Financial Accounting

Income Statements
 Sole trader is the owner of the business who runs the business on their

own.

Trading A/C (give gross profit) and

Income Statement
Profit and Loss A/C (give net profit)

Balance Sheet/Statement of Show that ASSETS= CAPITAL +

Financial Position LIABILITIES

 Financial statements (generally):

 The aim of business is to make a profit; this is calculated in the

financial statements which are usually prepared at the end of a

financial year.

 Financial statements are prepared from the trial balance

 Trading A/C: concerned with buying and selling goods, calculates

gross profit (SPOG- COS).

o SPOG (of goods sold) = net sales (Sales less returns)

o COS= total cost of goods only sold, i.e. Not always all the goods

bought.

o COS= OS+P (net purchases, less any additional purchases

drawings and/or returns)– CS

o P(net)= Purchases - Purchases Returns + Carriage inwards-

goods for own use.

NOTE: Cash discount/discount allowed and discount received will not be

included in the trading A/C as they arise from the early payment of debts,

and are not sales related.

 The income statement (PNL and Trading A/C) should have a heading

regarding the financial year/period covered and the name of the

business trading.

 A trading A/C can be prepared using a horizontal format (similar to a T

Ledger A/C) or a vertical format.

 The trading account is the part of the income statement, it is the part

until the gross profit

 The profit and loss A/C is concerned with profits, loss, gains and

expenses and other income (e.g. commission)/expenses (running

expenses). This gives you the profit for the year/ net profit (Gross profit

+ other income –other expenses)

 The expenses/ income A/C have to be credited/debited (respectively) to

be transferred to the IS

 Only the expenses & income that pertain to the financial year end date

have to be transferred to the income statement- matching concept.

This means that only the opening prepaid balance and the closing

accrued balances are included in the IS.

 In the income/expenses A/C, whenever details are not given and only

totals are given, they can be entered as ‘totals to date’

 Other than the inventory, gross profit and net profit, only one entry is

made (IN THE INCOME STATEMENT) to transfer the balances to the IS.

 The opening stock of one year is equivalent to the closing stock of the

previous year.

 The income statement has 2 entries regarding the inventory A/C (IN

THE INCOME STATEMENT), one to transfer the balance at the start of

the year as the opening stock/inventory and at the end of the year

from the income statement to the inventory A/C to show the closing

stock/inventory (indirectly credited from IS as it is shown as a

deduction from the expenses)

  The net profit is the return received by the owner for their investment

(increases amount owed to owner) and shall be debited from IS and

credited to the capital A/C and vice versa for a net loss (as it reduces

the amount owed to the owner.)

$ $

revenue

Less : return inwards

Less : cost of sales

Opening inventory

purchases

Less : purchase returns

Less : goods for drawings

Add: carriage inward

Less : closing inventory

Cost of sales

Gross profit

Add : other income (discount received, rent received )

Less : expenses (wages and salaries, rent and rates, telephone,

insurance, etc )

Operating profit
  The income statement of a service business (E.g.: accountant) (One

who does not buy or sell goods) will not have a trading A/C as no goods

are bought and sold/ Only a PNL is prepared, however the balance

sheet stays the same. There will be only the titles of Income and

Expenses

Income statement for the year ending 31 dec 2020

Statement of financial position

 A SOFP of a business on a certain date and shows the assets of a

business (what the business owns/ its resources) as being equal to its

capital (amount owed to the owner by the business/owner’s

investment/equity) plus any other liabilities (amount owed to any

external entity other than the owner). i.e. The assets show how the

resources are being used and the liabilities (including the capital- for

this case) show where these resources come from.

 Non-current liabilities are those which are not due in the next 12

months (E.g.: long term loans)

 Current liabilities are short term ones (due within the next 12 months)

and arise from the regular trading activities of the business whose

values constantly change (E.g.: trade payables & other payables)

 Assets and liabilities are arranged in different groups:

o Assets are divided into current (Values are constantly changing,

short term assets which arise from the regular trading of the

business, E.g.: Inventory) and non-current assets (long term

 assets which are not used for resale but help the business earn

revenue. E.g.: Motor Vehicles)

o Non-current assets are listed in order of increasing liquidity

(liquid= least permanent) (The ability to be converted into cash),

typically: Land and buildings, Machinery, Fixtures and equipment

and motor vehicles.

o Current assets are also listed in order of increasing liquidity

(furthest away from cash shown first), typically: Inventory, Trade

receivables, Other receivables, Bank, Cash. Trade receivables are

said to be more liquid as compared to the inventory as they can

be sold to other businesses.

o Current and Non-current liabilities appear in ascending order of

which liability must be paid first. Note: Other payables will

appear after trade payables.

o Other payables are accrued expenses or prepaid income, as the

business owes to a third party in this circumstance.

o Other receivables are accrued income and prepaid expenses as

the business is owed by a third party in this circumstance.

 A SOFP should have the heading of the date to which it relates and

must include the business's trading name.

 SOFPs can be prepared in the horizontal (2-sided) (typically assets on

the left and liabilities on the right, but the reverse is acceptable) or a

vertical format, which looks like an arithmetical calculation.

 After all the financial statements are prepared, every item on the trial

balance must have one effect (either IS or SOFP) on the financial

statements, and additional notes will have 2 effects on the financial

statements (one on the IS and the other on the SOFP)

 The balance of the capital A/C will increase in the SOFP if the business

has made a profit or decrease if the business has made a loss.

 If a vertical format of an SOFP has been prepared, the liabilities are

shown after the assets to show where the resources come from (the

reverse is OK).

 If more than one current liability is present, it is listed in the first

column, totaled, and taken to the second column.

 The main advantage of a vertical SOFP is that it shows the net current

assets/working capital (current assets- current liabilities), which is very

important.

 The non-current liabilities can be listed before or after the capital.

 In the vertical format of SOFP, the Assets-Liabilities = Capital. Other

formats keeping in line with the accounting equation are also

acceptable.

 When the business makes a profit, it is added to the capital as the

amount owed by the business increases, and thus, it can be concluded

that a profit is an increase in net assets (capital)

 Amounts to be subtracted are put in parentheses to ensure they are

not added.
  THE SOFP ALWAYS TALLIES unless you must find a balancing figure

( you add the balancing figure to tally the SOFP).

Statement of financial position as of 31 December 2020

$ $

Non-Current asset

Premises

Motor van

Office furniture

Current asset

Closing inventory

Trade receivables

Cash and cash

equivalents

Total assets

Capital and liabilities

Capital on 1 January

Add: profit for the year.

Less: loss for the year

Less: drawings

Capital on 31 December
 $ $

Noncurrent liabilities

Loan from Noor

Current liabilities

Trade payables

Other payables

Bank Overdraft

Total liabilities and

capital

Accounting Principles and concepts

 Accounting principles are rules applied when recording transactions

and preparing financial statements.

 Objectives of a set of financial statements is that they provide a true

and fair view of the profit or loss of the company for the year, and that

the SOFP likewise gives a true and fair view of the state of affairs of the

company at the end of the financial year; true indicates if the

transaction actually took place, fair implies transactions are shown in

accordance with accepted accounting rules of cost and valuation.

