CSEC Principles of Accounts STUDY NOTES UNITS UNIT 1—INTRODUCTION TO PRINCIPLES OF ACCOUNTS AND BALANCE SHEET UNIT 2- DOUBLE ENTRY, ASSETS, LIABILITIES AND CAPITAL UNIT 3-THE ASSET OF STOCK UNIT 4- DOUBLE ENTRY FOR EXPENSES AND REVENUES UNIT 5-— BALANCING OFF TRIAL BALANCE UNIT 6- TRADING, PROFIT AND LOSS ACCOUNT UNIT 7- ADJUSTMENTS TO FINAL ACCOUNTS:- DEPRECIATION UNIT 8- ADJUSTMENTS TO FINAL ACCOUNTS:- BAD DEBTS, PROVISION FOR BAD DEBTS UNIT 9-ADJUSTMENT TO FINAL ACCOUNTS:- ACCRUALS AND PREPAYMENTS AND FINAL ACCOUNTS AFTER ADJUSTMENTS UNIT 10 - BOOKS OF ORIGINAL ENTRIES:- a) SALES JOURNAL AND RETURNS INWARD JOURNAL b) PURCHASES JOURNAL AND RETURNS OUTWARD JOURNAL c) USES OF GENERAL JOURNAL d) ERRORS AND SUSPENSEUNIT 11 - CASH BOOK/PETTY CASH UNIT 12 - BANK RECONCILIATION UNIT 13 - CONTROL ACCOUNTS UNIT 14 —- SINGLE ENTRY AND INCOMPLETE RECORDS UNIT 15 - RECEIPTS AND PAYMENTS, INCOME AND EXPENDITURE UNIT 16 - MANUFACTURING ACCOUNTS UNIT 17 - PARTNERSHIP UNIT 18 - COMPANY ACCOUNTS (LIMITED LIABILITY COMPANY) UNIT 19 - COOPERATIVES UNIT 20 —- INTRODUCTION TO ACCOUNTING RATIOS UNIT 21 —- PAYROLL UNIT 22 — STOCK VALUATION GLOSSARY iUNIT 1 - INTRODUCTION TO PRINCIPLES OF ACCOUNTS AND BALANCE SHEET Definition of Terms * Accounting - the processes of classifying, summarizing, analyzing and interpreting financial information in order to make management decisions and plan for the future. * Book-keeping - the posting and recording of financial data in an accurate and systematic order in accordance with set rules. Users of Accounting Information Bankers for loan purpose Government for tax purpose Trade unions / Employees for wage negotiations purposes Owners of the Business for profit sharing purposes Management for decision making purposes Prospective investors for interest purposes VvVVVVY Purpose of Accounting 1. To keep proper records of business transactions 2. To keep proper control of the finances of a business 3. Toassist management in making decisions Basic Accounting Concepts and Conventions What if you were to work as an accountant in a business where there are no standards, rules, or set ways of doing things? There will be confusion and frustration with different methods and interpretations by the people who review the accounts. The standards or rules are the concepts and conventions which governthe accounting methods of a business, which must be based on objectivity, or agreement of all concerned, rather than subjectivity, or one’s personal preference. As you continue reading, note that most of the concepts and conventions presented here will be referred to in later chapters. Therefore, it is recommended that you refer to this chapter when you encounter these terms again. Concepts Concepts are the methods of recording transactions. There are seven (7) basic concepts, five (5) of which you will apply quite naturally as you complete this text. These are: cost, dual aspect, realization, accrual and business entity. The other two - going concern and money measurement - are advanced level topics. 1. The Cost Concept When recording assets, they are valued and shown at cost price rather than their current value. 2. The Dual Aspect Concept As you would remember from Chapter One, accounting looks at two areas: assets on the one hand, and the claims (capital and liabilities) made on them on the other, where they are equal to each other. Here is the accounting equation: Assets = Capital + Liabilities. All dual aspect transactions must have double entries (a debit and corresponding credit), to be dealt with in Section III 3. The Realization Concept Transactions are recorded with the understanding that profit is realized (or, earned) after goods and services are bought by customers, and after the trader pays operating expenses. 4. The Accrual Concept Net Profit is calculated as being the excess of income (or revenue) over expenses. Then:Net Profit = Income — Expenses 5, The Business Entity Concept Only entries made with respect to the business’ transactions are recorded in its books. Therefore, the personal purchases of a sole trader for a living-room suite will not be recorded in his or her business’ books. This should not be confused with additional capital and drawings, which affect both personal and business accounts. These are recorded because they affect the business. 6. The Going Concern Concept Assets are valued at cost price only during business operations (whether-present or future), but not when selling a business. At the time of sale, the current, saleable or market value is used. 7. The Money Measurement Concept You understand that accounting is the utilization of monetary values for transactions, to which the persons concerned agree to. Then, what about those things that affect income and expenses, which cannot be valued in dollars and cents, or which might raise disagreement over their values? Accounting records cannot give us this information, but management can. Some examples are: 1. Management policies and performances. 2. Marketing strategies and competition. 3. Productivity (the production levels of employees) of the labour force and employee turnover (how often workers leave the job). 4. Increased tariffs or taxes on goods imported. 5. Free trade arrangements. 6. Increase of taxable allowances. Conventions A convention is a practice or rule for dealing with business transactions of a similar nature in the same manner. In so doing, there must be quantifiability, which means that an accurate measure of the transaction must be made. The three majorconventions are materiality, consistency and conservatism/prudence (an advanced level topic). Materiality It would take a lot of time and money to pay an accountant to track the use of small items in a business, as to how much of it was used in the current trading period. An example is pens. Three boxes of pens are bought, which may last for six months. Now, the concern is how to make an accurate calculation of the number of pens office staff used each month, and charge this cost to the business when final accounts and balance sheet are prepared. As a solution, materiality provides for this by allowing a business to determine small and large amounts. Small amounts of expenses are charged to the period bought, as in the case of the pens, while large amounts are charged over the use of the item, making allowance for decrease in value. An example is the purchase of a machine for $40 000. As a material item, it will depreciate (decrease in value) every year it is in use, and the current value (cost — depreciation) used in the balance sheet. Consistency A consistent method is a fixed or set way of doing things. In accounting, therefore, a business will use the same accounting method for recording similar transactions. This makes it easy for you in your study. Once you know a principle in a given situation, you can apply it to other similar situations. Conservatism (or Prudence) The word “conservation” suggests that there is to be no excess or wastage, while “prudence” is the careful use of material resources, or the exercise of good judgment or common sense in practical matters. This careful use of resources is in direct reference to the valuations of assets and liabilities, and in estimations of profits. Here, assets must not be overvalued, and neither should the value of liabilities be too much under the actual value. These may mislead ‘one to get into too much debt and ultimately bankruptcy. Further, profits will be understated so that the capital