Financial Accounting (F3/FFA)

July 2012 Session

Syllabus Structure

Main capabilities
On successful completion of this paper, candidates should be able to: A. Explain the context and purpose of financial reporting B. Define the qualitative characteristics of financial information C. Demonstrate the use of double-entry and accounting systems D. Record transactions and events E. Prepare trial balance including identifying and correcting errors F. Prepare basic financial statements for incorporated and unincorporated entities G. Prepare simple consolidated financial statements H. Interpretation of financial statements

Detailed syllabus

A. The context and purpose of financial

reporting
The scope and purpose of, financial

statements for external reporting Users and stakeholders needs The main elements of financial reports The regulatory framework Duties and responsibilities of those charged with governance.

Continues

B. The qualitative characteristics of financial

information
The qualitative characteristics of financial information

Continues

C. The use of double-entry and accounting systems

Double entry bookkeeping principles including the

maintenance of accounting records and sources of information. Ledger accounts, books of prime entry, and journals

Continues

D.

Recording transactions and events Sales Cash Inventory Tangible non-current assets Depreciation Intangible non-current assets and amortisation Accrual and prepayments Receivables and payables Provisions and contingencies Capital structure and finance costs

Continues

E. Preparing trial balance Trial balance Correction of errors Control accounts and reconciliations Bank reconciliations Suspense accounts

Continues

F. Preparing basic financial statements

Statements of financial position

Income statements and statements of

comprehensive income Disclosure notes Events after the reporting period Statements of cash flows Incomplete records

Continues

G. Preparing simple consolidated financial

statements Subsidiaries Associates

Continues
H. Interpretation of financial statements

Importance and purpose of analysis of financial

statements Ratios Analysis of financial statements

Examination Approach

The syllabus is assessed by a two hour paper based or computer-based examination. Questions will assess all parts of the syllabus and will include both computational and noncomputational elements. The examination will consist of 50 two mark questions.

News!!!!
From December 2011, Paper F3/FFA saw two main new examinable areas added to its syllabus the preparation of simple consolidated financial statements and the interpretation of financial statements.

Lecture 1 The scope and purpose of, financial statements for external reporting

What is Accounting?

Accounting is the process of collecting, recording, summarising and communicating financial information. There are many purposes of accounting. You may have considered the following. Control over the use of resources Knowledge of what the business owes and owns Calculation of profits and losses Cash budgeting Effective financial planning

Objectives of a business - Financial

Profit maximisation Growth and market

sustainability Survival Discourage competitors

Non-financial

Welfare of employees

Customer satisfaction
Welfare of management Supplier relationship Responsibility to society

Users and stakeholders needs

Users of financial statements need relevant and

reliable information.
To provide such information, the profession has

developed a set of principles and guidelines called Conceptual Framework.

The framework is to be the foundation for building a

set of coherent accounting standards and rules.

Also to be a reference of basic accounting theory for

solving emerging practical problems of reporting.

User groups of financial Statements

Accounting information is required for a wide range of users

both within and outside the business. Managers Shareholders Suppliers Lenders The tax authorities Employees Government The Public

Continues
User Group Manager/Directors Explanation Managers/Directors are appointed by the company's owners to supervise the daily activities of the company on their behalf. They need information about the company's current and expected future financial situation, to make informed decisions. Want to assess how effectively management is performing and how much profit they can withdraw from the business for their own use.

Shareholders

Suppliers/Customers Suppliers want to know about the company's ability to pay its debts; customers need to know that the company is a secure source of supply and is in no danger of closing down.
Lenders Lenders will want to ensure that the company is able to meet interest payments, and eventually to repay the amounts advanced.

Continues
User Group The Tax authorities Employees Explanation Want to know about business profits in order to assess the tax payable by the company. Need to know about the company's financial situation because their future careers and the level of their wages and salaries depend on it. Interested in the allocation of resources and in the activities of enterprises. Also require information in order to provide a basis for national statistics. Want information because enterprises affect them in many ways, e.g. by providing jobs and using local suppliers, or by affecting the environment (e.g. pollution).

Government

The Public

Management accounting and financial accounting

Management accounts are produced for internal

purposes they provide information to assist managers in running the business. Financial accounts are produced to satisfy the information requirements of external users. Financial accounting is the preparation of accounting reports for external use. Management accounting is the preparation of accounting reports for internal use.

Continues
Management accountants produce information which is forward-looking,

and used to prepare budgets and make decisions about the future activities of a business.
They also compare actual performance with budget and try to take

corrective action where necessary.

Financial accountants, however, are usually solely concerned with

summarising historical data, often from the same basic records as management accountants but in a different way. This difference arises partly because external users have different interests from management and do not need very detailed information.
In addition, financial statements are prepared under constraints (such as

International Financial Reporting Standards and company law) which do not apply to management accounts.

Types of business entity

Sole Trader, Partnership and Limited Liabilities companies

Sole Trader/Proprietorship
A sole proprietorship business is owned by one

person who is called a sole proprietor. Since the sole proprietor is not a legal entity, the owner is entitled to all profits generated from the business. However, the owners liability is unlimited, not just when the business is having financial difficulty, but also when the business fails and he faces bankruptcy. In this case, the creditors may sue him for debts incurred and also obtain a court order to claim against his personal assets, including his house.