 There are 11 accounting principles and concepts

o Duality is the understanding that there are two aspects of each

transaction. Credit and Debit. It also involves the accounting

equation.
o Business Entity - It is when the business and its owner are

regarded as separate existence. A clear example of this concept

is when the owner puts in capital into the business. The credit in

the capital a/c shows that the business owes money to its owner.

o Money Measurement - Transactions which can be measured in

monetary terms are recorded in ledgers. The limitation is that

non-monetary values such as skill/satisfaction cannot be

measured.

o Historic Cost - Transactions are recorded at their cost to the

business. This ensures objectivity but however doesn’t consider

the changing value of money.

o Realisation - Revenue is accounted by the seller when it

is earned whether cash is received or not

o Consistency - Transactions of a similar nature must be recorded

in the same way.

o Materiality - Businesses might not record some transactions

using the accounting principles as the transaction might be

considered insignificant.

o Matching/accruals - Revenue and income must not be earned

more or less same applies to expenses which must not be more

or less.

o Prudence - Profits should not be overstated and losses should

be provided for as soon as they are recognized

 o Going Concern - It is when there is no intention to stop the

business in the coming future.

o Substance over form - When recording a transaction, this

concept states that the substance of the transaction should be

recorded rather than its legal form. Ex. Legally, if a company

doesn’t fulfil the payment of a machine it goes back to the seller,

but in substance the machine is the same as the others, its

being used in the process, hence substance over form.

 Goods on sale or return basis – when a trader sells on sale or return

basis to a customer, no sale takes place until the customer informs the

seller that he has decided to buy them

Accruals and prepayments (the matching

concept)
 Accruals are an expense which is due withing an accounting period but

which has not been paid, in the statement of financial position, it is

known as other payables.

 Prepayments are payments made by the business in advance of the

benefits to be derived from them, this is entered as other receivables

in the statement of financial position.

 Accrued expenses – amount owed to a creditor

Expense account

2020 $ 2020 $

Jan bal. b/d (previous year xx Jan Bal b/d (previous year xx
 2020 $ 2020 $

prepaid) owing)

xx xx
Jan-nov bank Dec 31 income statement
x x

Dec 31 bal c/d (current year

xx
owing)

XX XX
X X

Jan 1 bal. b/d xx

 Only xxx has been paid but a different amount(amount relevant to the

year) will be dr in the Income Statement as it is the cost relating to

that year, the bal. b/d will be shown in the SOFP under current

liabilities as accrued expenses.

 The accrued amount is added to the expense account.

 Prepaid expenses – payment in advance (debtor)

expense account

2020 $ 2020 $

Jan bal. b/d (previous year Jan Bal b/d (previous year
xx xx
prepaid) owing)

xx xx
Jan-dec bank Dec 31 income statement
x x

Dec 31 bal c/d (current year xx

prepaid) x
 2020 $ 2020 $

XX XX
X X

Jan 1 balance b/d xx

 The payments during the year add up by the bank but the income

statement has been debited with rent for one year, the amount that

relates to the next financial year is subtracted from the total amount

and this amount is entered under the SOFP as other receivables under

current assets.

 This amount is deducted from the expense amount in the trial balance

while including in the IS.

 Inventory of stores as an expense accounts – inventories of

consumable stores may be unused at the end of the year, as per

matching concept these should not be charged against the profit as

they are an asset, this is carried down as a dr balance hence why an

expense account may have both dr and cr balances.

  Example: In the year ended 31 dec 2020, Mr. Ceyard had paid 1200

dollars for stationery, at year end he owed 270 dollars for stationery

and had an inventory of unused stationery of 400 dollars.

2020 $ 2020 $

Dec Income 107

Jan 1
31 statement 0

Dec 120 Dec

Bank Inventory c/d 400
31 0 31

Dec Amt owing

270
31 c/d

147 147
0 0

2021 2021

Jan 1 balance b/d 400 Jan 1 Balance b/d 270

Stationery Account

 The amt owing is carried down and it is included under current

liabilities as other payables in the SOFP while the 400 dollars of unused

inventory would be under current assets as inventory of unused

stationery.

 Adjusting for income prepayments – incomes received in advance of its

due dates is a payable (income prepaid) and is therefore a credit

balance and is under current liabilities in the SOFP. The amount prepaid

is misused from the amount paid in the IS.

  Adjusting for income accrued – incomes accrued at the date it is due

indicates existence of debtors and is therefore a debit balance, this is

hence under current assets as other receivables in the SOFP, and it is

added to the amount received in the bank in the IS.

Income account

$ $

Balance b/d (owing previous xx Bal b/d (previous year

xx
year) x prepaid)

xx xx
Income statement Bank account
x x

Balance c/d (prepaid current xx Bal c/d (current year xx

year) x owing) x

XX XX
X X

xx xx
Balance b/d Balance b/d
x x

Suspense account
 Suspense account: An account opened to record a difference between

the debit and credit totals of the trial balance.

 The following checks are useful:

o Check the additions of the trial balance

o If difference is divisible by 2 then look for balance of half the

difference on the wrong side

 o If the difference is divisible by 9 look for balances where digits

have been reversed like 345 dollars entered instead of $354

o Check totals of sales and purchase ledger against the control

accounts

o Check extraction of the balances

 If the cause of difference has not been found then a suspense account

may be opened in order to temporarily balance the trial balance.

 A suspense account is opened in the general ledger with the balance

on whichever side of the account will make the trial balance agree

when the balance is inserted. If the total of the debit side of the trial

balance is 200 dollars less than the credit side, the suspense account

is opened will have a debit balance of $200

 Types of errors that call for a suspense account to be opened include:

o When it’s a single entry instead of a double entry

o When entries have been made on the same side of two separate

accounts

o When the entries have been made on the correct side but the

figures differ.

o An item on the wrong side of an account must be corrected by an

adjustment equal to twice the amount of the original error (once

to cancel the error and once to place the item on the correct side

of the account).
  Some errors do not affect the double entry; an example would be a

balance on a sales ledger account copied incorrectly onto a summary

of balances for inclusion in the trial balance. The summary of balances

should be amended and a one-sided entry in the journal prepared to

correct the suspense account. Such errors are not required to be

corrected by debit and credit entries

 The types of errors that don’t affect the trial balance and are hence not

corrected by a suspense accounts are; error of original entry, error of

principle, error of omission, error of commission, error of complete

reversal and compensating errors.

 Note whether or not a narrative is required when preparing the journal

entries.

 Revised profit or loss is calculated from the nominal account entries in

the journal.

Provision for the depreciation of non current

asset
 Capital income: Capital income is when the sale of an asset generates

income.

 Revenue incomes: Revenue income is income received by the sale of

goods and services daily; day to day operations.

 Capital expenditure: it is the use of funds by a company to purchase

non current assets such as machinery which benefits the business over

more than a year

 Revenue expenditure: it is the use of funds by a company to run the

day to day operations such as lunch for employees, fuel.

 Depreciation is a part of the cost of a non current asset that is

consumed during the period its used.

 Ex if a machine which lasts for 5 years is used for 1 year then the

depreciation is the value of the machine which is used for a year.

Depreciation has 2 methods to calculate the percentage or value to be

reduced.

 Purpose of depreciation: the main purpose of depreciation is to spread

the cost of the non-current asset to the useful life to cover the total

cost within the period of usefulness. In simpler ways, it’s to cover the

cost with the money earned using the asset.

 Concepts that comply with depreciation:

o Prudence concept – to avoid overstating the asset value

o Matching concept –if cost of using non current asset was not

included in the income statement or profit would be overstated.

o Consistency – the same method is to be applied each year to

reflect the usage of the asset.

