f3 Bpp Notes

Financial Accounting

Paper F3 (International)

Course Notes

BPP provides revision courses, question days, mock days and specific material to assist you in this important phase of your studies.

(Paper Based Exam)

Study Programme

Page

Introduction to the paper and the course... (ii) 1 Introduction to accounting ... 1.1 2 Home study chapter - The regulatory framework ... 2.1

3 Accounting conventions... 3.1 4 Sources, records and books of prime entry... 4.1 5 Ledger accounts and double entry ... 5.1

End of Day 1 – refer to Course Companion for Home Study

6 From trial balance to financial statements... 6.1 7 Sales tax... 7.1 8 Inventory... 8.1 9 Tangible non-current assets... 9.1 10 Intangible non-current assets ... 10.1 11 Accruals and prepayments... 11.1

End of Day 2 – refer to Course Companion for Home Study

12 Irrecoverable debts and allowances... 12.1 13 Provisions and contingencies... 13.1 14 Control accounts ... 14.1 15 Bank reconciliations... 15.1

End of Day 3 – refer to Course Companion for Home Study

16 Correction of errors... 16.1 17 Preparation of financial statements for sole traders ... 17.1 18 Incomplete records... 18.1 19 Partnerships ... 19.1

End of Day 4 – refer to Course Companion for Home Study

20 Introduction to company accounting... 20.1 21 Preparation of financial statements for companies... 21.1 22 Events after the balance sheet date... 22.1 23 Cash flow statements ... 23.1 24 Home study chapter - Information technology... 24.1

End of Day 5 – refer to Course Companion for Home Study

25 Answers to Lecture Examples ... 25.1 26 Pilot paper (Questions only) ... 26.1

Don’t forget to plan your revision phase! • Revision of syllabus

• Testing of knowledge • Question practice • Exam technique practice

Introduction to Paper F3 Financial Accounting (INT)

Overall aim of the syllabus

To develop knowledge and understanding of the underlying principles and concepts relating to financial accounting and technical proficiency in the use of double-entry accounting techniques including the preparation of basic financial statements.

The syllabus

The broad syllabus headings are:

A The context and purpose of financial reporting

B The qualitative characteristics of financial information and the fundamental bases of accounting C The use of double entry and accounting systems

D Recording transactions and events E Preparing a trial balance

F Preparing basic financial statements

Main capabilities

On successful completion of this paper, candidates should be able to: • Explain the context and purpose of financial reporting

• Define the qualitative characteristics of financial information and the fundamental bases of accounting • Demonstrate the use of double entry and accounting systems

• Record transactions and events

• Prepare a trial balance (including identifying and correcting errors)

• Prepare basic financial statements for incorporated and unincorporated entities

Links with other papers

This diagram shows where direct (solid line arrows) and indirect (dashed line arrows) links exist between this paper and other papers that may precede or follow it.

Paper F7 Financial Reporting, assumes knowledge acquired in paper F3 Financial Accounting, and develops and applies this further and in greater depth. Paper P2 Corporate Reporting, assumes knowledge acquired at the Fundamentals level including core technical capabilities to prepare and analyse financial reports for single and combined entities. Corporate Reporting (P2) Financial Reporting (P7) Financial Accounting (F3) Accountant in Business (F1)

Assessment methods and format of the exam

Examiner: Nicola Ventress

The examination is a two hour paper and all questions are compulsory. Questions will assess all parts of the syllabus and will contain both computational and non-computational elements.

Format of the Exam Marks

80 40 two mark questions

10 one mark questions 10

Course Aims

Achieving ACCA's Study Guide Outcomes

A The context and purpose of financial reporting

A1 The reasons for and objectives of financial reporting Chapter 1

A2 Users’ and stakeholders’ needs Chapter 1

A3 The main elements of financial reports Chapter 1

A4 The regulatory framework Chapter 2

B The qualitative characteristics of financial information and the fundamental bases of accounting

B1 The qualitative characteristics of financial reporting Chapter 3 B2 Alternative bases used in the preparation of financial information Chapter 3

C The use of double entry and accounting systems

C1 Double entry bookkeeping principles including the maintenance of accounting records

and sources of information

Chapters 4 & 5 C2 Ledger accounts, books of prime entry and journals Chapters 4 & 5 C3 Accounting systems and the impact of information technology on financial reporting Chapter 24

D Recording transactions and events

D1 Sales and purchases Chapters 4, 5, 7 & 14

D2 Cash Chapters 4 & 5

D3 Inventory Chapter 8

D4 Tangible non-current assets Chapter 9

D5 Depreciation Chapter 9

D6 Intangible non-current assets and amortisation Chapter 10

D7 Accruals and prepayments Chapter 11

D8 Receivables and payables Chapter 12

D9 Provisions and contingencies Chapter 13

D10 Capital structure and finance costs Chapters 20 & 21

E Preparing a trial balance

E1 Trial balance Chapter 6

E2 Correction of errors Chapter 16

E3 Control accounts and reconciliations Chapter 14

E4 Bank reconciliations Chapter 15

E5 Suspense accounts Chapter 16

F Preparing basic financial statements

F1 Balance sheets Chapter 17

F2 Income statements Chapter 17

F3 Events after the balance sheet date Chapter 22

F4 Accounting for partnerships Chapter 19

F5 Cash flow statements (excluding partnerships) Chapter 23

Classroom tuition and Home study

Your studies for BPP consist of two elements, classroom tuition and home study.

Classroom tuition

In class we aim to cover the key areas of the syllabus. To ensure examination success you will to spend private study time reinforcing your classroom course with question practice and reviewing areas of the Course Notes and Study Text.

Home study

To support you with your private study BPP provides you with a Course Companion which helps you to work at home and aims to ensure your private study time is effectively used. The Course Companion includes a Home Study section which breaks down your home study by days, one to be covered at the end of each day of the course. You will find clear guidance as to the time to spend on various activities and their importance.

