SECRET SAUCE

(AS LEVEL ACCOUNTING THEORY NOTES FOR 2020-2021)

OMAIR MASOOD

CEDAR COLLEGE (CLIFTON|PECHS)

Change  in  Syllabus  
Following  Questions  from  June  2007-­‐November  2015  (  Paper  2)  are  now  not  in  As  
level.  
Year   Variant   Question  Number  
June  2007   Not  applicable   1  
November  2009   1   2  
June  2010   2   1  
November  2010   2   2  
June  2011   1   2  
November  2011   3   2  (B)  
June  2012   2   1  
November  2012   1   2  
November  2012   3   1  
June  2013   1   1  ,  2  (D)  
June  2013   3   1  
November  2013   3   1  
June  2014   1   1  
June  2014   3   1  
June  2015   3   1  
November  2015   1   1  
November  2015   2   1  
     
                                                 Key  Changes  in  Terminology    
OLD   NEW  
TRADE  DEBTORS     TRADE  RECEIVABLES    
TRADE  CREDITORS   TRADE  PAYABLES  
STOCK   INVENTORY  
PROFIT  AND  LOSS  ACCOUNT   INCOME  STATEMENT  
TRADING  ACCOUNT   TRADING  SECTION  OF  INCOME  STATEMENT  
PREPAID  EXPENSES  AND  INCOME  OWING   OTHER  RECEIVABLES  
OWING  EXPENSES  AND  PREPAID  INCOME   OTHER  PAYABLES  
CASH  AT  BANK   CASH  AND  CASH  EQUIVALENT  
CASH  IN  HAND   CASH  IN  HAND  OR  
 CASH  AND  CASH  EQUIVALENT  (CASH)  
INTEREST  EXPENSE   FINANCE  COST  
CAPITAL   EQUITY    
FIXED  ASSETS   NON  CURRENT  ASSETS  
Sales   Revenue  
Purchases   Ordinary  Goods  Purchased  
Net  Profit   Profit  for  the  year  
Net  Loss   Loss  for  the  year  

 
ACCOUNTING  CYCLE  
 
The  Accounting  Cycle  is  a  series  of  steps,  which  are  repeated  every  reporting  period.  The  
process  starts  with  making  accounting  entries  for  each  transaction  and  goes  through  closing  the  
books.  This  Involves  recording  transactions  in  the  daybooks(  books  of  original  entry),  posting  
them  to  ledger,  extracting  a  trial  balance  and  finally  drawing  up  financial  statements.  
 
Step  1:    Recording  Transactions  in  Daybooks  (  DAYBOOKS  ARE  ALSO  REFFERED  AS  
JOURNALS)  
 
Each  transaction  is  recorded  first  in  one  of  the  following  daybook  (  book  of  original  entry)  
according  to  the  nature  of  the  transaction.  
 
1.  All  goods  sold  on  Credit  (  Credit  Sales)          ….>  Sales  Daybook  
2.  All  goods  purchased  on  Credit  (Credit  Purchases)  ….>  Purchases  Daybook  
3.  All  goods  sold  on  credit  but  now  returned  by  costumers  ..>  Sales  Return  (Inwards)  Daybook  
4.  All  goods  purchased  on  credit  but  now  returned  to  suppliers…>  Purchases  Return  Daybook  
 
The  above  four  daybooks  only  record  credit  transactions  related  to  movement  in  inventory.  
There  are  no  accounts  maintained  inside  the  daybooks.  It  Just  contains  Date,  Name,  Source  
document  number  and  Amount.  
 
5.  All  transactions  which  relate  to  receipts  and  payments  through  cash  or  cheque  ..>  Cashbook  
 
Cash  and  Bank  accounts  are  made  inside  the  cashbook  hence  it  also  serves  the  purpose  of  
ledger.  
 
6.  All  other  transactions  …..>  General  Journal  
 
     In  this  we  actually  write  the  double  entry  of  only  those  transactions  which  cannot  be  recorded  
in  the  above  five  daybooks.  To  name  a  few  
-­‐ Non  Current  Assets  Purchased  or  Sold  on  Credit  
-­‐ Writing  off  Bad  debts  
-­‐ Entries  for  Provisions  of  doubtful  debts  and  depreciation  
-­‐ Adjustments  for  Prepaid  and  Owings  
-­‐ Correction  of  Errors  
 
 
 
 
  
Step  2:  Posting  Transactions  In  Ledgers  
 
A  ledger  is  a  book  which  contains  accounts  (  the  actual  T  Accounts  guys).  There  are  three  types  of  
Ledgers.  In  each  type  we  have  different  type  of  accounts.  
 
Sales  Ledger:  This  contains  accounts  of  credit  costumers  (  people  to  who  we  sell  goods  on  credit)  –  
Trader  Receivables    
 
 At  the  end  of  the  year  all  the  account  balances  in  the  sales  ledger  are  listed  in  a  schedule  which  is  called  
list  of  Trade  receivables.  This  shows  the  individual  account  balances(  closing)  and  also  the  total  debtors  
which  goes  into  the  trail  balance.  
 
   Purchase  Ledger:  This  contains  accounts  of  credit  suppliers  (  people  from  whom  we  buy  goods  on  
credit)  –  Trader  Payables  
 
At  the  end  of  the  year  all  the  account  balances  in  the  purchase  ledger  are  listed  in  a  schedule  which  is  
called  list  of  Trade  Payables.  This  shows  the  individual  account  balances(  closing)  and  also  the  total  
creditors  which  goes  into  the  trail  balance.  
 
   
General  Ledger:  This  contains  all  the  other  accounts.  Like  all    assets,  capital  ,  liabilities  ,expenses  
,incomes  ,provisions  (literally  all  other  accounts)  
 
Please  remember  Sales  and  Purchases  accounts  are  in  the  General  Ledger  cause  they  are  not  our  
costumers  or  suppliers    
 
Once  all  the  transactions  are  posted  all  the  accounts  are  balanced  via  inserting  a  balance  C/d  in  all  
accounts.  
 
Step  3:  Extracting  a  Trial  Balance  
 
All  the  closing  balances  in  the  General  Ledger  along  with  the  figure  of  total  trade  receivables  and  
payables  are  listed  in  a  trail  balance.  Debit  balances  and  Credit  Balances  are  listed  separately  side  by  
side.  The  Sum  of  all  Debits  should  be  equal  to  sum  of  all  credit  balances.  The  trail  balances  is  used  to  
check  the  completion  of  the  double  entry.  The  trail  balance  will  balance  because    
-­‐ For  each  debit  entry  there  is  a  credit  entry  (  vice  versa)  
-­‐ The  sum  of  all  debit  entries  is  equal  to  the  sum  of  credit  entries    
 
 
 
  
Step  4:  Closing  Entries  with  Year  end  Adjustments  (Details  in  following  pages)  
 
After  making  the  trail  balance  we  also  have  to  adjust  for  certain  items.  Remember  only  Incomes  and  
Expenses  are  taken  into  account  while  calculating  profit.  These  accounts  are  closed  by  transferring  them  
to  the  income  statement  (  the  Profit  and  Loss  Account).  This  process  is  called  Closing  Entries.  
Some  common  adjustments  are  
-­‐ Expenses  and  Incomes  are  adjusted  for  prepaid  (advance)  and  accruals(Owings)  
-­‐ Non  Current  Assets  are  depreciated    
-­‐ Provision  for  doubtful  debt  is  adjusted  
-­‐ Closing  inventory  is  valued  by  physical  stock  take  and  it  is  adjusted  in  calculating  cost  of  
goods  sold  and  also  for  Balance  Sheet  
-­‐ Adjustments  for  goods  withdrawn  by  owner  or  Stock  Losses  
 
Step  5:  Final  Accounts:  
An  income  statement  and  Statement  of  Financial  Position  (  Balance  Sheet)  is  drawn  which  ends  the  
Accounting  Cycle.  Now  by  looking  at  Income  Statement  owner  can  check  his  Profit  and  by  looking  at  
statement  of  financial  position  he  can  check  his  worth  and  his  total  resources.  
 
 
WHAT  ARE  THE  BENEFITS  OF  KEEPING  FULL  DOUBLE  ENTRY  RECORDS  FOR  THE  BUSINESS?  
 
1. Helps  in  preparation  of  Trial  Balance  
2. Helps  in  preparation  of  Financial  Statements  
3. Less  Chances  of  Errors  
4. Less  Chances  of  Frauds  
5. Improves  the  Accuracy  of  Accounting  Records    
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  

                                                                                      ADJUSTMENTS  IN  DETAIL  

BAD  DEBTS  AND  PROVISION  FOR  DOUBTFUL(BAD)  DEBTS  
 
What  is  a  bad  debt?  
When  a  costumer  to  whom  goods  were  sold  on  credit  basis,  is  unable  to  pay  his  debt  then  it  results  into  
an  expense  for  the  business.  Selling  goods  on  credit  basis  involves  this  risk  of  bad  debt.  Any  amount  of  
debt  which  becomes  irrecoverable  should  be  written  off  as  bad  debt.  
 
         Debit:  Bad  Debts  
                     Credit  :  Person  Who  is  Bad  :>/Trade  receivable    
 
What  is  a  Provision  for  bad  debt?  
A  business  must  consider  that  some  costumers  might  not  pay  the  amount  owed  by  them;  these  debts  
are  considered  to  be  doubtful.  Since  the  business  does  not  know  the  exact  amount  of  the  doubtful  
debts(  and  also  which  costumer  might  not  pay),  an  estimate  for  such  amount  is  kept  in  a  provision  for  
doubtful  debt  account  (  this  account  is  not  an  expense  account,  it’s  a  reduction  in  asset  from  the  
statement  of  financial  position).  Provision  is  created  to  reduce  profit  now  for  an  expense  which  might  
happen  in  future.  This  is  done  to  be  pessimistic,  in  Accounting  we  call  this  being  prudent  or  the  
Prudence  Concept.  
 
A  business  usually  keeps  a  general  provision  (  an  estimated  %  of  the  all  debtors),  but  it  is  also  possible  to  
make  a  specific  provision  against  a  highly  doubtful  debt.  Specific  provision  mean  the  whole  amount  due  
by  a  particular  debtor  is  added  to  the  provision.  
 
For  example    
Trade  Receivables  At  End=  60000  
 
Case  1:  Only  General  Provision  of  5%  ..  >  provision  =  5%  of  60000  =  $3000  
 
Case  2:  A  specific  Provision  of  $2000  and  a  general  provision  of  4%  on  remaining  trade  receivables  
                 Provision  =  2000  (Specific)  +  4%  of  58000  (  general  provision  on  remaining  debtors)  
 
 How  is  the  amount  of  provision  estimated?  (  Factors  effecting  it)  
 
-­‐ Age  of  Debts  (  Since  how  long  they  owe  us),  higher  the  age  more  likely  bad  debts  (  so  high  
provision  is  kept  If  majority  of  the  debts  are  owed  for  long)  
-­‐ Historical  percentage  of  actual  bad  debts  from  previous  years  
-­‐ Reputation  of  people  who  us  money  in  the  market  
-­‐ Nature  of  Business  
-­‐ Some  specific  debts  may  be  identified  and  full  amount  of  them  is  charged  in  provision.  
  
What  is  the  difference  between  accounting  treatment  of  Provision  for  doubtful  debts  and  the  actual  
Bad  debts?  
 
The  Journal  entry  for  provision:  
 
To  create  /  Increase  
                 Debit  :  Profit  and  Loss    
                           Credit  :  Provision  for  doubtful  Debts  
 
To  Decrease  
                         Debit  :  Provision  for  doubtful  debts  
                                   Credit  :  Profit  and  Loss  
 
The  difference  in  accounting  treatment  is  that  the  whole  of  bad  debt  is  treated  as  an  expense  but  only  
the  change  in  provision  is  treated  as  either  an  expense  (if  increasing)  or  an  income  (  if  decreasing).  When  
we  write  off  a  bad  debt,  we  remove  the  debtor  from  our  books  but  in  case  of  a  provision  we  don’t  adjust  
the  debtor  account  as  a  separate  account  is  maintained.  
 
 
 
 
What  is  Bad  Debt  Recovered?  
This  is  when  a  debtor  whose  debt  was  previously  written  off  ,  pays  us  back.  This  is  treated  as  an  income  
in  the  year  in  which  the  debt  is  recovered  .  The  accounting  treatment  is  done  in  two  steps    
   
-­‐ Make  him  or  her  your  debtor  (receivable  )  as  the  debt  has  been  written  off  previously  and  
the  account  of  that  costumer  doesn’t  exist  in  our  books  
               Debit  :  Name  of  Person(debtor)  
                         Credit:  Bad  debt  recovered  account  
 
-­‐ Now  record  the  entry  to  receive  the  money  
           Debit:  Bank  
                         Credit  :  Name  of  person  (debtor)  
 

 
 
 
ACCOUNTING  FOR  NON  CURRENT  ASSETS  
 
Whenever  we  spend  money  we  call  it  expenditure.  The  expenditure  can  be  divided  in  two    
 
Capital  Expenditure     Revenue  Expenditure  
Any  expenditure  incurred  on  buying  new   Any  day  to  day  expense  to  run  the  business.  
non-­‐current  asset.  We  take  this  to  balance   We  take  this  to  income  statement  
Sheet  
Usually  one  off  (doesn’t  happen  on  daily   Its  recurring  in  nature  (  we  have  to  do  it  
basis)   again  and  again)  
Includes  initial  expenses  incurred  till  we   Usually  occurs  after  we  start  using  the  asset  
start  using  the  asset  e.g.  Installation,  
delivery  charges  
Increases  the  value  of  earning  capability  of   Maintains  the  value  or  earning  capability  of  
the  asset  e.g.  Adding  a  Safety  device   the  asset.  E.g.  Repainting  or  Repair  

 
In  the  same  way  we  can  have  Capital  receipts  and  Revenue  Receipts  .  
 
Capital  Receipts  would  include  money  received  from  capital  transactions  e.g.    taking  a  bank  loan  ,  selling  
a  non  current  asset  or  additional  capital  introduced  by  the  owners  (  note  this  money  coming  in  not  
earned  by  the  business  from  profits)    
Revenue  Receipts  are  incomes  generated  from  day  to  day  operations  of  a  business  (  taken  to  income  
statement)  e.g.  Sale  of  goods  ,  Interest  received  rent  received    
 
 
If  these  expenditures  and  receipts  are  treated  in  the  wrong  way  then  both  income  statement  and  
balance  sheet  will  be  wrong.  
 
