––
£701,815 £601,324
–––––––––––– ––––––––––––––––––––––– –––––––––––
Share capital 600,000 600,000
General reserves 101,815 1,324
–––––––––––– –––––––––––
£701,815 £601,324
–––––––––––– ––––––––––––––––––––––– –––––––––––
272 Financial Accounting
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INCOME STATEMENT
FOR THE YEAR ENDED 31 DECEMBER
20X7 20X6
£ £
Sales 524,536 395,764
Cost of sales 284,657 269,472
–––––––––– –––––––––––
Gross profit 239,879 126,292
Depreciation 65,655 59,685
Expenses 32,657 28,675
Interest paid 7,500 10,000
––––––––– –––––––––
105,812 98,360
–––––––––– –––––––––––
Net profit before tax 134,067 27,932
Taxation 33,576 29,465
–––––––––– –––––––––––
Retained profit for the year 100,491 (1,533)
–––––––––– ––––––––––––––––––––– –––––––––––
Note of retained earnings
Retained profit b/f 1,324 2,857
Profit (loss) for the year 100,491 (1,533)
––––––––––– –––––––––
Retained profit c/f £101,815 £1,324
––––––––––– –––––––––––––––––––– –––––––––
Notes
᭤ No non-current assets were sold during the year but £124,844 were bought.
᭤ Research and development expenditure is charged to the income statement.
᭤ Inventory is valued at historical cost.
᭤ The debentures were redeemed at nominal value.
Required
1 Draft an income statement for Kriton Manufacturers SA for the year
ended 31 December 20X7. Refer to Chapter 7 if you need to refresh your
knowledge of how to do this.
2 Redraft the income statement for Kriton prepared in answer to (1) above
in accordance with international generally accepted accounting practice
(i.e. the accounting practice of Hamilton Engineering Ltd).
3 Redraft the balance sheets at both 31 December 20X7 and 31 December
20X6 for Kriton, in accordance with international generally accepted
accounting practice (i.e. the accounting practice of Hamilton
Engineering Ltd).
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4 Redraft the cash flow statement for the year ended 31 December 20X7 in
accordance with best international practice, adopting the indirect method
of reporting. Refer to Chapter 9 if you need to refresh your knowledge of
how to do this.
5 Calculate the following ratios for both Kriton, using your newly drafted
accounts, and for Hamilton, for both 20X6 and 20X7, as far as the information
allows:
(a) Gross profit.
(b) Net profit.
(c) Return on capital employed.
(d) Return on owner’s equity.
(e) Gearing.
(f) Current.
(g) Quick.
(h) Debtors’ collection.
(i) Creditors’ payment.
(j) Inventory turnover.
(k) Sales to capital employed.
Refer to Chapter 11 if you need to refresh your knowledge of how to
do this.
6 Use the ratios as a basis for your recommendation to the directors of
Bairstow Holdings plc on which company, if either, they should invest
in. Refer to Chapter 11 if you need to refresh your knowledge of how to
do this.
Answers 1 To draw up the income statement for Kriton we need to convert the cash flows to
accruals-based accounting. Generally, you have completed the reverse of this exercise
when drawing up the cash flow statement from the income statement in
Chapter 9. For the sales calculation we take the receipts (cash) from customers and
adjust it for opening and closing debtors. Opening debtors we will assume are all
paid during the period and therefore have been included in the cash received and
thus we need to deduct €43,804. Closing debtors have obviously not paid and
therefore these will increase the cash received by €44,877. The other calculations
for purchases, expenses, taxation and dividends work in a similar way as you can
see below. For interest payable and receivable we have no other information available
and must assume that these equate to interest paid and received.
274 Financial Accounting
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KRITON MANUFACTURERS SA
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X7
€ €
Sales (654,836 – 43,084 + 44,877) 656,629
Opening inventory 86,582
Purchases (362,573 – 33,365 + 31,613) 360,821
–––––––––––
447,403
Less closing inventory 90,200 357,203
––––––––––– ––––––––––
Gross profit 299,426
Expenses (151,353 – 4,502 + 5,045) 151,896
Depreciation 85,343
Contingency 56,000
Profit on sale of assets (note 1)
(105,040 – 19,697) (85,343)
Debenture issue costs 2,150
Interest received (12,900)
Interest paid 5,238
–––––––––––
202,384
––––––––––
Net profit before tax 97,042
Tax 42,919
––––––––––
Net profit after tax 54,123
Dividends 42,300
11,823
Retained profit b/f 318,097
–––––––––––
Retained profit c/f €329,920
––––––––––––––––––––––
Note 1
Opening assets valuation 1,110,028
Add purchase new assets 278,200
–––––––––––
1,388,228
Less depreciation for the year 85,343
–––––––––––
1,302,885
Closing asset valuation 1,283,188
–––––––––––
Thus net book value assets sold €19,697
––––––––––––––––––––––
2 We now have to look at all the accounting policies of Kriton and convert to IAS
accounting policies where necessary. For example, we are told that the depreciation
policy of Kriton is different from that of international GAAP and if IAS policy had
been used the depreciation charge would have increased to €103,445. We need to
make changes for inventory, historical cost not selling price, and remove the contingency.
We also have to remember that the retained profits of Kriton will have been
calculated using Ecudia GAAP and we therefore need to amend the retained profit
brought forward.
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KRITON MANUFACTURERS SA
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X7
IN ACCORDANCE WITH INTERNATIONAL GAAP
€
Sales 656,629
Opening inventory 65,900
Purchases 360,821
––––––––––
426,721
Less closing inventory 67,250
––––––––––
359,471
––––––––––
Gross profit 297,158
Expenses 151,896
Depreciation 103,445
Contingency –
Debenture issue costs 2,150
Interest received (12,900)
Interest paid 5,238
Profit on sale of assets (85,343)
––––––––––
164,486
––––––––––
Net profit before tax 132,672
Taxation 42,919
––––––––––
Net profit after tax 89,753
––––––––––––––––––––
STATEMENT OF RETAINED EARNINGS
FOR THE YEAR ENDED 31 DECEMBER 20X7
IN ACCORDANCE WITH INTERNATIONAL GAAP
€
Retained profit b/f (note 1) 250,837
Retained profit for the year 89,753
Dividends (42,300)
––––––––––––
Retained profit c/f €298,290
––––––––––––––––––––––––
Note 1: Adjustment to retained profit b/f
Retained profit b/f as per balance sheet 318,097
Less previous years’ depreciation (46,578)
Less revaluation of closing inventory 31 December 20X6 (20,682)
––––––––––––
Retained profit b/f €250,837
––––––––––––––––––––––––
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3 Changes, to convert to international GAAP will be required to non-current assets,
inventory and liabilities (contingencies).
KRITON MANUFACTURERS SA
BALANCE SHEET AS AT 31 DECEMBER 20X7
UNDER INTERNATIONAL GAAP
€
Non-current assets (1,283,188 – 46,578 – 18,102) 1,218,508
Current assets
Inventory 67,250
Debtors 44,877
Bank 39,532
–––––––––
151,659
Current liabilities
Trade creditors 31,613
Other creditors 5,045
Taxation 42,919
Dividends 42,300
––––––––
121,877
–––––––––
29,782
–––––––––––
1,248,290
Non-current liabilities
Debentures 450,000
–––––––––––
€798,290
––––––––––––––––––––––
Share capital 500,000
General reserve 298,290
–––––––––––
€798,290
––––––––––––––––––––––
KRITON MANUFACTURERS SA
BALANCE SHEET AS AT 31 DECEMBER 20X6
AS PER INTERNATIONAL GAAP
€
Non-current assets 1,063,450
Current assets
Inventory 65,900
Debtors 43,084
Bank 19,572
–––––––––
128,556
Current liabilities
Trade creditors 33,365
Other creditors 4,502
Tax 63,045
Dividends 40,257
––––––––
141,169
–––––––––
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(12,613)
––––––––––––
1,050,837
Non-current liabilities
Debentures 300,000
––––––––––––
€750,837
––––––––––––
Share capital 500,000
General reserve 250,837
––––––––––––
€750,837
––––––––––––––––––––––––
4 This activity should be quite straightforward as you are now working from the international
GAAP prepared income statement and balance sheets as we did in Chapter 9.
KRITON MANUFACTURERS SA
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X7
€ €
Cash inflow from operating activities (note 1) 140,910
Interest paid (5,238)
Tax paid (63,045)
Net cash paid in investing activities
Purchase of assets (278,200)
Proceeds of sale of assets 105,040
Interest received 12,900
–––––––––––
(160,260)
Net cash from financing activities
Debenture issue 147,850
Dividends paid (40,257)
–––––––––––
107,593
–––––––––––
Change in cash and bank €19,960
––––––––––––––––––––––
Note 1
Operating profit for the year before tax,
interest and dividends
(132,672 + 5,238 – 12,900) 125,010
Add back:
Depreciation 103,445
Issue costs 2,150
Less profit on sale (85,343) 20,252
––––––––––– –––––––––––
145,262
Increase in inventory (1,350)
Increase in debtors (1,793)
Decrease in trade creditors (1,752)
Increase in other creditors 543
–––––––––––
(4,352)
–––––––––––
€140,910
––––––––––––––––––––––
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5 We have shown our ratios in two separate tables for ease of reference. The first
table shows the ratios themselves, while the subsequent table shows the underlying
calculations. Note that not all ratios can be calculated for Kriton, in the absence of
an income statement for 20X6. Such restrictions are often a feature of accounts
analysis, and conclusions and recommendations have to be determined from what
information is available. Note also that the fact that Kriton’s accounts are in a different
currency does not impact on the calculation of the ratios; the currency is
‘cancelled out’.
Kriton Hamilton
20X7 20X6 20X7 20X6
Gross profit 45.3% 45.7% 31.9%
Net profit 0.7% (note 1) 25.6% 7.1%
Return on capital
employed 0.8% (note 1) 12.7% 1.1%
Return on
shareholders’
funds 0.6% (note 1) 14.3% (0.5)%
Gearing 36.0% 28.5% 17.6% 25.0%
Current 1.24 0.91 0.99 1.14
Quick 0.69 0.44 0.64 0.67
Debtors’ collection 25 days 25 days 35 days
Creditors’ payment 32 days (note 2) 38 days 37 days
Inventory turnover 68 days 30 days 36 days
Sales to capital
employed 0.53 0.62 0.49
Note 1
The ‘raw’ net profit figure is €89,753. Using this gives a net profit to sales percentage
of 13.7%. However, our view is that this would be an unreliable figure, since it
includes a very substantial profit on the sale of non-current assets, which is unlikely
to be repeated, and is therefore a poor guide to future performance. The figure we
have used for profit therefore excludes this profit on sale of non-current assets, and
is consequently €4,410. The same figure has then also been used for the next two
ratios. Note that our identification of a sustainable profit here is a contentious issue
– the essential thing is to be consistent in any such adjustment policy.
Note 2
Since only the cost of sales figure is available for Hamilton, we have also used the
cost of sales figure for Kriton’s ratio calculation. Strictly, the denominator should, of
course, be the purchases figure, but our approach has the key merit of consistency.
The answers above have been calculated from the following fractions. You should
be able to identify the amounts involved below from the accounts.
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Kriton Hamilton
20X7 20X6 20X7 20X6
Gross profit 297,158 239,879 126,292
––––––––––– ––––––––– –––––––––
656,629 524,536 395,764
Net profit 4,410 134,067 27,932
––––––––––– ––––––––– –––––––––
656,629 524,536 395,764
Return on capital 9,648 107,991 8,467
––––––––––– ––––––––– –––––––––
employed 1,248,290 851,815 801,324
Return on 4,410 100,491 (1,533)
––––––––––– ––––––––– –––––––––
Shareholders’ funds 798,290 701,815 301,324
Gearing 450,000 300,000 150,000 200,000
––––––––––– ––––––––––– ––––––––– –––––––––
1,248,290 1,050,837 851,815 801,324
Current 151,659 128,556 66,382 65,137
––––––––––– ––––––––––– ––––––––– –––––––––
121,877 141,169 67,221 57,278
Quick 84,409 62,656 42,910 38,563
––––––––––– ––––––––––– ––––––––– –––––––––
121,877 141,169 67,221 57,278
Debtors’ collection 44,877 36,457 38,563
––––––––––– × 365 ––––––––– × 365 ––––––––– × 365
656,629 524,536 395,764
Creditors’ payment 31,613 29,756 27,463
––––––––––– × 365 ––––––––– × 365 ––––––––– × 365
359,471 284,657 269,472
Inventory turnover 67,250 23,472 26,574
––––––––––– × 365 ––––––––– × 365 ––––––––– × 365
359,471 284,657 269,472
Sales to capital 656,629 524,536 395,764
––––––––––– ––––––––– –––––––––
employed 1,248,290 851,815 801,324
6 Analysis and recommendations
The following points should be included in any report you prepare for Bairstow plc.
᭤ The absence of an income statement for Kriton for 20X6 means that some ratios
cannot be calculated.
᭤ The net profit figure to be used for Kriton for 20X7 is subject to debate over the
repeatability of the profit on the sale of the non-current assets.
᭤ The gross profit percentages for 20X7 are very similar between the two companies,
but the net profit percentages indicate that Kriton’s expenses are
substantially more than Hamilton’s, in relation to their respective turnovers. This
indicates that serious attention needs to be given to Kriton’s expenses.
᭤ The poor net profit in Kriton is also reflected in return on capital and on shareholders’
funds ratios; that is, they are much lower for Kriton than for Hamilton. It
is also worth noting that Hamilton’s ratios have improved since 20X6. Kriton thus
appears a less attractive possibility as an investment than Hamilton, if the objective
is a high return on that investment.
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᭤ The gearing ratio has increased in Kriton, while it has fallen in Hamilton. The high
gearing implies high interest charges, which is likely to leave little profit as a
return for investors. Again, the implication is that Kriton is unattractive as an
investment, relative to Hamilton.
᭤ The relative positions of the two companies as regards liquidity show Kriton to be
in the stronger position. Both its current and quick ratios have improved significantly
over 20X7, while Hamilton’s position has worsened, as evidenced by the
same two ratios. This may imply a concern over the future ability of Hamilton to
meet its obligations in the short term, despite its relatively good profitability.
᭤ Both debtor collection and creditor payment periods are similar for the two companies,
as far as can be determined from the limited information available for
Kriton. Credit management policies and practices are probably therefore similar
in the two companies.
᭤ The inventory turnover period, however, is much longer in Kriton than in
Hamilton. This is surprising, given that they are in the same industry, albeit operating
in different countries. It may be that Kriton’s relative inability to move its
inventory quickly is a cause of its relatively poor profitability.
᭤ The similarity of the sales to capital employed ratios suggest that both companies
are similar in their ability to generate sales from a given level of investment.
᭤ Overall, Kriton’s problems seem to stem from its high level of expenses, relative
to turnover, compared with what Hamilton has been able to achieve. This area
should certainly be investigated before any decision to invest in Kriton is made.
Furthermore, it may well be productive to investigate why Kriton has been unable
to shift its inventory as quickly as its competitor.
᭤ The better investment would therefore appear to be Hamilton. However, any decision
to invest should take into account the alternative investments open to
Bairstow. At its simplest, these could include, for example, placing the money in
a deposit account. This would, of course, probably be a significantly safer investment
than putting money into Hamilton, and the question of relative risk should
be considered alongside that of relative return.
Summary
This final chapter has attempted to pull together many of the issues that
you have studied in this book. It has been an extensive case study, and it is
likely that you did not find it very easy. However, we recommend that you
return to it at least once more – you should find it an excellent way to
revise and consolidate your understanding.
15 · The finale 281
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Appendix
Answers to self-assessment
questions
Chapter 1 What is accounting?
Answers to Question 1–8
1 (c) 2 (a) 3 (d) 4 (c) 5 (b) 6 (b) 7 (b) 8 (b)
Question 9
Income Statement A summary of gains and losses from operations realised by the
organisation during the past year
Balance Sheet A summary of the assets, liabilities and capital applicable to
the organisation at the end of the year
Cash Flow Statement A summary of liquid funds that flowed in and out of the
organisation in the past year
Question 10
1 List and consider the users, and their needs. In particular, financial statements in
the UK are mostly used by existing and potential investors and lenders.
2 Such users are concerned with whether the entity is now, and/or is likely to be in
future, a good source of financial return and security. This means that they are looking
to the statements for, in the words of the Framework for the Preparation and
Presentation of Financial Information, ‘information about the financial position, performance
and changes in financial position of an enterprise that is useful to a wide
range of users in making economic decisions’.
3 Other users’ needs should also be considered, in terms of the decisions they need
to make about the entity. For example, employees’ use of the financial statements
could be considered in relation to decisions about whether to join or leave the
entity, or pay rises.
4 Note the shortcomings of UK financial statements in that they only provide historical
information, while decision making is inherently forward looking.
5 Nevertheless, the usefulness of historical information for confirmatory purposes
should be considered in relation to specific users. However, stewardship is not
specifically highlighted in the Framework.
6 The generally accepted conclusion, then, is that the main rationale for financial
accounting and reporting in the UK is to aid users in decision making, but that the
confirmatory stewardship role, while secondary, is also valid.