Continues
a persons ability to run a sole proprietorship business is limited to his area of expertise, which means he relies mainly on himself. He has the freedom to use his entrepreneurial skills to the maximum, make his own decisions and run the business as he wishes. However, to be a successful entrepreneur, he will need to get relevant advice from experts in fields he is unfamiliar with. This expertise is sometimes unavailable when one operates as a sole proprietor.
Normally,

Advantages
Easy and cheap to set up since there is a limited

paperwork. The owner is in full control of the business He/she takes all the rewards alone Relax compliance for reporting obligations It is usually flexible

Disadvantages
His capital is limited to the availability of his funds and

the profit generated from the business, this would be the reason why many sole proprietorship businesses never take off in a big way. In many cases, even when a sole proprietorship business is successful, all profits generated are taxed on a personal basis and tax exemptions are limited to personal and family matters. Very often in sole-proprietorship operations, there is no business succession plan and the business may no longer operates with the retirement or demise of the sole proprietor. The owners liability is unlimited, in the event of bankruptcy.

Partnership
As its name suggests, this form of entity is when two or

more persons come together to carry out a business. However, the maximum number of persons allowed in a partnership is 20. Examples include an accountancy/audit firm, a medical practice and legal practice and they are generally formed by contractual agreement which is legally binding on all partners. In the UK, the provisions of the Partnership Act 1890 apply where no partnership agreement exists. Partnerships are not separate legal entities from their owners and they have unlimited personal liability for debts of the business. A new form of partnership called Limited liability partnership (LLP) has emerged in some jurisdictions.

Advantages
This form of business is cheap, easy to set up, with

minimal documentation and paperwork. There are much fewer guidelines and formalities wherein there is no requirement to appoint auditors, company secretary or tax agents. They do not need to disclose their financial statements to the general public. Access to wider pull of resources additional capital, skills and expertise. Division of roles and responsibilities. Risk is spread among partners. No company tax on the business

Disadvantages
Partners have unlimited liability in the case the

business runs into trouble. There are costs to be incurred in setting up the partnership agreements. In the event of the death or illness of partners, the partnership may cease to exist. Consensus between partners are required when taking decisions and this could lead to slower decision making. In the absence of any agreement to the contrary, the resignation of one partner automatically terminates the partnership agreement.

Limited liability companies

The meaning of limited companies is that the

liabilities of its members are limited to the amount of shares they hold in the company. Members/shareholders are not responsible for debts of the company unless if there is any personal guarantee. Shareholders may be individuals or other companies. Company Act 2006 is the legislation applicable in the UK. A LLC is a separate entity from its owners.

Agency theory
The principals (shareholders) appoint some

agents (directors) to run the business on their behalf. Shareholders are the owners they provide capital and receive a return usually inform of dividends. Declaration of dividends is at the discretion of the directors. In some cases directors could also be shareholders.

The reporting requirements for LLCs in the UK

Must be registered at Companies House There must be MoA and AoA deposited with the

Registrar of Companies Have at least one director for Private LLC and two for Public LLC who may also be the shareholder(s) Financial statements must be prepared for filing to Companies House Large companies should have audited financial reports The financial should be available to the shareholders

Advantages
The

most obvious advantage is the liability protection to its shareholders which limits their exposures to the amount of share capital that they subscribed for. Another advantage is the simplicity to transfer existing shares or issue additional shares to new investors. Unlike sole proprietors or partnerships, there is no need to wind up the company in the event of death of its shareholders or directors. They have access to wider pull of resources Tax advantages to being a LLC. The company tax rate may be lower than income tax rate for individuals. LLC is a separate entity from its owners which may sue or be sued separately.

Disadvantages
The companys financial affairs will be accessible by

the public. Compliance with the Companies Act. Although complying itself is not a disadvantage, the amount of effort required to comply with the Act is much more than a sole proprietor/partnership. The company had to perform annual audits on its financial statements. At least one company secretary is required to manage its statutory submissions and returns as well as attending and preparing minutes for board and shareholders meetings. Incorporation cost is high, and there are yearly recurring fees to be paid such as audit, accounting, company secretarial and tax fees.

Quiz time!!!

Solution
C 2. B 3. A 4. D
1.

Lecture 2 The qualitative characteristics of financial information

Statements of Financial Accounting Concepts

SFAC No.1: Objectives of Financial Reporting (Business) SFAC No.2: Qualitative Characteristics of Accounting Information

SFAC No.6. Elements of Financial Statements - defines the broad

classifications of items found in financial statements and replaces SFAC No.3, expanding its scope to include not-for profit organisations
SFAC No.4: Objectives of Financial Reporting (Non-Business)

Guidelines for Non-for-profit and governmental entities

SFAC No.5: Recognition and Measurement Criteria in Financial

Statements
SFAC No.7: Using Cash Flows information and Present Value in

Accounting Measurements

Overview of the conceptual Framework

Basic Objectives:
The basic objectives of financial reporting are to provide

information that is:1. Useful to those making investment and credit decisions who

have a reasonable economic activities

understanding

of

business

and

2. Helpful to present and future investors, creditors and other

users in assessing future cash flows

3. About economic resources, the claims on those resources

and the changes in them

Qualitative Characteristics
The

IASB has identified the qualitative characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision making purposes
accounting information