 
 
 
 
 
 
 
 
 
 
 
 
 Depreciation  
 
This  is  an  expense  recorded  to  allocate  a  non  current  asset  cost  over  its  useful  life.  Deprecation  is  used  
in  accounting  to  try  to  match  the  expense  of  an  asset  to  the  income  that  the  asset  helps  the  business  to  
earn.  For  example  if  a  business  buys  a  piece  of  equipment  for  $1  million  and  expects  to  use  it  over  a  life  
of  10  years,  it  will  be  depreciated  over  10  years  .    Every  accounting  year,  the  company  will  expense  
$100000  (assuming  straight  line  ,  which  will  be  matched  with  the  money  that  the  equipment  helps  to  
make  each  year.  )  
 
The  Double  Entry  for  Depreciation  is  :  
 
 Debit  :  Profit  and  Loss  Account  (  Income  Statement)  
                 Credit  :  Provision  for  Depreciation    

 
Methods  of  Depreciation:  
 
1. Straight  Line  :    
                 An  equal  amount  of  deprecation  is  charged  every  year.  It  is  always  calculated  on  cost  .  In  case  of  
scrap  value  (residual  value)    and  life  given  use  :  Cost  –Scrap/Life    
 
2. Reducing  Balance  Method:  
In  this  deprecation  for  initial  years  in  always  higher  then  the  later  years.  It  is  simply  a  percentage  on  net  
book  value  (written  down  value)  .  Net  Book  value  represents  cost  minus  total  deprecation  till  date.  
 
3. Revaluation  Method:  
               This  is  usually  used  for  loose  tools  (  or  any  asset  which  can  only  be  valued  collectively)  .  In  this  
method  at  the  end  of  the  year  the  market  value  is  estimated.  A  numerical  example  best  explains  this    
 
         At  the  start  of  the  year  Loose  Tools  Valued  at  $5000  
         During  the  year  Loose  Tools  purchased    =  $2000  
         Loose  Tools  Sold  =  $300  
       At  the  End  Loose  tools  are  worth  $4500  
Deprecation  =  5000  +  2000  –  300-­‐  4500  =  2200  
Opening  Value+  Purchased  –Sold  –  Closing  Value  
 
 
 
 
 
  
Which  Method  is  best  to  use?  
It  depends  on  the  nature  of  Non  Current  Asset  
 
Straight  Line  method  is  appropriate  for  assets  like  office  furniture  and  fittings  (which  are  used  evenly  
through  out  the  year  useful  life,  and  the  efficiency  of  them  doesn’t  fall  by  great  amount  in  initial  years)  
 
Reducing  Balance  Method  is  appropriate  for  assets  like  machinery  or  van.  Since  these  assets  are  more  
efficient  when  new,  more  depreciation  is  charged  in  initial  years.  As  the  asset  gets  old  it  looses  efficiency  
and  so  we  charge  less  deprecation.  Another  way  to  look  at  it  is  that  the  maintenance  and  repairs  of  
asset  will  increase  in  later  years  so  to  maintain  the  overall  expense  it  makes  sense  to  charge  more  
depreciation  in  initial  years  when  maintenance  is  low  and  then  reduce  it  as  maintenance  increases.  
 
How  to  record  disposal  of  Asset:  
Disposal  of  means  getting  ride  of  the  fixed  asset  .  it  can  be  sold  or  may  be  stolen  or  just  discarded.  
Usually  there  are  4  entries  to  record  sale  of  asset  
 
1. Remove  the  Cost  of  the  Asset  Sold  
Debit  :  Disposal            Credit:  Asset    
 
2.  Remove  the  Total  Deprecation    
Debit  :  Provision  for  Depreciation        Credit  :  Disposal  
 
3. Record  the  Selling  Price  
Debit:  Bank          Credit  :  Disposal  
 
If  exchanged  then    
               Debit  :  Asset      Credit  Disposal  
   
4. Close  the  Disposal  Account  
         Close  with  income  statement  .    
 
All  of  this  can  be  done  in  one  single  entry  without  using  disposal  
 
For  example    
Cost  of  Asset  Sold  =  50000  
Net  book  Value    =  30000  
 Sold  For  28000  
 
Note  :  total  depreciation  is  20000  as  NBV  is  30000  
 
  
We  can  do  
 
Bank                                      28000  
Prov  for  Depn      20000  
Loss                                          2000  
                                                   Asset              50000  
 
If  sold  for  $31000  then  
 
Bank                                  31000  
Prov  for  Depn    20000  
                                 Asset                          50000  
                                 Gain                            1000  

 
Adjusting  Entries  
 
To  Adjust  expenses  
 
Prepaid  :    
Debit  :  Prepaid  Expense    (  its  an  asset)  
         Credit  :  Expense                        (reduces  expense)  
 
Owing/Accrual    
 
Debit  :  Expense                                  (increases  expense)  
         Credit  :  Owing  Expense  (  it  is  a  liability)  
To  adjust  Incomes:  
 
Prepaid:  
 
    Debit:  Income       (as  the  income  reduces  because  it’s  prepaid)  
      Credit:  Prepaid  Income   (because  it’s  a  current  liability)  
 
Owing/Due  
 
    Debit:  Owing  Income       (because  it’s  an  asset)  
      Credit:  Income     (as  the  income  increases)  
  
To  adjust  closing  stock  
 
Overstated:  
    Debit:  Trading  account   (or  simply  Profit  and  Los)  
      Credit:  Closing  stock  
 
Understated:  
    Debit:  Closing  sock  
      Credit:  Trading  account  (or  simply  Profit  and  Loss)  
 
 
 
To  adjust  Opening  stock  
 
Overstated:  
    Debit:  Opening  Capital  
      Credit:  Trading  account  (or  simply  Profit  and  Loss)  
 
Understated:  
    Debit:  Trading  account  (or  simply  Profit  and  Loss)  
      Credit:  Opening  Capital  
 
 
This  is  because  opening  stock  has  opposite  relation  with  profits.  So  if  understated  profits  are  
overstated  and  we  need  to  reduce  them  (debit:  Trading  account).  Also  opening  stock  of  this  year  
was  closing  stock  of  last  year  so  we  need  to  amend  the  opening  capital.  
Concept  of  Sale  or  Return  basis:  
 
If  we  send  goods  on  sale  or  return  basis  which  means  goods  can  be  returned  by  the  customer  if  not  sold.  
When  goods  are  send  nothing  is  recorded,  just  a  memorandum  is  kept.  These  goods  should  not  be  
included  in  sales  and  should  be  included  in  closing  stock  (since  they  belong  to  us).  
 
If  this  is  recorded  as  sales  and  not  included  in  closing  stock,  then  we  need  to:  
• Correct  sales:  Cancel  them  
    Debit:  Sales  
      Credit:  Debtor  
 
• Correct  Closing  Stock  which  is  understated  
 
Note:   We  won’t  have  to  correct  the  stock  if  the  goods  were  included  in  closing  stock.  
  
Revaluation  of  NON  CURRENT  ASSETS  (Only  in  companies)  
 
Some  assets  do  appreciate  in  value,  e.g.  Land  and  companies  are  allowed  to  revalue  them.  
The  journal  entry  for  revaluation  is  
 
Debit:     Asset  (Cost)  
  Provision  for  Depn.  (Accumulated  Depreciation)  
    Credit:   Revaluation  Reserve  
 
For  example:  
An  asset  which  cost  $60  000  and  has  provision  for  depreciation  of  $8  000  is  now  revalued  at  $75  000.  
In  order  to  handle  this,  we  should  just  
 
Debit:   Asset       15  000  (Cause  it  was  already  at  60  and  we  want  to  make  it  75)  
  Provision  for  Depn.   8  000  (this  is  always  done  to  cancel  the  depreciation)  
    Credit:   Revaluation  Reserve   23  000  
 
The  23  000  is  the  difference  between  the  old  Net  Book  Value  (60  000  –  8  000)  52  000  and  the  new  value  
75  000.  
 
A  relatively  simpler  case  would  be  where  there  is  no  provision  for  depreciation.  Like  e.g.  Land  at  $60  000  
is  now  revalued  at  $75  000.  
 
Debit:  Land   15  000  
  Credit:  Revaluation  Reserve   15  000  

                     
 
 
 
 
 
 
BANK  RECONCILIATION  STATEMENTS  
 
Cashbook  is  owner’s  record  (Debit  means  +  balance,  Credit  means  –  balance)  
Bank  statement  is  bank’s  record  (Credit  means  +  balance,  Debit  means  –  balance)  
 
Some  entries  which  are  recorded  in  the  bank  statement  but  not  in  the  cashbook:  
For  these,  we  will  have  to  correct  the  cashbook  
 
1. Credit  transfer  (Bank  Giro):  Money  deposited  by  customer  directly  in  the  bank  account  
(We  should  add  it  to  cashbook  balance)  
2. Standing  order/  Direct  Debit:  Money  paid  to  supplier  directly  by  the  bank.  
(We  should  subtract  this  from  cashbook  balance)  
3. Bank  Charges/  Interest  Charged:  Money  deducted  directly  by  the  Bank.  
(We  should  subtract  this  from  cashbook  balance)  
4. Interest  Received/  Dividends  Received:  Money  added  to  the  bank  account  in  form  of  
interest  or  dividend  (We  should  ad  it  to  the  cashbook  balance)  
5. Dishonored  Cheque:  A  cheque  received  from  customer  but  not  acknowledged  by  the  
bank  (We  should  subtract  this  from  cashbook  balance  because  we  need  to  cancel  the  
entry  made  when  the  cheque  was  received).  
 
Some  entries  which  are  recorded  in  the  cashbook  but  not  on  the  bank  statement.  
 
For  this,  we  will  have  to  correct  the  bank  statement:  
 
1. Unpresented  Cheque:  Cheques  written  by  us  to  a  creditor  but  not  yet  presented  to  the  
bank  for  payment,  so  the  bank  has  not  deducted  money  from  our  account.  
(We  should  subtract  this  from  bank  statement  balance)  
2. Uncredited  Cheque  (Lodgments):  Cheques  received  by  us  but  not  yet  deposited  in  the  
bank,  so  the  bank  has  not  increased  the  bank  balance.  (We  should  add  this  to  the  bank  
statement  balance)  
 
FOR  MCQ’s  remember  
 
Balance  as  per  Bank  statement  +  Uncredited  Cheques  –  Unpresented  Cheques  =  Balance  as  
per  corrected  Cashbook.  
 
If  balance  as  per  corrected  cashbook  is  given  in  the  question,  simply  ignores  the  entries  
which  will  affect  the  cashbook  balance.    
 
If  there  is  an  overdraft  (for  either  cashbook  or  bank  statement),  take  it  as  a  negative  figure  
in  the  equation.  
 CONTROL  ACCOUNTS  
 
What  is  the  difference  between  Sales  Ledger  and  Salas  Ledger  Control  Account?  
 
Sales  ledger  is  where  we  make  individual  accounts  of  credit  customers.  It  is  part  of  double  entry  system  
and  it  gives  details  of  amounts  owing  by  each  customer.  A  list  of  debtors  is  extracted  from  the  sales  
ledger,  which  gives  the  figure  of  debtors  for  the  trial  balance.  
Sales  ledger  control  account  on  the  other  hand  is  the  total  debtors  account  in  the  general  ledger.  It  is  
not  part  of  the  double  entry  system.  It  I  often  referred  as  total  debtors  account.  All  the  entries  recorded  
here  are  totals  taken  from  daybooks  e.g.  Sales  figure  is  the  total  of  the  sales  daybook,  discount  allowed  
is  total  discount  allowed  from  the  discount  allowed  account  or  the  column  in  the  cashbook.  
 
USES  OF  CONTROL  ACCOUNT  
1. Helps  to  prevent  fraud  
2. Helps  to  detect  errors  
3. Quickly  provide  figures  of  total  debtors  and  creditor.  
LIMITATIONS  OF  CONTROL  ACCOUNT  
1. Cant  trace  error  of  omission    
2. Cant  trace  error  of  original  entry  
RECONCILIATION  OF  CONTROL  ACOUNT  
In  these  types  of  questions,  two  sets  of  balances  of  debtors  or  creditors  are  known.  One  is  from  the  
control  account  and  the  other  is  from  the  sales  ledger  (or  list  of  debtors).  
They  will  also  give  you  several  errors  and  you  will  have  to  reconcile  both  the  balances.  
Errors  can  be  classified  as:  
 
1. If  an  error  is  made  in  the  personal  (individual)  debtors  account,  than  it  will  only  affect  the  sales  
ledger  (list)  balances.  E.g.  Sales  made  not  posted  to  debtor’s  account,  this  means  we  should  
increase  the  debtor  balances  in  the  ledger.  
2. If  an  error  is  made  in  any  total  figure  of  the  daybook,  it  will  effect  only  the  control  account  
balance,  e.g.  Sales  daybook  undercast,  Total  sales  understated  so  add  it  to  control  account  
balance.  
3. If  an  entry  is  completely  omitted  from  the  books,  it  will  affect  both  the  balances.  E.g.  A  sales  
invoice  completely  omitted  from  the  books,  add  it  to  both  balances.  
4. If  an  entry  is  originally  recorded  in  the  daybook  with  the  wrong  amount,  it  will  affect  both  the  
balances,  as  the  total  will  also  be  wrong.  E.g.  A  sales  invoice  of  $500  was  originally  recorded  as  
$600,  this  means  the  total  sales  are  overstated  and  also  the  individual  account  of  the  customer  
has  been  debited  with  $600.  We  should  subtract  $100  from  both.  
5. If  a  balance  is  omitted  from  the  list  of  debtors,  it  will  only  affect  the  sales  ledger  (list)  balance.  It  
cannot  affect  control  account  balance.  
 
ERRORS  AND  SUSPENSE  
Error  not  affecting  the  Trial  Balance:    
1. Error  of  complete  omission:  When  nothing  has  been  recorded  in  the  books.  To  correct  this,  
simply  record  the  transaction.  
2. Error  of  original  entry:  Where  correct  double  entry  is  passed  but  with  the  wrong  amount.  To  
correct  this,  adjust  for  the  difference.  
3. Error  of  principal:  Where  a  wrong  type  of  account  has  been  debited  or  credited  instead.  For  
example,  we  have  debited  Rent  instead  of  Motor  Van.  
4. Error  of  commission:  Where  a  wrong  account  but  of  same  type  (usually  debtors  or  creditors)  has  
been  debited  or  credited  instead.  For  example,  we  have  credited  Mr.  A  instead  of  Mr.  B.  
5. Error  of  complete  reversal:  Where  a  completely  opposite  entry  is  passed  with  the  right  amount.  
To  correct  this,  pass  the  correct  entry  with  double  amounts.  
6. Compensating  error:  Where  one  error  compensates  for  other.  Like  a  debit  item  (say  purchase)  
and  a  credit  item  (say  sales)  are  both  undercast  with  same  amounts.  (don’t  worry  about  this  too  
much  :P)  
 
All  the  above  errors  do  not  affect  the  Trial  Balance  because  in  all  situations  the  total  debits  are  equal  to  
total  credits.  
 
Errors  can  be  made  which  can  lead  to  disagreement  of  the  trial  balance.  
This  is  when  either  we  have  only  debited  something  and  forgot  to  credit  (Incomplete  double  entry)  or  
we  have  debited  something  with  a  correct  amount  and  credited  the  other  with  the  wrong  amount  
(Incorrect  double  entry).  And  it  can  also  happen  if  any  daybook  is  over  or  under  cast.  E.g.  Sales  daybook  
is  undercast.  In  these  situations  Suspense  account  comes  into  the  picture.  Since  sales  daybook  is  
undercast,  this  means  only  the  total  sales  were  wrong  (understated),  so  we  need  to  amend  the  sales  
accounts.  
        Debit:  Suspense  
          Credit:  Sales  
 
Also  sometimes  an  error  is  made  in  the  list  of  debtors  or  creditors.  Like  a  debit  balance  is  excluded  from  
the  list  of  debtors.  This  makes  the  debtors  figure  in  the  trial  balance  understated.  Logically  we  should  
      Debit:  Debtors  
        Credit:  Suspense  
But  guys  do  you  realize  that  only  the  list  of  debtors  is  wrong  (which  is  not  an  account),  so  we  should  
      Debit:  NO  DEBIT  ENTRY  
        Credit:  Suspense  
 
What  if  there  is  still  balance  left  in  the  suspense  account?  
 