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Chapter 2 The balance sheet
Answers to Questions 1–6
1 (a) 2 (c) 3 (b) 4 (c) 5 (c) 6 (d)
Question 7
MORTLAKE LTD
BALANCE SHEET AS AT 31 DECEMBER
Non-current assets
Building 42,000
Vehicle 13,000
Current assets 55,000
–––––––––
Inventory 6,000
Debtors 4,000
–––––––––
10,000
Current liabilities
Creditors 5,000
–––––––––
5,000
–––––––––
£60,000
––––––––––––––––––
Equity £60,000
––––––––––––––––––
Notes:
1 The non-current assets have been valued at historical cost, rather than at the higher
market value, since the market value is uncertain, and it is, in any case, more prudent
(cautious) to apply the lower figure to the valuation. Prudence is a concept that
we will look at in more detail in Chapter 4.
2 The inventory has similarly been valued at the lower of the possible valuations. This
is our best estimate of the economic benefit that it represents to Mortlake.
3 The equity can be taken as the balancing figure because the balance sheet equation
defines equity as the difference between assets and liabilities, which is what
the first half of the balance sheet has calculated.
Question 8
(a) The total historical cost of the building is £380,000 and this is the figure that
should be used in the company’s balance sheet. The repairs have not improved
the building and have no continuing existence, so should be treated as an expense
and not as part of the value of the building.
(b) The key point here is that the car was written off after the balance sheet date, and
so did exist at that point. If we are to report the state of affairs at the balance
sheet date we must include that car. Valuing both cars, therefore at the usual historical
cost valuation gives a figure of £27,000.
(c) There are three valuations possible here, historical cost of £19,000, net realisable
value of £8,000 and replacement cost of £15,000. Historical cost does have the key
advantage of being objective – both the other valuations must be guesses, albeit
good ones. The figure to be used here would therefore be £19,000. If you are
unhappy about this choice then we can only say that many accountants would agree
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with you, since it is an obviously out of date, and therefore arguably irrelevant, figure.
Nevertheless, as we have seen, standard practice is normally to use historical cost.
(d) The only debtor we can rely on to pay us, and thus to provide some economic benefit
is the first, i.e. the one for £2,000. The others would not be shown as debtors
in the balance sheet because they are both unlikely to result in our receiving cash.
Question 9
(a) YEOVIL ELECTRONICS
BALANCE SHEET AT 31 DECEMBER 20X9
Non-current assets
Premises 345,000
Plant and machinery 104,800
–––––––––
449,800
Current assets
Inventory 67,250
Debtors 46,200
–––––––––
113,450
Current liabilities
Bank overdraft 56,780
Creditors 15,000
––––––––
71,780
–––––––––
41,670
491,470
–––––––––
Non-current liabilities
Long-term loan 120,000
–––––––––
371,470
––––––––––––––––––
Capital 371,470
––––––––––––––––––
(b) YEOVIL ELECTRONICS
BALANCE SHEET AT 31 DECEMBER 20X9
Non-current assets
Premises 480,000
Plant and machinery 95,000
–––––––––
575,000
Current assets
Inventory 61,000
Debtors 46,200
–––––––––
107,200
Current liabilities
Bank overdraft 53,600
Creditors 15,000
–––––––––
68,600
–––––––––
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38,600
–––––––––
613,600
Non-current liabilities
Long-term loan 120,000
–––––––––
493,600
––––––––––––––––––
Capital 493,600
––––––––––––––––––
(c) YEOVIL ELECTRONICS
BALANCE SHEET AT 31 DECEMBER 20X9
Non-current assets
Premises 450,000
Plant and machinery 40,000
–––––––––
490,000
Current assets
Inventory 83,650
Debtors 44,000
–––––––––
127,650
Current liabilities
Bank overdraft 56,780
Creditors 15,000
–––––––––
71,780
–––––––––
55,870
–––––––––
545,870
Non-current liabilities
Long-term loan 120,000
–––––––––
425,870
––––––––––––––––––
Capital 425,870
––––––––––––––––––
(d) There is no absolute answer to this question, of course. Feedback centres around
the following points:
1 The historical cost balance sheet (a) has the key merit of relative objectivity.
2 Historical cost is out of date, i.e. none of the figures represent the fair value
position at the balance sheet date, except by coincidence, even though the title
of the balance sheet says that they do.
3 The replacement cost balance sheet (b) is a current valuation.
4 There are, however, problems with the objective determination of the replacement
costs. These make the method both relatively subjective and relatively
expensive to implement.
5 It could be argued that the method rests on an assumption that assets will be
replaced with something similar. This may not be the case in times of changing
technologies and changing working methods.
6 The net realisable value use in balance sheet (c) is also a current method of
valuation, and preferable to historical cost on that ground.
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7 It has similar drawbacks to those of replacement cost, namely the difficulties of
objective determination and cost.
8 It has been objected that the use of realisable value implies the intention to liquidate
the organisation in the foreseeable future. This is probably even less supportable
than the automatic replacement assumption implicit in the use of the replacement
cost method.
Any decision on which balance sheet gives the most true and fair view should be justified
by reference to the above points. While there is no correct answer, note that the
IASB still effectively assumes historical cost. However, IAS 16 does allow for a move
towards replacement cost, or even deprival value, where historical cost is no longer
considered true and fair.
Chapter 3 The income statement
Question 1
Our answer starts with the calculation of closing inventory, i.e.:
5,000 + 2,000 – 3,000 = 4,000 units in inventory
Under FIFO, those sold are deemed to be from the first delivery, leaving 2,000 units at
£12, and the other 2,000 units therefore being from the delivery at £13. The closing
inventory valuation is therefore:
(2,000 × 12) + (2,000 × 13) = 50,000.
We can now calculate the cost of sales, being purchases less closing inventory – there
is no opening inventory to worry about in this case. The calculation is 531,946 –
50,000 = 481,946.
Next we need to allocate the expenses to their Companies Act categories. This is
best set out as a table.
Cost of sales Selling Administration
Cost of sales, as above 481,946
Wages 87,388 87,388 43,694
Transport 21,790 21,790 10,895
Rent and insurance 12,310 12,310 6,155
–––––––––– –––––––––– –––––––––
£603,434 £121,488 £60,744
–––––––––– –––––––––– ––––––––––––––––––– –––––––––– –––––––––
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Finally, we can put all the above together into our income statement, as follows:
ANARKHI LTD
INCOME STATEMENT
FOR THE YEAR ENDED 31 DECEMBER
Sales 794,062
Cost of sales 603,434
–––––––––
Gross profit 190,628
Selling and distribution expenses 121,488
–––––––––
Administration expenses 60,744
182,232
Net profit 8,396
Tax 3,900
–––––––––
Retained profit £4,496
––––––––––––––––––
Question 2
TAYSIDE GLASS LTD
INCOME STATEMENT
FOR THE YEAR ENDED 31 MARCH 20X9
Sales 80,007
Cost of sales:
Purchases 62,419
Less: closing inventory 4,200
––––––––
58,219
––––––––
Gross profit 21,788
Wages 9,650
Rent 4,600
Telephone 627
Light and heat 1,629
Office expenses 1,127
––––––––
17,633
––––––––
Net profit, transferred to reserves 4,155
––––––––––––––––
TAYSIDE GLASS LTD
BALANCE SHEET AT 31 MARCH 20X9
Non-current assets
Shop fittings 6,000
Delivery van 4,000
––––––––
10,000
Current assets
Inventory 4,200
Debtors 1,215
Bank 370
––––––––
5,785
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Current liabilities
Creditors 1,630
––––––––
4,155
––––––––
14,155
––––––––––––––––
Share capital 10,000
Reserves 4,155
––––––––
14,155
––––––––––––––––
Question 3
FIFO LIFO
Sales 575,200 575,200
Cost of sales
Opening inventory 11,000 11,000
Purchases 501,000 501,000
––––––––– –––––––––
512,000 512,000
Closing inventory
30 computers 18,000
at £600
30 computers 16,500
at £550 494,000 495,500
––––––––– ––––––––– ––––––––– –––––––––
81,200 79,700
––––––––– –––––––––––––––––– –––––––––
4 The arguments in favour of a receipts and payments account for the cricket club
would include;
᭤ Simplicity; it is a relatively easy statement to prepare
᭤ Understandability; being based solely on cash in and out it should be easier for
non-accountant members of the club to understand
᭤ Objectivity; it doesn’t rely on the estimates that are inherent in accruals accounting
The arguments in favour of using an income statement would include;
᭤ It arguably provides a more useful report since it takes into account events that
have not resulted in a cash flow in the current year, such as goods purchased for
fund raising activities but not yet paid for
᭤ Consistency with performance reports of most other organisations
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Chapter 4 Concepts and characteristics
Answers to Question 1–5
1 (b) 2 (d) 3 (b) 4 (c) 5 (d)
Question 6
1 The essay should start with a consideration of the stated purposes of the IASB. The
idea that the Board exists to establish and improve standards of financial accounting
and reporting is widely accepted.
2 The key question is how to achieve this. One major method is the publication of
accounting standards, that is, by specifying clear accounting practices.
3 Some consideration could be given to whether existing standards actually do this,
and, if not, why not.
4 One possible reason for perceived lack of clarity in the specification of accounting
standards is arguably the lack of general agreement on fundamental questions,
such as the purposes of financial accounting.
5 If this is accepted, then practical accounting standards can only be specified once
such underlying issues have been largely resolved. In other words, the theoretical
principles must be established in order to guide the determination of what practical
standards should be specified.
Question 7
UK French
Relevance Each company operates The question should be asked
differently and in a different relevant for whom? If we accept
environment. Accounts that the list of users in the
reflect this will be more relevant Framework then we note that
for users than those which many may not be financially
ignore such differences. literate, and the relative
simplicity of French accounting
will be an advantage.
Reliability The question should be asked Clear rules consistently applied
reliable for what? If we accept result in reliability.
decision making as the purpose
then it is necessary to prepare
accounts that reflect the real
differences between companies.
Comparability Accounts are arguably more Requiring all companies to
comparable if they have been prepare their accounts in the
prepared in the way most same way means that the user
appropriate for each company. can be sure that the same item
has been dealt with in exactly
the same way in different
companies’ accounts.
Understandability Attempting to reach a true and A single method leads to simpler
fair view may result in more accounts, which must result in
complex accounts, but they will more understandable accounts.
still be understandable if users
are financially literate.
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Question 8
1 The overall purpose of the Statement is to provide a coherent framework for the
determination of standard accounting practice.
2 The first part states the purposes of accounting as to aid decision making and also
to confirm the results of past activities. It also lists the legitimate users of financial
statements. The purpose is to define the aims of accounting, and so to set the general
direction for the following parts.
3 The second part deals with the qualitative characteristics of accounting, namely reliability,
relevance, comparability and understandability. It thus defines the hallmarks
of a ‘good’ set of financial statements.
4 The next part defines the ‘elements’ of financial accounting, thereby setting the
parameters of accounting. In other words, its purpose is to define the scope of
financial accounting. This complemented by recognition rules which limit recognition
of items in financial statements to those which both fall within the definitions of elements
and are capable of objective measurement.
5 Accordingly, the next part is concerned with valuation. It effectively focuses on deprival
value as the ideal, but the general purpose is more to provide a framework within
which decisions about the most appropriate valuation method can be decided.
6 Finally, the Framework explores the issue of capital maintenance, and the issue of
what we mean by ‘capital’ and the net worth of an organisation.
Chapter 5 The double-entry system
Question 1
CAPITAL ACCOUNT
30.4. Bal c/d £20,000 1.4. Bank £20,000
––––––––– –––––––––
1.5. Bal b/d 20,000
BANK ACCOUNT
1.4. Capital 20,000 1.4. Premises etc 17,000
12.4. Cash 1,305 2.4. Cash 500
17.4. A Britton 400 17.4. R Sevier 500
22.4. S Boatman 50 22.4. P Ocean 900
25.4. Cash 570 30.4. Bal c/d 3,425
––––––––– –––––––––
£22,325 £22,325
––––––––– –––––––––––––––––– –––––––––
1.5. Bal b/d 3,425
PREMISES ACCOUNT
1.4. Bank £8,000 30.4. Bal c/d £8,000
–––––––– –––––––––––––––– ––––––––
1.5. Bal b/d 8,000
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CASH ACCOUNT
2.4. Bank 500 2.4. Stationery 175
3.4. Sales 450 5.4. Wages 160
5.4. Sales 250 9.4. Sundries 80
9.4. Sales 340 12.4. Wages 160
12.4. Sales 340 12.4. Bank 1,305
18.4. Sales 550 18.4. Sundries 60
22.4. Sales 850 19.4. Wages 160
24.4. Wages 160
24.4. Sundries 50
24.4. Drawings 400
25.4. Bank 570
–––––––– ––––––––
£3,280 £3,280
–––––––– –––––––––––––––– ––––––––
DRAWINGS ACCOUNT
24.4. Cash £400 30.4. Bal c/d £400
–––––– –––––––––––– ––––––
1.5. Bal b/d 400
FIXTURES ACCOUNT
1.4. Cash £5,000 30.4. Bal c/d £5,000
–––––––– –––––––––––––––– ––––––––
1.5. Bal b/d 5,000
INVENTORY ACCOUNT
1.4. Bank £4,000 30.4. Income statement £4,000
––––––––– –––––––––
30.4. Income statement £3,500 30.4. Bal c/d £3,500
––––––––– –––––––––––––––––– –––––––––
1.5. Bal b/d 3,500
WAGES ACCOUNT
5.4. Cash 160
12.4. Cash 160
19.4 Cash 160
24.4. Cash 160 30.4. Income statement 640
–––––– ––––––
£640 £640
–––––– –––––––––––– ––––––
PURCHASES ACCOUNT
8.4. R Sevier 950
16.4. P Ocean 1,500 30.4. Income statement 2,450
–––––––– ––––––––
£2,450 £2,450
–––––––– –––––––––––––––– ––––––––
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STATIONERY AND SUNDRIES ACCOUNT
2.4. Cash 175
9.4. Cash 80
18.4. Cash 60
24.4. Cash 50 30.4. Income statement 365
–––––– ––––––
£365 £365
–––––– –––––––––––– ––––––
SALES ACCOUNT
3.4. Cash 450
4.4. A Britton 650
5.4. Cash 250
9.4. Cash 340
10.4 R Sewell 440
12.4. Cash 340
15.4. S Boatman 260
18.4. Cash 550
30.4. Income statement 4,130 22.4. Cash 850
–––––––– ––––––––
£4,130 £4,130
–––––––– –––––––––––––––– ––––––––
S BOATMAN ACCOUNT
15.4 Sales 260 22.4. Bank 50
30.4. Bal c/d 210
–––––– –––––––––––– ––––––
£260 £260
–––––– –––––––––––– ––––––
1.5. Bal b/d 210
P OCEAN ACCOUNT
22.4. Bank 900 16.4. Purchases 1,500
30.4. Bal c/d 600
––––––––– –––––––––
£1,500 £1,500
––––––––– –––––––––––––––––– –––––––––
1.5. Bal b/d 600
A BRITTON ACCOUNT
4.4. Sales 650 8.4. Returns 100
17.4. Bank 400
30.4. Bal c/d 150
–––––– ––––––
£650 £650
–––––– –––––––––––– ––––––
1.5. Bal b/d 150
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R SEVIER ACCOUNT
11.4. Returns 230 8.4. Purchases 950
17.4. Bank 500
30.4. Bal c/d 220
–––––– ––––––
£950 £950
–––––– –––––––––––– ––––––
1.5. Bal b/d 220
R SEWELL ACCOUNT
10.4. Sales £440 30.4. Bal c/d £440
–––––– –––––––––––– ––––––
1.5. Bal b/d 440
RETURNS INWARDS ACCOUNT
8.4. A Britton £100 30.4. Income statement £100
–––––– –––––––––––– ––––––
RETURNS OUTWARDS ACCOUNT
30.4. Income statement £230 11.4. R Sevier £230
–––––– –––––––––––– ––––––
TRIAL BALANCE AS AT 30.4.X1
Dr Cr
Capital 20,000
Premises 8,000
Fixtures 5,000
Inventory 4,000
Wages 640
Purchases 2,450
S Boatman 210
A Britton 150
P Ocean 600
Returns inwards 100
Returns outwards 230
Bank 3,425
Stationery 365
Sales 4,130
R Sevier 220
R Sewell 440
Drawings 400
––––––––– –––––––––
£25,180 £25,180
––––––––– –––––––––––––––––– –––––––––
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INCOME STATEMENT FOR THE MONTH ENDED 30.4.X1
£ £ £
Sales 4,130
Less returns inwards 100 4,030
–––––––
Opening inventory 4,000
Add purchases 2,450
Less returns outwards 230 2,220
––––––– –––––––
6,220
Less closing inventory 3,500 2,720
––––––– –––––––
Gross profit 1,310
Wages 640
Stationery 365 1,005
––––––– ––––––––––––––
Net profit £305
––––––––––––––
BALANCE SHEET AS AT 30.4.X1
Non-current assets
Premises 8,000
Fixtures 5,000 13,000
–––––––
Current assets
Inventory 3,500
Debtors: S Boatman 210
A Britton 150
R Sewell 440 800
–––––––
Bank 3,425
–––––––
7,725
Current liabilities
Creditors: P Ocean 600
R Sevier 220 820 6,905
––––––– ––––––– –––––––––
£19,905
––––––––––––––––––
Capital 20,000
Add net profit 305
Less drawings 400 (95)
––––––– –––––––––
£19,905
––––––––––––––––––
Question 2
CAPITAL ACCOUNT
5.6. Balance c/d 50,000 1.6. Bank 50,000
–––––––– ––––––––
6.6. Balance b/d 50,000
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BANK ACCOUNT
1.6. Capital 50,000 1.6. Premises etc. 25,000
5.6. Roberts 60 1.6. Furn & fitt 2,000
5.6. Cash 1,440 1.6. Purchases 10,000
2.6. Cash 400
5.6. Davids 250
5.6. Balance c/d 13,850
–––––––– ––––––––
51,500 51,500
–––––––– –––––––––––––––– ––––––––
6.6. Balance b/d 13,850
PREMISES ACCOUNT
1.6. Bank 19,000 5.6. Balance c/d 19,000
–––––––– ––––––––
6.6. Balance b/d 19,000
FURNITURE & FITTINGS ACCOUNT
1.6. Bank 6,000
1.6. Bank 2,000 5.6. Balance c/d 8,000
––––––– –––––––
8,000 8,000
––––––– –––––––––––––– –––––––
6.6. Balance b/d 8,000
PURCHASES ACCOUNT
1.6. Bank 10,000
3.6. Davids 600
5.6. Cash 250 5.6. Balance c/d 10,850
–––––––– ––––––––
10,850 10,850
–––––––– –––––––––––––––– ––––––––
6.6. Balance b/d 10,850 6.6. Income statement 10,850
CASH ACCOUNT
2.6. Bank 400 2.6. Sundries 90
2.6. Sales 300 4.6. Office 70
3.6. Sales 550 5.6. Purchases 250
4.6. Sales 400 5.6. Bank 1,440
5.6. Sales 200
–––––– ––––––
1,850 1,850
–––––– –––––––––––– ––––––
SUNDRIES ACCOUNT
2.6. Cash 90 5.6. Balance c/d 90
––– –––––– –––
6.6. Balance b/d 90 5.6. Income statement 90
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OFFICE ACCOUNT
4.6. Cash 70 5.6. Balance c/d 90
––– –––––– –––
6.6. Balance b/d 70 5.6. Income statement 70
SALES ACCOUNT
2.6. Cash 300
2.6. Roberts 100
3.6. Cash 550
4.6. Cash 400
4.6. Richards 350
5.6. Cash 200
5.6. Balance c/d 2,380 5.6. Martins 480
–––––––– ––––––––
2,380 2,380
–––––––– –––––––––––––––– ––––––––
6.6. Income statement 2,380 6.6. Balance b/d 2,380
ROBERTS DEBTOR ACCOUNT
2.6. Sales 100 6.6. Bank 60
5.6. Balance c/d 40
––––– –––––
100 100
––––– –––––––––– –––––
6.6. Balance b/d 40
RICHARDS DEBTOR ACCOUNT
4.6. Sales 350 5.6. Balance c/d 350
––––– –––––––––– –––––
6.6. Balance b/d 350
MARTINS DEBTOR ACCOUNT
5.6. Sales 480 5.6. Balance c/d 480
––––– –––––––––– –––––
6.6. Balance b/d 480
DAVIDS CREDITOR ACCOUNT
5.6. Bank 250 3.6. Purchases 600
5.6. Balance c/d 350
––––– –––––
600 600
––––– –––––––––– –––––
6.6. Balance b/d 350
INVENTORY ACCOUNT
5.6. Income statement 9,500
296 Financial Accounting
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TRIAL BALANCE AS AT 5.6.X1
Dr Cr
Capital 50,000
Bank 13,850
Premises 19,000
Furniture and fittings 8,000
Purchases 10,850
Sundries 90
Office 70
Sales 2,380
Roberts debtor 40
Richards debtor 350
Davids creditor 350
Martins debtor 480
–––––––– ––––––––
52,730 52,730
–––––––– –––––––––––––––– ––––––––
INCOME STATEMENT FOR THE WEEK ENDED 6.6.X1
Sales 2,380
Purchases 10,850
Inventory 9,500 1,350
–––––––– –––––––
Gross profit 1,030
Sundries 90
Office 70 160
–––––––– –––––––
Net profit 870
––––––––––––––
BALANCE SHEET AS AT WEEK ENDED 6.6.X1
Non-current assets
Premises 19,000
Furniture and fittings 8,000 27,000
––––––––
Current assets
Inventory 9,500
Debtors: Roberts 40
Richards 350
Martins 480 870
–––––
Bank 13,850
––––––––
24,220
Current liabilities
Davids creditor 350 23,870
–––––––– ––––––––
50,870
––––––––––––––––
Capital 50,000
Profit 870
––––––––
50,870
––––––––––––––––
Appendix: Answers to self-assessment questions 297
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Question 3
To maintain orderly recording of all business transactions in such a way that errors (but
not all of them) are avoided. To enable the extraction at a point in time of balances to
identify the position of the business.
