AS LEVEL ACCOUNTING THEORY

ACCOUNTING CYCLE

The Accounting Cycle is a series of steps, which are repeated every reporting period. The
process starts with making accounting entries for each transaction and goes through closing
the books. This Involves recording transactions in the daybooks, posting them to ledger,
extracting a trial balance and finally drawing up financial statements.

Step 1: Recording Transactions in Daybooks

Each transaction is recorded first in one of the following daybook ( book of original entry)
according to the nature of the transaction.

1. All goods sold on Credit ( Credit Sales) ….> Sales Daybook

2. All goods purchased on Credit (Credit Purchases) ….> Purchases Daybook
3. All goods sold on credit but now returned by costumers ..> Sales Return (Inwards) Daybook
4. All goods purchased on credit but now returned to suppliers…> Purchases Return Daybook

The above four daybooks only record credit transactions related to movement in inventory.
There are no accounts maintained inside the daybooks. It Just contains Date, Name, Source
document number and Amount.

5. All transactions which relate to receipts and payments through cash or cheque ..> Cashbook

Cash and Bank accounts are made inside the cashbook hence it also serves the purpose of
ledger.

6. All other transactions …..> General Journal

In this we actually write the double entry of only those transactions which cannot be
recorded in the above five daybooks. To name a few
- Non Current Assets Purchased or Sold on Credit
- Writing off Bad debts
- Entries for Provisions of doubtful debts and depreciation
- Adjustments for Prepaid and Owings
- Correction of Errors
Step 2: Posting Transactions In Ledgers

A ledger is a book which contains accounts ( the actual T Accounts guys). There are three types of
Ledgers. In each type we have different type of accounts.

Sales Ledger: This contains accounts of credit costumers ( people to who we sell goods on credit) -
Trader Receivables

At the end of the year all the account balances in the sales ledger are listed in a schedule which is
called list of Trade receivables. This shows the individual account balances( closing) and also the total
debtors which goes into the trail balance.

Purchase Ledger: This contains accounts of credit suppliers ( people from whom we buy goods on
credit) - Trader Payables

At the end of the year all the account balances in the purchase ledger are listed in a schedule which is
called list of Trade Payables. This shows the individual account balances( closing) and also the total
creditors which goes into the trail balance.

General Ledger: This contains all the other accounts. Like all expenses ,incomes ,provisions (literally all
other accounts)

Please remember Sales and Purchases accounts are in the General Ledger cause they are not our
costumers or suppliers .

Once all the transactions are posted all the accounts are balanced via inserting a balance C/d in all
accounts.

Step 3 : Extracting a Trial Balance

All the closing balances in the General Ledger along with the figure of total trade receivables and
payables are listed in a trail balance. Debit balances and Credit Balances are listed separately side by
side. The Sum of all Debits should be equal to sum of all credit balances. The trail balances is used to
check the completion of the double entry. The trail balance will balance because
- For each debit entry there is a credit entry ( vice versa)
- The sum of all debit entries is equal to the sum of credit entries
Step 4: Closing Entries with Year end Adjustments ( Details in following pages)

After making the trail balance we also have to adjust for certain items. Remember only Incomes and
Expenses are taken into account while calculating profit. These accounts are closed by transferring
them to the income statement ( the Profit and Loss Account). This process is called Closing Entries.
Some common adjustments are
- Expenses and Incomes are adjusted for prepaid (advance) and accruals(Owings)
- Non Current Assets are depreciated
- Provision for doubtful debt is adjusted
- Closing inventory is valued by physical stock take and it is adjusted in calculating cost of
goods sold and also for Balance Sheet
- Adjustments for goods withdrawn by owner or Stock Losses

Step 5 : Final Accounts:

An income statement and Balance Sheet is drawn which ends the Accounting Cycle. Now by looking at
Income Statement owner can check his Profit and by looking at the Balance Sheet he can check his Net
worth of the Business.

ADJUSTMENTS IN DETAIL
BAD DEBTS AND PROVISION FOR DOUBTFUL(BAD) DEBTS

What is a bad debt?

When a costumer to whom goods were sold on credit basis, is unable to pay his debt then it results
into an expense for the business. Selling goods on credit basis involves this risk of bad debt. Any
amount of debt which becomes irrecoverable should be written off as bad debt.

Debit: Bad Debts

Credit : Person Who is Bad :>/Trade receivable

What is a Provision for bad debt?

A business must consider that some costumers might not pay the amount owed by them; these debts
are considered to be doubtful. Since the business does not know the exact amount of the doubtful
debts( and also which costumer might not pay), an estimate for such amount is kept in a provision for
doubtful debt account ( this account is not an expense account, it’s a reduction in asset from the
balance sheet). Provision is created to reduce profit now for an expense which might happen in
future. This is done to be pessimistic , in Accounting we call this being prudent or the Prudence
Concept.
A business usually keeps a general provision ( an estimated % of the all debtors), but it is also possible to
make a specific provision against a highly doubtful debt. Specific provision mean the whole amount due
by a particular debtor is added to the provision.

For example
Trade Receivables At End= 60000

Case 1: Only General Provision of 5% .. > provision = 5% of 60000 = $3000

Case 2: A specific Provision of $2000 and a general provision of 4% on remaining trade receivables
Provision = 2000 (Specific) + 4% of 58000 ( general provision on remaining debtors)

How is the amount of provision estimated? ( Factors effecting it)

- Age of Debts ( Since how long they owe us), higher the age more likely bad debts ( so
high provision is kept If majority of the debts are owed for long)
- Historical percentage of actual bad debts from previous years
- Reputation of people who us money in the market
- Nature of Business
- Some specific debts may be identified and full amount of them is charged in provision.

What is the difference between accounting treatment of Provision for doubtful debts and the actual
Bad debts?

The Journal entry for provision:

To create / Increase
Debit : Profit and Loss
Credit : Provision for doubtful Debts

To Decrease
Debit : Provision for doubtful debts
Credit : Profit and Loss

The difference in accounting treatment is that the whole of bad debt is treated as an expense but only
the change in provision is treated as either an expense (if increasing) or an income ( if decreasing). When
we write off a bad debt, we remove the debtor from our books but in case of a provision we don’t adjust
the debtor account as a separate account is maintained.
What is Bad Debt Recovered?
This is when a debtor whose debt was previously written off , pays us back. This is treated as an
income in the year in which the debt is recovered . The accounting treatment is done in two steps

- Make him or her your debtor (receivable ) as the debt has been written off previously
and the account of that costumer doesn’t exist in our books
Debit : Name of Person(debtor)
Credit: Bad debt recovered account

- Now record the entry to receive the money

Debit: Bank
Credit : Name of person (debtor)

ACCOUNTING FOR NON CURRENT ASSETS

Whenever we spend money we call it expenditure. The expenditure can be divided in two

Capital Expenditure Revenue Expenditure

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

In the same way we can have Capital receipts and Revenue Receipts .

Capital Receipts would include money received from capital transactions e.g. taking a bank loan ,
selling a non current asset or additional capital introduced by the owners ( note this money coming in
not earned by the business from profits)
Revenue Receipts are incomes generated from day to day operations of a business ( taken to income
statement) e.g. Sale of goods , Interest received rent received

If these expenditures and receipts are treated in the wrong way then both income statement and
balance sheet will be wrong.
 Depreciation

This is an expense recorded to allocate a non current asset cost over its useful life. Deprecation is used
in accounting to try to match the expense of an asset to the income that the asset helps the business
to earn. For example if a business buys a piece of equipment for $1 million and expects to use it over a
life of 10 years, it will be depreciated over 10 years . Every accounting year, the company will expense
$100000 (assuming straight line , which will be matched with the money that the equipment helps to
make each year.

The Double Entry for Depreciation is :

Debit : Profit and Loss Account ( Income Statement)

Credit : Provision for Depreciation

Methods of Depreciation:

1. Straight Line :
An equal amount of deprecation is charged every year. It is always calculated on cost . In case of
scrap value (residual value) and life given use : Cost -Scrap/Life

2. Reducing Balance Method:

In this deprecation for initial years in always higher then the later years. It is simply a percentage on
net book value (written down value) . Net Book value represents cost minus total deprecation till
date.