This  means  all  the  errors  are  still  not  found.  If  the  balance  comes  on  the  debit  side,  then  treat  it  as  a  
current  asset  in  the  balance  sheet,  if  it  comes  on  the  credit  side  then  treat  it  as  a  current  liability.  
INCOMPLETE  RECORDS:  
 
Remember  Net  profit  can  be  calculated  using  the  following  formula.  If  a  question  says  make  a  trading  
profit  and  loss  account,  than  this  doesn’t  apply.  Only  when  it  says  to  calculate  net  profit  or  make  a  
statement  showing  net  profit.  
 
  Opening  Capital  +  Additional  Capital  +  Net  profit  –  Drawings  =  Closing  Capital  
 
(I  really  hope  you  can  solve  for  net  profit),  don’t  memorize  the  formula,  it’s  the  equity  section.  J  
 
For  the  final  account  questions  (where  the  income  statement  and  statement  of  financial  postion  is  
required),  always  make  the  following  accounts.  (By  always,  I  mean  always).  
 
1. Sales  ledger  control  account  (If  business  only  deals  in  cash  sales,  then  don’t)  
2. Purchase  ledger  control  account  
3. Bank  account  (if  it  is  already  given  in  the  question,  then  it’s  okay)  
4. Cash  account  (only  make  this  when  the  question  gives  cash  balances)  
 
Once  you  have  filled  in  your  accounts,  and  then  move  to  the  Final  accounts.  Don’t  panic  if  it  doesn’t  
balance,  because  marks  are  for  working.  Don’t  spend  your  entire  lifetime  on  this  question.  
 
NEVER  NEVER  NEVER  forget  depreciation.  They  will  usually  give  you  net  book  values  at  start  and  end.  
Depreciation  =    
 
  Opening  NBV  +  Purchase  of  assets  –  Sale  of  assets  (at  NBV)  –  Closing  NBV  
 
Also  make  expense  accounts  or  adjust  for  prepaid  and  owings  directly.  But  show  all  working.  
 
In  Equity  by  section,  you  will  need  opening  capital.  This  will  come  from  Opening  Assets  –  Opening  
Liabilities.  Don’t  forget  to  include  the  opening  balance  of  the  bank  account  in  your  calculation  (like  other  
idiots).  
 
 
 
 
 
 
 
 
MARGINS  AND  MARK-­‐UPS  
 
These  are  tools  used  to  compute  the  missing  figures  of  sales,  figures  or  stocks.  If  either  of  these  
percentages  is  given  
MARGINS  
Represent  Gross  Profit  as  a  percentage  of  selling  price.  
 

MARK-­‐UP  
Represent  Gross  profit  as  a  percentage  of  cost.    
 
Try  to  use    
Sales  –  Cost  =  Profit  
 
If  Mark  up  if  given  Profit  is  a  %  of  Cost  and  IF  margin  is  given  Profit  is  a  %  of  Sales  
 
For  eg.  
 
Sales  =  80000  
Cost  =  ?  
Margin  =  25%  
 
Sales  –  Cost  =  Profit  
80000-­‐  x  =  25  %  of  80000  
 
Cost  =  60000  
 
But  if      
Sales  =  80000  
Cost  =  ?  
Markup  =25%  
 
Sales  –  Cost  =  Profit  
80000-­‐  x  =  25  %  of  X  
 
Cost  =  64000  
 
 
 
 
 
 
PARTNERSHIP  ACCOUNTS  
 
A  partnership  is  defined  by  the  Partnership  Act  1890  as  a  relationship,  which  exists  between  two  or  
more  persons  who  carry  business  with  a  view  of  profit.  
 
CHARACTERISTICS  OF  PARTNERSHIP  
• Partners  are  jointly  and  severally  liable  for  the  debts  of  the  partnership.  They  have  
unlimited  liabilities  for  the  debts  of  the  partnership.  
• The  minimum  number  of  partners  is  usually  two  and  maximum  number  is  twenty,  with  
exception  of  banks,  where  the  maximum  number  is  fixed  at  ten  and  some  professional  
practices  where  there  is  no  maximum  number.  
• All  partners  usually  participate  in  the  running  of  their  business.  
• There  is  usually  a  written  partnership  agreement.  
 
THE  PARTNERSHIP  AGREEMENT  
 
The  partnership  agreement  is  a  written  agreement  which  sets  up  the  terms  of  the  partnership,  
especially  the  financial  arrangements  between  the  partners.  
The  contents  of  the  partnership  agreement  can  vary  from  one  partnership  to  another.  A  standard  
Partnership  Agreement  may  include  the  following  items:  
1. The  name  of  the  firm,  business  type  and  duration  
2. Capital  contribution.  
3. Profit  sharing  ratios.  
4. Interest  on  Capital.  
5. Partners’  salaries.  
6. Drawings.  
7. Interest  on  drawings.  
8. Arrangements  in  case  of  dissolution,  death  or  retirement  of  partners.  
9. Arrangement  for  settling  disputes.  
 
In  absence  of  a  formal  agreement  between  the  partners,  certain  rules  laid  down  by  the  Partnership  
Act  1890  are  presumed  to  apply.  These  are:  
1. Residual  profits  are  shared  equally  between  the  partners.  
2. There  are  no  partners’  salaries.  
3. No  interest  is  charged  on  drawings  made  by  the  partners  
4. Partners  receive  no  interest  on  capital  invested  in  the  business.  
5. Partners  are  entitled  to  interest  of  5%  per  annum  on  any  loans  they  advance  to  the  business  in  
excess  of  their  agreed  capital.  
 
CHANGES  IN  THE  PARTNERSHIP  
A  change  in  partnership  is  when  the  agreement  has  to  be  changed  between  the  partners  due  to  
 
-­‐ Admission  of  a  new  partner  
-­‐ Retirement  of  an  existing  partner  
-­‐ Or  simply  change  in  profit  sharing  ratio.  
 
Whenever  there  is  a  change  in  a  partnership,  partners  are  allowed  to  revalue  their  assets.    This  is  done  
to  make  the  situation  fair  for  all  parties.  Since  the  values  on  the  statement  of  financial  position  might  be  
different  from  the  market  so  any  gain  or  loss  is  first  adjusted  between  the  old  partners  For  this  purpose,  
they  make  a  revaluation  account.    
 
In  revaluation  account  we  simply  record  the  gains  or  losses  on  each  asset  due  to  revaluation.    This  
account  is  then  closed  by  transferring  the  balance  to  partners’  capital  account  in  the  old  profit  sharing  
ratio.  
 
 
Goodwill    
This  is  an  added  advantage  which  an  old  business  has  over  a  similar  new  business,  due  to  its  location,  
brand  value,  costumer  base  etc.  
 
Whenever  there  is  a  change  in  partnership  ,we  need  to  adjust  for  goodwill,  so  that  the  old  partners  
benefit  and  get  the  credit  of  the  efforts  they  have  done  to  make  good  reputation  of  the  business.  The  
adjustment  is  done  in  the  capital  accounts  ,  where  we  first  create  the  goodwill  in  the  old  profit  sharing  
ratio  (  thus  giving  credit  to  the  old  partners),  and  then  we  right  it  off  (  always  )  in  the  new  ratio  (  so  that  
the  partner  who  is  gaining  stake  in  the  business  actually  pays  for  it  ).  
 
ADVANTAGES  OF  PARTNERSHIP  OVER  SOLE  TRADER  
 
1. Additional  capital  from  other  partners,  and  also  easier  to  get  loans.  
2. Additional  expertise.  
3. Additional  management  time.  
4. Risk  (losses)  is  shared.  
 
 
DISADVANTAGES  OF  PARTNERSHIOP  OVER  A  SOLE  TRADER  
 
1. Profit  are  shared  
2. Possibility  of  disputes  
3. Loss  of  control  
  
 
What  is  a  current  account?  
 
Majority  of  partnership  keep  a  fixed  capital  account,  whenever  they  have  fixed  capital  accounts,  they  
will  have  to  maintain  a  current  account  for  each  partner.  By  fixed  capital  account,  we  mean  that  all  the  
appropriation  and  drawings  will  pass  through  a  temporary  capital  account  (current  account),  only  
additional  investment  by  a  partner  will  be  recorded  in  the  capital  account.  This  gives  information  
relating  to  long  term  and  short  term  aspects  separately.  This  also  helps  to  determine  the  investment  
made  by  partner  in  the  business.  
Some  partnerships  also  maintain  a  fluctuating  capital  account;  in  this  case  they  will  not  maintain  a  
current  account.  All  the  transactions  will  pass  through  the  capital  account.  
 
What  is  total  share  of  profit?  
 
This  is  different  than  just  the  remaining  share  of  profit  which  we  get  at  the  end  of  appropriation  
account.  Total  share  of  profit  means  out  of  this  year’s  net  profit,  how  much  profit  goes  to  a  particular  
partner.  As  we  know  interest  on  capital  and  salary  etc  are  deducted  from  net  profit  only  so  they  also  
constitute  as  part  of  profit.  Hence,  total  share  of  profit  is:  
 
  Interest  on  capital  +  Salary  +  Remaining  share  of  Profit  –  Interest  on  drawings  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
LIMITED  COMPANIES  
 
Limited  companies  are  business  organizations,  whose  owners’  liabilities  are  limited  to  their  capital  
contributed  or  guarantees  made.  
 
CHARACTERISTICS  OF  LIMITED  COMPANIES  
1. Separate  legal  entity:   A  company  is  regarded  as  a  separate  person  from  its  owners  and  
managers.  As  a  result,  it  can  sue  or  be  sued,  it  can  own  property.  
This  concept  is  often  referred  to  as  veil  of  incorporation.  
2. Limited  liability:   Shareholders’  liability  is  limited  to  what  they  have  paid  for  
shares.  
3. Perpetual  succession:   Unlike  partnership  and  sole  trader,  a  company  does  not  cease  to  
exist  on  the  death  or  retirement  of  any  of  the  owners.  Owners  
can  buy  and  sell  their  shares  without  affecting  the  running  of  the  
business.  
4. Number  of  members:   There  is  no  limit  as  to  the  number  of  members  
5. Capital:   Company’s  capital  is  raised  through  the  issuance  of  shares  
6. Profit  distribution:   Profits  are  distributed  to  members  through  dividends.  
7. Retained  profits:   The  retained  profits  are  capitalized  are  reserves.  
8. Legislation:   Companies  are  highly  regulated.  They  are  required  to  comply  
with  the  requirements  of  Company’s  ACT  as  well  as  Financial  
Reporting  Standards.  
 
ADVANTAGES  OF  OPERATING  AS  A  LIMITED  COMPANY:  
1. The  liability  of  the  shareholders  is  limited.  Therefore,  in  case  of  company  going  bankrupt,  the  
individual  assets  of  the  owners  will  not  be  used  to  meet  the  company’s  debts.  Only  shareholders  
who  have  only  partly  paid  for  their  shares  can  be  forced  to  pay  the  balance  owing  on  the  shares,  
but  nothing  else.  
2. There  is  a  formal  separation  between  the  ownership  and  management  of  the  business.  This  
helps  in  clearly  identifying  the  responsible  persons.  
3. Ownership  is  vastly  shared  by  many  people,  hence  diversifying  risk,  and  funds  become  available  
is  substantial  amounts.  
4. Shares  in  the  business  can  be  transferred  relatively  easily.  
 
DISADVANTAGES:  
1. Formation  costs  are  normally  very  high.  
2. Companies  are  highly  regulated.  
3. Running  costs  are  also  very  high  i.e.  preparation  and  submission  of  annual  returns,  audit  fees  
etc.  
4. Profit  distribution  is  also  subject  to  some  restrictions.  Not  all  surpluses  from  the  business  
transactions  can  be  distributed  back  to  the  shareholders.  
5. Company  accounts  must  be  available  for  inspection  to  the  public.  
There  are  two  types  of  limited  companies:  
1. Public  limited  companies:  
a-­‐ They  have  the  abbreviation  Plc  of  public  limited  company  at  the  end  of  their  names  
b-­‐ Their  minimum  allotted  share  is  required  to  be  £50  000.  
c-­‐ They  can  invite  the  general  public  to  subscribe  for  their  shares  
d-­‐ Their  shares  may  be  traded  in  the  stock  exchange  i.e.  they  can  be  quoted  with  the  stock  
exchange.  
2. Private  limited  companies:  
a-­‐ They  have  the  abbreviation  ‘Ltd’  for  limited  at  the  end  of  their  names.  
b-­‐ They  are  not  allowed  to  invite  general  public  for  the  subscription  of  their  share  capital.  
 
COMPANY  FINANCE  
 
As  is  a  case  with  sole  traders  and  partnerships,  companies  also  have  two  main  sources  of  finance,  
namely;  capital  and  liabilities.  The  difference  is  on  naming  and  classification  of  these  terms.  
 
When  the  company  is  formed,  it  normally  issues  shares  to  be  subscribed  by  the  potential  members.  
People  who  subscribe  and  buy  company’s  shares  are  known  as  shareholders,  and  they  become  the  legal  
owners  of  the  company  depending  in  the  proportion  and  type  of  shares  they  hold.  They  receive  
dividends  as  return  on  their  invested  capital.  Dividends  are,  therefore,  appropriations  of  the  profits.  
 
On  the  other  hand,  the  company  can  borrow  funds  from  other  people  who  are  not  owners.  The  main  
form  of  company  borrowings  is  by  issuing  debenture,  which  is  a  written  acknowledgement  of  a  loan  to  a  
company,  given  under  the  company’s  seal.  The  debenture  holders  are  not  owners  of  the  company  but  
they  are  liabilities.  Debenture  holders  receive  a  fixed  percentage  of  interest  on  the  loan  amount.  
Debenture  interest  is  a  business  expense,  which  must  be  paid  when  is  due.  Other  forms  of  borrowings  
include  trade  creditors  and  bank  overdrafts.  
 