Primary qualities are relevance and reliability of

Secondary

qualities are comparability consistency of reported information

and

Primary qualities - Relevance

To be relevant, accounting information must be capable of

making a difference in a decision

For information to be relevant, it should have predictive or

feedback value, and it must be presented on a timely basis

Predictive value helps users make predictions about

ultimate outcome of past, present and future events

Feedback value - helps users confirm or correct prior

expectations
Timeliness - available to decision makers before it loses its

capacity to influence their decisions

Primary qualities - Reliability

Information is reliable when it can be relied on to represent the

true situation
For accounting information to be reliable, it should be verifiable, is

a faithful representation, and it is reasonably free of error and bias

Verifiability when given the same information and using the

same measurement methods, independent users can obtain the same results
Representational faithfulness - when it represents what really

existed or happened
Neutrality when it is factual, truthful and unbiased

Secondary qualities - Comparability

Comparability and consistency of reported information Information about an enterprise is more useful if it can be

compared with similar information about another enterprise (comparability) and with similar information about the same enterprise at other points in time (consistency)
For information to be comparable, it must be 1.

Measured and reported in a similar manner for different enterprises Useful to users in identifying real similarities and differences between enterprises

2.

Secondary qualities - Consistency

Entity is considered to be consistent in its use of accounting

standards when it applies the same accounting treatment to similar events from period to period
Companies can change methods, if the change results in

better reporting
Disclosure for change :-

Nature of the change 2. Effect of the change 3. Justification for the change
1.

Basic Elements of Financial Statements

Balance Sheet
Assets: Probable future

Income Statement
Comprehensive Income: All

economic benefits resulting from past transactions Liabilities: Probable future sacrifices of economic benefits resulting from past transactions Equity/Net assets: Residual interest in assets after deducting liabilities or ownership interest Investment by Owners: Increases in net assets Distributions to Owners: Decreases in net assets

changes in equity from non-owner sources Revenues: Inflows from entitys ongoing operations Expenses: Outflows from entitys ongoing operations Gains: Increases in equity from incidental transactions Losses: Decreases in equity from incidental transactions

Recognition and Measurement in Financial Statements of Business Enterprises.

Basic Assumptions:
Economic Entity Assumption - The economic activities of an entity can be

accumulated and reported in a manner that assumes the entity is separate and distinct from its owners or other business units.
Going-Concern Assumption - In the absence of contrary information, a

business entity is assumed to remain in existence for an indeterminate period of time. The current relevance of the historical cost principle is dependent on the going-concern assumption.
Monetary Unit Assumption - In the United Kingdom, economic activities of an

entity are measured and reported in pound. These pounds are assumed to remain relatively stable over the years in terms of purchasing power. In essence, this assumption disregards any inflation or deflation in the economy in which the entity operates.
Periodicity Assumption - The life of an economic entity can be divided into

artificial time periods for the purpose of providing periodic reports on the economic activities of the entity.

Basic Principles
Historical Cost Principle -

Acquisition cost is the most objective and verifiable basis upon which to account for assets and liabilities of a business enterprise. Cost has been found to be more definite and determinable than other suggested valuation methods. process is virtually complete and an exchange transaction has occurred. Generally, this takes place when a sale to another individual or independent entity has been confirmed. Confirmation is usually accomplished by a transfer of ownership in an exchange transaction.

Revenue Recognition Principle - Revenue is recognised when the earning

Matching Principle - Accountants attempt to match expenses incurred while

earning revenues with the related revenues. Use of accrual accounting procedures assists the accountant in allocating revenues and expenses properly among the fiscal periods that compose the life of a business enterprise.
Full Disclosure Principle - In the preparation of financial statements, the

accountant should include sufficient information to permit the knowledgeable reader to make an informed judgment about the financial condition of the enterprise in question.

The regulatory framework

The Regulatory framework of accounting

The main objective of accounting is to present

financial information to users. Users need to be able to rely on the information provided in those financial statements to enable them to make appropriate decisions. Accountants need some guidance in the way in which they prepare the financial statements. We shall look at some of the ways in which accountants take decisions on methods of accounting and valuation for certain items in future lectures.

Accounting Conventions/concepts/principles
Going concern - Going concern implies that the

business will continue in operation for the foreseeable future, and that there is no intention to put the company into liquidation or to make drastic cutbacks to the scale of operations. Accruals - The accruals concept states that, in computing profit, amounts are included in the accounts in the period when they are earned or incurred, not received or paid. Prudence - Prudence is the concept that specifies, in situations where there is uncertainty, appropriate caution is exercised in recognising transactions in financial records.

Continues
Consistency - The consistency convention is

that the accounting treatment of like items should be consistently applied from one accounting period to the next. Materiality - A matter is material if its omission or misstatement would reasonably influence the decisions of a user of the accounts. In preparing accounts it is important to decide what is material and what is not, so that time and money are not wasted in the pursuit of excessive detail.

Continues
Substance over form - Substance over form is the

principle that transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal from. Business entity (the entity concept) - This convention separates the individual(s) behind a business from the business itself, and only records transactions in the accounts that affect the business. Money measurement - This limits the recognition of accounting events to those that can be expressed in money terms.

