Accounting Notes
What is accounting? Accounting is the process of recording, reporting and interpreting financial information pertaining to an organization. According to American Institute of Certified Public Accountants: Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events, which are, in part at least of a financial character, and interpreting the results thereof. If we analyze this definition, we get the following components:
It is about recording transactions
Transactions should be only of financial nature
The recorded transactions are then classified according to set rules
Results are then interpreted for people who are interested in this information
Difference between Book-keeping and Accounting
Book keeping is mainly concerned with record keeping or maintenance of books of account. It includes identifying the financial transactions, measuring them in terms of money, recording them in the books of original entry and then classifying them into ledger. Accounting is more than Book-keeping. Apart from the standard practices of Bookkeeping it involves summarizing the classified information in the form of Profit and Loss Account and Balance Sheet, drawing meaningful information from them and communicating this information with the interested parties i.e. stakeholders. „Booking keeping‟ is a part of accounting as it only involves recording of economic events.
Purpose of Accounting The main purpose of accounting is
To keep a systematic record of business transactions
To calculate Profit and Loss
To ascertain the financial position of the business
To provide financial information to different users of this information.
Who are users of accounting information? These stakeholders or users might include
Owner/Shareholders: How much profit?
Managers: How business performed and how they can improve the performance in future
Employees: To know the profits so that they could demand better wages?
Investors: Is it safe and profitable to invest in the business?
Suppliers: Will the business be able to pay for their supplies?
Government: How much tax should be collected?
Lenders: It is safe to lend money to the business?
Types of Accounting Financial Accounting: It is about recording business transactions in a systematic manner, to ascertain the profits or losses of the business by preparing Profit and Loss Account and Balance Sheet. Cost Accounting: It involves finding out the total cost and unit cost of goods and services produced by the business. Management accounting: Accounting table and formats may not make sense to a person other than an accounting. This is where Management accounting comes in. It is presenting the accounting information in a manner which a layman manager could understand. It involves ratio analysis, budgets, cash flows etc. We will be covering some parts of Management accounting in Analysis of Final Accounts section.
Basic Accounting Concepts Business Entity Concept/Accounting Entity Concept According to this concept, the business is considered as a separate business entity from its owner(s). Thus the financial information of the business will be recorded and reported separately from its owner‟s personal financial information.
Going Concern For accounting purposes, it is assumed that the business will operate for an indefinite period of time and thus considered as „going concern‟. For this reason, the realizable value of the property owned by business will not be relevant.
Money Measurement Only those transactions will be recorded in the financial books which can be measured in terms of money. Anything which cannot be measured in monetary terms will not be considered as a part of the accounting data.
Historical Cost All assets will be recorded at their cost price. This means that machinery purchased years ago will be recorded at its original cost of purchase even though its value is lower now. The reason for doing so is because the business is considered as a going concern and we need not be worried about the saleable value of the asset.
Accounting Period The life a business is considered to be indefinite. But for accounting purposes, the life of the business is divided into specified periods of time. The period may be a month, a half year, a full year or any length of time.
Accrual Concept Accrual concept states that revenue is recognized when it is earned and expenses when they are incurred. Any income or revenue generated must be recorded in the books of accounts whether the payment for it is received or not. Similarly, any expense done by the business should be recorded irrespective of the fact that the business has paid for it or not.
Objectivity
Any transaction which is recorded in the accounting books should be verifiable. In other words, the transaction should backed by some proof in the form of a receipt, invoice, cheque, voucher etc.
Accounting Conventions Consistency According to this concept, the same accounting method should be applied in each accounting period when preparing financial reports. This makes it easy to compare results of one period with another period and the stakeholders can get a more realistic idea about the performance of the business.
Prudence It involves being cautious while reporting accounting information. The assets should not be overstated and the liabilities should not be understated. This is why closing stock is always valued at the lower of cost or market value so that the profits are not overstated.
Matching Principle This principle is based on accrual concept of accounting. It states that revenue earned during a specific period has to be matched with the expenses incurred with earning that revenue. The following point should be considered:
If an item of revenue is shown in the Profit and Loss account, all expenses incurred on it, whether paid or not, should be shown as expenses in the Profit and Loss account.
An expense will be recorded in the books of accounts if the revenue associated with it has not been realized.
Incomes received in advance should not be shown in Profit and Loss account.
All the cost and expenses incurred on good remaining unsold at end of the year must be carried forward to next year as these goods will be sold in the next accounting period.
Accounting Procedures Provision for Doubtful Debts Even after deducting the amount of actual bad-debts from the Debtors, there may still be some debts which may be regarded as bad or doubtful. Thus a business might make an estimate of the amount of such doubtful debts, that is, debts that are likely to become bad, and charge them as an expense against the current period‟s revenue.
When Provision for Doubtful Debts is set up for the first time Accounting Entries Doubtful Debts Account
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Provision for doubtful debts (Being creation of provision for doubtful debts)
Closing Entries Doubtful Debts Account is an expense for the business and thus it will be debited to the Profit and Loss account
Profit and Loss Account
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Doubtful debts Account (Being transfer of doubtful debts expense to the Profit and Loss Account) It will be deducted from the Sundry Debtors in the Balance Sheet.
Increasing the Existing Provision for Doubtful Debts Adjusting Entry Doubtful debts Account
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Provision for doubtful debts Account (Being increase of provision for doubtful debts)
Closing Entry Being a loss for the business the Doubtful Debts Account is transferred to the debit side of Profit and Loss Account.
Profit and Loss Account
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Doubtful Debts (Being transfer of doubtful debts expense to the Profit and Loss Account)
Decreasing the Existing Provision for Doubtful Debts Adjusting Entry Provision for doubtful debts Account Doubtful debts Account (Being decrease of provisions for doubtful debts)
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Closing Entry Being a gain for the business the Doubtful Debts Account is transferred to the Credit side of Profit and Loss Account.
Doubtful Debts Account
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Profit and Loss Account (Being transfer of doubtful debts expense to the Profit and Loss Account) In the Balance Sheet the debtors will appear net of the Provision for Doubtful debts.
Closing Stock Closing stock refers to the goods remaining unsold during the year. They are valued at Cost price or Market Price whichever is lower.
Closing entries Closing Stock Account
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Trading Account (For closing Stock transferred to trading account)
Treatment in Final Accounts When closing stock is given outside the Trial Balance It will appear on
The credit side of the Trading Account
Under Current Assets in the Balance Sheet.
When closing stock appears inside the Trail Balance This means that the Closing stocks have already been deducted from the Purchases and thus it will ONLY appear in the Balance Sheet under Current Assets.
Writing off Bad Debts There may be occasions when the business might not be able to collect its debts. This may be due to the dishonesty of a debtor or may be due to the death or insolvency of a debtor.
Bad Debts Account
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Debtors Account (Bad debts written off)
This amount is then written off the books as „Bad debts‟. It is a loss for the business and thus it is written on the debit side of the Profit and Loss account.
Closing Entry Profit and Loss Account
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Bad Debts Account (Transfer of bad debts to Profit and loss Account)
Accounting Treatment Bad debts appear on the debit side of the Profit and Loss account because it is a loss. Bad debts are deducted from the Debtors in the Current assets in the Balance Sheet.