The  difference  between  shareholders  and  debenture  holders  can  be  analyzed  in  terms  of:  
1. Ownership;  and  
2. Return  on  investment  (Debenture  holders  will  get  it  even  if  the  company  makes  losses)  
 
SHARE  CAPITAL  
Share  capital  is  normally  of  two  types:  
1. Ordinary  share  capital;  and  (  the  real  shareholders)  
2. Preference  share  capital  
 
 
 
 
 
What  are  the  different  Types  of  Preference  Shares?  
1. Non-­‐cumulative  Preference  shares:  In  case  company  doesn’t  pay  enough  profits,  these  
shareholders  will  get  no  dividends  in  the  year  and  that  amount  of  dividend  will  never  be  given.  
2. Cumulative  Preference  Shares:  In  case  company  doesn’t  have  enough  profits,  these  
shareholders  will  get  no  dividend  in  the  year  and  that  amount  of  dividend  will  be  carried  
forward  to  next  year,  when  the  company  makes  enough  profit,  the  entire  amount  will  be  
payable  as  dividend.  
3. Participating    Preference  Shares  : Preference  shares  which,  in  addition  to  paying  a  specified  
dividend,  entitle  preference  shareholders  to  participate  in  receiving  an  additional  dividend  if  
ordinary  shareholders  are  paid  a  dividend  above  a  stated  amount.  
4. Redeemable  Preference  Shares:    Preference  shares  which  can  be  bought  back  by  the  company  
at  a  given  date  (  They  are  treated  like  liability  and  not  equity  ).  The  dividends  given  to  them  are  
treated  like  interest  expense.  
Their  difference  is  summarized  in  the  table  below:  
Aspect   Ordinary  shares   Preference  shares  
Voting  power   Carry  a  vote   Limited  or  no  voting  power  
Dividends   1. Vary  between  one  year  to   1. Fixed  percentage  of  the  nominal  
another,  depending  on  the   value.  
profit  for  the  period.   2. Cumulative.  If  not  paid  in  the  
2. Rank  after  preference   year  of  low  or  no  profits,  it  is  
shareholders.   carried  forward  to  the  next  years.  
3. Not  cumulative.   3. They  may  be  non-­‐cumulative.  
Liquidation   Entitled  to  surplus  assets  on   1. Priority  of  payment  before  
(Company  closing   liquidation,  after  all  liabilities  and   ordinary  shareholders,  but  after  
down)   preference  shareholders  have  been   all  other  liabilities.  
paid.  Whatever  is  left,  go  to   2. Not  entitled  to  surplus  assets  on  
Ordinary  shareholders.   liquidation.  
SHARE  CAPITAL  STRUCTURE  
Authorized  share  capital:   the  maximum  share  capital  that  the  company  is  empowered  to  issue  per  
its  memorandum  of  association.  It  is  sometimes  called  as  registered  
capital.  
Issued  share  capital:   The  total  nominal  value  of  share  capital  that  has  actually  been  issued  to  
the  shareholders.  
Called-­‐up  capital:   This  is  a  part  of  issued  capital  that  the  company  has  already  asked  the  
shareholders  to  pay.  Normally  when  the  company  issues  shares,  it  does  
not  require  its  shareholders  to  pay  the  full  price  on  spot.  Rather  it  calls  
the  installments  from  time  to  time.  It  is  the  amount  that  is  included  in  
the  balance  sheet.  
Paid-­‐up  capital:   This  is  the  total  amount  of  the  money  already  collected  from  the  
shareholders  to  date.  Dividend  is  paid  on  this.  
 
Uncalled  capital:     This  is  the  part  of  issued  capital,  which  the  company  has  not  yet  
requested  its  shareholders  to  pay  for.  
  
 

The  distinctions  between  reserves,  provisions  and  liabilities  

The  distinctions  between  reserves,  provisions  and  liabilities  are  of  the  utmost  importance  and  must  be  
learned.  
 
Provisions  are:  
amounts  written  off  or  retained  by  way  of  providing  for  depreciation,  renewals  or  diminution  in  
the  value  of  assets.    
Or,   retained  by  way  of  providing  for  nay  known  liability  of  which  the  amount  cannot  be  determined  
with  substantial  accuracy.  
Increases  and  decreases  in  provisions  are  debited  or  credited  in  the  Profit  and  Loss  account  and  credited  
to  a  Provision  account.  
 
Reserves  are:  
any  other  amounts  set  aside  out  of  profits  by  debiting  Profit  and  Loss  Appropriation  account  and  
crediting  the  relevant  provision  accounts,  
and   amounts  placed  to  capital  reserve  in  accordance  with  the  Companies  Act  such  as  share  
premium,  unrealized  surpluses  on  the  revaluation  of  non  current  assets,  and  amounts  set  aside  
out  of  distributable  reserves  to  maintain  capital  when  shares  are  redeemed.  
Liabilities  are  :amounts  owing  which  can  be  determined  with  substantial  accuracy.  
ISSUE OF SHARES

Public Issue: This is normal issue of shares to general public. A company can issue shares to
public to raise more capital , this is done at the market price. Public issues have higher cost of
issue ( this means the company has to incur high expenses when issuing the shares I.e.
advertising and administration ). The main advantage of issuing shares is that no interest has to
be paid on it and the company only have to provide a return when they actually make profits.

Rights Issue : A rights issue represents the offer of shares to the existing shareholders in
proportion to their existing holding at a lower price compared to the market value.

Advantages of Rights Issue over Public issue

• Rights issue are cheaper to administer and less risky way of raising capital

• Shareholders will get some incentive as they will get shares at a lower price.

Disadvantages

• Market price will fall

• The company could have raised more funds through a public issue

Bonus Issue: Is the issue of shares to existing shareholders for free .When the company is
short of cash and can’t give dividends so they give out shares for free to the ordinary
shareholders. Other reasons for bonus issue include.

• To utilize the capital reserves

• To increase confidence in the company’s future prospects as it is normally taken as a

signal of strength by the general public.

When doing bonus issue company will always use capital reserves first and then the revenue
reserves i.e.

We use share premium first and then revaluation reserve but if we don’t have enough
balance in both of these reserves then we will move to

• General Reserve

• Profit and Loss. ( Retained Earnings)

DEBENTURES  
 
A  debenture  is  a  document  containing  details  of  a  loan  made  to  a  company.  The  loan  may  be  secured  on  
the  assets  of  the  company,  when  it  is  known  as  a  mortgage  debenture.  If  the  security  for  the  loan  is  on  
certain  specified  assets  of  the  company,  the  debenture  is  said  to  be  secured  by  a  fixed  charge  on  the  
assets.  If  the  assets  are  not  specified,  but  the  security  is  on  the  assets  as  they  may  exist  from  time  to  
time,  it  is  known  as  a  floating  charge  on  the  assets.  An  unsecured  debenture  is  known  as  a  simple  or  
naked  debenture.  
Debentures  carry  the  right  to  a  fixed  rate  of  interest  which  forms  part  of  the  subscription  of  the  
debentures..  The  interest  must  be  paid  whether  or  not  the  company  makes  a  profit.  This  is  one  of  the  
distinctions  between  debentures,  and  shares  on  which  dividends  may  only  be  paid  if  profits  are  
available.  Debenture  interest  is  debited  as  an  expense  in  the  Profit  and  Loss  account  to  arrive  at  the  
profit  before  tax.  
 

RESERVES  
The  net  assets  of  the  company  are  represented  with  capital  and  reserves.  While  capital  represents  the  
claim  that  owners  have  because  of  the  number  if  shares  they  own,  reserves  represent  the  claim  that  
owners  have  because  of  the  wealth  created  by  the  company  over  the  years  but  not  distributed  to  them.  
There  are  two  main  types  of  reserves:  
Revenue  Reserve  
The  reserves  which  arise  from  profit  (Trading  activities  of  the  company).  These  are  transferred  from  the  
Appropriation  account.  Examples  include  General  Reserve  and  Retained  Profit  (Profit  and  Loss).  
Dividends  can  only  be  paid  to  the  amount  of  revenue  reserve  on  the  balance  sheet.  i.e.  the  maximum  
dividend  possible  is  the  sum  of  both  revenue  reserves.  
Capital  Reserve  
These  are  reserves  which  the  company  is  required  to  set  up  by  law  and  cannot  be  distributed  as  
dividends.  They  normally  arise  out  of  capital  transactions.  These  include  Share  Premium  and  Revaluation  
Reserve.  
Share  Premium  
Share  premium  occurs  when  a  company  issues  shares  at  a  price  above  its  nominal  (par)  value.  This  
excess  of  share  price  over  nominal  value  is  what  is  known  as  share  premium.  
What  are  the  uses  of  Share  Premium?  
1. Issue  Bonus  Shares  
2. Write  off  Formation  (Preliminary  Expenses)  
3. Write  off  Goodwill.  
Revaluation  Reserve    
 When  value  of  Assets  go  up  ,  companies  are  allowed  to  revalue  them  upwards  but  gain  has  to  
be  recorded  in  a  reserve  rather  then  income  statement  .  This  reserve  can  only  be  used  to  issue  
bonus  shares  or  devalue  the  same  asset  which  was  revalued  upwards  before  
 RATIOS  
 
PROFITABILITY  
 
GROSS  PROFIT  MARGIN       (   Gross  Profit   x      100   )  
                 Net  Sales  
While  the  gross  profit  is  a  dollar  amount,  the  gross  profit  margin  is  expressed  as  a  percentage  of  net  
sales.  The  Gross  Profit  Margin  illustrates  the  profit  a  company  makes  after  paying  off  its  Cost  of  Goods  
sold.  The  Gross  Profit  Margin  shows  how  efficient  the  management  is  in  using  its  labour  and  raw  
materials  in  the  process  of  production  (In  case  of  a  trader,  how  efficient  the  management  is  in  
purchasing  the  good).  There  are  two  key  ways  for  you  to  improve  your  gross  profit  margin.  First,  you  can  
increase  your  process.  Second,  you  can  decrease  the  costs  of  the  goods.  Once  you  calculate  the  gross  
profit  margin  of  a  firm,  compare  it  with  industry  standards  or  with  the  ratio  of  last  year.  For  example,  it  
does  not  make  sense  to  compare  the  profit  margin  of  a  software  company  (typically  90%)  with  that  of  an  
airline  company  (5%).  
 
Reasons  for  this  ratio  to  go  UP  (opposite  for  down)  
1. Increase  in  selling  price  per  unit  
2. Decrease  in  purchase  price  per  unit  due  to  lower  quality  of  goods  or  a  different  supplier.  
3. Decrease  in  purchase  price  per  unit  due  to  bulk  (trade)  discounts.  
4. Extensive  advertising  raising  sales  volume  (units)  along  with  selling  price.  
5. Understatement  of  opening  stock.  
6. Overstatement  of  closing  stock.  
7. Decrease  in  carriage  inwards/Duties  (trading  expenses)  
8. Change  in  Sales  Mix  (maybe  we  are  selling  some  new  products  which  give  a  higher  margin).  
 
NET  PROFIT  MARGIN       (   Operating  Profit   x      100   )  
               Net  Sales  
Net  profit  margin  tells  you  exactly  how  the  management  and  operations  of  a  business  are  performing.  
Net  Profit  Margin  compares  the  net  profit  of  a  firm  with  total  sales  achieved.  The  main  difference  
between  GP  Margin  and  NP  Margin  are  the  overhead  expenses  (Expenses  and  loss).  In  some  businesses  
Gross  Margin  is  very  high  but  Net  Margin  is  low  due  to  high  expenses,  e.g.  Software  Company  will  have  
high  Research  expenses.  
 
Reasons  for  this  ratio  to  go  UP  (opposite  for  down)  
All  the  reasons  for  GP  margin  apply  here.  Additionally  
1. Increase  in  cash  discounts  from  suppliers  
2. A  decrease  in  overhead  expenses  
3. Increase  in  other  incomes  like  gain  on  disposal,  Rent  Received  etc.  
Return  on  Capital  Employed  (ROCE)    
This  is  the  key  profitability  ratio  since  it  calculates  return  on  amount  invested  in  the  business.  If  this  ratio  
is  high,  this  means  more  profitability  (In  exam  if  ROCE  is  higher  for  any  firm  it  is  better  than  the  other  
firm  irrespective  of  GP  and  NP  Margin).  This  return  is  important  as  it  can  be  compared  to  other  
businesses  and  potential  investment  or  even  the  Interest  rate  offered  by  the  bank.  If  ROCE  is  lower  than  
the  bank  interest  then  the  owner  should  shoot  himself.  This  ratio  can  go  up  if  profits  increase  and  capital  
employed  remains  the  same.  Also  if  Capital  employed  decreases,  this  ratio  might  go  up.  
 
     Operating  Profit_     x   100  
   Capital  Employed  
                           Net  Profit  before  Interest  and  Tax  
 
 
Return  on  Total  Assets  
 
This  shows  how  much  profit  is  generated  on  total  assets  (Fixed  and  Current).  The  ratio  is  considered  and  
indicator  of  how  effectively  a  company  is  using  its  assets  to  generate  profits.  
 
   Operating  Profit_     x   100  
               Total  Assets  
 
Return  on  Shareholders’  Funds/Return  on  Net  Assets/Return  on  Owners  capital  
 
Since  all  the  capital  employed  is  not  provided  by  the  shareholders,  this  specifically  calculates  the  return  
to  the  shareholders  (It’s  almost  the  same  thing  as  ROCE)  
 
  Net  Profit  after  Tax   x   100  
  Shareholders  Funds  
 
            O.S.C  +  P.S.C  +  RESERVES  
NOTE:  
  Capital  Employed     =  Non  Current  Assets  +  Current  Assets  –  Current  
Liabilities  
 
  OR  
=    Total  Equity  +  Non  Current  Liabilities    
 
LIQUIDITY  AND  FINANCIAL  
 
As  we  know  a  firm  has  to  have  different  liquidity.  In  other  words  they  have  to  be  able  to  meet  their  day  
to  day  payments.  It  is  no  good  having  your  money  tied  up  or  invested  so  that  you  haven’t  enough  money  
to  meet  your  bills!  Current  assets  and  liabilities  are  an  important  part  of  this  liquidity  and  so  to  measure  
the  firms  liquidity  situation  we  can  work  out  a  ratio.  The  current  ratio  is  worked  out  by  dividing  the  
current  assets  by  the  current  liabilities.  
 
CURRENT  RATIO   =        Current  assets  _  
        Current  liabilities  
 
The  figure  should  always  be  above  1  or  the  form  does  not  have  enough  assets  to  meet  its  liabilities  and  
is  therefore  technically  insolvent.  However,  a  figure  close  to  1  would  be  a  little  close  for  a  firm  as  they  
would  only  just  be  able  to  meet  their  liabilities  and  so  a  figure  of  between  1.5  and  2  is  generally  
considered  being  desirable.  A  figure  of  2  means  that  they  can  meet  their  liabilities  twice  over  and  so  is  
safe  for  them.  If  the  figure  is  any  bigger  than  this  then  the  firm  may  be  tying  too  much  of  their  money  in  
a  form  that  is  not  earning  them  anything.  If  the  current  ratio  is  bigger  than  2  they  should  therefore  
perhaps  consider  investing  some  for  a  longer  period  to  earn  them  more.  
 
However,  the  current  assets  also  include  the  firm’s  stock.  If  the  firm  has  a  high  level  of  stock,  it  may  
mean  one  of  the  two  things,  
1. Sales  are  booming  and  they’re  producing  a  lot  to  keep  up  with  demand.  
2. They  can’t  sell  all  they’re  producing  and  it’s  piling  up  in  the  warehouse!  
 
If  the  second  of  these  is  true  then  stock  may  not  be  a  very  useful  current  asset,  and  even  if  they  could  
sell  it  isn’t  as  liquid  as  cash  in  the  bank,  and  so  a  better  measure  of  liquidity  is  the  ACID  TEST  (or  
QUICK)  RATIO.  This  excludes  stock  from  the  current  assets,  but  is  otherwise  the  same  as  the  current  
ratio.  
 