Question 4
The double entry system of accounting is based on the concept of DUALITY.
Question 5
ASSETS = CAPITAL + LIABILITIES
Question 6
An asset or expense.
A credit balance b/d is a liability, income or capital.
Question 7
The trial balance checks that the system has been correctly maintained in that for
every debit an equal and opposite credit entry has been made and that accounts have
been added correctly.
Question 8
Similar question to Activity 5.11 but well worth the revision.
᭤ an entry completely missing
᭤ an entry in the wrong account
᭤ errors that cancel
᭤ transposed debit and credit entries.
Question 9
INCOME STATEMENT FOR NARN FOR THE YEAR ENDED 31 MARCH 200X
£ £
Sales 79,000
Opening inventory 2,700
Purchases 32,000
––––––––
34,700
Closing inventory 4,200 30,500
–––––––– ––––––––
Gross profit 48,500
Salaries and wages 15,600
Heating and lighting 3,600
Motor expenses 4,500
Rent 10,400
Other expenses 2,300 36,400
–––––––– ––––––––
Net profit 12,100
––––––––––––––––
298 Financial Accounting
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BALANCE SHEET FOR NARN AS AT 31 MARCH 200X
£ £
Non-current assets
Fixtures and fittings 5,600
Vehicles 10,900 16,500
–––––––– ––––––––
Current assets
Inventory 4,200
Debtors 6,600
Bank and cash 5,500
––––––––
16,300
Current liabilities
Creditors 5,700 10,600
–––––––– ––––––––
Total net assets 27,100
––––––––––––––––
Capital injection by Narn 15,000
Net profit 12,100 27,100
–––––––– –––––––––––––––– ––––––––
Question 10
CORRECTED TRIAL BALANCE FOR NARN 31 MARCH 200X
£ £
Sales (79,000 +900) 79,900
Purchases 32,000
Inventory 2,700
Salaries and wages 15,600
Heating and lighting 3,600
Rent 10,400
Other expenses (2,300 + 450) 2,750
Fixtures and fittings 5,600
Vehicles 10,900
Motor expenses 4,500
Debtors (6,600 + 900) 7,500
Creditors 5,700
Capital injection 15,000
Bank and cash (5,500 – 225 – 225) 5,050
––––––––– –––––––––
100,600 100,600
––––––––– –––––––––––––––––– –––––––––
Appendix: Answers to self-assessment questions 299
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INCOME STATEMENT FOR NARN FOR THE YEAR ENDED 31 MARCH 200X
£ £
Sales 79,900
Opening inventory 2,700
Purchases 32,000
––––––––
34,700
Closing inventory 4,200 30,500
–––––––– ––––––––
Gross profit 49,400
Salaries and wages 15,600
Heating and lighting 3,600
Motor expenses 4,500
Rent 10,400
Other expenses 2,750 36,850
–––––––– ––––––––
Net profit 12,550
––––––––––––––––
BALANCE SHEET FOR NARN AS AT 31 MARCH 200X
£ £
Non-current assets
Fixtures and fittings 5,600
Vehicles 10,900 16,500
––––––––
Current assets
Inventory 4,200
Debtors 7,500
Bank and cash 5,050
––––––––
16,750
Current liabilities
Creditors 5,700 11,050
–––––––– ––––––––
Total net assets 27,550
––––––––
Capital injection by Narn 15,000
Net profit 12,550 27,550
–––––––– ––––––––––––––––
Chapter 6 Adjustments, including entries in ledger accounts
Question 1
STATIONERY ACCOUNT
X5 Cash 450
31.12.X5 Bal c/d 50 31.12.X5 Income statement 500
–––––– ––––––
£500 £500
–––––– –––––––––––– ––––––
1.1.X6 Bal b/d 50
300 Financial Accounting
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INSURANCE ACCOUNT
X5 Cash 600 31.12.X5 Income statement 300
31.12.X5 Bal c/d 300
–––––– ––––––
£600 £600
–––––– –––––––––––– ––––––
1.1.X6 Bal b/d 300
MOTOR EXPENSES ACCOUNT
X5 Cash 550 1.1.X4 Bal b/d 70
31.12.X5 Bal c/d 90 31.12.X5 Income statement 570
–––––– ––––––
£640 £640
–––––– –––––––––––– ––––––
1.1.X6 Bal b/d 90
RENTS PAID ACCOUNT
1.1.X5 Bal b/d 600 31.12.X5 Income statement 1,350
X5 Cash 1,500 31.12.X5 Bal c/d 750
–––––––– ––––––––
£2,100 £2,100
–––––––– –––––––––––––––– ––––––––
1.1.X6 Bal b/d 750
RENTS RECEIVABLE ACCOUNT
31.12.X5 Income statement 600 X5 Cash 500
31.12.X5 Bal c/d 100
–––––– ––––––
£600 £600
–––––– –––––––––––– ––––––
1.1.X6 Bal b/d 100
Question 2
(a) False. An accrued expense will increase the charge for expenses to the income
statement so if it is ignored the profit will be overstated.
(b) True. An accrued expense brought forward from a previous period will reduce the
charge to the income statement in the current year so if this is ignored the charge
will be increased and profit understated.
(c) False. An accrued expense has not been paid but has been used up in generating
revenue.
(d) True. Refer to rents paid above.
(e) True. Refer to stationery above.
(f) False. An accrued expense has not been paid therefore is a liability.
(g) True. This is income due in the period and therefore a form of debtor.
Appendix: Answers to self-assessment questions 301
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Question 3
Matching.
Question 4
Office expenses accrue £75, income statement charge £1,500.
Rents prepaid £1,200, income statement charge £3,600. Students may well ask
where the charge is for the period 1 January 20X5 to 31 March 20X5. This should
have been identified as a prepayment of the previous period.
Sales accrue £2,500 = income statement charge. Raise a debtor of £2,500 also.
Of the insurance payment of £3,600, £900 relates to the previous period £2,700 to
this. Accrue £990 for the period 30 September to 31 December. Charge to income
statement £3,690.
Question 5
Reliability. This is to ensure that assets – debtors – are not overstated in the balance
sheet.
Question 6
False. There is still a possibility that further debts could turn bad.
Question 7
BAD DEBTS ACCOUNT
A Bloggs 780
B Swift 320
P Trent 750 Income statement 1,850
–––––––– ––––––––
£1,850 £1,850
–––––––– –––––––––––––––– ––––––––
PROVISION FOR BAD DEBTS ACCOUNT
Balance b/d 2,100
Income statement 495
Balance c/d 2,595
––––––– –––––––
2,595 2,595
––––––– –––––––––––––– –––––––
Balance b/d 2,595
302 Financial Accounting
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Calculation of required provision:
£
Debtors 54,500
Bad debts written off 1,850
––––––––
52,650
Less: Debt to be paid 750
––––––––
51,900
––––––––
Provision at 5% 2,595
Balance sheet extract:
£ £
Debtors 52,650
Less: Provision 2,595 50,055
––––––––
Question 8
Bad debts to be written off £450 + £650 + £216 = £1,316
Debtors figure after write-off £45,680 – £1,316 = £44,364 but £24 requires no further
provision for bad debt therefore provision for bad debt is calculated as
(£44,364 – £24) * 4% = £1,774
Charge to income statement bad debts £1,316, provision for bad debts £1,774
Debtors balance £42,590.
Question 9
Cost of the asset, estimate of useful life to the business, estimate of residual value at
the end of that useful life at current prices, assessment of method of use of asset
in the business.
Question 10
(a) False. Depreciation is the measure of the use of the asset in generating revenues.
This may or may not equate to net realisable value.
(b) True.
(c) False. They may use the asset differently therefore the method will be different
and also residual value and estimated life may be different.
(d) False. The method used should equate to how the asset is used, not the type of
asset. However, in many businesses vehicles are depreciated by reducing balance
and buildings by straight line.
(e) True.
(f) True. Depreciation is an expense so if omitted expenses will be understated and
therefore profit overstated.
Question 11
BUILDINGS ACCOUNT
1.1.X0 Bank £60,000 31.12.X0 Bal c/d £60,000
––––––––– –––––––––––––––––– –––––––––
1.1.X1 Bal b/d £60,000 31.12.X1 Bal c/d £60,000
––––––––– –––––––––––––––––– –––––––––
1.1.X2 Bal b/d £60,000 31.12.X2 Bal c/d £60,000
––––––––– –––––––––––––––––– –––––––––
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VEHICLES ACCOUNT
1.1.X0 Bank £12,000 31.12.X0 Bal c/d £12,000
––––––––– –––––––––––––––––– –––––––––
1.1.X1 Bal b/d £12,000 31.12.X1 Bal c/d £12,000
––––––––– –––––––––––––––––– –––––––––
1.1.X2 Bal b/d £12,000 1.12.X2 Sale £12,000
––––––––– –––––––––––––––––– –––––––––
EQUIPMENT ACCOUNT
1.1.X0 Bank £9,000 31.12.X0 Bal c/d £9,000
–––––––– –––––––––––––––– ––––––––
1.1.X1 Bal b/d £9,000 31.12.X1 Bal c/d £9,000
–––––––– –––––––––––––––– ––––––––
1.1.X2 Bal b/d 9,000 1.1.X2 Sale 1,500
31.12.X2 Bal c/d 7,500
–––––––– ––––––––
£9,000 £9,000
–––––––– –––––––––––––––– ––––––––
PROVISION FOR DEPRECIATION OF BUILDINGS ACCOUNT
31.12.X0 Bal c/d £1,000 31.12.X0 Income statement £1,000
–––––––– ––––––––
1.1.X0 Bal b/d 1,000
31.12.X1 Bal c/d 2,000 31.12.X1 Income statement 1,000
–––––––– ––––––––
£2,000 £2,000
–––––––– –––––––––––––––– ––––––––
1.1.X2 Bal b/d 2,000
31.12.X2 Bal c/d 3,000 31.12.X2 Income statement 1,000
–––––––– ––––––––
£3,000 £3,000
–––––––– –––––––––––––––– ––––––––
PROVISION FOR DEPRECIATION OF VEHICLES ACCOUNT
31.12.X0 Bal c/d £3,000 31.12.X0 Income statement £3,000
–––––––– –––––––––––––––– ––––––––
1.1.X1 Bal b/d 3,000
31.12.X1 Bal c/d 5,250 31.12.X1 Income statement 2,250
–––––––– ––––––––
£5,250 £5,250
–––––––– –––––––––––––––– ––––––––
1.12.X2 Sale 5,250 1.1.X2 Bal b/d 5,250
–––––––– –––––––––––––––– ––––––––
PROVISION FOR DEPRECIATION OF EQUIPMENT ACCOUNT
31.12.X0 Bal c/d £820 31.12.X0 Income statement £820
–––––––– –––––––––––––––– ––––––––
1.1.X1 Bal b/d 820
31.12.X1 Bal c/d 1,640 31.12.X1 Income statement 820
–––––––– ––––––––
£1,640 £1,640
–––––––– –––––––––––––––– ––––––––
1.12.X2 Sale 280 1.1.X2 Bal b/d 1,640
31.12.X2 Bal c/d 2,040 31.12.X2 Income statement 680
–––––––– ––––––––
£2,320 £2,320
–––––––– –––––––––––––––– ––––––––
304 Financial Accounting
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SALE OF VEHICLES ACCOUNT
1.12.X2 Asset 12,000 1.12.X2 Cash 6,500
1.12.X2 Depreciation 5,250
31.12.X2 Income statement 250
––––––––– –––––––––
£12,000 £12,000
––––––––– –––––––––––––––––– –––––––––
SALE OF EQUIPMENT ACCOUNT
1.12.X2 Asset 1,500 1.12.X2 Cash 1,200
1.12.X2 Depreciation 280
31.12.X2 Income statement 20
–––––––– ––––––––
£1,500 £1,500
–––––––– –––––––––––––––– ––––––––
INCOME STATEMENT FOR THE YEAR ENDED 31.12.X2
£
Depreciation of buildings 1,000
Depreciation of equipment 680
Loss on sale of vehicles 250
Loss on sale of equipment 20
BALANCE SHEET AS AT 31.12.X2
Cost Depreciation Net book value
Buildings 60,000 3,000 57,000
Equipment 7,500 2,040 5,460
––––––––– ––––––– –––––––––
£67,500 £5,040 £62,460
––––––––– ––––––– –––––––––––––––––– ––––––– –––––––––
Question 12
WORKINGS
Fixture and fittings
As at 1.10.X5 these are three years old therefore depreciation provided as at this date is
3 * (25,000 – 1,800)/8 = 8,700
The new fixtures and fittings will be depreciated by 15,200/8 = 1,900 per annum.