You are also provided with progress tests and two course exams which should be submitted for marking as they become due.

These may include questions on topics covered in class and home study.

BPP Learn Online

Come and visit the BPP Learn Online free at www.bpp.com/acca/learnonline for exam tips, FAQs and syllabus health check.

ACCA Forum

We have thriving ACCA bulletin boards at www.bpp.com/accaforum. Register and discuss your studies with tutors and students.

Helpline

If you have any queries during your private study simply contact your class tutor on the telephone number or e-mail address that they will supply. Alternatively, call +44 (0)20 8740 2222 (or your local training centre if outside the London area) and ask for a tutor for this paper to speak to you or to call you back within 24 hours.

Feedback

The success of BPP’s courses has been built on what you, the students tell us. At the end of the course for each subject, you will be given a feedback form to complete and return.

If you have any issues or ideas before you are given the form to complete, please raise them with the course tutor or relevant head of centre.

Key to icons

Question practice from the Study Text

This is a question we recommend you attempt for home study.

Section reference in the Study Text

Syllabus Guide Detailed Outcomes

Having studied this chapter you will be able to:

• Define and understand the principles of financial reporting.

• Identify and define the different business entities of: sole trader, partnership and limited liability company and recognise the legal differences between them.

• Identify the advantages and disadvantages of operating as each of the three types of business entity. • Identify the users of financial statements and state and differentiate between their information needs.

• Understand and identify the purpose of each of the main financial statements.

• Define and identify assets, liabilities, equity, revenue and expenses.

Exam Context

This chapter introduces the subject of accounting. Questions on this area will most likely focus on the different characteristics of the three types of business entity: sole trader, partnership and limited liability company.

Qualification Context

Sole trader and partnership accounts are only examined in Financial Accounting. The Fundamentals and Professional level papers of Financial Reporting (F7) and Corporate Reporting (P2) are set in the context of a limited liability company. These papers will test your understanding of the content of financial statements and the detailed accounting rules which companies must apply.

Introduction

to accounting

Overview

Income statement Balance sheet

Users of financial information

Limited liability company

Sole trader Partnership

Introduction to accounting

Concept of separate entity Types of business entities

1 Accounting

Definition

1.1 Accounting is a way of recording, analysing and summarising transactions of a business.

2 Proforma financial statements

Income statement

2.1 Income statement for the year ended 31 December 20X7:

$ $

Sales 200,000

Less: _{Cost of sales}

Opening _{inventories 40,000} Purchases 110,000 Carriage _{inwards 20,000} 170,000 Closing inventories _(50,000) (120,000) Gross profit 80,000 Sundry income 5,000 Discounts receivable 3,000 88,000 Less: Expenses Rent 11,000 Carriage _{outwards 4,000} Telephone 1,000 Electricity 2,000

Wages and salaries 9,000

Depreciation 7,000

Bad and doubtful debts 3,000

Motor _{expenses 5,000}

Discounts _{allowable 1,000}

(43,000)

Balance sheet

2.2 Balance sheet as at 31 December 20X7:

$ $ ASSETS

Non-current assets

Land and buildings 100,000

Office equipment 50,000

Motor vehicles 30,000

Furniture and fixtures 20,000

200,000 Current assets

Inventories 50,000

Trade receivables 30,000

Less: allowance for receivables (2,000)

28,000

Prepayments 5,000

Cash in hand and at bank 7,000

90,000

Total assets 290,000

CAPITAL AND LIABILITIES Capital Capital 170,000 Profit 45,000 Less: drawings (25,000) 190,000 Non-current liabilities Bank loans 40,000 Current liabilities Bank overdraft 16,000 Trade payables 40,000 Accruals 4,000 60,000

3 Users of financial information

Lecture example 1

What information would these users of financial information be interested in?

Solution

(f) Governments and their agencies

4 Accounting

records

4.1 In order to be able to produce an income statement and a balance sheet a business needs to keep a record of all its transactions.

4.2 This process is called bookkeeping.

4.3 Accounting records should be complete, accurate and valid if the information produced is to be useful for the users of financial information.

4.4 The mechanics of bookkeeping and the accounting records a business should keep will be covered in Chapters 4, 5 and 6.

5 Types of business entities

(a) Sole trader

(b) Partnership

(c) Limited liability company

The sole trader is the simplest of these forms.

6 The concept of business entity (separate entity)

transactions of the owner should never be mixed with the business transactions. 6.2 When considering a limited liability company this distinction is laid down in law – the

company has a separate legal identity.

6.3 In preparing accounts, any type of business is treated as being a separate entity from its owner(s).

Quick Quiz Q2

7 Summary of Chapter 1

7.1 Financial statements are used by a wide variety of users, each with different information needs. Satisfying the investors’ needs will mean that the majority of other users’ needs are also met.

7.2 There are three main types of businesses. For sole traders and partnerships the owners have unlimited liability and bear all the risks and reap all the rewards of being in business. For a limited liability company the shareholders' liability is limited to the extent of their investment.

1.1 In a sole trader and a partnership the owners are personally liable if the business cannot meet its debts. Is this statement true or false?

A True

B False (1 mark)

1.2 If a limited liability company goes into liquidation will the shareholders have to make a financial contribution to help the company pay its creditors?

A Yes

B No (1 mark)

1.3 Which of the following statements most accurately defines the business entity concept? A The business must be treated as being separate from its owners.

1.1 A 1.2 B 1.3 A

Syllabus Guide Detailed Outcomes

Having studied this chapter you will be able to:

• Understand the role of the regulatory system including the roles of the – International Accounting Standards Committee Foundation (IASCF) – International Accounting Standards Board (IASB)

– Standards Advisory Council (SAC)

– International Financial Reporting Interpretations Committee (IFRIC) • Understand the role of International Financial Reporting Standards (IFRS)

Exam Context

Questions on this chapter will be knowledge based and so it is important that you are familiar with the role of each body. The role of IFRIC was tested in the Pilot Paper.

