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What
is
accounting?
Recording
of
financial
information
Organise
information
in
systematic
and
methodical
way
Analyse
information
for
decision
making
Doing business involves a lot of decisions to be taken. Decisions are taken out
of available information. However, different decision requires different types of
information. For instance, deciding on a wage increase may require an analysis
of profit trends as well as liquidity situation. Therefore, accounting involves the
preparation of financial statements like income statement to calculate profit, the
balance sheet to show financial position of the business and any such statements
that would help management of a business make good decision.
So what is the difference between book-keeping and accounting?
As discussed above, book-keeping is the accurate and systematic recording of
business transactions. It is part of accounting. However, accounting is bookkeeping plus the organising, interpreting and reporting of financial information
and preparing of financial statements that enable decisions to be taken.
The role of accounting
Accounting is the systematic recording of financial transactions and the reporting of
such transactions for decision making purposes.
As such, it can be seen that the main role of accounting is to assist in better
decision making. The type of decision varies from business to business in terms of
nature, size, form and location. Below is a list of some of the role of accounting in
the decision making process:
1. It allows the entrepreneur to know how much is earned. This can be compared
with other alternatives to doing business. For example, an entrepreneur who is
earning $1 000 a month from business but would otherwise earn $1 500 as an
employee may prefer to close down business and take up a job.
balance sheet can be obtained at few clicks. Also, reports can be processed in different formats to
suit the needs of the users.
Ability to process high volumes of information
Computers have the ability to do the jobs that would require several workers had a manual
system been used. Examples include preparation of control accounts, financial statements and
preparing payroll. It only requires the right software to be used.
Performing reconciliations
Accounting software allows reconciliations to be performed automatically and rapidly. These
include reconciling cash book balance with balance on bank statement and reconciling control
account balances with balances from sales ledger and purchases ledger.
Ease and capacity of information storage
Computers provide virtually unlimited space for storing data on discs (hard disks, servers,
removable disks and even on the internet). These require very little space and may retain
information for years. Besides, information can be safeguarded by making backups (keeping
same information on different disks). Using computers reduces considerably the use of filing
cabinets.
Security
Information on computers are considered to be safe. This is because access to information can be
restricted by using passwords. Also, in some accounting software which allows multi-users, it is
easy to trace which user has performed what transaction. This reduces the risk of fraud.
Human errors
Computers may be accurate in performing calculations and producing reports. Human beings are
not. Inputting the wrong information will result in incorrect reports to be produced (garbage in,
garbage out).
Viruses
Computer programs are prone to viruses. Viruses can damage hardware and software and
therefore cause loss of information.
Security
Computer systems are not foolproof. Hackers may enter computer systems to collect or modify
financial information.
Accounting
Equation
Assets
= Owners Equity +
Liabilities
Assets refer to all that a business possesses and that have
money value. Obviously, these assets have been obtained from
the
owner
or
were
bought
later.
Examples
of
assets
are:
it
can
be
said
that
the
business
owes
its
owner
the
amount
the
latter
invested
in
the
business.
Liabilities refer to the amount that the business owes to other persons other than the owner. Such persons include credit
suppliers and banking institutions. They have a claim on the assets of the business to the amount they have given credit facilities or
they have lent.
Let
us
consider
the
following
case:
Bill started business on 1st January as a computer reseller. He invested $100 000 cash which he took from his past
savings.
Now, remember that, as from this point, Bill and his business are considered as two different persons (see business entity concept).
Therefore,
now
the
$100
000
belongs
to
the
business,
though
Bill
has
a
claim
over
it.
Hence:
We have seen above that what the business has is called an asset. Therefore, the asset of Bill's business is cash of $100 000.
The claim that an owner has over its business is called capital or owners equity
This gives us the following equation:
On 2nd January, Bill bought computers for resale (goods in this case) on
credit
from
Sam
for
$25
000.
On one hand the business is receiving goods. Now, anyone would agree that
whatever you buy, whether for cash or on credit, belongs to you. In the same
way, the business has bought computers for resale. So, the computers belong
to
the
business.
Therefore, assets of the business now include inventory costing $25 000.
Note:
Goods
for
resale
are
termed
as
Inventory.
On the other hand, given that goods were bought on credit, the business owes
Sam, a credit supplier, $25 000. Sam being an outsider to the business, the
amount
owed
is
a
liability.
Therefore, the liabilities of the business now include trade payables
amounting
to
$25
000.
Note: Amount owed to a credit supplier is termed as Trade Payables.
Hence:
The validity of the Accounting Equation can be tested with any transaction. It shall always hold. Besides, the accounting equation is
applied in the Balance Sheet.
Ledger
The ledger is a special book in which transactions are recorded. In other words, a book
in which accounts are kept.
The ledger differs from other books in the way columns are drawn to record transactions
as follows:
Dr
The Ledger
Cr
Dat
e
Details
Folio
Amoun
t
$
Date
Details
Folio Amount
Types of ledger:
In a real business, there are so many accounts to keep
and each account may need lots of space to record
transactions for the whole accounting year. For this
reason, a business usually keeps, not one, but several
ledgers. These ledgers are classified into three types:
Sales Ledger
The book (or set of books) in which the personal accounts of credit
customers are kept.
A credit customer is also called a debtor.
The balance of a customers account shows the amount that the
customer owes the business. Therefore, the total of balances in the
sales ledger is the total amount the business is owed by its credit
customers. This amount is called trade receivables or accounts
receivables.
Trade receivables is shown as a current asset in the balance sheet.
Purchases Ledger
The book (or set of books) in which the personal accounts of credit
suppliers are kept.
A credit supplier is also called a creditor.
The balance of a suppliers account shows the amount that the business
owes the supplier. Therefore, the total of balances in the purchases
ledger is the total amount the business owes by its credit suppliers. This
amount is called trade payables or accounts payables.
Trade payables is shown as a current liability in the balance sheet.
General Ledger
The book (or set of books) in which all other accounts are kept.
Types of Accounts
An account records changes to a specific item.
For example:
- The cash account records changes in the amount of cash available in hand.
- The bank account records changes in the amount of cash held at the bank.