ACID  TEST  RATIO   =   Current  assets  –  stock  
               Current  liabilities  
 
Ideally  this  figure  should  also  be  above  1.5  for  the  firm  to  be  comfortable.  That  would  mean  that  they  
can  meet  all  their  liabilities  without  having  to  pay  any  of  their  stock  and  still  have  some  buffer.  This  
would  make  potential  investors  feel  more  comfortable  about  their  liquidity.  If  the  figure  is  below  1,  they  
may  begin  to  get  worried  about  their  firm’s  ability  to  meet  its  debts.  
 
 
 
Note  :  Working  Capital  =  Current  Assets  –  Current  Liabilities  
  
Rate  of  Stock  Turnover  
 
It  shows  the  number  of  times,  on  average,  that  the  business  will  sell  its  stock  in  a  given  period  of  time.  It  
basically  gives  an  indication  of  how  well  the  stock  has  been  managed.  A  high  ratio  is  desirable  because  
the  quicker  the  stock  is  turned  over,  more  profit  can  be  generated.  A  low  ratio  indicates  that  stocks  are  
kept  for  a  longer  period  of  time  (which  is  not  good).  
 
    Cost  of  Goods  Sold     =   ____  Times          (  higher  the  better)  
           Average  Inventory  
 
 
 
Inventory  Days:  
This  is  Rate  of  Inventory  turnover  in  days.  Lower  the  better.  
 
       Average  Inventory              x  365  =   ____  Days                  (  lower  the  better)  
    Cost  of  Goods  Sold  
 
Trade  Recieveables  Days(  Collection  Period)  
Shows  how  long  it  takes  on  average  to  recover  the  money  from  debtors.  Lower  the  better.  
 
         Closing  Trade  Receiveables            x  365   =   ____  Days                                    (lower  
the  better)  
             Credit  Sales  
 
Trade  Payables  Days:  (Payment  Period)  
Shows  how  long  it  takes  on  average  to  payback  the  creditors.  Higher  the  better.  
 
       Closing  Trade  Payables  x  365   =   ____  Days  
           Credit  Purchases  
 
Note:  
  Average  Inventory     =   Opening  +  Closing  
                                 2  
 
 
  
 
Utilization  Ratios  (All  higher  the  better)  
 
Total  Asset  utilization  (Total  Asset  Turnover)  
 
Shows  how  much  sales  are  being  generated  on  Total  Assets.  Higher  ratio  indicates  better  utilization  of  
Total  Assets.  
         Net  Sales         =   ____  Times  
    Total  Assets  
 
 
 
Non  Current    Asset  Utilization  (Non  Current  Asset  Turnover)  
 
Shows  how  much  sales  are  being  generated  on  Non  current  assets.  Higher  ratio  indicates  better  
utilization  of.  
         Net  Sales         =   ____  Times  
    Non  Current  Assets  
 
Working  Capital  Utilization  (Working  Capital  Turnover)  
 
Sows  how  much  sales  are  being  generated  on  Working  Capital.  Higher  ratio  indicates  better  utilization  of  
Working  Capital.  
                   Net  Sales                 =   ____  Times  
    Working  Capital  
 
Advantages  of  Ratios  
1. Shows  a  trend  
2. Helps  to  compare  a  single  firm  over  a  two  years  (time  –  series)  
3. Helps  to  compare  to  similar  firms  over  a  particular  year.  
4. Helps  in  making  decisions  
 
 
 
 
 
 
  
 
Disadvantages  (Limitations):  
1. A  ratio  on  its  own  is  isolated  (We  need  to  compare  it  with  some  figures)  
2. Depends  upon  the  reliability  of  the  information  from  which  ratios  are  calculated.  
3. Different  industries  will  have  different  ideal  ratios.  
4. Different  companies  have  different  accounting  policies.  E.g.  Method  of  depreciation  used.  
5. Ratios  do  not  take  inflation  into  account.  
6. Ratios  can  over  simplify  a  situation  so  can  be  misleading.  
7. Outside  influences  can  affect  ratios  e.g.  world  economy,  trade  cycles.  
8. After  calculating  ratios  we  still  have  to  analyze  them  in  order  to  derive  a  conclusion.  
 
How  to  Comment:  
Usually  in  CIE  they  assign  2  marks  for  comment  on  each  ratio.  One  mark  is  for  indicating  if  the  ratio  is  
better  or  worse  (not  higher  or  lower).  The  second  mark  is  to  explain  the  importance  or  the  reason  of  the  
change  in  ratio.  For  e.g.  If  Gross  Profit  Margin  was  40%  and  now  its  50%,  you  should  say  that  the  Gross  
profit  Margin  has  improved  (rather  than  increased)  and  this  may  be  due  to  an  increase  in  selling  price  or  
a  decrease  in  cost  of  goods  sold  (depending  upon  the  question).  
 
Also  remember  that  the  liquidity  and  utilization  ratios  should  be  close  to  industry  average.  Too  less  or  
too  much  liquidity  is  bad!  
 
At  the  end  of  your  answer,  always  give  a  conclusion  
• When  comparing  a  single  firm  over  two  years  then  do  mention  performance  of  which  year  is  
better.  (In  terms  of  profitability  and  liquidity)  
• When  comparing  two  different  firms  over  the  same  year  do  mention  performance  of  which  firm  
is  better.  (In  terms  of  profitability  and  liquidity).  
 
 
If  the  question  says  evaluate  profitability  then  use  (GP  Margin,  NP  Margin  and  ROCE)  
 
If  the  question  says  evaluate  liquidity,  use  (Current  Ratio,  Acid  Test  and  Rate  of  Stock  Turnover)    
 
If  the  question  says  evaluate  the  performance  it  means  both  profitability  and  liquidity.  
 
Best  way:  
 
3  –  Profitability  
2  –  Liquidity  &  
1  –  Utilization  
 
  
 
INVENTORY  VALUATION  (  STOCK)  
 
Remember  stock  is  valued  at  lower  of  cost  or  net  realisable  value  (N.R.V).  This  is  basically  the  current  
market  value  of  the  stock  after  deducting  any  repair  cost.  This  is  application  of  the  prudence  concept.  
E.g.  If  a  piece  of  stock  costing  $40  is  damaged.  Now  it  can  be  sold  for  $48  but  only  if  $10  of  repair  is  
undertaken.  This  means  the  NRV  of  stock  is  38  (48  –  10).  Since  NRV  (38)  is  lower  than  the  cost  (40),  we  
should  value  it  as  38.  It  lets  say  the  NRV  was  $41,  then  than  the  stock  would  have  been  valued  at  $40.  
 
Assumptions  in  Stock  Valuations  
 
FIFO  
Advantages  
1. Good  representation  of  sound  storekeeping  as  oldest  stock  is  issued  first.  
2. Stock  is  shown  close  to  the  current  market  value  (because  it  is  valued  at  most  recent  price)  
3. This  method  is  acceptable  by  accounting  regulations  
Disadvantages  
1. In  inflation  stock  is  valued  the  highest  and  it  overstates  profit  
2. Since  the  value  of  stock  issued  fluctuates,  this  will  lead  to  a  different  cost  for  an  identical  unit.  
AVCO  
Advantages  
1. Since  the  value  of  stock  issued  does  not  fluctuate,  this  will  lead  to  a  same  cost  for  an  identical  
unit.  
2. This  method  is  acceptable  by  accounting  regulations.  
Disadvantages  
1. Difficult  to  calculate.  
2. Average  price  does  not  represents  the  true  value  of  stock  
 
 
 
 
 
 
 
 
 
 
 
 
  
ACCOUNTING  CONCEPTS  
 

TABLE/SUMMARY/SNAPSHOT  OF  ACCOUNTING  CONCEPTS/CONVENTION  

   
Accounting  period   Also  known  as  Time  Period  where  business  operation  can  be  
Concept   divided  into  specific  period  of  time  such  as  month,  a  quarter  or  a  
year  (accounting  period)  
 
Final  accounts  are  prepared  at  the  end  of  the  accounting  period,  
i.e.  one  year.  Internal  accounts  can  be  prepared  monthly,  
quarterly  or  half  yearly.  
 
   
Accrual  Concept  /   Requires  all  revenues  and  expenses  to  be  taken  into  account  for  
Matching   the  period  in  which  they  are  earned  and  incurred  when  
determining  the  profit  /  (loss)  of  the  business.  The  net  profit  /  
(loss)  is  the  difference  between  the  revenue  EARNED  and  the  
expenses  INCURRED  and  not  the  difference  between  the  revenue  
RECEIVED  and  expenses  PAID.  
Major  application  of  this  concept  is    
1. prepayments  and  accruals  
2. Depreciation  of  Non  current  Assets  
3. Bad  debts  and  Provision  for  doubtful  debts  
4. Capitalization  of  development  cost  
 
   
Business  Entity   Also  known  as  Accounting  Entity  or  Separate  Entity  convention  
which  states  that  the  business  is  an  entity  or  body  separate  from  
its  owner.  Therefore  business  records  should  be  separated  and  
distinct  from  personal  records  of  business  owner.  
Major  application  of  this  concept  is    
1. Capital  accounts  and  Drawings  account  are  kept  for  the  
owner  
2. Owners  personal  transactions  are  not  recorded  in  business  
books    
 
   
Consistency  Concept   According  to  this  convention,  accounting  practices  should  remain  
unchanged  from  one  period  to  another  unless  there  is  a  proper  
need  to  change  them.  For  example,  if  depreciation  is  charged  on  
non  current  assets  according  to  a  particular  method,  it  should  be  
done  year  after  year.  This  is  necessary  for  purpose  of  comparison.  
But  if  a  wrong  policy  has  been  applied  in  the  previous  years  like  
straight  line  method  for  Machinery  then  we  can  change  the  policy  
to  reducing  balance  method  (  the  change  must  be  disclosed  in  the  
accounts  to  the  stakeholders)  
  
   
Dual  Aspect  Concept   Double  entry  system.  For  every  debit,  there  is  a  credit  entry  of  an  
equal  amount.  All  transactions  in  accounting  are  recorded  in  this  
form.  
 
   
Going  Concern  Concept   The  business  will  follow  accounting  concepts  and  methods  on  the  
assumption  that  business  will  continue  its  operation  to  the  
foreseeable  future  or  for  an  indefinite  period  of  time.  The  major  
application  of  this  concept  is  that  we  record  our  assets  at  cost  less  
estimated  deprecation  rather  then  the  market  values  .  Since  we  
know  that  the  market  values  will  keep  on  changing  and  we  have  to  
continue  our  business  .  BUT  if  the  business  is  about  to  shut  down  
then  the  Non  current  assets  must  be  shown  at  market  values  (  
disposal  values)    
 
  Business  should  report  its  activities  or  economic  events  at  their  
Historical  Cost  Concept   actual  costs.  For  example,  Non  current  assets  are  recorded  at  their  
cost  in  account  except  for  land  which  can  be  revalued  due  to  
appreciation  
 
  The  concept  of  materiality  recognises  that  some  types  of  
Materiality  Concept   expenditure  are  less  important  in  a  business  context  than  others.  
So,  absolute  precision  in  the  recording  of  these  transactions  is  not  
absolutely  essential.    

For  example  :  A  business  purchases  a  ruler.  The  ruler  costs  $0.45.  

It  estimated  that  the  ruler  should  last  for  three  years.  Technically,  
the  ruler  is  a  non-­‐current  asset  and  should  therefore  be  classified  
as  capital  expenditure.  To  do  this  would  be  rather  silly  for  such  a  
trivial  amount.  The  $0.45  would  be  treated  as  revenue  
expenditure  and  would  be  debited  to  either  general  expenses  or  
office  expenses.  This  treatment  is  not  going  to  have  a  significant  
impact  on  profits  or  the  valuation  of  net  assets  on  a  statement  of  
financial  position  –  the  absolute  accuracy  of  its  treatment  is  not  
material.    

   
Money  Measurement   Also  known  as  Monetary  unit.  Transactions  related  to  the  
Concept   business,  and  having  money  value  are  recorded  in  the  books  of  
accounts.  Events  or  transactions  which  cannot  be  expressed  in  
term  of  money  do  not  find  a  place  in  the  books  of  accounts.  For  
example  motivation  /  skill  /  morale  of  employees  cannot  be  
recorded  in  accounts.  Also  the  internally  generated  goodwill  of  the  
business  should  be  written  off  immediately    
 
   
 Prudence  /  Conservatism   Take  into  account  unrealized  losses,  not  unrealized  profits/gains.  
Concept   Assets  should  not  be  over-­‐valued,  liabilities  under-­‐valued.  
Provisions  are  example  of  prudence  or  conservatism  concept.  Also  
under  this  prudence/conservatism  concept,  stock/inventory  is  
value  at  lower  of  cost  or  market  value.  This  concept  guides  
accountants  to  choose  option  that  minimize  the  possibility  of  
overstating  an  asset  or  income.  Major  Applications  include  
1. Provision  for  doubtful  debts  
2. Provision  for  depreciation  
3. Valuation  of  inventory  
4. Writing  off  goodwill  
 
   
Substance  Over  Form   Real  substance  takes  over  legal  form  namely  we  consider  the  
economic  or  accounting  point  of  view  rather  than  the  legal  point  
of  view  in  recording  transactions.  Major  application  is  when  we  
are  leasing  the  assets  we  don’t  have  the  legal  ownership  but  the  
economic  benefits  do  flow  towards  the  firm  so  it  is  recorded  as    an  
asset  .  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
COST  ACCOUNTING  
 
What  is  Cost  Accounting?  
 
Cost  accounting  is  basically  the  determination  of  cost  whether  for  a  specified  thing  or  activity.  To  
determine  cost,  we  need  to  apply  accounting  and  costing  principles  and  techniques.  The  cost  accounting  
information  is  used  within  the  business  for  planning,  controlling  and  decision  making.  
 
What  is  a  Cost  Centre?  
 
Cost  centre  is  the  area  or  a  department  in  a  business  for  which  cost  are  accumulated.  There  are  two  
main  types  of  Cost  Centres  
• Production  Cost  Centre:  Departments  which  are  involved  directly  in  production  of  a  product.  For  
example,  Moulding,  Cutting  or  Assemble  Department.  
• Service  Cost  Centre:  Departments  in  which  production  doesn’t  take  place  but  they  provide  
service  to  the  production  departments.  For  example:  store  Department  or  Maintenance  
Department.  
What  is  a  Cost  Unit?  
Costs  are  always  related  to  some  object  or  function  or  service.  For  example,  the  cost  of  a  car,  a  haircut,  a  
ton  of  coal  etc.  Such  units  are  known  as  cost  units  and  can  be  defined  as  
 
‘A  unit  of  product  or  service  in  relation  to  which  costs  are  determined’.  
 
Cost  unit  may  be  units  of  production,  e.g.  kilos  of  cement,  gallons  of  beer  OR  may  be  units  of  service,  
e.g.  consulting  hours,  Patient  nights,  Kilowatt  hour.  
 
How  is  cost  classified?  
 