Qualification Context

Financial Accounting introduces the International Accounting Standards Board's role in issuing IFRSs and paper F3 examines some key standards. All of these standards are built upon in the Fundamentals level paper Financial

Reporting (F7) and the Professional level paper Corporate Reporting (P2).

Home study chapter -

Overview

1 Introduction

1.1 Financial statements are produced by an entity's managers in order to show its owners how the entity has performed over a period of time.

1.2 Company financial statements particularly need to show a true and fair view.

This means a system of regulation is necessary to ensure that financial statements are produced to a high standard and are comparable across different companies.

2 Regulatory

system

Standards Advisory Council (SAC)

International Financial Reporting Interpretations Committee (IFRIC) International Accounting Standards Board (IASB) (14 Board members) International Accounting Standards Committee Foundation

(IASCF) (22 Trustees) Key: Appoints Reports to Advises

International Accounting Standards Committee Foundation (IASCF)

2.2 The IASCF is a not-for-profit organisation based in the United States which heads up the regulatory system.

Its Trustees appoint members to the IASB, IFRIC and SAC. They also oversee the regulatory system and raise the finance necessary to support it.

It has no involvement in the standard setting process.

International Accounting Standards Board (IASB)

2.3 The IASB's principal aim is to develop a single set of high quality accounting standards: International Financial Reporting Standards (IFRS).

It also liaises with national accounting standard setters (for example the UK's ASB) to achieve convergence in accounting standards around the world.

International Financial Reporting Interpretations Committee (IFRIC)

2.4 The IFRIC issues guidance on both how to apply existing IFRSs in company financial statements and how to account for new financial reporting issues where no IFRS exists. It reports to the IASB.

Standards Advisory Council (SAC)

2.5 The SAC's principal role is to advise the IASB on a range of issues which include: • The IASB's agenda and timetable for developing IFRSs

• Advising the IASB of areas that may need to be considered by IFRIC.

3 The role of International Financial Reporting

Standards (IFRS)

3.1 IFRSs provide guidance as to how items should be shown in a set of financial statements both in terms of their monetary amount and any other disclosure.

For example: IAS 2: Inventory states at what amount a company should value its inventory and also requires that the financial statements breakdown the inventory figure between its components such as raw materials, work in progress and finished goods.

3.2 If a company follows the relevant accounting standards its financial statements should show a true and fair view.

Lecture example 1

What is the role of the International Accounting Standards Committee Foundation? A To appoint members of the IASB

B To advise the IASB on new accounting standards they should consider issuing.

Lecture example 2

Which of the following bodies is involved is trying to achieve convergence of global accounting standards?

A IASB B IFRIC

Solution

4 Summary of Chapter 2

4.1 The IASCF appoints members to the IASB, IFRIC and SAC. 4.2 The IASB issues International Financial Reporting Standards. 4.3 The IFRIC issues guidance on how to apply accounting standards. 4.4 The SAC advises the IASB on its agenda.

2.1 Accounting standards are prepared by A the IASB

B the IASC Foundation

C the IAASB (1 mark)

2.2 Which of the following best describes the role of The International Financial Reporting Interpretations Committee?

A Issues International Financial Reporting Standards. B Provides advice on the development of standards.

2.1 A 2.2 C

Syllabus Guide Detailed Outcomes

Having studied this chapter you will be able to:

• Define, understand and apply accounting concepts and qualitative characteristics. • Understand the balance between qualitative characteristics.

• Identify and explain the main characteristics of alternative valuation bases (for example net realisable value). • Understand the advantages and disadvantages of historical cost accounting.

• Understand the provision of International Financial Reporting Standards governing financial statements regarding changes in accounting policies.

• Identify the appropriate accounting treatment if a company changes a material accounting policy.

Exam Context

Questions on this chapter are likely to test your understanding of the qualitative characteristics of information. For example, the Pilot Paper required you to identify the factors that make information reliable. Questions may also ask you to define accounting conventions.

Qualification Context

Your understanding of the remaining chapters of IASB Framework will be developed in the Fundamentals level paper

Financial Reporting (F7). You should also expect to see more detailed calculations on IAS 8 tested in Paper F7.

Overview

The objective of financial statements

Accounting conventions

Underlying assumptions

Qualitative characteristics of

financial information Elements of financial statements

IASB Framework

Other issues

Concepts and conventions Alternative valuation bases

IAS 8: Accounting policies, changes in accounting

1 Introduction

1.1 As noted in Chapter 2 financial statements should show a true and fair view of, or present fairly, the entity's activities. They are produced to provide information to the entity's owners. 1.2 In order for this information to be useful it must possess certain characteristics.

2 The IASB's Framework for the Preparation and

Presentation of Financial Statements

Conceptual framework

2.1 The IASB's Framework is not an accounting standard.

2.2 It is a set of principles which underpin the foundations of financial accounting.

2.3 Whenever a new accounting standard is issued it will be based on the principles of the IASB

Framework. Furthermore its principles should be applied to account for any item where no

accounting standard exists.

2.4 The Framework is divided into seven sections.

1) The objective of financial statements

2) Underlying

assumptions 3) Qualitativecharacteristics

of financial information 7) Concepts of capital and capital maintenance 6) Measurement of the elements of financial statements 5) Recognition of the elements of financial statements 4) The elements of financial statements Framework

Only sections 1 – 4 are examinable at Paper F3.

The objective of financial statements

2.5 To provide information about the financial position, financial performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.

Underlying assumptions

2.6 Accruals basis

The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the period to which they relate.

Going concern

The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future.

If this is not appropriate, then additional disclosure about the basis of preparation must be made in the financial statements.

Qualitative characteristics of financial information

2.7 Quick Quiz Q3

Quick Quiz Q4, Q10

• For same entity over different periods: consistency • Between different entities:

disclosure of accounting policies

• Information should be readily understandable by users who are assumed to have reasonable knowledge

Understandability Comparability

Relevance _Reliability

• Assist users in evaluating past and predicting future events

• Materiality

• Faithful representation • Substance over form • Neutrality

• Prudence • Completeness

2.8 The elements of financial statements

The five elements of financial statements and their definitions are listed below. Asset

A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Liability

A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of economic benefits.