will appear to be lessthan it is. At this point, all losses will be recorded, whereas profits the business anticipates are not recorded until they are realized. Business Organizations There are several types of business organizations which include: Sole Trader Partnership Corporations (limited companies) Cooperatives Non-profit Organizations Sole Trader In a sole proprietorship, one person owns the business and very little capital is needed for starting up. However, it does not mean that the owner is the only person who works in the business. Sole proprietorships are most often small businesses that are especially established and easy to operate. Partnership A partnership is a business that is jointly operated by the parties involved. One of the ways by which the sole trader can expand his business is to turn it into a partnership. The minimum number of persons in a partnership is two while the maximum is twenty. Some professional groups such as banks are only allowed a maximum of ten partners. Corporations (limited companies) A company is another type of business unit. It is a form of business organization that is recognized by law as a separate entity from the persons who actually own it. Limited liability means that the investors or shareholders are not liable for debts incurred by the company beyond the amounts they invested. Limited companies are either private or public companies.Cooperatives Cooperatives are businesses formed by groups with similar ‘objectives and/or interests. The groups may be producers or users of products or services. There are several types of cooperatives which include: = Buyers’ cooperative = Retail/consumer cooperative = Financial cooperative Non-profit Organizations Anon-profit organization is one from which its shareholders or trustees do not benefit financially. Any money earned must be retained by the organization and used for its own expenses, operations and programs. They usually have an educational, charity, religious, professional, cultural and/or public service objective. The Accounting Cycle Step 1 Collect source documents Step? Enter transactions in books of prime entry Step 5 Draw up final accounts Step 3 Post to double entry accounts in ledgers Step 4Simple five Step Cycle The accounting cycle is a repetitive circular flow of activities in a specific sequence in each accounting or trading period (the time span considered in preparing accounts to ascertain profit or loss; which may be two weeks, one month, one quarter, six months, or one year). It is somewhat different for each form of business. However, the ten steps for the sole trader is the base for all others. A Tdentiy Source Documents to 2 Preparea. Journalize Balance Sheet ‘Operang Entries » ff ‘Draw up Trading and Profit & Loss Accounts as Extract 2 Post-Closing, Trial Balance 7} ‘Teuralize and Bost Extract Adjising Enkiet ‘The Thal Balance 6 _— Toutnaze and Bost ~ Ceresion of ‘Trial Balance ErrorsThe Ten Steps of the Accounting Cycle for the Sole Trader: 1. Identify source documents. It is necessary to know which documents are needed for specific purposes prior to preparing the book-keeping journals and ledgers. 2. Journalize opening entries in the journal. Record is made of all previous balances of assets, capital and liabilities. 3. Enter transactions in books of original entry. Transactions must be analyzed and recorded in the subsidiary books or books of original entry. These are, General Journal, Cash Book, Petty Cash Book, Sales Book/Journal, Returns Inwards Book/Journal, Purchases Book/Journal, and Returns Outwards. Book/Journal. 4. Post to ledger accounts. The transactions entered in the subsidiary (helping) books are transferred (posted) to the ledger, where accounts are prepared for each person and business activity to show their balances. 5. Extract a trial balance. After all the ledger accounts are prepared, their balances are listed so that debits equal credits. The purpose is to check the arithmetical accuracy of ledger accounts before preparing final accounts (Trading and Profit & Loss) and balance sheet. 6. Journalize and post correction of errors discovered after the extraction of the trial balance. Several errors may have been made, some affecting the agreement of the trial balance totals, and others not affecting them 7. Journalize and post adjusting entries. Sometimes adjustments are made to the balances of accounts in the trial balance. These adjustments must be carefully analyzed and changes made in the relevant accounts before final accounts and balance sheet are prepared. Adjustments include payments in advance or prepayments; expenses the business owes (or expenses accrued, due or outstanding); bad debts provision increase or decrease; and an allowance for depreciation of fixed assets.8. Extract a post-closing trial balance. This is prepared to prove that adjusting and closing entries are accurate before preparing final accounts and balance sheet. 9. Draw up trading and profit and loss accounts (referred to as final accounts) to ascertain a business’ gross profit or loss in the trading account, and net profit or loss in the profit and loss account. 10. Prepare a balance sheet to show a firm’s financial position on a specific day. Impact of Technology on Accounting Just imagine that you are the chief accountant ina large firm. It has two thousand employees and one million customers in thirty (30) different countries. It purchases supplies from fifty (50) suppliers to produce twenty five different products, and has forty branches around the world. Could you see yourself trying to keep track of all the business activities on paper of in books? Think about it. = How many assistants would you need? = How long do you think it will take to decide which products are making great profits and which are not? = How will you keep track of the assets? = What kind of management and accountability will be required for efficiency? The list of questions could go on and on Computer, a twentieth century invention, has made it possible for small, medium and large businesses to keep records of their numerous transactions, which are retrievable at the click of a mouse. Computer programmers have created software which is designed to record transactions in_ different types of accounts. Where calculations are necessary, formulae are created so that data entered can be manipulated (calculated) by the programme and the result displayed. E.g. The formula a + b = cis given. When numerical values are entered for a and b, cis the result. Therefore if a = 5 and b =4, the programme will give the result, c = 9. 11Some computer softwares are available on compact discs (CDs) from manufacturers. These softwares are written to maintain sales ledger or purchases ledger accounts, general ledger accounts, preparing payroll, stock records, or final accounts from the financial records. Examples are Ms Excel, EBooks and Peachtree. Persons using these softwares in a firm are usually specially trained to use them and have been formally trained in accounting. This is necessary since one need to know what data to enter, where to enter such data and to discover errors which were made at the time of entering transactions. A trained person in accounting is more likely to discover and correct such errors. Finally, you will remember that accounting analyses the financial position of a business. This is accomplished through computer software that has been designed to provide results of statistical information for analysis and interpretation of financial statements. Each business decides which software is best suited to its operations. Some may even choose to have programmes created, which are designed especially for their use. The Accounting Equation ASSETS = CAPITAL + LIABILITIES 1. Assets Value of resources which a business OWNS 2. Liabil ies | Amounts the business OWES for resources it received from outside parties. 