AC4052 2023/24

FINANCIAL ACCOUNTING

Student seminar questions and notes

Including answers

1
 Who needs accounting?

Definition of accounting

Accounting is the process of

 identifying

 measuring and

 communicating

 financial information about an entity

 to permit informed judgment and

 decision

 by users of the information.

The development of a conceptual framework

A conceptual framework for accounting is a system which provides generally accepted

guidance for the development of new reporting practices and for challenging and evaluating the
existing practices.

 Who are the users of financial statements?

 What is the information needs of users?

 What types of financial statements will best satisfy their needs?

 What are the categories of financial statements which meet these needs?

 What are the principles for defining and recognizing items in financial statements?

 What are the principles for measuring items in financial statements?

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Weetman, Financial Accounting, 7e, Instructor’s Manual

External reporting and internal reporting

A conceptual framework is particularly important when practices are being developed for
reporting to those who are not part of the day-to-day running of the business.

This is called external or financial accounting.

For those who are managing the business on a day-to-day basis, special techniques have been
developed.

This is called internal or management accounting.

Types of business entity

SOLE TRADER

PARTNERSHIP

LIMITED COMPANY

Sole trader

An individual may enter into business exclusively, either selling goods or providing a service.

If cash is not available, the sole trader may introduce capital to start the business.

The sole trader’s business may be very much intertwined with the sole trader’s personal life.

For accounting purposes, the business is regarded as a separate entity, of which the sole trader
is the owner who takes the risk of the bad times and the benefit of the good times.

The owner may hardly feel any great need for accounting information because he or she
…………………………operates alone………………………………………………………but
accounting information will be needed by:

Government (in the form of HM Revenue and Customs) for tax collecting purposes;

the Bank for the purposes of lending money to the business; or

a person who wants to buy the business when the existing owner retires.
Weetman, Financial Accounting, 7e, Instructor’s Manual

Partnership

One method by which the sole trader may expand is to enter into partnership with other
persons.

This permits a pooling of skills or may allow one person with ideas to work with another who
has the money to provide the resources needed to turn the ideas into a profit.

However, there are real financial risks if the business is unsuccessful.

One partner may be required to meet debts and obligations of the partnership if the other
partner does not have sufficient personal property, possessions and cash. This is described in
law as joint and several liability.

For accounting purposes, the partnership is seen as a business, owned by the partners.

Need for accounting information:

 Partners. wishing to be sure that they are receiving a fair share of the partnership profits

 HM R…………………………….and C…………………

 BANKING……….……………… who provide finance

 Other persons who may be INTERESTED.

The major risk attached to either a sole trader or a partnership is that

THEY HAVE…………… Unlimited
liability………………………………………………………….………

including the family home if the business fails.

Limited liability company

To encourage the development of larger business entities, owners needed the protection of
………PERSONAL LIABILITY…………………………………; this meant that if the
business failed, then the owners might lose all the money they had put into the business but their
personal wealth would be safe.

Forms of limited liability company

A private limited company has the word ‘……Limited…………………’ (abbreviated as

‘Ltd’) in its title.

A public limited company has the abbreviation ‘…plc…….’ in its title.

Weetman, Financial Accounting, 7e, Instructor’s Manual

A private limited company is prohibited by law from offering its shares to the public
(appropriate to a family-controlled business). The public limited company is …………………
permitted to offer its shares to the public. In return, it has to satisfy more onerous regulations.

Some major differences

Differences between a partnership and a limited liability company

Partnership Limited liability company

Formation By agreement but not necessarily Registering the company

in writing under the Companies Act
Memorandum and articles
of association setting out
the powers allowed to the
company.

Running the business All partners share in the running Shareholders appoint
of the business directors to run the
business.

Accounting information Not obliged to make accounting Companies must make

information available to the public accounting information
available to the public
through the Register of
Companies. Annual
Financial Statement (The
Accounts).

Meeting obligations Partners are jointly and severally The personal liability of
liable for money owed by the firm each shareholder being
limited to any unpaid
amount on their shares.
Weetman, Financial Accounting, 7e, Instructor’s Manual

Users and their information needs

Management

Owners as investors

Employees

Lenders

Suppliers or trade creditors

Customers

Governments and their agencies

Public interest

General purpose or specific purpose financial statements?

Each user group has its own specific information needs.

However, there is a view that a ……………………………………………………………..

financial statement can be designed, which is useful to more than one user group.

Owners and long-term lenders are regarded as …………………………. but all potential users
are interested in ……………………………………………………………………………….

Agency theory

Relationship between ………………….. (principal) and …………………………… (agents)

There is an inherent conflict between the interests of owners and managers. This conflict is
partly resolved by the managers being required to provide information on a regular basis to the
owners so that their decisions and behaviour can be monitored and assessed.
A systematic approach to financial reporting: the
accounting equation

ASSETS − R…………………available to the business.

LIABILITIES − O……………………. of the business.

The accounting equation

Statement of financial position

Assets minus Liabilities equals Ownership interest

A − L = OI

The ownership interest is the residual claim after liabilities to third parties have been satisfied.

AL OI

_________________________________________

Alternative ways of expressing the accounting equation

Assets Equals Liabilities plus Ownership interest

A = L + OI

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Weetman, Financial Accounting, 7e, Instructor’s Manual

The balance analogy can be represented as:

A L+
OI

A disturbance on one side of the balance will require a corresponding disturbance

on the other side if the balance is to be maintained.

Measurement

Historical cost is the amount …………….for an asset or ……………for a liability on the date

when………………………………………….

Fair value is the price that would be received to sell an ………....or transfer a …………..

in an orderly transaction between……………………………………….at the measurement date.

Definition of an asset

A p………………………………..

c………………………………………………….

as a result of ………………………………………………………

Present economic resource: Is it capable of producing economic benefit?

Controlled by the entity: Can we restrict access to the item?

Past events: Has an agreement or event taken place that has resulted in the organisation
obtaining control of the item?