Equity

The residual interest in the assets of an entity after deducting all its liabilities, so EQUITY = NET ASSETS = SHARE CAPITAL + RESERVES

Income

Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

Expenses

Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or increases of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

3 Alternative valuation bases

Historic cost

3.1 Financial statements are generally produced using the historical cost convention where items are recorded at their historic cost.

For example, if an entity purchased a building in 20X6 for $1 million then the building would be recorded as an asset at $1 million. The $1 million asset would then be depreciated to reflect the wearing out of the building. However, in reality, the value of the building may appreciate over time depending on market values.

Lecture example 1

What are the advantages and disadvantages of recording the building at its historic cost of $1 million? (consider the Framework's qualitative characteristics).

Solution

Advantages of historic cost (1)

(2) (3)

Disadvantages of historic cost (1)

(2)

3.2 Note that in times of rising prices using the historical cost convention will lead to asset values being too low and profits too high in a set of financial statements.

3.3 Due to the limitations of historic cost, alternative valuation bases exist. They are:

• replacement cost

• net realisable value

• economic value

Replacement cost

3.4 Assets are carried at the amount it would cost to acquire an equivalent asset today. Liabilities are shown at the amount that would be required to settle the obligation today. Replacement cost is also known as 'current cost'.

Net realisable value

3.5 This values items at their expected selling price less any costs that need to be incurred before the item can be sold.

Inventory should always be shown in the financial statements at the lower of cost (historic cost) and net realisable value.

Lecture example 2

A Ltd has 100 items in inventory at the year end. The following information is available:

$

Total cost of items to date 1,000

Expected selling price per item 11

Costs which still need to be incurred per item before item can be sold 2

Required

(a) What is the historic cost of the inventory? $ (b) What is the net realisable value of the inventory? $ (c) What value for inventory should be shown in the financial statements? $ Workings

Economic value

3.6 This is the value of an item derived from its ability to generate net cash flows. It can also be known as 'present value'.

For example, the economic value of a machine would be calculated by determining the value in today's prices, of the future cash inflows from selling items produced by the machine less the related cash outflows.

4 Summary of Chapter 3

4.1 The IASB Framework provides a set of principles on which financial accounting is based.

4.2 Financial statements should provide information on an entity’s financial position, financial performance and changes in financial position.

4.3 In order for this information to be useful to users the financial statements should contain the qualitative characteristics of understandability, relevance, reliability and comparability.

5 Other examinable concepts and conventions

5.1 In addition to the concepts and conventions set out in the Framework, the following are also relevant in the preparation of financial statements.

The business entity concept

5.2 This recognises the distinction between the business and its activities and the owners or managers themselves. This is particularly important when considering sole trader or partnership accounts as these businesses are not separately identified by law.

The money measurement concept

5.3 Only items which are capable of being measured in monetary terms should be recognised in the financial statements. For example, even though a loyal workforce may be of benefit to a business this value cannot be measured in monetary terms and is therefore not included on the balance sheet.

The duality concept

5.4 Every transaction has two effects. This is the underlying principle of the double entry accounting system.

The historical cost convention

5.5 Assets and liabilities are recorded at their historical cost. This is the amount recorded when the transaction took place.

6 IAS 8: Accounting policies, changes in accounting

estimates and errors

Accounting policies – definition

6.1 Accounting policies are the significant principles, bases, conventions, rules and practices applied by an entity in preparing and presenting the financial statements.

It is the way the entity has decided to treat an item in its financial statements, for example whether non-current assets are carried at historic cost or a revalued amount.

Changes in accounting policy

6.2 Changes in accounting policy will only arise if:

(a) There is a new accounting standard or statutory requirement.

Accounting treatment

6.3 Financial statements contain two years worth of figures. For example a company whose year end is 31 December 20X7 will show information for 20X7 and 20X6.

The current year figures (20X7) will be produced using the new accounting policy. In order for the financial statements to be comparable over time the comparative figures (20X6) will be restated. This means they will be reproduced and drawn up using the 20X7 accounting policies.

6.4 Disclosure

The following disclosure should be made:

(a) The nature of the change in accounting policy (b) The reasons for the change

(c) The amount of the adjustment in the current period and the comparative period.

Errors

6.5 These are material omissions from, or misstatements in, the financial statements that ought to have been identified before the financial statements were finalised.

An error is accounted for in exactly the same way as a change in accounting policy.

For example, an entity may discover a material error in the 20X6 figures whilst producing the 20X7 financial statements. When the 20X7 financial statements are produced the 20X6 comparatives should be restated and the error corrected.

3.1 The Framework for the Preparation and Presentation of Financial Statements identifies two assumptions which are the bedrock of accounting. What are they?

A Consistency and prudence B Accruals and going concern

C Materiality and separate entity (1 mark)

3.2 In which of the following circumstances can a change of accounting policy be made? (i) If the directors want to improve the balance sheet value

(ii) If required by an accounting standard

(iii) If it results in reliable and more relevant information A (ii) only

B (i) and (ii) C (ii) and (iii)

3.1 B 3.2 C

Syllabus Guide Detailed Outcomes

Having studied Chapters 4 and 5 you will be able to:

• Identify and explain the function of the main data sources in an accounting system and how the accounting system provides useful information.

• Outline the contents and purpose of different types of business documentation such as an invoice. • Identify the main types of business transactions, for example, sales, purchases, payments and receipts. • Understand and apply the concept of double entry accounting, the duality concept and the accounting equation.

• Identify the main types of ledger account and illustrate how to balance and close a ledger account.

• Understand and illustrate the uses of journals and the posting of journal entries into ledger accounts.

• Identify correct journals from given narrative.

• Record credit sale, credit purchase and cash transactions in ledger accounts and day books.