3. Capital —_ Value of resources that the proprietor/owner put into the business. This can be done at any time of the year, (beginning, during or at the end). NOTE: Capital is also known as owner’s equity or net worth Examples of Assets and Liabilities ASSETS LIABILITIES Land and Buildings Creditors Motor Vehicle Short-term & Long-term Loans Fixtures & Fittings Mortgage FurnitureUsing the Accounting Equation to find Missing Figures The accounting equation also called the Balance Sheet equation, it can be used to find the missing assets, liabilities or capital figures as shown below: Eg. 1 Ifthe total value for assets is $100, liabilities $25 and Capital $75; the accounting equation will be: - Assets 100 Capital + Liabilities 75 + 25 Eg.2 IfAssets =$525 Capital = $425 then Liabilities can be calculated using the equation: A= C +L 525 = 425 +L A- Cc 325 — 425 = 100 Make L the subject Answer: ies = $100 The Balance Sheet The Balance Sheet is a financial statement showing the assets, liabilities and capital of a particular business at a particular date. NOTE: THE BALANCE SHEET IS NOT AN ACCOUNT The items in the Balance Sheet are categorized and arranged in a particular way 1. Assets are categorized as either * Fixed Assets - assets which are bought to be used by the business for more than one accounting year and are not for resale. * Current Assets - assets with value constantly changing or will be used up during the accounting year.Categories of Assets FIXED ASSETS CURRENT ASSETS Land & Building/Premises _ | Stock of Goods/inventory Machinery Debtors Motor Vehicles Cash at bank Furniture Cash in hand Fixtures & Fittings 2. Liabilities are categorized as either * Current Liabilities — amount owed for which payments is due within one year. « Long-term Liabilities — debts for which payments is due over cone year. Categories of Liabi ies CURRENT LIABILITIES LONG-TERM LIABILITIES Creditors Long-Term Loans Short — term Loans Mortgages Bank overdraft 3. Capital is categorized as either * Owner's Capital - value of resources the owner has invested in the business * Working Capital - It measures the amount of funds a business has available for meeting the day-to-day expenses after taking ‘out amount owed. The Order of the Balance Sheet Items in the balance sheet can be arranged into two orders:-Order of Permanency This means that the assets are arranged in descending order from the most permanent down (those kept the longest in the business) to the least permanent, as shown below. Land Buildings/Premises Machinery Fixtures and Fittings Furniture Equipment Motor Vehicles Stock of goods Debtors Cash at bank Cash in hand Order of Liquidity This means that the assets are arranged from the most liquid asset (asset easiest to convert to cash) down to the hardest to convert to cash, as shown below, Cash in hand Cash at bank Debtors Stock of goods Motor Vehicles Equipment Furniture Fixtures and Fittings Machinery Buildings/ Premises Land Note: Cash is the most liquid asset. The Format of the Balance Sheet There are two formats: - > Horizontal > VerticalThe Vertical Format NAME OF BUSINESS/PERSON BALANCE SHEET AS AT (DATE) FIXED ASSETS $ $ $ XXXX XXXX! XXXX CURRENT ASSETS XXX XXX XXX XXX XXX Less CURRENT LIABILITIES XXX XXX XXX WORKING CAPITAL FINANCED BY: CAPITAL XXXX LONG-TERM LIABILITIES XXXX XOX NBV (net book value) — which is the value of the asset at that date. Note: If there is only one current liability it should be recorded directly under the current asset.The Horizontal Format Name of Company BALANCE SHEET AS AT (DATE) $ $ $ $ FIXED ASSETS CAPITAL AND LIABILITIES XXXX CAPITAL XXXX XXXX LON S XXXXX] XXXX CURRENT ASSETS CURRENT LIABILITIES XXXX XXXX XXX XXXX XXXX XXXXX XXXXX NOTE: DO NOT FORGET TO WRITE THE BALANCE SHEET TOTALS (WHICH MUST BE THE SAME FIGURES ON BOTH SIDES) IN THE SAME LINE AND DOUBLE LINE THE FIGURES. Working Capital Working capital is the excess of Current Assets over Current Liabilities. The formula used to calculate working capital is: WORKING CAPITAL = CURRENT ASSETS ~ CURRENT LIABILITIES Eg.1 If total Current Liabilities is $9 800 and total Current Assets is $16 200, what is the working capital? wc = CA - cL 6400 = 16200 - 9800UNIT 2 - DOUBLE ENTRY FOR ASSETS, LIABILITIES AND CAPITAL Double Entry Each transaction affects two accounts therefore it is recorded twice: * One account is DEBITED * The other is CREDITED NOTE: For every debit entry there is a corresponding credit entry and for every credit entry there is a corresponding debit entry. Double Entry Rules ACCOUNTS TO RECORD ENTRY IN ACCOUNT ASSETS AN INCREASE DEBIT A DECREASE CREDIT LIABILITIES AN INCREASE CREDIT A DECREASE DEBIT CAPITAL AN INCREASE CREDIT A DECREASE DEBIT The Ledger or ‘T’ Account (A/C) Each item has its own ledger account which is drawn up like the capital letter "T’. E.g.1 Cash Cash AC DEBIT CREDITEg.2 Bank Bank A/C DEBIT | CREDIT + - E.g.3° Creditors Creditors AIC DesiT | CREDIT : + The LEFT hand side is the DEBIT (Dr) side. The RIGHT hand side is the CREDIT (Cr) side. The ledger account must contain the following information: v¥ Name / Title of the account e.g. Cash A/C Date of transaction e.g. 2010 September 4 v Y Details / Particulars (name of corresponding entry) e.g. Capital ¥ Amount e.g. $3 000 Format of the Ledger Account Dr Side NAME OF ACCOUNT Cr Side pate | verats | rouo | avout | pare | vetaus | rouo | amount STEPS TO WRITE UP LEDGER 1. Identify the accounts mentioned in the transaction eg Started business with $200 cash. The accounts are cash and capital. 2. Open each of the accounts identified by writing the name of the account in the centre of the page.Example: Cash A/C pare | verats | rove | amounr | oare | veraus | Fouo | amount Capital AIC pare _| nerats | rouo | amounr | nate | vetaus | rouo | amount 3. Identify if the account is an asset, a liability or capital; e.g. cash is ‘an asset and capital is capital. 4, Identify if the account is increasing or decreasing e.g. cash is put into the business therefore the amount of cash the business has will increase. While capital represents the value of the business and if money goes into the business, then the business’ value will also increase. 5. Identify which side of each account the increase or decrease must be recorded on by applying the double entry rules below. A. Assets . To record an increase DEBIT the asset account . To record a decrease CREDIT the asset account Or ASSET A/C Cr INCREASE DECREASE bilities * To record an increase CREDIT the liability account * To record a decrease DEBIT the liability account Dr LIABILITY A/C Cr DECREASE INCREASE 20C. Capital * To record an increase CREDIT the capital account * Torecord a decrease DEBIT the capital account DOr CAPITAL A/C cr DECREASE INCREASE NOTE: The Double entry system rules for Liabilities and Capital GENERAL NOTE: All transactions involving CHEQUE must be entered in the BANK account. BALANCING OFF THE ACCOUNT This is done to find out how much is left in each account. Step 1 Total each side of the account Step 2 Find the difference between the two sides Step 3 Place the difference on the smaller side. The date would be the end of the month and the detail would be balance carried down or brought forward (balance cid or b/f) Step 4 Total each side of the account making sure both sides are equal and the totals in the same line Step 5 The amount ending for one month would be the start of the next month. The balance carried down becomes the balance brought down or brought forward. (balance b/d or b/f) This amount is recorded on the side which had the biager total. 