Examples of assets

 L…………………………………… owned by the business

 R…………………………………… owned by the business

 W…………………………………….. employed by the business

 Major a ………………………………………… undertaken by the business

Weetman, Financial Accounting, 7e, Instructor’s Manual

Should it be recognised as an asset? That is, should it be reported as a business asset in its
statement of financial position (balance sheet)?

Only if:

it meets the definition of an ………………………;

the resulting information is ………………………and provides a ………………………….;

the costs pf providing information are not excessive in relation to the ………………….

If there is a high level of uncertainty, then although the item might meet the definition of an
asset, it should not be reported (recognised) in the statement of financial position (balance sheet)
as an asset.

Recognise or not recognise?

Recognise Not recognise

………………………….. ……………………………………

Why? Why?

Relative certainty of future benefit Uncertainty of benefits: lack of evidence that

cash will flow to the business in the future

Liability: definition

A liability is defined as …………………………………

to transfer ………………………………………….

the settlement of which is expected to result in ………………………………………………….

Present obligation: legal or as a result of commercial reality

Transfer an economic resource: cash or other resource leaving the business

Past events: normally receiving goods or services or borrowing money

Recognition

Recognise if:

it meets the definition of a liability;

Weetman, Financial Accounting, 7e, Instructor’s Manual

the resulting information is relevant and provides a faithful representation; and

the costs of providing information are not excessive in relation to the benefits.

Examples

 B……………………………………………. by the business

 S………………. (VAT) payable by a business based on past sales.

Liabilities not recognised

An item that fails the recognition test, that is, it is not reported in the statement of financial
position (balance sheet), might well be reported in the notes to the accounts as a ‘contingent
liability’.

Example of the ‘prudent’ nature of financial reporting practice.

For example, potential liability for defective products (will a legal action actually be
undertaken?)

Defining the ownership interest

The ownership interest is the …………………………….. found by deducting all of the entity’s
liabilities from all of the entity’s assets.

The term ………………………………………………… is used as a shorter way of saying

‘total assets less total liabilities’.

Recognition of the ownership interest

There are no separate recognition criteria for the ownership interest.

It is wholly dependent on the recognition of assets and liabilities.

Changes in the ownership interest

How much better or worse off are the owners? This is calculated by comparing the financial
position of the business at two points in time.

At time t = 0 Assets(t0) −Liabilities(t0) = Ownership interest(t0)

At time t = 1 Assets(t1) −Liabilities(t1) = Ownership interest(t1)

Weetman, Financial Accounting, 7e, Instructor’s Manual

Taking one equation away from the other may be expressed as:

Change in equals Change in ownership interest

(assets minus liabilities)
or
change in net assets

Common causes of change in the total amounts of assets and liabilities and hence ownership
interest is as follows:

 Normal business transactions: supplying goods and services to customers.

 Owner contributing resources to the business (invest cash in the business).

or

 Withdrawing resources from the business (withdraw cash from the business).

Example

At the start of the year, a business had assets of £10m and liabilities of £6m.

At the end of the year, the same business had assets of £12m and liabilities of £5m.

What was the ownership interest at the start of the year? ………………….

What was the ownership interest at the end of the year? ……………………

What was the change in ownership interest during the year? ………………….

Revenue and expenses

Business transactions that result in an increase in ownership interest (i.e. increase in net assets)
are called …………………………

Providing a service to a customer for which payment is made

Business transactions that result in a decrease in ownership interest (i.e. decrease in net assets)
are called expenses.

Cost of providing a service to a customer

Weetman, Financial Accounting, 7e, Instructor’s Manual

The net impact of business transactions is:

Revenue
minus equals Profit
Expenses

Another equation may now be derived from the basic accounting equation

Change in Ownership Capital contributed/withdrawn by

interest equals the owner
plus Revenue
minus Expenses

Position after a change has occurred

At the end of the accounting period, there will be a new level of assets and liabilities recorded.
These assets and liabilities will have resulted from the activities of the business.

Assets equals Ownership interest at the

minus start of the period
Liabilities plus Capital contributed/withdrawn
at the end of the in the period
period plus Profits for the period
 Debit and credit bookkeeping

Assets equals Liabilities plus Ownership interest

Combinations of increases and decreases of the main elements of transactions

Left-hand side

Assets Increase Decrease

Right-hand side

Liabilities Decrease Increase

Ownership interest Decrease Increase

RULES

1. Ask yourself: Is this item an asset or a liability or a part of the ownership interest?

2. Choose the line in the table.

Asset
Liability
Ownership interest

3. Ask yourself: Has the item increased or decreased?

4. Choose the box that contains the answer.

Asset Increase Decrease
Liability Decrease Increase
Ownership interest Decrease Increase

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© Pearson Education Limited 2016
Weetman, Financial Accounting, 7e, Instructor’s Manual

5. Follow the action at the foot of the column (make a debit entry or a credit entry).
Asset Increase Decrease
Liability Decrease Increase
Ownership interest Decrease Increase
ACTION TO TAKE DEBIT ENTRIES IN A CREDIT ENTRIES IN A
LEDGER ACCOUNT LEDGER ACCOUNT

The ownership interest may be increased by:

earning revenue

new capital contributed by the owner

The ownership interest may be decreased by:

incurring expenses

capital withdrawn by the owner

So the ‘ownership interest’ section may be expanded as follows:

Rules of debit and credit for ledger entries, distinguishing different aspects of
ownership interest

Debit entries in a Credit entries in a ledger

ledger account account

Left-hand side of the equation

Asset Increase Decrease

Right-hand side of the equation

Liability Decrease Increase

Ownership interest Expense Revenue

Capital withdrawn Capital contributed

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© Pearson Education Limited 2016
 Ensuring the quality of financial statements

Fundamental qualitative characteristics

Relevance and faithful representation

Relevance

 Predictive value

 …………………………………………………..