Therefore depreciation charge for the year ended 30.9.X6 and for 30.9.X7 is 4,800.
Vehicles
The van as at 1.10.X5 is three years old and depreciation charges of:
᭤ Year 1: 4,000, net book value 12,000
᭤ Year 2: 3,000, net book value 9,000
᭤ Year 3: 2,250, net book value 6,750
will have been made.
The depreciation charge for year ended 30.9.X6 will be £1,688 and net book value at
this date will be £5,062.
Appendix: Answers to self-assessment questions 305
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In December the van is destroyed and £3,200 received in settlement – this can be
treated as a sale and thus loss on disposal is £1,862.
The new van will require depreciation of £4,625 in the year ended 30.9.X7.
FIXTURES AND FITTINGS
1.10.X5 Balance b/d 25,000
1.11.X5 Bank 15,200 30.9.X6 Balance c/d 40,200
–––––––– ––––––––
40,200 40,200
–––––––– –––––––––––––––– ––––––––
1.10.X6 Balance b/d 40,200 30.9.X7 Balance c/d 40,200
–––––––– –––––––––––––––– ––––––––
VEHICLES
1.10.X5 Balance b/d 16,000 30.9.X6 Balance c/d 16,000
–––––––– –––––––––––––––– ––––––––
1.10.X6 Balance b/d 16,000 31.12.X6 Disposal 16,000
–––––––– –––––––––––––––– ––––––––
5.1.X7 Bank 18,500 30.9.X7 Balance c/d 18,500
–––––––– –––––––––––––––– ––––––––
1.10.X7 Balance b/d 18,500
DISPOSAL OF VEHICLE ACCOUNT
31.12.X6 Vehicle 16,000 31.12.X6 Bank 3,200
31.12.X6 Depreciation 10,938
30.9.X7 Loss on disposal 1,862
–––––––– ––––––––
16,000 16,000
–––––––– –––––––––––––––– ––––––––
PROVISION FOR DEPRECIATION F&F
30.9.X6 Balance c/d 13,500 1.10.X5 Balance b/d 8,700
30.9.X6 IS 4,800
–––––––– ––––––––
13,500 13,500
–––––––– –––––––––––––––– ––––––––
1.10.X6 Balance b/d 13,500
30.9.X7 Balance c/d 18,300 30.9.X7 IS 4,800
–––––––– ––––––––
18,300 18,300
–––––––– –––––––––––––––– ––––––––
1/10/X7 Balance b/d 18,300
PROVISION FOR DEPRECIATION VEHICLES
1.10.X5 Balance b/d 9,250
30.9.X6 Balance c/d 10,938 30.9.X6 IS 1,688
–––––––– ––––––––
10,938 10,938
–––––––– –––––––––––––––– ––––––––
31.12.X6 Disposal 10,938 1.10.X6 Balance b/d 10,938
30.9.X7 Balance c/d 4,625 30.9.X7 IS 4,625
–––––––– ––––––––
15,563 15,563
–––––––– –––––––––––––––– ––––––––
1.10.X7 Balance b/d 4,625
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EXTRACT BALANCE SHEET AS AT 30.9.X6
Cost Depreciation NBV
Fixtures and fittings 40,200 13,500 26,700
Vehicles 16,000 10,938 5,062
EXTRACT BALANCE SHEET AS AT 30.9.X7
Fixtures and fittings 40,200 18,300 21,900
Vehicles 18,500 4,625 13,875
Question 13
An assessment of the amount of an asset used up in generation of revenue for a given
period.
Question 14
Cost, residual value, useful life to the business, method of usage (i.e. equal amount
each period or some other method of usage).
Question 15
Depreciation charges are as follows:
31 December 20X0 buildings £4,000, equipment £8,000 and vehicles £11,000
31 December 20X1 buildings £4,000, equipment £7,200 and vehicles £9,900.
From the information given buildings should be depreciated on a straight line basis as
follows:
400,000 – 250,000
–––––––––––––––––– = 5,250, i.e. 1.3%
40
Equipment percentage depreciation is calculated from the following:
1 – 8/1,000
––––––––––– = 42%
80,000
and vehicles
1 – 6/6,000
––––––––––– = 38%
110,000
Black is underestimating the depreciation charges.
Question 16
ADJUSTED INCOME STATEMENT TOSUSO YEAR ENDED 31.12.200X
£ £
Unadjusted profit 10,870
Depreciation (54,000 – 5,400)/10 4,860
Bad debts 6,700
Provision for bad debts (63,000 – 6,700) * 5% – 3,000 (185)
Electricity accrual 1,500
Prepayment of rent (4,500) 8,375
–––––––
Adjusted profit 2,495
––––––––––––––
Appendix: Answers to self-assessment questions 307
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Chapter 7 Preparation of income statement and balance
sheet from trial balance and adjustments
Question 1
INCOME STATEMENT FOR THE YEAR ENDED 31.12.X5 FOR RODNEY
Sales 71,230
Opening inventory 4,340
Purchases 29,760
––––––––
34,100
Less closing inventory 4,870 29,230
–––––––– ––––––––
Gross profit 42,000
Rates 800
Heat and light 2,770
General expenses 2,420
Motor expenses 3,240
Wages 8,250
Bad debts 360
Depreciation: Premises 600
Fixtures and fittings 800
Vehicles 1,320
Provision for bad debts 40
Loan interest 600 21,200
–––––––– –––––––––
Net profit £20,800
––––––––––––––––––
BALANCE SHEET AS AT 31.12.X5 FOR RODNEY
Cost Depreciation Net book
value
Non-current assets
Premises 30,000 3,000 27,000
Fixtures and fittings 8,000 2,400 5,600
Vehicles 12,000 6,720 5,280
–––––––– –––––––– –––––––––
50,000 12,120 37,880
–––––––– –––––––––––––––– ––––––––
Current assets
Inventory 4,870
Debtors 6,400
Less bad debts provision 320 6,080
––––––––
Bank 820
––––––––
11,770
Current liabilities
Creditors 5,210
Accruals 800 6,010 5,760
–––––––– –––––––– –––––––––
43,640
308 Financial Accounting
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Non-current liabilities
Loan 12,000
–––––––––
£31,640
––––––––––––––––––
Capital 15,500
Add net profit 20,800
Less drawings 4,660 16,140
–––––––– –––––––––
£31,640
––––––––––––––––––
Workings
1 The following adjustments are required to the trial balance as given:
£ £
Debit heat and light account 120
Credit accruals account 120
Debit expenses account 80
Credit accruals account 80
Debit loan interest account 600
Credit accruals account 600
2 The depreciation charges are calculated as follows:
Premises £30,000 × 2% = £600
Fixtures and fittings £8,000 × 10% = £800
Vehicles £(12,000 – 5,400) × 20% = £1,320
3 The adjustment for bad debts is as follows:
Debit bad debts account 130
Credit debtors account 130
The debtors balance now becomes:
£6,530 – 130 = £6,400
The provision for bad debts is required to be set at:
5% × £6,400 = £320
The provision already in the trial balance is £280 therefore an additional provision of
£40 is required.
Appendix: Answers to self-assessment questions 309
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Question 2
INCOME STATEMENT FOR THE YEAR ENDED 31.12.X9 FOR ATEC
£ £
Sales 53,500
Opening inventory 5,400
Purchases 29,200
––––––––
34,600
Closing inventory 6,200 28,400
–––––––– ––––––––
Gross profit 25,100
Rents receivable 600
Profit on sale of asset 12,100
––––––––
37,800
Other expenses 120
Electricity 930
Salaries and wages 12,330
Rates 600
Telephone 370
Office expenses 150
Provision for depreciation premises 300
equipment 1,200
vehicles 2,250
new vehicles 1,250
Bad debts 120
Provision for bad debts 4 19,624
–––––––– ––––––––
Net profit 18,176
––––––––––––––––
BALANCE SHEETS AS AT 31.12.X9 ATEC
Non-current assets Cost Depreciation Net book
value
Premises 15,000 2,400 12,600
Equipment 12,000 9,600 2,400
Vehicles 17,000 6,500 10,500
–––––––– –––––––– ––––––––
44,000 18,500 25,500
–––––––– –––––––––––––––– ––––––––
Current assets
Inventory 6,200
Debtors 4,680
Provision for bad debts 94 4,586
––––––––
Rents 50
Cash 90
––––––––
10,926
310 Financial Accounting
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Current liabilities
Creditors 5,200
Accruals 550
Bank 2,000 7,750 3,176
–––––––– –––––––– ––––––––
28,676
––––––––––––––––
Capital 21,500
Profit 18,176
Drawings 11,000 7,176
–––––––– ––––––––
28,676
––––––––––––––––
Workings
Premises
The trial balance figure for depreciation of £4,200 implies a useful life of 50 years (i.e.
30,000/50 × 7 years)
Premises left after sale cost £15,000 thus depreciation for the year is £300.
Premises sold cost £15,000
Dep. £2,100
–––––––––
NBV £12,900
Price £25,000
–––––––––
Profit £12,100
––––––––––––––––––
Equipment
The trial balance figure for depreciation implies a useful life of 10 years (i.e.
12,000/10 × 7).
Thus depreciation for the year is £1,200.
Vehicles
These were bought a year ago and NBV at 1.1.X9 is £9,000. Depreciation is calculated
at the rate of 25% reducing balance, thus current year charge is £9,000 × 25%
= £2,250.
The van bought 1.2.X9 needs to be recorded as an asset of the business not a
charge against drawings. Using 25% reducing balance as depreciation policy gives a
charge for this asset for the current year of £1,250.
Chapter 8 Accounts of limited companies
Question 1
Sole trader Company
(a) No Yes – Companies Acts
(b) The sole trader The shareholders
(c) The sole trader The directors appointed by the shareholders
(d) No Yes
(e) Yes No
(f) No Yes
(g) Drawings Dividends
(h) No Possible if a plc
Appendix: Answers to self-assessment questions 311
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Question 2
Options available:
(a) issue of further share capital either ordinary or preference.
(b) issue of long-term loans for example debentures.
The company would probably find it relatively easy to raise further capital by the issue
of debentures given there are no long-term loans in existence.
Question 2
(a) Par value is £1.
(b) Book value is 37/20 = £1.85.
(c) Interest payable on the debentures is 5% that is £400,000.
(d) Lower.
Question 4
CUDDLY TOY LTD PUBLISHED INCOME STATEMENT FOR THE YEAR ENDED
31.12.X5
£000
––––––––––
Turnover 1,562
Cost of sales 1,005.8
––––––––––
Gross profit 556.2
Distribution expenses 114.65
(98 + 4.9 + 11.75)
Administration expenses (24 + 4.9) 28.9 143.55
–––––––––––– ––––––––––
Operating profit 412.65
Interest 21
––––––––––
Profit before taxation 391.65
Taxation 200
––––––––––
Profit after taxation 191.65
Interim dividends 54
––––––––––
Retained profits for the year 137.65
Retained profits b/f 185
––––––––––
£322.65
–––––––––
Cost of sales calculation:
Opening inventory 660
Purchases 885
––––––––––––
1,545
Less closing inventory 560
––––––––––––
985
Depreciation: Equipment 11
Premises 9.8 20.8
–––––––––––– ––––––––––––
£1,005.8
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BALANCE SHEET AS AT 31.12.X5
£000 £000 £000
Cost Depreciation Net book
value
Non-current assets
Land 1,010 1,010
Buildings 980 409.6 570.4
Equipment 55 29 26
Vehicles 72 36.75 35.25
–––––––– –––––––––– –––––––––––
£2,117 £475.55 £1,641.65
–––––––– –––––––––––––––––– ––––––––––
Current assets
Inventory 560
Debtors 180
Bank 121
––––––––––
861
Current liabilities
Creditors 235
Taxation 200
Debenture interest 21
Interim dividends 54 510 351
–––––––– –––––––––– –––––––––––
Total assets less 1,992.65
current liabilities
Non-current liabilities
5% debentures 420
–––––––––––
£1,572.65
––––––––––––––––––––––
Capital and reserves
Ordinary £1 shares 900
Share premium 350
Retained profits 322.65
–––––––––––
£1,572.65
––––––––––––––––––––––
Appendix: Answers to self-assessment questions 313
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Question 5
GERRY LTD INCOME STATEMENT FOR THE YEAR ENDED 31.3.X6
Sales 271,700
Opening inventory 14,167
Purchases 186,000
––––––––
200,167
Closing inventory 23,483
––––––––
Cost of sales 176,684
––––––––
Gross profit 95,016
Depreciation 21,000
Provision for bad debts 226
General expenses 16,352
(1,5840 + 1,437 – 925)
Wages and salaries 31,862 69,440
–––––––– ––––––––
25,576
Debenture interest 2,400
––––––––
Net profit before taxation 23,176
Taxation 9,700
––––––––
Net profit after taxation 13,476
Dividends: Preference paid 1,200
1,200
–––––––– ––––––––
Retained profit for the year 12,276
Retained profit b/f 976
––––––––
13,252
Transfer to general reserve 3,000
––––––––
Retained profit c/f £10,252
––––––––––––––––
BALANCE SHEET AS AT 31.3.X6
Cost Depreciation Net book
value
Non-current assets 210,000 40,000 170,000
–––––––– ––––––––
Current assets
Inventory 23,483
Debtors 10,450
Prepayments 925
Bank 9,731
––––––––
44,589
Current liabilities
Creditors 7,500
Accruals 2,637
Taxation 9,700 19,837 24,752
–––––––– –––––––– ––––––––
194,752
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Non-current liabilities
8% debentures 30,000
––––––––––
£164,752
––––––––––
Capital and reserves
Ordinary shares of £1 100,000
6% preference shares 20,000
Share premium 9,500
Revaluation reserve 10,000
General reserve 15,000
Retained profit 10,252
––––––––––
£164,752
––––––––––––––––––––
Question 6
HOBO LTD: INCOME STATEMENT FOR THE YEAR ENDED 30.9.X6
Turnover 623,300
Cost of sales 459,675
––––––––––
Gross profit 163,625
Distribution expenses 56,635
Administration expenses 44,038 100,673
––––––––– ––––––––––
Operating profit 62,952
Interest 6,650
––––––––––
Profit before taxation 56,302
Taxation 22,680
––––––––––
Profit after taxation 33,622
Retained profit b/f 1.10.X5 26,000
––––––––––
£59,622
––––––––––––––––––––
Calculations
Cost of sales:
Opening inventory 18,950
Purchases 426,500
––––––––––
445,450
Less: Closing inventory 20,650
––––––––––
424,800
Production wages 32,900
Depreciation: Buildings 1,375
Equipment 600 34,875
––––––––– ––––––––––
£459,675
––––––––––––––––––––
Distribution expenses:
Warehouse wages 30,200
Delivery expenses 22,060
Depreciation buildings 1,375
Equipment 600
Vehicles 2,400
––––––––––
£56,635
––––––––––––––––––––
Appendix: Answers to self-assessment questions 315
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Administration expenses:
Audit fee 1,200
Bad debts 5,320
Provision of bad debts 4,618
Salaries 15,200
Rents 12,100
Other 5,600
–––––––––
£44,038
––––––––––––––––––
BALANCE SHEET AS AT 30.9.X6
Cost Depreciation Net book
value
Non-current assets
Premises 275,000 6,500 268,500
Equipment 12,000 4,800 7,200
Vehicles 18,500 8,900 9,600
–––––––––– –––––––––– ––––––––––
305,500 20,200 285,300
–––––––––– –––––––––––––––––––– ––––––––––
Current assets
Inventory 20,650
Debtors 87,742
Prepayments 500
Bank 51,810
––––––––––
160,702
Current liabilities
Creditors 111,450
Taxation 22,680
Debenture interest 6,650
Accruals 600 141,380 20,678
–––––––––– –––––––––– ––––––––––
Total assets less current 304,622
liabilities
Non-current liabilities
7% debentures 95,000
––––––––––
£209,622
––––––––––––––––––––
Capital and reserves
Ordinary 50p shares 100,000
Share premium 50,000
Retained profits 59,622
––––––––––
£209,622
––––––––––––––––––––
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Question 7
Workings
Production expenses Distribution expenses
Opening inventory 6,230 Warehouse wages 10,100
Purchases 15,260 Warehouse expenses 950
––––––––
21,490 Depreciation premises 1,000
Closing inventory 4,560 equipment 1,250
––––––––
16,930 vehicles 1,126
––––––––Production wages 12,320 14,426
––––––––––––––––Production expenses 7,210
Depreciation premises 2,000 Administration expenses
equipment 2,500 Debenture discount 500
––––––––
40,960 Provision for bad debts 412
–––––––––––––––– Administration salaries 14,200
Administration expenses 950
Depreciation calculations: Depreciation premises 1,000
premises equipment 1,250
––––––––
200,000 * 2% = 4,000 18,312
––––––––––––––––equipment
50,000 * 10% = 5,000
vehicle 4,503 * 25% = 1,126
Vehicle sale Cost Depreciation NBV
Balance 15,000 6,560 8,440
Sale 7,000 3,063 3,937
–––––––– –––––––– ––––––––
Balance 8,000 3,497 4,503
–––––––– –––––––– –––––––––––––––– –––––––– ––––––––
BURN LTD PUBLISHED INCOME STATEMENT FOR THE YEAR ENDED 31.12.X9
Sales 79,710
Production costs 40,960
––––––––
Gross profit 38,750
Distribution expenses 14,426
Administration expenses 18,312 32,738
–––––––– ––––––––
Operating profit 6,012
Loss on sale of vehicle 187
––––––––
Profit before interest and taxation 5,825
Interest 6% debentures 3,000
5% debentures 500 3,500
–––––––– ––––––––
Profit before tax 2,325
Taxation 1,200
––––––––
Profit after tax 1,125
Retained profits b/f (62,000 – 9,500) 52,500
––––––––––––––––
Retained profits c/f 53,625
––––––––––––––––
Appendix: Answers to self-assessment questions 317
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BURN LTD PUBLISHED BALANCE SHEET AS AT 31.12.X9
Non-current assets Cost Depreciation NBV
Premises 200,000 24,000 176,000
Equipment 50,000 20,000 30,000
Vehicles 8,000 4,623 3,377
––––––––– ––––––––– –––––––––
25,800 48,623 209,377
––––––––– –––––––––––––––––– –––––––––
Current assets
Inventory 4,560
Debtors 8,240
Provision bad debts 412 7,828
–––––––––
Bank 103,520
Cash 250
–––––––––
116,158
Current liabilities
Creditors 7,210
Debenture interest 3,500
Taxation 1,200 11,910 90,248
––––––––– ––––––––– –––––––––
313,625
Total assets less current liabilities
Non-current liabilities
6% debentures 50,000
5% debentures 10,000 60,000
––––––––– –––––––––
253,625
––––––––––––––––––
Capital and reserves
Ordinary shares £1 140,000
Share premium 60,000
Retained profits 53,625
–––––––––
253,625
––––––––––––––––––
Question 8
BLACK LTD INCOME STATEMENT FOR THE YEAR ENDED 31.12.20X5
Sales 537,600
Less returns inwards 2,450
–––––––––
535,150
Opening inventory 22,300
Purchases 321,700
–––––––––
344,000
Less returns outwards 4,670
–––––––––
339,330
Less closing inventory 22,000
–––––––––
317,330
Production wages 74,000
Depreciation 5,500 396,830
––––––––– –––––––––
Gross profit 138,320
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Distribution expenses 41,708
Administration expenses 80,670
Profit on sale (3,000) 119,378
––––––––– –––––––––
Profit before interest 18,942
Interest on debentures 3,000
–––––––––
Profit before tax 15,942
Taxation 9,860
–––––––––
Profit after tax 6,082
Retained profits b/f 9,870
–––––––––
Retained profits c/f 15,952
––––––––––––––––––
BLACK LTD BALANCE SHEET AS AT 31.12.20X5
Non-current assets Cost Depreciation NBV
Premises 150,000 13,100 136,900
Equipment 50,000 29,500 20,500
Vehicles 85,000 43,188 41,812
––––––––– ––––––––– –––––––––
285,000 85,788 199,212
––––––––– –––––––––––––––––– –––––––––
Current assets
Inventory 22,000
Debtors 41,990
Prepayments 5,600
–––––––––
69,590
Current liabilities
Creditors 34,200
Debenture interest 3,000
Accruals 3,500
Bank overdraft 2,290
Taxation 9,860 52,850 16,740
––––––––– ––––––––– –––––––––
215,952
Total assets less current liabilities
Non-current liabilities
Debentures 50,000 50,000
––––––––– –––––––––
165,952
––––––––––––––––––
Capital and reserves
Ordinary shares £1 150,000
Retained profits 15,952
–––––––––
165,952
––––––––––––––––––
Appendix: Answers to self-assessment questions 319
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Question 9
Rights issue is a pro-rata issue of shares to current shareholders at a value below
market value of the shares. Cash is brought into the company from the rights issue.