Recovery of Bad Debts
Sometime a debts written off as Bad debts may be recovered later on. Cash is coming in thus Cash account is debited whereas „Recovery of bad debts‟ is credited because it a gain.
Accounting Entries Cash Account
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Recovery of bad debts (Being bad debts recovered)
Recovery of bad debts
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Profit and Loss account (Being transfer of recovery of bad debts to Profit and Loss Account)
Partial Settlement of Debtors Sometimes, a business might only be able to recover a part of the debts. This means the rest of the unrecovered debts will be written off as bad debts.
Accounting Entries Cash Account
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Bad Debts Account
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Debtor‟s Account (Being partial recovery of debts)
Depreciation
Depreciation may be defined as the permanent and continuing diminution in the quality or the value of an asset. William Pickles Depreciation is the gradual and permanent decrease in the value of an asset from any cause. R.N. Carter. Depreciation is fall in the value of the fixed assets (except Land).
Depreciation is charged as an expense in the Profit and Loss Account in order to spread the cost of a fixed asset over the asset‟s useful life.
Depreciation is charged on a continuous basis. Once the depreciation is charged, it must be charged on regular basis in the succeeding period also.
Calculation of Depreciation Straight line or Fixed Installment Method A fixed or equal amount is to be charged as depreciation every year during the life time of the asset. The amount of depreciation remains equal from year to year. The expected lifetime of the asset is calculated and the cost of the asset is spread over its lifetime. Depreciation expense per annum=Original cost/number of years of useful life If the fixed asset is expected to have a scarp value at the end of its useful life, then Depreciation expense per annum= (Original cost-Estimated scrap value)/Number of years of useful life
Reducing Balance or Diminishing Balance Method The value of asset goes on diminishing year after year, the amount of depreciation charged every year also goes on declining. Every year a fixed percentage of the net book value of the asset is reduced. For example 20% depreciation is charged. If the asset has a value of $10000, the depreciation for the first year will be 20% of $10000 i.e. $4000. The book value for the next year will be now $6000. This year the depreciation will be again 20% of the remaining value i.e. 20% of 6000=$1200. So the remaining value of the asset is now $6000-$1200=$4800.
Revaluation Method Under this method, the fixed asset is valued at the end of every accounting period. The difference between its value at the end of the period and the beginning of the period will be the depreciation for that period.
Depreciation expense=Value of asset at the end-Value of asset at the beginning + Any new purchase
Recording Depreciation in the Books Once the depreciation expense is calculated, the adjusted entry would be:
Method 1 Depreciation Account Dr. Provision for Depreciation Account The nominal account is closed and the balance transferred to the Profit and Loss Account by: Profit and Loss Account Depreciation Account
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The Provision for Depreciation Account shows the accumulated depreciation on the fixed asset. Like other liability accounts, it is closed by bringing its balance down. The Fixed Assets account is always maintained at its original cost. In the Balance Sheet, the fixed asset is shown at it book value, thus is, cost minus the provision for depreciation.
Method 2 In this method, depreciation expense is directly credited into the fixed asset itself. In this case, the book value of the fixed asset is the balance in the Asset Account. The entries are: Depreciation account Fixed asset Account
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Depreciation account is closed and its balance is transferred to the Profit and Loss account. Profit and Loss Account Depreciation Account
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The effect on the Profit and Loss account and the Balance Sheet remains unchanged. When no Provision for Depreciation Account is set up to record all the accumulated depreciation, the Fixed asset is brought down to its book value at the close of each accounting period after depreciation is written off.
Capital Expenditure Capital expenditure occurs when a business gets a long term advantage due to that expenditure. It is usually incurred for accusation of an asset. These expenditures do not occur in the regular day to day transactions of the business. Common examples
Purchase of furniture, office building etc.
Purchase of additional furniture or machinery
Expenditure incurred in connection with the purchase of a fixed asset. For example, carriage paid of machinery purchased.
Purchase of patent right, copy rights etc.
Revenue Expenditure Expenditure which is not for increasing the value of fixed assets, but for running the business on a day to day basis, is known as revenue expenditure.
Difference between Capital and Revenue expenditure Buy a car is capital expenditure because its benefit to the business will be spread over a long time. Fuel cost for running this care is revenue expenditure and it will be used up in few days and does not add to the value of the fixed asset.
Capital receipts Capital receipts consist of
additional payments made to the business either by owner or shareholder of the business; or
from sale of fixed assets of the business.
Revenue receipts
Any receipt in the normal running or through day to day transactions of the business is categorized as Revenue receipt.
Sales receipts of the business are revenue receipts.
Verification of accounting records Bank Reconciliation Statement Bank reconciliation statement is a statement prepared mainly to reconcile the difference between the ‘Bank Balance’ shown by the Cash book and Bank statement. Usually, the trader maintains a Bank Column in the Cash book and does all the entries related with bank. At the end of the month, when he receives a Bank statement from the bank he might find some differences between bank balance shown by Bank Statement and his Cash book. These differences might arise due to many reasons. In order to reconcile and tally the differences he will prepare a Bank Reconciliation Statement. Now the question arise,
What are the reasons for difference in Bank Statement and Cash Book? These can be summarized as follows:
Cheque issued by the trader but the customer has not yet presented it to the bank for encashment.
This will show a less bank balance in the trader‟s Cash book as he has already issued the cheque, but the bank will not reduce the amount till the cheque is presented to it.
Cheque received by the trader was deposited into the bank for collection but the bank did not realize the funds and did not credit the Trader‟s account.
Trader deposited a cheque into bank but it was dishonored by the bank. The reason may be the customer does not have sufficient cash in his bank account.
Bank pays interest to the trader on his deposit but the trader will not come to know this till he receives the Bank statement and thus his cash book will show less balance as compared to bank statement.
Bank might receive direct payment of interest or dividends on behalf of the trader for any investments made by the trader. The trader will not come to know the details till he gets a bank statement and thus his Cash book will be understated.
Bank might charge transaction fees or Bank charges or interest on any overdraft which the trader will only know when he receives the bank statement.
A customer or debtor might directly pay into the trader‟s bank account and the trader might not be aware of this.
A Bank may pay bills, insurance premiums or some payment based on the standing instruction of the trader. The details of these transactions will only be available to the trader once he receives the bank statement. A bank reconciliation statement can be prepared by taking the balance either as per cash book or as per pass book as a starting point. If the statement is started with the balance as per bank column of the cash book, the answer arrived at the end will be balance as per pass book. Alternatively, if the statement is started with the balance as per pass book, the answer arrived at in the end will be the balance as per cash book. A debit balance as per cash book shows the amount of the money in the bank, whereas, a credit balance means that the business has taken an overdraft. In the same way, a credit balance as per pass book shows a positive bank balance whereas debit balance as per pass book shows an Overdraft.
Method 1: Bank reconciliation statement by Debit balance of Bank Column of Cash Book.
Method 2: Bank reconciliation statement by Credit balance as Cash Book (Overdraft).
Method 3: Bank reconciliation statement by Credit balance as per Bank Statement .