- Furniture account records changes in the values of furniture owned by the
business etc.
Just as the ledger has been classified into different types, accounts also are classified
into different types as below:
Personal accounts
As the name says, personal accounts are accounts of
persons. They, therefore, bear the names of persons.
Such persons can be credit customers or credit
suppliers. Therefore, personal accounts are kept in
either:
-
Sales ledger, or
Purchases ledger
Impersonal accounts
As seen in the above diagram, impersonal accounts
are of two types:
-
Real accounts
Nominal accounts
Real accounts
Real accounts record property/ assets of the
business. Examples of real accounts are:
furniture account, building account, vehicles
account etc
Nominal accounts
Nominal accounts record liabilities, expenses,
revenues, capital and drawing. Examples of
nominal accounts are loan account, sales
account, commission
received account,
salaries account, rent account, capital account,
drawings account etc.
Assets
Liabilities
Equity
Revenues
Expenses
We have seen that assets, liabilities and equity (capital) form part
of the accounting equation as follows:
Assets = Liabilities + Equity
Now, given that equity increases when the business earns profit
and it decreases when the business makes losses, we can derive
the following extended accounting equation:
Ledger
Amount Date
Details
Details
Cr
Amount
It can be seen that if the equation Assets + Expenses = Liabilities + Equity + Revenue is
compared with ledger with the double line at the center of the ledger representing the equal sign
of the equation, assets and expenses represent the debit (Dr) side while liabilities, equity and
revenue represent the credit (Cr) side.
(Please note that the above comparison is simply made to help remember the principles of
recording transactions in the ledger and are not necessarily rules in accounting)
Rules for recording assets, liabilities, equity, revenue and expenses
Whether to debit or credit an account depends on what balance it usually has and this depends
whether the account is one that records an asset, a liability, equity, a revenue or an asset. Usually,
an increase is recorded on the same side as the balance and a decrease is recorded on the opposite
side.
The table below shows what balance accounts under each category have and how to record
increase and decrease:
CATEGORY
Assets
Liabilities
Equity
Revenue
Expenses
BALANCE
Dr
Cr
Cr
Cr
Dr
INCREASE
Dr
Cr
Cr
Cr
Dr
DECREASE
Cr
Dr
Dr
Dr
Cr
Note from the table above that we record an increase in an account on the same side as its balance is. A decrease is recorded on
the opposite side.
BALANCE
Dr
Cr
Cr
Cr
Dr
INCREASE
Dr
Cr
Cr
Cr
Dr
DECREASE
Cr
Dr
Dr
Dr
Cr
5. Verify that there are one debit entry and one credit entry of the same amount.
6. Record the transaction.
Please note that for the sake of understanding at such an early stage, we shall keep separate
accounts for cash in hand and for cash at bank. These will be combined in the cash book at a later
stage.
We shall cover the following:
(Click to go to the relevant page)
A: Recording of equity
B: Recording the buying of an asset
To be completed soon:
C: Recording liabilities
D: Recording movement of inventory in the Revenue account, Purchases account, Revenue Returns account and Purchases Returns
account
E: Recording drawings
A. Recording equity
Consider the following transaction:
February 1
$25 000
1. This means Susan is the owner of the business and she is investing $25 000. So, this
$25 000 represents owners equity (capital). So, this has to be recorded in the equity
account. At the same time, the cash at bank belongs the possession of the business.
This is an asset and is recorded in the bank account.
2. As already said above, bank account is categorised under assets while equity is
simply equity.
3. Both, the amount of cash at bank and equity are increased. They both now have a
balance of $25 000.
4. Using the table of balances, we can see that when equity increases, equity account is
credited and when an asset increases the account for that asset is debited.
Accounts Affected
Category
Increase or Decrease
Debit or Credit
Equity
Equity
Increase
Credit
Bank
Asset
Increase
Debit
5. From the above table, we can see that there is one debit entry in the bank account and
one credit entry in the equity account. So we can record the transactions.
In the ledger of Susan
Dr
Date
Details
Dr
Date
Feb 1
Details
Equity
Equity account
Amount Date
Feb 1
Bank account
Amount Date
25 000
Details
Bank
Cr
Amount
25 000
Details
Cr
Amount
On top of all account, the name of the person (Susan) owning the business is
mentioned as follows: In the Ledger of Susan.
The name of the account is written at the top centre of the account. The first
account drawn above is the equity account and the second is the bank account.
Equity account has been credited. An entry has been made on its credit side.
Detail in equity account is Bank which is also the name of the other account
affected for the transaction.
iv.
Bank account has been debited. An entry has been made on its debit side.
Detail in equity account is Equity which is also the name of the other
account affected for the transaction.
March 1
March 1
(ii)
Bank
Asset
Increase
Debit
Accounts Affected
Category
Increase or Decrease
Debit or Credit
Equity
Equity
Increase
Credit
Cash
Asset
Increase
Debit
Dr
Date
Mar 1
Details
Details
Equity
Equity account
Amount Date
Mar 1
Mar 1
Bank account
Amount Date
10 000
Details
Bank
Cash
Cr
Amount
10 000
5 000
Details
Cr
Amount
A. Recording equity
Consider the following transaction:
February 1
$25 000
1. This means Susan is the owner of the business and she is investing $25 000. So, this
$25 000 represents owners equity (capital). So, this has to be recorded in the equity
account. At the same time, the cash at bank belongs the possession of the business.
This is an asset and is recorded in the bank account.
2. As already said above, bank account is categorised under assets while equity is
simply equity.
3. Both, the amount of cash at bank and equity are increased. They both now have a
balance of $25 000.
4. Using the table of balances, we can see that when equity increases, equity account is
credited and when an asset increases the account for that asset is debited.
Accounts Affected
Category
Increase or Decrease
Debit or Credit
Equity
Equity
Increase
Credit
Bank
Asset
Increase
Debit
5. From the above table, we can see that there is one debit entry in the bank account and
one credit entry in the equity account. So we can record the transactions.
In the ledger of Susan
Dr
Date
Details
Dr
Date
Feb 1
Details
Equity
Equity account
Amount Date
Feb 1
Bank account
Amount Date
25 000
Details
Bank
Cr
Amount
25 000
Details
Cr
Amount
On top of all account, the name of the person (Susan) owning the business is
mentioned as follows: In the Ledger of Susan.