Bonus issue is a pro-rata issue of shares to current shareholders which is free and
capitalises existing reserves. No extra cash is brought into the company.
Question 10
GAMMA EXTRACT FROM BALANCE SHEET AS AT 31.12.X6
£
Ordinary share capital (1,000,000 + 400,000 RI + 400,000 BI) 1,800,000
Share premium (RI 200,000* £2.25) 450,000
Accumulated profits (456,000 – 40,000 BI) 56,000
–––––––––––
2,306,000
––––––––––––––––––––––
Net assets before share issues was 1,456,000
Cash raised from rights issue 200000*4.25 = 850,000
–––––––––––
Net assets after share issues 2,306,000
––––––––––––––––––––––
Chapter 9 Cash flow statements
Question 1
Cash flow statements identify net cash inflows from operations, net cash inflows from
investments in non-current assets, net flows from financing activities and payments in
respect of interest, dividends and taxation. None of these are identifiable from the
income statement or balance sheet.
It also identifies the extent to which reported profit is matched by cash flows. Thus
the distinction between profit and cash flow is clearly made. The user of the statement
has more relevant information on which to assess the solvency of the business.
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Question 2
Reconciliation of operating profit and net cash flows from operating activities:
£000
Net profit for the year before tax 158
Add interest charged 12
–––––
Net profit before interest and tax 170
Amortisation 15
Depreciation 187
Profit on sale (45)
–––––
157
–––––
327
Increase in inventory (26)
Increase in debtors (58)
Increase in creditors 6
–––––
(78)
–––––
Net cash inflows from operating activities 249
––––––––––
CASH FLOW STATEMENT FOR SPARROW LTD FOR THE YEAR ENDED 31.12.X5
Net cash flow from operating activities 249
Interest paid (12)
Taxation paid (64) (76)
–––––
Net cash used in investing activities
Payments to acquire tangible non-current assets (376)
Payments to acquire investments (20)
Sale of non-current assets 133 (263)
–––––
Net cash used in financing activities
Equity dividends paid (60)
Issue of shares 150
Issue of debentures 50 140
––––– –––––
Increase in cash balances £50
––––––––––
This increase in cash balances equates to the change shown on the balance sheets –
balance at bank of £26,000 from an overdrawn balance of £24,000.
Question 3
The cash flow statement identifies the following in respect of the financial operations
and position of Sparrow Ltd for the year ended 31.12.X5:
᭤ Tax, dividend and interest payments were more than covered by the net cash inflow
from operating activities.
᭤ The outflow of cash in respect of the acquisition of non-current assets and investments
has been covered by cash generated from operating, cash generated from
sale of assets and the rest from new capital raised by way of share and loan.
᭤ Cash raised from new capital has cleared the overdrawn bank balance and left
£26,000 in the bank.
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᭤ Working capital has increased substantially.
᭤ It appears that Sparrow Ltd has been expanding its activities by its investment in
increased working capital and new assets. Management must ensure that cash
flows from operating also increase in line with this expansion.
Question 4
Reconciliation of operating profit to net cash flow from operating activities:
£m
Operating profit 238
Add depreciation 38
Less profit on disposal of asset (4)
Add reduction in inventory 24
Less increase in debtors (33)
–––––
Net cash inflow 362
––––––––––
Cash flow statement for the year ended 30.9.0Y
Net cash inflow from operations 362
Returns on investment and servicing of finance:
Interest paid (10)
Taxation paid (38) (48)
–––––
Net cash used in investing activities
Purchase tangible non-current assets (313)
Sale of tangible non-current assets 35
Interest received 6 (272)
–––––
Net cash used in financing activities
Equity dividends paid (39)
Issue of ordinary shares 42
Redemption of debentures (17) (14)
––––– –––––
Increase in cash and cash equivalents 28
–––––
Cash equivalents included 30-day government bond
Question 5
(a) Reconciliation of operating profit to net cash flow from operating activities:
£
Net profit for the year before tax 48,590
Less interest and dividends received 22,500 26,090
–––––––––
Add interest charged 7,500
–––––––––
Net profit before interest and tax 33,590
Depreciation on buildings 38,600
Depreciation other 25,000
Loss on sale 9,600 73,200
––––––––– –––––––––
106,790
Increase in inventory (1,000)
Decrease in debtors 5,550
Decrease in creditors (27,990) (23,440)
––––––––– –––––––––
Net cash inflows from operating activities £83,350
––––––––––––––––––
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CASH FLOW STATEMENT FOR PEAK LTD FOR THE YEAR ENDED 31.12.X5
Net cash flow from operating activities 83,350
Interest paid (7,500)
Taxation paid (10,500) (18,000)
––––––––––
Net cash used in investing activities
Payments to acquire tangible
Non-current assets (161,350)
Payments to acquire investments (86,000)
Sale of non-current assets 17,900
Interest received 15,000
Dividends received 7,500 (206,950)
–––––––––
Net cash used in financing activities
Issue of shares 60,000
Issue of debentures 105,000
Equity dividends paid (35,000) 130,000
–––––––––– ––––––––––
Decrease in cash balances £11,600
––––––––––––––––––––
(b) The cash flow shows that:
᭤ The amount generated from operating activities more than covered the net interest,
dividends and tax paid for the company during the year ended 31 December 20X5.
᭤ Non-current assets were purchased in excess of sales of £229,450. This was
financed by the issue of shares and debentures of £165,000 cash. The remaining
£64,450 was financed from internal resources of the company resulting in a
cash reduction of £11,600.
᭤ The interest and dividends received on the investments is at a good level.
᭤ Questions should be asked in respect of the fall in the profit for the year.
᭤ Gearing has increased during the year but does not appear to be at a high risk level.
᭤ The company has expanded its assets by the use of long-term capital resources
in the main.
(c) The cash flow statement:
᭤ Identifies the factors which have caused the change in the cash and cash equivalent
position.
᭤ Identifies the extent to which profits result in inflows of cash.
᭤ Is more objective and verifiable than the income statement as it has no need for
accruals and other estimates.
᭤ Provides information on something familiar to users – cash. Profit is not universally
understood by users.
᭤ Provides information on the financial adaptability of a business and its liquidity.
However:
᭤ The information provided is all historical. Will this provide an indication of the
future that can be relied on?
᭤ The format presentation, many would say, is cluttered and lacks clarity.
᭤ This question again attempts to encourage students to access learning resources.
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Question 6
(a) Reconciliation of operating profit to net cash flow from operating activities
£ £
Net profit for the year before tax 32,590
Less interest and dividends received 20,500
Add interest charged 7,500
––––––––––
Net profit before interest and tax 19,590
Depreciation on buildings 119,600
Depreciation other 25,000
Loss on sale 5,600 150,200
–––––––––– –––––––––––
169,790
Increase in inventory (11,000)
Decrease in debtors 15,550
Decrease in creditors (6,990) (2,440)
––––––––––– –––––––––––
Net cash inflows from operating activities £167,350
––––––––––––––––––––––
CASH FLOW STATEMENT FOR THE YEAR ENDED 31.12.X5
Net cash flow from operating activities 167,350
Interest paid (7,500)
Taxation paid (18,500) (26,000)
––––––––––
Net cash used in investing activities
Payments to acquire tangible
Non-current assets (478,350)
Payments to acquire investments (106,000)
Sale of non-current assets 21,900
Interest received 12,000
Dividends received 8,500 (541,950)
–––––––––
Net cash used in financing activities
Issue of shares 304,000
Issue of debentures 105,000
Equity dividends paid (25,000) 384,000
–––––––––– ––––––––––
Decrease in cash balances £16,600
––––––––––––––––––––
(b) The cash flow shows that:
᭤ The amount generated from operating activities more than covered the net interest,
dividends and tax paid for the company during the year ended 31 December 20X5.
᭤ Non-current assets were purchased in excess of sales of £562,450. This was
financed by the issue of shares and debentures of £409,000 cash. The remaining
£153,450 was financed from internal resources of the company resulting in
a cash reduction of £16,600.
᭤ The interest and dividends received on the investments is at a good level.
᭤ Questions should be asked in respect of the fall in the profit for the year.
᭤ Gearing has increased quite substantially during the year.
᭤ The company has expanded its assets by the use of long-term capital resources
in the main.
(c) As per question 5.
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Chapter 10 Regulatory framework in the UK compared with
European examples and the international
framework
Question 1
The determinants of accounting practice tend to be:
᭤ providers of finance
᭤ accounting profession
᭤ economic environment
᭤ type of law – common or codified
᭤ other countries’ influences.
Question 2
Only those countries that are members of the EU are required by the EU Fourth
Directive to incorporate the concept of true and fair into their legislation. The interpretation
placed on this phrase may be different in each country. Given the difficulty we
have in understanding this phrase in the UK, translating it into another language will
increase those difficulties.
Question 3
Discussion should revolve around want constitutes influence. Worldwide influence here
would seem to imply that IASB standards should be adopted by all countries. However
influence could be assumed to be that over world stock markets. Given the rise of
China’s economy in the global market place then the IASB will not exert world influence
unless the major stock markets and the major companies in China report under IASs.
However this influence could still exist even if the other (non-quoted) companies in
China report under China’s standards. To date, China has more or less adopted IASs as
it has developed its accounting framework.
Chapter 11 Interpretation, including ratio analysis and
consideration of additional information required
Question 1
᭤ Debtors – Supermarket: Does not normally have debtors as most business
is conducted by cash.
– Manufacturer: Supplies goods on credit therefore its debtors
will be quite high.
᭤ Inventory – Supermarket: Inventory turnover periods will be short as items
have a limited life.
– Manufacturer: A large amount of money may be tied up in
inventory and inventory turnover periods may be quite long.
᭤ Cash – Supermarket: Probably quite low as cash will flow through the
business daily, but will then be invested so as to earn interest.
– Manufacturer: May have reserves of cash to meet unforeseen
events.
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᭤ Current Liabilities – Supermarket: Creditors may be quite high and form a major
part of the liabilities of the business.
– Manufacturer: Creditor turnover period will normally be of the
order of 40 days. However, as he will take a long time to turn
these goods into finished products he will need cash available
to go on purchasing goods.
In conclusion, the current assets of the supermarket may well be much lower than its
current liabilities and therefore its current ratio may well be less than 1:1. This is not
unsafe for the supermarket, as the supermarket has cash flowing through the tills every
day, but would be for the manufacturer. It would therefore not be appropriate to compare
a supermarket with a manufacturer. Like must be compared with like in any assessment
of the performance, financial status and investment potential of a business.
Question 2
OLIVET LTD
Ratios 20X4 20X5
Return on capital 20 + 5 = 28.2% 10 + 7.5 = 13.5%
––––––– –––––––––
employed 88.5 129.5
GP percentage 50% 40%
NP percentage 20% 10%
Sales to capital employed 1.13 0.77
Return on owners’ equity 52% 18.3%
Gearing ratio 56.5% 57.9%
Current ratio 49/30 = 1.6:1 57.5/42 = 1.37:1
Acid test 0.72:1 0.6:1
Debtors’ turnover period 73 days 91 days
Creditors’ turnover period 146 days 182.5 days
Inventory turnover period 201 days 198 days
Dividend cover 2 1
Interest cover 5 2.3
From the information given in the question we can identify that:
᭤ Sales have remained static but cost of sales has increased.
᭤ Expenses other than interest have been slightly reduced.
᭤ Dividend has remained at 20X4 level even though profits were reduced. In fact in
20X5 all the profit earned has been paid out in dividend.
᭤ Land appears to have been revalued as the revaluation reserve has increased by
£10,000.
᭤ Further buildings, equipment and investments have been purchased during 20X5.
᭤ Inventory, debtors and creditors have all increased in 20X5.
᭤ There is a bank overdraft in 20X5.
The above would seem to suggest that Olivet has attempted to expand by the purchase
of further non-current assets but this does not appear to have produced extra sales.
Ratios of all types have worsened, indeed the ROCE has halved as has the net profit
percentage. The return on owners’ equity has fallen sharply and the current dividend
policy appears somewhat imprudent.
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It is possible, of course, that Olivet increased its investment in non-current assets
towards the end of the year and therefore these non-current assets will not have generated
revenue for a full year. However, even if this is the case the decline in the profit
percentages is still a potentially dangerous situation.
Question 3
RATIO CALCULATIONS
A Ltd B Ltd
R on CE 470/2370=19.8% 174/876=19.9%
R on SHF 450/2170=20.7% 114/276=41.3%
GP/Sales 720/2150=33.5% 364/1512=24.1%
NP/Sales 470/2150=21.9% 174/1512=11.5%
Sales/CE 2150/2370=0.91 times 1512/876=1.73 times
Current ratio 1360:760=1.79:1 1020:1040=0.98:1
Acid test 940:760=1.24:1 680:1040=0.65:1
Debtors period 900/2150*365=153 days 680/1512*365=164 days
Creditors period 360/1430*365=92 days 400/1148*365=127 days
(calculated using cost of sales as proxy for purchases)
Gearing 200/2370=8.4% 600/876=68.5%
Interest cover 470/20=23.5 times 174/60=2.9 times
Dividend cover 350/200=1.75 times 84/80=1.05 times
Return on capital employed is very similar for both companies but B’s return on shareholders’
funds is double that of A reflecting the high gearing of B at 68.5%. B is
borrowing at 10% and earning at 19.9% with the difference going to shareholders.
A earns a much better gross and net profit margin than B but B operates on higher
efficiency, i.e. B’s capital employed earns 1.73 times sales to A’s 0.91.
B’s liquidity is much lower than A’s due to the large bank overdraft of B. This overdraft
could be regarded as long term rather than short term, thus increasing B’s
liquidity ratio to 1020:480 = 2.125:1.
