Accounting for Non-Accounting Students 9th Edition

Dyson, John R.; Franklin, Ellie

http://catalogue.pearsoned.co.uk/pearsonhigheredgb/educator/product/products_detail.page?isbn=9781292128979&forced_logout=forced_logged_out#downlaoddiv

SOLE TRADER ACCOUNTS

Sole traders are merely required to keep a record of all their incomes and expenses so that
they can work out the profit on which they have to pay tax. Nowadays due to EDP almost all
entities use a double-entry bookkeeping system and a full set of statements.

Chapter 3 finished by showing how to prepare a trial balance. The TB has two main purposes:
1. confirm that all transactions have been entered correctly
2. to provide the information necessary to prepare the basic financial statments

PREPARING BASIC FINANCIAL STATMENTS

1. SPL - statement of profit & loss - showing profit or loss for a certein period (usually
one year)
2. SRE - statement of retained earnings - showing how much of that profit the owners
are reinvesting in the business
3. SFP - statement of financial position – showing the net assets and liabilities the
business has at a point in time known (usually at the end of the year).

The statments will be prepared in exactly that order. Before closing / banancing the statment
of profit & loss some adjustments for inventory, depreciation, accruals and prepayments, and
bad and doubtful debts are needetd. (adjustmenents - later in this chapter)

Process:
1. Double-check that your trial balance (TB) balances.
2. Go through the TB line by line, inserting against each balance ‘C’ (for a capital item),
‘R’ (for a revenue item) and ‘D’ (for distributions to owners).
a. Transfer all ‘R’ balances in the calculation of profit or loss (the so-called
statement of profit or loss). This allows you to calculate the profit for the year.
b. Transfer the profit calculated above and the ‘D’ balance in the statement of
retained earnings to work out how much of the profit is reinvested back in the
business.
c. Transfer the retained earnings calculated above and the ‘C’ balances to the
statement of financial position.
Refer to Example 4.1 in the book.

YEAR-END ADJUSTMENTS

INVENTORY
In accounting terminology, purchases still on hand at the period end are referred to as
inventory (or stock). We want to match the sales revenue earned for the period with the cost
of goods sold. The cost of goods sold is made up of three elements: opening inventory (we
know), purchases (we know) and closing inventory (we do not know). This means that we
have to check the quantity of inventory we have on hand at the end of the year (we can do this
by making a physical stock take) and put a value on it. The cost of goods sold for the year is
charged to the statement of profit or loss as an expense.
Expressed as a formula, it is shown as: Cost of goods sold = (opening inventory + purchases)
− closing inventory (eg. COGS = 1.500)

Posting the cost of goods sold:

Debit Cost of Goods Sold Expense 1.500 P&L Account
Credit Stock 1.500 Asset Account

After calculating COGS one can determine the Gross Profit:

Sales 4.000
COGS -1.500
Gross Profit 2.500

DEPRECIATION
Expenditure that covers more than one accounting period is known as capital expenditure.
Capital expenditure is not normally included in the statement of profit or loss but it would be
misleading to exclude it altogether from the calculation of profit. Expenditure on non-current
assets (such as plant and machinery, motor vehicles and furniture) is necessary in order to
help provide a general service to the business. The benefit received from the purchase of non-
current assets must (by definition) extend beyond at least one accounting period (future
benifit). So the cost of the benefit provided by non-current assets ought to be charged to those
accounting periods that benefit from such expenditure. The problem is in determining what
charge to make. In accounting terminology, such a charge is known as depreciation.
The method most commonly adopted is known as straight-line depreciation. This method
charges an equal amount of depreciation to each accounting period that benefits from the
purchase of a non-current asset.
Another method that you might come across is reducing balance. The reducing balance
method of calculating depreciation results in a much higher charge in the early life of the asset
than does straight-line depreciation.
Some non-current assets (such as property) may be revalued at regular intervals. If this is the
case, the depreciation charge will be based on the revalued amount and not on the historic
cost. The depreciation charge for the year is charged to the statement of profit or loss as an
expense. Eg: Machine (asset) historic cost = 1.000, estimated use = 5 years, depreciation =
1.000 / 5 = 200

Posting depreciation:
Debit Depreciation Expense 200 P&L Account
Credit Accumulated Depreciation 200 Asset Account

The statement of financial position would include the following details for each group of non-
current assets:
1. the historic cost (or revalued amount), i.e. the gross book value (GBV);
2. the accumulated depreciation;
3. the net book value (NBV).
In other words, line 1 minus line 2 = line 3.

Net book value of the machine

historic cost 1.000
depreciation – 200
net book value 800

ACCRUALS AND PREPAYMENTS

Accruals
An accrual is an amount owing for a service provided during a particular accounting period
but still unpaid for at the end of it. Eg:

Prepayments
A prepayment is an amount paid in cash during an accounting period for a service that will be
provided in a subsequent period. The Prepayment expense account is named an expense
account but is an asset account. The prepayments are „parked“ there as an asset until they will
be expenced.

BAD AND DOUBTFUL DEBTS

The realisation rule allows us to claim profit for any goods that have been sold, even if the
cash for them is not received until a later accounting period. If the goods are not eventually
paid for, we will have overestimated the profit for that earlier period.
Fortunately, there is a technique whereby we can build in an allowance for any possible bad
or doubtful debts, as they are called.

Bad debts
Once it is clear that a debt is bad then it must be written off to the statement of profit or loss
immediately as an expense. On the statement of financial position we then show trade
receivables after deducting any bad debts that have been written off. Eg: Toms Ltd. is owing
our entity 5.000. On December 2018 we got to know that Tom went into financial difficulties
and left the country.

Debit bad dept write-off expense 5.000 P&L Account

Credit Toms reciveables 5.000 Asset Account

Allowance for doubtful debts

It seems prudent to allow for the possibility that some debts may become bad. We can do this
by setting up a allowance for doubtful debts (an allowance is simply an estimate of the impact
of something that is highly likely to happen) it is necessary to estimate first the likely level of
irrecoverable debts.
• A debt should never be written off until it is absolutely certain that it is bad, because
once it is written off, it is highly unlikely that any further attempt will ever be made to
recover it.
• It is prudent to allow for the possibility of some doubtful debts.
The level that you choose can have a big effect on the profit for the period in question.

Accounting defects
Accounting profit can only be as accurate (reliable) as the assumptions upon which it is based.
You should always question accounting information before accepting it.
The main reasons
• Goods are treated as being sold when the legal title to them changes hands and not
when the customer has paid for them. In some cases, the cash for some sales may
never be received.
• Goods are regarded as having been purchased when the legal title to them is
transferred to the purchaser, although there are occasions when they may not be
received, e.g. if a supplier goes into receivership.
• Goods that have not been sold at the period end have to be quantified and valued.
Counting and espcially valuing inventory involves a considerable amount of
subjective judgement.
• There is no clear distinction between capital and revenue transactions. Estimates have
to be made to allow for accruals and prepayments.
• The cost of non-current assets is apportioned between different accounting periods
using methods that are fairly simplistic.
• Arbitrary reductions in profit are made to allow for doubtful debts.
• Historic cost accounting makes no allowance for inflation. So the value of £100 (say)
at 1 January 2016 is not the same as £100 at 31 December 2016.
But having said all that, ‘it is better to be vaguely right than precisely wrong’.
So remember that: Accounting profit is not the same as an increase in cash.
Why? Most of the reasons are contained within the above list of accounting defects.