Method 4: Bank reconciliation statement by Debit balance as per Bank Statement (Overdraft).
Control Accounts Not all the transactions done in a business are in cash. Now days, businesses do a lot more transactions in credit and thus there is a long list of debtors and creditors. Since the bulk of entries are made in the accounts of debtors and creditors, these two classes of accounts are taken out of the General Ledger and put in a subsidiary ledger. Subsidiary ledgers include Sales Ledger: Which contains all debtors accounts Purchases Ledger: contains all creditors‟ accounts. This is where control account comes in… Control account is a summary of all the accounts in the subsidiary ledgers.
The summary of all accounts in the Sales ledger make up the Debtors control account and the summary of all accounts in the Purchase Ledger is known as the Creditors control account.
How to make Debtors Control Account
Sales transaction takes place
It is recorded in the Sales Journal
From the Sales Journal entry is posted to the Sales Ledger.
From where do you get information to draw Debtors Control Accounts? Information
Source
Total Opening Balance
Trial Balance at close of previous period
Total Sales
Sales Journal
Dishonoured Cheques
Cash Book
Discount allowed withdrawn
General Journal
Any charges to debtors
General Journal
Total cash and cheques received from debtors
Cash book
Discount allowed
Cash Book
Returns inwards and allowances
Returns Inwards journal
Bad Debts
General Journal
How do we prepare Creditors Control Account? Also known as Purchases Ledger Control Account It accounts for all Creditors appearing in the Purchases Ledger.
From where do you get information to draw Creditors Control Accounts? Information
Sources
Total cash and cheques paid to creditors
Cash Book
Discount received
Cash Book
Returns outwards and allowances
Returns Outwards Journals
Total opening balances
Trial Balance at close of previous period
Total purchases
Purchases Journal
Any charges by creditors
Journal
Minority balances in Control Accounts Normally, debtors accounts have debit balances Creditors accounts contain credit balances. There may instances when debtors might return some goods after their accounts have been settled and this may lead them to have a credit balance.
What to do? The Debtors control Account will have both the debit and credit balances brought down. Same procedure will take place for Creditors Control Account. Through this the true financial position is shown i.e. the exact amount owing by debtors as well as the amount owing to them.
Trial Balance Trial Balance is a statement prepared with the debit and credit balances of ledger accounts to verify the arithmetical accuracy of the book. The Trial Balance checks the equality of debits and credits in the ledger by listing each account along with its ending balance.
Accounts to be placed on debit side
Accounts to be placed on credit side
Assets Expenses Drawings
Liabilities Capital Revenue
Errors revealed by Trial Balance Errors in calculation Any calculation mistake, especially totaling mistake or balancing mistake will be revealed by Trial Balance as both the side will not match.
Errors of omission of one entry If by mistake only one entry is made for a transaction, Trial Balance will not balance.
Posting to the wrong side of an account In case any entry is made on the wrong side of the account, it will be revealed by the Trial Balance. For example Credit sale of $100 was debited to Sales account.
Posting of wrong amount When two different amounts are entered for the same entry, both the sides of the Trial balance will not match. For example, Credit sales of $123 to James. James was debited with $123 but Sales was wrongly credited as $132.
Limitation of Trial Balance Though Trial Balance is prepared to check the arithmetical accuracy of double entries, there are still some mistakes which cannot be identified by Trial Balance. These are:
Errors of omission These are errors where the transactions are totally omitted. They are neither recorded in the Journal or Ledge and thus do not appear in the Trial Balance.
Errors of commission This means that a wrong amount is entered from the very starting in the Journal or Ledger and thus a Trial Balance based on this amount may not show any mistake at all.
Errors of principle These errors occur when the classification of accounts is wrongly done. For example revenue expenditure may be considered as capital expenditure. Repairs of machinery $200 was debited to Machinery account whereas it should have been debited to „Repairs of machinery account‟.
Complete reversal of entries Complete reversal of entries cannot be revealed by Trial Balance. This is when entries have been made to both the sides and thus there is no arithmetical mistake. Good sold to Raman were entered as Sales debited and Raman Credited, whereas, it should have been vice versa.
Compensating errors These errors are those which cancel themselves because the same error is committed on both sides. For example, Purchases were debited by $100 more and at the same time Sales were also credited by $100. This will neutralize the effect of both the entries.
Final Accounts Accounts of clubs and societies What are Non Profit Organizations? Sole trader, Partnership and Limited companies have Profit as their main objective. However, Clubs, societies and associations does not only exist to make profit. They may be formed to promote cultural and recreational interest. Thus their final accounts are different from those organizations which solely exist to earn profit.
The final accounts of a non-profit organization includes of 1. Trading Accounts (only if there is a restaurant or canteen) 2. Receipts and Payments Accounts 3. Income and Expenditure Account 4. Balance Sheet
What can be classified as Revenue receipts & revenue expenditure? Revenue receipts
Revenue expenditure
Subscription
Entertainment expenses
Competition fees
Rent of club premises
Income from Socials
Competition prizes
Rental fees
Cost of fund raising projects
Donation (if not capitalized)
Repairs and maintenance of property
Proceeds from fund-raising projects (not capitalized)
Sundry expenses to run the activities of club
Interest on bank deposits
Staff wages
Receipts from sale of food in club restaurant
Postage & Stationery expenses Electricity and water expenses Depreciation
What can be classified as Capital receipts and Capital Expenditure? Capital receipts Legacies Building funds Entrance fees Life membership fees (if capitalized)
Capital Expenditure Purchase of fixed assets
Receipts and Payments Account Format for Receipts and Payments Account Receipt and Payments Account for the year ended 31 December 2010 Dr.
Cr. Receipts
Balance b/d (Opening balance)
All Cash receipts
Amount XXXX
Payments All cash payments
Amount xxxxx
XXXX
XXXX Balance c/f (closing balance) XXXXX
Cash (beginning) + all cash receipts (revenue receipts and capital receipts) - All Cash payments (revenue expenditure and capital expenditure) Cash (end)
Features
Similar to Cash Book
Cash receipts are on Debit side and Cash payments are on Credit side
All cash receipts and payments are recorded irrespective of their relation to current year.
There is an opening balance and a closing balance
xxxxx
XXXXX
Income and Expenditure Account Income and Expenditure Account for the year ended 31 December 2010 Dr.
Cr. Expenditure
Revenue expenses only
Surplus (when income is more than expenditure)
Amount XXXX
XXXX
Income
Amount
Trading Profit (if any)
XXXX
Revenue Incomes only
XXXX
Deficit (when expenditure is more than income)
xxxxx
XXXXX
Step in constructing an Income and Expenditure Account 1. If there is a Trading Profit put it on the Credit side. 2. Put all the revenue incomes on the Credit side. 3. Put all the revenue expenses on Debit side. 4. Balance both the sides. 5. If the Income side is more than the expenditure side then we get a SURPLUS. 6. If the Expenditure side is more than the income side we get a DEFICIT.
Note
Only revenue receipts and expense are posted in this account
Only incomes and expenses pertaining that particular year are recorded. Incomes and expenses pertaining to previous year or future year are adjusted for.