3. Revaluation Method:
This is usually used for loose tools ( or any asset which can only be valued collectively) . In this
method at the end of the year the market value is estimated. A numerical example best explains this

At the start of the year Loose Tools Valued at $5000

During the year Loose Tools purchased = $2000
Loose Tools Sold = $300
At the End Loose tools are worth $4500
Deprecation = 5000 + 2000 - 300- 4500 = 2200
Opening Value+ Purchased -Sold - Closing Value
Which Method is best to use?
It depends on the nature of Non Current Asset

Straight Line method is appropriate for assets like office furniture and fittings (which are used evenly
through out the year useful life, and the efficiency of them doesn’t fall by great amount in initial
years)

Reducing Balance Method is appropriate for assets like machinery or van. Since these assets are more
efficient when new, more depreciation is charged in initial years. As the asset gets old it looses
efficiency and so we charge less deprecation. Another way to look at it is that the maintenance and
repairs of asset will increase in later years so to maintain the overall expense it makes sense to charge
more depreciation in initial years when maintenance is low and then reduce it as maintenance
increases.

How to record disposal of Asset:

Disposal of means getting ride of the fixed asset . it can be sold or may be stolen or just discarded.
Usually there are 4 entries to record sale of asset

1. Remove the Cost of the Asset Sold

Debit : Disposal Credit: Asset

2. Remove the Total Deprecation

Debit : Provision for Depreciation Credit : Disposal

3. Record the Selling Price

Debit: Bank Credit : Disposal

If exchanged then
Debit : Asset Credit Disposal

4. Close the Disposal Account

Close with income statement .
All of this can be done in one single entry without using disposal

For example
Cost of Asset Sold = 50000
Net book Value = 30000
Sold For 28000

Note : total depreciation is 20000 as NBV is 30000

We can do

Bank 28000
Prov for Depn 20000
Loss 2000
Asset 50000

If sold for $31000 then

Bank 31000
Prov for Depn 20000
Asset 50000
Gain 1000
 Adjusting Entries

To Adjust expenses

Prepaid :
Debit : Prepaid Expense ( its an asset)
Credit : Expense (reduces expense)

Owing/Accrual

Debit : Expense (increases expense)

Credit : Owing Expense ( it is a liability)

To adjust Incomes:

Prepaid:

Debit: Income (as the income reduces because it’s prepaid)

Credit: Prepaid Income (because it’s a current liability)

Owing/Due

Debit: Owing Income (because it’s an asset)

Credit: Income (as the income increases)

To adjust closing stock

Overstated:
Debit: Trading account (or simply Profit and Los)
Credit: Closing stock

Understated:
Debit: Closing sock
Credit: Trading account (or simply Profit and Loss)
 To adjust Opening stock

Overstated:
Debit: Opening Capital
Credit: Trading account (or simply Profit and Loss)

Understated:
Debit: Trading account (or simply Profit and Loss)
Credit: Opening Capital

This is because opening stock has opposite relation with profits. So if understated profits are
overstated and we need to reduce them (debit: Trading account). Also opening stock of this year
was closing stock of last year so we need to amend the opening capital.

Concept of Sale or Return basis:

If we send goods on sale or return basis which means goods can be returned by the customer if not sold.
When goods are send nothing is recorded, just a memorandum is kept. These goods should not be
included in sales and should be included in closing stock (since they belong to us).

If this is recorded as sales and not included in closing stock, then we need to:
• Correct sales: Cancel them
Debit: Sales
Credit: Debtor

• Correct Closing Stock which is understated

Note: We won’t have to correct the stock if the goods were included in closing stock.

Revaluation of Fixed Asset (Only in companies)

Some assets do appreciate in value, e.g. Land and companies are allowed to revalue them.
The journal entry for revaluation is

Debit: Asset (Cost)

Provision for Depn. (Accumulated Depreciation)
Credit: Revaluation Reserve
For example:
An asset which cost $60 000 and has provision for depreciation of $8 000 is now revalued at $75 000. In
order to handle this, we should just

Debit: Asset 15 000 (Cause it was already at 60 and we want to make it 75)
Provision for Depn. 8 000 (this is always done to cancel the depreciation)
Credit: Revaluation Reserve 23 000

The 23 000 is the difference between the old Net Book Value (60 000 - 8 000) 52 000 and the new value
75 000.

A relatively simpler case would be where there is no provision for depreciation. Like e.g. Land at $60 000 is
now revalued at $75 000.

Debit: Land 15 000

Credit: Revaluation Reserve 15000
BANK RECONCILIATION STATEMENTS
Cashbook is owner’s record (Debit means + balance, Credit means - balance)
Bank statement is bank’s record (Credit means + balance, Debit means - balance)

Some entries which are recorded in the bank statement but not in the cashbook:
For these, we will have to correct the cashbook

1. Credit transfer (Bank Giro): Money deposited by customer directly in the bank account
(We should add it to cashbook balance)
2. Standing order/ Direct Debit: Money paid to supplier directly by the bank.
(We should subtract this from cashbook balance)
3. Bank Charges/ Interest Charged: Money deducted directly by the Bank.
(We should subtract this from cashbook balance)
4. Interest Received/ Dividends Received: Money added to the bank account in form of
interest or dividend (We should ad it to the cashbook balance)
5. Dishonored Cheque: A cheque received from customer but not acknowledged by the
bank (We should subtract this from cashbook balance because we need to cancel the
entry made when the cheque was received).

Some entries which are recorded in the cashbook but not on the bank statement.

For this, we will have to correct the bank statement:

1. Unpresented Cheque: Cheques written by us to a creditor but not yet presented to the
bank for payment, so the bank has not deducted money from our account.
(We should subtract this from bank statement balance)
2. Uncredited Cheque (Lodgments): Cheques received by us but not yet deposited in the
bank, so the bank has not increased the bank balance. (We should add this to the bank
statement balance)

FOR MCQ’s remember

Balance as per Bank statement + Uncredited Cheques - Unpresented Cheques = Balance as per
corrected Cashbook.

If balance as per corrected cashbook is given in the question, simply ignores the entries
which will affect the cashbook balance.

If there is an overdraft (for either cashbook or bank statement), take it as a negative figure in
the equation.
 CONTROL ACCOUNTS
What is the difference between Sales Ledger and Salas Ledger Control Account?

Sales ledger is where we make individual accounts of credit customers. It is part of double entry system
and it gives details of amounts owing by each customer. A list of debtors is extracted from the sales ledger,
which gives the figure of debtors for the trial balance.
Sales ledger control account on the other hand is the total debtors account in the general ledger. It is
not part of the double entry system. It I often referred as total debtors account. All the entries recorded
here are totals taken from daybooks e.g. Sales figure is the total of the sales daybook, discount allowed is
total discount allowed from the discount allowed account or the column in the cashbook.

USES OF CONTROL ACCOUNT

1. Helps to prevent fraud
2. Helps to detect errors
3. Quickly provide figures of total debtors and creditor.
LIMITATIONS OF CONTROL ACCOUNT
1. Cant trace error of omission
2. Cant trace error of original entry
RECONCILIATION OF CONTROL ACOUNT
In these types of questions, two sets of balances of debtors or creditors are known. One is from the
control account and the other is from the sales ledger (or list of debtors).
They will also give you several errors and you will have to reconcile both the balances.
Errors can be classified as:

1. If an error is made in the personal (individual) debtors account, than it will only affect the sales
ledger (list) balances. E.g. Sales made not posted to debtor’s account, this means we should
increase the debtor balances in the ledger.
2. If an error is made in any total figure of the daybook, it will effect only the control account
balance, e.g. Sales daybook undercast, Total sales understated so add it to control account
balance.
3. If an entry is completely omitted from the books, it will affect both the balances. E.g. A sales
invoice completely omitted from the books, add it to both balances.
4. If an entry is originally recorded in the daybook with the wrong amount, it will affect both the
balances, as the total will also be wrong. E.g. A sales invoice of $500 was originally recorded as
$600, this means the total sales are overstated and also the individual account of the customer
has been debited with $600. We should subtract $100 from both.
5. If a balance is omitted from the list of debtors, it will only affect the sales ledger (list) balance. It
cannot affect control account balance.
ERRORS AND SUSPENSE
Error not affecting the Trial Balance:
1. Error of complete omission: When nothing has been recorded in the books. To correct this,
simply record the transaction.
2. Error of original entry: Where correct double entry is passed but with the wrong amount. To
correct this, adjust for the difference.
3. Error of principal: Where a wrong type of account has been debited or credited instead. For
example, we have debited Rent instead of Motor Van.
4. Error of commission: Where a wrong account but of same type (usually debtors or creditors) has
been debited or credited instead. For example, we have credited Mr. A instead of Mr. B.
5. Error of complete reversal: Where a completely opposite entry is passed with the right amount.
To correct this, pass the correct entry with double amounts.
6. Compensating error: Where one error compensates for other. Like a debit item (say purchase)
and a credit item (say sales) are both undercast with same amounts. (don’t worry about this too
much :P)

All the above errors do not affect the Trial Balance because in all situations the total debits are equal to
total credits.