 Reasons for depreciation

o Wear and tear

o Obsolescence

o Passage of time

o Using up or exhaustion (physical deterioration)

  How to calculate depreciation:

o Straight line method: the total amount of depreciation is the

total cost- the residual value or the value after it completes its

period of usefulness . After finding that value ,it is then spread

over the years of usefulness. Calculation formula:

o cost of non current asset - residual value/period of usefulness in

years

 Ex. A machine worth 100,000 dollars has a usefulness of 10

years after which it would be sold for 1000 dollars. The

total depreciation is 100,000-1000=99000 which when

spread over 10 years comes around 9900 dollars per

annum.

o Reducing Balance method: the depreciation is taken by a

fixed percentage on the net book value (written down value) of

assets every year.

 Ex. A machine costs 100,000 dollars and has a period of

usefulness over 6 years. Depreciation is used to calculate

for 20% per annum on reducing balance. Therefore, the

results are in the table below.

Calculatio

n

Cost 100,000

Year1(20% x (20,000)
 Calculatio

n

100,000)

Net book value 80,000

Year2(20% x
(16,000)
80,000)

64,000

Year3(20% x
(12800)
64,000)

51,200

Year4(20% x
(10,240)
51,200)

40,960

Year5(20% x
(8,192)
40,960)

32,768

Year6(20% x
(6,554)
32,768)

26,214

Henceforth, the residual value is 26,214 dollars moreover if the company

sells the machine for more than the residual value the company makes a

profit where as if the company sells it for lesser than the residual value then

the company makes a loss.

  Revaluation method: Used to calculate the cost of consumption in

the accounting period of small non current asset such as power tool.

o This is used to find how much to charge as an expense to the

income statement when each tool may have a different useful

life while their total value is large, and it may not cost enough to

treat them separately.

o Opening valuation + purchase during year – closing value

= depreciation charge

When to choose which Depreciation.

 Straight line: usually used for assets that are expected to earn revenue

evenly over useful life. Also for assets whose earning power is

uncertain. This method is used for assets that have fixed lives

(leases); easier to calculate, less risk of mistakes than reducing

balance as the provision doesn’t change annually.

 Reducing balance method: used when assets earning power will

diminish as the asset ages. This is also used where assets loses more

of its value in the early stages of life. Example; motor vehicles,

computers. Advancements in technology affects value. Reducing

charges for depreciation compensates for increasing repair costs as it

ages.

 Accounting for disposal of non current assets:

1. Debit: Disposal a/c

Credit: Non current assets a/c( original cost**)

2. Debit: Provision for depreciation a/c

Credit: Disposal a/c

3. Debit: Bank a/c

Credit: Disposal a/c

4. A debit balance is a loss on disposal

A credit balance is a profit on disposal

Following are the three accounts when accounting for disposal.

Non current asset at Cost a/cNon current asset at Cost a/c

2020 $ 2020 $

Jan Bal xxx Dec 2 Non current asset xx

21 b/d x 1 disposal x

Provision for depreciation for non current asset accountProvisio

n for depreciation for non current asset account

202 202
$ $
0 0

Dec Non current asset Jan Bal xx

xxx
21 disposal 21 b/d x

Non current asset disposal a/cNon current asset disposal a/c

202 202
$ $
0 0

Dec Non current xx Dec Provision for xx

202 202
$ $
0 0

21 asset at cost x 21 depreciation x

xx
Bank(proceeds)
x

Dec Income statement (loss

xx
31 on disposal)

xx xx
x x

 Part exchange: In part exchange, the company gives the machinery in

exchange for a new machine. In this case, the exchange value of the

asset being disposed will be debited to the non current assets a/c and

then credited to the disposal a/c (in place of the proceedings as per

usual procedure).

 A business may depreciate its assets either:

o A full years depreciation

o Month by month basis

o Exceptional depreciation : when the amount recoverable on

disposal is below it net book value this asset is said to be

impaired, in this case this asset needs to be immediately written

down to the amount which would be received if sold.

Provision for the depreciation of non current
asset
 Capital income: Capital income is when the sale of an asset generates

income/ Non-recurring income.

 Revenue incomes: Revenue income is income received by the sale of

goods and services daily; day to day operations/ Income recurring

every year.

 Capital expenditure: it is the use of funds by a company to purchase

non current assets such as machinery which benefits the business over

more than a year/ Non-recurring expenses

 Revenue expenditure: it is the use of funds by a company to run the

day to day operations such as lunch for employees, fuel/ Expenses

recurring every year.

 Depreciation is a part of the cost of a non current asset that is

consumed during the period its used.

 Ex if a machine which lasts for 5 years is used for 1 year then the

depreciation is the value of the machine which is used for a year.

Depreciation has 2 methods to calculate the percentage or value to be

reduced.

 Purpose of depreciation: the main purpose of depreciation is to spread

the cost of the non-current asset to the useful life to cover the total

cost within the period of usefulness. In simpler ways, it’s to cover the

cost with the money earned using the asset.

 Concepts that comply with depreciation:

o Prudence concept – to avoid overstating the asset value and the

profit for the year.

o Matching concept –if cost of using non current asset was not

included in the income statement or profit would be overstated.

o Consistency – the same method is to be applied each year to

reflect the usage of the asset( if changed the depreciation for the

full life of the asset needs to be changed).

 Reasons for depreciation

o Wear and tear

o Obsolescence

o Depletion

o Passage of time

o Using up or exhaustion (physical deterioration)

 How to calculate depreciation:

o Straight line method: the total amount of depreciation is the

total cost- the residual value or the value after it completes its

period of usefulness . After finding that value ,it is then spread

over the years of usefulness. Calculation formula:

o cost of non current asset - residual value/period of usefulness in

years

 Ex. A machine worth 100,000 dollars has a usefulness of 10

years after which it would be sold for 1000 dollars. The

 total depreciation is 100,000-1000=99000 which when

spread over 10 years comes around 9900 dollars per

annum.

o Reducing Balance method: the depreciation is taken by a

fixed percentage on the net book value (written down value) of

assets every year.

 Ex. A machine costs 100,000 dollars and has a period of

usefulness over 6 years. Depreciation is used to calculate

for 20% per annum on reducing balance. Therefore, the

results are in the table below.

Calculatio

n

Cost 100,000

Year1(20% x
(20,000)
100,000)

Net book value 80,000

Year2(20% x
(16,000)
80,000)

64,000

Year3(20% x
(12800)
64,000)

51,200

Year4(20% x (10,240)
 Calculatio

n

51,200)

40,960

Year5(20% x
(8,192)
40,960)

32,768

Year6(20% x
(6,554)
32,768)

26,214

Henceforth, the residual value is 26,214 dollars moreover if the company

sells the machine for more than the residual value the company makes a

profit where as if the company sells it for lesser than the residual value then

the company makes a loss.

 Revaluation method: Used to calculate the cost of consumption in

the accounting period of small non current asset such as power tool.

o This is used to find how much to charge as an expense to the

income statement when each tool may have a different useful

life while their total value is large, and it may not cost enough to

treat them separately.

o Opening valuation + purchase during year – closing value

= depreciation charge

When to choose which Depreciation.

  Straight line: usually used for assets that are expected to earn revenue

evenly over useful life. Also for assets whose earning power is

uncertain. This method is used for assets that have fixed lives

(leases); easier to calculate, less risk of mistakes than reducing

balance as the provision doesn’t change annually.

 Reducing balance method: used when assets earning power will

diminish as the asset ages. This is also used where assets loses more

of its value in the early stages of life. Example; motor vehicles,

computers. Advancements in technology affects value. Reducing

charges for depreciation compensates for increasing repair costs as it

ages.