21UNIT 3 - THE ASSET OF STOCK Four accounts are used for the recording of stock. 1. PURCHASES - The buying of goods for resale. When goods are bought, stock of goods is being increased therefore the Purchases A/C will be debited. The Purchases A/C is used only to record goods bought or goods taken by owner for himself. Examples: Jan4 Bought goods paying by cheque/cash $200. Jan2 Bought goods from A. Forbes $600 on credit. RETURNS INWARDS / SALES RETURN — Goods previously sold on credit are returned to the firm by the customers. The Return Inwards A/C is used only for the return of goods into the firm by its customers. Goods coming into the firm will increase stock therefore return inwards will be debited. Example: June 1, G. Cunningham return goods $45. SALES - Selling of goods previously included in purchases. When goods are sold, the stock of goods is being decreased therefore the Sales A/C is used to record the sales of goods only. Examples: Jan 2 Sold goods for cash $300. Jan@ Sold goods on credit to J. Simpson $450. RETURNS OUTWARDS / PURCHASES RETURN This refers to stock of goods returned by the firm to its suppliers. The return outwards a/c is used to record goods the returned to suppliers. Return outwards a/c will be credited as goods returned will decrease stock. Example: Return $50 worth of goods to S. Blake. 22UNIT 4 - DOUBLE ENTRY FOR EXPENSES AND REVENUE Income and Expenses Expenses represent payments made for a number of benefits and or services received by a firm, but which do not directly provide an asset owned by the firm. These benefits and services are advantages to the business and are therefore similar to assets in that respect e.g. wages paid for services provided. Like asset accounts, expense accounts carry debit balances. To increase an expense account we debit the account and to decrease an expense account we credit the account. Income represents payments received for benefits or services supplied €.g. monies received from renting part of a building. When monies are received, we would debit cash account and credit rental income account. Income accounts, like liability accounts therefore carry credit balances. To increase an income account we credit the account and to decrease an income account we debit the account. BALANCING OFF ACCOUNTS In balancing off the accounts relating to stock, Revenue and Expenses the same steps are followed as on page 17. These accounts do not carry a balance therefore the detail record is different. Stock account detail would be trading account while expenses and revenues will be profit and loss. 14, T. Grant had the following balances on his books in 31 May, 1994 $ Cash 850 Furniture 1500 Creditors 475 Debtors 615 ‘Stock 750 Motor Van 975 Overdraft 240 During the month of June, he had made the following transactions’ 23$ 1 Purchased furniture for cash 500 2 Purchased stock for cash 200 3. Stock costing $150 was sold on credit for 180 4 Paid rent 300 (i), What was his working capital on 31, May 1994? (Show your calculation). (ii) State with the amount, the effect (i.e. INCREASE, DECREASE OR NO EFFECT) of EACH of the following transactions 1 to 4, ‘on your working capital. ANSWER (i) — Working capital on May 31 WC = Assets — Liabilities = (Cash $850+Furniture $1500+Debtors $615+Stock $750 +Motor Van $975) — (Creditors $475+Overdraft $240) = $4690 - $715 = $3979 (ii) Do working in your notebook then complete this table. Transaction Effect on Working Capital INCREASE DECREASE | NO EFFECT Joss] 24UNIT 5 — BALANCING OFF TRIAL BALANCE The Trial Balance * This is a schedule or listing of balances both debits and credits, extracted (taken) from the accounts in the ledgers, including both the cash and bank balances in the cash book. * The trial balance is not a part of the double entry system i.e. the trial balance is not an account. The trial balance usually has three columns: name of account, debit balances and credit balances. Purposes of the Trial Balance The main purposes of the trial balance are: (i) To check the arithmetical accuracy of postings to the ledgers (ii) To provide a summary of the balances on the individual accounts (iii) To aid in the preparation of the final accounts, namely the income statement and the balance sheet. You could be asked to prepare a trial balance from a list of balances! This means that the accounts and their balances given to you would have to be stored so that the name of the account is in the first column followed by the figure under either the debit or credit column. At the end the totals (for debit and credit column) should agree. The following pneumonic will help you in making up your trial balance. PREPARING THE TRIAL BALANCE FROM THE LEDGER Step 1 Use only those account into which you recorded a difference. The name of these accounts would be recorded into the detail column. Step 2 Look for the side on which the difference was placed and record it on the opposite side in the trial balance Step 3. The amount that is to be record in the trial balance is the difference figure ‘Step 4 Total both sides which MUST be equal when all accounts are recorded DEAL Debtors, Expenses, Assets and Losses have debit balances. 25CLIP Capital, Liabilities, Income and Profits have credit balances. This means that items such as purchases, wage, discount allowed, plant, machinery, debtors etc are debit balances whereas, sales, discount received, capital, loans, creditors etc are credit balances. NOTE: Ifthe trial balance does not agree and there is a large balance and no capital was given in the problem, then this difference should be treated as capital. Trial Balance Layout DATE PARTICULARS DEBIT CREDIT Capital Rent. Motor Expenses. Drawings. Salaries... Rates.. Sales. . Purchases. Return Inwards. . Return Outwards. Premises.... Motor Van. Fixtures... (Expense) Discount allowed... Discount Received. Bank. Cash (Expense) Carriage Outwards. Carriage Inwards. Rent received . Bank Overdraft... Commission Received. Loans — J. Brown... Stock.. Machinery......... Equipment. ° Bad Debts. . Provision for Bad Debts... secseseeeeeeeee Creditors. . Debtors. 26REMINDER! 