B is high geared and thus potentially at risk if profits decrease. B is also paying
most of its earnings in the form of dividends thus reducing the potential for reinvestment
in the company. This could be risky as the assets of B are currently 74%
depreciated implying they are reaching the end of their useful life and will need replacing.
A’s assets are only 36% depreciated. Note also that if the overdraft is regarded as
long term this increases B’s gearing.
B is high risk but currently earning good returns for shareholders. B’s vulnerability
must be monitored.
A is low geared and appears stable.
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Question 4
OCEAN LTD
(a) (i) Sales have increased by 66% from 20X0 levels
(ii) Cost of sales have increased by 76% on 20X0 levels
(iii) All expenses have increased
(iv) Profit after tax increased by 50%
(v) Debenture interest payable in 20X1
(vi) Debentures and shares issued 20X1, more capital raised
(vii) Non-current assets increased substantially
(viii) Net current assets reduced but inventory, debtors, creditors all increased in value.
(b) (i) ROCE 20X0 20X1
94 186
–––– = 12.8% –––– = 18.9%
730 982
This indicates an increase in profitability of the business from the increased investment
(ii) Net profit margin 94 186
–––––– = 8% –––––– = 9.6%
1,168 1,944
Increase in margins due to control of expenses or increased sales prices
(iii) Volume of trade 1,168 1,944
–––––– = 1.6 times –––––– = 1.98 times
730 982
Ocean is earning more sales per pound of net assets or capital employed in 20X1
than 20X0.
(iv) Gross profit margin 390 574
–––––– = 33.4% –––––– = 29.54%
1,168 1,944
This reduction in the ratio is probably due to a decrease in sales prices which has
generated more sales or an increase in costs of goods sold.
(v) Expenses to sales 296 388
–––––– = 25.3% –––––– = 20%
1,168 1,944
This decrease indicates better control of expenses.
(vi) Non-current assets to sales 560 856
–––––– = 0.48 –––––– = 0.44
1,168 1,944
Invert 2.08 2.27
Non-current assets are earning 2.27 times their value in sales in X1 compared to
2.08 times in X0.
(vii) NCA to sales 170 126
–––––– = 0.15 –––––– = 0.06
1,168 1,944
Invert 6.87 15.4
NCA are earning more sales in X1 than X0.
(viii) Inventory turnover 98 109
––––––––––– = 46 days –––––––––––– = 29 days
778 × 365 1,370 × 365
Inventory has increased in turnover showing greater efficiency.
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(ix) Debtors turnover 120 226
––––––––––––– = 37 ––––––––––––– = 29 days
1,168 × 365 1,370 × 365
Debtors are taking longer to pay which could indicate that Ocean have encouraged
sales by allowing a credit period.
(x) Creditors’ turnover 69 148
–––––––––––= 46 days –––––––––––––= 39 days
778 × 365 1,370 × 365
Ocean are taking longer to pay suppliers which may indicate they are using creditors
to finance their business operations.
(xi) Wages/sales 13.3% 10.4%
Amount of wages to generate £1 of sales has decreased.
(xii) Other expenses/sales 9.3% 6.4%
Shows better control of expenses in 20X1.
(xiii) Depreciation/sales 2.7% 3.2%
Depreciation has marginally increased as a proportion of sales possible due to an
increase in assets.
(xiv) ROOE 94 170
––––= 29% ––––= 20.7%
730 822
The shareholders in 20X1 have benefited by the return to debenture holders
being constrained to 10% whereas their capital earned (see ROCE at (i)) 18.9%.
(xv) Current ratio 312:142 = 2.2:1, 468:342 = 1.4:1
Substantial reduction but still appears viable.
(xvi) Acid ratio 218:142 = 1.5:1, 344:342 = 1:1
Again reduced but remains viable with careful monitoring.
(xvii) Gearing ratio not relevant 160:822 = 19.5%
Gearing of Ocean Ltd is low.
(xviii) Interest cover not relevant 186
–––– = 11.6
16
The interest payable in fixed capital, debentures is more than adequately covered
by earnings.
Overall the company has performed well in raising capital to finance expansion
in assets which had resulted in increased sales and greater return on earnings.
Chapter 12 Valuation and performance measurement
Question 1
This is a difficult and contentious area. Nevertheless, the answer attempts to outline
the main points for and against such a development. You should have listed some or
all of the same points.
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For change
1 The meaning of the balance sheet figure is uncertain, given that it is not only subject
to subjective amounts of depreciation, but also out of date.
2 Periodic revaluations depend on the decisions of individual companies, and there is
thus little consistency between the balance sheets of different companies. This
makes any comparative analysis very difficult, if not meaningless. A requirement for
all to adopt another valuation could largely remove the inconsistency.
3 It is theoretically incorrect to add together amounts for assets bought at different
times, which, as a result of inflation, are thus not expressed in the same currency.
For retaining historical cost
1 Historical cost is objective, and hence relatively easily audited.
2 The simplicity of historical cost makes it a cheaper method to implement, since no
time need be spent in determining an alternative valuation.
3 It is probably more easily understood by non-accountants.
4 Its widespread acceptance allows for better comparison between companies.
Question 2
(a)
Historical cost Deprival value
Freehold land 3,600,000 4,700,000
(no depreciation)
Vehicles
cost 1,300,000 1,100,000
depreciation 325,000 275,000
––––––––––– –––––––––––
975,000 825,000
––––––––––– –––––––––––
4,575,000 5,525,000
The recoverable amount of the land is the greater of the economic value of
£5,000,000 and the net realisable value of £4,200,000, i.e. £5,000,000.
Deprival value is then the lower of the £5,000,000 and the replacement cost of
£4,700,000, i.e. £4,700,000. Following the same logic, the recoverable amount
of the vehicles is the greater of £800,000 and £1,100,000, and this is compared
with the replacement cost, which is still the same as the historical cost of
£1,300,000. The lower of these is the deprival value of £1,100,000.
Depreciation is simply a quarter of the valuation.
(b)
Revaluation Account
Land 1,100,000
Vehicles 125,000
–––––––––––
1,225,000
––––––––––––––––––––––
The vehicle revaluation is the difference between the present historical cost carrying
value of £975,000 and the undepreciated deprival value of £1,100,000.
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Question 3
(a)
All figures in £000s.
Asset cost
1/1/X7 Bank 520
31/12/X8 Revaluation 280
–––––
800 1/9/X9 Sale of asset 800
––––– –––––
800 800
––––– –––––––––– –––––
Provision for depreciation
31/12/X8 Revaluation 26 31/12/X7 Income statement 26
––––– –––––
1/9/X9 Sale of asset 40 31/12/X8 Income statement 40
––––– –––––––––– –––––
Revaluation
31/12/X8 Asset cost 280
31/12/X8 Prov for depn 26
–––––
1/9/X9 P&L reserve 306 306
––––– –––––
306 306
––––– –––––––––– –––––
Sale of Asset
1/9/X9 Asset cost 800 1/9/X9 Prov for depn 40
1/9/X9 Bank (proceeds) 750
1/9/X9 Income statement (loss) 10
––––– –––––
800 800
––––– –––––––––– –––––
(b) At 31 December 20X9 the Asset Cost and Provision for Depreciation accounts
both carry a nil balance, having been cleared by transfer to the Sale of Asset
account. There is thus no impact on the Final Accounts. The balance on the
Revaluation account of £306,000 is dealt with by direct transfer to the Revenue
Reserve account, or equivalent. It is important to note that, in accordance with IAS
16, it does not go to the Income statement for the year. Finally, the debit balance
of £10,000 on the Sale of Asset account represents the loss on sale, and is taken
as a charge to the Income statement for the year.
(c) Holderness Ltd could have adopted either the net realisable value (NRV) or the
economic value (EV) methods of valuation, as alternatives to the replacement cost
basis used on revaluation. NRV is the amount which the building could be sold for
at arm’s length on the open market, net of any direct selling expenses. EV sums
the present values of the future additional net revenues expected to be received
by Holderness Ltd as a result of its use of the building. It involves estimating such
future inflows, and the selection of a suitable discount rate. Both these issues are
problematic, and the method is therefore not widely found in practice.
Reasons for revaluation include the desire to show a more current valuation of the
company’s worth, in the interests of a true and fair view. More practically, the revaluation
will usually, as in this case, increase the valuation of the company, making it seem
more attractive to less financially literate potential investors and lenders.
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Question 4
(a) Problems with historical cost accounting may be listed as:
᭤ It results in out-of-date valuations in the balance sheet.
᭤ The valuations will usually be lower than a current value, so that the net worth
of the organisation will be understated.
᭤ The same physical amount of inventory will be valued more highly at the year
end than at the start of the year, because we will have paid more for it. This
real overstatement of closing inventory will result in the consequent understatement
of the cost of sales, and hence in the overstatement of gross profit.
᭤ The understatement of non-current assets will lead to the understatement of
the depreciation charge for the year, and hence to the overstatement of net
profit.
᭤ Decisions based on the accounts will therefore be questionable, since they are
based on non-current data.
(b) Sales 400,000
Purchases 340,000
Closing inventory 65,000
––––––––––
275,000
––––––––––
Gross profit 125,000
––––––––––––––––––––
(c) There is no absolute, correct answer to this, but a good answer might be expected
to include the following points:
᭤ Historical cost is simpler, and hence more understandable.
᭤ Historical cost takes no account of the fact that prices are changing.
᭤ Current cost is more up to date, and takes some account of changing prices.
᭤ Being more up to date, current cost may be a better basis for decisions about
the future.
᭤ Current cost arguably maintains the real, physical capital need for the business
to continue to be a going concern.
᭤ Historical cost is more objective and thus more easily audited.
᭤ Current cost inevitably involves some estimation of current values and may
therefore be less reliable.
Chapter 13 Control of accounting systems
Answers to Question 1–8
1 (c) 2 (c) 3 (a) 4 (d) 5 (a) 6 (a) 7 (b) 8 (b).
Question 9
(a) The items you should have identified are:
᭤ The cheques paid out dated 18th (£305.75) and 30th (£182.85) are not on
the bank statement.
᭤ The £50.00 paid in on the 30th was not shown on the bank statement.
᭤ The bank statement did show bank charges of £25.00. This has not yet been
entered in the cash book. The amended cash book will be as follows:
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CASH BOOK
Date Detail Amount Date Detail Amount
1 Opening balance 500.00 1 Bradley Software Ltd 106.78
4 Cash sales 390.00 4 Clee & Co 690.00
10 Weelsby Partners 504.80 8 Halton Supplies 45.07
15 Cash sale 80.00 16 Tetney Merchandising 230.70
20 Atlantis Publishing plc 680.50 18 Bradley Software Ltd 305.75
27 Weelsby Partners 218.00 24 Vehicle rentals plc 530.00
30 Cash sale 50.00 28 Corner Newsagency 12.43
30 Halton Supplies 182.85
30 Bank charges 25.00
30 Balance c/f 294.72
–––––––––– ––––––––––
2,423.30 2,423.30
–––––––––– –––––––––––––––––––– ––––––––––
(b) JULIA
BANK RECONCILIATION STATEMENT AT 30 SEPTEMBER
Balance per bank statement 733.32
Less: Unpresented cheques:
18 May, Bradley Software Ltd 305.75
30 May, Halton Supplies 182.85
–––––––––
488.60
–––––––––
244.72
Add: Uncredited lodgement:
30 May, cash sale 50.00
–––––––––
Balance per cash book (as updated) 294.72
––––––––––––––––––
Question 10
(a) Opening balance 500
Add: Cheques banked 4,003
––––––
4,503
Less: Cheques issued 3,638
––––––
Cash book balance at 31 July 865
––––––––––––
(b) Balance as above 865
Less: Bank charges 232
––––––
633
Less: Worthless cheque previously added 240
––––––
393
Less: Error in entry 9
––––––
Cash book balance, as adjusted 383
––––––––––––
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(c) PETER LEE
BANK RECONCILIATION STATEMENT AT 31 JULY
Balance per bank statement 622
Less: Unpresented cheques 843
––––
Overdrawn 221
Add: Uncredited lodgements 605
––––
Balance per cash book, as adjusted 384
––––––––
Question 11
(c) An external audit is an independent, expert examination of the records and financial
statements of an organisation, to enable the auditor to form an opinion on
whether the accounts show a true and fair view or not. External auditors report primarily
to the shareholders of a company, and are nominally appointed by them.
External audit is not an attempt to find fraud, and it is not a management control.
Internal audit is an expert investigation of financial, and sometimes other, systems
within an organisation. The purpose is for the internal auditors to be able to
report to the management of the organisation on the effectiveness of those systems,
and on how they might be improved. Internal audit may be directed towards
detecting fraud, and is part of management control.
(b) A qualified audit report is one in which the auditor has reservations and which
have a material effect on the financial statements. The circumstances giving rise
to a qualification will be either:
᭤ where there is a limitation on the scope of the audit, and hence an unresolvable
uncertainty, which prevents the auditor from forming an opinion, or
᭤ where the auditor is able to form an opinion, but, even after negotiation with
the directors, disagrees with the financial statements.
The likely effect of a qualified audit report will be to significantly reduce the reliability of
the financial statements in the eyes of any user of those statements. This may well
then impact on the company’s ability to raise finance or trade credit from such users.
This may make trading conditions more difficult for the company and lead to a fall in
the share price.
Chapter 14 Information technology and accounting
Answers to Question 1–8
1 (d) 2 (b) 3 (c) 4 (d) 5 (b) 6 (c) 7 (d) (correct choice is 1, 3, 4 and 5) 8 (d)
Question 9
The nature of the activity means that there is no formal feedback to this question.
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Question 10
1 Determine the information required from the system, e.g. budgets, income statement.
2 Determine the source documents and other data to be processed by the system.
3 Decide on back-up and security arrangements.
4 Investigate suitable software.
5 Investigate suitable hardware.
6 Get the manual system up to date.
7 Transfer the account balances from the manual system to the computer system.
8 Back up the computer records.
9 Run both systems in parallel.
10 Monitor the audit trail for the computer system.
11 Move wholly to the computer system.
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336 Financial Accounting
Account The named place in the ledger system
where one side of the double entry involved in
recording a financial transaction of an organisation
will be made, e.g. an expense of wages
paid by cash will be entered in the wages
account and the cash account.
Accounting Standards Board (ASB) The body
which sets the accounting standards in the UK
under the auspices of the FRC. Now works in
conjunction with the International Accounting
Standards Board (see below)
Accrual An amount owed by the business to a
supplier of a service at the balance sheet date.
When preparing the income statement, revenue
and profits are matched with the
associated costs and expenses incurred in earning
them. This is often also referred to as the
‘matching’ concept.
Alternative methods of valuation There are three
alternatives to historical cost. These are
replacement cost, net realisable value and economic
value. They may be synthesised using
the deprival value model.
Annual report The report produced annually by a
company, incorporating the format presentation
of the financial statements and various
other information required by law or deemed
appropriate for companies to produce.
Appropriation account The last section of the
income statement. It is a statement of what
has happened to the net profit and usually
consists of tax, dividends and retained profit.
Articles of Association These define the rights of
shareholders, the rules of operation of the
company, and the rights and duties of owners
and employees of the company.
Assets An asset represents the control of future
economic benefits as a result of past transactions
or events. In most cases we can reduce
this to ‘an asset is what you own’, but note
that you do not always have to own an asset to
control it; for example, a leased asset is controlled
but not owned.
Audit External audit is the independent, expert
scrutiny of an entity’s financial statements and
supporting information, usually to assess
whether or not those statements give a true
and fair view, and reporting to the funders.
Internal audit is a tool of management
intended to assess the effectiveness of control
systems within an organisation, and reporting
to that management.
Audit trail The record of entries to record, process
and present a particular transaction or event.
Back-ups Duplicate records of accounting data
and information, prepared on a regular basis as a
precaution against problems with the originals.
Bad debt Those debts that will not be paid by the
debtor to the organisation. The debt will never
be received and therefore must be written off
as an expense of trading.
Balance off To balance off is the process by
which we extract a debit or credit balance from
a ledger account.
Balance sheet This is a summary of the assets
and liabilities of the organisation at a specific
time.
Balance sheet equation Assets – Liabilities =
Capital. The equation can be expressed in different
ways.
Bank reconciliation A statement proving that the
entity’s bank balance agrees with the balance
according to the bank, subject to items legitimately
in transit.
Benchmarks Indicators against which an item or
items can be measured.
Cash flows Cash that is flowing into or out of an
organisation.
Glossary
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Cash flow statement A statement showing the
cash inflows and outflows. A summary of cash
received and paid during a period, usually of
one year.
Characteristics The features which distinguish
good accounting from bad. They are held to be
relevance, reliability, comparability and under-
standability.
Closing inventory The value of the inventory at
the end of the accounting period.
Closing inventory account The ledger account
used to record the value of the remaining
inventory left with the organisation at a specific
date, generally the balance sheet date.
Concepts The ideas which underpin the practice
of accounting.
Control accounts Statements to prove that the
total balance of individual debtors or creditors
agrees with a total balance calculated from
global postings. It is a control over the completeness
and accuracy of the debtors and
creditors accounting.
Corporate entity The notion of corporate entity
means that several people can band together as
owners of a business, by investing capital in
the business, and the business will be a legal
entity separate from the owners. It also means
that the owners – the investors of capital – can
be changed without the need also to change
the legal entity of the company.