 Accounting for disposal of non current assets:

1. Debit: Disposal a/c

Credit: Non current assets a/c( original cost**)

2. Debit: Provision for depreciation a/c

Credit: Disposal a/c

3. Debit: Bank a/c

Credit: Disposal a/c

4. A debit balance is a loss on disposal

A credit balance is a profit on disposal

Following are the three accounts when accounting for disposal.

Non current asset at Cost a/cNon current asset at Cost a/c

 2020 $ 2020 $

Jan Bal xxx Dec 2 Non current asset xx

21 b/d x 1 disposal x

Provision for depreciation for non current asset accountProvisio

n for depreciation for non current asset account

202 202
$ $
0 0

Dec Non current asset Jan Bal xx

xxx
21 disposal 21 b/d x

Non current asset disposal a/cNon current asset disposal a/c

202 202
$ $
0 0

Dec Non current xx Dec Provision for xx

21 asset at cost x 21 depreciation x

xx
Bank(proceeds)
x

Dec Income statement (loss

xx
31 on disposal)

xx xx
x x

 Part exchange: In part exchange, the company gives the machinery in

exchange for a new machine. In this case, the exchange value of the

asset being disposed will be debited to the non current assets a/c and
 then credited to the disposal a/c (in place of the proceedings as per

usual procedure).

 A business may depreciate its assets either:

o A full years depreciation

o Month by month basis

o Exceptional depreciation : when the amount recoverable on

disposal is below it net book value this asset is said to be

impaired, in this case this asset needs to be immediately written

down to the amount which would be received if sold.

Irrecoverable and doubtful debts

 Irrecoverable debt is a debt due from a customer which it is expected

will never be paid to them.

 When the debtor has become bankrupt and is unable to pay

o DR : Irrecoverable debt account

o CR : debtor

 At end of the financial year, this balance will be transferred to the

income statement as an expense.

o DR : income statement

o CR : irrecoverable debts

Irrecoverable debts accounts

202
$ 2020 $
0

Nov Debtor xx Dec Income xx

202
$ 2020 $
0

1 1 x 31 Statement x

Debtor xx
2 x

xx xx
x x

 The irrecoverable debts are deducted from the trade receivables in the

SOFP.

 Irrecoverable debts recovered

o A debt that has been written off as irrecoverable may be

recovered at a later date if the customer is able to pay

o The debt must first be recorded once more on the sales ledger

via journal entry

 DR customers account

 CR irrecoverable debts recovered

o Once the amount has been received

 DR : cash book

 CR : customers account

 The balance of irrecoverable debts recovered account will be credited

in the income statement, it must be shown after gross profit added as

part of other incomes.

 Provisions for doubtful debts

 o a debt due from a customer where it is uncertain whether or not

it will be repaid by them, it may eventually be irrecoverable. It

would therefore overstate the assets if this is not removed

making the SOFP misleading however it may be wrong to write it

off as an expense as its not yet irrecoverable.

 When the provision is first created :

o DR : income statement

o CR : provision for doubtful debt

 Afterwards in the year following any increase in the amounts will be DR

in the income statement and CR in the provision for doubtful debts,

(treated as an expense), while in the case of a decrease in the amount

the reverse is followed hence (treated as an income).

 The provision for doubtful debts is deducted from the trade receivables

in the SOFP.

 How to calculate the amount of a provision for doubtful debts :

o Specific – the provision will be equal to the total of those doubtful

debts, this amount is based on specific knowledge the owner has

of the customers financial position.

o General – provision calculated as a percentage of the total trade

receivables.

o Specific and general – provision is made up of debts that are

thought to be doubtful plus a % of the remainder.

  Specific provisions must always be deducted from trade receivables

first, before the general provision is calculated. [total receivables –

specific ] x general% = general provision.

Provision for doubtful debts account

$ $

Balance c/d (transferred xx xx

Balance b/d
to SOFP) x x

Income statement (increase in xx

provision) x

 Provisions for doubtful debts and the concepts

o Prudence – the trade receivables should not be overstated in

the SOFP, the IS should hence provide for the loss and not

overstate profit.

o Matching – the possible loss of revenue should be provided in

the relevant period in which the revenue was earned.

Bank reconciliation statements

What is a bank reconciliation statement?

 This is a statement that is prepared periodically to ensure that the

bank account in the business cash book matches the business bank

account shown on the bank statement.

 This may be due to

o Timing difference – delay between items being entered in the

cash book and the entry on the bank statement

 o Items on the bank statement that have not been entered in the

cash book (bank charges, interest, direct debits, standing orders,

et).

 How to prepare a bank reconciliation statement?

o Compare the entries in the cash book with the bank statement.

Check out the ones that coincide with both places

o Enter into the cash book the items that remain unticked in the

bank statement and then calculate the updated cash book

balance accordingly.

o Prepare the reconciliation statement. First start with the balance

on the bank statement and adjust for any items that are unticked

in the cash book. The result should equal with the balance in the

updated cash book.

 Therefore this figure will now be able to be recorded In the statement

of financial position.

 This division of duties is called internal check in which external auditors

rely on to help them verify the accuracy of the financial data

 Unpresented cheques are cheques payments recorded in the cash

book but not yet appearing on the bank statement

 Uses of bank reconciliation

o Reveal the correct amount of cash at bank, without the

reconciliation the bank statement and cash book will be

misleading.
 o Ensure that the correct bank amount is entered in the statement

of financial position

o They are a crucial system of control – unintended drawings can

be avoided, surplus of cash at bank can be highlighted, if

reconciliations prepared regularly errors can be discovered early.

o Since its prepared by someone else, the chances of fraud is

reduced.

 The formats for the reconciliation include

Bank reconciliation statement at 31 march 2016

$ $

Balance as per bank statement xx

Add: items not credited in the bank

xxx
statement

xxx

xx
Deduct: cheques not presented
x

xx (xxx
x )

Balance as per cash book xxx

Alternative format : Bank reconciliation statement at 31 march 2016

$ $

Balance as per cash book xx

 $ $

Add: unpresented cheques xxx

Deduct: items not credited on the bank (xxx

statement )

(xxx
xxx
)

Balance as per bank statement xxx

Control accounts
 Control accounts contains the totals of all postings made to the

accounts in a particular ledger.

 These are usually maintained for sales and purchase ledgers, the totals

of the books of prime entry are made to the ledger, hence the balance

of the control account should equal to the total of the balance of the

ledger it controls.

 A control checks on the arithmetical accuracy of a single ledger while a

trial balance checks the accuracy of all the ledgers. Not part of the

double entry.

 A difference between a control account balance and the total of the

balance of the ledger it controls, helps show where a cause of a

difference on a trial balance may be found.

 The Purchase Ledger and Its Control Account (trade payables control

acc)
 Purchase ledger control account

 Bal b/d (total of purchase ledger

dr balances from previously if Bal b/d
Debit
any)

Purchase returns (purchase returns Total credit purchases (purchase

journal) journal_

Refunds from supplied (cash

Cash paid to suppliers (cash book)
book)

Interest charged on overdue

Cash discounts received (cash book)
invoices (purchases journal)

Total of dr balance (if any) at end

Purchase ledger bal set off (journal)
of period in purchase ledger c/d

Balance c/d (to agree with the total

of cr balance in purchase ledger)

balances in the purchase ledger must never be netted against

(deducted from) the credit balances. The credit balances come under

current liabilities as trade payables while debit balance are under

current assets as trade receivables In the SOFP.

 only credit purchases are entered in the purchase ledger control

account. No cash purchases are entered.