1. ALL ASSETS CARRIES A DEBIT BALANCE 2. | ALL EXPENSES CARRIES A DEBIT BALANCE 3. ALL LIABILITIES CARRIES A CREDIT BALANCE 4. CAPITAL CARRIES A CREDIT BALANCE DEBIT CREDIT EXPENSES DRAWINGS TRIAL BALANCE PURCHASES SALES RETURN INWARDS RETURN OUTWARDS - REVENUE TRADING & PROFIT & LOSS ACCOUNT GROSS PROFIT NET PROFIT Liability Asset Capital The left-hand side of the accounts in double entry. DR The right-hand side of the accounts in double entry. CR Cost of operating the business. Cash or goods taken out of a business by its owner for his private use; private ‘expenses paid from the business’ funds or included in the expenses of the firm A list of balances in the books, shown in Debit and Credit columns. Goods bought by the business for the purpose of selling them again Goods sold by the business. Goods returned to the business by its customers. Goods returned by the business to its suppliers. Monetary value of goods and services supplied to the customers. Combined account in which both gross and net profits are calculated. Sales less cost of goods sold Gross profit less total expenses Asset - Capital Capital + Liability Asset - Liability 27UNIT 6 — TRADING, PROFIT AND LOSS ACCOUNT The main objective of a business is to make a profit. At the end of an accounting year the proprietor will want to know if the business has made a profit and by how much. Final accounts are drawn up to reveal this. A business that does not manufacture its own goods will draw up a trading, profit and loss account and a balance sheet. The trading, profit and loss account is divided into two parts: (a) (b) The Trading Account The trading account is used to calculate the gross profit. The gross profit is profit earned by the business before expenses are deducted. GP = Sales — Cost of Sales The Profit and Loss Account This account is used to calculate the net profit. Net profit is profit remaining after all expenses have been deducted, NP = Gross Profit — Total Expenses BALANCING UP THE ACCOUNT At the end of each period the total purchases is transferred from the purchases account to the trading account. Credit Purchases account Debit Trading account The total sales is transferred from the sales account to the trading account Debit Sales account Credit Trading account Each expense is transferred to the profit and loss account. Credit Expense account Debit Profit and loss account 28Only the amount due for a period is charged to the profit and loss account. All expenses are listed on the debit side of the profit and loss account. Each revenue is transferred to the profit and loss account. Debit Revenue account Credit Profit and loss account Only the total revenue to be received for a period is charged to the profit and loss account. All revenues are listed on the credit side of the profit and loss and added to the gross profit. Hence net profit may also be: NP = (Gross Profit + Other Revenues) - Expenses TRADING, PROFIT & LOSS - FURTHER CONSIDERATIONS 1 OPENING STOCK: If the business has been in existence for some time, there may be stock left over from previous years. This should be included in the current year’s trading account and is added to the purchases. CARRIAGE: This refers to the transporting of goods. There are two types: (a) Carriage Inwards (carriage on purchases): This refers to the cost of transporting goods into the firm. Carriage inwards increases the cost of goods purchased, therefore it is added to the purchases. (b) Carriage Outwards (carriage on sales): This refers to the cost of transporting goods out of the firm to its customers. Carriage outwards is an expense that relates to the selling of goods and is therefore included with the expenses in the profit and loss account RETURNS OUTWARDS: This refers to goods returned by the firm to its suppliers. When goods are returned out of the firm, it decreases the actual 29purchases made. Returns Outwards is deducted from the purchases figure in the trading account. 4. RETURNS INWARDS: This refers to goods returned to the business by its customers. Goods returned to the business decreases the actual sales made and is therefore deducted from the sales figure in the trading account The trading account starts with the heading name of person/business, title of what is being prepared and date. The layout of a simple Trading Account is shown below: Horizontal Style NAME OF BUSINESS/PERSON TRADING ACCOUNT FOR THE YEAR ENDING (DATE) $ $ $ $ Purchases 200K] Sales 000K Less Closing Stock x Cost of Goods Sold OO Gross Profit XXXXX Vertical Style NAME OF BUSINESS/PERSON TRADING ACCOUNT FOR THE YEAR ENDING (DATE) Sales XXXX Less cost of goods sold Purchases HK Less closing stock “XX Ts Gross profit XXX 30The layout of a simple profit and loss account is shown below: Horizontal Style NAME OF BUSINESS/PERSON PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING DATE) XXX Vertical Style NAME OF BUSINESS/PERSON PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING DATE) Gross Profit Less Expenses: Electricity Telephone Wages Net Profit 31The layout of a trading, profit and loss account is shown below: Horizontal Style NAME OF BUSINESS/PERSON TRADING, PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING DATE) $ Opening Stock Purchases XXX¥ Less Returns Outwards __! Add Carriage Inwards Goods available for sale Less Closing Stock Cost of Goods Sold Gross Profit cid Operating Expenses: Discount Allowed Insurance Wages Travelling Stationery Cleaning Net Profit Less Returns Inwards Gross Profit bid Other Revenues: Rent Received $ YOXXK, XX XXXK xX XxX 32Vertical Style NAME OF BUSINESS/PERSON TRADING, PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING DATE) | s f[ $ 7 Ss | Sales | XXXx} | Less Retum Inwards _ XXX) | XXXX | | Less Cost of Goods Sold: | Opening Stock XXXX Purchases XXXK | Less Retum Outwards (XXX) | XXXX | Carriage Inwards | xxx Cost of goods available for resale XXXX | Less Closing Stock EXO) | XXN) | | Gross Profit XXXX | | Add Revenue | | Rent received {XXX 1 Commission recei | xox} yoo | | XXXX Less Expenses | | Carriage outwards XXX | | Rent and rates XXX Pay XXXX | | Insurance ; xx! | Motor expenses (xxx! Office expenses | xxx! | | Lighting and heating expenses | XXX | | General expenses NetProft 33UNIT 7 - ADJUSTMENTS TO FINAL ACCOUNTS — DEPRECIATION DEPRECIATION Depreciation is that part of the fixed asset that is consumed or used up during period. Depreciation is regarded as an expense just like items such as rent, wages, etc. Because depreciation is an expense itis charged to the profit and loss therefore reduces net profit. CAUSES OF DEPRECIATION 4. Physical Deterioration (a) Wear and Tear: Because of consistent use of a fixed asset, it will eventually wear out and value less. (b) Erosion, Rust, Rot and Decay: Land may be eroded or wasted away by action of wind, rain, sun and other elements of nature. Similarly the metals in a motor vehicle or machinery will rust or corrode. Wood will eventually rot and decay. 2 Economic factors (a) Obsolescence: This is the process where fixed assets may become outdated because of technological development which leads to the manufacture of more sophisticated and new machinery. (b) Inadequacy: This is the process whereby assets are no longer used because the growth and changes in the size of the firm has led to their replacement with much larger ones. 3. ‘Time Factor This refers to assets that have legal life fixed in terms of years. For instance if a building is rented for ten years (leased), when the years are finished, the lease is worth nothing. Whatever is paid for the lease is now of no value. Asimilar asset is patent right where a person is given complete right so that he alone can produce something. When the patent time has finished, it no longer has any value. 