There  are  three  possible  classifications  
 
• Type  1:  Direct  and  Indirect  Cost  (classification  as  per  traceability  of  cost)  
 
Direct  cost:  This  includes  all  such  cost  which  can  easily  be  traced  to  the  item  being  manufactured.  E.g.  
Direct  Material,  Direct  Labour  and  Direct  Expenses  (royalties  or  artwork).  There  can  also  be  Direct  Selling  
Cost  like  Installation  or  Sales  Commission.  
 
Indirect  Cost:  All  the  cost  which  cannot  be  easily  traced  to  the  item  is  the  Indirect  Cost.  These  are  widely  
known  as  Overheads.  Overheads  can  be  production  or  non-­‐production  (selling  and  administration).  
 
 
 • Type  2:  Production  and  Non-­‐Production  Cost  (classification  as  per  function)  
Any  cost  which  is  incurred  in  manufacturing  the  item  is  referred  as  Production  Cost.  All  the  other  cost  is  
Non  production  (Selling  )  ,  Non  production  (  Administration  )  ,  Non  Production  (  Financial  charges).      
 
• Type  3:  Variable  and  Fixed  Cost  (  classification  as  per  behavior  of  cost)  
Variable  Cost:  Those  cost  that  change  in  total  in  direct  proportion  to  changes  in  level  of  activity.  An  
increase/decrease  in  activity  brings  proportional  increase/decrease  in  total  variable  cost.  E.g.  Direct  
Material,  Direct  Labor.  Always  remember  Variable  Cost  per  Unit  will  remain  constant.  
 
Fixed  cost:  Those  cost  that  DOES  NOT  change  regardless  of  changes  in  activity  level.  E.g.  Rent,  
Depreciation  etc.  Fixed  Cost  does  not  change  in  Total  but  Fixed  Cost  per  unit  will  decrease  as  more  units  
are  produced.  
 
Semi  Variable  (Mixed)  Cost:  Include  both  fixed  and  variable  elements.  For  example  Repairs,  
Maintenance  and  Electricity.  

     
 
For  example  the  cost  of  a  service:  $2  per  unit  produced  up  to  a  maximum  of  $5  000  per  year  will  show  
the  following  pattern  on  a  graph:  
 

 
Another  example  of  semi-­‐variable  costs  in  the  form  of  standing  charge  of  $2  500  for  maintenance  
charges  for  a  specific  level  plus  a  charge  of  $  5  per  unit  to  a  maximum  of  $10  000  per  year,  will  show  the  
following  outline  on  a  graph:  

 
 
The  graphs  for  the  fixed  cost  per  unit  and  variable  cost  per  unit  look  exactly  opposite  to  total  fixed  costs  
and  total  variable  costs  graphs.  Although  total  fixed  costs  are  constant,  the  fixed  cost  per  unit  changes  
with  the  number  of  units.  The  variable  cost  per  unit  is  constant.  
 

                               
 
What  is  the  difference  between  direct  cost  and  variable  cost?  
 
The  direct  cost  is  directly  related  to  a  product  and  it  can  be  easily  traced  to  the  item  being  manufactured  
but  it  does  not  include  any  type  of  variable  overheads.  The  variable  cost  includes  all  direct  cost  and  
variable  overheads  as  well.  For  e.g.  the  variable  part  of  the  electricity.  
 
 
 
 
What  is  a  Sunk  Cost?  
 
This  is  an  expenditure  which  has  already  been  incurred  and  it  has  no  importance  in  future  decision  
making  since  the  cost  has  already  been  spent.  For  example,  a  business  conducts  a  feasibility  study  of  
buying  a  new  machine  and  incurs  an  expense  of  $5  000.  Now  whether  the  machine  is  brought  or  not,  
$5,000  has  already  been  spent  and  cannot  be  recovered,  so  we  should  not  consider  them  in  decision  
making.  This  cost  is  treated  as  an  expense  in  the  profit  and  loss  account  for  the  year.  Other  example  
would  be  cost  incurred  on  market  research  before  launching  a  new  product.  
 
What  is  the  effect  on  variable  cost  line  for  bulk  purchase  discount  on  purchase  of  raw  materials?  
 
Sometimes,  suppliers  offer  bulk  purchase  discount  to  a  manufacturing  business.  For  example,  if  a  
business  purchases  1  000  units,  a  price  of  $5  may  be  charged  per  unit.  On  additional  1  000  units,  the  
price  may  be  reduced  to  $4.50  per  units  and  so  on.  It  will  reflect  the  following  image  on  the  graph  paper  
and  it  is  known  as  saw-­‐tooth  curve.  
 

 
 
 
 
 
 
What  is  Stepped  Cost?  
This  is  type  of  cost  which  is  constant  till  a  certain  level  of  Activity  (Relevant  Range)  but  it  will  increase  
significantly  as  the  activity  level  increases.  For  example  Rent  is  constant  till  the  factory  maximum  
capacity  is  reached  but  then  we  need  another  factory  to  increase  production  so  the  rent  will  double.    If  
we  plot  this  on  a  graph  it  will  look  like.  
 
 
  
 
 
 
 
 

                                                                                                       ABSORPTION  COSTING  
 
What  is  Absorption  Costing?  
 
It  is  a  costing  method  in  which  the  overheads  (estimated)  of  a  manufacturing  business  are  charged  first  
to  a  cost  centre  (departments)  by  means  of  allocation  and  apportionment  and  then  a  predetermined  
overhead  absorption  rate  is  calculated  to  charge  the  amount  of  overheads  onto  a  job  or  a  product.  The  
overheads  may  be  absorbed  on  the  basis  of  activity  like  direct  labor  hours,  machine  hours  or  direct  labor  
cost  or  direct  material  cost.  The  basis  of  absorption  depends  upon  the  intensity  of  the  department.  E.g.  
a  machine  intensive  department  would  use  machine  hours.  
 
What  is  Overhead  Absorption  rate?  
 
A  manufacturer  needs  to  calculate  the  total  cost  of  the  product  before  he  actually  produces  it.  This  is  
because  once  the  total  cost  is  determined,  he  or  she  can  set  the  selling  price.  Since  the  Overhead  cost  is  
not  easy  to  trace,  a  rate  is  calculated  in  order  to  trace  the  overheads  as  per  the  level  of  activity.  For  
example,  if  the  overhead  Absorption  Rate  is  $3  per  direct  labor  hour  and  a  particular  unit  requires  4  
hours  of  labour,  the  amount  of  Overheads  charged  will  be  $3  x  4  hours  =  $12.  
 
Formula  for  Overhead  Absorption  Rate  (OAR)  =                            Budgeted  Overheads                      _  
            Budgeted  Activity  (e.g.  Labor  hours)  
 
Why  do  we  use  Budgeted  figures?  
  
As  mentioned  above,  cost  has  to  be  determined  before  the  actual  production  takes  place.  The  actual  
overheads  and  activity  is  not  known  at  that  point.  This  would  make  it  impossible  to  quote  the  selling  
price  to  the  customer.  
 
How  are  Overheads  Allocated  and  Apportioned  to  the  departments?  
 
Firstly  all  the  overheads  are  split  amongst  the  department  by  using  suitable  basis.  For  some  overheads  
we  don’t  need  to  use  basis  because  they  are  pre  allocated,  e.g.  indirect  materials  (they  are  usually  
divided  between  the  departments),  and  some  overheads  need  to  be  apportioned  using  suitable  basis,  
e.g.  rent  can  be  split  on  basis  of  floor  area.  Once  all  the  overheads  are  shared  to  departments  (Primary  
Apportionment),  the  cost  of  service  departments  is  re-­‐apportioned  (Secondary  Apportionment)  to  the  
production  department  since  they  provide  service  to  the  production  departments.  
   
Some  factories  do  not  split  the  overheads  into  different  departments  and  just  calculate  a  single  
overhead  absorption  rate  for  the  whole  factory.  This  method  is  less  accurate  than  the  method  in  which  
separate  rates  are  calculated  for  each  department.  
 
 
What  is  Over  or  Under  absorption  of  overheads?  
 
The  Overhead  Absorption  Rate  is  calculated  using  budgeted  figures  but  the  actual  figures  of  overheads  
and  activity  are  always  different.  This  causes  a  difference  between  the  amount  of  overheads  absorbed  
and  the  actual  overheads  spend.  
 
Remember  Absorbed  Overheads  mean  the  amount  of  overheads  we  have  applied  to  our  cost  of  
production.  
 
Absorbed  Overheads  =  Budgeted  Overheads   x            Actual  Activity  
         Budgeted  Activity  
 
To  determine  the  amount  of  overhead  absorbed  and  under  absorbed  always  compare  the  Absorbed  
Overheads  with  Actual  Overheads.  
 
Over  Absorption  occurs  when  Absorbed  Overheads  are  more  that  the  Actual  Overheads  (that’s  why  its  
called  Over  Absorbed,  Absorbed  is  more).  This  basically  means  we  have  over  charged  the  cost.  (Should  
be  treated  as  a  gain  in  the  profit  statement  because  profit  is  understated).  
 
Under  Absorption  occurs  when  Absorbed  Overheads  are  less  than  the  Actual  Overheads  (that’s  why  it’s  
called  Under  Absorbed,  Absorbed  is  less).  This  basically  means  we  have  under  charged  the  cost.  (Should  
be  treated  as  a  loss  in  profit  statement  because  profit  is  overstated)  
 
Another  way  is  using  this  formula  
This  can  be  calculated  by  comparing  budgeted  OAR  with  the  Actual  OAR.    
Formula      (Budgeted  OAR  –ACTUAL  OAR  )    *  Actual  Hours  
Positive  answer  would  give  over  absorbed  and  negative  will  give  under  absorbed.  
 
 
What  are  different  types  of  Overhead  Absorption  Rates  (OAR)  
 Overhead  absorption  rate  can  be  calculated  on  different  basis.  Remember  that  best  methods  to  use  
are  either  machine  hour  or  labor  hour  ,  depending  upon  if  the  department  (or  the  factory)  is  machine  
intensive  or  labor  intensive.  But  following  OAR’S  are  used  by  different  businesses.  
1. Machine  Hours  
2. Labor  Hours  
3. Direct  Wages  (Direct  Labor  Cost)    
4. Direct  Material  (Direct  Material  Cost)  
5. Prime  Cost  
6. Per  Unit  Rate  
 
 
 
 
Which  Rate  is  Most  Appropriate  ?  
 Like  I  said  before  time  based  rates  like  machine  hour  and  labor  hour  are  the  most  appropriate  
depending  on  the  intensity  of  the  factory.  The  other  rates  are  useful  when  
 Per  Unit  Rate  :    If  all  products  produced  are  very  similar  in  nature      
 Direct  Labor  Cost  Rate  :  If  similar  products  and  labor  is  paid  uniformly  
Direct  Material  Cost  Rate  :    Material  of  uniform  value  ,  production  time  proportional  to  
material  usage  ,similar  type  of  equipment  used  in  all  products  
 
However  the  machine  hour  rate  (  if  capital  intensive  )  and  labor  hour  rate  (  if  labor  intensive  )  
are  used  most  widely.  
 
What  are  the  problems  with  using  pre-­‐determined  (  Budgeted  OAR)  ?  
 
Use  of  estimated  data  can  lead  to  inaccurate  costing  and  results  in  over  or  under  absorption  of  
overheads.  If  the  cost  absorbed  is  too  low  (  under  absorbed)  this  will  lead  to  an  understated  cost  which  
will  effects  profit  of  the  business  (  as  our  selling  price  based  on  budgeted  cost  will  be  low).  On  the  other  
hand  if  absorbed  cost  is  too  high  (  over  absorbed)    this  will  overstate  cost  making  the  product  
uncompetitive  and  will  reduce  demand.  
 
 
  
What  is  a  good  format  to  show  the  total  cost  of  any  order/job/unit/batch?  
 
Direct  Material  
+   Direct  Labor  
+   Direct  production  expense  (if  any)  e.g.  royalties  or  artwork.  
=   Prime  Cost  
Add:   Factory  Overheads  
+   Department  A  
+   Department  B  
=   Cost  of  Production  
Add:   Selling  and  Admin  cost  (if  any)  
  Installation  or  Delivery  
  General  Admin  Overheads  
=   Total  Cost  
 
                                                               
 
 
 
Marginal  Costing  
 
It  is  a  costing  technique  for  decision  making,  which  is  based  on  marginal  (variable)  cost  of  a  product.  It  
emphasizes  on  cost  behavior  and  clearly  distinguishes  between  variable  cost  and  fixed  cost.  It  is  based  
on  the  principle  that  due  to  change  in  level  of  activity  only  the  variable  cost  change  and  the  fixed  cost  
remain  constant.  
 
What  is  a  marginal  cost?  
This  is  all  the  variable  cost  to  produce  and  sell  a  unit.  It  may  be  described  as  the  additional  cost  to  
produce  and  sell  each  additional  unit.  This  includes  Direct  Material  (DM),  Direct  Labor  (DL),  Direct  
Expenses,  Variable  Production  Overheads  and  Variable  Admin  Overheads  and  Variable  Selling  
Overheads.  Basically  the  entire  possible  variable  cost.  
 
What  is  Contribution?  
This  is  amount  left  to  cover  for  fixed  cost  and  profit.  
 
Total  Contribution  =  Sales  –  Variable  Cost  (Marginal  Cost)  
 
Contribution/  unit  =  Selling  Price/  unit  –  Variable  Cost  
      Or  
 
Contribution/  unit  =  Total  Contribution/  number  of  units  
 
Note:  Sales  –  Variable  Cost  =  Contribution  –  Fixed  Cost  =  Profit  
  So  Contribution  =  Fixed  Cost  +  Profit  
 
As  mentioned  above  the  amount  for  fixed  cost  and  profit.  
 
 
 
 
 
 
 
 
 
USES  OF  MARGINAL  COSTING  (INCLUDES  THE  RULES  FOR  DECISION  
MAKING)  
 
Marginal  costing  is  widely  used  by  the  managers  in  making  various  business  decisions.  The  concept  is  
that,  it  is  assumed  that  the  fixed  cost  will  not  change  so  all  decisions  are  based  keeping  this  fact  in  mind.  
 
• Provides  quick  calculation  of  total  cost.  As  the  fixed  cost  remains  constant  and  only  the  variable  
cost  changes  
    Total  Cost  =  (variable  cost/  unit  x  no.  of  units)  +  Fixed  cost  
 
• Provides  quick  calculation  of  profit  at  different  levels    
               Profit  =  (Contribution/  unit  x  no.  of  units)  –  Fixed  Cost  
• Used  in  break-­‐even  analysis  (see  below)  
 
• Helps  in  making  decision  on  whether  to  make  a  product  or  buy  from  outside.  
 
  Rule:  Only  buy  from  outside  if  his  price  is  lower  than  our  variable  cost  to  produce  
  (variable  cost  to  producer  does  not  include  variable  selling  overheads)  
 
• Helps  in  decision  making  on  acceptance  or  rejection  of  special  orders  under  idle  capacity.  
 
  Rule:  Accept  all  orders  under  idle  capacity  as  long  as  it  covers  the  variable  cost.  
  In  other  words,  it  gives  a  positive  contribution.  
 
• Helps  in  making  decision  on  whether  to  continue  or  discontinue  a  product.  
  