• Understand and record sales and purchase returns.

• Understand the need for a record of petty cash transactions and security over the petty cash system.

• Describe the features and operation of a petty cash imprest system.

• Account for petty cash using imprest and non-imprest methods.

Exam Context

Questions are unlikely to feature solely on this chapter, however, you should have a good understanding of what constitutes an asset, liability, capital, income and expense. You should also be aware of the principal contents of each book of prime entry and the purpose of the memorandum ledgers.

Qualification Context

These topics are only examined in Financial Accounting.

Sources, records and

books of prime entry

Overview

Income statement

Memorandum ledgers Sources, records and

books of prime entry Balance sheet

Books of prime entry

1 The balance sheet

1.1 An individual could prepare a list of everything they own and everything by owe.

Lecture example 1

List out everything you own and owe.

Solution

(a) Own

(b) Owe

1.2 For a business, this list is formalised as a balance sheet and show the entity's assets and liabilities.

(a) Asset: is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

(b) Liability: is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of economic benefits.

Proforma balance sheet – sole trader

1.3 Balance sheet as at 31 December 20X7:

$ $ ASSETS

Non-current assets

Land and buildings 100,000

Office equipment 50,000

Motor vehicles 30,000

Furniture and fixtures 20,000

200,000 Current assets

Inventories 50,000

Trade receivables 30,000

Less: allowance for receivables (2,000)

28,000

Prepayments 5,000

Cash in hand and at bank 7,000

90,000

Total assets 290,000

CAPITAL AND LIABILITIES Capital Capital 170,000 Profit 45,000 Less: drawings (25,000) 190,000 Non-current liabilities Bank loans 40,000 Current liabilities Bank overdraft 16,000 Trade payables 40,000 Accruals 4,000 60,000

Total capital and liabilities 290,000

Key features

1.4 (a) Always headed as at, for the date of the balance sheet.

(b) Non-current assets - assets held and used in the business over the long-term (i.e. more than one year).

(c) Current assets - not non-current assets! Conventionally listed in increasing order of liquidity (i.e. closeness of assets to cash).

(d) Capital - what the business owes the proprietor/owner. In this case the sole trader owns all of the business, i.e. its total net worth.

∴ CAPITAL = ASSETS - LIABILITIES

(e) Don't include a caption (item heading) if there isn’t a value for it.

The balance sheet is a snapshot of the business at one point in time.

2 The income statement

Profit – example

2.1 Suppose a business buys three books for $10 each. Then it sells them for $15 each:

$

Sales 45 Income

Cost of sales (30) Expenditure

Gross profit 15

Profit is the excess of total income over total expenditure.

NOTE: The business may have other expenses such as rent, telephone bills, etc. to take off before the ‘true’ profit is shown.

Proforma income statement - sole trader

2.2 Income statement for the year ended 31 December 20X7:

$ $

Sales 200,000

Less: _{Cost of sales}

Opening _{inventories 40,000} Purchases 110,000 Carriage _{inwards 20,000} 170,000 Closing inventories _(50,000) (120,000) Gross profit 80,000 Sundry income 5,000 Discounts receivable 3,000 88,000 Less: Expenses Rent 11,000 Carriage _{outwards 4,000} Telephone 1,000 Electricity 2,000

Wages and salaries 9,000

Depreciation 7,000

Bad and doubtful debts 3,000

Motor _{expenses 5,000}

Discounts _{allowable 1,000}

(43,000)

Key features

2.3 (a) Headed up with the period for which the income and expenses are being included.

(b) The top part Sales X

Cost of sales (X)

Gross profit X

is called the trading account as it records just the trading activities (buying and selling) of the business.

(c) Sundry income includes items like bank account interest. (d) Do not include nil value captions.

The income statement is a summary of the business' performance over a period of time – think of it as a DVD!

3 Relationship between the balance sheet and the

income statement

3.1 Balance sheet – shows the worth of business at a point in time (financial position). Income statement – shows the trading activities over a period of time (financial performance).

3.2 The accounting period is the period for which the income statement was prepared. This is usually a year.

3.3 Therefore, there will be a balance sheet at the beginning of the year (prior year end) and at the end of the accounting period.

The income statement is for the intervening period.

Income statement for the year ended 31.12.X7

Balance sheet as at 31.12.X6 Balance sheet as at 31.12.X7

4 From business transactions to financial statements

CASH TRANSACTIONS

Sales Purchases Wages Stationery Acquisition

of non-current

assets

CREDIT TRANSACTIONS

Sales Purchases

Ultimately all of these transactions must be summarised in the business' financial statements (ie the balance sheet and income statement).

4.2 This is achieved by having accounting records to record each stage of the process:

Assorted transactions

(eg invoices)

Categorised (in Books of Prime Entry)

Summarised (eg nominal ledger, trial balance)

FINANCIAL STATEMENTS

(eg Balance Sheet and Income Statement)

5 Books of prime entry

5.1 The business' transactions are categorised with other similar transactions in the books of prime entry.

5.2

Cash book

5.3 (a) Records receipts and payments into and out of the bank.

(b) For exam purposes often assumed to be two books, one for receipts, one for payments.

Cash book (receipts)

5.4 Example:

Date Narrative Total $ Capital $ Sales $ Receivables $ 2.1.X7 F. Bloggs 4,000 4,000 5.1.X7 J. Spalding 200 200 6.1.X7 J. Smith 500 500 4,700 4,000 500 200 total cash

received reason why cash was received Books of prime entry

Cash book Sales day

book Purchase day book Petty cash book Journal book

Receipts

Cash transactions Credit purchases

Payments Small cash transactions Adjustments and errors Credit sales

Cash book (payments)

5.5 Example:

Date Narrative Total $ Purchases $ Van $ Rent $ Payables $ Petty cash $ Drawings $ 6.1.X7 Manley & Co. 350 350 6.1.X7 Petty Cash 50 50 8.1.X7 Digby Co 1,000 1,000 1,400 1,000 350 50 total cash

payment reason why payment was made

Sales day book

5.6 Lists all sales made on credit, i.e. each individual invoice raised. 5.7 Example: Date Customer $ 3.1.X7 J. Spalding 200 5.1.X7 G. McGregor 400 8.1.X7 J. Spalding 400 14.1.X7 G. McGregor 300 TOTAL 1,300

Purchase day book

5.8 Lists all purchases made on credit, i.e. each individual invoice received. 5.9 Example:

Date Supplier $

1.1.X7 Tewson Co. 400

4.1.X7 Manley & Co. 350

16.1.X7 Manley & Co. 200

Petty cash book

5.10 (a) Records the movement of physical cash (kept on the premises) in and out of the petty cash tin.