344. Depletion Some assets have a wasting character perhaps as a result of the extraction of raw material. Eg, bauxite. Methods of Calculating Depreciation 4. Straight Line Method: This method is also called the fixed installment method. The same amount is charged to the profit and loss account each year. Depreciation = Cost Price ~ Scrap value # of years OR Depreciation = Cost x Percentage 2. Reducing Balance Method: This is where a reduced sum is charged to the profit and loss each year. A fixed percentage is charged in the first year. In the second and later years the same percentage is charged but is taken from a reduced balance, i.e. (cost — depreciation already charged). Depreciation = (Cost - Total Previous Depreciation) x Percentage Example: Mrs. Bigg bought a machine for $12,500. It is to be kept for 4 years and then sold for an estimated figure of 5120. Show the calculations of the figures for depreciation for each of the four years using: a) the straight line method; and b) _the reducing balance method, assuming a rate of 20%. Solution — Straight Line Method a) Depreciation charge = Cost Price ~ Scrap Value for the year Number of useful years = $12,500 ~ 5120 4 = $1,845 35Year 1 Cost 12,500 Less depreciation 1,845 Net Book Value (NBV) 10,655 Year 2 Less depreciation 1,845 Net Book Value (NBV) 8,810 Year 3 Less depreciation 1,845 Net Book Value (NBV) 6,965, Year 4 Less depreciation 1,845 Scrap Value 5.120 b) Solution — Reducing Balance Method Depreciation in the first year is calculated on cost; however for subsequent years it is calculated on the reduced or diminished balance (known as NBV). Year 1 Cost 12,500 Less depreciation (12,500 x 20%) 2,500 Net Book Value (NBV) 10,000 Year 2 Less depreciation (10,655 x 20%) 2,000 Net Book Value (NBV) 8,000 Year 3 Less depreciation (8810 x 20%) 1,600 Net Book Value (NBV) 6,400 Year 4 Less depreciation (6,965 x 20%) 1,280 Scrap Value 5,120 Double Entry Records for Depreciation Using the modern method, no entry is made in the asset account itself for depreciation; instead, depreciation is shown in a separate provision for depreciation account. This means that the asset will normally be shown at cost price. To Record Depreciation: DR Profit and Loss a/c CR Provision for Depreciation a/c At the end of the trading period, the balance (c/d) on the provision for depreciation account is subtracted from the cost of the asset in the balance sheet. 36Monthly depreciation charges Here a fixed asset is being depreciated for each month that the asset is in the possession of the business. Thus, if an asset is owned for only three months, then, at the end of the trading period, the asset should be depreciated for three months only. As a result, where an asset is bought (oF sold) part-way in a trading year, the period of ownership in that year must be ascertained and the asset depreciated accordingly. The following phrases are usually used to indicate that an asset should be depreciated on a monthly basis: Depreciation should be calculated on a monthly basis. The asset should be depreciated/or each month of ownership; One month's ownership requires one month's depreciation; The asset should be depreciated for each proportion of a year; and Depreciation should be pro-rated. QeeENS Note: Where the date on which fixed assets are bought is known, depreciation should be calculated for each month of ownership. Where such dates are unknown follow the instruction given in the examination. Example: Jamie Curtis bought 2 motor vans during 2009 by cheque; January1 $8000 and April 1 $7000. Show all necessary entries for the first 2 years if the first machine is depreciated at 10% reducing balance method and the second 20% straight line method. $ MVan1 2009 Cost 8,000 Year {depreciation (8,000 x 10%) 800 Net book Value 7,200 2010 Year 2 depreciation (7,200 x 10%) 720 6,480 M Van 2 - April 09 Cost 7,000 Dec 09 Depreciation charge = Cost x 20% x 9/12 ,000 x 20% x 9/12 1,050 Steps: 1 Record the purchase of Motor Vans in the Fixed Asset a/c. Dr Fixed Asset alc Cr Bank/Cash ale 37At the end of each year, balance off the fixed asset a/c and bring down the balance to start the New Year. Balance c/d each year is taken to the balance sheet as the cost. Motor Van ale Date _Detail Folio $ | Date —_ Detail Folio = $ 2009 2009 Jan1 Bank cB 8000 | Dec31 Balance cid 15000 Apri Bank cB 009 15000 45000, 2010 2010 Jan1 Balance bid 15000 | Dec31 Balance old 15000, 2011 Jan1 Balance bid 15000 2.At the end of each year record the depreciation charge for the current year in the Provision for depreciation a/c and the Profit and Loss a/c. 3.Balance off the Provision for depreciation a/c each year, this amount represents the accumulated (total) depreciation which will be deducted from the fixed asset cost in the balance sheet. Bring down the balance b/d to start the each New Year. Provision for Depreciation _a/c - Motor Van. Date Detail ~=-Folio. «= § | Date ~—_—Deetail Folio § 2009 2009 Dec31 Balance old 1850 | Dec 31 Profit and Loss alc 1850 2010 2010 Dec31 Balance cid 3970 | Jan1 —_Balance bd 1850 2010 Dec 31 Profit and Loss ale 2120 3970 3970 2011 Jan1 Balance bs 3970 + ($800 mach 1) + ($1050 mach 2) = $1850 382010 depreciation charge : ($720_mach 1) + ($2120 mach 2) $2120 Profit and Loss a/c Extract for year ended Dec 31. Operating Expenses: Gross Profit XXX 2009 Other Revenues x Depreciation: Motor Van 1850 2010 Depreciation: Motor Van 2120 Balance Sheet Extract as at Dec 31 Accumulated Fixed Asset Depreciation | Net Book Value 2009 $ $ Motor Van 1850 6,100 2010 Motor Van 3970 11,030 Remember! Cost - this is the balance c/d taken from the individual fixed asset account. If there is more than one type of fixed asset, they would be listed in order of permanency. Accumulated Depreciation — This is the balance c/d at the end of each year from the Provision for Depreciation account. NBV - This is the value left on the asset at year end after subtracting all depreciation charged on the asset to date from the cost of the fixed asset. ie. NBV = Cost — Accumulated Depreciation 39UNIT 8 - ADJUSTMENTS TO FINAL ACCOUNTS:- BAD DEBTS, PROVISION FOR BAD DEBTS BAD DEBTS Where a business finds it impossible to collect a debt, it should write off that debt as bad. This means that the debt will be ‘called a loss’, and should be treated as an expense of the firm To write off a debt as bad: DR Bad debts alc CR Debtor's alc At the end of the trading period, the total of bad debts written off in the period should be transferred to the profit and loss account: DR Profit and Loss a/c CR Bad Debts a/c Example 1: On April 1, 2009, both Mr. Simple and Ms. Nuff owed the firm $1200 and $800 respectively. During December Mr. Simple paid $700 cash and was unable to pay the balance. This amount was written off on December 31, 2009; At March 31, 2010 Ms. Nuffs debt was deemed to be irrecoverable. Show the relevant entries required to record the above transactions. Mr. Simple /e Date Detail $ | Date Detail $ 2009 2009 Apr1 Balance b/d 1200 | Dec. Cash 700 2009 e Dec 31 Bad Debts 500 1200 1200 40Ms. Nuff a/c Date _ Detail $ | Date Detail $ 2009 2010 Apr1 Balance b/d 800 | Mar 31 Bad Debts 800 Bad Debts alc Date Detail $ | Date Detail $ 2009 2010 Dec31 Mr. Simple 500} Mar31 Profit&Loss 1300 2010 Mar 31 — Ms. Nuff 800 Our Business Profit and Loss a/c extract for year ended Mar 31, 2010 Expenses: $ | Gross Profit + Revenues: $ Bad Debts 1300 BAD DEBTS RECOVERED This is where money is being received for a debt that was previously written off as bad. The recovery of a bad debt may be recorded as below: Before the receipt can be recorded, the debt should first be reinstated (restored). To reinstate the debt: DR Debtor CR Bad Debts Recovered To record the receipt DR Cash/Bank CR Debtor At the end of the trading period, the fofal bad debts recovered in the period should be transferred to the credit of the profit and loss account: DR Bad Debts Recovered CR Profit and Loss 41Thus, bad debts recovered should be regarded as an income to the firm. Example 2: Assuming the amount owed by Ms. Nuff (from example 1 above) was received in cash on Mar 31, 2011; show the necessary entries to reflect this in the books. Ms. Nuff alc Detail Detail Balance b/d Bad Debts Bad Debts Recovered Cash Bad Debts Recovered a/c Date Detail $ | Date Detail s 2011 2011 Mar31 Profit & Loss g00 | Mar31 Ms. Nuff 800 Our Business Profit and Loss a/c extract for year ended Mar 31, 2011 Expenses: $ | Gross Profit + s Revenues: Bad Debts Recovered 800 N.B. The cash a/c was ignored since its usage was not being tested in this topic. PROVISION FOR BAD (DOUBTFUL) DEBTS Provision for bad debts is made for amounts owed to the business, which may eventually turn out to be bad, Itis an amount set aside out of profits, to write off any bad debts that may occur: Hence there is an element of uncertainty surrounding Provision for bad debts. Generally, provision for bad debts is based on a percentage of total debts outstanding and not a specific debt as it is with bad debts. The percentage is normally based on past trends. 