Credit transactions Financial transactions of an
organisation that do not involve the immediate
payment of cash, e.g. a sale made by an
organisation where payment will be received
in two weeks’ time.
Current cost accounting A system of inflation
accounting which attempts to maintain the
ability of the entity to do the same things from
one year to the next.
Current purchasing power A system of inflation
accounting which attempts to maintain the
purchasing power of the owners of a business,
despite the falling value of their investment in
the entity.
Dearing Committee A committee established by
government to review the working of the
Accounting Standards Committee.
Debentures Capital raised by the company in the
form of long-term loans.
Decision making The main purpose of accounting
is deemed to be to provide useful information
to a range of users so that they can make economic
decisions based on that information.
Depreciation The measure of the amount of an
asset that is used up in generating revenues.
Deprival value The lower of replacement costs
and recoverable amount, which is the greater
of net realisable value and economic value. It
provides a single, logically coherent, alternative
to historical cost.
Designing an accounting system The process of
specifying what we want an accounting system
to be able to do (the outputs), what data it must
cope with (the inputs), and how the two can be
most effectively and efficiently connected.
Determinants The factors that determine the
accounting framework of a particular country.
Direct method A method of determining the net
cash flows from operating activities by recording
the flows by function or activity, e.g.
receipts from customers, payments to suppliers.
Dividend The cash payment made to shareholders
as their return on their investment. The
dividend is appropriated out of the profits
made and available for distribution by the
company. The dividend paid is shown as a
change in equity
Double entry The method by which financial
transactions of an organisation are entered into
the ledger accounts; for every debit entry there
will be an equal and opposite credit entry.
E-accounting (electronic accounting) The use of
information technology to aid accounting
practice.
Earnings per share (EPS) A key ratio for measuring
the performance of a company. Compares
the earnings in a period to the number of ordinary
shares issued.
Economic value Economic value is arrived at by
summing the present values of the inflows
attributable to an asset; in other words, it is
the present value of those inflows.
Extended trial balance A working paper on
which the adjustments to the double entry
accounts will be made. This speeds up the
process of producing an income statement and
balance sheet without having to wait for all
the ledger accounts to be adjusted.
Glossary 337
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External audit – see Audit.
Financial Reporting Council (FRC) The supervisory
body which ensures that the UK accounting
standards setting system is working.
Format presentation The Companies Act actually
specifies four formats that can be used for the
presentation of the income statement of a
company and two for the balance sheet.
Fourth and Seventh Directives Directives on
company law issued by the European Union.
Funds flow The flow of funds in and out of the
organisation, such as share capital, working capital,
etc. Funds are not necessarily flows of cash.
Gearing ratio The fixed-term capital in a company
compared to the shareholders’ capital.
Going concern There is an assumption that the
business will continue to operate for the foreseeable
future.
Harmonised reporting framework An attempt to
produce a framework that will serve the purposes
of all countries.
Implementation of an accounting system The
practice of turning the designed accounting
system into a functioning, live system.
Income and expenditure account The equivalent
of an income statement used by non-profit
making entities.
Income statement List of expenses incurred by
an organisation set against its revenues. The
result is a profit or a loss. It covers a specific
period which is generally one year.
Indirect method A method of determining the
net cash flows from operating activities by
adjusting the income statement balance for
such entries as changes in working capital and
depreciation provision.
Information technology In the context of accounting,
the use of hardware and software to aid in
the recording, processing, presentation and even
in the interpretation of financial information.
International Accounting Standards Board (IASB)
The independent body that sets international
accounting standards.
Inventory valuation The method chosen for valuing
inventory, usually first-in, first-out (FIFO).
Ledger The place where double entry accounts
are recorded.
Ledger adjustment All adjustments necessary to
the ledger accounts to take account of such
things as accruals, prepayments, bad debts,
depreciation, etc.
Liabilities A liability is the obligation to transfer
benefits to someone else as a result of past
transactions or events. ‘Obligation’ is interpreted
very strictly, so that it means being
unable to avoid the transfer out, not just that
the payment is commercially sensible.
Limited company An organisation established as
a company whose owners, the shareholders,
have limited liability.
Limited liability Shareholders’ loss is limited to
that of their initial investment in the company.
Matching – see ‘Accrual’.
Measurement bases The particular valuation
basis chosen from among historical cost,
replacement cost, net realisable value and economic
value.
Memorandum of Association Defines the relationship
between the company and any
external parties and states the objectives of the
company, i.e. what sort of trade it will undertake.
It also identifies the maximum capital to
be invested in the company by the owners,
known as the share capital.
Needs and objectives of users The needs and
objectives of users of financial statements as
defined by the Framework for the Preparation
and Presentation of Financial Statement, issued
by the IASB. In the UK the equivalent statement
from the ASB is the Statement of Principles.
Net cash flows from operating activities Those
cash flows, inflow and outflow, resulting
directly from the operating activities of the
organisation, e.g. sale and purchase of inventory
for cash.
Net profit margin (NPM) A ratio comparing net
profit to sales.
Net realisable value Valuing what the asset could
be sold for today, less any costs of selling.
Non-current asset Previously in the UK known as
fixed asset but under the influence of international
standards these are referred to as
non-current assets. Non-current assets are
assets with a life of more than one year which
are not held for sale or consumption in the
normal operating cycle.
Opening inventory The value of the inventory
(stock of goods for sale or use within the organisation)
at the start of the accounting period.
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Period end adjustments Ledger adjustments
made to the ledger accounts but at a period end
(this is likely to be the balance sheet date), e.g.
accruals, prepayments, bad debts, depreciation.
Premium The amount paid by the purchaser of a
share which is over and above the nominal
value of the share.
Prepayment An amount paid in advance to the
provider of a service to the organisation at the
balance sheet date.
Presentation Publishing economic information
about the business entity in a form which
complies with any applicable rules, such as
those given by law and accounting standards.
Price/earnings ratio (P/E) A ratio comparing earnings
per share to the price of a share on the
inventory market.
Processing Turning the raw data that we have
recorded into useful information that can be
presented to those interested in knowing about
the organisation.
Profit and loss account Since the advent of international
accounting standards into the UK this
statement is more properly known as the
Income Statement. However, the use of the
term ‘profit and loss account’ is likely to continue
for a few years yet, especially in relation
to small and medium-sized companies.
Provision for bad debt A charge made in the
income statement for those debts that might
go bad (remain unpaid) in the future. The provision
is normally made at so many per cent of
the total debtors outstanding at the balance
sheet date based on past experience of the
amount that goes bad.
Realisation Only recognising, i.e. making an
accounting entry for, those transactions where
the money has changed hands, or is almost
certain to do so in the near future.
Receipts and payments account A summary of
monies in and out of an entity’s bank account.
Often used instead of an income statement for
small, simple organisations, such as clubs.
Recording The gathering of raw economic data
into a structured form, such as double entry
bookkeeping.
Reducing balance A method for the calculation
of depreciation. It assumes the same percentage
of the net book value of the asset is used
up each period.
Regulatory framework The framework of
accounting specified by the ASB and by company
law in the UK. On the international stage
the IASB sets the international accounting
standards which form the backbone of the regulatory
framework.
Replacement cost Valuing an asset at what it
would cost to replace today.
Reserves Accumulated profits and capital gains
available to shareholders. These reserves can be
termed realised and unrealised.
Return on capital employed (ROCE) A ratio to
measure the return made on the capital
invested in a business. It generally refers to
profit before tax and interest, compared to
shareholder capital plus long-term capital
employed in the business.
Return on shareholders’ funds (ROSHF) or return
on owner’s equity (ROOE) A ratio that compares
the return made by the business with the
shareholder funds invested in the business. It
generally refers to profit after tax but before
ordinary shareholder dividends, compared
with ordinary shares and reserves.
Revenue recognition Revenue is the inflow of
economic benefits arising from ordinary activities.
Its recognition should be made only when
it both arises from ordinary activities and is
reasonably certain to be realised.
Sale of non-current asset account The ledger
account to record the sale of a fixed asset. The
proceeds of the sale are recorded on the credit
side and the net book value of the asset in the
books at the time of the sale is transferred to
the debit side of the account. This account will
over time become known as sale on non-current
asset account.
Shares The capital of a company is divided into
shares which are issued to the shareholders as
collateral for their investment. The shares can
have various nominal values and be of several
types, e.g. ordinary, preference.
Sources and applications of funds Sources are
where the money has come from, for example
previous profits, share issues and amounts
borrowed. Applications are where the money
has gone, either spent on expenses or on
assets. Given this definition, total sources must
always equal total applications.
Glossary 339
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Statement of changes in equity A summary of all
gains and losses accounted for (‘recognised’)
during a period, usually of one year. It differs
from an income statement by including unrealised
gains as well as the realised gains that
will appear in an income statement. In the UK,
until the advent of international accounting
standards, the equivalent statement was the
‘statement of total recognised gains and losses’
(see below).
Statement of total recognised gains and losses
See ‘statement of changes in equity’.
Stewardship A secondary purpose of accounting
is to record the economic events relevant to an
entity, so that those who provided the finance
can see what has been done with their money.
In other words, the managers of the entity are
held to be stewards of the money.
Straight line A method by which the provision
for depreciation is calculated. It assumes that
the asset is used up in equal amounts in each
period.
Taxation The charge levied by government
authorities on the profits of a company.
Time value of money The operation of interest
means that money has a value, not only in
terms of the absolute amount, but also
in terms of when it is received. The sooner it
is received, the better, since it can be placed
on deposit and earn interest. This value
according to when the money is received is its
time value.
Trading account The first part of what is loosely
called the income statement. It consists of
sales, cost of sales and hence gross profit.
Trial balance The check on the double entry
system whereby each debit balance and each
credit balance is extracted from the ledgers,
listed in either a debit or credit column, and
the two columns totalled to see if they agree.
True and fair view This term is the over-riding
legal requirement for financial reporting in the
UK but is undefined by law. Accordingly, what
it effectively means is whatever accountants
have defined it to mean through compliance
with the accounting standards. Note that the
requirement is to show ‘a true and fair view’
not ‘the true and fair view’.
Value in use What an asset is worth as it is being
used, i.e. the benefits of its use for the entity. It
is accordingly measured by its economic value.
Volume of trade (VofT) A ratio comparing sales to
capital employed.
Working capital Current assets minus current liabilities.
Also known as ‘net current assets’ or
‘net current liabilities’.
XML (eXtensible Mark-up Language) A method
of tagging each item of financial data with a
label marking its meaning, to aid in processing
that data.
340 Financial Accounting
FNAC_Z02.QXD 12/10/05 10:47 am Page 340
ACCA (Association of Chartered
Certified Accountants) 178, 237
accounting
changes in xi–xii, 11–12, 47
characteristics of good 54–5, 62, 337
choice in see choice
conceptual framework 60
financial and management
accounting compared 3, 8–9
purposes 1–3
and taxation 183, 225
types 3–9
uncertainty see uncertainty
accounting concepts/principles 53–61,
176–8, 181, 337
China 186
conflicts between 177–8
France 184–5
Germany 184
the Netherlands 185–6
see also accounting policies
accounting framework, determinants
183–7
accounting policies 53, 60, 181
accounting principles see accounting
concepts/principles
accounting ratios 193–210
accounting standards 40, 53
see also Financial Reporting
Standards; International
Accounting Standards; Statements
of Standard Accounting Practice
Accounting Standards Board (ASB) 130,
179, 180–1, 182, 183, 225
Statement of Principles 10
Accounting Standards Committee (ASC)
178–9, 180, 183, 225
Dearing Committee and 179, 337
accounting systems 234, 236, 257–60
controls 234–48
designing 257–8
implementing 258–60
information to be extracted from
257, 263–4
accounts, double entry system see
double entry
accounts (financial statements) see
financial statements
accruals 97, 336
adjustments 92–9, 116
cash flow statements 159
accruals (matching) concept 53, 54, 55,
59, 181
Companies Act 1985 56
double entry 84
France 185
Germany 184
inventory 60
Netherlands 186
prudence concept 177–8
accumulated profits 138–9
acid test 203, 204
adjustments
accruals 92–9, 116
bad and doubtful debts 99–103, 116
depreciation 106–8, 116
inventory 84, 93
ledgers/ledger accounts 93–9, 106–8,
115–24, 338
non-current asset sales 108–9
period-end 115–24, 339
prepayments 92–9, 116
AIA (Association of International
Accountants) 237
alternative valuation methods see under
valuation
analysis 166–7, 193–210
Annual General Meeting, limited
companies 129
annual report 129, 147, 336
see also financial statements
APB (Auditing Practices Board) 237
applets 262
appropriation accounts 37–8, 336
Index
FNAC_Z03.QXD 12/10/05 2:16 pm Page 341
Articles of Association 128, 336
ASB see Accounting Standards Board
ASC see Accounting Standards Committee
assets 7, 18–19, 24, 61, 62, 216, 336
in balance sheets 20
depreciation see depreciation
revaluation see revaluation
revenue and 61
sales, cash flow statements and 159
valuation see valuation
value in use 216
see also current assets; non-current
assets
Association of Chartered Certified
Accountants (ACCA) 178, 237
Association of International
Accountants (AIA) 237
assumptions 51–2, 215
changing 265
audit reports 238–40
emphasis of matter 238
modified 238–9
audit trails 256, 263, 336
auditing, International Standards of
Auditing 236, 237, 238
Auditing Practices Board (APB) 237
auditors 237
audits 235–40, 336
Authorised Share Capital 130
average cost (AVCO) valuations 42–3
back-ups 259, 260, 336
bad and doubtful debts 24, 99, 336
adjustments 99–103, 116
balance sheet equation 20, 56, 336
balance sheets 7, 17, 23–6, 336
cash flow statements and 161, 163–6
double entry system 87–8
formats 20–3, 142–3
ledgers/ledger accounts 115
non-commercial organisations 23
preparation from trial balance and
adjustments 115–24
balancing off 78–82, 336
bank accounts, in double entry system 71
bank reconciliations 235, 240–4, 245,
336
benchmarks 191–2, 336
bonus issues (shares) 133–4
book value per share 200–1
Britain see United Kingdom
browsers 261–2
budgets 8
bureaucracy 336
business, value to the 224
business entity 56
businesses, ‘average’ 224
capital 18
cost of 217
limited companies 129, 130–6, 137–40
loan 134
maintenance 224
working 21–2, 162, 340
see also debentures; finance; shares
capital reserves 138–9
case law 128, 176, 180, 183
cash
definitions 161, 163
need for 154, 161
cash books 240–4, 244-5
cash equivalents 163
cash flow 155–6, 337
and funds flow 161–2
and ratio analysis, worked example
206–10
cash flow forecasts 9
cash flow statements 7, 8, 154–68, 337
definition of cash 163
direct method 158, 161
drawbacks 161
indirect method 159, 161
interpretation 166–7
net cash flow from operating
activities 157–61, 338
purpose 161
relationship with income statements
and balance sheets 161, 163–6
CCA (Current Cost Accounting) 224, 337
CCAB (Consultative Committee of
Accounting Bodies) 178, 179
characteristics of good financial
reporting 54–5, 62, 337
charities 17, 44, 144
Chartered Institute of Management
Accountants (CIMA) 178
Chartered Institute of Public Finance