Continues
Historical cost The historical cost of an asset is the

original amount paid for an asset when it was acquired and thus non-current assets should be stated in their historical costs less accumulated depreciation. The dual aspect - This convention is the basis of doubleentry bookkeeping and it means that every transaction entered into has a double effect on the position of the entity as recorded in the ledger accounts at the time of that transaction. The realisation convention - This convention states that we recognise sales revenue as having been earned at the time when goods or services have been supplied and a sales invoice issued.

The theory of capital expenditure

Current purchasing power (CPP) accounting - This

method of accounting considers the effects of changing price levels by reference to an index, for example movements in the retail price index (RPI) in the UK. It distinguishes between monetary and non-monetary items. RPI - The RPI is a measure of inflation published each month. It is based on the prices of items bought by the average family. Monetary items - Examples of monetary items include cash and bank balances, receivables and payables. These are valued in a currency such as dollar, yen or sterling regardless of the changes in the price level.

Non-monetary assets
These are items that do not suffer a loss in value in a

period of changing price levels. They include noncurrent assets, inventories and shareholders equity (ordinary shares and reserves). Holding gains/losses - The holding of monetary items will, in periods of inflation, give rise to holding gains or losses.

Current cost accounting

Current cost accounting (CCA) is a method of adjusting

historical cost accounts for the effects of changing price levels by using indices specific to the organisation. Thus CCA attempts to measure the actual rate of inflation experienced by the business whereas CPP attempts to measure the rate of inflation experienced by the business owners. Fair Value - fair value may be defined as the value of an asset in an arms length transaction between knowledgeable buyer and seller of that asset.

Duties and responsibilities of those charged with governance

Duties
Those

charged with governing a company are responsible for the preparation of the financial statements. Corporate governance (CG) is the system used in directing and controlling a company. This is necessitated because the management and ownership of a company reside in the hands of different people and this could lead to conflicts of interest. The board of directors (BOD) of a company are usually charged with governance of a company since they are the top echelons. The duties and responsibilities of directors are usually laid down in law and are wide ranging.

Legal responsibilities of directors

Directors have a duty of care to show reasonable

competence in the discharge of their duties and may have to indemnify the company against loss caused by their negligence. Directors also have fiduciary duty to the company which means that they must act in the best interest of the company, in utmost good faith and honesty. The Company Act 2006 in the UK sets out 7 statutory duties of directors as shown below:

Directors should:
Act within their powers Promote the success of the company Exercise independent judgement Exercise reasonable skill, care and diligence Avoid conflicts of interest Not accept benefits from their parties Declare an interest in a proposed transaction or

arrangement The primary aim is create wealth for the shareholders

Responsibility for the financial statements

The

responsibility to the preparations of financial statements lies with the directors. This preparation must be in accordance with the applicable financial reporting framework such as IFRS. Directors are responsible for the internal controls necessary to forestall any material misstatement to due to error or fraud in the preparation of the financial statements. They are also responsible for the prevention and detection of fraud. It is also their responsibility to ensure that company complies with relevant laws and regulations. This responsibility should be stated in the financial statements. The company should be reported as going concern unless if there is any information to the contrary.

Quiz time

Solution
1. 2. 3. 4. 5.

6.
7. 8.

9.
10.

C C D A B C C C A B

Lecture 3 The books of prime entry

Books of prime entry

Books of prime entry are used to list and summarise the information on source documents. Sales day book - all credit sales are recorded in the sales day book. Sales returns day book any credit sales returned by the customers are recorded in the sales returns day book. Purchase day book all credit purchases are recorded in the purchase day book.

Continues
Purchase returns day book any credit purchases

returned to the suppliers are record in the purchase returns day book. Cash book All cash transaction are recorded in the cash book. Petty cash book lists all cash payments for small items, and occasional small receipts. Journal is a record of unusual transactions. It is used to record any double entries made which do not arise from the other books of prime entry.

Sales and purchase day books

The sales day book list all invoices sent out to customers.

Sales Day Book

Date
Jan 10

Invoice
247 248 249 250

Customer
Jones & Co Smith Ltd. Alex & Co FTMS College

Sales ledger ref

SL14 SL8 SL6 SL9

Total amt invoiced

105.00 86.40 31.80 1,264.60 1,487.80

Continues
The column called sales ledger ref is a reference

to the sales ledger which is a record of what each customer owes the business. It means, for example, that the sale to Jones & Co for $105 is also recorded on page 14 of the sales ledger.

The Purchase day book

The purchase day book list all invoices from suppliers.

Purchase Day Book

Date Supplier Purchase ledger ref
PL 31 PL 46 PL 42 PL 12

Total amount invoiced

315.00 29.40 116.80 100.00 561.20

Purchases

Electricity

Mar 15 Abbey Ahmad TEN Emmy

315.00 29.40 116.80 100.00 444.40 116.80

Continues
The purchase ledger reference is a reference

to the purchase ledger which is a record of what each supplier is owed. The purchase day book analyses the invoices which have been received. In this example, three of the invoices related to goods which the business intends to re-sell (called purchases) and the other invoice was an electricity bill.