 The sales ledger and its control account (trade receivables control

account).
 Sales ledger control account

 Bal b/d (total of sales ledger

Bal b/d
credit balance)
Only
Sales returns (total of sales returns
Credit sales (sales journal)
journal)

Refunds to credit customers (cash Cash received from credit customers

book) (cash book)

Dishonoured cheques (cash book) Cash discounts allowed (cash book)

Interest charged on overdue acc

Irrecoverable debts (journal)
(sales journal/cash book)

Sales ledger balances set off

Total of credit balance (if any)
(journal)

Balance c/d to agree with total of

c/d
debit balances in sales ledger

credit sales should be entered in the sales ledger control account.

Never enter cash sales or provisions for doubtful debts in a sales

ledger control account.

 Reasons why a credit balance may occur in a customers account [ if

reversed between buyer and seller, reasons why debit balances occur

in a suppliers account]

o Customer may have overpaid their invoice

o Customers may have paid in advance

o Customer may have paid invoice in full and later returned some

or all of the goods

 Uses of control account

o It alerts possible errors in the ledgers they control if totals of the

balances

o May identify the ledger in errors have been made

o Totals of trade receivables and trade payables are provided

quickly

o Reduces fraudulent activity as a control account is prepared by

someone not involved in maintaining ledgers [internal check].

o When businesses don’t maintain full double entry systems,

control accounts are a vital part of preparing financial

statements.

 Limitations of using control account

o Control accounts may contain errors themselves

o They don’t guarantee the accuracy of individual ledger accounts.

o It may add to business costs although a computerised

accounting system will prepare it automatically, individual with

specialist knowledge is required to verify the accuracy.

 How to reconcile control accounts with ledgers

 When there’s a difference between the balance on the control account

as well as the total of balance on the ledger it controls, it has to be

reconciled

o Error of omission: If a transaction is omitted from a journal, it will

be omitted from the personal account in the sales or purchase

 ledger and from the control account. Both records will be wrong

and the control account will not reveal the error, hence it will be

adjusted in both places

o Error of original entry: if a transaction is incorrectly entered in a

journal, this error will be repeated in the ledger it controls and

hence in the control account. Both records will be wrong and the

control account will not reveal the error; both will need to be

adjusted.

o If an item is copied incorrectly from the journal to a personal

account in the sales of purchase ledger, the control account will

not be affected, and it will reveal the error.

o If the total in a day book is incorrect, the control account will be

incorrect but the sales or purchase ledger will not be affected.

The control account will reveal that an error has been made.

Incomplete accounts
 Incomplete records: Any method of recording transactions that is not

based on the double-entry model. Usually maintained by small

business owners who lack sufficient knowledge of double entry hence

resort to single entry bookkeeping.

 Capital is calculated by listing the assets and liabilities in a statement

of affairs. This is similar to a SOFP. However, in the statement of affairs

the assets and liabilities are only listed. Headings such as non-current

assets or current liabilities are not included.

 Profit/(loss)= closing capital + drawing in the period – new capital

introduced – opening capital

 Capital or net assets = assets – liabilities

 When an asset is valued at more or less than cost, it should be

included in a statement of affairs at valuation

 Preparing an income statement and a statement of financial position

from incomplete records

o prepare opening statement of affairs, this allows opening capital

to be calculated

o prepare receipts and payment account(similar to a cash or bank

account), this is needed to calculate the closing bank/cash

balances for the closing SOFP

o prepare control accounts for trade receivables and trade

payables in order to calculate sales and purchases

o Adjust the receipts and payments for accruals and prepayments

at the beginning and end of the period.

o Calculate provisions for doubtful debts, depreciation and any

other matters not mentioned above.

o Prepare the income statement and statement of financial

position from the information now available.

 Valuing the inventory at selling price goes against three important

accounting principles:
 o realisation – profit was shown as realised in the year ended 31

December 2015 even though no sale had taken place.

o matching – the profit has not been matched to the time the sale

took place.

o prudence – the profit was overstated in 2015; it was not even

certain then that the goods could be sold at a profit.

 It is an important principle that inventory should never be valued at

more than cost. Valuing inventory at historic cost observes the

principles of realisation, matching and prudence.

 Another important principle is that the method used to value inventory

should be used consistently from one accounting period to the next.

 Incorrectly valuing inventory, either by mistake or deliberately, will

result in the income statement showing the wrong gross profit and

profit for the year as well as the current assets in the SOFP will be

incorrect. Which is hence misleading leading to wrong decisions being

made.

 Inventories should be valued at the lower of cost and net realisable

value. Cost has already been considered. net realisable value is the

price that may be expected to be received from the sale of the goods,

less the cost of putting them into a saleable condition.

 Margin and mark-up

o Margin is gross profit expressed as a percentage or fraction of

selling price:
  Profit/selling price x 100

o Mark-up is gross profit expressed as a percentage or fraction of

cost of sales.

 Profit/cost price x 100

 If margin is 1/3 then markup is 1/(3-1)=1/2

 If markup is 1/6 then margin is 1/(6+1)=1/7

 Markup and margin is useful in calculating inventory lost in fire or theft.

 Advantages of keeping full accounting records

o Allows financial statements of business to be prepared quickly

soon after year end

o Allows financial statements to be prepared more than once a

year which may help the manager run more efficiently

o Helps guard against errors and possible fraud by employees as

inventory or cash loss can be picked up early

o Accuracy of the ledgers can be improved

o May be a legal requirement to keep certain records

 Disadvantages of keeping full accounting records

o Time taken to set up and maintain them

o Cost of purchasing a computer package along with training cost

o Business owners may lack expert knowledge on how to prepare

double entry which may lead them to employ a specialist which

may be costly.
  How far owners go to keeping financial records for business depends

on

o Accounting knowledge and skill of owner

o Time available to write up records

o Cost of employing a member to prepare accounting records

Partnership accounts
 A partnership is formed when two or more people carry on business

together with the intention of making profit

 Partnership agreement: An agreement, usually in writing, setting out

the terms of the partnership

 Partnership Act 1890: The rules which govern a partnership in the

absence of a formal partnership agreement

o All partners are entitled to contribute equally to the capital

o Partners aren’t entitled to interest on capital

o Partners aren’t entitled to salaries

o No interest charged in their drawings o Partners will share profit

and losses equally

o Partners entitled to interest at 5% per annum on loans made to

partnership (this will be considered as an expense and treated as

any other loan; debited into the income statement)

 Appropriation account: An account prepared after the income

statement. It is used to show how the profit for the year is divided

between each partner.

 o Partnership salary : a share of the partnership profit for the year

paid to one (or more) of the partners in addition to their normal

profit share usually for extra skill or work undertaken, these are

never debited to the income statement as expense.

o Interest on partners capital : A share of the profit for the year

(usually) based on a percentage of the amount of fixed capital

each partner has contributed to the partnership

o Interest on drawings: A charge made on the annual drawings

made by each partner, usually calculated as a percentage of the

drawings made.

Draft of appropriation account

$ $

PRofit for the year xxx

Add: Interest on drawings - xx

A x

xx
-B xxx
x

xxx

xx
Less: Interest on capital - A
x

xx (xxx
-B
x )

Less: Partners salaries - A (xxx

 $ $

xxx

Profit share - A (profit share xx

%) x

xx (xxx
- B (profit share %)
x )

 Preparing partnership accounts

o Capital account An account to record the sum of money which a

partner introduces into the partnership. It is only adjusted for any

further capital introduced, any capital withdrawn, any share of

goodwill or any profit on the revaluation of partnership assets.