and Accountancy (CIPFA) 178
China
accounting framework 186
communism 186
taxation 186
342 Index
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choice 44, 52, 53, 181
prudence and 55
see also accounting policies
CIMA (Chartered Institute of
Management Accountants) 178
CIPFA (Chartered Institute of Public
Finance and Accountancy) 178
closing inventory 34, 337
closing inventory account 84, 337
clubs 2, 44–6, 122–3, 144–6
Co-operative Insurance Services,
“Sustainability Pays” 12
common law 183
communism, China 186
companies see limited companies
Companies Acts 6, 56, 128
and audits 235–6, 237
and financial statements 7, 20, 46,
142, 176
and true and fair view 57, 61
company directors 129, 237, 240
company law, review of 130, 181
comparability 6, 55, 63, 64, 66, 181
see also inter-firm comparisons
compatability 263
completeness 64
comprehensive income 47
computers and computerised systems
47–8, 120, 122, 234, 245, 252–66
and errors 235
see also information technology
concepts see accounting concepts
consistency 53, 55, 64, 184, 185, 186
see also comparability
Consultative Committee of Accounting
Bodies (CCAB) 178, 179
contingency planning 259, 260
control accounts 235, 244–8, 259, 337
controls 234–48
computer accounting systems and
47–8, 245, 252–7, 259
see also security
corporate entity 128, 176, 337
corporation tax 138
cost analysis 9
cost bases (measurement bases) 60, 181,
183, 185, 338
see also historical cost and its
alternatives
cost of capital 217
cost of sales (cost of goods sold) 35
cash statement and 159
CPP (Current Purchasing Power)
accounting 223–4, 337
credit side, double entry system 71
credit transactions 27, 76–7, 337
cash statement and 159
creditors 76–7
period 198
reserves and 139
separate valuation 56
creditors’ buffer 139
cumulative preference shares 131
current assets 20–2
net (working capital) 21–2, 162, 340
current cost see replacement cost
Current Cost Accounting (CCA) 224,
337
current liabilities 21–2
net (working capital) 21–2, 162, 340
Current Purchasing Power (CPP)
accounting 223–4, 337
current ratio 203, 204
customers 9, 10, 13
customisation 258
data
presentation see presenting data
shared 260–4
sources of 265
types of 258–9
data exchange 48
data loss 259
data transfer 258–60, 262–3
databases 265
day books 244
Dearing Committee 179, 337
debentures 134–6, 137–8, 337
debit side, double entry system 71
debt finance 18, 20
debtors 24, 76–7, 99
period 198
separate valuation 56
decision making 2–3, 337
depreciation 59, 103–4, 222, 337
adjustments 106–8, 116
calculation methods 104–5
cash flow statements and 159
non-current asset sales 108–9
provisions 106–8
and revaluations 227–30
depreciation to sales ratio 199
deprival value 218–20, 224, 226, 337
Index 343
FNAC_Z03.QXD 12/10/05 2:16 pm Page 343
design of accounting systems 257–8,
337
determinants of the accounting
framework 183–7, 337
direct method (cash flow statements)
158, 161, 337
Directives, EU see under European Union
directors 129, 237, 240
disclosure, requirements to disclose
accounting policies 60, 64
discount factors 217–18
distribution 37
dividend cover 201–2
dividends 37, 131, 135–6, 137–8, 139,
337
accounting methods and 224
ratios 201–3
statement of changes in equity 37
documentation 258–9, 265
double entry 4, 69–89, 337
accounts 71–82, 336
balance sheets 87–8
balancing off 78–82, 336
computer systems and 252–7
control accounts 235, 244–8
credit side 71
credit transactions 76–7
creditors 76–7
debit side 71
debtors 76–7
duality 56, 71–3
income statements 84–6
inventory 84
one-legged entries 235
trial balances 82–3, 87
see also ledgers/ledger accounts
doubtful debts see bad and doubtful
debts
duality 56, 71–3
e-accounting 260–3, 337
e-mail 263, 265
earnings per share (EPS) 202, 337
economic value 24, 26, 216, 218–20, 337
electronic mail (e-mail) 263, 265
employees 4, 9, 10, 13, 28–9, 51, 57, 62
environmental accounting 5, 11–12
EPS (earnings per share) 202, 337
equity 62, 199–200
statement of changes in see statement
of changes in equity
equity finance 18, 20
errors 235, 241, 244–8, 253–5
audit trails and 256
estimation 60
ethical investment 5
European Union 175, 185, 187
Directives 184
Fourth Directive 142, 182, 338
and ISAs 182, 187–8
listed companies 175–6
Seventh Directive 182, 338
small and medium-sized companies
176
exchange of data 48
expenses to sales ratio 196, 199
extended trial balances 116, 120–2,
337–8
extensible mark-up language 263–4, 340
external audits 235–40, 336
fair value 61
faithful representation 64
FIFO (first in, first out) valuations 41–4,
338
final dividends 135–6, 137–8
finance
debt 18, 20
equity 18, 20
sources of 183, 184
see also capital; funds
financial accounting see accounting
financial information, presentation see
presenting data
Financial Reporting Council (FRC) 179,
180–1, 338
Financial Reporting Exposure Drafts
(FREDs) 179
Financial Reporting Review Panel (FRRP)
180–1
Financial Reporting Standards (FRSs)
179–80
FRS 18 ’Acounting Policies’ 181
financial statements
analysis of 166–7, 193–210
formats see under formats
simplified 65–6
see also balance sheets; income
statement; statement of changes in
equity
first in, first out (FIFO) valuations 41–4,
338
344 Index
FNAC_Z03.QXD 12/10/05 2:16 pm Page 344
fixed assets see non-current assets
flexibility 6
flow see cash flow; funds flow
formats
computerised data 262, 263
financial statements 20–3, 46, 84, 86,
142–3, 176, 338
Fourth Directive see under European
Union
Framework for the Preparation and
Presentation of Financial
Statements 3, 10, 54, 62–6, 67
France, accounting rules 6, 52, 184–5
fraud 235, 236, 253
FRC (Financial Reporting Council) 179,
180–1, 338
FREDs (Financial Reporting Exposure
Drafts) 179
FRRP (Financial Reporting Review Panel)
180–1
FRSs see Financial Reporting Standards
funds
sources of 161–2
use of word 162
see also finance
funds flow 161–2, 338
future economic benefit 62
GAAP (Generally Accepted Accounting
Principles) 185–6, 187–8
gearing 203–4, 338
Generally Accepted Accounting
Principles (GAAP) 185–6, 187–8
Germany, accounting framework 184
going concern concept 53, 54, 55, 59,
181, 338
France 185
Germany 184
Netherlands 186
and valuation 26, 54
gross dividend yield 202–3
gross profit 34
gross profit margin 196
harmonisation of accounting standards
182
harmonisaton of reporting frameworks
187, 338
historical cost
alternatives to 24–6, 181, 183, 185,
215–16
and historical cost accounting 25–6,
57, 59, 215, 220–1
inventory 40
Holland see Netherlands
HTML 263
human resources, measurement and
inclusion 4, 28–9, 51, 57, 62
hypertext mark-up language 263
IASB (International Accounting
Standards Board) 175, 181, 182,
338
Framework 3, 10, 54, 62–6, 67
IASC (International Accounting
Standards Committee) 181
IASs see International Accounting
Standards
ICAEW (Institute of Chartered
Accountants in England and
Wales) 178, 183, 237
ICAI (Institute of Chartered Accountants
in Ireland) 178, 237
ICAS (Institute of Chartered
Accountants of Scotland) 178, 237
implementation of accounting systems
258–60, 338
income, comprehensive 47
income and expenditure accounts 44,
45–6, 338
income statements 7, 8, 338, 339
appropriation accounts 37–8
cash flow statements and 161, 163–6
double entry system 84–6
formats 46, 84, 86, 142–3
nature and content 33–8
preparation from trial balance and
adjustments 115–202
price-adjusted 222
proposed changes 47
statement of changes in equity and
33, 47
trading accounts and 34–6
index-linking 223–4
indicators (benchmarks) 191–2, 336
indirect method (cash flow statements)
159, 161, 338
individual determination (separate
valuation) 56, 184
inflation 25, 183, 205, 220, 221, 225
and different types of business 224
inflation accounting 220–6
Index 345
FNAC_Z03.QXD 12/10/05 2:16 pm Page 345
information see data
information technology (IT) 47–8,
252–66, 338
and prices 224
see also computers
Institute of Chartered Accountants in
England and Wales (ICAEW) 178,
183, 237
Institute of Chartered Accountants in
Ireland (ICAI) 178, 237
Institute of Chartered Accountants of
Scotland (ICAS) 178, 237
integrated systems 258, 264
inter-firm comparisons 191–2, 204–6,
265
interest cover 204
interest on debentures 136, 137–8
interim dividends 135–6, 137–8
internal audits 235, 236
International Accounting Standards
Board (IASB) 6, 13, 54, 175, 181,
182, 338
Framework 3, 10, 54, 62–6, 67
International Accounting Standards
Committee (IASC) 181
International Accounting Standards
(IASs) 19, 181
“Accounting Policies, Changes in
Accounting Estimates and Errors”
(IAS 8) 53, 60, 66
cash flow statements (IAS 7) 157, 159
EU and 182, 187–8
“Financial Accounting in
Hyperinflationary Economies” (IAS
29) 225
“Inventories” (IAS 2) 40, 44
listed companies 175–6, 182
“Presentation of Financial
Statements” (IAS 1) 53
“Property, Plant and Equipment” (IAS
16) 229
“Revenue Recognition” (IAS 18)
60–1
International Auditing and Assurance
Standards Board 236
International Financial Reporting
Standards 183
international issues and practice 60,
181–2, 187–8, 338
International Organisation of Securities
Commissions (IOSCO) 181
international standards, adoption of xi
International Standards of Auditing
236, 237
“The Auditor’s Report on Financial
Statements” (ISA 700) 238
Internet 48, 261–2, 263, 265
see also website
interpretation of financial statements
166–7, 193–210
inventory 18, 34–5
adjustments 84, 93
closing 34, 337
double entry system 84
opening 35, 339
turnover 198
valuation 40–4, 60, 338
investment ratios 200–3
IOSCO (International Organisation of
Securities Commissions) 181
IT see information technology
journals 244–5
judicial review 180
last in, first out (LIFO) valuations 41–4
ledgers/ledger accounts 77, 115, 244–6,
338
adjustments 93–9, 106–8, 115–24, 338
balance sheets 115
legal cases 128, 176, 180
liabilities 7, 18–19, 338
in balance sheets 20
long-term 21–2
see also current liabilities
liability 128, 338
LIFO (last in, first out) valuations 41–4
limited companies 2, 338
advantages 128
Annual General Meeting 129
annual report 129, 147, 336
Authorised Share Capital 130
capital 129, 130–6, 137–40
corporate entity 128, 176
debentures 134–6, 137–8
directors 129
dividends 135–6, 137–8
formation 128–9
list of shareholders 131
reserves 138–40
taxation 138
see also financial statements; shares
and related entries
346 Index
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limited liability 128, 338
liquidity ratios 203–4
loan capital 134
see also debentures
long-term liabilities 21–2
lower of cost and net realisable value
40–1
management accounting 3, 8–9
mark-up language 263–4
matching concept see accruals concept
materiality 57, 59, 64
measurability 12, 33, 62
see also monetary measurement
measurement bases (cost bases) 60, 181,
183, 185, 338
see also historical cost and its
alternatives
memorandum accounts 246
Memorandum of Association 128–9,
338
mistakes see errors
Modernising Company Law 130
modified audit reports 238–9
modular systems 258
monetary measurement 57, 59
money, time value of 216–18, 340
mutual aid 260
needs of users see under users
net cash flow from operating activities
157–61, 338
net current assets/liabilities (working
capital) 21–2, 162, 340
net dividend 201
net profit 36
net profit margin (NPM) 195–6, 338
net realisable value (NRV) 24, 26, 40–1,
216, 218–20, 338
net worth 23, 63
Netherlands, accounting framework
185–6
networks 261
neutrality 64
nominal value 130, 134
non-current assets 20–2, 338
sales 108–9, 227–30
valuation see valuation
see also depreciation
non-profit/non-trading organisations 2,
17, 23, 44–6
NPM (net profit margin) 195–6, 338
NRV (net realisable value) 24, 26, 40–1,
216, 218–20, 338
objectivity 57
objectivity of users see under users
on-line information sources 265
one-legged entries 235
opening inventory 35, 339
operating activities, cash flow 157–61,
338
operating capability 224
ordinary activities 61
ordinary shares 131
organisations, types of 2
see also limited companies; non-profit/
non-trading companies; sole traders
owners, and business entities 56
P/E ratio 203
Pacioli, Luca 69
par value see nominal value
parallel hardware 260
parallel running 259
partnerships 2
passwords 256, 263
Pensions and Investment Research
Consultants (PIRC) 12
performance comparisons 191–2,
204–6, 265
performance and financial position of
business, example of analysis using
ratio analysis 206–10
performance ratios 195–200
period-end adjustments 115–202, 339
physical capital maintenance 225–6
PIRC (Pensions and Investment Research
Consultants) 12
plcs (public limited companies) 129
policies see accounting policies
preference shares 131, 137–8
premium 131–2, 339
prepayments 97, 339
adjustments 92–9, 116
cash flow statements and 159
present value 217–18
presenting data 7–9, 339
see also formats
price/earnings (P/E) ratio 203, 339
primary statements, see also balances
sheets; cash flow statements;
income statements; statement of
changes in equity
Index 347
FNAC_Z03.QXD 12/10/05 2:16 pm Page 347
principles see accounting
concepts/principles
private companies 129
processing 6, 339
see also accounting systems
profit 18
accumulated 138–9, 139
gross 34
margins 195–6, 338
net 36
retained 37
see also reserves
profit and loss account see income
statement
provisions
bad debts 100–3, 339
depreciation 106–8
prudence concept 53, 55–6, 59, 64, 116,
177–8, 181
and choice 55
France 185
Germany 184
Netherlands 186
and uncertainty 55, 64, 181
public limited companies 129
public sector organisations 2, 17, 144
qualified audit reports see modified
audit reports
quantifiability 12, 33, 62
see also monetary measurement
quick assets ratio 203, 204
ratio analysis 193–210
and cash flow, worked example 206–10
realisable value 22–3, 40–1
realisation concept 53, 54, 59, 60, 339
recalculations 265
see also revaluation
receipts and payments account 44–5, 339
recognition see measurability; revenue
recognition
recording 3–6, 339
records 258–9, 265
redeemable preference shares 131
reducing balance method of calculating
depreciation 104, 105, 339
Registrar of Companies 128
regulatory framework 178–87, 339
see also under United Kingdom
relevance 54, 63–4, 65, 181
reliability 54–5, 55, 63, 65, 181
religious bodies 44
replacement cost (current cost) 24,
25–6, 216, 218, 226, 339
and deprival value 218–20, 224, 226
inventory 40
and realisable value 24, 26
reporting frameworks, harmonisation of
187, 338
reserves 27, 138–40, 229–30, 339
Retail Price Index (RPI) 223, 224
retained profits 37
see also reserves
return on capital employed (ROCE)
195–6, 199–200, 339
return on owners’ equity (ROOE)
199–200, 339
return on shareholders’ funds (ROSHF)
199–200, 339
revaluation 26–7, 181, 227–30
revaluation reserves 27, 139–40, 229–30
revenue 60–1
revenue recognition 54, 60–1, 339
revenue reserves 139
rights issues 133
ROCE (return on capital employed)
195–6, 199–200, 339
Roman law 183, 184
ROOE (return on owners’ equity)
199–200, 339
ROSHF (return on shareholders’ funds)
199–200, 339
RPI (Retail Price Index) 223, 224
sale of fixed asset accounts 339
sales
cost of see cost of sales
on credit, cash flow statements 159
of non–current assets 108–9, 227–30
sales journals 244–5
sales ratios 196–7
Salomon v Salomon & Co Ltd (1987) 128,
176
security 261, 262–3
selling price 40–1
see also realisable value
separate valuation (individual
determination) 56, 184, 185
Seventh Directive see under European
Union
share capital 18
shareholders 129, 131
and accounting framework 183
348 Index
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and auditors 236, 237, 240
funds 162, 199–200
list of 131
shares 129, 130–4, 135–6, 339
bonus issues 133–4
book value per share 200–1
earnings per share 202
nominal/par value 130
preference 131, 137–8
premium 131–2, 339
return on 135–6
rights issues 133
see also debentures
sharing accounting data 260–4
sharing accounting facilities 260
small companies 176, 240
social accounting 5, 11–12
societies see clubs
sole traders 2, 128
taxation 138
sources and applications of funds
17–20, 339–40
spreadsheets 122, 264, 265
SSAPs see Statements of Standard
Accounting Practice
standards see accounting standards
statement of changes in equity 7, 8,
26–7, 37, 38–40, 231, 340
income statements and 33, 47
Statement of Principles, ASB 10
statements, primary see primary
statements
Statements of Standard Accounting
Practice (SSAPs) 178–9
“Accounting for Changes on the
Purchasing Power of Money”
((P)SSAP 7) 224, 226
“Current Cost Accounting” (SSAP 16)
224–6, 226
“Disclosure of Accounting Policies”
(SSAP 2) 53
stewardship 3, 183, 340
stock exchanges 129, 131
straight line method of calculating
depreciation 104, 105, 340
study advice x–xi
substance over form 66
tags 263–4
taxation 138, 340
and accounting 183, 225
templates 264
time value of money 216–18, 340
trade payables xii
see also creditors
trade receivables xii
see also debtors xii
trading accounts 34–6, 340
training 48, 262
trial balance 82–3, 87, 340
errors shown up by 235, 245
extended 116, 120–2
income statement and balance sheet
preparation from 115–24
true and fair view 52, 53, 57, 61, 183,
234–5, 340
accounting standards/Statement of
Principles and 179, 180
audits 235, 236, 238
EU 175, 184
Framework and 64
France 185
Germany 184
historical cost and alternatives 222
Netherlands 185, 186
UITF (Urgent Issues Task Force) 180–1
uncertainty 27, 63
prudence and 55, 64, 181
uncredited lodgements 241
understandability 55, 63, 64, 65, 181
United Kingdom
convergence programme 182
and IAS GAAP 187–8
legal and regulatory framework 6, 7,
176–81, 183
see also European Union
Urgent Issues Task Force (UITF) 180–1
use, value in 216, 340
users 9–11, 13, 189–90
needs and objectives 10, 13, 183,
190–1, 338
valuation 63
alternative methods 24–6, 59,
215–26, 336
going concern concept 54
inventory 40–4, 60, 338
revaluation 26–7, 181, 227–30
statement of changes in equity 26–7
see also historical cost; time value of
money
Index 349
FNAC_Z03.QXD 12/10/05 2:16 pm Page 349
value added 4
value, fair 61
value to the business 224
value in use 216, 340
variance reports 8–9
volume of trade (VofT) 195, 340
wages to sales ratio 199
wealth 63
website xi
‘what-if ’scenarios 265
White Papers, Modernising Company Law
130
word processors 264
working capital 21–2, 162, 340
worksheets (extended trial balances) 120–2
World Wide Web see Internet
XBRL 264
XML 263–4, 340
350 Index
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