The name of the account is written at the top centre of the account. The first
account drawn above is the equity account and the second is the bank account.
Equity account has been credited. An entry has been made on its credit side.
Detail in equity account is Bank which is also the name of the other account
affected for the transaction.
Bank account has been debited. An entry has been made on its debit side.
Detail in equity account is Equity which is also the name of the other
account affected for the transaction.
March 1
March 1
March 1
(ii)
Bank
Asset
Increase
Debit
Accounts Affected
Category
Increase or Decrease
Debit or Credit
Equity
Equity
Increase
Credit
Cash
Asset
Increase
Debit
Details
Dr
Date
Mar 1
Details
Equity
Bank account
Amount Date
10 000
Details
Equity
Cash account
Amount Date
5 000
Dr
Date
Mar 1
Equity account
Amount Date
Mar 1
Mar 1
Details
Bank
Cash
Cr
Amount
10 000
5 000
Details
Cr
Amount
Details
Cr
Amount
Buying of furniture and fittings is recorded in the furniture and fittings account. In
fact, any item bought to be used in business, that is not for resale, is recorded in that
items account. Also, whatever the business buys becomes the possession of the
business. Hence, furniture and fittings here are assets.
Accounts Affected
Category
Increase or Decrease
Debit or Credit
Cash
Asset
Decrease
Credit
Details
Dr
Date
Feb 3
Details
Cash
i.
Cash account
Amount Date
Feb 3
Details
Furniture and fittings
Cr
Amount
3 000
Cr
Amount
Now, it should easily be deduced that motor vehicles and bank are both assets.
Accounts Affected
Category
Increase or Decrease
Debit or Credit
Motor vehicles
Asset
Increase
Debit
Bank
Asset
Decrease
Credit
Details
Bank account
Amount Date
Feb 9
Details
Motor vehicles
Cr
Amount
30 000
Dr
Date
Feb 9
iii.
Details
Bank
Cr
Amount
Bought office equipment for $18 200 from Best Equip Ltd.
We all agree that office equipment is an asset which have been bought on credit.
Though it has not been said above that this is a credit transaction, it is implied as
being a credit transaction as no mention has been made of payment and the name of
the person/ company with whom the transaction occurred is given.
Since the equipment was bought on credit, the amount of $18 200 is owed to Best
Equip Ltd. And is therefore a liability.
Whenever the business owes someone, an account is opened in the name of the
person owed. Therefore, here, Best Equip Ltd is to be opened.
Accounts Affected
Category
Increase or Decrease
Debit or Credit
Office Equipment
Asset
Increase
Debit
Details
Dr
Date
Apr 1
Details
Best Equip Ltd
Cr
Amount
18 200
Cr
Amount
A business may return goods bought to its suppliers. There are various
reasons for that such as goods received were of the wrong
specification, were damaged, were supplied in excess etc. In that case
the business may return the goods to the supplier. Such returns are
termed
as Returns
Outwards or Purchases
Returns.
When goods are returned to a supplier, it means the business
owes that supplier less (that is original amount less amount of goods
returned). Therefore, the business will decrease the amount owed to
the supplier by a "Debit Entry" in the supplier's account.
At the same time, the business will send with the goods returned
a Debit Noteto inform the supplier that his/ her account has been
decreased (in this case debited) by the amount of goods returned.
Discounts
What are discounts?
Generally speaking, a discount is any amount taken off the actual price of a commodity or the
actual payable. A person who benefits a discount pays less and therefore gains.
Discounts involve 2 parties: The giver and the receiver.
The giver is usually the seller or the creditor who allows discounts.
The receiver is usually the buyer or the debtor who receives discounts.
As such, discounts can be either
discount allowed or discount
received. Discount allowed is
discount given to customers or
debtors and discount received is
discount received from sellers or
creditors.
There are two types of discounts:
Trade discount
Cash discount
The differences between trade discounts and cash discounts are as follows:
Trade discount
Cash discount
1. A reduction in the selling price of a 1. A reduction in the amount owed by a
commodity.
debtor.
2. Allowed or given for bulk purchase
2. Allowed for prompt/ quick payment
3. Not recorded in the books/ accounts
3. Recorded in the books
To better understand the differences between trade discount and cash discount see the links below:
Trade Discount
Cash Discount
Trade discount
To have a better understanding of trade discount and cash discount, consider the story below:
Details
Dr
Date
Feb 3
Details
Revenue (Sales)
Julies account
Amount Date
300
Details
Note: The discount of $50 is not recorded in the books. However, it is normal
business practice to show it on the invoice if the seller wants to.
Cr
Amount
300
Cr
Amount
The above story continues with Julie paying Romy and receives a cash discount on the following page:
Cash Discount
Cash discount
To have a better understanding of cash discount, consider the story of Romy and Julie that
continues below:
Dr
Details
Revenue (Sales)
Julies account
Amount Date
300 Feb 18
Feb 18
300
Bank account
Details
Bank
Discount allowed
Cr
Amount
285
15
300
Cr
Date
Feb 18
Details
Julie
Dr
Date
Feb 18
Details
Julie
Amount Date
285
Details
Amount
Cr
Amount
Note:
The discount of $15 is deducted from Julies account which now shows no balance
as she owes nothing.
The balance on the discount allowed account will be entered in the income
statement as a business expense.
For the sake of simplicity, the cheque received from Julie has been entered in the
bank account. This is, in reality, recorded in the cash book.
Debit Side
This side usually starts with either capital introduced if the
business has just started or with opening balance of cash in
hand and cash at bank for an ongoing business.
On the debit side, receipts of cash and cheques are
recorded, that is, items thatincrease the cash balance or the
bank balance.
Examples are: Revenue (sales), rent received, commission
received, cash received from customers, cheques received
from customers.
Credit Side
In case the business has a bank overdraft at the start of a
month, this side starts with an opening bank overdraft
balance.
On the credit side, payments of cash and cheques are
recorded, that is, items thatdecrease the cash balance or
the bank balance.