42If the provision is not made, then the financial statements would not be giving a true and fair view of the financial position of the business. To create a provision Dr Profit & Loss alc Cr Provision for Bad Debts a/c At the end of the trading period, balance (c/d) on the Provision for Bad Debts a/c will be carried forward to the next year, and should be subtracted from the total debtors figure on the balance sheet, hence reducing the debtors figure. Example: Debtors $40,000 Bad Debts 4,000 Provision 2% of debtors Note here that provision cannot be made for debts that are already bad. This means that bad debts must be deducted before the provision is calculated. Hence, provision for bad debts = 2% ($40,000 - $4,000) = $720 Profit and Loss Extract Balance Sheet Extract as at ..... Expenses: $ Current Assets $ $ Bad Debts 4,000 Stock XXXXX Provision For Bad debts 720 Debtors 36,000 Less Prov. For Bad debts 120 Adjusting the Provision In future periods, we may consider our provision to be too smalll or too large; at such time it will only be necessary to either increase or decrease the provision. Increasing the Provision Let us assume that in the following year, the debtors figure is now $50,000, there are no bad debts and provision is still 2% of the debtors. 4BSince the provision account is already showing a balance of $720 only an additional amount of $280 is needed i.e. Dr Profit & Loss a/c $280 Cr — Provision for Bad Debts a/c $280 Profit and Loss Extract Balance Sheet Extract, Expenses: S$ Current Assets s Increase in Provision 280 Debtors 50,000 Less Prov. For Bad debts -1,000 49,000 Decreasing the Provision If in year 3 the debtors figure is $45,000, bad debts are $5,000 and provision is still 2% of debtors. New Provision = 2% ($45,000 - $5,000) 10 Note here that the provision account is carrying a balance of $1,000; hence we will now need to reduce this amount to $800. ie. Dr — Provision For Bad debts a/c $200 Cr Profit & Loss a/c $200 Profit and Loss Extract Balance Sheet Extract Revenues: Current Assets: Stock XXXXX Decrease in Provision 200 Less Expenses: Debtors 40,000 Bad Debts 5,000 Less provision 800 39,200 Main Points: 1. Increase in Provision for bad debts should be grouped with expenses in the Profit & Loss a/c. 2 Decrease in Provision for bad debts should be added to Gross Profit. 44Given both provision for bad debts and provision for discounts, the amount of the provision for bad debts should first be deducted from debtors before the discount is calculated, because discounts are not given on bad or potential bad debts. Provision for Bad Debt (worked example) A business starts on 1 January 2002 and its financial year-end is 31 December annually. A table of the debtors, the bad debts written off and the estimated bad debts at the rate of 2 percent of debtors at the end of each year is now given. The double entry accounts and the extracts from the final accounts and balance sheet follow. Year to 31 | Debiors al end of | Bad debts written | Debts thought at end ofF December | year (after bad | off during year _| year to impossible to debts written off) Collect: 2% of debtors $ $ $ 2002 6,000 423 120 (2% of $6,000) 2003 7,000 510 140 (2% of $7,000) 2004 7,750 604 155 (2% of $7,750) 2005 6,500 610 130 (2% of $6,500) Bad Debts 2002 2002 $s Dec 31 Various debtors Dec 31 ProfitandLoss 423 2003 2003 Dec 31 Various debtors Dec 31 Profit and Loss 510 2004 2004 Dec 31 Various debtors Dec 31 ProfitandLoss 604 2005 2005 Dec 31 Various Dec 31 ProfitandLoss 610 Provision for Doubtful Debts 2002 2002 Dec 31 Balance c/d Dec 31 Profitandloss 120 2003 2003 Jan 1 Balance b/d Dec 31 Profit and loss Dec 31 Balance c/d 2004 Dec 31 Balance c/d 2004 Jan 1 Balance b/d Dec 31 Profit and loss 452005 2005 Dec 31 Profit and loss 25 | Jan 1. Balance bid Balance cid 130 155 2006 Jan 1_Balance b/d 155 155 130 Profit and Loss Account (extracts) for the year ended 31 December $ Gross profit for 2002, 2003, 2004 2002 Less Expenses: Bad debts 423 Provision for doubtful debt (increase) 120 2003 Less Expenses: Bad debts 510 Provision for doubtful debts (increase) 20 2004 Less Expenses: Bad debts 604 Provision for doubtful debt (increase) 15 2005 Gross profit ‘Add Reduction in provision for doubtful debts Less Expenses: Bad debts Balance Sheet (extracts) as at 31 December Current Assets $ 2002 Debtors 6000 Less Provision for doubtful debt) 120 2003 Debtors 7000 Less Provision for doubtful debts (increase) _140 2004 Debtors 7750 Less Provision for doubtful debt (increase) _155 2005 Debtors 6500 Less Provision for doubtful debts 130 $ XXX (643) (630) (619) Xxx 25 (610) (685) 5880 6860 7595 6370 46UNIT 9 - ADJUSTMENTS TO FINAL ACCOUNTS:- ACCRUALS AND PREPAYMENT In relation to expenses and incomes (revenues), when preparing trading and profit and loss accounts, it is necessary to make a clear distinction between amounts due for the accounting period and amounts paid or received during the period. This distinction is necessary because only expenses and incomes due for an accounting period, and not necessarily amounts paid or received, should be included in the trading and profit and loss account for that period. As a result, it may be necessary to make adjustments for under/over-payment of expenses and/or under/over-receipt of incomes. Accruals represent shortfalls in payments (or receipts) and should therefore be added to amounts already paid (or received) in order to determine amounts due for the accounting period. Accrued Expenses Assume that rent of $1,000 per year payable at the end of every three months. The rent was paid on time in March, but this is not always the case. Amount Rent due Rent paid $250 31 March 2005, 31 March 2005 $250 30 June 2005 2 July 2005 $250 30 September 2005 4 October 2005 $250 31 December 2005 5 January 2006 Rent 2005 Mar 31 Cash 250 Jul 2 “ 250 Oct 4 “ 250 The rent for the last quarter was paid on 5 January 2006 and so will appear in the books of the year 2006 as the result of a double entry made on that date. The expense for 2005 is obviously $1,000 as that is the year's rent, and this is the amount needed to be transferred to the profit and loss account. But, if $1,000 was put on the credit side of the rent account (the debit being in the profit and loss account) the account would be out of balance by $250 because the payment due on 31 December 2005 47was not made until 5 January 2006. That is, if we posted $1,000 to profit and loss on 31 December, we would have $1,000 on the credit side of the account and only $750 on the debit side. Rent ‘2005 $ 2005 $ Mar 31 Cash 250 Dec 31 Profitandloss 1,000 