Rule:  Continue  products  giving  positive  contribution  unless  a  replacement  product  can  
generate  more  positive  contribution.  Discontinue  the  product  giving  negative  
contribution.  This  is  because  the  fixed  cost  should  be  ignored  as  it  doesn’t  changes  with  
decision  to  continue  or  discontinue.  Hence  a  product  which  is  making  a  loss  (negative  
net  profit)  but  is  giving  a  positive  contribution  should  not  be  discontinued.  
 
Similarly  a  product  which  might  give  a  positive  contribution  should  be  added  to  current  product  
range.    
 
 
 
 
 
 
COMPARISON  OF  ABSORPTION  AND  MARGINAL  COSTING  
   
 
  ABSORPTION  COSTING   MARGINAL  COSTING  
1.   It  is  based  on  total  production  cost  including   It  is  based  only  on  variable  cost.  
variable  and  fixed  costs.  
2.   It  divides  cost  into  production  and  non   It  divides  cost  between  variable  and  fixed.  
production  
3.   Stocks  include  the  total  production  cost  (DM,   Stocks  include  only  the  variable  production  
DL,  VPOH  and  FPOH)   cost  (DM,  DL  and  VPOH)  
4.   It  is  more  suitable  for  external  use  as  the   It  is  more  suitable  for  internal  use  as  
profit  and  loss  is  based  on  this.   decisions  are  based  on  this  
5.   Treats  fixed  cost  as  a  product  cost.   Treats  Fixed  cost  as  a  period  cost.  
6.   Gives  Gross  Profit   Gives  Contribution.  
7.   Required  adjustment  for  Over  and  Under   No  adjustment  is  required  as  actual  fixed  cost  
Absorbed.   is  taken.  
 
 

Breakeven  Analysis  
Formulas:  
Contribution  to  Sales  Ratio  =  Contribution  per  unit/  Selling  price  per  unit  Or  
                   (csratio)                                                                                  Total  Contribution/Total  Sales  
 
Breakeven  in  Units  =   Fixed  Cost  /  Contribution  per  unit  
Breakeven  in  value  (Sales  Revenue)  =  Breakeven  in  Units  x  Selling  Price  /  Unit  or    Fixed  Cost/Cs  Ratio  
Margin  of  Safety:      
This  represents  the  difference  between  the  actual  (or  budgeted)  level  of  activity  and  the  breakeven  level  
of  activity.  For  e.g.  if  a  factory  produces  (or  plans  or  produce)  6  000  units  and  the  breakeven  is  at  2  000  
units,  this  means  4  000  units  are  in  margin  of  safety.  
Margin  of  safety  provides  an  assessment  of  risk    by  indicating  the  extent  to  which  expected  output  can  
fall    before  a  loss  is  made  .  It  shows  the  ability  to  withstand  adverse  trading  conditions    

 
Margin  of  Safety  in  Units:  =  Sales  (Units)  –  Breakeven  Units  
 
Margin  of  Safety  in  Value:  =  Margin  of  Safety  in  Units  x  Selling  Price  per  Unit  
 
Margin  of  Safety  as  a  %  =  Margin  of  Safety  units  /  Sales  (Units)  x  1  000  
 
Sales  for  Target  Profit  =  Fixed  Cost  +  Target  Profit  
         C  S  Ratio  
 
  Assumption   Limitations  
1.   Fixed  Cost  remains  constant.   Fixed  cost  might  change  at  some  level  
2.   Total  cost  are  divided  into  variable  and   It  is  difficult  to  perfectly  do  that.    
fixed.   Majority  of  cost  are  semi-­‐variable.  
3.   Variable  cost  per  unit  remains  constant   Economies  of  scale  and  bulk  discounts  
and  is  perfectly  proportional   will  affect  this.  
4.   Selling  Price  unit  remains  constant.   Increase  in  sales  volume  may  require  a  
price  reduction  
5.   Technology  and  efficiency  remain   Changes  in  them  will  definitely  take  
unchanged   place.  
6.   There  are  no  stock  levels   Every  business  will  have  stock  levels  
 
Note:  due  to  the  assumptions,  the  usefulness  of  breakeven  analysis  is  limited.  
 
 
 
 
 
 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
Example:    Through  Diagram  
    Fixed  Cost      =   $20  000  
    Variable  Cost  /  Unit     =   $6  
    Selling  Price  /  Unit   =   $10  
    Units       =   10  000  Units  
 
 
How  is  break-­‐even  found  on  the  graph?  
 
Continuing  the  above  example,  the  following  steps  are  illustrated  to  draw    break-­‐even  graph:  
 
Step  1:   The  horizontal  line  is  knows  as  X-­‐axis.  Draw  X-­‐axis  for  number  of  units  at  the  distance  of  
1  000  each  and  up  to  10  000  units.  The  vertical  line  is  known  as  Y-­‐axis.  Draw  Y-­‐axis  for  
cost  and  revenue  up  to  $100  000  at  the  distance  of  $10  000  each  on  the  graph  paper.  
  

Where  the  two  axes  meet  is  called  the  origin  and  it  denotes  zero  for  both  axes.  
 
 
 
 
 
 
 
Step  2:     Draw  fixed  cost  line  parallel  to  x-­‐axis  for  $20  000  as  follows:  
  
 
 
 
 
 
 
 
 
 
 
 
 
 
Step  3:   Draw  total  cost  line.  It  will  begin  from  $20  000  on  Y-­‐axis.  The  total  costs  are  equal  to  
fixed  cost  plus  variable  cost  that  is  $20  000  +  ($6  x  10  000  =  $60  000)  =  $80  000,  as  
follows:  
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Step  4:   Draw  sales  revenue  line,  it  will  begin  from  origin.  The  total  sales  revenue  is  $100  000  
(i.e.  $10  x  10  000)  

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Step  5:   Mark  the  Break-­‐Even  point.  The  break-­‐even  point  is  the  interaction  of  total  sales  line  
and  total  cost  line,  as  follows:  

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Step  6:   Mark  the  following  point  on  the  break-­‐even  chart:  
 
    A  =  Profit  
     B  =  Loss  
    C  =  Margin  of  safety  in  value  
    D  =  Margin  of  safety  in  units  
    E  =  Margin  of  safety  percentage.  
 
 
 

E  =  Margin  of  
 Safety  ratio  
C  =  Margin  of  
Safety  in  value  

A  =  Profit  

B  =  Loss  

D  =  Margin  of  
safety  in  units  

 
 
 
 
 
 
 
 
 
 
 
 
 
 
What  is  profit-­‐volume  chart?  
  
The  profit-­‐volume  chart  is  the  alternate  graphical  method  used  for  breakeven  analysis.  It  shows  the  
relationship  between  costs  and  revenues  and  it  basically  focuses  on  profits  and  losses  at  different  level  
of  activities.  It  shows  break-­‐even  point  when  the  profit  and  loss  line  intersects  the  sales  line.  The  sales  
line  may  be  based  on  sales  units  or  sales  revenue.  The  profit-­‐volume  chart  is  very  useful  to  show  the  
breakeven  point  for  range  of  products.  
 
How  is  profit-­‐volume  chart  drawn?  
 
The  following  steps  are  involved  to  draw  the  profit-­‐volume  chart:  
 
Step  1:   The  vertical  line  is  known  as  Y-­‐axis  and  has  origin  at  the  central  point  because  the  X-­‐axis  
begins  from  the  central  point.  Draw  Y-­‐axis  for  profits  and  losses  at  the  distance  of  
$10,000  each.  All  the  points  above  the  origin  represent  amounts  of  profit  at  different  
level  of  sale  an  all  the  points  below  origin  represent  amounts  of  loss  at  different  level  of  
sale.  The  horizontal  line  is  known  as  X-­‐axis,  which  may  be  used  for  sale  in  units  or  value.  
Draw  X-­‐axis  for  number  of  units  at  the  distance  of  1  000  each  and  up  to  10  000  units.  
The  X-­‐axis  begins  from  the  center  of  Y-­‐axis.  

 
Step  2:     Draw  the  profit  and  Loss  points,  as  follows:  
 
     For  example,  if  the  business  sells  10  000  units,  as  budgeted,  it  is  it  is  expected  to  earn  an  
    amount  of  profit  of  $20  000  I.e.  10  000  x  ($10  –  $6  =  $4)  =  $40  000  contribution  minus    
    fixed  cost  $20  000  =profit  $20  000.  If  no  unit  is  produced  or  sold,  business  will  earn  no    
    contribution  and  the  fixed  cost  will  result  into  a  loss  of  the  business.  

 
Step  3:     Connect  the  profit  and  loss  points  as  drawn  in  step  2  above.  The  point  at  which  the    
    profit  and  loss  line  intersects  the  sale  line,  it  is  known  as  break-­‐even  point.  

 
Step  4:     The  profit-­‐volume  chart  may  be  used  to  find  out  the  amount  of  profit  and  loss  at    
    different  level  of  output.  
     For  example,  the  amount  of  profit  at  8  000  units  or  loss  at  3  000  units  can  be      
    determined  on  the  chart  as  follows:  

 
 
 
Note:  if  there  is  more  than  one  product  then  Profit  is  plotted  against  Sales.  
What  is  cash  break-­‐even?  
Cash  break-­‐even  determines  the  level  of  sales  at  which  the  business  generates  enough  cash  to  meet  its  
operating  cash  requirements.  The  cash  break-­‐even  does  not  consider  the  non-­‐cash  expense,  like  
depreciation,  which  is  excluded  from  total  fixed  costs.  
Example:  
The  following  information  is  taken  from  the  foregoing  example:  
      Selling  Price   $10  per  unit  
      Variable  costs   $6  per  unit  
      Fixed  costs   $20  000  per  annum  (including  depreciation  of  $4  000)  
Illustration:  
Cash  Break-­‐even   Total  fixed  costs  –  Depreciation    =  $20  000  –  $4  000    =      4  000  units      
In  units                =                    Contribution  per  Unit          $4  
 

To  convert  in  value  simply  multiply  the  units  with  selling  price  
 
 

Business  Planning  (  This  is  only  important  for  theory  )  

The management of the business need to plan in advance in order to run a successful
business.

Planning can be broken down into two parts

Long term Planning : ( Strategic or Corporate Planning ): Management identifies the

current position of the business by looking at the accounting data. This is the
starting point for all future strategies. After analyzing the current position they
try to analyze the circumstances that the business is likely to encounter in the
period of the plan for e.g likely future demand of the product , influence of
competition etc.

Short Term Planning: ( Operational Planning ) Operational plans on short term

basis are called budgets . They show what management hope to achieve in a
future time period in terms of overall plans and individual departmental plans.

ADVANTAGES OF BUDGETS

● The preparation of individual budgets means that planning must take place.
Plans need to be prepared in a coordinated way and this requires
communication throughout all levels of the business.

● The budgeting process defines areas of responsibility and targets to be

achieved by different personnel.

● Budgets can act as a motivating influence at all levels, although this is usually
only true when all staff are involved in the preparation of budgets. If budgets are
imposed on staff who have had little or no involvement in their development
they can have a negative effect on morale and lead to staff feeling demotivated.

● Budgets are a major part of the overall strategic plan of the business and so
individual departmental and personal goals are more likely to be an integral part
of the ‘bigger picture’.

● Budgets generally lead to a more efficient use of resources at the disposal of

the business – leading to a better control of costs.
DISADVANTAGES OF BUDGETS

● Budgets are only as good as the data being used. If data are inaccurate, the
budget will be of little use. Should one departmental budget be too optimistic
or too pessimistic this will have a knock-on effect on other associated budgets.

● Budgets might become an overriding goal. This could lead to a misuse of

resources or incorrect decisions being made.

●Budgets might act as a demotivator if they are imposed rather than

negotiated.

● Budgets might be based on plans that can be easily achieved – so making

● Budgets might lead to departmental rivalry.

●Smaller businesses may find that they experience only limited benefits from
what can be a lengthy, complicated procedure to implement.

●While budgets are being prepared, any limiting factors need to be identified
and taken into account.

What is Budgetary Control?

Controlling the organization by use of different budgets and evaluating actual

performance using budgets is called Budgetary Control. The advantages and
disadvantages of this system are same as Budgets ( Mentioned Above)

 
 
 
 
ALL  THE  SMALL  THINGS.  
  