Examples are: Purchase of goods, payment to suppliers in
cash, payment bycheque to suppliers, payment of electricity,
rent, telephone expenses among many others.
Discount allowed:
This is discount given to customers for prompt payment (as explained in the page on cash
discount). For example, if a customer named Susan owes $100 and is allowed a reduction of 5%
for paying early, the customer finally pays $95. If he pays by cheque, the bank column of the
cash book is debited by $95. If a 3-column cash book is being used, the discount allowed of $5 is
recorded on the same line in the discount allowed column.
See example below:
Dr
Date
May 4
Cash Book
Receipts
Discoun
t
Allowed
Cas
h
Susan
Ban
k
Date
Cr
Payments
$
95
Discoun
t
Receive
d
$
Cas
h
Ban
k
In the above 3-column cash book extract, the entry on the debit side shows that on May 4, $95
was received from Susan and she was given a cash discount (discount allowed) of $5.
Adding the amount received ($95) with the discount allowed ($5) gives the amount settled by
Susan ($100). This may also represent the amount owed if the customer settles her full account.
Cash Book
Receipts
Discoun
t
Allowed
Cas
h
Ban
k
Date
May 7
Cr
Payments
Tony
Discoun
t
Receive
d
$
8
Cas
h
$
Ban
k
$
72
In the above 3-column cash book extract, the entry on the credit side shows that on May 7, $72
was paid to Tony and the latter gave a cash discount (discount received) of $8.
Adding the amount paid ($72) with the discount received ($8) gives the amount settled by us
($80).
Ledger Account for Accruals and
Prepayments
(Other payables and other receivables)
Part 1 - Introduction
i.
Expenses
At any point in time, expenses may be:
Accrued/ Due/
Prepaid/ Paid in
Outstanding/
advance
Owing
Liability
Asset
Credit balance
Debit balance
ii.
Income
At any point in time, incomes may be:
Accrued/ Due/
Prepaid/
Outstanding/
Received in
Owing
advance
Asset
Liability
Debit balance
Credit balance
Accruals
concept:
In calculating profit for a given period, revenue earned in that period is matched against expenses incurred during that period,
whether
such
revenues
have
been
received
or
not
and expenses
paid
or
not.
As such, when calculating profit or loss for a given period adjustments are made for accruals and prepayments of both expenses and
income.
Points to remember when preparing ledger accounts involving accruals and prepayments:
Account of
an expense
Dr side
Cr side
Dr side
Cr side
Cr side
Dr side
Account of
an income
Cr side
Dr side
Cr side
Dr side
Dr side
Cr side
1 Jan
Details
Bank
Rent Account
Amount
Date
$
13 000 31 Dec
31 Dec
13 000
1 000
Details
Income Statement
Balance c/d - prepaid
Cr
Amount
$
12 000
1 000
13 000
Rent incurred remains at $1 000 per month, that is $12 000 for the year. The $1 000 ($13 000 $12 000) paid in excess is a prepayment.
Details
Bank
Balance c/d - due
Cr
Amount
$
1 850
13 000
350
$350 was due. BUT amount incurred remains $1 850 and is entered in the income statement as
telephone expenses.
In balance sheet: Other payables (telephone expenses due) is $350 [current liabilities]
With opening balances
Example 3
On 1 January, a business had insurance prepaid of $90. During the year, insurance paid by
cheque amounted to $950. Insurance for the current year amounted to $840. Show the Insurance
account.
Dr
Date
Details
Jan 1
Dec 31
Jan 1
Insurance Account
Amount
Date
$
90 Dec 31
950 Dec 31
1 040
200
Details
Income Statement
Balance c/d - prepaid
Cr
Amount
$
840
200
1 040
At the start of the year, there was a prepayment of $90 and this is an asset. So, it is shown as a
debit balance in the insurance account. Amount paid during the year $950 is debited to the
insurance account. The amount incurred for the year of $840 is transferred to the income
statement and is credited to insurance account. When the insurance account is balanced, it
reveals there was a prepayment of insurance of $200 at the end of the period.
In balance sheet at 31 Dec: Other receivables (insurance prepaid) is $200 [current asset]
Example 4
On 1 January, general expenses prepaid amounted to $45. During the year, amount paid for
general expenses were $560 by cheque and $140 in cash. General expenses incurred for the year
amounted to $800. Show the General Expenses account.
Dr
Date
Jan 1
Dec 31
Dec 31
Dec 31
Cr
Amount
$
800
800
55
Note from the above account that at the beginning of a period, there may be a prepayment for a
particular expense but there is an accrual at the end of the period.
There may also be an accrual at the start of a period and a prepayment at the end as in e.g 5
below:
Example 5
On 1 January, Maintenance Expenses owing amounted to $150. During the year, Maintenance
Expenses paid were $6 400 by cheque. Total Maintenance Expenses that relate to the current
accounting year amounted to $6 020. Show the Maintenance Expenses account.
Dr
Date
Dec 31
Jan 1
Cr
Amount
$
150
6 020
230
6 400
Example 6
On 1 January, inventory of stationery amounted to $60. Stationery were bought as follows during
the year: $200 in cash, $150 by cheque and $630 on credit from Coco. Stationery used during the
year amounted to $825. Show the stationery account.
Dr
Date
Jan 1
Details
Balance b/d
Stationery Account
Amount
Date
$
60 Dec 31
Details
Income statement
Cr
Amount
$
825
Dec 31
Dec 31
Dec 31
Jan 1
Cash
Bank
Coco
Balance b/d
200
150
630
1 040
215
Dec 31
Balance c/d
215
1 040
The above example shows Stationery account. Unlike, the previous accounts, the Dr balances do
not really represent prepayments for stationery but rather unused stock of stationery. The opening
balance of $60 shows that $60 worth of stationery were unused from the previous period and
have been transferred to the current period. The closing balance represents unused stock
transferred to the next accounting period.
Part 3 - Ledger accounts for accruals and prepayment of Incomes
Example 1
On 1 January, commission receivable was outstanding by $250. During the year, $1 850 was
received by cheque for commission. Actual commission earned for the year amounted to $1 975.
Show the Commission Receivable account.