Jul 2 Cash 250 Oct__4 Cash 250 This does not seem correct! To make the account balance the $250 rent owing for 2005, but paid in 20X6, must be carried down to 2006 as a credit balance because it is a liability on 31 December 2005. Instead of rent owing it could be called rent accrued or just simply an ‘accrual’. The completed account can now be shown: Rent 2005 $ 2005 $ Mar 31 Cash 250 Dec 31 Profit and loss 1,000 Jul 2 Cash 250 Oct 4 Cash 250 Dec 31Accruedcid _250 7,000 2006 Jan_1 Accrued b/d 250 The balance cld has been described as ‘accrued c/d’, rather than as ‘palance cid’. This is to explain what the balance is for. It is for an accrued expense. Prepayments represent excess payments (or receipts) and should accordingly be deducted from amounts already paid (or received) in order to arrive at amounts due for the period. Prepaid Expenses Insurance for a business is at the rate of $840 a year, starting from 1 January 2005. The business has agreed to pay this at the rate of $210 every three months. However, payments were not made at the correct times. Details were: 48Amount Insurance due Insurance paid $210 31 March 2005 $210 28 February 2005 $210 30 June 2005 $210 30 September 2005 $420 31 November 2005 $210 ‘31 December 2005 $420 18 November 2005, The insurance account in the ledger for the year ended 31 December 2005 is: Insurance 20X5 $ 2005 $ Feb 28 Bank 210 Dec 31 Profit and loss 840 Aug 31 Bank 420 Nov 18 Bank 420 The last payment of $420 is not just for 20X5. It can be split as $210 for the three months to 31 December 20X5 and $210 for the three months ended 31 March 20X86. For a period of 12 months the cost of insurance is $840 and this is, therefore, the figure needing to be transferred to the profit and loss account. If $840 is posted to the debit of profit and loss at 31 December 20X5, the insurance account will still have a debit balance of $210. This is a benefit paid for but not used up at the end of the period. It is an asset and needs carrying forward as such to 20X6, i.e. as a debit balance. Items like this are called prepaid expenses, ‘prepayments’, or ‘amounts paid in advance’ The account can now be completed Insurance 2005 $ | 2005 $ Feb 28 Bank 210 Dec 31 Profit and loss 840 Aug 31 Bank 420 Nov 18 Bank 420 | Dec 31 Prepaidcid _240 1,050 1,050 2008 — Jan 1 Stock b/d 400 Prepayment happens when items other than purchases are bought for use in the business, but are not fully used up in the period. For instance, packing materials are normally not entirely used up over the period in which they are bought, there being a stock of packing materials in hand at the end of the period. This stock is, therefore, a 49form of prepayment and needs carrying down to the following period in which it will be used. This can be seen in the following example: Year ended 31 December 2005: Packing materials bought in the year = $2,200. Stock of packing materials in hand as at 31 December 2005 = $400. Looking at the example, it can be seen that in 2005 the packing materials used up will have been $2,200 - $400 = $1,800. (We are assuming that there was no stock of packing materials at the start of 2005.) We have a stock of $400 packing materials at 31 December 2006 to be carried forward to 2006. The $400 stock of packing materials will be carried forward as an asset balance (i.e. a debit balance) to 2006: Packing Material 2005 $ 2005 $ Dec 31 Bank 2,200 Dec 31 Profit and loss 1,800 Dec 31 Stock c/d 400 2.200 2.200 2006 Jan__1_ stock b/d 400 The stock of packing materials is not added to the stock of unsold goods in hand in the balance sheet, but is added to the other prepayments of expenses. Examp! Where different expenses are put together in one account, it can get even more confusing. Let us look at where rent and rates are joined together. Here are the details for the year ended 31 December 2005: Rent is payable at $6000 per annum Rates of $4,000 per annum are payable by installments. At 1 January 2005, rent of $1,000 had been prepaid in 2004. On 1 January 2005, rates of $400 were owed. During 2005, rent of $4,500 was paid During 2005, rates of $5,000 were paid. On 31 December 2005, rent $500 was owed. On 31 December 2005, rates of $6000 had been prepaid. IO™MoOD> 50A Combined rent and rates account is to be drawn up for the year 20X5 showing the transfer to the profit and loss account and balances are to be carried down to 20X6. Rent and Rates 3] 2005 $ Rent prepaid b/d (C) 1,000 | Jan 1 Ratesowing bid (D) 400 Bank: rent (E) 4,500 | Dee 31 Profit and loss ale (A)+(B) 10,000 Bank: rates (®) 5,000 Rent accrued ed (G) —_500 Dec 31 Rates prepaid c/d (H) _600 es prepa a dant Jan 1 Rates prepaid bd (H) 600 | 49, Jan_1 Rent accrued bid ___(G)_500 2006 To enter the correct figures, you need to keep the two items separate in your own mind. This is easiest if you produce a schedule like the one we produces above for packing materials stock. The one for rent would look like this: $ $ Rent due during the year 6,000 Less: Rent prepaid at start of year 1,000 Rent paid during the year 4,500 (6,500) Rent accrued at the end of the year 500. Note: If the accruals or prepayments relate to a previous period, then the opposite will apply, ie. prepayments should be added and accruals subtracted. Where an expense is owing, ot an income is received in advance, this is treated as a liability (current) of the firm and will therefore result in a credit balance (b/d or b/f) on the account. If, on the other hand, the expense is paid in advance, or the income is owing, this is treated as an asset (current) and will therefore result in a debit balance on the account. Income Accrued and Prepaid Income accounts are treated in the opposite way as expenses as they relate to accrual and prepayment SlFINAL ACCOUNTS AFTER ADJUSTMENTS TREATMENTOF DEPRECIATION It was previously seen that depreciation of fixed assets is charged to the profit and loss account as an expense, then deducted from the assets on the balance sheet. Note, however, that 1. Only the current depreciation on fixed assets is considered as an expense for the profit and loss account, information relating to current depreciation will normally be contained in the ‘adjustments’ (or footnotes) relating to the question. 2. The total depreciation charged to date (also called accumulated or aggregate depreciation) on each fixed asset is deducted from the cost of the asset on the balance sheet. Depreciation to date is found by adding any depreciation already charged on the asset with the current depreciation on that asset. 3. Depreciation already charged may be shown either as provision for depreciation (in the trial balance) or by the difference between the cost and book value of the asset. TREATMENT OF LOAN INTEREST Whether the interest has been paid or not, so long as it is due, it must be charged to the profit and loss account. /f the interest is paid in full, then it should only be charged to the profit and loss account. If however, itis owing, then it must also be carried to the balance sheet as a current liability. STOCK TAKEN FOR PRIVATE USE Where the proprietor takes stock out of the business for personal use, this is reflected in the books as drawings. If the goods are taken at cost price the entries should be: DR Drawings CR Purchases If, however, they are taken at selling price, the entries are: DR Drawings CR Sales Consequently, if the proprietor had taken stock for his personal use at cost price, without recording this in the books, then, when preparing the 52