Errors can be made which can lead to disagreement of the trial balance.
This is when either we have only debited something and forgot to credit (Incomplete double entry) or
we have debited something with a correct amount and credited the other with the wrong amount
(Incorrect double entry). And it can also happen if any daybook is over or under cast. E.g. Sales daybook
is undercast. In these situations Suspense account comes into the picture. Since sales daybook is
undercast, this means only the total sales were wrong (understated), so we need to amend the sales
accounts.
Debit: Suspense
Credit: Sales

Also sometimes an error is made in the list of debtors or creditors. Like a debit balance is excluded from
the list of debtors. This makes the debtors figure in the trial balance understated. Logically we should
Debit: Debtors
Credit: Suspense
But guys do you realize that only the list of debtors is wrong (which is not an account), so we should
Debit: NO DEBIT ENTRY
Credit: Suspense

What if there is still balance left in the suspense account?

This means all the errors are still not found. If the balance comes on the debit side, then treat it as a
current asset in the balance sheet, if it comes on the credit side then treat it as a current liability.
INCOMPLETE RECORDS:
Remember Net profit can be calculated using the following formula. If a question says make a trading
profit and loss account, than this doesn’t apply. Only when it says to calculate net profit or make a
statement showing net profit.

Opening Capital + Additional Capital + Net profit - Drawings = Closing Capital

(I really hope you can solve for net profit), don’t memorize the formula, it’s the financed by section. J

For the final account questions (where the trading, profit and loss account and a balance sheet is
required), always make the following accounts. (By always, I mean always).

1. Sales ledger control account (If business only deals in cash sales, then don’t)
2. Purchase ledger control account
3. Bank account (if it is already given in the question, then it’s okay)
4. Cash account (only make this when the question gives cash balances)

Once you have filled in your accounts, and then move to the Final accounts. Don’t panic if it doesn’t
balance, because marks are for working. Don’t spend your entire lifetime on this question.

NEVER NEVER NEVER forget depreciation. They will usually give you net book values at start and end.
Depreciation =

Opening NBV + Purchase of assets - Sale of assets (at NBV) - Closing NBV

Also make expense accounts or adjust for prepaid and owings directly. But show all working.

In your financed by section, you will need opening capital. This will come from Opening Assets -
Opening Liabilities. Don’t forget to include the opening balance of the bank account in your calculation
(like other idiots).

On the following pages, I have given few exercises. Try to fill in the missing figures.
MARGINS AND MARK-UPS

These are tools used in conjunction with trading account to compute the missing figures of sales, figures or
stocks. If either of these percentages is given, it is a sign that we are expected to compute the missing
figures by using the trading account technique.

MARGINS
Represent Gross Profit as a percentage of selling price.

Example:
A company sells its goods at a selling price of $80. Its profits are set at 20% no selling price.
Profits will be $80 x 20% = $16
By using trading account format, we can determine the cost of goods sold as:
$
Sales 80
Less: Cost of goods sold (balancing figure) (64)
Profit 16_

MARK-UP
Represent Gross profit as a percentage of cost. Its application is like margin, that if we get one of the
trading figures, we will be able to compute the others.

Let us assume that the information we have from the above example is that a company sells goods,
which cost $64. Its profit on cost is 25%. Profits would be computed as follows:
Profits = $64 x 25%
= $16.
By using trading account format, we can determine sales as:
$
Sales (balancing figure) 80
Less: Cost of goods sold (64)
Profit 16_

Try to use
Sales - Cost = Profit

If Mark up if given Profit is a % of Cost and IF margin is given Profit is a % of Sales

For eg.

Sales = 80000
Cost = ?
Margin = 25%

Sales - Cost = Profit

80000- x = 25 % of 80000

Cost = 60000
But if
Sales = 80000
Cost = ?
Markup =25%

Sales - Cost = Profit

80000- x = 25 % of X

Cost = 64000
PARTNERSHIP ACCOUNTS
A partnership is defined by the Partnership Act 1890 as a relationship, which exists between two or
more persons who carry business with a view of profit.

CHARACTERISTICS OF PARTNERSHIP
• Partners are jointly and severally liable for the debts of the partnership. They have
unlimited liabilities for the debts of the partnership.
• The minimum number of partners is usually two and maximum number is twenty, with
exception of banks, where the maximum number is fixed at ten and some professional
practices where there is no maximum number.
• All partners usually participate in the running of their business.
• There is usually a written partnership agreement.

THE PARTNERSHIP AGREEMENT

The partnership agreement is a written agreement which sets up the terms of the partnership,
especially the financial arrangements between the partners.
The contents of the partnership agreement can vary from one partnership to another. A standard
Partnership Agreement may include the following items:
1. The name of the firm, business type and duration
2. Capital contribution.
3. Profit sharing ratios.
4. Interest on Capital.
5. Partners’ salaries.
6. Drawings.
7. Interest on drawings.
8. Arrangements in case of dissolution, death or retirement of partners.
9. Arrangement for settling disputes.

In absence of a formal agreement between the partners, certain rules laid down by the Partnership Act
1890 are presumed to apply. These are:
1. Residual profits are shared equally between the partners.
2. There are no partners’ salaries.
3. No interest is charged on drawings made by the partners
4. Partners receive no interest on capital invested in the business.
5. Partners are entitled to interest of 5% per annum on any loans they advance to the business in
excess of their agreed capital.
CHANGES IN THE PARTNERSHIP
A change in partnership is when the agreement has to be changed between the partners due to

- Admission of a new partner

- Retirement of an existing partner
- Or simply change in profit sharing ratio.

Whenever there is a change in a partnership, partners are allowed to revalue their assets and also attach a
value of goodwill to the business. For this purpose, they make a revaluation account.

In revaluation account we simply record the gains or losses on each asset due to revaluation. We can
also include the goodwill in this account on the credit (gain) side. This account is then closed by
transferring the balance to partners’ capital account in the old profit sharing ratio.
Two situations for Goodwill:

1. If partners decide to keep the goodwill, then we will show the amount of goodwill in the balance
sheet. (No other entry needs to be made if we already included the goodwill in the revaluation
account).
2. If partners decide to write off the goodwill then we will write off the entire goodwill from the
capital account (debit side) in the new profit sharing ratio. Goodwill will not be shown in the
balance sheet in this case.
ADVANTAGES OF PARTNERSHIP OVER SOLE TRADER

1. Additional capital from other partners, and also easier to get loans.
2. Additional expertise.
3. Additional management time.
4. Risk (losses) is shared.

DISADVANTAGES OF PARTNERSHIOP OVER A SOLE TRADER

1. Profit are shared

2. Possibility of disputes
3. Loss of control

What is a current account?

Majority of partnership keep a fixed capital account, whenever they have fixed capital accounts, they
will have to maintain a current account for each partner. By fixed capital account, we mean that all the
appropriation and drawings will pass through a temporary capital account (current account), only
additional investment by a partner will be recorded in the capital account. This gives information
relating to long term and short term aspects separately. This also helps to determine the investment
made by partner in the business.
Some partnerships also maintain a fluctuating capital account; in this case they will not maintain a
current account. All the transactions will pass through the capital account.

What is total share of profit?

This is different than just the remaining share of profit which we get at the end of appropriation
account. Total share of profit means out of this year’s net profit, how much profit goes to a particular
partner. As we know interest on capital and salary etc are deducted from net profit only so they also
constitute as part of profit. Hence, total share of profit is:

Interest on capital + Salary + Remaining share of Profit - Interest on drawings

LIMITED COMPANIES
Limited companies are business organizations, whose owners’ liabilities are limited to their capital
contributed or guarantees made.

CHARACTERISTICS OF LIMITED COMPANIES

1. Separate legal entity: A company is regarded as a separate person from its owners and
managers. As a result, it can sue or be sued, it can own property.
This concept is often referred to as veil of incorporation.
2. Limited liability: Shareholders’ liability is limited to what they have paid for
shares.
3. Perpetual succession: Unlike partnership and sole trader, a company does not cease to
exist on the death or retirement of any of the owners. Owners
can buy and sell their shares without affecting the running of the
business.
4. Number of members: There is no limit as to the number of members
5. Capital: Company’s capital is raised through the issuance of shares
6. Profit distribution: Profits are distributed to members through dividends.
7. Retained profits: The retained profits are capitalized are reserves.
8. Legislation: Companies are highly regulated. They are required to comply
with the requirements of Company’s ACT as well as Financial
Reporting Standards.

ADVANTAGES OF OPERATING AS A LIMITED COMPANY:

1. The liability of the shareholders is limited. Therefore, in case of company going bankrupt, the
individual assets of the owners will not be used to meet the company’s debts. Only shareholders
who have only partly paid for their shares can be forced to pay the balance owing on the shares,
but nothing else.
2. There is a formal separation between the ownership and management of the business. This
helps in clearly identifying the responsible persons.
3. Ownership is vastly shared by many people, hence diversifying risk, and funds become available
is substantial amounts.
4. Shares in the business can be transferred relatively easily.