Partnership capital account

o A B A B

Balance b/d (profit from share

Capital Withdrawn
from appropriation acc)

:pss share (from

Capital introduced
appropriation acc)

Revaluation loss Revaluation gain

Balance c/d
  Current account: An account which records a partner’s share of profits

and any drawings made by them. Partners current account

 A B A B

$ $ $ $

Drawings x x Balance b/d x x

Interest on
x x Interest on loan x x
drawings

xx xx Interest on
Balance c/d x x
x x capital

Partners salary x x

Share of profit x x

xx xx xx xx
x x x x

xx xx
Balance b/d
x x

 Drawings account

o If partners do not maintain current accounts, the double entry for

interest, their salaries and shares of profit must be completed in

their capital accounts

o Advantages of partnerships

 The capital invested by partners is often more than can be

raised by a sole trader.

  A greater fund of knowledge, experience and expertise in

running a business is available to a partnership.

 A partnership may be able to off er a greater range of

services to its customers (or clients).

 The business does not have to close down, or be run by

inexperienced staff , in the absence of one of the partners;

the other partner(s) will provide cover.

 Losses are shared by all partners.

o Disadvantages of partnerships

 A partner doesn’t have the same freedom to act

independently as a sole trader has.

 A partner may be frustrated by the other partner(s) in their

plans for the direction and development of the business.

 Profits have to be shared by all partners.

 A partner may be legally liable for acts of the other

partner(s)

Partnership changes
 When partners agree to change the profit/loss share

o The profits/losses incurred before the change in the shares must

be shared among the partners in the old profit share ratio,

afterwards once the change is imposed the profit/loss following

must be shared in the new ratio. Hence causing realised or

unrealised profit or losses to occur.

 o Realised profit/loss : recognised in the income statement such as

revenue or expenses these are apportioned on a time basis

however exceptional cases such as a change in the interest of a

partners loan would require it to be apportioned on an actual

basis o Unrealised profit/loss : gains/losses arising from

revaluation of assets and liabilities at the date of the change

resulting in adjustments to partners capital.

 Revaluation of an asset in a partnership : this is done to reward the

existing partners for their efforts in building up the business over its

life. In the case the partner retires it is only fair they are rewarded for

their efforts as well

o step 1 : DR revaluation account CR asset account(book value of

being revalued)

o step 2 : CR revaluation account DR liability account(book value of

the liability)

o step 3 : CR revaluation account DR asset account(new value of

the asset )

o step 4 : DR revaluation account CR liability account(new value of

the liability)

o an alternative method could include

o Revaluation account
 Decrease in asset Increase in asset
value value

Increase in liability Decrease in liability

value value

Profit on revaluation Loss on revaluation

- Partner A - Partner A

- Partner B - Partner B

 The remaining balance will be the profit or loss on revaluation which

will be shared between the partners in the current profit sharing ratio

in the capital account

 If the balance was on the debit side it will be a profit on revaluation, if

the balance was on the credit side it will be a loss on revaluation.

 Accounting for goodwill : Goodwill is the amount by which the value of

the entity or partnership as a going concern exceeds the net value of

its assets if they were sold individually. It is an intangible asset

 There are two types of goodwill : purchased goodwill and inherent

goodwill

 Purchased goodwill arises when one business buys another, if the

purchaser pays more then the net book value of the assets the

difference is goodwill, IAS allows this to be shown as an intangible non

current asset in the SOFP

 Inherent goodwill is internally generated and is not paid for and so

does not have an objective value.

  Goodwill is never brought into the revaluation account or current

account.

 Goodwill is not recorded for two reasons; value placed on goodwill is

difficult to justify and if goodwill is included it would be difficult to

convince a buyer to pay more for the business.

 When there’s a change in the partnership (change in profit sharing

ratio or admission/retirement of an existing partner) goodwill will need

to be adjusted, the following could be done :

o Goodwill could be opened and maintained: DR goodwill CR old

partners capital [old ratio]

o Or goodwill account can be opened and removed subsequently

 Step 1 : CR partners capital account with share of goodwill

in the old profit sharing ratio DR goodwill

 Step 2 : DR partners capital account with share of goodwill

in the new profit share ratio CR goodwill

 Capital account

 X Y X Y

Goodwill (shared in xx xx Goodwill (shared in xx xx

new ratio; step 2) x x old ratio; step 1) x x

 When apportioning profit while there’s a change in the profit share

ratio in the middle of the financial year

 If the profit is assumed to have been earned evenly throughout the

year, it should be divided between the old and new partnerships on a

time basis

 Some expenses may not have been incurred on a time basis and must

be allocated to the period they belong these expenses will be

specified, this can be done by splitting the gross profit between the

two trading periods before and after the change in the terms of

agreement

 Admission of a partner/when a partner leaves

o When a partner leaves or a new partner joins, it suggests the end

of partnership and the start of a new one, the following accounts

must be taken care of

o \

1. Asset revaluation – calculate the profit/loss on revaluation

o \

1. Adjustments for Goodwill

o \

1. Prepare the income and appropriation account for the two

periods before and after the admission

o \

1. Changes in the profit share ratio

o \

1. Prepare the current account

 Death/retirement of a partner

o The following takes place when a partner retires

 Revaluation of the assets and liabilities

 Goodwill adjustment

 Settlement of retiring partner : transfer the current account

balance of the retiring partner to the capital account

o After revaluation and goodwill entries in the capital account

balance the retiring partners column in the capital account the

missing figure is the amount payable to the retiring partner,

shown below

 A pay cash or cheque DR retiring partners capital CR

cash/bank

 B retiring partner takes asset of the business DR retiring

partner capital account CR asset account

 C transfer amount payable to a loan account by DR retiring

partners capital account CR loan a/c

 Partnership dissolution

o This is the process by which all the assets of the partnership are

sold and liabilities paid where the partnership ceases trading

o Reasons for dissolution

 Partnership is no longer profitable

 Partners disagree on borrowing the partnership and can no

longer work together

  Partner has died, retired or being declared bankrupt and

remaining partners agree to close down the business

 When a partnership business is being taken over by a

limited company or by another partnership or being

merged with another business

o Steps involved with partnership dissolution

 Transfer all assets and liabilities to the realisation account

except the bank balance. Realisation account: An account

prepared when a partnership is ceasing to trade, to record

the book value of the assets and liabilities and how much is

received for them if sold, or paid out in respect of liabilities.

The result will be a profit or loss on realisation.

 Enter the bank balance in the bank account

 Enter the capital balance in the capital account

 If there is a current account balance transfer them to the

capital account

 Show all the entries related with the sale of the asset

settlement by DR bank CR realisation

 Show the entries of the dissolution expenses by DR

realisation account CR cash/bank

 Balance the realisation account and transfer it to the

capital account, if the balance is one the debit side of the

 realisation then it is a realisation profit and should be

credited to the capital account in the profit sharing ratio.

 Balance the partners capital account and transfer the

missing figure to the bank account

 The bank account should balance

DR realisation CR asset account DR liabilities CR realisation Realisation

Account

$ $

Non current asset (at Trade

cost) payables

Other
Inventory
payables

Trade receivables

Other receivables

Capital account entries for admission, exit and dissolution of partnership.

( Some entries may not apply to all situations. e.g no capital will be brought

in during dissolution). Following normal ledger format. Left debit and right

credit.