Faithful representation

 Complete

 Neutral

 ………………….

Materiality

 Threshold for considering an item: Would a user’s decision change if the information were
………………………………………?

 Error of £10m in expense item. Overall profit £500m. Error is not material at …….% of profit.

 Error of £10m in expense item. Overall profit £20m. Error is material at ………..% of profit.

 Bad debt expense described as ………………………………. Materially misleading?

Enhancing qualitative characteristics

 C………………

 V……………….

 T……………….

 U………………..

Accounting principles

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 G………………………………….

 A………………………………….

 C…………………………………..

 P…………………………………..

Going concern

Asset cost £100, depreciation £10, market price if sold in crisis = £60; record ……….. net book value.

Accruals

Telephone paid £100, invoice due £20; recorded expense is ……………

Consistency

Use similar policies from one year to next or explain reason for and …………………..

Prudence – see later.

Prudence

Inclusion of a ………………………………. in accounting judgements under conditions of uncertainty

for example, inventory (stock) valuation

uncertainty is ……………………………………………..

Avoid

 Overstatement of ………………………

 Understatement of ……………………………..

Because both of these will lead to overstatement of profit

Assets −liabilities = Capital (including profit)

Create an asset. How does the equation balance? Answer: ………………….

Omit a liability. How does the equation balance? Answer: …………………..

Regulation of financial reporting

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 Financial statements
Objective: Information that is useful to …………………………………...

 Annual reports
Mixture of regulated and non-regulated contents …………………………. is audited.

 IAS Regulation
Overrides national company law
Requires all listed groups to prepare financial statements using IFRS.

 UK Company law
Requires true and fair view
Accounting rules apply to companies not following IAS Regulation.
Contains other rules for management and audit of a company.

 Financial Reporting Council

Authorised by the UK government to make arrangements for accounting standards, auditing standards,
oversight of professional bodies and firms and enforcement of standards.

(advised by the Accounting Council) Sets accounting standards for use in UK (by companies not
applying the IAS Regulation).

(advised by the Audit and Assurance Council) Sets auditing standards (based on International Standards
on Auditing) and a code of ethics for auditors.

Has oversight of professional bodies and accountancy firms

Monitors compliance with …………………………………….

May ask companies to …………………………………. wrong accounts

Investigates complaints against accountants and applies penalties

Sets Code on Corporate Governance for directors running a company

 Financial Conduct Authority

Regulates market for ………………….…………….

Has accounting rules for ………………………….… market

 Auditors

Give opinions on true and fair view from financial statements

 The tax system

Taxable profit is based on accounting profit but with additional rules, for example, depreciation rates
fixed specified by tax law.

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Is regulation necessary?

Conflicting views:

FOR REGULATION

(a) Supply and demand do not meet unless …………………………………………..

(b) Stakeholders may lose confidence or …………………………………...

(c) Scandals result where there is …………………………………………………….

AGAINST REGULATION

(a) Market forces ensure ………………………………………..

(b) Lenders will ensure they have good information for ……………………………...

(c) Costs may ……………………………………………...

Reviewing published financial statements

Look at ……………………………. in ……………………….. statements.

 S………………..

 G……………………

 P…………… before tax

 P…………….after tax

Trends in key figures

What kinds of …………………….. are held?

What kind of l………………………………. are held?

What is the ………………………………………….? Inflow or outflow?

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Analysis of debit and credit aspect of each transaction of the medical practice

Date Business transactions of medical practice Amount Debit Credit

Oct 1 Dr Lee provides the practice with cash to 50,000

allow business to start.

Oct 2 The entity acquires medical equipment for 30,000

cash.

Oct 2 One month’s rent is paid in advance for 1,900

consulting rooms.

Oct 2 Office furniture is purchased on two months’ 6,500

credit from Office Supplies Company.

Oct 7 The practice purchases medical supplies on 1,200

credit from P. Jones and receives an invoice.

Oct 8 Dr Lee pays the medical receptionist for one 300 Wages Cash
week’s work, 2 to 8 October.

Oct 10 Four patients are examined, each paying 2,000

£500 cash.

Oct 11 The business pays P. Jones in cash for the 1,200

goods it acquired on credit.

Oct 14 The business pays an electricity bill in cash. 100 Electricity Cash

Oct 15 Dr Lee pays the medical receptionist for one 300 Wages Cash
week’s work, 9 to 15 October.

Oct 17 Three patients are examined, their employer 1,500

(Mrs West) being sent an invoice requesting
payment of £500 for each.

Oct 22 Dr Lee pays the medical receptionist for one 300 Wages Cash
week’s work, 16th to 22nd October.

Oct 23 The employer (Mrs West) pays in cash for 1,500

the examination of three patients.

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 Oct 24 Four patients are examined, their employer 2,000 Mr East Fees
(Mr East) being sent an invoice requesting
payment of £500 for each.

Oct 28 Dr Lee draws cash from the business for 1,000 Owner Cash
personal use.

Oct 29 Dr Lee pays the medical receptionist for one 300 Wages Cash
week’s work, 23 to 29 October.

Oct 31 The medical equipment and office furniture 250 Depreciatio Equipmen
is estimated by Dr Lee to have fallen in n t and
value over the month. furniture

Oct 31 Dr Lee checks the inventory (stock) of 350 Medical Inventory

medical supplies and finds that items costing supplies (stock)
£350 have been used during the month. expense

Form of ledger accounts

Three-column ruling

Date Particulars Page Debit Credit Balance

£p £p £p

Form of a ‘T’ ledger account

Page number and name of the account

Debit entries Credit entries

Date Particulars Page £ p Date Particulars Page £ p

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Dr Lee’s medical practice: analysing the debit and credit entries for each transaction

Ledger accounts required to record these transactions are as follows:

L1 Cash L8 Inventory (stock) of medical supplies

L2 Ownership interest L9 P. Jones

L3 Medical equipment and office furniture L10 Electricity

L4 Office Supplies Company L11 Mrs West

L5 Rent L12 Mr East

L6 Wages L13 Depreciation

L7 Patients’ fees L14 Expense of medical supplies

Enter the first transaction for Dr Lee’s medical practice.