Dr
Date
1 Jan
31 Dec
1 Jan
Cr
Amount
$
1 850
375
2 225
Commission receivable is an income. Income due is an asset and is shown as a debit balance of
$250. Amount received ($1 850) is credited to the Commission Receivable account. The amount
earned ($1 975) is entered on the debit side and credited to income statement.
Example 2
A business sublets part of its building at an annual rent of $1 800. At 1 January, rent received in
advance was $200. During the year, rent was received as follows: $800 in cash on 31 March and
$1 100 by cheque on 31 October. Prepare the rent receivable account.
Dr
Date
31 Dec
31 Dec
Cr
Amount
$
200
800
1 100
2 100
1 Jan
300
Details
Bank
Balance c/d Due
Rent Account
Amount
Date
Details
$
4 580 1 Feb 11 Balance b/d Due
220 31 Jan 12 Income Statement
4 800
1 Feb 12 Balance b/d Due
Cr
Amount
$
450
4 350
4 800
220
Unlike previous examples, the above example provides figures for opening and closing
balances and amount paid. However, amount incurred is not provided. This is calculated as
the balancing figure in the account. Also note that, had the balance c/d been a prepayment
and therefore, on the credit side, the detail income statement would have been inserted
without its amount before the balance c/d. After plugging in all available figures, the
amount to be transferred is then calculated as the balancing figure. This is because balance
c/d is always the last item in a ledger account before calculating the totals. Similarly,
balance b/d is always the first item in a ledger account.
Example 2
The following information is available:
Wages due at 1 April 2010
$780
Wages prepaid at 31 March 2011
$120
Wages paid during the year were as follows:
In cash
$1 560
By cheque
$4 440
Prepare the Wages account.
Dr
Date
Details
Wages Account
Amount
Date
$
Details
Cr
Amount
$
31 Mar 11 Cash
31 Mar 11 Bank
1 Apr 11
1 560
4 440
1 Apr 10
31 Mar 11
31 Mar 11
6 000
120
Example 3
The following information is available:
Commission received in advance at 1 March 2011
Commission received as follows during the year:
30 July 2011 in cash
4 January 2012 by cheque
Commission in arrears at 29 February 2012
780
5 100
120
6 000
$78
$4 560
$8 420
$82
1 Mar 12
Cr
Amount
$
78
4 560
8 420
82
13 140
Correction of Errors
While recording transactions, whether manually or using a computer system, errors may arise.
Such errors need to be corrected. However, in accounting, errors are not corrected using erasers
or correction fluids but rather by making other accounting entries that would set off those errors
and at the same time show a correct financial state of the business.
Error of omission
Error of commission
Error of principle
Error of original entry
Complete reversal of entries
vi.
vii.
viii.
Compensating errors
Error of duplication
Error of transposition
i.
Error in total
In ledger:
ii.
iii.
iv.
v.
In trial balance:
vi.
Error in amount
vii.
Omission of a balance
Correcting errors:
Correcting errors are normal accounting tasks and are carried out using the double entry system.
The basic steps to follow are:
Step 1: Identify the transaction and state the entries that should have been made.
Step 2: State the entries actually made
Step 3: State the entries to be made to cancel wrong entries
Step 4: State the entries to complete missing entries
Step 5: Complete double entry through suspense account, if needed
Step 6: Combine entries in steps 3, 4 and 5
Errors not affecting trial balance:
For these errors, at least 2 accounts are affected. Combined, total of debit entries should be equal
to total of credit entries.
Errors affecting trial balance:
These errors are corrected through the suspense account.
Suspense Account:
The suspense account is a temporary account opened when the trial balance does not agree. Its
balance represents the difference between the Dr total and the Cr total of the trial balance.
If the Dr total of the trial balance is greater than the Cr total, then the suspense account will have
a Dr balance and vice versa.
After all errors have been corrected, the suspense account will no longer have a balance.
Types of Errors
Correction of Errors
Errors not affecting trial balance
Worked examples
1. Goods sold on credit to John, $230, was not recorded in
the books.
Type of Error
Error of omission
Step 1
Dr John $230
Cr Sales $230
Step 2
none
Step 3
none
Step 4
Completing missing
entries
Dr John $230
Cr Sales $230
Step 5
Suspense account
none
Step 6
Combined correction
required
Dr John $230
Cr Sales $230
Error of commission
Step 1
Dr Purchases $500
Cr Jane $500
Dr Purchases $500
Cr Jenny $500
Step 2
Step 3
Dr Jenny $500
Step 4
Completing missing
entries
Cr Jane $500
Step 5
Suspense account
none
Step 6
Combined correction
required
Dr Jenny $500
Cr Jane $500
3. Repairs to motor vehicles paid by cheque $650 have been debited to motor vehicles
account.
Type of Error
Error of principle
Step 1
Step 2
Step 3
Step 4
Completing missing
entries
Step 5
Suspense account
none
Step 6
Combined correction
required
4. The purchase of a van by cheque $2 000 was wrongly entered in the books as $2 200 due
to an error in the invoice received.
Type of Error
Step 1
Step 2
Step 3
Step 4
Completing missing
entries
Dr Van $2 000
Cr Bank $2 000
Dr Van $2 200
Cr Bank $2 200
Dr Bank $2 200
Cr Van $2 000
Dr Van $2 000
Cr Bank $2 000
Step 5
Suspense account
none
Step 6
Combined correction
required
Dr Bank $200
Cr Van $200
5. Goods returned by Sam $560 was debited to Sams account and credited to returns
inwards account.
Type of Error
Step 1
Step 2
Step 3
Step 4
Completing missing
entries
Step 5
Suspense account
None
Step 6
Combined correction
required
6. Purchases returns account and wages account are both overstated by $300.
Type of Error
Compensating error
Step 1
Step 2
Step 3
Step 4
Completing missing
entries
Step 5
Suspense account
Step 6
Combined correction
required
Error of transposition
Step 1
Step 2
Step 3
Step 4
Completing missing
entries
Step 5
Suspense account
None
Step 6
Combined correction
required
Dr Stationery account $9
Cr Cash account $9
8. Cheque of $900 received from Jerry was posted twice in the books.
Type of Error
Error of duplication
Step 1
Step 2
Step 3
Step 4
Completing missing
entries
None
Step 5
Suspense account
None
Step 6
Combined correction
required
Correction of Errors
Errors affecting trial balance
Worked examples
1. Sales day book was overcast by $100. Individual entries
were correctly posted to personal accounts in the sales
ledger.