Loss on realisation/
Bal b/d
revaluation

Current account( positive Profit on realisation/

balance) revaluation

New goodwill Old goodwill

 Loss on realisation/
Bal b/d
revaluation

Current account( negative

Asset taken by partner
balance)

Bank/capital brought in by
Partners loan
partner

Bank

Bal c/d

** \n **

Limited companies
 A limited company is a separate legal entity whose existence is

separate from its owners; the liabilities of the members are limited to

the amounts paid (or to be paid) on the shares issued to them i.e.

limited liability

 when a company is formed certain documents are registered by people

who are the founders with the registrar of companies and various fees

and duties are paid to the registrar

 the two documents needed are the articles of association (this is the

main constitutional document of a company that defines the existence

of the company and regulates the structure and control of the

company and its members ) and the memorandum of association ( this

 forms part of the article and defines the relationship of the company to

the rest of the world )

 the main difference between private and public companies is that

public companies are allowed to offer their shares to the public and

may arrange for the shares to be bought and sold on the stock

exchange while private companies cannot.

 Capital structure of a limited company

o Authorised share capital – the share capital the company is

allowed by law to issue to the public.

o Issued capital – total amount the company has issued on the

stock exchange

o Called up capital – the amount of shares taken up by

shareholders without having to pay the entire amount, usually in

instalments

o Paid up share capital – part of share capital for which the

company has actually received cash from shareholders

 Classes of shares

o Ordinary share capital – also known as equity of the company,

they are entitled to attend the AGM and vote on propositions,

they are paid a dividend on the profit that remains after

preference dividend id paid, they are hence the risk takers as

they may not receive dividends at all, all the reserves also

belong to them
 o Preference share capital – a share which doesn’t give the owner

any ownership rights in the company, dividends are normally

received at a fixed rate, payable before dividends to ordinary

shareholder. These may be redeemable of non redeemable, if its

redeemable companies can buy back the shares and hence will

appear under non current liabilities. Non redeemable would

mean the company cannot buy them back and will appear as

equity along with ordinary shares.

 Non cumulative preference share – not entitled to have any

arrears of dividends carried forward to future years if

profits are insufficient to pay dividends in full

 Cumulative preference shares – entitled to have arrears of

dividends carried forward to future years If profits are

insufficient

 Shares issued at a premium – this is the excess over the nominal or par

value of a share when it is issued, this is known as a capital reserve

and is hence non distributable: DR bank/cash account (with the total

cash received for the issue)

 CR share capital account (with the nominal value of the share)

 CR share premium (with the premium received)

 Revenue reserves – The profits made by a company which have not

been distributed to shareholders, these are created by transferring an

amount from profit for the year. These may be created for a specific
 purpose (replacement of non current asset, planned expansion, etc) or

general reserve to strengthen the financial position of the company.

These are usually distributable and used to pay dividends; retained

earnings and general reserve come under this class of reserve

 Capital reserve - Gains which (usually) arise from non-trading

activities, such as the revaluation of a company’s non current assets,

they represent gains that haven’t been realised yet, these may include

o Share premium – usually to pay up unissued shares to existing

shareholder as fully paid bonus issue, to write off expenses

arising on new share issue at premium and to write off any

commission paid on new share issue at premium

o Capital redemption reserve – created when a company redeems

or buys back shares from existing shareholders without using the

proceeds from issue of new shares created by DR retained

earnings CR capital redemption

o Revaluation reserve - A company may revalue its non-current

assets and any gain on the revaluation must be credited to a

revaluation reserve; it is an unrealised profit and must not be

credited to the income statement. May be used in bonus issues.

 Income statement for a limited company as per IAS 1

X’s income statement for the year ended ………

 $

Revenue

(-) cost of sales

Gross profit

(+) operating income

(-) distribution costs

(-) administrative
expenses

Profit/loss from
operations

(+) finance income

(-) finance cost

Profit before tax

(-) taxation

Profit for the year

 The statement of financial position as per IAS 1

X Limited’s statement of financial position as at ……….

Non current asset (net book

value):
 $

Plant Property Equipment

Intangible assets (goodwill)

Long term investments

Current assets:

Inventory

Trade receivables

Other receivables

Short term investments

Cash and cash equivalents

Total assets

Equity:

Ordinary share capital

Retained earnings

Share premium

General reserve

Non current liabilities:

Bank loans

Debentures
 $

Current liabilities:

Trade payables

Other payables

Tax payable

Bank overdraft

Total equity and liabilities

 The above format is for accounts which will be published by the

company and available for the general public to look at, internal

accounts will be in much more detail than this.

 IAS 1 allows for alternative ways of setting out the statement of

changes in equity. One such alternative is to prepare a statement of

recognised income and expenses. This is much less detailed, as it

includes such things as the profit for the year and gains on revaluation

of non-current assets. But no dividends paid or share issue

 Statement of changes in equity

 This is a statement prepared to show the changes in a company’s

share capital, reserves and retained earnings over a reporting period.

Statement of changes in equity for the year ended …
SHAREC SHAREPR GENERALR RETAINEDE TOT
 Any dividends that proposed will not be shown in the financial
APITAL EMIUM ESERVE ARNING AL

OPEN
X X X X X
BAL

PROFI
X X
T

DIVID
(X) (X)
END

SHAR
E X X X
ISSUE

RIGHT
S X X X
ISSUE

BONU
S X (X) X
ISSUE

TRANS
FER
TO
GENE X (X) X
RAL
RESER
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TOTAL
(BAL
C/D)

statements
 o Provisions are an amount set aside out of profits to reduce the

recorded value of an asset or to cover an expected liability even

if the exact amount or timing of the liability is uncertain.

o Dividends of two types, interim dividends and final dividends,

interim dividends are paid to existing shareholders during the

year given the directors are satisfied with the profits and cash

resources are sufficient while final dividends are paid after the

end of the financial year while director can only recommend the

amount of dividend to be paid, shareholders must approve the

payment

o Distributable profits consists of accumulated realised profits

which has been undistributed and its accumulated realised loss

which haven’t been previously written off.

 Difference between shares and debentures

 Share Debentures


Shareholders are members of § Debenture holders are creditors to

the company. the company

Shown in the statement of Shown in the SOFP under non current

financial position under equity liability

Shareholders are the last Debenture holders are entitled to be

people to be repaid when a repaid before shareholders are wound
company is wound up up

Dividends can only be paid if

Interest on debentures must be paid
distributable profits are
even if no profits are made
available

They receive an interest which is

Dividends are an appropriation
shown under finance cost as an
of profit.
expense in the income statement

Bonus share issue – this is an issue of free shares to existing

shareholders from the accumulated reserves of the company usually in

proportion to the existing ordinary shares using their reserves with no

payment

 The capital reserves are used for this (share premium)

o Share capital will increase on the SOFP

o Reserves will decrease

Example : if directors made a bonus issue of shares on the basis of three for

every five shares held

3/5 x the number of issued shared x par value

DR reserves CR share capital

 If its in the most flexible form the least flexible reserves are used first the

least being share premium and most flexible being general reserve.

 Rights issue – the purpose of rights issue is to raise finance further for

the company, this offers existing shareholders opportunity to purchase

additional shares at a price below the current market price, the

shareholders can either take up the shares and pay for it or sell the

rights on the stock market.