DISADVANTAGES:
1. Formation costs are normally very high.
2. Companies are highly regulated.
3. Running costs are also very high i.e. preparation and submission of annual returns, audit fees
etc.
4. Profit distribution is also subject to some restrictions. Not all surpluses from the business
transactions can be distributed back to the shareholders.
5. Company accounts must be available for inspection to the public.
There are two types of limited companies:
1. Public limited companies:
a- They have the abbreviation Plc of public limited company at the end of their names b-
Their minimum allotted share is required to be £50 000.
c- They can invite the general public to subscribe for their shares
d- Their shares may be traded in the stock exchange i.e. they can be quoted with the stock
exchange.
2. Private limited companies:
a- They have the abbreviation ‘Ltd’ for limited at the end of their names.
b- They are not allowed to invite general public for the subscription of their share capital.

COMPANY FINANCE

As is a case with sole traders and partnerships, companies also have two main sources of finance,
namely; capital and liabilities. The difference is on naming and classification of these terms.

When the company is formed, it normally issues shares to be subscribed by the potential members.
People who subscribe and buy company’s shares are known as shareholders, and they become the legal
owners of the company depending in the proportion and type of shares they hold. They receive
dividends as return on their invested capital. Dividends are, therefore, appropriations of the profits.

On the other hand, the company can borrow funds from other people who are not owners. The main
form of company borrowings is by issuing debenture, which is a written acknowledgement of a loan to a
company, given under the company’s seal. The debenture holders are not owners of the company but they
are liabilities. Debenture holders receive a fixed percentage of interest on the loan amount.
Debenture interest is a business expense, which must be paid when is due. Other forms of borrowings
include trade creditors and bank overdrafts.

The difference between shareholders and debenture holders can be analyzed in terms of:
1. Ownership; and
2. Return on investment (Debenture holders will get it even if the company makes losses)

SHARE CAPITAL
Share capital is normally of two types:
1. Ordinary share capital; and
2. Preference share capital
Their difference is summarized in the table below:

Aspect Ordinary shares Preference shares

Voting power Carry a vote Limited or no voting power
Dividends 1. Vary between one year to 1. Fixed percentage of the nominal
another, depending on the value.
profit for the period. 2. Cumulative. If not paid in the
2. Rank after preference year of low or no profits, it is
shareholders. carried forward to the next years.
3. Not cumulative. 3. They may be non-cumulative.
Liquidation Entitled to surplus assets on 1. Priority of payment before
(Company closing liquidation, after all liabilities and ordinary shareholders, but after
down) preference shareholders have been all other liabilities.
paid. Whatever is left, go to 2. Not entitled to surplus assets on
Ordinary shareholders. liquidation.

SHARE CAPITAL STRUCTURE

Authorized share capital: the maximum share capital that the company is empowered to issue per
its memorandum of association. It is sometimes called as registered
capital.

Issued share capital: The total nominal value of share capital that has actually been issued to
the shareholders.

Called-up capital: This is a part of issued capital that the company has already asked the
shareholders to pay. Normally when the company issues shares, it does
not require its shareholders to pay the full price on spot. Rather it calls
the installments from time to time. It is the amount that is included in
the balance sheet.

Paid-up capital: This is the total amount of the money already collected from the
shareholders to date. Dividend is paid on this.

Uncalled capital: This is the part of issued capital, which the company has not yet
requested its shareholders to pay for.

Dividends: According to the new law, we only subtract the amount of dividends
paid from profit. Dividends which are announced are ignored.
The distinctions between reserves, provisions and liabilities
The distinctions between reserves, provisions and liabilities are of the utmost importance and must be
learned.

Provisions are:
amounts written off or retained by way of providing for depreciation, renewals or diminution in
the value of assets.
Or, retained by way of providing for nay known liability of which the amount cannot be determined
with substantial accuracy.
Increases and decreases in provisions are debited or credited in the Profit and Loss account and credited to
a Provision account.

Reserves are:
any other amounts set aside out of profits by debiting Profit and Loss Appropriation account and
crediting the relevant provision accounts,
and amounts placed to capital reserve in accordance with the Companies Act such as share
premium, unrealized surpluses on the revaluation of fixed assets, and amounts set aside out of
distributable reserves to maintain capital when shares are redeemed.
Liabilities are amounts owing which can be determined with substantial accuracy.

DEBENTURES
A debenture is a document containing details of a loan made to a company. The loan may be secured on
the assets of the company, when it is known as a mortgage debenture. If the security for the loan is on
certain specified assets of the company, the debenture is said to be secured by a fixed charge on the
assets. If the assets are not specified, but the security is on the assets as they may exist from time to
time, it is known as a floating charge on the assets. An unsecured debenture is known as a simple or
naked debenture.
Debentures carry the right to a fixed rate of interest which forms part of the subscription of the
debentures.. The interest must be paid whether or not the company makes a profit. This is one of the
distinctions between debentures, and shares on which dividends may only be paid if profits are
available. Debenture interest is debited as an expense in the Profit and Loss account to arrive at the
profit before tax.
RESERVES
The net assets of the company are represented with capital and reserves. While capital represents the
claim that owners have because of the number if shares they own, reserves represent the claim that
owners have because of the wealth created by the company over the years but not distributed to them.

There are two main types of reserves:

Revenue Reserve
The reserves which arise from profit (Trading activities of the company). These are transferred from the
Appropriation account. Examples include General Reserve and Retained Profit (Profit and Loss).

Dividends can only be paid to the amount of revenue reserve on the balance sheet. i.e. the maximum
dividend possible is the sum of both revenue reserves.

Capital Reserve
These are reserves which the company is required to set up by law and cannot be distributed as
dividends. They normally arise out of capital transactions. These include Share Premium and Revaluation
Reserve.

Share Premium
Share premium occurs when a company issues shares at a price above its nominal (par) value. This
excess of share price over nominal value is what is known as share premium.

What are the uses of Share Premium?

1. Issue Bonus Shares

2. Write off Formation (Preliminary Expenses)
3. Write off Goodwill.

What are the different Types of Preference Shares?

1. Non-cumulative Preference shares: In case company doesn’t pay enough profits, these
shareholders will get no dividends in the year and that amount of dividend will never be given.
2. Cumulative Preference Shares: In case company doesn’t have enough profits, these
shareholders will get no dividend in the year and that amount of dividend will be carried
forward to next year, when the company makes enough profit, the entire amount will be
payable as dividend.
3. Participating Preference Shares: These shareholders have limited voting right, i.e. they can
participate in the decision making.
 RATIOS
PROFITABILITY

GROSS PROFIT MARGIN ( Gross Profit x 100 )

Net Sales
While the gross profit is a dollar amount, the gross profit margin is expressed as a percentage of net
sales. The Gross Profit Margin illustrates the profit a company makes after paying off its Cost of Goods
sold. The Gross Profit Margin shows how efficient the management is in using its labour and raw
materials in the process of production (In case of a trader, how efficient the management is in
purchasing the good). There are two key ways for you to improve your gross profit margin. First, you can
increase your process. Second, you can decrease the costs of the goods. Once you calculate the gross
profit margin of a firm, compare it with industry standards or with the ratio of last year. For example, it
does not make sense to compare the profit margin of a software company (typically 90%) with that of an
airline company (5%).

Reasons for this ratio to go UP (opposite for down)

1. Increase in selling price per unit
2. Decrease in purchase price per unit due to lower quality of goods or a different supplier.
3. Decrease in purchase price per unit due to bulk (trade) discounts.
4. Extensive advertising raising sales volume (units) along with selling price.
5. Understatement of opening stock.
6. Overstatement of closing stock.
7. Decrease in carriage inwards/Duties (trading expenses)
8. Change in Sales Mix (maybe we are selling some new products which give a higher margin).

NET PROFIT MARGIN ( Operating Profit x 100 )

Net Sales
Net profit margin tells you exactly how the management and operations of a business are performing.
Net Profit Margin compares the net profit of a firm with total sales achieved. The main difference
between GP Margin and NP Margin are the overhead expenses (Expenses and loss). In some businesses
Gross Margin is very high but Net Margin is low due to high expenses, e.g. Software Company will have
high Research expenses.