Sales and purchase returns day books

The sales returns day book lists goods (or services

returned (or rejected) by customers for which credit notes are issued. Sales returns day book
Date 30 April Customer Emily Goods 3 pairs of boots Sales ledger ref SL 82 Amount 135.00

The purchase returns day book

The purchase returns day book lists goods (or

services) returned to suppliers (or rejected) for which credit notes have been received or are expected. Purchase returns day book
Date Supplier Goods Purchase ledger ref Amount

29 April

Boxes Ltd

300 boxes

PL 123

46.60

The cash book

The cash book lists all money received into and paid

out of the business bank account. The cash book records transactions involving the bank account, such as cheque payments, lodgements of cash and cheques into the bank account, standing orders, direct debits and bank charges. Some cash, in notes and coins, is usually kept on the premises in order to make occasional payments for small items of expense. This cash is accounted for separately in a petty cash book (which we will look at shortly).

Lecture example 1
At the beginning of 1 September, Robin Plenty had $900 in the bank. During 1 September 2011, Robin Plenty had the following receipts and payments. a) Cash sale receipt of $80 b) Payment from credit customer Hay $400 less discount allowed $20 c) Payment from credit customer Been $720 d) Payment from credit customer Seed $150 less discount allowed $10

Continues
e) Cheque received for cash to provide a short-term

f)
g) h) i) j) k) l) m)

loan from Len Dinger $1,800 Second cash sale receipts of $150 Cash received for sale of machine $200 Payment to supplier Kew $120 Payment to supplier Hare $310 Payment of telephone bill $400 Payment of gas bill $280 $100 in cash withdrawn from bank for petty cash Payment of $1,500 to Hess for new plant and machinery

Solution
The receipts part of the cash book for 1 September would look like this. CASH BOOK (RECEIPTS) Date Narrative Total 2011 $ 1 Sept Balance b/d* 900 Cash sale 80 Receivable: Hay 380 Receivable: Been 720 Receivable: Seed 140 Loan: Len Dinger 1,800 Cash sale 150 Sale of non-current asset 200 4,370 2 Sept Balance b/d* 1,660 * 'b/d' = brought down (i.e. brought forward)

Continues
The cash received in the day amounted to $3,470.

Added to the $900 at the start of the day, this comes to $4,370. However this is not the amount to be carried forward to the next day. First we have to subtract all the payments made during 1 September.

Continues
The payments part of the cash book for 1 September would look like this. CASH BOOK (PAYMENTS) Date Narrative Total 2011 $ 1 Sept Payable: Kew 120 Payable: Hare 310 Telephone 400 Gas bill 280 Petty cash 100 Machinery purchase 1,500 Balance c/d 1,660 4,370

Continues
Payments during 1 September totalled $2,710. We

know that the total of receipts was $4,370. That means that there is a balance of $4,370 $2,710 = $1,660 to be 'carried down' to the start of the next day. As you can see this 'balance carried down' is noted at the end of the payments column, so that the receipts and payments totals show the same figure of $4,370 at the end of 1 September. And if you look to the receipts part of this example, you can see that $1,660 has been brought down ready for the next day.

Lecture example 2 - Two-column cash book

2011 February 1 Opening cash balance RM 10,000. Opening bank balance RM 600. 2 3 4 5 7 9 10 11 Kong lent us RM 20,000 by cheque. Paid building rent by cash RM 2,300. We paid Mehdi by cheque RM 8,600. Cash sales RM 1,900. Kwai paid us by cheque RM 340. We paid Moore in cash RM 920. Vehicles repairs of RM 460 were paid by cheque. Cash sales paid direct into the bank RM 1,510.

Continues
15 Hood paid us in cash RM 960.

16
19 21 22 25 26 30

Owner withdrew by cheque RM 1,000.

We repaid a previous loan taken from Robertson RM5,000 by cheque. Goods for resale were purchased. This was paid by cash, RM 1,300. Cash sales paid direct into the bank RM 1,220. Paid wages by cash RM 2,760. Paid a fine to the government by cheque RM 750. Withdrew RM 2,000 from the bank account for personal use of the owner.

31

Paid consultancy fees in cash RM 3,200.

Hood paid us in cash RM 960.

Solution
Bank (RM)
Balance b/d
Kong Sales Kwai Sales 340 1,510

Cash book

Cash (RM)
10,000
1,900

Bank (RM)
Building rent
Mehdi Moore Vehicle repairs Drawings 460 1,000 8,600

Cash (RM)
2,300
920

600
20,000

Hood
Sales 1,220

960

Robertson
Purchases Wages Fine Drawings Consultancy fee Balance c/d

5,000
1,300 2,760 750 2,000 3,200 5,860 23,670 2,380 12,860

23,670

12,860

Bank statements
Weekly or monthly, a business will receive a bank

statement. Bank statements are used to check that the balance shown in the cash book agrees with the amount on the bank statement. This agreement or 'reconciliation' is the subject of a later chapter.

Petty cash book

The petty cash book lists all cash payments for small

items, and occasional small receipts. Most businesses keep a small amount of cash on the premises to make occasional small payments in cash e.g. to buy a few postage stamps etc. This is often called the cash float or petty cash account. Petty cash can also be used for occasional small receipts, such as cash paid by a visitor to make a phone call or to take some photocopies. There are usually more payments than receipts and petty cash must be 'topped up' with cash from the business bank account.