L1 Cash

Date Particulars Page Debit Credit Balance

£ £ £

Oct 1 Owner’s capital L2 50,000 50,000

L2 Ownership interest

Date Particulars Page Debit Credit Balance

£ £ £

Oct 1 Cash L1 50,000 (50,000)

FULL LEDGER ACCOUNTS (see pp. 122–127 for discussion of each).

L1 Cash

Date Particulars Page Debit Credit Balance

£ £ £

Oct 1 Ownership interest L2 50,000 50,000

Oct 2 Medical equipment L3 30,000 20,000

Oct 2 Rent L5 1,900 18,100

Oct 8 Wages L6 300 17,800

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Oct 10 Patients’ fees L7 2,000 19,800

Oct 11 P. Jones L9 1,200 18,600

Oct 14 Electricity L10 100 18,500

Oct 15 Wages L6 300 18,200

Oct 22 Wages L6 300 17,900

Oct 23 Mrs West L11 1,500 19,400

Oct 28 Ownership interest taken as drawings L2 1,000 18,400

Oct 29 Wages L6 300 18,100

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L2 Ownership interest

Date Particulars Page Debit Credit Balance

£ £ £

Oct 1 Cash contributed L1 50,000 (50,000)

Oct 28 Cash drawn L1 1,000 (49,000)

L3 Medical equipment and office furniture

Date Particulars Page Debit Credit Balance

£ £ £

Oct 2 Cash L1 30,000 30,000

Oct 4 Office Supplies Company L4 6,500 36,500

Oct 31 Depreciation L13 250 36,250

L4 Office supplies company

Date Particulars Page Debit Credit Balance

£ £ £

Oct 2 Office furniture L3 6,500 (6,500)

L5 Rent

Date Particulars Page Debit Credit Balance

£ £ £

Oct 2 Cash L1 1,900 1,900

L6 Wages

Date Particulars Page Debit Credit Balance

£ £ £

Oct 8 Cash L1 300 300

Oct 15 Cash L1 300 600

Oct 22 Cash L1 300 900

Oct 29 Cash L1 300 1,200

L7 Patients’ fees

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Date Particulars Page Debit Credit Balance

£ £ £

Oct 10 Cash L1 2,000 (2,000)

Oct 17 Credit: Mrs West (as employer) L11 1,500 (3,500)

Oct 24 Credit: Mr East (as employer) L12 2,000 (5,500)

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L8 Inventory (stock) of medical supplies

Date Particulars Page Debit Credit Balance

£ £ £

Oct 7 P. Jones L9 1,200 1,200

Oct 31 Expense of medical supplies L14 350 850

L9 P. Jones

Date Particulars Page Debit Credit Balance

£ £ £

Oct 7 Inventory (stock) of medical supplies L8 1,200 (1,200)

Oct 11 Cash L1 1,200 nil

L10 Electricity

Date Particulars Page Debit Credit Balance

£ £ £

Oct 14 Cash L1 100 100

L11 Mrs West

Date Particulars Page Debit Credit Balance

£ £ £

Oct 17 Patients’ fees L7 1,500 1,500

Oct 23 Cash L1 1,500 nil

L12 Mr East

Date Particulars Page Debit Credit Balance

£ £ £

Oct 24 Patients’ fees L7 2,000 2,000

L13 Depreciation

Date Particulars Page Debit Credit Balance

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 £ £ £

Oct 31 Medical equipment and office furniture L3 250 250

L14 Expense of medical supplies

Date Particulars Page Debit Credit Balance

£ £ £

Oct 31 Inventory (stock) of medical supplies L8 350 350

Comprehensive Exercise

On 1 December 2017, P Roberts started a business with £4,500 in the bank and £600 cash. The
following transactions took place.

Dec 2 He bought trading goods on credit for £700 from J. Martin.

Dec 3 He sold goods for £300 on credit to G. Goddard.

Dec 7 He sold goods for £1,100 to K. Lemon on credit.

Dec 12 He bought equipment for £3,000, paying by cheque.

Dec 18 He paid wages of £50 by cheque.

Dec 20 K. Lemon returned goods, £50, to the business

De 20 He bought goods for £350, from A. Green, paying immediately by cheque.

Dec 21 He took £80 cash for own use.

Dec 28 He paid J. Martin £250 by cheque.

Dec 29 G. Goddard settled his account in full by cheque.

Dec 31 He transferred £200 cash into bank

Required:

a) Record the above transactions in the appropriate ledger accounts.

b) Balance off the accounts at 31 December 2017

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c) Extract a trial balance as at 31 December 2017

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Checking the accuracy of double-entry records

At periodic intervals, it may be considered necessary for a number of reasons to check the accuracy of the
entries made in ledger accounts. For instance, the omission of an entry on the debit side of a customer’s
ledger account for goods sold on credit terms could result in a failure to issue reminders for payment of an
amount owed to the business.

In the ledger accounts shown in this example, the balances have been kept as running totals. A summary of
all the balances at the end of the accounting period is called a ………………………………………………..
(‘trial’ means ‘tests the accuracy’ of the balances). If the total of the debit balances equals the total of the
credit balances, then we know that the total of the debit entries in the ledger accounts must equal the total of
the credit entries in the ledger accounts.

Trial balance at 31 October for Dr Lee’s medical practice

Ledger account title Debit Credit

£ £

L1 Cash at bank 18,100

L2 Ownership interest 49,000

L3 Medical equipment and office furniture 36,250

L4 Office Supplies Company 6,500

L5 Rent 1,900

L6 Wages 1,200

L7 Patients’ fees 5,500

L8 Inventory (stock) of medical supplies 850

L9 P. Jones nil

L10 Electricity 100

L11 Mrs West nil

L12 Mr East 2,000

L13 Depreciation 250

L14 Expense of medical supplies 350

Totals 61,000 61,000

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Error detection using the trial balance

Errors which will be detected by unequal totals in the trial balance

……………………… one aspect of a transaction (e.g. a debit entry but no credit entry).