Reasons for this ratio to go UP (opposite for down)

All the reasons for GP margin apply here. Additionally
1. Increase in cash discounts from suppliers
2. A decrease in overhead expenses
3. Increase in other incomes like gain on disposal, Rent Received etc.
Return on Capital Employed (ROCE)
This is the key profitability ratio since it calculates return on amount invested in the business. If this ratio is
high, this means more profitability (In exam if ROCE is higher for any firm it is better than the other firm
irrespective of GP and NP Margin). This return is important as it can be compared to other
businesses and potential investment or even the Interest rate offered by the bank. If ROCE is lower than the
bank interest then the owner should shoot himself. This ratio can go up if profits increase and capital
employed remains the same. Also if Capital employed decreases, this ratio might go up.

Operating Profit_ x 100

Capital Employed
Net Profit before Interest and Tax

Return on Total Assets

This shows how much profit is generated on total assets (Fixed and Current). The ratio is considered and
indicator of how effectively a company is using its assets to generate profits.

Operating Profit_ x 100

Total Assets

Return on Shareholders’ Funds/Return on Net Assets/Return on Owners capital

Since all the capital employed is not provided by the shareholders, this specifically calculates the return to
the shareholders (It’s almost the same thing as ROCE)

Net Profit after Tax x 100

Shareholders Funds

O.S.C + P.S.C + RESERVES

NOTE:
Capital Employed = Fixed Assets + Current Assets - Current Liabilities

OR

= Ordinary Share Capital + Preference Share Capital +

Reserves + Long-term Liabilities
LIQUIDITY AND FINANCIAL

As we know a firm has to have different liquidity. In other words they have to be able to meet their day to
day payments. It is no good having your money tied up or invested so that you haven’t enough money to
meet your bills! Current assets and liabilities are an important part of this liquidity and so to measure the
firms liquidity situation we can work out a ratio. The current ratio is worked out by dividing the
current assets by the current liabilities.

CURRENT RATIO = Current assets _

Current liabilities

The figure should always be above 1 or the form does not have enough assets to meet its liabilities and is
therefore technically insolvent. However, a figure close to 1 would be a little close for a firm as they would
only just be able to meet their liabilities and so a figure of between 1.5 and 2 is generally
considered being desirable. A figure of 2 means that they can meet their liabilities twice over and so is safe
for them. If the figure is any bigger than this then the firm may be tying too much of their money in a form
that is not earning them anything. If the current ratio is bigger than 2 they should therefore
perhaps consider investing some for a longer period to earn them more.

However, the current assets also include the firm’s stock. If the firm has a high level of stock, it may
mean one of the two things,
1. Sales are booming and they’re producing a lot to keep up with demand.
2. They can’t sell all they’re producing and it’s piling up in the warehouse!

If the second of these is true then stock may not be a very useful current asset, and even if they could
sell it isn’t as liquid as cash in the bank, and so a better measure of liquidity is the ACID TEST (or
QUICK) RATIO. This excludes stock from the current assets, but is otherwise the same as the current
ratio.

ACID TEST RATIO = Current assets - stock

Current liabilities

Ideally this figure should also be above 1 for the firm to be comfortable. That would mean that they can
meet all their liabilities without having to pay any of their stock. This would make potential investors feel
more comfortable about their liquidity. If the figure is far below 1, they may begin to get worried about
their firm’s ability to meet its debts.
Rate of Stock Turnover

It shows the number of times, on average, that the business will sell its stock in a given period of time. It
basically gives an indication of how well the stock has been managed. A high ratio is desirable because the
quicker the stock is turned over, more profit can be generated. A low ratio indicates that stocks are kept for
a longer period of time (which is not good).

Cost of Goods Sold = ____ Times

Average Stock

Stock Days:
This is Rate of stock turnover in days. Lower the better.

Average Stock x 365 = ____ Days

Cost of Goods Sold

Debtor Days:
Shows how long it takes on average to recover the money from debtors. Lower the better.

Average Debtors x 365 = ____ Days

Credit Sales

Creditor Days: (Creditor Payment Period)

Shows how long it takes on average to payback the creditors. Higher the better.

Average Creditors x 365 = ____ Days

Credit Purchases

Working Capital Cycle: (Only for MCQ). (Lower the better)

Stock Days + Debtor Days - Creditor Days = ____ Days

Note:
Average Stock = Opening + Closing
2
IF Average cannot be calculated in these ratios use Closing Figures as average.
Utilization Ratios (All higher the better)

Total Asset utilization (Total Asset Turnover)

Shows how much sales are being generated on Total Assets. Higher ratio indicates better utilization of
Total Assets.
Net Sales = ____ Times
Total Assets

Fixed Asset Utilization (Fixed Asset Turnover)

Shows how much sales are being generated on Fixed Assets. Higher ratio indicates better utilization of
Fixed Assets.
Net Sales = ____ Times
Fixed Assets

Working Capital Utilization (Working Capital Turnover)

Sows how much sales are being generated on Working Capital. Higher ratio indicates better utilization of
Working Capital.
Net Sales = ____ Times
Working Capital

Advantages of Ratios
1. Shows a trend
2. Helps to compare a single firm over a two years (time - series)
3. Helps to compare to similar firms over a particular year.
4. Helps in making decisions
Disadvantages (Limitations):
1. A ratio on its own is isolated (We need to compare it with some figures)
2. Depends upon the reliability of the information from which ratios are calculated.
3. Different industries will have different ideal ratios.
4. Different companies have different accounting policies. E.g. Method of depreciation used.
5. Ratios do not take inflation into account.
6. Ratios can ever simplify a situation so can be misleading.
7. Outside influences can affect ratios e.g. world economy, trade cycles.
8. After calculating ratios we still have to analyze them in order to derive a conclusion.

How to Comment:
Usually in CIE they assign 2 marks for comment on each ratio. One mark is for indicating if the ratio is
better or worse (not higher or lower). The second mark is to explain the importance or the reason of the
change in ratio. For e.g. If Gross Profit Margin was 40% and now its 50%, you should say that the Gross
profit Margin has improved (rather than increased) and this may be due to an increase in selling price or a
decrease in cost of goods sold (depending upon the question).

Also remember that the liquidity and utilization ratios should be close to industry average. Too less or
too much liquidity is bad!

At the end of your answer, always give a conclusion

• When comparing a single firm over two years then do mention performance of which year is
better. (In terms of profitability and liquidity)
• When comparing two different firms over the same year do mention performance of which firm
is better. (In terms of profitability and liquidity).

If the question says evaluate profitability then use (GP Margin, NP Margin and ROCE)

If the question says evaluate liquidity, use (Current Ratio, Acid Test and Rate of Stock Turnover)

If the question says evaluate the performance it means both profitability and liquidity.

Best way:

3 - Profitability
2 - Liquidity &
1-Utilization
 STOCK VALUATION

Remember stock is valued at lower of cost or net realisable value (N.R.V). This is basically the current
market value of the stock after deducting any repair cost. This is application of the prudence concept.
E.g. If a piece of stock costing $40 is damaged. Now it can be sold for $48 but only if $10 of repair is
undertaken. This means the NRV of stock is 38 (48 - 10). Since NRV (38) is lower than the cost (40), we
should value it as 38. It lets say the NRV was $41, then than the stock would have been valued at $40.

Assumptions in Stock Valuations

FIFO
Advantages
1. Good representation of sound storekeeping as oldest stock is issued first.
2. Stock is shown close to the current market value (because it is valued at most recent price)
3. This method is acceptable by accounting regulations
Disadvantages
1. In inflation stock is valued the highest and it overstates profit
2. Since the value of stock issued fluctuates, this will lead to a different cost for an identical unit.
AVCO
Advantages
1. Since the value of stock issued does not fluctuate, this will lead to a same cost for an identical
unit.
2. This method is acceptable by accounting regulations.
Disadvantages
1. Difficult to calculate.
2. Average price does not represents the true value of stock
 ACCOUNTING CONCEPTS
TABLE/SUMMARY/SNAPSHOT OF ACCOUNTING CONCEPTS/CONVENTION

Accounting period Also known as Time Period where business operation can be
Concept divided into specific period of time such as month, a quarter or a
year (accounting period)

Final accounts are prepared at the end of the accounting period,

i.e. one year. Internal accounts can be prepared monthly,
quarterly or half yearly.

Accrual Concept / Requires all revenues and expenses to be taken into account for
Matching the period in which they are earned and incurred when
determining the profit / (loss) of the business. The net profit /
(loss) is the difference between the revenue EARNED and the
expenses INCURRED and not the difference between the revenue
RECEIVED and expenses PAID.

Business Entity Also known as Accounting Entity convention which states that the
business is an entity or body separate from its owner. Therefore
business records should be separated and distinct from personal
records of business owner.

Consistency Concept According to this convention, accounting practices should remain

unchanged from one period to another. For example, if
depreciation is charged on fixed assets according to a particular
method, it should be done year after year. This is necessary for
purpose of comparison.