Example, the company made a rights issue of one new share for every five

shares already held. Then

1/5 x no. of issued shared x selling price

DR cash/bank [total amount received ]

CR share capital [rights issue x par value]

CR share premium [rights issue x share premium ]

Rights and bonus issues compared

Rights issue Bonus issue

§ Shareholders don’t pay for

Subscribers pay for shares
shares

The company net assets increased The net assets of the company are
by cash received unchanged

Shareholders do not have to

All the ordinary shareholders will
exercise their right to subscribe for
receive their bonus shares
the new shares

Shareholders may sell their rights if Shareholders may sell their bonus
 Rights issue Bonus issue

shares if they do not wish to keep

they do not wish to exercise them
them

 Other sources of finance for a limited company may include

o Bank loans

o Bank overdrafts

o Hire purchase - Hire purchase enables a purchaser to have the

beneficial use of an asset while the ownership of the asset

remains with the hire purchase company, at the end of the

agreement the company may own the asset

o Leasing – the asset is leased to the company for

a rental charge by a leasing company who will

own
 Internal stakeholders Reasons for interest

To assess business performance. \n To

Owner [in the case of a
identify areas of problem and take
sole trader or partnership]
corrective action.

Assess overall performance. Consider the

Existing shareholders security of their investment. Return in
terms of dividends and capital growth

Salary and bonus often linked with

Managers and directors
business performance.

To see if future pay or salary increases will

Workers
be made and if they have job security

External stakeholders Reasons for interest

Assess if loan overdraft should be granted.

Banks Interested to see if the business can be
able to pay back existing loans

Comparing several returns from several

Future shareholders
businesses and decide which to invest in

Investors [an individual who

Determine the return they will receive and
has been asked by the
the security of any investment
owner to invest fund]

Whether or not to supply to the business.

Supplier of the business To check if the business is liquid enough to
pay back

Assess performance to see if business will

Customers of the business
be able to supply to them In the future

Level of tax charged on profit. To decide

whether or not to give a grant. Check if
Government
business is in compliance with laws and
regulations

Local community If the business will provide employment

Assess their profitability to see if their

Trade unions
members pay could increase

Whether or not the business is operating

General community
 o the asset, the asset will never be owned by the company

o Long term capital

o Trade payables

o Working capital

Analysis and communication of accounting

information to stakeholders
 Stakeholder concept : individuals who are interested in the decisions

taken by the business and are as a result affected by it

 The purpose of financial statements, such as the income statement

and statement of financial position, is to present information in a

meaningful way. To be useful, information must be clear, complete,

reliable and timely.

 Limitations of published accounts

o Not clear to people who have insufficient knowledge on

accounting

o Information given isn’t complete, crucial data may be

confidential.

o Comparability is limited as accounting policies used differ

o Historic nature; information relates to past and circumstances

may have changed.

 Accounting ratios

 Profitability ratios

o Return on capital employed

  Formula:

 Operating profit/capital employed*100

 Comment: how much profit was generated per 100 dollars

invested in the form of equity, reserves and long term

liabilities. This measures the overall efficiency of a

company in employing the resources available to it, this

should be compared with the previous years ROCE, with

competitors and the industry average. The higher it is the

better, this indicates the business is efficiency managing

its equity.

o Gross margin

 Formula:

 gross profit/operating profit*100

 Comment: how much gross profit was generated per 100

dollars in sales, how efficient the trading activities of the

business. The higher the figure the greater the business is

at converting revenue to gross profit. A lower gross profit

would indicate that

 A rise in the price of goods purchased which weren’t

passed onto customers.

 Purchase of goods from a difference supplier at a

higher price.
  Selling price may have been cut to increase volume

of sales, to fight competition, as an introductory offer

for a new product, as a result of seasonal sales, to

get rid of old inventory, to increase cash flow.

 The cost of sales may have increased by the theft of

inventory.

o Profit margin:

 Formula:

 profit for the year/sales X 100

 Comment: how much profit is generated from revenue, this

indicates how efficiently the business can convert revenue

to profits, a lower percentage would indicate that the

business has not been able to control its expenses.

o Mark up

 Formula:

 gross profit/cost of sales * 100

 Comment: how much business has marked up costs before

arriving at the selling price. A fall in this ratio is bad for the

company as it indicates they may have has to buy from

more expensive suppliers and unable to pass the full

increase in purchase price to its customers. A business

may have had to reduce its mark up because of more

competition.
 o Expenses to revenue ratio

 Formula:

 operating expenses/revenue *100

 Comment: how effective are the managers in controlling

business expenses. In some cases. overheads may

increase as a percentage of sales, but the increase may not

match the increase in gross margin. The reason is that

most overheads, such as rent, do not vary as a result of an

increase in sales. Other overheads may vary although not

in proportion to sales.

 Liquidity ratios

o Current ratio

 Formula:

 Current assets/current liabilities : 1

 Comment: shows the relationship between current assets

and current liabilities, if the business is liquid enough to

pay creditors. A higher ratio may indicate the business has

enough funds to pay the current liabilities. A favourable

range for this ratio would be 1.5-2 : 1. But this depends on

the kind of business, a low ratio could mean danger, a high

ratio could mean the resources aren’t put to efficient use

and capital is lying idle as a result instead of being used

profitably.
 o Liquid ratio [acid test ratio]

 Formula:

 current assets - inventory/current liabilities : 1

 Comment: excludes inventory from the calculation and

shows liquid assets that is available to pay the current

liabilities. A good range would be 1-1.5 : 1. Businesses like

supermarkets would expect their sales on a daily basis

having a constant inflow of cash, while they enjoy a period

of credit to pay suppliers their ratio may not exceed 0.8:1.

A motor manufacturer on the contrary would have more

current assets then current liabilities making it seem

unfavourable without knowing the business, hence making

acid test ratio more suitable.

 Efficiency ratio

o Non current asset turnover

 Formula:

 net revenue/total net book value of non current

assets

 Comment: number of times the non current assets are

turned over, how well the non current assets are used to

generate revenue. The main reason for purchasing a non-

current asset is for it to either generate revenue for the

 business or reduce cost, both of which will hopefully

increase the profit. The higher the ratio is better.

o Trade receivables turnover [in days]

 Formula:

 trade receivables/credit sales * 365

 Comment: how long it takes credit customers to pay back

(credit period). The longer customers take to pay, the

company may be losing control over its customers and

deteriorating cash flow, the risk of incurring irrecoverable

debts is higher.

o Trade payables turnover [in days]

 Formula:

 trade payables/credit purchases*365

 Comment: length of time the business takes to pay its

creditors. The longer it takes to pay its creditors would

mean that cash outflow would be less, however this may

result in suppliers may withdraw their credit facilities in the

future.

o Inventory turnover [in days]

 Formula:

 average inventory/cost of sales * 365

 Comment: how it takes for the inventory to be sold. The

quicker the inventory is sold, the sooner the profit is

 realised and the more times profit is earned. A slow

turnover would mean excessive inventory is held and risk

of obsolete or spoiled inventory increases, hence inventory

being locked up would mean it is not earning revenue.

Days must be rounded up.

o Rate of inventory turnover times

 Formula:

 cost of sales/average inventory

 Average inventory is found by adding up the opening

and closing inventory divided by 2.

 Comment: the number of times a year the inventory is

turned over. Businesses like supermarkets would have a

higher turnover than a for instance a business like a

diamond retailer.

o Working capital cycle

 Formula:

 inventory days + trade receivables days - trade

payables days

 Comment: The working capital cycle measures the time it

takes for cash to circulate around the working capital

system. It calculates the interval that occurs between the

time a business has to pay its creditors (trade payables)

and the time it receives cash from its customers.

 Limitations of ratio

o Some useful information may not be disclosed

o Information may not be timely available only available at year

end

o Ratios don’t explain the cause of the change in results

o Ratios don’t recognise seasonal factor