Writing …………………amounts in ……….. entry (e.g. debit £290 but credit £209).

Writing both entries in …………………………………… (e.g. two debits, no credit).

Incorrect …………………………………. of ledger account balance.

Errors which will not be detected because they leave the trial balance totals equal

…………………………………… of a transaction.

Errors in both ………………… and ………………… entry of the same magnitude.

Entering the ……………….. amount in the ……………….. ledger account (e.g. debit for wages

expense entered as debit for heat and light expense)

CORRECTION OF ERRORS

Errors not affecting the trial balance

The following are errors that do not affect the agreement of the trial balance:
i. Error of omission - a transaction is completely omitted from the books. E.g. cash paid
for motor repairs £67, was entirely omitted from the books.
ii. Error of commission – this occurs when the correct amount is entered, but in the wrong
person’s account. E.g. A sale of £80 made to A. Blair was wrongly entered in A. Blake
account in the sales ledger.
iii. Error of principle – this error breaks the ‘rules’ of an accounting principle or concept.
E.g. the purchase of Motor Vehicle £8,000 was debited to vehicle maintenance
expenses account.
iv. Compensating errors – these errors exactly cancel themselves out. The errors are equal
and opposite to each other. E.g. the discount allowed account was overcast by £90,
and so was the commission received account.
v. Error of original entry – where the original figure is incorrect, yet double entry is still
observed using this incorrect figure. E.g. A mistake in calculating the figure on a sales

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 invoice to P. Paul has resulting in using £150 in both the Sales and the debtor accounts
instead of £180.
vi. Complete reversal of entries – where the correct amounts are used but each item is
shown on the wrong side of the account. E.g. a cheque for £400 paid to K King in full
settlement of an outstanding debt was instead recorded in both the cash book and K.
King’s account as a receipt.

Errors that affect the trial balance totals

The following errors will cause a disagreement of the trial balance totals:
i. Incorrect additions in any account.
ii. Making an entry on only one side of the accounts e.g. a debit but no credit; a credit but
no debit.
iii. Entering a different amount on the debit side from the amount on the credit side e.g.
transposition error.

The suspense accounts

This is an account showing a balance equal to the differences in a trial balance. It is used to
temporarily balance an out-of-balance trial balance. After the errors have subsequently found
and corrected, the balance on the suspense account should be entirely removed.

The suspense account is also used as a temporary account to hold the other corresponding entry
in a double entry until the correct account is determined later. E.g. when a cheque is received, but
the purpose of the payment is not very clear.

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EXERCISE 1

B. Potters has been in business for several years making up accounts up to

30 April each year.

The trial balance as at 30 April 20X5 did not agree and the difference of £2,513 was debited to
a suspense account.

A subsequent audit revealed that the following errors was made in the books during the
accounting period that ended 30 April 20X5:
i. A purchase of Office Furniture on credit £500 from Teal Ltd, in December 20X4 was
omitted from the books.
ii. The office cleaning expense account was overstated by £100. The interest income
account was also overstated by the same amount.
iii. Discount received of £324 was posted to the debit of the discount allowed account.
iv. Wages of £2,963 paid in February 20X5 have not been posted from the cash book.
v. A credit note £900, issued to K. Matthew in November 20X4 has been posted to the
credit of K. Mathias.
vi. No adjustment was made in the accounts for closing stock of £1,500 on 30 April 20X5.
vii. A payment of £341 to P. Wright in January 20X5 has been posted to his account as
£143.
viii. A remittance of £2,000 received from N. Nathan, a credit customer, in March 20X5 has
been credited to sales, as cash sales.

The draft accounts for the year ended 30 April 20X5 show a net profit of £24,000.

Required:
a) Show the relevant journal entries to correct the above errors.
b) Prepare the suspense account to reflect the necessary corrections.
c) Show the corrected net profit for the year ended 30 April 20X5 after the correction of the
above errors.

31
 EXERCISE 2
The trial balance of the business of S. Smith at 31 March 20X5 did not balance and the difference
of £190 was debited to a suspense account.

The following errors were located after the year end:

i. The total credit sales for March 20X5 was £3,456 but it was posted in error to the sales
account as £3,546. The postings to the debtor accounts were correct.

ii. The postings from the cash book to the motor repairs account for a cheque payment of
£150 in December 20X4 has been omitted.

iii. A cheque payment of £216 to A. Amos has been entered in the books as £261.

iv. A credit sale of £500 to M. Morris has been debited to M. Moore’s account.

v. Bank interest income for January 20X5 £50 entered in the cash book as a receipt has not
been posted to the nominal account.

Required:

Prepare the relevant journal entries to correct the above errors and write up the suspense
account.

32
EXERCISES – ACCRUALS AND PREPAYMENTS
ACCRUALS: Example 1
A firm prepared accounts to 31 October 2014.
Petrol expenses are paid monthly on receipt of the invoice from the garage.
Invoices for November 2013 to September 2014:
were all received on the last day of the month and paid on the 8th of the following month.
Invoices for the 11 months totalled £605.
October’s invoice for £60 was received late and was not paid until 18th November 2014

Required:

Show:
a. Motor expense in the statement of profit or loss for the year ended 31 October 2014
b. Accruals figure in Statement of financial position at 31 October 2014

ACCRUALS: Example 2

Following are the transactions for Electricity (Light and Heat) for the year ended 30 November
2014:

Payments made quarterly for electricity used in the previous 3 months: £

1 December 2013 cash paid 480

1 March 2014 cash paid 630

1 June 2014 cash paid 720

1 September 2014 cash paid 450

1 December 2014 cash paid 520

Additional information:
Year ended 30 November 2013: £480 accrued

Required:

Show:
a) Calculate the electricity expense to be charged to the statement of profit or loss for the
year ended 30 November 2014

b) Accruals figure in Statement of financial position at 30 November 2014

PREPAYMENTS: Example 1

33
A firm prepares accounts to 30 September 2014.
Insurance premiums £3,600 (for the year up to 31 December 2014) were paid 2 January 2014.