Continues
Under what is called the imprest system, the amount of

money in petty cash is kept at an agreed sum or 'float' (say $100). Expense items are recorded on vouchers as they occur. $ Cash still held in petty cash X Plus voucher payments X Must equal the agreed sum/float X

Continues
The total float is made up regularly (to $100,or

whatever the agreed sum is) by means of a cash payment from the bank account into petty cash. The amount paid into petty cash will be the total of the voucher payments since the previous topup. The format of a petty cash book is the same as for the cash book, with analysis columns for items of expenditure.

The Journal
The journal is a record of unusual transactions. It is

used to record any double entries made which do not arise from the other books of prime entry. Whatever type of transaction is being recorded, the format of a journal entry is as follows. Date Debit $ X Credit $ X

Account to be debited Account to be credited (Narrative to explain the transaction)

Continues
A narrative explanation must accompany each

journal entry. It is required for audit and control, to indicate the purpose and authority of every transaction which is not first recorded in a book of prime entry.

Lecture example 3
The following is a summary of the transactions of Abbey beauty salon 1 January Put in cash of $2,000 as capital Purchased brushes and combs for cash $50 Purchased hair driers from Gilroy Ltd on credit $150 30 January Paid three months rent to 31 March $300 Collected and paid-in takings $600 31 January Gave Mrs Sullivan a perm, highlights etc on credit $80 Although these entries would normally go through the other books of prime entry (eg the cash book), it is good practice for you to show these transactions as journal entries.

Solution
JOURNAL $ Dr. 1 January Cash account Capital account (Initial capital introduced) 1 January Brushes & combs a/c Cash account (The purchase for cash of brushes & combs as non-current assets) 1 January Hair dryer asset account Sundry payables account * 30 January Rent expense account Cash account (The payment of rent to 31 March) 300 300 150 150 50 50 2,000 2,000 $ Cr.

(The purchase on credit of hair driers as non-current assets)

Continues
30 January Cash account Sales account 600 (Cash takings) 31 January Receivables account 80 Sales account 80 (The provision of a hair-do on credit) * Note. Payables who have supplied non-current assets are included amongst sundry payables. Payables who have supplied raw materials or goods for resale are trade payables. It is quite common to have separate payables accounts for trade and sundry payables. Dr. 600 Cr.

Quiz time

Lecture 4 Double entry and accounting system

Bookkeeping
What is it?
System of recording financial transactions Known as double-entry bookkeeping Two sides to every transaction Is part of and feeds into the financial reporting

system.

Aims
This lecture seeks to provide a introduction to

bookkeeping what it is and how it is carried out. To do this we will consider:

The financial reporting system Examine how records are kept Explain the transactions and how they are recorded Consider how adjustments can be made And how the records are used to generate month end and year end figures

Lecture Content
The lecture will aim to cover:
an introduction to financial reporting terminology the accounting process the financial statements

Financial Reporting

Definitions

Financial Reporting
What is it? Financial reporting is the means of reporting what has happened in the past in an organisation It is part of the accountability system It relates yesterdays activities in financial terms
Reports

Annual Financial Statements o Annual Report and Statutory Accounts Monthly control reports

Example: Monthly Control Report

Current Month
Budget Actual Variance

As at 30th June
Expenditure Supplies and General Charges Budget to Date

Year to date
Actual to Date Variance

40,000 25,000 15,000 20,000 18,000 21,000 10,000 6,000 5,000 1,000 2,000 1,000 500 1,500 800 200 700 200 3,000 1,000 171,900

43,000 26,000 14,500 19,000 20,000 24,000 6,000 6,000 4,000 1,500 1,800 2,000 500 2,000 700 500 100 3,500 1,000 176,100

-3,000 -1,000 500 1,000 -2,000 -3,000 4,000 0 1,000 -500 200 -1,000 0 -500 100 -300 600 2000 -500 0 -4,200

Basic pay Part tim e basic Casual pay Adm inistrative staff Photocopy costs Materials Books Heating Pow er & Light Cleaning Fax Telephone Consum ables Hospitality Maintenance Travelling Expenses Stationery Office Expenses Office Equipm ent Rent & Rates Sundries

Sub Total

230,000 150,000 90,000 150,000 100,000 120,000 50,000 39,000 30,000 6,000 12,000 6,000 9,000 6000 5,000 1,000 4,000 1,000 20,000 6,000 1,029,000

250,000 165,000 80,000 148,000 110,000 125,000 56,000 40,000 31,000 5,000 10,000 6,000 10,000 7000 4,500 1,500 5,000 1,500 19,000 10,000 1,077,500

-20,000 -15,000 10,000 2,000 -10,000 -5,000 -6,000 -1,000 -1,000 1,000 2,000 0 -1,000 -1,000 500 -500 -1,000 -500 1,000 -4,000 -48,500

Key Terms

assets

liabilities/ capital

expenses

revenue /income

What is an expense?
An expense is a short term consumable, which will be

incurred repeatedly, for example the cost of a telephone call, a days pay, a box of bandages, a litre of fuel They are items which have a oneoff use..once bought and useda second must be bought..and a third..etc In general, expense items represent day-to-day operational activity.low value long term items .. such as a mobile phone will also be included Expenses are recorded and totalled at the end of each month and each year.

What is income?
Income is the sum earned for providing goods or

service, whether or not any payment has been received. It too represents monies from operational activity and, items which are frequently repeated for example, the sale of a chocolate bar or the price of a bus ticket. Income is totalled monthly and annually to reflect what has been earned during that time period.