XXXXX
Distinction between Receipts and Payments Accounts and Income and Expenditure Accounts Receipts and Payments Accounts
Income and Expenditure Account
Similar to a cash account showing total cash receipts and total cash payments during a particular period.
Similar to Profit and Loss account showing incomes and expenses arising during a particular period.
There is an opening balance representing cash or bank balance
No opening balance
Records all cash receipts and cash payments whether capital or revenue in nature.
Only records income and expenses of revenue nature
Records all receipts and payments irrespective of their relation to this year, previous year or next year.
Records only receipts and expenses relating to the current year.
At the end of the year excess of receipts over payments shows a positive cash balance whereas a negative balance signifies an overdraft
Excess of income over expenditure represents net income whereas vice versa represents a net loss.
Adjustments in Final Accounts (Non-trading concerns) Subscription Account Subscriptions are paid by members as charges for using the facilities of a club or society for a particular period of time. Usually it is on a yearly basis.
Receipt and Payment account records the actual subscription received. It may pertain to any year. However, In order to post it to the Income and Expenditure Account adjustments have to be made to the subscription as only subscription pertaining to that particular year is recorded in I/E account.
How to calculate e.g. for Year 2009 Total subscription received
1000
Less Subscription in arrears, at the starting of the year
200
Add Subscription received in advance for 2009, in previous years.
100
Add Subscription in arrears, at the end of 2009
300
Less Subscription received in advance (for next year), at the end of the year
100
Subscription revenue for Year 2010
1100
You can also make a separate Subscription Account and then post the final subscription amount in the Income and Expenditure Account Dr.
Subscription Account Amount
Subscription in arrears (b/d)
Amount
XXXX
Subscription received in advance b/d (collected during previous year)
XXXX
XXXX
Total Cash received as subscription during the current year
XXXX
(not collected during the previous year) Subscription received during current year (from Income & Expenditure Account)
Cr.
Subscription in advance c/d
XXXX
Subscription in arrears c/d (not yet collected for current year)
(collected for subsequent year) XXXX Subscription in arrears b/d
XXXX
XXXX
XXXX Subscription in advance b/d
XXXX
'Subscription Account Format' Note:
Subscription in arrears appears as Current Assets in the Balance Sheet.
Subscription received in advance appears as Current Liability in the Balance Sheet.
Other adjustments Donations: Donations for general purpose unless specifically mentioned appear in Income and Expenditure Account. However, Donations for specific purpose such as construction of building and mentioned as „capitalized‟ will appear in Receipt & Payment Account and Balance Sheet. Similarly, all other receipts, unless mentioned, as „capitalized‟ will appear Receipts and Payments Account and Income and Expenditure Account. If they are „capitalized‟ then they will appear in Receipts and Payments Account and Balance Sheet
What are Final Accounts? Final Accounts consists of
Trading Account
Profit and Loss Account
Balance Sheet
Trading Account It is a Nominal Account and is prepared for calculating the GROSS PROFIT or GROSS LOSS arising as a result of trading activities of a business. According to J.R.Batliboi:-
„The Trading Account shows the results of buying and selling of goods. In preparing, this account, the general establishment charges are ignored and only the transactions in goods are included‟
Importance of Trading Account Trading Account is prepared for the following reasons
To know the Gross Profit or Gross loss arising due to trading activities of the business.
To find out the direct expenses incurred by the business for the goods sold during the year.
Find out how much closing stock is left as compared to previous years and thus find out the performance of the business.
Gives the trader an idea of the increase/decrease in Gross Profit /Gross Loss and to assess the performance of the business and take corrective measures, if needed.
Preparation of Trading Account The following items usually appear in a Trading Account
Sales turnover Both Cash and Credit sales are included. Net Sales is recorded after deducting Sales returns (Return inwards).
Opening Stock The closing stock of the previous accounting year is taken as the Opening stock for the present year. If there is no Opening Stock then no entry is made. Opening stock is derived by balancing the Stock Account and bringing down its balance to the next period.
Purchases Purchases include all the Cash and Credit purchases of goods made by the business during the year. Purchase returns (Return outwards) is deducted from the Purchases to arrive at Net Purchases.
Direct Expenses All expenses which are incurred in purchasing the goods and bringing them to the trading place are recorded under this category. These include:
Wages e.g. Warehouse worker wages.
Carriage Inwards i.e. the cost of transport of goods to the trading place. The expense is usually borne by the buyer.
Duty on purchases, for example, Import duty or excise duty.
Closing Stock All the goods which remain unsold at the end of the year are known as „Closing stock‟. The closing is stock is valued at Cost price or Market price, whichever is lower. The reason for taking the lower value of the two is in accordance with the „Prudence Principle‟. Normally, „Closing stock‟ is given outside the Trial Balance. This is so because its valuation is made after the accounts have been closed. Note: Sometimes, the „Closing Stock‟ may be given inside the Trail Balance. This means that the entry to incorporate the closing stock in the books has already been passed and it has already been deducted from the Purchases Account. In this case, „Closing Stock‟ will not be shown in the Trading Account will only appear in the Asset side of Balance Sheet‟.
Cost of goods sold This means the finding the cost of only those goods which have been sold during the year. It can be calculated as follows: (Net Purchases+Opening Stock) - Closing Stock
Profit and Loss Account According to Prof. Carter: „A Profit and Loss Account is an account into which all gains and losses are collected, in order to ascertain the excess of gains over the losses or vice-versa‟.
Why Profit and loss account is made?
To find out the Net Profit or Net Loss
Compare the net profit of the business with previous years and to assess the performance of the business.
Find out the amount of overheads of a business.
Items appearing on a Profit and Loss account Any Incomes or gains Any income or gains of the business from sources other than sales are recorded on the Credit side of Profit and loss account.
Gross Profit or Loss It is transferred to the P/L account from the Trading Account. Gross Profit is transferred to the Debit side whereas Gross Loss is transferred to the Credit side.
Office and Administrative expenses Example include salaries, office rent, lighting, stationery etc.
Selling and Distribution expenses Include advertising expense, commission, carriage outwards, bad-debts etc.
Miscellaneous expenses Such as, interest on loan, interest on capital, depreciation etc.
Balance Sheet Balance Sheet is a statement which shows the financial position of the business on a particular day. According to A. Palmer “The Balance Sheet is a statement at a particular date showing on one side the trader‟s property and possessions and on the other hand the liabilities”.
Thus we can say that Balance sheet is a statement not an account.
It is prepared to show the financial position of the business.
It records all the assets and liabilities of the business.
It shows the financial position on a particular day not for a period of time.
Need and Importance of Preparing a Balance Sheet A Balance Sheet serves the following purposes:
The true financial position of the business can be ascertained at a particular point of time.
Reveals the amount of assets owned by the business for example machinery, cash, debtors and so on.
Show the liabilities of the business such as total creditors, share capital etc.
To adjudge weather the firm is solvent or not.
Opening entries for the next financial year are based on the Balance Sheet of the previous year.
Items appearing on a Balance Sheet Assets Assets of a business are what it owns. They can be classified as: Fixed assets: All those assets which are owned by the business and last for more than an accounting year. Examples include Land, building, machinery, vehicle, furniture and fixtures and the like. Current assets: It includes all those assets which either in the form of cash or can be easily converted into cash within one accounting period. Current Assets include Cash, Debtors and Stock.