Required:

Calculate the insurance prepaid and show extracts in the statement of profit or loss and the
statement of financial position at 30 September 2014.

Prepayment: ? / 12 x £3,600= £?

PREPAYMENTS: Example 2

Using the previous example:

Insurance premiums of £4,000 (for a year up to 31 December 2015) were paid on 5 January 2015:

Required:
Calculate the insurance expense for year ended 30 September 2015

34
Depreciation
Example 1:

Cost of Machinery £50,000

Estimated useful life 4 years
Residual value £10,000

Required:
Calculate the annual depreciation charge for the 4 years

Example 2:

Cost of Motor Vehicle £50,000

Depreciation is to be charged at 20% p.a. based on the reducing balance method.

Required:
Calculate the depreciation charge for the first three years

Example 3: Disposal of Non-current asset

You have been provided with the following information from the books of B. Blue at 31 Jan 31 2016:

Machine traded in: £

Cost 42,000
Depreciation to date of trade in 25,200
Trade in value 17,500

New Machine
Loan raised 26,000
Balance of cost (paid to supplier by cheque) 8,000

Required:

(a) What is the profit or loss on disposal of the machine traded in?

(b) What is the balance to be recorded in the Machinery Account on completion of the transactions

Illustration - bad debt and allowance for receivables

The following information is given regarding the trade receivables of B. George, who prepares accounts up
to 31 January each year:
Trade Receivables at 31 January 2014 £30,000

35
 Trade Receivables at 31 January 2015 £45,000

The allowance for receivables at each year-end is to be 5 per cent, after writing off bad debts. Bad debts to
be written off are as follows:
for year-end 31 January 2014 £3,000
for year-ended 31 January 2015 £2,000

Required:

(a) What charge will be included in the statement of profit and loss for bad debt and allowance for
receivables?

(b) Show extracts from the statement of financial position for Trade Receivables for the relevant years

PRACTICE QUESTIONS

1. William has been trading for a number of years as a sole trader. The following is a trial balance
of the business as at 31 March 2016.
DR CR
£ £
Capital 83,000
Sales 259,800
Sales returns 600
Trade payables 19,840
Provision for doubtful debt 512
Discount allowed 2,300
Discount received 1,750
Purchases 135,500
Purchases returns 740
Drawings 19,342
Rent, rates and insurance 25,900
Heating and lighting 13,400
Salaries and wages 38,500
Bad debt 2,010
Cash in hand 640
Cash at bank 4,600
Inventory as at 01 April 2015 19,650
Trade receivables 27,400
Fixtures and fittings - at cost 150,800
Accumulated depreciation on fixtures and fittings
as at 01 April 2015 63,000
Loan - payable 2020 12,000
440,642 440,642

The following additional information as at 31 March 2016 is available:

(i) Inventory held at the year-end was valued at £17,700

(ii) Insurance was prepaid by £1,120

36
 (iii) Heating and lighting accrued by £1,340

(iv) The provision for doubtful debt is to be adjusted to 3% of trade receivables

(v) Depreciation is to be charged on fixtures and fittings at 25% per annum on the

reducing-balance basis.

Required

Prepare:

(i) The statement of profit or loss for the year ended 31 March 2016

(ii) The statement of financial position as at 31 March 2016

2. Below is an extract relating to the Machinery account and the related accumulated depreciation
of Bravo, a sole trader.

200,00
Machinery at cost 0

72
Accumulated depreciation on Machinery at 01 sept 2015 ,000

Bravo depreciates his machinery at 20% on the reducing balance basis

Bravo's policy is to charge full depreciation during the year of purchase and no depreciation

during the year of disposal.

A piece of machinery bought on 01 April 2014 for £10,000 was sold for £6,900 on 30 June 2016

Required:

(a) Calculate the depreciation charge for Machinery at 30 September 2016

(b) Calculate the gain or loss on the machinery that was disposed of on 30 June 2016

(c) Calculate the carrying amount of Machinery for the statement of financial position

at 30 September 2016.

37
38
LIMITED COMPANIES

TWILIGHT LTD
The following balances were extracted from the accounting records of Twilight Ltd

Trial Balance as at 31 March 2017

DR CR
Revenue 940,000
Purchases 472,000
Inventory, 01 April 2016 125,000
Salaries and wages 64,000
Directors' remuneration 10,000
Audit fees 4,000
Heat and light 28,000
Debenture Interest 10,000
Interim dividend paid 150,000
Communications expenses 20,000
Building at cost 500,000
Building - accumulated depreciation 01 Apr 2016 5 0,000
Fixtures and fittings at cost 100,000
Fixtures and fittings - accumulated depreciation, 01 Apr 2016 20,000
10% Debentures - 2020 200,000
Ordinary share capital (fully paid) 1,000,000
Trade payables 80,000
Trade receivables 120,000
Bank 467,000
Retained earnings 146,000
Share premium account 180,000
General reserve 25,000
Long-term investments 571,000
2,641,000 2,641,000

The following additional information at 31 March 2017 should be taken into account:

(i) Inventory was valued at £127,000

(ii) Audit fees of £1,000 were outstanding
(iii) The outstanding debenture interest is to be provided for
(iv) Depreciation is to charged on buildings at 5% on the straight line basis and on
fixtures and fittings at 20% on the reducing balance basis
(v) The directors decided to transfer £50,000 to the general reserve account

Required:

Prepare for Twilight Ltd:

(a) the statement of profit or loss for the year ended 31 March 2017
(b) the statement of changes in equity for the year ended 31 March 2017
(c ) the statement of financial position for the year ended 31 March 2017

Reporting cash flows

39
Definitions

Cash comprises cash on hand and demand deposits.

Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of
cash and are subject to an insignificant risk of changes in value.

The direct method and the indirect method

Data for illustration

Income statement (profit and loss account), Year 2

£
Revenue 100
Cost of sales: materials (40)
Wages (20)
Depreciation (10)
Operating profit 30

Statement of financial position (balance sheet)

Year 2 Year 1
£ £
Non-current assets 90 100
Current assets
Inventory (stock) of materials 55 40
Trade receivables (debtors) 12 15
Cash 35 10
Total current assets 102 65
Total assets 192 165
Current liabilities
Trade payables (creditors) (11) (14)

Non-current liabilities
Long-term loans (100) (100)
Total liabilities (111) (114)
Net assets 81 51

Ownership interest 81 51

Direct method

40
 £
Cash received from customers 103
Cash paid to suppliers (58)
Wages paid (20)
Operating cash flow 25

Indirect method

Indirect method

£
Operating profit 30
Add back depreciation 10
40
(Increase) in inventory (15)
Decrease in receivables 3
(Decrease) in payables (3)
Operating cash flow 25

Which to choose – direct or indirect?

 Both are allowed by IAS 7.

 Both give the same answer for operating cash flow.

 Indirect method emphasises management of working capital.

 Direct method gives information that is not available elsewhere in the annual report.

Indirect method format

£m £m
1 Cash flows from operating activities
2 Profit before taxation xx
3 Adjustment for items not involving a flow of cash:
4 Depreciation, amortisation, gain or loss on disposal of non-current assets, etc. xx
5 Adjusted profit xx
6 (Increase)/decrease in inventories xx
7 (Increase)/decrease in trade receivables xx
8 (Increase)/decrease in prepayments xx
9 Increase/(decrease) in cash due to (increases)/decreases in current assets xx
10 Increase/(decrease) in trade payables xx
11 Increase/(decrease) in accruals xx
12 Increase/(decrease) in cash due to increases/(decreases) in liabilities xx

41
 13 Increase/(decrease) in cash due to working capital changes xx
14 Cash generated from operations xx
15 Interest paid (xx)
16 Taxes paid (xx)
17 Net cash inflow from operating activities xx
18 Cash flows from investing activities
19 Purchase of non-current assets xx
20 Proceeds from sale of non-current assets xx
21 Interest received xx
22 Dividends received xx
23 Net cash used in investing activities xx
24 Cash flows from financing activities
25 Proceeds from issue of share capital xx
26 Proceeds from long-term borrowing xx
27 Dividends paid xx
28 Net cash used in financing activities xx
29 Increase/(decrease) in cash and cash equivalents xx
30 Cash and cash equivalents at the start of the period xx
31 Cash and cash equivalents at the end of the period xx

Line 1 Cash flows from operating activities

–Shows how cash flows are generated from the operations of the business

Line 2 Profit before taxation

–Starts with the operating profit before deducting interest and taxation

Line 3 Adjustment for items not involving a flow of cash

–Depreciation, amortisation, provisions, unrealised gains and losses

Line 4 Adding back depreciation, amortisation, gain or loss on disposal, etc.

–Add back because these items are not part of cash flow and therefore are not needed

Line 5 Adjusted profit

–Subtotal line

Line 6 Increase/decrease in inventories (stocks)

–Increase inventories, use up cash; reduce inventories, release cash

Line 7 Increase/decrease in trade receivables (debtors)

–Increase debtors, reduce cash flow; decrease debtors, increase cash flow

42
Line 8 Increase/decrease in prepayments

–Increase prepayments, use more cash; decrease prepayments, reduce the need for cash

Line 9 Increase/decrease in cash due to (increases)/decreases in current assets

–Subtotal

Line 10 Increase/decrease in trade payables (creditors)

–Increase creditors, reduce the need for cash; decrease creditors, use up cash faster

Line 11 Increase/decrease in accruals

–Increase accruals (unpaid expenses), reduce the need for cash; reduce accruals, use up cash faster

Line 12 Increase/decrease in cash due to increases/decreases in liabilities

–Subtotal

Line 13 Increase/decrease in cash due to working capital changes

–Subtotal for change in current assets minus change in current liabilities

Line 14 Cash generated from operations

–Subtotal

Line 15 Interest paid

–Cash paid in the period

Line 16 Taxes paid

–Cash paid in the period

Line 17 Net cash inflow from operating activities

–Subtotal

Line 18 Cash flows from investing activities

–Start of second major section

Line 19 Purchase of non-current assets

–Cash paid for non-current (fixed) assets

43
Line 20 Proceeds from sale of non-current assets

–Cash received (this is not the same as gain or loss on disposal)

Line 21 Interest received

–Cash received as interest on deposits or loans made

Line 22 Dividends received

–Cash received as dividends on shareholdings

Line 23 Net cash used in investing activities

–Subtotal

Line 24 Cash flows from financing activities

–Start of third major section

Line 25 Proceeds from issue of share capital

–Cash received equals increase in nominal value plus increase in share premium reserve

Line 26 Proceeds from long-term borrowings

–Cash received from lenders

Line 27 Dividends paid

–Dividends paid during the financial year (usually proposed dividend from previous year plus interim of
current year)

Line 28 Net cash used in financing activities

–Subtotal

Line 29 Increase/(decrease) in cash and cash equivalents

–Total of lines 17 + 23 + 28 (sum of each main section)

Lines 30 and 31 Cash and cash equivalents at the start and end of the period

–Taken from the statement of financial position (balance sheet)