What is an asset?
An asset is an item owned by the organisation, it has

value and can be fixed or current. Fixed assets provide benefit beyond a year and current assets have a life less than one year. Fixed assets are made up of physical and financial assets. Land, buildings, equipment, vehicles and furniture and fittings make up the physical fixed assets, which put in place the infrastructure through which operational activity is conducted. Stock, debtors and cash make up the current assets.

What is a liability?
Liabilities are sums owed from the organisation.

They can be short-term such as overdraft or sums owed to suppliers, known as creditors, or long-term such as loans, leases and mortgages. These latter items contribute to long term funding, without which, the organisation would not be able to purchase assets. All liabilities carry with them the obligation to repay and many of them carry interest payments.

What is capital?
Capital is the owners original investment although it is rarely repaid, it is technically a debt.
Without this money the organisation would not exist.

Further investment from the owners increases this sum. A key way this sum is increased is through the Income and Expenditure account. Any excess income over expenditure belongs to the owners and can be left in the organisation by way of an increase in capital.
grow, as without purchased. money new assets cannot be

Without capital an organisation cannot begin its life nor

key terms..

assets

liabilities/ capital revenue /income

balance sheet income statement

expenses

The statement of financial position

Is a position statement which evaluates wealth at a

point in time. It considers capital costs. Consists of assets and claims on those assets Assets (owned) Current Non-Current Claims (owed) Current liabilities Long-term Loans Owners capital

But, as Claims = Liabilities + Capital then, Assets = Liabilities + Capital

Income Statement

The difference between costs & income Profit & loss account / Income & expenditure account Shows where the resource was spent Covers a period of time Matches expenses and income to time period Expenses represent the cost INCURRED, resource used or consumed in providing the service during the accounting period Income is that which is EARNED from and related to the service provided

The Accounting Process

Basis of Preparation
= Accrual Accounting
Income and expenditure based system Income and expenditure are matched so that they are allocated to the period in which the benefit /expense is incurred Starting point: Transactions must be recorded. Basis of gathering accounting information is doubleentry bookkeeping

The double entry system

Records transactions - two sides to each debit and credit side Separate accounts uniquely identified called ledger accounts based on chart of accounts
Ledgers - books of record
general/nominal accounts payable accounts receivable

Trial balance

..etc...
Trial Balance Adjustments
stock/inventory depreciation bad debts accruals and prepayments

Annual Financial Statements

... but it begins with recording transactions.

The ledgers
General /nominal
Main list of all accounts Total balances maintained on this ledger

Accounts payable
Records purchases Links to suppliers / creditors / payables Also called purchase or bought ledger

Accounts receivable
Records sales or income Links to customers / debtors /receivables Also called sales ledger

Ledger Accounts
Each item (asset, expense, liability, capital or income) has its

own ledger account It records the details of transactions relating to the particular item Original paper system was T accounts Each account is identified by a unique code Debit Credit

Lecture example 1
The accounts of MSU

reveal the following: Capital 18 900 Fixtures 3 500 Loan 2 000 Stocks 4 950 Debtors 3 280 Creditors 1 600 Vehicles 4 200 Cash - bank 6 450 Cash - hand 120

Consider how the following

transactions will affect the accounts;

MSU buys stocks of goods on

credit for 770. One of the debtors pays 280 in cash. New fixtures are purchased with a cheque for 1000.

Double Entry Book-Keeping

asset

liabilities/capital income

expenses

= debit

= credit

Rules of Debit & Credit

Every transaction effects two accounts A debit
increases an asset or expense account decreases an income or liability account

A credit
increases an income or liability account decreases an asset or expense account

Types of accounts
Asset and liability accounts are ongoing

accounts
Non Current (fixed) assets, loan and capital accounts once

established remain.. Current assets and liability accounts also remain but move very regularly up and down as, for example, cash at bank

Income and expenditure accounts differ in that

each year we start with a zero balance and record all income and all expenditure into its own separate account. The aim is to establish a total amount for each item, e.g. telephone

An exception purchases/stock
Purchases are an expense item
For example chocolate bars in a shop

Inventory/Stock is an asset
Unsold chocolate bars in a shop

We record all purchases as expenses..

At year endwe measure if we have any items

left

What remains = stock/inventory to carry forward, i.e.: closing

stock/inventory Whats used = purchases Purchases are the only expense item where we cannot simply look to the balance on the account

But
Through the year we record all the purchases of each

stock item at the end we then see how much we have leftthis determines how much of the item we have used..i.e. the expense incurred
But we may have
had stock/inventory at the beginningopening

stock/inventory sent goods backreturns outwards been charged for deliverycarriage in

All the above help determine the value of the items

used

Returns..
When we send something back
returns outwards

When something comes back to us

returns inwards

Set up separate accounts for each

For a return outwards:

reduce supplier account increase returns outwards account

For a return inwards:

reduce customer account increase returns inwards account

..and how much did we use?

Opening Stock/Inventory + Purchases - Returns outwards + Carriage inwards - Closing Stock/Inventory = Cost of Goods Used X X (X) X (X) X

Lecture example 2
A hospital is trying to establish the cost of

cleaning materials used in a year. Opening stock/inventory value 12,400 Purchases 87,300 Returns 7,600 Carriage inwards 1,200 Closing stock/inventory 14,250 What is the cost of the cleaning materials used?