Liabilities Liabilities represents what the business owes to outside persons other than owners. These liabilities are classified on basis of time period of repayment.
Long term liabilities: These are liabilities which the business owes for more than one accounting period, e.g. long term bank loans, debentures etc. Current liabilities: These are short term debts of the business that are to be repaid within one accounting period, e.g. creditors and bank overdraft.
Owner’s Equity Owner‟s equity represents what the business owes its owner. It is equal to total assets minus total liabilities.
Important points regarding Balance Sheet
The Balance Sheet is not an account but a statement.
It does not have debit or credit side but has two sections i.e. assets and liabilities.
The heading of Balance Sheet is „as on a particular date‟. Thus a Balance Sheet may have different figure on different dates.
The balances shown in the Balance Sheet act as Opening Balances for the next accounting period.
Balance Sheet is based on the accounting equation Assets= Owner’s Equity + Liabilities
Difference between Trial Balance and Balance Sheet Objective Trial Balance is prepared to verify the arithmetical accuracy of the books of account whereas Balance Sheet shows the financial position of the business.
Headings Trial Balance is two sides i.e. Debit and Credit whereas Balance Sheet has Assets and Liabilities.Profit and LossTrial Balance does not show any information about the profit or loss of a business, whereas Balance Sheet records the Profit or Loss of the business.
Closing stock The valuation of closing stock is not necessary to prepare a Trial Balance whereas Balance Sheet cannot be prepared unless the Closing stock for that particular accounting year is not ascertained.
Types of Accounts Balances of all types of accounts are recorded in a Trial Balance i.e. Personal, real and nominal. Balance Sheet records balances of personal and real accounts only.
Adjustments Adjustment for outstanding expenses, prepaid expenses and accrued incomes are not required for the preparation of Trial Balance. A Balance sheet is only complete after all the necessary adjustments are made.
Closing Stock Closing stock refers to the goods remaining unsold during the year. They are valued at Cost price or Market Price whichever is lower.
Closing entries Closing Stock Account
Dr.
Trading Account (For closing Stock transferred to trading account)
Treatment in Final Accounts When closing stock is given outside the Trial Balance It will appear on
The credit side of the Trading Account
Under Current Assets in the Balance Sheet.
When closing stock appears inside the Trail Balance This means that the Closing stocks have already been deducted from the Purchases and thus it will ONLY appear in the Balance Sheet under Current Assets.
Accrued expenses or outstanding expenses Expenses which have been incurred but not been paid for till the end of the accounting year are known as Accrued expenses or outstanding expenses. For example, Total salaries to be paid for the year were $10,000, but by the end of the year $1000 were not paid and will be treated as outstanding salary.
Adjusting Entry Salaries Account
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Outstanding Salaries Account (Being salaries outstanding)
Accounting treatment Outstanding expense amount is added to that particular expense account in the Profit and loss or Trading Account because it was the expense for that year. (Based on the matching principle) Outstanding expenses are liabilities for the business. Thus they will appear under the Current Liabilities in the Balance Sheet. Note: If the Outstanding expense appears in the Trial Balance then it will only be recorded in the Liabilities side of the Balance Sheet.
Prepaid Expenses All those expenses which are due next year but paid for in advance during the current year are termed as Prepaid Expenses.
Adjustment Entries Prepaid Expense Account
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Expense Account (For expense paid in advance)
Accounting Treatment The concerned expense will be deducted by the prepaid amount in the Trading Account or Profit & Loss account. Prepaid expenses are assets for the business thus it will appear under the Current Assets in the Balance Sheet. Note: If the Prepaid expense is given inside the Trial Balance, then the prepaid expense will only appear in the Current Asset of the Balance Sheet.
Depreciation Depreciation is the fall in the value of fixed assets over a period of time.
Adjustment Entries Depreciation Account Assets Account (Being depreciation charged)
Dr.
Accounting Treatment Depreciation amount is entered as expense on the Debit Side of Profit and Loss account. Depreciation is deducted from the value of the concerned asset in the Balance Sheet.
Accrued Income Incomes which are earned during the year but not received till the end of the accounting year are termed as Accrued Income / Earned Incomes/ Income Receivable.
Adjustment Entries Accrued Income Account
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Income Account (Being income received in advance)
Accounting treatment Accrued income will be added to the concerned income account in the Profit and Loss account because it the income for that particular year (matching principle) Accrued incomes are asset for the business and appear under the Current Assets in the Balance Sheet. Note: If Accrued Incomes appear inside the Trial Balance then it will ONLY appear under the Current Assets in the Balance Sheet.
Unearned Income/Revenue All incomes or revenues which are received in advance but not earned during the year are treated as unearned revenue. There may be times when a certain income is received in the current year but the whole amount of it does not belong to the current year.
Adjusting Entries Revenue Account
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Revenue received in advance Account (For revenue received in advance)
Accounting Treatment Unearned incomes/revenues are not the actual income for that particular year and thus deducted from that particular revenue account in the Profit and Loss Account. Unearned incomes/revenues are treated as liability for the business and thus appear under the Current Liabilities in the Balance Sheet. Note: If unearned income/revenue appears inside the Trial balance then it will ONLY appear under the Liabilities in the Balance Sheet.
Interest on Capital Usually the owner gets an Interest on his investment the business. According to the principle of separate entity, Capital is considered as Liability for the business and the owner is paid a certain amount of interest on the capital employed.
Accounting Entries Interest on Capital
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Capital Account (Interest allowed on Capital)
Accounting Treatment in Final Accounts Interest on Capital is an expense for the business and thus appears on the Debit side of the Profit and Loss account. It is a gain for the owner and thus it is added to the Capital in the Balance Sheet.
Interest on Drawings Many times during the operation of business, the owner may take out some cash from the business for his personal use. These withdrawals from the business are considered as Drawings. Considering the fact that the business is a separate accounting entity, it charges an interest on the drawings to the owner.
Adjusting Entries Drawing Account Interest on drawings account (Being interest charged on drawings)
Dr.
Accounting Treatment Interest on drawings is an income for the business and appears on the Credit side of the Profit and Loss Account. Interest on drawings is an expense for the proprietor and thus it is deducted from the Capital Account in the Balance Sheet.
Interest on Loan Interest paid on loans taken by the business is treated as expense and will appear on the Debit side of the Profit and loss account. Sometimes the interest on loan may not be fully paid and may be outstanding when the final account is prepared. In this case, the Interest on loan account will be debited by the outstanding interest amount.
Adjusting Entries Interest on Loan account
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Outstanding Interest account (Being outstanding interest on loan)
Accounting treatment Interest on loan is an expense for the business and appears on the Debit side of the Profit and Loss account. Interest on loan is a liability for the business and is added to the Loan Account in the Liabilities section of the Balance Sheet.
Writing off Bad Debts There may be occasions when the business might not be able to collect its debts. This may be due to the dishonesty of a debtor or may be due to the death or insolvency of a debtor.
Bad Debts Account
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Debtors Account (Bad debts written off)
This amount is then written off the books as „Bad debts‟. It is a loss for the business and thus it is written on the debit side of the Profit and Loss account.