Check on calculations

44
Lines 29 +30 = Line 31

45
Direct method

£m £m
1 Cash flows from operating activities
2 Cash receipts from customers xx
3 Cash paid to suppliers xx
4 Cash paid to employees xx
5–13 (Lines not used)
14 Cash generated from operations xx
15 Interest paid (xx)
16 Taxes paid (xx)
17 Net cash inflow from operating activities xx
18 Cash flows from investing activities
19 Purchase of non-current assets xx
20 Proceeds from sale of non-current assets xx
21 Interest received xx
22 Dividends received xx
23 Net cash used in investing activities xx
24 Cash flows from financing activities
25 Proceeds from issue of share capital xx
26 Proceeds from long-term borrowing xx
27 Dividends paid xx
28 Net cash used in financing activities xx
29 Increase/(decrease) in cash and cash equivalents xx
30 Cash and cash equivalents at the start of the period xx
31 Cash and cash equivalents at the end of the period xx

Direct method

Line 2 Cash receipts from customer

–Cash received from customers

(Check that cash received = sales of the period + receivables at start − receivables at end)

Line 3 Cash paid to suppliers

–Cash paid to suppliers (check that cash paid = purchases of the period + payables at start – payables at end)

46
Line 4 Cash paid to employees

–Usually, there are no wages or salaries unpaid at the end of a period.

Lines 14–31: Same as for indirect method

Summary

 Cash comprises cash on hand and demand deposits.

 Cash equivalents are short-term, highly liquid investments that are readily convertible to known
amounts of cash and are subject to an insignificant risk of changes in value.

 The indirect method and the direct method are alternative approaches for calculating the cash flow
arising from operating activities.

 The indirect method starts with the profit from operations, eliminates non-cash expenses such as
depreciation and adds on or deducts the effects of changes in working capital to arrive at the cash flow
arising from operating activities.

 The direct method takes each item of operating cash flow separately from the cash records to arrive at
the cash flow arising from operating activities.

RATIO ANALYSIS

Systematic approach to ratio analysis

 Investor ratios

 Analysis of management performance

 Liquidity

 Gearing (referred to in American texts as ‘Leverage’)

Case study: Peter (Television) plc

Lecture examples will calculate the ratios for Year 2.

After the lecture, calculate the ratios for Year 1 and attempt to comment on the picture presented by
these ratios.

Compare your calculations and comments with the textbook, Section 13.7

Peter (Television) plc

47
 Income statement (profit and loss account)
for the year ended 31 December Year 2

Year 2 Year 1
£000’s £000’s £000’s £000’s
Sales (revenue) 720 600
Cost of sales (432) (348)
Gross profit 288 252
Distribution costs (72) (54)
Administrative expenses (87) (81)

(159) (135)
Operating profit 129 117
Interest payable (24) (24)
Profit before taxation 105 93
Taxation (42) (37)
Profit for the period 63 56

48
 Statement of financial position (balance sheet) as on 31 December Year 2

Year 2 Year 1
£000’s £000’s £000’s £000’s
Non-current (fixed) assets:
Land and buildings 600 615
Plant and equipment 555 503
Total non-current assets 1,155 1,118
Current assets:
Inventory (stock) 115 82
Trade receivables (debtors) 89 61
Prepayments 10 9
Bank 6 46
Total current assets 220 198
Total assets 1,375 1,316
Current liabilities
Trade payables (creditors) (45) (30)
Taxation (21) (19)
Accruals (29) (25)
Total current liabilities (95) (74)

6% debentures (400) (400)

Total liabilities (495) (474)
Net assets 880 842
Ordinary shares of £1 500 500
Retained profits 380 342
880 842

Statement of changes in equity

£m
Share capital and reserves end year 1 842
Less dividend paid (25)
Add profit year 2 63
Share capital and reserves end year 2 880

Market price on 1 March Year 2 202 pence

Market price on 1 March Year 3 277 pence

49
Directors’ report

Directors propose a dividend of 6.0 pence per share.

Investor ratios

Earnings per share

Price–earnings ratio

Dividend per share

Dividend cover (payout ratio)

Dividend yield

50
Analysis of management performance

Return on shareholders’ equity

Return on capital employed

Operating profit on sales

Gross profit percentage

Total assets usage

100%

Non-current (fixed) assets

usage 100%

51
Liquidity and working capital

Current ratio Current assets:Current liabilities

Acid test (Current assets minus stock):Current liabilities

Inventory (stock) holding period

× 365

Customers collection period

× 365

Suppliers payment period

× 365

Working capital cycle Stock holding period +

Customers collection period −

Suppliers payment period

52
 Example of working capital cycle
Inventory (stock) holding 83.2 days
Customers collection 45.1 days
127.3 days
Suppliers payment 35.3 days
Finance needed for 92.0 days

Gearing

Debt/equity ratio

Interest cover

53
Peter Television: Statement of cash flows

(Assume depreciation £50m)

£m £m
Cash flows from operating activities
Profit before taxation 129
Adjustment for items not involving a flow of cash:
Depreciation 50
179
Increase in inventories (stocks)
(115 − 82) 33
Increase in trade receivables (debtors)
(89 − 61) 28
Increase in prepayments (10 − 9) 1

Reduction in cash due to increases in current assets 62

Increase in trade payables (creditors) (45 − 30)
(15)
Increase in accruals (29 − 25) ( 4)
Increase in cash due to increases in liabilities (19)
Reduction in cash due to working capital changes (43)
Cash generated from operations 136
Interest paid (24)
Taxes paid (42 + 19 − 21) (40)
Net cash inflow from operating activities 72
Cash flows from investing activities
Capital expenditure (87)
(1,155 − 1,118 + 50)

Cash flows from financing activities (15)

Equity dividends paid (25)
(dividend proposed at end of Year 1)

Decrease in cash (40)

Check in statement of financial position (balance sheet) 40
Decrease in bank (46 − 6)

54
EBITDA

Earnings before deducting:

 interest

 taxation

 depreciation

 amortisation

An approximation to cash flow

Free cash flow

No precise definition but used to reflect operating cash flow minus capital expenditure – ‘free’ for future
investment or for paying dividends.

55