Balances on Accounts
Each ledger account is balanced off all debit balances are assets or expenses all credit balances are liabilities or income Balance sheet = asset & liability accounts The balances on these accounts are ongoing ie closed and re-opened for the next accounting period Income statement = income & expenses The closing balances on these accounts are transferred out and the new accounting period starts with zero balances.

Balancing off accounts

Supplier A
10/5 Returns out 40 24/5 Paid cash 300 bal c/d 416 756 1/5 4/5 Purchases Purchases 690 66 756 416

1/6 bal b/d

A balance on a supplier account is a credit balance which means we have a creditor (payable). For customer accounts, a debit balance means we have a debtor (receivable).

Trial Balance
List of balances on ledger

Dr
Income Purchases Expenses Wages Vehicle Fittings Capital 60 25 30 120 70

accounts Total debit entries = total credit entries Starting point for the derivation of the financial statements Adjustments to the trial balance lead to the creation of the operating statement and the balance sheet

Cr 155

150 305 305

Preparing accounts
From trial balance we prepare year end and

month end figures.. Accrual basis 4 main adjustments

Stock/inventory Depreciation of fixed assets

Bad debts
Accruals & prepayments

Fixed Assets
Capital expenditure
buildings, equipment, vehicles, fixtures and fittings

Provide benefit beyond the accounting period Accruals system

- match cost to benefit

- by depreciation

Depreciation
Allocation of the cost of an asset to the years in

which benefit is gained

Key historic cost useful life residual value method main - straight line or reducing balance

Assets recorded at : Net Book Value = cost - accumulated depreciation

Lecture example 3
An asset is bought for 100,000

It has an estimated useful life of 4 years

The residual value will be 20 000. What depreciation - assuming the straight line

basis is appropriate - will be charged to the I&E accounts in each of the years and what is shown in the balance sheet? Using a reducing balance of 33% recalculate the above.

Entering the transactions

Cost of asset is recorded when purchased
Only removed when asset disposed of

Two accounts record depreciation Depreciation expense

Income Statement account

Depreciation provision (accumulated depreciation)

Balance sheet account

Carry forward each year of assets life

Offsets cost to give NBV on balance sheet

Bad Debts
Debtors are sums owing to us but not yet paid Bad debt - money owed which is unlikely to be received

Treatments specific debts are written off

Dr Cr

bad debts expense account debtor account

general provision is established as policy Dr bad debts expense Cr bad and doubtful debt provision Provision is a balance sheet account it offsets the debtors in the BS the account is carried forward and is adjusted each year based on debtors balance any movement in the provision is treated as an expense on the income statement.

The Month End result

Management accounts

On-going figures on a monthly basis

Current month and year to date Reports on individual cost centres
Line items included

Compared to budgets - variances Basis is accruals prepayments and accruals

included

Example: Monthly Control Report

Current Month
Budget Actual Variance

As at 30th June
Expenditure Supplies and General Charges Budget to Date

Year to date
Actual to Date Variance

40,000 25,000 15,000 20,000 18,000 21,000 10,000 6,000 5,000 1,000 2,000 1,000 500 1,500 800 200 700 200 3,000 1,000 171,900

43,000 26,000 14,500 19,000 20,000 24,000 6,000 6,000 4,000 1,500 1,800 2,000 500 2,000 700 500 100 3,500 1,000 176,100

-3,000 -1,000 500 1,000 -2,000 -3,000 4,000 0 1,000 -500 200 -1,000 0 -500 100 -300 600 2000 -500 0 -4,200

Basic pay Part tim e basic Casual pay Adm inistrative staff Photocopy costs Materials Books Heating Pow er & Light Cleaning Fax Telephone Consum ables Hospitality Maintenance Travelling Expenses Stationery Office Expenses Office Equipm ent Rent & Rates Sundries

Sub Total

230,000 150,000 90,000 150,000 100,000 120,000 50,000 39,000 30,000 6,000 12,000 6,000 9,000 6000 5,000 1,000 4,000 1,000 20,000 6,000 1,029,000

250,000 165,000 80,000 148,000 110,000 125,000 56,000 40,000 31,000 5,000 10,000 6,000 10,000 7000 4,500 1,500 5,000 1,500 19,000 10,000 1,077,500

-20,000 -15,000 10,000 2,000 -10,000 -5,000 -6,000 -1,000 -1,000 1,000 2,000 0 -1,000 -1,000 500 -500 -1,000 -500 1,000 -4,000 -48,500

The Year- End Result

Accounting statements
Operating Statement Income and Expenditure Profit and Loss Account Income Statement Balance Sheet Accounting policies Additional notes

Reportscontent in brief
Balance Sheet

Income Statement
Income
Less

Own Assets
Non-Current Current

Expenses
=

Owe Liabilities
Long term Current

Profit/Loss

Capital
Original
Accumulated surpluss

Basic Income Statement

Income Cost of goods sold Gross Profit

Expenses Net Profit to be retained

1000 (750) 250 (50) 200

Balance

Sheet

The Balance Sheet - format

Non-Current Assets
Current Assets Inventory Receivables Cash Total Assets Current Liabilities Payables Overdraft Long Term Liabilities Net Assets Capital Owners Share Capital Retained profit 300 1000

150 250 200 600 1600 150 250 400

900

700 200 900