Dual Aspect Concept Double entry system. For every debit, there is a credit entry of an
equal amount.

Going Concern Concept The business will follow accounting concepts and methods on the
assumption that business will continue its operation to the
foreseeable future or for an indefinite period of time.

Historical Cost Concept Business should report its activities or economic events at their
actual costs. For example, fixed assets are recorded at their cost in
account except for land which can be revalued due to appreciation
Materiality Concept The accountant should attach importance to material details and
ignore insignificant details otherwise accounting will be burdened
with minute details. Only items that are deemed significant for a
given size of operation.

Money Measurement Also known as Monetary unit. Transactions related to the

Concept business, and having money value are recorded in the books of
accounts. Events or transactions which cannot be expressed in
term of money do not find a place in the books of accounts.

Objectivity and Objectivity is following rules of the industry and based on

Subjectivity objective evidence and subjectivity is to follow one’s own rules
and methods.

Prudence / Conservatism Take into account unrealized losses, not unrealized profits/gains.
Concept Assets should not be over-valued, liabilities under-valued.
Provisions are example of prudence or conservatism concept. Also
under this prudence/conservatism concept, stock/inventory is
value at lower of cost or market value. This concept guides
accountants to choose option that minimize the possibility of
overstating an asset or income.

Substance Over Form Real substance takes over legal form namely we consider the
economic or accounting point of view rather than the legal point
of view in recording transactions.

Realization Concept Revenue is recognized when goods are sold either for cash or
credit namely the debtor accepts the goods or services and the
responsibility to pay for them.
 COST ACCOUNTING

What is Cost Accounting?

Cost accounting is basically the determination of cost whether for a specified thing or activity. To
determine cost, we need to apply accounting and costing principles and techniques. The cost accounting
information is used within the business for planning, controlling and decision making.

What is a Cost Centre?

Cost centre is the area or a department in a business for which cost are accumulated. There are two
main types of Cost Centres
• Production Cost Centre: Departments which are involved directly in production of a product. For
example, Moulding, Cutting or Assemble Department.
• Service Cost Centre: Departments in which production doesn’t take place but they provide
service to the production departments. For example: store Department or Maintenance
Department.

What is a Cost Unit?

Costs are always related to some object or function or service. For example, the cost of a car, a haircut, a
ton of coal etc. Such units are known as cost units and can be defined as

‘A unit of product or service in relation to which costs are determined’.

Cost unit may be units of production, e.g. kilos of cement, gallons of beer OR may be units of service,
e.g. consulting hours, Patient nights, Kilowatt hour.

How is cost classified?

There are three possible classifications

• Type 1: Direct and Indirect Cost

Direct cost: This includes all such cost which can easily be traced to the item being manufactured. E.g.
Direct Material, Direct Labour and Direct Expenses (royalties or artwork). There can also be Direct Selling
Cost like Installation or Sales Commission.

Indirect Cost: All the cost which cannot be easily traced to the item is the Indirect Cost. These are widely
known as Overheads. Overheads can be production or non-production (selling and administration).
 • Type 2: Production and Non-Production Cost
Any cost which is incurred in manufacturing the item is referred as Production Cost. All the other cost is
Non production (Selling and Administration)

• Type 3: Variable and Fixed Cost

Variable Cost: Those cost that change in total in direct proportion to changes in level of activity. An
increase/decrease in activity brings proportional increase/decrease in total variable cost. E.g. Direct
Material, Direct Labor. Always remember Variable Cost per Unit will remain constant.

Fixed cost: Those cost that DOES NOT change regardless of changes in activity level. E.g. Rent,
Depreciation etc. Fixed Cost does not change in Total but Fixed Cost per unit will decrease as more units
are produced.

Semi Variable (Mixed) Cost: Include both fixed and variable elements. For example Repairs,
Maintenance and Electricity.

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

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

The direct cost is directly related to a product and it can be easily traced to the item being manufactured
but it does not include any type of variable overheads. The variable cost includes all direct cost and
variable overheads as well. For e.g. the variable part of the electricity.

What is a Sunk Cost?

This is an expenditure which has already been incurred and it has no importance in future decision
making since the cost has already been spent. For example, a business conducts a feasibility study of
buying a new machine and incurs an expense of $5 000. Now whether the machine is brought or not,
$5,000 has already been spent and cannot be recovered, so we should not consider them in decision
making. This cost is treated as an expense in the profit and loss account for the year. Other example
would be cost incurred on market research before launching a new product.

What is the effect on variable cost line for bulk purchase discount on purchase of raw materials?

Sometimes, suppliers offer bulk purchase discount to a manufacturing business. For example, if a
business purchases 1 000 units, a price of $5 may be charged per unit. On additional 1 000 units, the
price may be reduced to $4.50 per units and so on. It will reflect the following image on the graph paper
and it is known as saw-tooth curve.
What is Stepped Cost?
This is type of cost which is constant till a certain level of Activity (Relevant Range) but it will increase
significantly as the activity level increases. For example Rent is constant till the factory maximum
capacity is reached but then we need another factory to increase production so the rent will double. If we
plot this on a graph it will look like.
 ABSORPTION COSTING

What is Absorption Costing?

It is a costing method in which the overheads (estimated) of a manufacturing business are charged first to a
cost centre (departments) by means of allocation and apportionment and then a predetermined overhead
absorption rate is calculated to charge the amount of overheads onto a job or a product. The overheads
may be absorbed on the basis of activity like direct labor hours, machine hours or direct labor cost or direct
material cost. The basis of absorption depends upon the intensity of the department. E.g. a machine
intensive department would use machine hours.

What is Overhead Absorption rate?

A manufacturer needs to calculate the total cost of the product before he actually produces it. This is
because once the total cost is determined, he or she can set the selling price. Since the Overhead cost is
not easy to trace, a rate is calculated in order to trace the overheads as per the level of activity. For
example, if the overhead Absorption Rate is $3 per direct labor hour and a particular unit requires 4 hours
of labour, the amount of Overheads charged will be $3 x 4 hours = $12.

Formula for Overhead Absorption Rate (OAR) = Budgeted Overheads _

Budgeted Activity (e.g. Labor hours)

Why do we use Budgeted figures?

As mentioned above, cost has to be determined before the actual production takes place. The actual
overheads and activity is not known at that point. This would make it impossible to quote the selling
price to the customer.

How are Overheads Allocated and Apportioned to the departments?

Firstly all the overheads are split amongst the department by using suitable basis. For some overheads we
don’t need to use basis because they are pre allocated, e.g. indirect materials (they are usually divided
between the departments), and some overheads need to be apportioned using suitable basis, e.g. rent
can be split on basis of floor area. Once all the overheads are shared to departments (Primary
Apportionment), the cost of service departments is re-apportioned (Secondary Apportionment) to the
production department since they provide service to the production departments.

Some factories do not split the overheads into different departments and just calculate a single
overhead absorption rate for the whole factory. This method is less accurate than the method in which
separate rates are calculated for each department.
What is Over or Under absorption of overheads?

The Overhead Absorption Rate is calculated using budgeted figures but the actual figures of overheads
and activity are always different. This causes a difference between the amount of overheads absorbed
and the actual overheads spend.

Remember Absorbed Overheads mean the amount of overheads we have applied to our cost of
production.

Absorbed Overheads = Budgeted Overheads x Actual Activity

Budgeted Activity

To determine the amount of overhead absorbed and under absorbed always compare the Absorbed
Overheads with Actual Overheads.

Over Absorption occurs when Absorbed Overheads are more that the Actual Overheads (that’s why its
called Over Absorbed, Absorbed is more). This basically means we have over charged the cost. (Should be
treated as a gain in the profit statement because profit is understated).

Under Absorption occurs when Absorbed Overheads are less than the Actual Overheads (that’s why it’s
called Under Absorbed, Absorbed is less). This basically means we have under charged the cost. (Should be
treated as a loss in profit statement because profit is overstated)

What are different types of Overhead Absorption Rates (OAR)

Overhead absorption rate can be calculated on different basis. Remember that best methods to use are
either machine hour or labor hour , depending upon if the department (or the factory) is machine
intensive or labor intensive. But following OAR’S are used by different businesses.
1. Machine Hours
2. Labor Hours
3. Direct Wages (Direct Labor Cost)
4. Direct Material (Direct Material Cost)
5. Prime Cost
6. Per Unit Rate
What are the problems with using pre-determined ( Budgeted OAR) ?

Use of estimated data can lead to inaccurate costing and results in over or under absorption of
overheads. If the cost absorbed is too low ( under absorbed) this will lead to an understated cost which will
effects profit of the business ( as our selling price based on budgeted cost will be low). On the other hand if
absorbed cost is too high ( over absorbed) this will overstate cost making the product
uncompetitive and will reduce demand.