(b) Used for small incidental expenses. 5.11 Example:

Receipts Payments

Date Narrative Total $

Date Narrative Total $ Stationery $ Travel $ 6.1.X7 Cheque cashed 50 7.1.X7 City Stationers 10 10 8.1.X7 F. Bloggs Metro fare 2 2 12 10 2

Controlling petty cash – the imprest system

An imprest system acts as an accounting control by having a set amount of petty cash. 5.12 (a) Pre-set limit, say $50.

(b) Voucher filled in when money is taken out to pay expenses. (c) At any time, vouchers + cash = pre-set limit.

(d) At the end of the week/month, the petty cash book is filled in from the vouchers. (e) The amount needed to bring the balance back up to the pre-set limit = money spent.

Journal book

5.13 Certain transactions do not ‘fit’ in the main books, for example: (a) period end adjustments

(b) correction of errors

The journal book lists these sundry transactions.

6 Memorandum

ledgers

Purpose

6.1 To know how much is owed by a particular customer or to a certain supplier at a point in time.

For example, the sales day book shows the sales made on credit to all customers and the cash book receipts shows the cash received from all sources.

J. Spalding owes the business $400 but this cannot be seen from the books of prime entry without trawling back through the detailed information.

A separate memorandum ledger is kept to show this information. Quick Quiz Q5, Q6

6.2 There are two types of memorandum ledgers kept by the business:

(a) Receivables ledger – showing how much is owed by each individual customer. (b) Payables ledger – showing how much is owed to each individual supplier.

6.3 The entries in these ledgers are made by rearranging the information in the day books into individual customer and supplier accounts.

Receivables ledger

6.4 Example:

J. Spalding (Customer)

Date Narrative Sales $ Cash $ Total _$ 3.1.X7 5.1.X7 8.1.X7 Invoice 1032 Cash received Invoice 1101 200 400 200 200 – 400 G. McGregor (Customer)

Date Narrative Sales $ Cash $ Total _$ 5.1.X7 14.1.X7 Invoice 1033 Invoice 1129 400 300 400 700

Payables ledger

Tewson Co. (Supplier)

Date Cash $

Purchases

$ Total _$

1.1.X7 Invoice A112 400 400

Manley & Co. (Supplier)

Date Cash $ Purchases $ Total $ 4.1.X7 6.1.X7 16.1.X7 Invoice 063 Cash book Invoice 097 350 350 200 350 – 200

7 Summary of Chapter 4

7.1 The balance sheet shows the assets and liabilities of a business at a particular point in time whilst the income statement shows its performance over a period.

7.2 In order to produce a set of financial statements the business’ transactions must first be categorised into the books of prime entry. The totals on these books are then summarised in the nominal ledger.

4.1 Which of the following is not a book of prime entry? A Wages day book

B Cash book

4.1 C

Syllabus Guide Detailed Outcomes

Having studied Chapters 4 and 5 you will be able to:

• Identify and explain the function of the main data sources in an accounting system and how the accounting system provides useful information.

• Outline the contents and purpose of different types of business documentation such as an invoice. • Identify the main types of business transactions, for example, sales, purchases, payments and receipts. • Understand and apply the concept of double entry accounting, the duality concept and the accounting equation.

• Identify the main types of ledger account and illustrate how to balance and close a ledger account.

• Understand and illustrate the uses of journals and the posting of journal entries into ledger accounts.

• Identify correct journals from given narrative.

• Record credit sale; credit purchase and cash transactions in ledger accounts and day books.

• Understand and record sales and purchase returns.

• Understand the need for a record of petty cash transactions and security over the petty cash system.

• Describe the features and operation of a petty cash imprest system.

• Account for petty cash using imprest and non-imprest methods.

Exam Context

Your understanding of double entry will be crucial to passing Financial Accounting. Whilst an individual question may not ask you to produce a double entry it will be instrumental in answering the question. For example, a question may ask you to derive the income statement expense for electricity where amounts need to be accrued at the year end. You will only get this right if you understand the double entry for recording expenses and accruals. A question could also describe a transaction and ask you to identify the correct double entry to record this.

Qualification Context

Being confident at double entry will help you account for many of the more complex accounting standards you will meet in the Fundamentals level paper, Financial Reporting (F7) and the Professional level paper, Corporate Reporting (P2).

Ledger accounts

Overview

Ledger accounts and double entry

Balancing off

Ledger accounts Double entry

1 Introduction

1.1 This chapter is designed to enable you to explain the principles of double entry and apply these principles to the preparation of accounting records within the nominal/general ledger. 1.2 In Chapter 4 we saw how transactions were categorised in books of prime entry, the next

step is to summarise the information in a format nearer to that of the final financial statements.

The nominal ledger

1.3 (a) Each item in the balance sheet or income statement will have an "account" (which might be a page in a book or a record on a computer).

(b) All the accounts are collected together in the nominal ledger.

(c) The books of prime entry are totalled up and two entries will be made in these accounts with each of these totals – this is called double entry.