Type of Error
Step 1
Step 2
Step 3
Step 4
Step 5
Suspense account
Step 6
Combined correction
required
Type of Error
Step 1
Step 2
Step 3
None
Step 4
Completing missing
entries
Step 5
Suspense account
Step 6
Combined correction
required
Step 1
Step 2
Step 3
Step 4
Completing missing
entries
Step 5
Suspense account
Step 6
Combined correction
required
4. Furniture bought on credit from James, $575, was correctly debited to furniture account
but credited to James account at $775.
Type of Error
Step 1
Step 2
Step 3
Step 4
Completing missing
entries
Step 5
Suspense account
Step 6
Combined correction
required
Error in calculation
Step 1
Step 2
Step 3
Step 4
Step 5
Suspense account
Step 6
Error of omission
This is an error where a transaction is completely omitted from the books. No entries
were made at all for the transaction. It is as if the transaction has not existed.
ii.
Error of commission
In this case, double entry was observed but the transaction was posted to a wrong
account of the same class. For example goods sold to John was correctly credited to
Revenue (Sales) account but debited to Janes account.
iii.
Error of principle
Double entry observed but an entry made in the wrong class of account. For example,
payment by cheque for vehicle repairs correctly credited to bank account but debited
to vehicle account instead. In this case, not only the account is wrong (vehicle instead
of vehicle repairs) but also the class of account is different. Vehicle account is a real
account (asset) whereas vehicle repairs account is a nominal account (expense).
iv.
v.
For a given transaction, the account to be debited was credited and the account to be
credited was debited. For example, goods sold to Nadia for $500 was debited to
Revenue (Sales) account and credited to Nadias account, both by $500.
vi.
Compensating errors
Errors on the debit side of the ledger have been set off by errors on the credit side of
the ledger. For example, vehicle account (debit balance) and commission received
account (credit balance) were both understated by $200.
vii.
Error of duplication
A transaction was recorded twice in the ledger. Double entry was observed in each
case.
viii.
Error of transposition
For a given transactions, double entry was correctly observed but the figures in
amount were not written in the correct order. Examples are: writing $450 instead of
$540, $71 instead of $17, $1 425 instead of $1 452, etc. For example, cash received
from Sam $164 was debited to cash account and credited to Sams account at $146.
Control Accounts
Trade Receivables Control Account and Trade Payables Control Account
We have seen Types of Ledger that there are three types of ledger: Sales Ledger,
Purchases Ledger and General Ledger.
While the accuracy of the General Ledger is assessed by preparing the Trial
Balance, the accuracy of the Sales Ledger and the Purchases Ledger are checked
by preparing control accounts.
Remember that the Sales Ledger (Receivables Ledger) is the book in which
accounts of credit customers are kept. Amount owed by customers is called trade
receivables. To control the Sales Ledger, the Trade Receivables Control Account
is prepared. It is often called Receivables Control Account.
Purchases Ledger (Payables Ledger) is the book in which accounts of credit
suppliers are kept. Amount owed to suppliers is called trade payables. To control
the Purchases Ledger, the Trade Payables Control Account is prepared. It is often
called Payables Control Account.
Purposes of Control Accounts
Primary Purpose
The primary purpose of control accounts is to act as independent check on the
accuracy of the Sales Ledger and the Purchases Ledger. This is done by using
totals from subsidiary books in control accounts to calculate trade receivables
and trade payables. These figures are then compared with figures obtained from
the list of balances from Sales Ledger and Purchases Ledger.
Secondary Purposes
Other purposes of control accounts are as follows:
- They are used to calculate the total of trade receivables and trade payables
quickly, especially when the trial balance has not yet been prepared.
- They are used to detect errors.
- They are used to deter fraud.
- They may also be used to check the work of inexperienced staff members like
the receivables ledger and payables ledger clerk.
Sources of information for Control Accounts
As mentioned earlier, control accounts act as independent check on the accuracy
of the Sales Ledger and the Purchases Ledger. As such, the source of information
to prepare control accounts should be different from that used to prepare
accounts in the sales ledger and purchase ledger. The latter are prepared from
individual entries of subsidiary books and are also corresponding entries for
entries on the opposite side (debit or credit) of the General Ledger.
To act independently, control accounts are prepared rather from totals of
subsidiary books.
Income Statement
Part 1- Calculation of Gross Profit
Worked Examples
From the information given below, prepare Income Statement for the year ended 31 December 2010 to calculate Gross Profit for the
business of Moy
Sales Revenue
Purchases
Inventory 1Jan 10
Inventory 31Dec10
$
22 000
12 000
6 500
7 500
Answer:
Add Purchases
Cost of goods available for sale
Less Closing Inventory
Gross Profit
12 000
18 500
(7 500)
11 000
11 000
Balance Sheet
A Balance Sheet is a statement that shows the financial position of a business at a given
date.
A Balance Sheet, unlike an Income Statement is not prepared "for a given period" but "at
a given date". This is because the Balance Sheet changes after each and every
transaction.
Financial Position
What the business has Asset
How are the assets financed :
Liabilities
Therefore,
Assets = Equity + Liabilities
The above equation is called the accounting equation. So, the Balance Sheet applies the
accounting equation
Assets
Non-Current Assets
To be classified as a non-current asset an item has to satisfy all of the following criteria:
Bought
to
- Is used for
-
be
used
in
the
business,
therefore
a long period of time (usually more
Has
significant
Examples
of
Non-Current
Land and building, Fixtures and Fittings, Equipment, Motor Vehicles
not
than
for
resale
one year)
value
Assets:
Current Assets
These are the assets of a business that are easily convertible into cash within the normal
operating cycle, which is within the accounting year.
Current Assets are often referred to as Liquid Assets and are listed in the Balance Sheet
according to their order of liquidity - usually starting with the least liquid and ending with the
most liquid.