What is a good format to show the total cost of any order/job/unit/batch?

Direct Material
+ Direct Labor
+ Direct production expense (if any) e.g. royalties or artwork.
= Prime Cost
Add: Factory Overheads
+ Department A
+ Department B
= Cost of Production
Add: Selling and Admin cost (if any)
Installation or Delivery
General Admin Overheads
= Total Cost
Marginal Costing

It is a costing technique for decision making, which is based on marginal (variable) cost of a product. It
emphasizes on cost behavior and clearly distinguishes between variable cost and fixed cost. It is based
on the principle that due to change in level of activity only the variable cost change and the fixed cost
remain constant.

What is a marginal cost?

This is all the variable cost to produce and sell a unit. It may be described as the additional cost to
produce and sell each additional unit. This includes Direct Material (DM), Direct Labor (DL), Direct
Expenses, Variable Production Overheads and Variable Admin Overheads and Variable Selling
Overheads. Basically the entire possible variable cost.

What is Contribution?
This is amount left to cover for fixed cost and profit.

Total Contribution = Sales - Variable Cost (Marginal Cost)

Contribution/ unit = Selling Price/ unit - Variable Cost

Or

Contribution/ unit = Total Contribution/ number of units

Note: Sales - Variable Cost = Contribution - Fixed Cost = Profit

So Contribution = Fixed Cost + Profit

As mentioned above the amount for fixed cost and profit.

USES OF MARGINAL COSTING (INCLUDES THE RULES FOR DECISION

MAKING)

Marginal costing is widely used by the managers in making various business decisions. The concept is
that, it is assumed that the fixed cost will not change so all decisions are based keeping this fact in mind.

• Provides quick calculation of total cost. As the fixed cost remains constant and only the variable
cost changes
Total Cost = (variable cost/ unit x no. of units) + Fixed cost

• Provides quick calculation of profit at different levels

Profit = (Contribution/ unit x no. of units) - Fixed Cost
 • Used in break-even analysis (see below)

• Helps in making decision on whether to make a product or buy from outside.

Rule: Only buy from outside if his price is lower than our variable cost to produce
(variable cost to producer does not include variable selling overheads)

• Helps in decision making on acceptance or rejection of special orders under idle capacity.

Rule: Accept all orders under idle capacity as long as it covers the variable cost. In
other words, it gives a positive contribution.

• Helps in making decision on whether to continue or discontinue a product.

Rule: Continue products giving positive contribution unless a replacement product can
generate more positive contribution. Discontinue the product giving negative
contribution. This is because the fixed cost should be ignored as it doesn’t changes with
decision to continue or discontinue. Hence a product which is making a loss (negative
net profit) but is giving a positive contribution should not be discontinued.

Similarly a product which might give a positive contribution should be added to current product
range.

COMPARISON OF ABSORPTION AND MARGINAL COSTING

ABSORPTION COSTING MARGINAL COSTING

1. It is based on total production cost including It is based only on variable cost.
variable and fixed costs.
2. It divides cost into production and non It divides cost between variable and fixed.
production
3. Stocks include the total production cost (DM, Stocks include only the variable production
DL, VPOH and FPOH) cost (DM, DL and VPOH)
4. It is more suitable for external use as the It is more suitable for internal use as
profit and loss is based on this. decisions are based on this
5. Treats fixed cost as a product cost. Treats Fixed cost as a period cost.
6. Gives Gross Profit Gives Contribution.
7. Required adjustment for Over and Under No adjustment is required as actual fixed cost
Absorbed. is taken.
 Breakeven Analysis
Formulas:
Contribution to Sales Ratio = Contribution per unit/ Selling price per unit Or
(csratio) Total Contribution/Total Sales

Breakeven in Units = Fixed Cost / Contribution per unit

Breakeven in value (Sales Revenue) = Breakeven in Units x Selling Price / Unit or Fixed Cost/Cs Ratio

Margin of Safety: This represents the difference between the actual (or budgeted) level of activity and the
breakeven level of activity. For e.g. if a factory produces (or plans or produce) 6 000 units and the
breakeven is at 2 000 units, this means 4 000 units are in margin of safety.

Margin of Safety in Units: = Sales (Units) - Breakeven Units

Margin of Safety in Value: = Margin of Safety in Units x Selling Price per Unit

Margin of Safety as a % = Margin of Safety units / Sales (Units) x 1 000

Sales for Target Profit = Fixed Cost + Target Profit

C S Ratio

Assumption Limitations
1. Fixed Cost remains constant. Fixed cost might change at some level
2. Total cost are divided into variable and It is difficult to perfectly do that.
fixed. Majority of cost are semi-variable.
3. Variable cost per unit remains constant Economies of scale and bulk discounts
and is perfectly proportional will affect this.
4. Selling Price unit remains constant. Increase in sales volume may require a
price reduction
5. Technology and efficiency remain Changes in them will definitely take
unchanged place.
6. There are no stock levels Every business will have stock levels

Note: due to the assumptions, the usefulness of breakeven analysis is limited.

Example: Through Diagram
Fixed Cost = $20 000
Variable Cost / Unit = $6
Selling Price / Unit = $10
Units = 10 000 Units

How is break-even found on the graph?

Continuing the above example, the following steps are illustrated to draw break-even graph:

Step 1: The horizontal line is knows as X-axis. Draw X-axis for number of units at the distance of
1 000 each and up to 10 000 units. The vertical line is known as Y-axis. Draw Y-axis for
cost and revenue up to $100 000 at the distance of $10 000 each on the graph paper.

Where the two axes meet is called the origin and it denotes zero for both axes.
Step 2: Draw fixed cost line parallel to x-axis for $20 000 as follows:
Step 3: Draw total cost line. It will begin from $20 000 on Y-axis. The total costs are equal to
fixed cost plus variable cost that is $20 000 + ($6 x 10 000 = $60 000) = $80 000, as
follows:
Step 4: Draw sales revenue line, it will begin from origin. The total sales revenue is $100 000
(i.e. $10 x 10 000)
Step 5: Mark the Break-Even point. The break-even point is the interaction of total sales line
and total cost line, as follows:
Step 6: Mark the following point on the break-even chart:

A = Profit
B = Loss
C = Margin of safety in value
D = Margin of safety in units
E = Margin of safety percentage.

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

A = Profit

B = Loss

D = Margin of
safety in units
What is profit-volume chart?

The profit-volume chart is the alternate graphical method used for breakeven analysis. It shows the
relationship between costs and revenues and it basically focuses on profits and losses at different level of
activities. It shows break-even point when the profit and loss line intersects the sales line. The sales line
may be based on sales units or sales revenue. The profit-volume chart is very useful to show the
breakeven point for range of products.

How is profit-volume chart drawn?

The following steps are involved to draw the profit-volume chart:

Step 1: The vertical line is known as Y-axis and has origin at the central point because the X-axis
begins from the central point. Draw Y-axis for profits and losses at the distance of
$10,000 each. All the points above the origin represent amounts of profit at different
level of sale an all the points below origin represent amounts of loss at different level of
sale. The horizontal line is known as X-axis, which may be used for sale in units or value.
Draw X-axis for number of units at the distance of 1 000 each and up to 10 000 units. The
X-axis begins from the center of Y-axis.
Step 2: Draw the profit and Loss points, as follows:

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

Step 3: Connect the profit and loss points as drawn in step 2 above. The point at which the
profit and loss line intersects the sale line, it is known as break-even point.
Step 4: The profit-volume chart may be used to find out the amount of profit and loss at
different level of output.
For example, the amount of profit at 8 000 units or loss at 3 000 units can be
determined on the chart as follows:

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

Cash Break-even Total fixed costs - Depreciation = $20 000 - $4 000 = 40 000
In value = Contribution to sales ratio
ALL THE SMALL THINGS.

Financial Accounting

- Written down value or net book value means after depreciation.