The dual effect

1.4 The method used stems from the fact that every transaction affects two things, for example: (a) A sole trader pays $6,000 in the business bank account:

Cash increases by $6,000 Capital increases by $6,000

(b) A sole trader purchases goods on credit for $400: Purchases increase by $400

Trade payables increase by $400

2 Ledger

accounts

(T-accounts)

2.1 Debit CAPITAL Credit

$ $

Decrease Capital Increase Capital

We make two entries from each total extracted from the books of prime entry, and call one a Debit (Dr), and the other one a Credit (Cr).

Principles of double entry bookkeeping

2.2 The cash account is a good starting point:

Dr CASH Cr

$ $

CASH IN = DEBIT CASH OUT = CREDIT

General rules

2.3 (a) DEBIT entry represents: (i) an increase in an asset; (ii) a decrease in a liability; (iii) an item of expense. (b) CREDIT entry represents:

(i) an increase in a liability; (ii) a decrease in an asset; (iii) an item of income. This can be remembered as follows

Debits Credits (increase) (increase) Expenses Liabilities Assets Income Drawings Capital Quick Quiz Q1 - 4

Lecture example 1

What is the double entry for each of the following? Explain each entry in terms of the general rules above.

Solution

Transaction Debit Credit

(a) Sales for cash.

(b) Sales on credit.

(c) Purchase for cash.

(d) Purchase on credit.

(e) Pay electricity bill.

(f) Receive cash from a credit customer.

Transaction Debit Credit

(h) Borrow money from the bank.

Lecture example 2

Douglas

Douglas had the following transactions during January: (1) Introduced $5,000 cash as capital;

(2) Purchased goods on credit from Richard, worth $2,000; (3) Paid rent for one month, $500;

(4) Paid electricity for one month, $200; (5) Purchased car for cash, $1,000;

(6) Sold half of the goods on credit to Tish for $1,750; (7) Drew $300 for his own expenses;

(8) Sold goods for cash, $2,100.

Required

Post transactions (1) to (8) to the relevant ledger accounts.

3 Flow

of

information

3.1 In Lecture example 2 the original transactions were posted to the ledger accounts. A business would firstly categorise this information in the books of prime entry. The totals from the books of prime entry are then posted to the nominal ledger using double entry. 3.2

4 Balancing off the ledger accounts

4.1 The totals from the books of prime entry may be posted to the nominal ledger each month. A business will want to know the balance on each account. This is done by 'balancing off' each account.

Lecture example 3

The following information has been posted to the cash account below.

Required

Balance off the cash account to determine the amount of cash held at the end of January.

Solution

Steps

4.2 (1) Add the debit and credit sides separately. (2) Fill in the higher of the two totals on both sides.

(3) Literally 'balance' the account (what number do we need and on which side to make the two sides equal?) – balance c/d

(4) Complete the 'double entry' – balance b/d on opposite side.

Lecture example 4

Douglas

Refer to Lecture example 2 on page 5.6.

Required

Balance off the ledger accounts for Douglas

Solution

Complete in the solution space for Lecture example 2.

5 Summary of Chapter 5

5.1 The totals on the books of prime entry are posted to the nominal ledger using double entry. 5.2 The principles of double entry work on the basis that for each debit entry there must be a

credit entry.

5.3 A debit entry increases assets, expenses and drawings and a credit entry increases liabilities, income and capital – this can be remembered as DEAD CLIC.

5.4 At the end of each period the nominal ledger accounts (T accounts) are 'balanced off' to determine the closing balance on each account.

5.1 A credit balance of $3,000 brought down on X Co’s account in Y Co’s books means that A X Co is owed $3,000 by Y Co

B Y Co is owed $3,000 by X Co

C Y Co has sold $3,000 of goods to X Co (1 mark)

5.2 Which of the statements below best describes the nominal ledger? A A list of all assets and liabilities at a point in time

B A collection of accounts to record the transactions of the business C A record of amounts owed to/from individual suppliers and customers

5.1 A The balance represents the outstanding amount i.e. purchases less cash paid. 5.2 B

Syllabus Guide Detailed Outcomes

Having studied this chapter you will be able to: • Identify the purpose of a trial balance. • Extract ledger balances into a trial balance. • Prepare extracts of an opening trial balance.

• Identify and understand the limitations of a trial balance.

Exam Context

Questions on this chapter may require you to derive missing figures (for example, profit for the period) using the accounting equation and identify the correct double entry to record transactions such as closing inventory or drawings.

Qualification Context

Financial Accounting is the only paper where you are required to produce financial statements for a sole trader. Financial statements for limited liability companies are tested in detail in the Fundamentals level paper, Financial

Reporting (F7) and the Professional level paper, Corporate Reporting (P2).

From trial balance to

financial statements

Overview

From trial balance to financial statements

Income statement

Trial balance Closing inventory adjustment

Balance sheet

1 Introduction

1.1 We saw in Chapters 4 and 5 that:

• transactions are categorised in the books of prime entry;

• the totals are then posted to the ledger accounts in the nominal ledger using double entry;

• the ledger accounts are then balanced off and the balances brought down.

2 The

trial

balance

2.1 The trial balance consists of a list of the balances brought down on each ledger account, separated in to debits and credits as below.

Example

2.2 Miss Smith – Trial Balance at as 31 December 20X7:

Account Debit $ Credit $ Cash Capital Sales Purchases Furniture Electricity Telephone Drawings Total 720 1,100 500 120 60 200 2,700 500 2,200 2,700 2.3 The trial balance should balance, i.e.

Total debits = Total credits

If the trial balance doesn't balance then an error must have occurred. The correction of errors is covered in Chapter 16.

Lecture example 1

Douglas

Refer to Lecture example 2 in Chapter 5 on page 5.6 where the ledger accounts were balanced off.

Using the ledger accounts for Douglas, prepare the trial balance as at the end of January.

3 The closing inventory adjustment

Objective

3.1 Whilst a business will purchase items to sell during the year it is unlikely that all of them will have been sold by the year end.

The items still held at the year end are known as inventories.

These are an asset of the business and so should be included in inventories in the balance sheet.