Liabilities
Non-Current Liabilities
These are debts/ obligations/ amount owed by the business but that are repayable after
more than one year.
An example of non-current liabilities is loan.
Current Liabilities
These are short term debts; that is debts/ obligations that will be paid within one financial
year. In other words, these will be paid before the next balance sheet date.
Examples of current liabilities are bank overdraft, amount owed to suppliers (trade payables)
and amount owed for expenses (other payables).
owner's
equity
does
not
remain
fixed.
It
Net
changes.
Profit
Net profit belongs to the owner. It is the reason why the owner has started business.
Therefore, it is added to the owner's equity. On the other hand, a loss is deducted from
owner's
equity.
Drawings
This is the amount (in cash and in kind) that the owner has taken from the business for his
private use. It is deducted from owner's equity.
Financed by
Equity (Capital)
Opening balance
Add Profit for the year (Net profit)/ Less Loss
Less Drawings
Cost
$
200 000
25 000
12 000
52 000
289 000
Aggregat
e
Depreciat
ion
$
25 000
7 500
2 400
10 400
45 300
Net
Book
Value
$
175 000
17 500
9 600
41 600
243 700
18 900
7 500
236
5 960
240
250
7 264
1 236
150
2 550
890
30 990
6 450
24 540
268 240
50 000
218 240
200
22
222
4
218
000
540
540
300
240
Companies:
Financing
part
for
companies
shows
amount
of
share
capital,
reserves
and
retained
profits.
Partnerships:
For partnerships, the financing part shows the closing balances of partners' capital and current accounts
Partnership Accounts
What is a partnership business?
A partnership is a form of business organisation. It is owned by two
or more persons (but limited to twenty, except for banks which is
limited to ten). These persons are called partners.
People enter into partnership when they have a common objective to
earn profit. Very often, a partnership is formed by members of the
same family or by a circle of friends. They pool their resources
together to do business and share profits and losses on an agreed
basis.
In the UK, partnership businesses are governed by the Partnership
Act 1890.
Difference between partnership business and sole trading business
Here are the main differences between a partnership business and a sole trading business:
Features
Ownership
Number of owners
Capital
Control
Decision making
Profits and Losses
Current Account
Sole trader
Owned by the proprietor or the sole
trader
One
Brought in by the proprietor
By the owner
Solely by the owner
Proprietor takes all profits and bear
all losses
Not prepared
Partnership
Owned by partners
Two or more (but not more than 20)
Contributed by the partners
Shared among partners
Collectively by all partners
Shared by partners on an agreed
basis
Prepared
Difference between Receipts and Payments Account and Income Expenditure Account
Incomplete Records
Profit as the
capitals/ equity
difference
between
$100 000
$125 000
Exercises:
1. The following information is available for a business:
Equity at 31 December 2010
Equity at 31 December 2011
$126 000
$134 000
$748 000
$654 000
Equity at start
Additional equity brought in
Profit for the year
Drawings
Equity at end
$127 500
$178 400
$20 000
$10 000
Statement of profit and loss for the year ended 31 December 2011
$
178 400
10 000
188 400
(20 000)
(127 500)
40 900
Exercises:
1. The following information is available for a business:
Equity at 1 May 2011
Equity at 30 April 2012
Additional equity brought in
Drawing for the year
$432 500
$460 400
$8 000
$22 400
$632 000
$594 500
$10 000
$31 500
(632 000)
(16 000)
Payroll Accounting
Payroll
Payroll refers to the costs associated with hiring employees by a business. The costs
include salaries and wages payable and contributions to be made to such funds as
required by the legislation of the country in favour of employees (National pension
fund, national insurance etc).
Payroll Accounting
Payroll accounting refers to the process of collecting and processing data to
compute payroll. It ensures that proper records and documentations are kept for
each employee and for the business, wages and salaries are calculated according to
current legislations, statutory and non statutory deductions are effected and to
appropriate funds/ bodies and employees are paid timely and accurately.
Clock cards
This is a card or a sheet that each employee has. The
card is inserted in a machine called the clock card
machine. The machine punches in or prints the time
the employee attends work (time in) and leaves work
(time out) for each day. The clock card is an official
document and is used by the payroll department to
calculate hours worked (including overtime) by an
employee and gross pay.
Time sheet
This is a sheet that an employee fills in everyday
about details of hours worked. Therefore, the time
sheet is used to calculate number of hours an
employee has worked for each day. The payroll
department uses the time sheet to calculate number
of overtime hours and gross pay.
Payslip
This is a document that the law requires all
employers to give to their employees on pay day. It is
used to inform the employee about his basic wages/
salaries, overtime, gross pay, statutory and nonstatutory deductions and net pay. It also contains
identifications of the employee like his name, national
insurance number etc.
Payroll register
Contains a list of all employees and details like
employee number, job title, national insurance
number, tax account number, payment mode, bank
account number, contact details (address and
telephone number) and date on which the employee
joined the business.
Wages sheet
Prepared on each pay day. It contains a list of all
employees and details about their respective payroll:
wages/ salaries, overtime, gross pay, statutory and
non-statutory deductions and net pay.
Time basis
An employee paid on a time basis is one whos wages is calculated according to the
number of hours worked. For example, an employee may be paid at the rate of $10
per hour. If he works 8 hours a day, he earns (8 hours x $10) $80.
However, this basis does not account for labour productivity. An employee who
works hard is paid the same rate per hour as someone who is less productive.
Piecework basis
An employee paid on a piecework basis is one who is paid according to the units
produced. This basis is especially applicable to factory workers. It also takes into
account labour productivity. For example, a factor pays its workers $5 per unit
produced. Employee A produces 10 units in an 8 hour working day. So he earns (8
units x $5) $40. Whereas employee B makes only 5 units and so earns only (5 units
x $5) $25.