Financial  Accounting  
 
-­‐ Written  down  value  or  net  book  value  means  after  depreciation.  
-­‐ Only  assets  and  expenses  and  drawings  have  debit  balances,  all  the  other  things  in  the  world  will  
have  a  credit  balance.  
-­‐ Sales  invoice  would  mean  good  sold  on  credit.  
-­‐ If  bad  debt  is  inside  the  trial  balance  then  it  means  that  it  has  already  been  subtracted  from  the  
Trade  Receivables    
-­‐ Everything  outside  the  Trial  Balance  has  to  come  TWICE.  
-­‐ Provision  for  depreciation  is  a  Contra  Asset  Account.  It  is  NOT  AN  EXPENSE,  since  its  balance  is  
brought  down.  
-­‐ All  the  balance  c/d  go  to  the  Statement  of  Financial  Position.  
-­‐ All  the  expenses  and  incomes  are  in  the  Income  Statement  
-­‐ Revenue  =  Sales.  
-­‐ If  NOTHING  is  specified  about  the  policy  of  Depreciation,  then  you  account  for  it  MONTHLY.  
-­‐ Every  Asset  has  an  Opening  Debit  balance  and  Closing  Credit  balance.  
-­‐ Every  Liability  has  an  Opening  Credit  balance  and  closing  Debit  balance.  
-­‐ The  Amount  of  Loan  interest  still  owing  and  not  paid  (which  was  to  be  paid  this  year)  comes  in  
the  Current  Liabilities.  
-­‐ Departmental  Account:  If  given  with  prepayment  any  expenses,  then  we  SHOULD  FIRST  ADJUST  
the  accruals  and  prepayments,  and  then  divide  them  into  %  of  EACH  department.  
-­‐ Control  Account  is  not  part  of  the  double  entry.  It  is  THE  THIRD  ENTRY.  
-­‐ List  price  is  the  price  WITHOUT  deducting  TRADE  DISCOUNT.  
-­‐ Set  off  always  reduces  the  Control  Account!  
-­‐ Credit  Notes  received  =  Purchases  Returns  
-­‐ Credit  Notes  sent  =  Sales  Returns  
-­‐ BAD  DEBTS  recovered  comes  on  the  debit  side  of  the  Sales  Ledger  Control  Account  (S.L.C.A)  and  
even  on  the  credit  side.  
-­‐ Whenever  you  receive  a  cheque  from  BANK  marked  ‘REFER  TO  DRAWER’  then  it  is  CHEQUE  
DISHONOURED  
-­‐ FIX  NET  PROFIT:  In  the  Journal,  if  the  account  doesn’t  go  in  the  balance  sheet,  then  if  something  
is  being  CREDITED  it  will  INCREASE  N.P,  or  if  it  DEBITED,  then  it  will  DECREASE  N.P.  
-­‐ To  find  the  opening  balance  in  the  Suspense  LEAVE  THE  FIRST  two  lines  empty.  
-­‐ The  amount  of  stationery  used,  goes  in  the  Profit  and  Loss  as  an  expense.  
-­‐ Sundry  Expense  means  miscellaneous  expenses.  
-­‐ Whatever  goes  in  the  Income  statement  is  REVENUE  EXPENDITURE.  
-­‐ Whatever  goes  in  the  BALANCE  SHEET  is  CAPITAL  EXPENDITURE.  
-­‐ CAPITAL  EMPLOYED  (Sole  Trader)  =  CAPITAL  OWNED  +  LONG-­‐TERM  LOAN.  
-­‐ CAPITAL  OWNED  (Sole  trader)  =  Assets  –  Liabilities.  
-­‐ CAPITAL  EMPLOYED  (COMPANY)  =  OSC  +  PSC  +  RESERVES  (share  premium,  Retain  profits,  all  
reserves)  +  Long  Term  Liabilities.  
-­‐ REFUND  FROM  Supplier  is  recorded  on  the  Credit  side  of  the  Purchase  Ledger  Control  Account.  
-­‐ In  closing  Assets,  you  write  the  Bet  Book  Value  (N.B.V)  
-­‐ DRAWINGS  ARE  Neither  AN  Asset  NOR  A  LIABILITY.  
-­‐ If  they  ask  you  to  make  a  STATEMENT  TO  find  Profit  or  Loss,  then  just  make  that  financed  by  
(Opening  capital  +  Net  Profit  (x)  +  Capital  Introduced  –  Drawings  =  Capital  at  end)  
-­‐ If  they  say  make  final  accounts,  then  make  Income  Statemet  and  Statement  of  financial  position.  
-­‐ Closing  Stock  has  a  direct  relation  with  profit.  If  closing  stock  is  overstated,  profit  will  be  
overstated.  
-­‐ Opening  stock  has  an  inverse  relation  with  profit.  If  opening  stock  is  overstated,  profit  will  be  
understated.  
-­‐ Goods  sent  on  sale  or  return  basis  should  not  be  counted  as  sale  unless  accepted  by  the  
customer.  Infact  they  should  be  included  in  the  stock.  
-­‐ If  no  account  is  wrong,  like  there  is  an  error  in  the  list  of  debtors  then  we  only  correct  it  through  
suspense  account  (its  only  one  entry,  e.g.  Debit:  Suspense,  Credit:  –  )  
-­‐ We  only  double  the  amount  if  it  is  written  on  the  wrong  side  of  the  account.  
-­‐ If  we  find  purchases/sales  through  control  account  we  will  still  have  to  subtract  returns  
-­‐ Unpresented  cheques  are  payment  by  us.  
-­‐ Uncredited  cheques  are  receipts  by  us  (also  called  LODGMENTS).  
-­‐ If  you  can’t  find  the  average  inventory,  use  closing  figure  instead  of  instead  of  average.  
-­‐ If  nothing  is  specified,  we  can  assume  all  sales  and  purchases  are  on  credit  basis.  
-­‐ Provision  for  bad  debt  is  a  separate  account.  We  can  record  the  provision  in  debtors  account,  
net  debtors  mean  after  deducting  provision.  
-­‐ We  only  take  the  change  in  provision  in  the  Income  statement  
-­‐ Cashbook  is  both  a  daybook  and  a  ledger.  
-­‐ We  only  record  credit  sales  and  purchases  in  the  Sales  and  Purchase  Daybook,  cash  and  bank  
transactions  are  in  the  cashbook.  
-­‐ If  a  daybook  is  overcast  only  that  amount  will  be  wrong.  E.g.  if  Sales  daybook  is  undercast,  this  
means  only  the  Sales  account  is  wrong.  
-­‐ If  profit  is  given  inside  the  trial  balance,  the  stock  should  be  closing  stock  (because  we  don’t  
need  the  opening  stock).  
-­‐ Similarly  if  depreciation  for  the  year  is  inside  the  trial  balance,  the  provision  for  depreciation  
would  already  include  this  year’s  depreciation.  
-­‐ Gross  profit  ratio  will  not  change  because  of  sales  volume  (number  of  units),  but  net  profit  ratio  
will  increase.  
-­‐ Net  Assets  =  Assets  –  Liabilities,  but  in  some  cases  CIE  uses  Net  Assets  as  Capital  Employed  
which  is  Assets  –  Current  Liabilities.  
-­‐ Sale  or  Purchase  is  recorded  when  the  goods  are  accepted  not  when  the  invoice  is  sent  or  the  
payment  is  made.  
-­‐ If  only  net  book  values  are  available  Depreciation  for  the  year  =  Opening  Net  Book  Value  +  
Purchase  of  Asset  –  Sale  of  Asset  (Nbv)  –  Closing  Net  book  value.  
 -­‐ In  most  question  they  don’t  mention  depreciation,  that  doesn’t  mean  there  is  no  depreciation,  
use  the  above  formula  to  determine.  (Don’t  forget  the  depreciation  like  idiots).  
-­‐ Cash  banked  will  come  on  the  debit  side  of  bank  and  credit  side  of  cash  account.  
-­‐ Loan  is  as  long  term  liability  unless  payable  within  one  year.  If  nothing  is  written,  assume  long  
term.  
-­‐ POOP  is  for  expenses.  
-­‐ OPPO  is  for  incomes.  
-­‐ Net  realizable  value  =  current  selling  price  –  any  expenses  (repairs)  
-­‐ We  always  ignore  replacement  cost  in  stock  valuation.  
-­‐ Perpetual  methods  are  those  where  we  make  a  table.  
-­‐ Markup  is  on  cost  (cost  is  100)  
-­‐ Margin  is  on  sales  (Sales  is  100)  
 
 
COST  ACCOUNTING  
 
-­‐ Cost  centre  means  departments.  
-­‐ If  a  business  doesn’t  split  overheads  into  different  departments,  they  will  only  have  one  
Overhead  absorption  rate  for  the  whole  factory  (also  called  blanket  OAR).  
-­‐ Absorption  costing  means  total  costing.  It  is  used  to  calculate  total  cost.  
-­‐ We  only  use  OAR  to  calculate  the  overheads  for  a  unit/job/order/batch.  
-­‐ OAR  can  be  calculated  on  any  basis  like  machine  hours,  labour  hours,  unit,  labour  cost  (direct  
wages),  material  cost  etc.  
-­‐ If  no  basis  are  given  use  either  labour  hours  or  machine  hours  depends  on  what  is  more  
(intensity).  
-­‐ Absorbed  Overheads  =  OAR  x  Actual  Activity.  
-­‐ Over  absorbed  means  Absorbed  are  more  than  actual  overheads  
-­‐ Under  absorbed  means  Absorbed  are  less  than  actual  overheads.  
-­‐ Usually  if  actual  activity  is  above  budget,  we  will  OVER  ABSORB  
-­‐ If  actual  activity  is  below  budget,  we  will  UNDER  ABSORB  
-­‐ Total  cost  is  cost  of  Production  +  the  non-­‐production  cost.  
-­‐ Stocks  can  only  include  production  cost.  In  absorption  costing,  we  use  total  production  cost  
whereas  in  marginal  we  use  only  variable  production  cost.  
-­‐ Marginal  costing  is  about  decision  making.  
-­‐ Decisions  are  based  on  contribution  not  profits.  It  is  assumed  that  fixed  cost  will  still  be  
incurred.  
-­‐ (contribution/unit  x  #  of  units)  –  Fixed  Cost  =  Profit.  
-­‐ Lower  breakeven  point  is  better.  Higher  margin  of  safety  is  better.  
-­‐ Positive  contribution  product  or  department  should  never  be  closed  down.  
-­‐ Positive  contribution  product  should  be  accepted  under  idle  capacity.  
 -­‐ When  deciding  on  if  we  should  buy  from  outside  or  not,  we  only  consider  variable  production  
cost  (ignore  Variable  Selling  cost)  
-­‐ Only  change  the  fixed  cost  if  the  question  tells  you  to.  
-­‐ Only  make  Profit  Statement  on  absorption  if  the  question  says  so.  Otherwise  always  marginal.  
-­‐ Profit  +  Fixed  Cost  =  Total  Contribution.  
-­‐ If  firm  makes  a  single  product,  profit  volume  chart  will  be  Profit  against  units.  
-­‐ If  firm  makes  multiple  products,  Profit  Volume  chart  will  be  Profit  against  Sales  Revenue  (Total  
Sales).  
-­‐ Direct  Labour  per  hour  =  Wage  rate  per  hour.  
-­‐ Normal  level  of  activity  is  budgeted  level  of  activity.  Fixed  production  Overheads/unit  is  
calculated  using  this.  
-­‐ In  calculating  contribution  per  unit  we  need  direct  labour  per  unit.  
-­‐ MARGINAL  COSTING  =  SALES  –  VARIABLE  COST  =  CONTRIBUTION  –  FIXED  COST  =  NET  PROFIT.  
-­‐ In  marginal  costing,  we  always  take  the  total  fixed  cost.  (We  never  calculate  it  on  per  unit  as  per  
normal  level  of  activity).  
-­‐ ABSORPTION  COSTING  =  SALES  –  PRODUCTION  COST  =  GROSS  PROFIT  –  NON  PRODUCTION  
COST  =  NET  PROFIT.  
-­‐ Under  absorbed  is  added  to  Cost  and  Over  absorbed  is  subtracted.  We  only  have  to  do  this  in  
  absorption  statement.  
-­‐ In  marginal  costing,  we  always  take  the  total  fixed  cost.  (We  never  calculate  it  on  per  unit  as  per  
normal  level  of  activity).  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
FORMATS    
Financial statements of a sole trader – trading business
Income statement

Sole Trader (Name)

Income statement for the year ended 31 December 2013
$000 $000 $000
Revenue (sales) 520
Less Sales returns 3
517
Less Cost of sales
Opening inventory 46
Purchases 196
Less Purchase returns 4
192
Less Goods for own use 2
190
Carriage inwards 5 195
241
Less closing inventory 56 185
Gross profit 332
Discount received 2
Rent received 14
Commission received 4
* Profit on disposal of non-current assets -
** Reduction in provision for doubtful debts -
352
Less Expenses
Wages and salaries 84
Office expenses 52
Rent and rates 26
Insurance 19
Motor vehicle expenses 28
Selling expenses 22
Loan interest 2
* Loss on disposal of non-current assets 7
** Provision for doubtful debts 3
Depreciation of fixtures and fittings 9
Depreciation of office equipment 6
Depreciation of motor vehicles 8 266
*** Profit for the year 86

Notes:
* If only one asset was sold during the year only one of these items will appear.
** If the provision reduces, the surplus amount is added to the gross profit: if the provision increases, the
amount required is included in the expenses.
*** If the expenses exceed the gross profit plus other income, the resulting figure is described as a
net loss.
 
Statement  of  financial  position  

Sole Trader (Name)

Statement of financial position at 31 December 2013
$000 $000 $000
ASSETS
Non-current assets Cost Depreciation Book
to date value
Land and buildings 50 - 50
Fixtures and fittings 49 39 10
Office equipment 36 16 10
Motor vehicles 85 32 53
220 87 123
Current assets
Inventory 56
Trade receivables 53
Less Provision for doubtful debts 6 47
Other receivables 6
* Cash at bank 12
Cash on hand 2 123
Total assets 226

CAPITAL & LIABILITIES          

Capital          
Opening balance         152
Add Profit for the year *         86
        238
Deduct drawings         62
        176
Non-current liabilities        
Bank loan         20
       
Current liabilities        
Trade payables     21  
Other payables     6  
Bank overdraft     3   30
Total capital and liabilities         226
       

Note:
* If there is a net loss, this will be deducted rather than added.
Financial statements (final accounts) of a partnership business

Income statement
The income statement of a partnership is the same as the income statement of a sole trader. The net
profit is then appropriated to the partners as follows.

Partnership appropriation account for the year ended………………………

$ $
Profit for the year
Add: Interest on drawings

Less: Interest on capital

Less: Partners’ salaries

Profit before appropriation

Profit shared
 Statement of financial position of a partnership

………………………………………………

Statement of financial position at ..........................................

$ $
Non-current assets

Current assets

Total assets $

Capital accounts

Current accounts

Non-current liabilities

Current liabilities

Total capital and liabilities $

 Income statement of a limited company

…………………………………………………………………………

Income statement for the year ended .......................................................

Revenue

Cost of sales

Gross profit

Distribution costs

Administration expenses

Profit / (loss) from operations

Finance costs

Profit / (loss) before tax

Tax

Profit for the year

Statement of changes in equity for the year ended 31 December 2013

Share Share Revaluation Retained

capital premium reserve earnings Total
$ $ $ $ $

Balance at start of year 150,000 5,000 20,000 108,000 283,000

Share issue 30,000 3,000 33,000

Profit for the year 58,000 58,000

Revaluation 30,000 30,000

Dividends paid (12,000) (12,000)

Balance at end of the year 180,000 8,000 50,000 154,000 392,000

 XYZ Limited
Statement of financial position at 31 December 2013

2013 2012
$000 $000
ASSETS
Non-current assets
Goodwill 7,700 8,000
Property, plant & equipment 100,000 92,100
107,700 100,100
Current assets
Inventories 1,000 800
Trade and other receivables 5,000 4,000
Cash and cash equivalents 500 300
6,500 5,100

Total assets 114,200 105,200

EQUITY & LIABILITIES

Capital and reserves
Issued capital 40,000 40,000
Share premium 2,000 2,000
General reserve 10,000 10,000
Retained earnings 52,500 43,000
104,500 95,000
Non-current liabilities
Bank loan 5,000 5,200

Current liabilities
Trade and other payables 1,200 1,000
Tax liabilities 3,500 4,000
4,700 5,000
Total equity and liabilities 114,200 105,200
  
EXAM  TIPS  
 
PAPER  1  
 
You  have  60  minutes  of  30  mcqs.  2  minutes  for  each.  
 
First  only  attempt  those  questions  which  you  are  100%  sure  of  and  skip  others.  
 
Read  the  MCQ  carefully,  because  CIE  likes  to  play  around.  
 
Now  spend  time  on  these  questions.  
 
If  you  are  stuck  try  to  eliminate  the  most  obvious  wrong  answer.  
 
5-­‐6  questions  are  theoretical,  at  least  read  them  thrice.  
 
Sometimes  it’s  best  to  use  the  answer  to  check  if  it’s  wrong  or  right.  
 
If  you  see  something  in  the  answer  choice  which  you  haven’t  heard  of  (that  can  never  be  the  answer).  
 
Please  don’t  leave  it  blank.  Take  an  educated  guess.  There  is  no  negative  marking.  
 
PAPER  2  
 
You  have  90  minutes  for  90  marks.    
 
Always  attempt  the  question  which  you  know  the  best  out  of  4  first.  This  will  give  you  confidence  and  
save  time.  You  will  end  up  spending  time  and  getting  it  wrong  if  you  do  the  toughest  one  first.  
 
Don’t  panic,  usually  in  every  paper  one  question  is  tricky.  Do  it  at  last.  
 
You  won’t  get  any  award  if  you  balance  the  balance  sheet.  If  the  balance  sheet  is  off  by  a  large  amount,  
that  doesn’t  mean  everything  is  wrong,  might  be  a  single  big  figure  which  you  have  missed.  DON’T  
WASTE  YOUR  TIME.  
 
Remember  you  don’t  have  to  get  90  on  90.  Go  for  the  maximum.  
 

HOPE  THIS  HELPS  J