Closing Entry Profit and Loss Account
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Bad Debts Account (Transfer of bad debts to Profit and loss Account)
Accounting Treatment Bad debts appear on the debit side of the Profit and Loss account because it is a loss. Bad debts are deducted from the Debtors in the Current assets in the Balance Sheet.
Recovery of Bad Debts Sometime a debts written off as Bad debts may be recovered later on. Cash is coming in thus Cash account is debited whereas „Recovery of bad debts‟ is credited because it a gain.
Accounting Entries Cash Account Recovery of bad debts (Being bad debts recovered)
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Recovery of bad debts
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Profit and Loss account (Being transfer of recovery of bad debts to Profit and Loss Account)
Partial Settlement of Debtors Sometimes, a business might only be able to recover a part of the debts. This means the rest of the unrecovered debts will be written off as bad debts.
Accounting Entries Cash Account
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Bad Debts Account
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Debtor‟s Account (Being partial recovery of debts)
Provision for Doubtful Debts Even after deducting the amount of actual bad-debts from the Debtors, there may still be some debts which may be regarded as bad or doubtful. Thus a business might make an estimate of the amount of such doubtful debts, that is, debts that are likely to become bad, and charge them as an expense against the current period‟s revenue.
When Provision for Doubtful Debts is set up for the first time Accounting Entries
Doubtful Debts Account
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Provision for doubtful debts (Being creation of provision for doubtful debts)
Closing Entries Doubtful Debts Account is an expense for the business and thus it will be debited to the Profit and Loss account
Profit and Loss Account
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Doubtful debts Account (Being transfer of doubtful debts expense to the Profit and Loss Account) It will be deducted from the Sundry Debtors in the Balance Sheet.
Increasing the Existing Provision for Doubtful Debts Adjusting Entry Doubtful debts Account
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Provision for doubtful debts Account (Being increase of provision for doubtful debts)
Closing Entry Being a loss for the business the Doubtful Debts Account is transferred to the debit side of Profit and Loss Account.
Profit and Loss Account
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Doubtful Debts (Being transfer of doubtful debts expense to the Profit and Loss Account)
Decreasing the Existing Provision for Doubtful Debts Adjusting Entry Provision for doubtful debts Account
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Doubtful debts Account (Being decrease of provisions for doubtful debts)
Closing Entry Being a gain for the business the Doubtful Debts Account is transferred to the Credit side of Profit and Loss Account.
Doubtful Debts Account
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Profit and Loss Account (Being transfer of doubtful debts expense to the Profit and Loss Account) In the Balance Sheet the debtors will appear net of the Provision for Doubtful debts.
Provision for Discount on Debtors A provision for discounts to debtors who pay early is created in the current year itself. Accounting Entries Profit and Loss Account Dr. Provision for Discount on Debtors Account (For provision for discount created on Debtors) It is shown on the Debit side of the Profit and Loss Account. Provision for Discount on Debtors is deducted from the Debtors in the Balance Sheet. Note: Provision for discount on debtors will be deducted after „Further bad debts‟ and „Provision for doubtful debts‟ are deducted from the Debtors.
Provision for Discount on Creditors When the business makes prompt payments of its debts, it is bound to receive Discounts from its creditors. Although the discounts will be earned in the next year, the discounts so earned are an income of the current year. A Provision for such discount is made in the current year itself so that that the discounts thus earned may be credited to the Profit and Loss Account of the current year.
Provision for Discount on Creditors Account
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Profit and Loss Account (For provision for discount on Creditors)
Accounting Treatment Provision for Discount on Creditors will be shown on the Credit side of the Profit and Loss Account. It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet.
Provision for Discount on Creditors When the business makes prompt payments of its debts, it is bound to receive Discounts from its creditors. Although the discounts will be earned in the next year, the discounts so earned are an income of the current year. A Provision for such discount is made in the current year itself so that that the discounts thus earned may be credited to the Profit and Loss Account of the current year.
Provision for Discount on Creditors Account
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Profit and Loss Account (For provision for discount on Creditors)
Accounting Treatment Provision for Discount on Creditors will be shown on the Credit side of the Profit and Loss Account. It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet.
Manufacturing Account It is prepared to ascertain the cost of goods manufactured during an accounting period. This account is prepared only by a business which is manufacturing goods.
Items appearing on the debit side Stock It is of three types:
Raw materials: raw material purchased but not yet consumed.
Work in progress: Goods which are still semi-finished.
Finished goods: Completed goods but yet unsold and laying in warehouse waiting to be sold. Raw materials consumed during the period is calculated as follows
Opening Stock of Raw material
xxxx
Add: Purchase of Raw Materials
xxxx xxxx
Less: Closing Stock of Raw Materials
xxxx xxxx
Carriage Inwards All expenses incurred for bringing the raw materials to the factory e.g. custom duty, excise etc.
Factory overheads
All indirect expenses related to the operation of factory such as indirect materials (not direct raw material used in manufacturing) e.g. lubricants for machinery
indirect labour (not direct labour) e.g. supervisor wages
indirect expenses such as factory insurance, rent, depreciation of machinery
Items appearing on Credit Side Sale of Scrap Scrap is the waste products during the process of manufacturing. Money realized by their sales (an income!)
Any Work in Progress Any unfinished goods left with the manufacturer at the end of the accounting period.
How to calculate the Cost of Production? Total Debit Side – Total Credit Side This balance is known as the Cost of Production It is transferred to the Trading Account.
Format of Manufacturing Account
What is Single entry system? According to Carter ‘Single Entry system is a method or a variety of methods, employed for the recording of transactions, which ignore the two-fold aspect and consequently fails to provide the businessman with the information necessary for him to be able to ascertain the position’
Features
Usually, only Personal Accounts are prepared.
Cash Book records both business and personal transactions.
Too much dependence on Source documents to ascertain final status of the business.
There is no standard procedure in maintaining records and vary from firm to firm.
Usually found in a sole trader or a partnership firm.
Advantages
It is easy and simple method of recording business transactions.
Less expensive as qualified staff is not required.
Suitable for small businesses where cash transactions occur and very few assets and liabilities exists.
Flexible method as there are no set procedures and principles followed.
Disadvantages
No double entry, thus Trial Balance cannot be prepared to check the arithmetical accuracy of books of accounts.
Information related to assets and liabilities cannot be reliable because respective accounts have not been maintained.
True Profit and Loss cannot be ascertained.
Comparison of accounting performance with previous year or other firms not possible as any standard principle or procedure is not followed.
Finding Profit or Loss from Incomplete Records Two methods to find out the Profit or loss from incomplete records
Statement of Affairs methods
Conversion into Double entry method
FIRST METHOD-Statement of Affairs method In this method the capital of the business in the beginning of the period is compared with its capital at the end of the period. The difference represents profit or loss during the period.
If the closing capital is more than opening capital, it shows a profit for the business.