Overtime
Overtime refers to the excess of hours worked over and above normal or minimum
hours per week. Working overtime implies the employee is sacrificing his rest and
leisure time for the benefit of the business. Therefore, to compensate for working
unsocial hours, the employee is paid at higher rates for hour in excess of normal
weekly hours. For example, an employee is paid at the rate of $10 per hour for a
normal 40 hours week. He is paid at the rate of time and a half for any excess hours
over and above the 40 hours. He works 50 hours in a particular week. So he earns:
Basic hours ($10 x 40 hours) =
$400
$150
Gross pay
$550
Financial Ratios
financial analysis and interpretation of
accounts
-
Profitability ratios
Mark up on cost
Net profit margin
Expenses to sales
Efficiency ratios
Liquidity ratios
Profitability Ratios:
Consider the following example:
Revenue (Revenue)
Cost of sales
Gross profit
Year
1 ($)
100
75
25
Year 2
($)
150
120
30
Gross Profit
Revenue
x 100
Gross profit margin
Year 1
Year 2
$2 x
5 100
$1 =
00 25%
Can also be
expressed as
25
100
$30
$150
x 100 = 30%
1
5
Gross Profit
Cost of sales
x 100
Markup on cost
Year 1
Year 2
$25
x 100 = 33 .3 %
$75
Can also be expressed as
25
75
$30
x 100 = 25%
$120
Can also be expressed as
30
120
Relationship
between
margin
and
markup:
As can be seen above, gross profit margin and markup
are related. This is because they are calculated by the
Markup
1 +
Marku
p
1. Gross Profit
Margin =
Gross Profit
Margin
1 Gross
Profit Margin
2. Markup =
Net Profit
Revenue
x 100
Expenses
Revenue
x 100
Efficiency Ratio:
Rate of Inventory turn
Shows on average the number of times inventory was sold off and replaced.
Given holding inventory implies funds are tied up, it is important to calculate this ratio so as to
assess how efficient the business has been in managing both funds and inventory. Note that the
rate of inventory turn varies for different types of goods. Perishables like vegetables and fruits
are bought very frequently (may be everyday) and so normally have a high rate of inventory turn.
Calculation:
Note: The answer is always given in number of times, for example 10 times, 3 times etc.
Rate of inventory turn may increase or decrease.
Implications of an increase in rate of inventory turn
1. Implies a reduction of warehouse expenses and less inventory is being kept.
2. Goods are selling rapidly.
3. Cash is not being tied up in holding inventory and can be used for other business
activities.
4. BUT, may also mean too few inventory is being kept which may result in goods being
out of stock regularly and therefore sales are not made.
3. Cash tied up in excessive inventory. Therefore, the business may have difficulties in
paying for expenses and short term debts.
Liquidity Ratios:
Liquidity refers to the ability of a business to satisfy its short term obligations.
Short term obligations include payment to suppliers of goods, payment of expenses for the day to
day running of the business and also repayment of short term borrowings. One indication of
liquidity is the net current asset, that is, current assets current liabilities.
Positive net current assets implies the business has sufficient liquid assets to pay its debts when
they fall due. However, too much liquidity may imply the business is keeping too much cash and
may be foregoing opportunities to earn more profit.
On the other hand, negative net current assets, which is known as net current liabilities implies
the business does not have enough liquid resources to pay its short term debts and actions need to
be taken to remedy this situation.
Ratios:
Working capital ratio, also known as current ratio
Calculation
$120 000
Current liabilities
Current ratio
$108 000
= 1.11: 1
(Current liabilities should always be represented as 1)
This ratio shows the ability of the business to pay its short term obligations. In other words, it
shows to what extent current liabilities is covered by current assets.
Ideally, a business needs to have its current assets exceed its liabilities. Therefore, a ratio of more
than 1: 1 is considered acceptable.
However, though the ratio may be favourable (more than 1: 1), the business may still find itself
in difficulties to settle short term obligations. This may arise, especially, when current assets
comprise a significant amount representing inventory. There is no guarantee than inventory will
already be converted into cash when payments for expenses and debts fall due.
Therefore, current ratio may not be enough as a measure of liquidity. This is why acid test ratio
also known as quick ratio is also calculated:
Quick ratio, also known as acid test ratio
This ratio shows the ability of the business to pay its short term obligations with its most liquid
assets. This ratio gives an indication of the liquidity position of a business in a harsh situation,
that is if short term debts are to be paid so soon that it may not be possible to convert inventory
into cash.
Quick ratio is also given as x:1
Implications of poor liquidity position
1. Creditors may lose trust in the business and may stop giving credit facilities.
2. Additional cost may be incurred (e.g interest on loans and overdrafts) to pay creditors
and expenses.
3. The business may be unable to pay for specific services resulting in suppliers of such
services to cease supply. This may disturb the normal running of the business.
4. Inability to pay salaries may result in workers strike and resignations.
Accounting Concepts
In most cases an accounting period is a year. Note that the accounting year need
not be the same as the calendar year. For example, the accounting year for
business X can be from 1 June to 31 May, for business B from 1 September to 31
August or for business C from 1 April to 31 March.
Implication
Accounts of the business are closed at a specific date every year and final accounts
are prepared (profits/ losses calculated)
customers.
Materiality Concept
Definition
According to this concept, when recording transactions, the accountant should
consider whether disclosure and non-disclosure of such transaction will affect the
decisions of persons reading the accounts. Also, the accountant should consider
whether the benefits obtained from the particular treatment to a transaction is
worth the effort put to it.
A classical example here would be the way an accountant will treat a stapler costing
$2 in the accounts. Though this item is bought by a business and will be used for
several years, it does not have significant value.
Implication
Some items (stapler, paper clips etc) are not considered non-current assets though
they may be used by the business for a long period of time. Rather, their costs are
written off at one against profit in the period they are bought.
Consistency Concept
Definition
All similar items need to be given the same accounting treatment in the same
accounting period and from one period to another.
Unless there is a valid reason, no changes are allowed in the accounting policy
chosen. This concept especially prevents accountants from manipulating the results
of a business by simply changing the accounting policies
Implication
The same depreciation method is applied for similar items in the same period and
from one period to another.
Dual Aspect Concept
Definition
This concept takes into account the two aspects of a accounting represented on one
side by the assets of the business and on the other by the claims against those
assets.
This duality is also explained by the accounting equation as follows:
Assets = Capital + Liabilities
Implication
Transactions are recorded using the double entry system whereby each transaction
has a debit entry and a corresponding credit entry.