- Only assets and expenses have debit balances, all the other things in the world will have a credit
balance.
- Sales invoice would mean good sold on credit.
- If bad debt is inside the trial balance then it means that it has already been subtracted from the
Debtors.
- Everything outside the Trial Balance has to come TWICE.
- Provision for depreciation is a Contra Asset Account. It is NOT AN EXPENSE, since its balance is
brought down.
- All the balance c/d go to the Balance Sheet.
- All the expenses and incomes are in the Profit and Loss a/c.
- Revenue = Sales.
- When it is NOT specified how you bought Machinery, you make it BANK! Automatically.
- If NOTHING is specified about the policy of Depreciation, then you account for it MONTHLY.
- Every Asset has an Opening Debit balance and Closing Credit balance.
- Every Liability has an Opening Credit balance and closing Debit balance.
- The Amount of Loan interest still owing and not paid (which was to be paid this year) comes in
the Current Liabilities.
- Departmental Account: If given with prepayment any expenses, then we SHOULD FIRST ADJUST
the accruals and prepayments, and then divide them into % of EACH department.
- Control Account is not part of the double entry. It is THE THIRD ENTRY.
- List price is the price WITHOUT deducting TRADE DISCOUNT.
- Set off always reduces the Control Account!
- Credit Notes received = Return Outwards
- Credit Notes sent = Return Inwards
- BAD DEBTS recovered comes on the debit side of the Sales Ledger Control Account (S.L.C.A) and
even on the credit side.
- Whenever you receive a cheque from BANK marked ‘REFER TO DRAWER’ then it is CHEQUE
DISHONOURED
- FIX NET PROFIT: In the Journal, if the account goes in the N.P, then if something is being
CREDITED it will INCREASE N.P, or if it DEBITED, then it will DECREASE N.P.
- To find the opening balance in the Suspense LEAVE THE FIRST two lines empty.
- The amount of stationery used, goes in the Profit and Loss as an expense.
- Sundry Expense means miscellaneous expenses.
- Whatever goes in the Profit and Loss is REVENUE EXPENDITURE.
- Whatever goes in the BALANCE SHEET is CAPITAL EXPENDITURE.
- CAPITAL EMPLOYED (Sole Trader) = CAPITAL OWNED - LONG-TERM LOAN.
- CAPITAL OWNED (Sole trader) = Assets - Liabilities.
- CAPITAL EMPLOYED (COMPANY) = OSC + PSC + RESERVES (share premium, Retain profits, all
reserves) + Long Term Liabilities.
- REFUND FROM Supplier is recorded on the Credit side of the Purchase Ledger Control Account.
- In closing Assets, you write the Bet Book Value (N.B.V)
- DRAWINGS ARE Neither AN Asset NOR A LIABILITY.
- If they ask you to make a STATEMENT TO find Profit or Loss, then just make that financed by
(Opening capital + Net Profit (x) + Capital Introduced - Drawings = Capital at end)
- If they say make final accounts, then make Profit and Loss and Balance Sheet.
- Closing Stock has a direct relation with profit. If closing stock is overstated, profit will be
overstated.
- Opening stock has an inverse relation with profit. If opening stock is overstated, profit will be
understated.
- Goods sent on sale or return basis should not be counted as sake unless accepted by the
customer. Infact they should be included in the stock.
- If no account is wrong, like there is an error in the list of debtors then we only correct it through
suspense account (its only one entry, e.g. Debit: Suspense, Credit: - )
- We only double the amount if it is written on the wrong side of the account.
- Club accounts will never have drawings.
- If we find purchases of control account we will still have to subtract return outwards.
- Unpresented cheques are payment by us.
- Uncredited cheques are receipts by us (also called LODGMENTS).
- If you can’t find the average debtors or stock or creditors, use closing figure instead of instead of
average.
- If nothing is specified, we can assume all sales and purchases are on credit basis.
- Provision for bad debt is a separate account. We can record the provision in debtors account,
net debtors mean after deducting provision.
- We only take the change in provision in the Pnl.
- Cashbook is both a daybook and a ledger.
- We only record credit sales and purchases in the Sales and Purchase Daybook, cash and bank
transactions are in the cashbook.
- If a daybook is overcast only that amount will be wrong. E.g. if Sales daybook is undercast, this
means only the Sales account is wrong.
- If profit is given inside the trial balance, the stock should be closing stock (because we don’t
need the opening stock).
- Similarly if depreciation for the year is inside the trial balance, the provision for depreciation
would already include this year’s depreciation.
- Long term donations are in the balance sheet of clubs and short term are incomes.
- Gross profit ratio will not change because of sales volume (number of units), but net profit ratio
will increase.
 - In trading account we show stock of finished goods at transfer value. In balance sheet, they
should be recorded at cost.
- Indirect Material, Indirect Labour, Depreciation of plant and machinery will always be Factory
Overheads.
- Administration and selling goes in the profit and loss account.
- Net Assets = Assets - Liabilities, but in some cases CIE uses Net Assets as Capital Employed
which is Assets - Current Liabilities.
- Sale or Purchase is recorded when the goods are accepted not when the invoice is sent or the
payment is made.
- If only net book values are available Depreciation for the year = Opening Net Book Value +
Purchase of Asset - Sale of Asset (Nbv) - Closing Net book value.
- In most question they don’t mention depreciation, that doesn’t mean there is no depreciation,
use the above formula to determine. (Don’t forget the depreciation like idiots).
- Accumulated funds at start or Capital at start = Opening Asset - Opening Liabilities (please don’t
forget the opening balance of bank account).
- Cash banked will come on the debit side of bank and credit side of cash account.
- Subscription owing is an asset and prepaid is a liability.
- Loan is as long term liability unless payable within one year. If nothing is written, assume long
term.
- POOP is for expenses.
- OPPO is for incomes.
- Net realizable value = current selling price - any expenses (repairs)
- We always ignore replacement cost in stock valuation.
- Perpetual methods are those where we make a table.
- Markup is on cost (cost is 100)
- Margin is on sales (Sales is 100)

COST ACCOUNTING

- Cost centre means departments.

- If a business doesn’t split overheads into different departments, they will only have one
Overhead absorption rate for the whole factory (also called blanket OAR).
- Absorption costing means total costing. It is used to calculate total cost.
- We only use OAR to calculate the overheads for a unit/job/order/batch.
- OAR can be calculated on any basis like machine hours, labour hours, unit, labour cost (direct
wages), material cost etc.
- If no basis are given use either labour hours or machine hours depends on what is more
(intensity).
- Absorbed Overheads = OAR x Actual Activity.
- Over absorbed means Absorbed are more than actual overheads
 - Under absorbed means Absorbed are less than actual overheads.
- Usually if actual activity is above budget, we will OVER ABSORB
- If actual activity is below budget, we will UNDER ABSORB
- Total cost is cost of Production + the non-production cost.
- Stocks can only include production cost. In absorption costing, we use total production cost
whereas in marginal we use only variable production cost.
- Marginal costing is about decision making.
- Decisions are based on contribution not profits. It is assumed that fixed cost will still be
incurred.
- (contribution/unit x # of units) - Fixed Cost = Profit.
- Lower breakeven point is better. Higher margin of safety is better.
- Positive contribution product or department should never be closed down.
- Positive contribution product should be accepted under idle capacity.
- When deciding on if we should buy from outside or not, we only consider variable production
cost (ignore Variable Selling cost)
- Only change the fixed cost if the question tells you to.
- Only make Profit Statement on absorption if the question says so. Otherwise always marginal.
- Profit + Fixed Cost = Total Contribution.
- If firm makes a single product, profit volume chart will be Profit against units.
- If firm makes multiple products, Profit Volume chart will be Profit against Sales Revenue (Total
Sales).
- Direct Labour per hour = Wage rate per hour.
- Normal level of activity is budgeted level of activity. Fixed production Overheads/unit is
calculated using this.
- In calculating contribution per unit we need direct labour per unit.
- MARGINAL COSTING = SALES - VARIABLE COST = CONTRIBUTION - FIXED COST = NET PROFIT.
- ABSORPTION COSTING = SALES - PRODUCTION COST = GROSS PROFIT - NON PRODUCTION
COST = NET PROFIT.

Note: Under absorbed is added to Cost and Over absorbed is subtracted. We only have to do this in
absorption statement.

In marginal costing, we always take the total fixed cost. (We never calculate it on per unit as per normal
level of activity).
EXAM TIPS

PAPER 1

You have 60 minutes of 30 mcqs. 2 minutes for each.

First only attempt those questions which you are 100% sure of and skip others.

Read the MCQ carefully, because CIE likes to play around.

Now spend time on these questions.

If you are stuck try to eliminate the most obvious wrong answer.

5-6 questions are theoretical, at least read them thrice.

Sometimes it’s best to use the answer to check if it’s wrong or right.

If you see something in the answer choice which you haven’t heard of (that can never be the answer).

Please don’t leave it blank. Take an educated guess. There is no negative marking.

PAPER 2

You have 90 minutes for 90 marks. 30 marks for each question.

Always attempt the question which you know the best out of 3 first. This will give you confidence and
save time. You will end up spending time and getting it wrong if you do the toughest one first.

Don’t panic, usually in every paper one question is tricky. Do it at last.

You won’t get any award if you balance the balance sheet. If the balance sheet is off by a large amount,
that doesn’t mean everything is wrong, might be a single big figure which you have missed. DON’T
WASTE YOUR TIME.