If the closing capital is less than opening capital, the business had a loss. Opening balance of capital can be ascertained by preparing an „Opening Statement of Affairs‟. Statement of Affairs is quite similar to a Balance Sheet (NOT exactly). Click here to download FORMAT-STATEMENT OF AFFAIRS (pdf) The difference between the assets and liabilities of the business is the OPENING CAPITAL of the business. Capital = Assets – Liabilities Similarly, prepare a „Closing Statement of Affairs‟ to get the CLOSING CAPITAL of the business.
Adjustments in the Closing Capital
Drawings are added to the Closing Capital.
Additional Capital is deducted from the Closing Capital Once the Closing Capital is calculated, the Opening Capital is deducted from it.
If Closing Capital is MORE than Opening Capital, it is a PROFIT.
If Closing Capital is LESS than Opening Capital, it is a LOSS.
Net Formula Profit = Closing Capital + Drawings – Additional Capital – Opening Capital
Some Adjustment The profit achieved from this method is not the final net profit. Adjustments which result in increase in expenses or losses must be deducted from the Profit figure to get the accurate net profit. These are
Depreciation
Outstanding expenses
Interest on Capital
Interest on Loans
Provisions for Doubtful debts Adjustments which result in increase in incomes and gains must be added to the Profit figure. These are
Prepaid expenses
Interest on investments At the end a final Statement of Affairs is prepared after these adjustments are done. Note: When the Opening Capital is more than the Closing Capital, it shows a LOSS. In this case, the adjustments which result in an increase in expense are added to the loss amount and the adjustments which result in increase income are deducted.
SECOND METHOD-Conversion into Double entry methods by finding missing information Following steps have to be taken
Opening Capital is calculated by preparing an Opening Statement of Affairs.
Cash Book is updated by adding all the missing information. Opening and closing cash balance has to be ascertained.
Total Debtors Account has to be prepared.
Total Creditors Account has to be prepared.
Final Accounts are prepared i.e. Trading and Profit & Loss Account and Balance Sheet from the information collected in Steps 1 to 4.
Finding Missing information using Accounting Ratios If Gross Profit is expressed as a percentage of the cost price. In order words, Mark up is given. Mark up = Gross Profit/Cost price
Example Calculate the Gross profit if the Sales = $54,000, Mark up is 20%. Goods costing $100 has been sold at $120. If sales are $54000 then the Gross Profit = 20/120 * 54,000= $9000
If Gross Profit is expressed as a percentage of selling price i.e. Gross profit margin. Gross profit margin = Gross profit/ Selling price If Stock turnover ratio is stated Stock turnover is the rate at which the stock of goods is sold. Stock turnover= Cost of goods sold/ Average stock
Example Cost of goods sold= $3000 Opening Stock= $400 Closing Stock = $600
AVERAGE
$400+$600
=
STOCK =
2
$500
Therefore, Stock turnover = $3000/$500 = 6 times per year or 2 months
What is partnership form of business? A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business. A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return.
Advantages of forming a partnership The following are often seen as being positive attributes of being in a partnership:
Partners may possess complimentary skills, which can be very cost-effective. Partners may specialise and become more efficient in certain aspects of their creative business. One partner might be good at selling work and presenting to clients, while another is better at bookkeeping.
Partners have access to a wider pool of knowledge, skills and contacts.
Partnerships provide moral support and will allow for more creative brainstorms Partnerships have access to large amount of capital and find it easier to expand as compared to sole proprietor.
Partnerships have better administration and financial systems in place than sole traders.
Disadvantages
A partnership is for the long term, and expectations and situations can change, which can lead to dramatic split ups. You might spend more time with your business partner than with anybody else, so losing that very intimate and personal business relationship can lead to major problems when splitting up.
You have to consult your partner and negotiate more as you cannot take decisions by yourself. So you need to be more flexible.
You both are responsible for the business debts and errors of others. So if the business fails and incurs debts, and your partner doesn‟t pay his or her share, you will still be required to pay. This is even the case if debts were incurred by your partner‟s dishonesty or mismanagement without your knowledge.
You have to share your profits and decide on how you value each other‟s time and skills. What is more valuable to the company - a fantastic creative idea generator or somebody who can sell this idea to a customer? What happens if one person puts in 60 hours a week and the other one turns up late very regularly? What happens if one partner can put in less time due to personal circumstances, such as caring responsibilities or illness?
Partnership Deed/ Agreement Before starting a partnership business, the partners need to come to a common understanding. A typical partnership agreement would include
Capital - the amount of capital put in by each partner, which will include both money and equipment and other capital goods.
The role and responsibilities of each partner.
The apportionment of profits and losses. Is this equal (50/50) and if not how is this split and why?
The amount of drawing allowed to each partner.
The salary, if nay, to be paid to any partner.
There interest, if any, to be allowed on capital and charged on drawing.
What are the arrangements in case of dissolving the company, including the retirement, death or long-term illness of a partner.
Management of the finances, bank account, signing of cheques and orders
Hours of work and holidays allocated.
Arrangement for arbitration in the event of disagreement. Click here to download Sample of Partnership Agreement (PDF)
Capital account Each partner in the business has a Capital account. It carries the record of initial capital and any additional capital contributed by the partner. It is fixed and is not affected by any entry other than contribution of capital.
Current account This account records the share of profits and losses and drawing of a partner. Credit balances in the Current Accounts at the end of the accounting year represents undrawn profits whereas debit balance indicates that the partner has overdrawn from his account and owes to the firm.
Profit and Loss Appropriation Account This account is prepared to show the division of profit or loss among the partners
Balance Sheet Balance Sheet of a Partnership firm carries the following information:
Capital Account of all the partners
Current Account of all the partners
Interest on Capital Partners who contribute more capital than other partners are granted interest on capital. It is calculated on the capital at the beginning of the trading period. If the partner brings in additional capital, interest will be calculated for the period beginning from the date the capital is injected into the business. Interest is deducted from the profit and the remaining profit is divided among the partners.
Interest on Drawings Withdrawals made by partners from the firm are known as drawings. These drawings may be in cash or in form of goods. The firm charges interest on these drawings. The interest is calculated for the period beginning from the date of withdrawal to the end of the trading period. Interest on drawing is debited to the Current Account of the partner who makes the drawings.
Loans from Partners When a partner makes a cash loan separate from the capital, it is credited to the partner‟s Capital Account. A separate Loan Account is created and credited with the loan amount. The amount received by the firm is debited to the Cash account. Interest is payable to the partner who makes the loan. The interest amount is
Credited to the partner‟s Current Account.
Loan Interest Account is debited as it is an expense for the firm.
Partners’ Salaries Salaries paid to the partners is Credited to their respective Current Account If Salary is paid in Cash, then Cash Book is credited instead of Partner‟s Current Account, Debited to Partnership Salaries Account which is later on transferred to the Profit and Loss Appropriation Account.
Analysis and Interpretation Ratio Analysis Accounts make little sense to Managers and people who don‟t have the technical knowledge. This has resulted in the evolvement of a new stream in Accounting known as Management Accounting. Ratio analysis is a part of management accounting, whereby complicated accounting information can be presented in a more simplified and presentable manner for laymen in accounting to understand and absorb the information. A statistics has little value in isolation. The statement „a business earned a profit of $100m‟ does not make much sense unless it is related to either its sales turnover or its assets.