Also when a business determines its profit for the year it should match the sales revenue earned to the cost of goods it sold, ie, cost of sales.

Lecture example 2

Colin opens a business selling cordless telephones. In the first month he buys 50 phones for $20 each, and sells 20 for $30 each. Complete the trading account below.

Solution

$ $

Sales Cost of sales

Purchases

Less: closing inventories

Gross profit

Accounting treatment

3.2 The closing inventory adjustment is accounted for via a journal entry. The double entry is: Dr Inventories (B/S)

Cr Closing inventories (COS – I/S)

3.3 This adjustment is usually made after the preliminary trial balance has been prepared. 3.4 Last period's closing inventories will become this period's opening inventories. These items

will be sold in the year and so will form part of cost of sales. As the items are sold they will no longer be an asset of the business and should be removed from the balance sheet. The double entry is:

Dr Opening inventories (COS – I/S) Cr Inventories (B/S

4 The income statement

4.1 The income statement is part of the double entry system and can be shown as a T-account.

Completing the income statement

4.2 The balances on all the income and expenditure T-accounts are transferred to the income statement and the closing inventory adjustment is made.

4.3 The income and expenditure accounts have now been closed out and a new account will be created for each income and expenditure item next year.

Lecture example 3

Douglas

Refer to Lecture example 1 on page 6.4

The cost of goods remaining unsold at year end was $250.

Required

Prepare an income statement in ledger account form.

Solution

5 The balance sheet

Completing the balance sheet

5.1 Balance sheet:

(a) lists all ledger accounts with balances remaining; (b) i.e. all assets and liabilities;

(c) is not part of double entry system so these balances are not transferred out.

5.2 At end of period, clear balances on income statement and drawings to capital account.

Lecture example 4

Douglas

Refer to Lecture example 3 on page 6.6.

Required

Draw up an income statement for the period and a balance sheet at the end of January.

Solution

DOUGLAS

INCOME STATEMENT FOR THE MONTH OF JANUARY

$ $

Sales Less cost of sales:

Purchases

Less: closing inventories

Gross profit Less expenses: Rent Electricity Net profit

DOUGLAS

BALANCE SHEET AS AT 31 JANUARY

NON-CURRENT ASSET $ $ Motor vehicle CURRENT ASSETS Inventories Trade receivables Cash PROPRIETOR’S INTEREST $ $

Capital introduced on 1 January Profit for the year

Less: drawings

Balance 31 January

CURRENT LIABILITIES

Trade payables

Lecture example 5

Douglas

Refer to Lecture example 4 on page 6.7.

Required

Transfer the profit and drawings to the capital account.

Solution

Drawings

5.3 Drawings are amounts being taken out of a business by its owner. Drawings are generally in the form of cash, but an owner may also take inventory out of the business. Drawings of inventories are recorded at the cost of the inventories not the sales price.

6 The

accounting

equation

6.1 The accounting equation expresses the balance sheet as an equation. 6.2 At its most simple:

Different types of liabilities (credits)

CAPITAL PROFIT

(less drawings) PAYABLES

ASSETS

(debits) = LIABILITIES(credits)

Proprietor’s interest

Lecture example 6

Douglas

Refer to Lecture example 5.

Required

Prepare the accounting equation for Douglas.

7 Summary of Chapter 6

7.1 The trial balance consists of a list of the balances brought down on each ledger account. 7.2 At the end of the year an adjustment must be made for closing inventory to match sales

revenue to the cost of making those sales and also to reflect the fact that the inventories are an asset of the business.

7.3 The opening inventory balance should also be transferred to cost of sales. 7.4 The income statement and balance sheet are then produced from the trial balance

(incorporating any adjustments such as closing inventory).

7.5 The accounting equation expresses the balance sheet as an equation.

8 Double Entry Summary for Chapter 6

8.2 Opening inventory adjustment:

8.3 The accounting equation: Dr Inventories (B/S) Cr Closing inventories (I/S)

Dr Opening inventories (I/S) Cr Inventories (B/S)

Assets = Liabilities

6.1 At the end of the accounting period and after the balance sheet and income statement have been prepared for a sole trader:

A All journals are reversed

B The balances on asset and liability accounts are transferred to the capital account

C The balances on the income statement and drawings account are transferred to the capital account D Balances are carried forward on all the accounts in the nominal ledger (2 marks)

6.2 A business has cash of $1,100, trade payables of $2,500, a mortgage liability of $8,000 and land of $16,000.

What is the proprietor's interest? $ (2 marks)

6.3 Joe, a sole trader, set up business on 1 October 20X6 with $40,000 of his own money. During the year to 30 September 20X7 he won $50,000 on the lottery and paid $30,000 of this into his business. He took cash drawings of $5,000 during the year and at 30 September 20X7 the net assets of the business totalled $59,000.

What was the profit or loss of the business for the year ended 30 September 20X7? A $4,000 profit

B $6,000 profit C $16,000 loss

D $6,000 loss (2 marks)

6.4 Joan

Joan, a second hand bookseller, has been in business for two months. In this time she: (1) paid in cash $5,000 as capital;

(2) took the lease of a stall and paid two months’ rent. The annual rental was $1,200; (3) purchased, on credit from J Fox, books at cost of $825;

(4) spent $420 cash on the purchase of other books from W Smith;

(5) paid an odd-job man $75 to paint the exterior of the stall and repair a broken lock; (6) put an advertisement in the local paper at a cost of $10;

(7) sold three volumes containing "The Complete Works of Shakespeare" to an American for $60 cash;

(8) sold six similar sets on credit to a local school for $300; (9) paid J Fox $525 on account for the amount due to him; (10) received $200 from the school;

(11) purchased cleaning materials at a cost of $10 and paid a char lady $30; (12) took $100 from the business to pay for her own personal expenses; (13) made other cash sales during the two months of $1,500;

(14) all books had been sold by the end of two months.

Required

(a) Write up the relevant ledger accounts for these transactions. (b) Balance off all of the ledger accounts.