People who are interested in knowing financial information are known as Stakeholders. These are Stakeholders
Owners Worker Managers Consumers Government
Who are they
Objectives
They invest capital in the business and get profits from the business
Profits, growth of the business
Employees of the business who give in their time and effort to make a business successful
Job security, job satisfaction and a satisfactory level of payment for their efforts
Employees of the business who manage a business. They lead and control the workers to achieve organisational goals
High salaries, Job security, Status and growth of the business
These are the people who buy the goods and services of the business.
Safe and reliable products, value for money, proper after sales service
Government manages the economy.
Successful businesses,
The community
The government charges a tax from the business and also monitors the working of businesses in the country
employments to be created, more taxes, follow laws
Community is all the people who are directly or indirectly affected by the actions of the business.
They expect more jobs, environmental protection, socially responsible products and actions of the business.
Stakeholders are interested in getting information about business, in order:
To compare the business performance over several financial periods. This is known as Intra-firm comparison.
To compare the business performance with that of other businesses within the same industry also known as Inter-firm comparison
Ratios can be broadly classified as: Profitability ratios These ratios measure the profit in relation to sales or capital employed.
Gross profit margin Gross Profit Margin shows the relationship of gross profit and sales turnover. Gross Profit Gross Profit Margin=
X 100 Sales turnover
A lower ratio may be the result of the following factors:
Decrease in selling price of goods sold
Increase in cost of goods sold
Over valuation of opening stock or under valuation of closing stock
Net profit margin It is an index of efficiency and profitability of a business. Net Profit X 100
Net Profit Margin=
Sales turnover
Mark up cost refers to profit expressed as a percentage of cost price. Gross Profit Mark Up=
X 100 Cost of goods sold
Rate of return on Capital (ROCE) It shows the return on the investment made by the owner. Net Profit Return on Capital employed=
X 100 Capital
These ratios state how efficiently certain areas of the business are performing.
Stock turnover ratio It indicates the number of times in a year the average stock can be sold off. The more times the stock is sold the more efficient the business. Cost of goods sold Stock turnover ratio=
Average stock at cost price
Average Stock is calculated as (Opening stock + Closing stock)/2
Asset turnover ratio
Asset turnover is a measure of how effectively the assets are being used to generate sales. It is one of the ratios that would be considered when interpreting the results of profitability ratio analyses like ROCE. Sales turnover Asset turnover ratio=
Total assets-current liabilities
If the asset turnover is high than its competitors, it shows as an over investment in assets. However, a new firm may have a higher asset turnover ratio than its competitors as the assets are newer and have a higher value. Moreover, some firms may use a lower rate of depreciation than its competitors. In some cases, firms may purchase assets whereas its competitors firms are leasing assets.
Trade debtor collection period (Debtors days) This ratio indicates how efficient the company is at controlling its debtors. Total Debtors Debtors days=
X 360 Total Sales turnover
Trade creditor payment period (Creditors Days) This ratio indicates how the company uses short term financing to fund its activities. Total Creditors Creditors days=
X 360 Cost of sales
Both these ratios are useful for intra-firm comparison.
Liquidity ratios It measures the availability of cash and other liquid assets to meet the current liabilities of the firm.
Current Ratio The current ratio compares total current assets to total current liabilities and is intended to indicate whether there are sufficient short-term assets to meet the short-term liabilities. Current assets: Current liabilities The ratio when calculated may be expressed as either a ratio or 1, with current liabilities being set to 1, or as „number of times‟, representing the relative size of the amount of total current assets compared with total current liabilities. A ratio of 2:1 or current assets as 2 times is considered to be healthy for a business.
Acid test ratio It is quite similar to Current ratio. The only difference in the items involved between the two ratios is that the acid test ratio or quick ratio does not include stock. Current assets-Stock Acid Test ratio
= Current liabilities
An acid test ratio 1:1 is considered as healthy. If it is below 1 it suggest the business has insufficient liquid assets to meet their short term liabilities.
Candidates should be able to recognise the limitations of accounting statements due to such factors as:
historic cost difficulties of definition non-financial aspects
KEY (COMMAND) WORDS IN ACCOUNTING EXAMINATIONS ADVISE Write down a suggested course of action in a given situation. Often linked with “Suggest” – see below. CALCULATE Self-explanatory – “work out”. Often no format specified. Often accompanied by – “show workings”/”show calculations” COMMENT Make relevant statements, usually on given figures, or results of calculations COMPARE Write down the differences between two accounting statements/two businesses/methods of recording something etc COMPLETE Self-explanatory – “Fill in”. Often use in relation to tables/ sentences/ “boxes”. DEFINE Write down an explanation of the meaning of an accounting term. e.g. “Define depreciation”/“Define current assets”. DISCUSS Often linked with “Comment” see above. Write down a reasoned explanation of the causes/effects of a course of action/the difference between two sets of figures/two accounting statements etc. DRAW UP Sometimes used in place of “Prepare”. Present something in statement or account format etc. Often used in relation to bank reconciliation, statement of corrected net profit etc. ENTER Sometimes used in place of “Make entries”. Record given information in specified accounts/ books/ledgers EXPLAIN Give a written account of what something means/why it is done/ the outcome of it etc. Examples include – “Explain the entries in an account”/“Explain why a trader ……………..” GIVE Sometimes used in place of “State”. Write down. Sometimes used as “Give 2 examples ………………”. LIST Self-explanatory – write down information in a number of points – usually no further explanation is necessary. MAKE ENTRIES See “Enter” above. Record information in specified accounts etc. NAME Self-explanatory – write down the title of etc. Often used for short one-word answers e.g. “Name a fixed asset”/“Name an example of ………….”. OUTLINE Write down. Often linked to “State” – see below. Give a brief written account of something, e.g. “Outline the ways to reduce bad debts”/“Outline the imprest system of petty cash”. PREPARE See “Draw up” above. Present some accounting information in a suitable format e.g. “Prepare final accounts”/“Prepare journal entries”/“Prepare a bank reconciliation statement”. RECORD Self-explanatory. Used in place of “Enter” or “Write up”. Make the necessary entries in a set of accounting records e.g. “Record a series of transactions in the cash book/ledger/books of prime entry” SELECT Self-explanatory – choose relevant information from that given. Often linked to a further instruction e.g. “Select the relevant information and prepare a Manufacturing Account/Trial Balance”. SHOW Self-explanatory - write down your workings/calculations or write down how an item will appear in some accounting statement. Often used when requiring preparation of Balance Sheet extracts/Profit and Loss Account extracts etc. STATE Self-explanatory – “write down”. Often used instead of “Give” – see above. Used when requiring written explanation of something e.g. “State 2 ways in which …………….”/“State how the trader can…………….” STATE AND Usually requires a little more detail than just “State” and often an EXPLAIN explanation of why/how. SUGGEST Requiring knowledge to be related to a given situation. Offer explanation why something occurred/how a situation can be improved/methods available to deal with a situation etc. USING Refer back to some previous information e.g. using your answer to Part (a), and calculate some figure or make suitable comments. WRITE UP May be used in place of “Prepare” see above. Often used in connection with ledger accounts, cash books, books of prime entry etc.
