Learning Accountancy: The Novel Way [2nd ed.] 1443863939, 9781443863933

Citation preview

Learning Accountancy

Learning Accountancy: The Novel Way Second Edition

By

Zarir Suntook

Learning Accountancy: The Novel Way Second Edition, by Zarir Suntook This book first published 2010. This edition published 2014 Cambridge Scholars Publishing 12 Back Chapman Street, Newcastle upon Tyne, NE6 2XX, UK

British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library

Copyright © 2014 by Zarir Suntook All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. ISBN (10): 1-4438-6393-9, ISBN (13): 978-1-4438-6393-3

I would like to dedicate this book to my wife, Feroza, whose help, encouragement and inspiration have been invaluable in bringing this project to fruition.

TABLE OF CONTENTS

Chapter 1 ..................................................................................................... 1 Introduction Chapter 2 ..................................................................................................... 3 Some Basic Accounting Terms and Concepts Chapter 3 ..................................................................................................... 7 Cash Flow, Profit and Loss Account and Balance Sheet a) Cash Flow and Profit or Loss b) Balance Sheet Chapter 4 ................................................................................................... 17 Recording Business Transactions—John Smith Example Chapter 5 ................................................................................................... 24 Double Entry Bookkeeping a) Rules of Double Entry b) Simple Examples c) John Smith Example reworked Chapter 6 ................................................................................................... 36 More Accounting Terms and Concepts a) Capital b) Revenue Reserves c) Current Liabilities d) Debtors and Prepayments e) Current Assets f) Fixed Assets g) Depreciation h) Goodwill i) Capital Reserve Chapter 7 ................................................................................................... 42 D. Harvey Example

viii

Table of Contents

Chapter 8 ................................................................................................... 54 Manual Accounting System a) Purchases b) Purchases Returns c) Sales d) Sales Returns e) Payments for Purchases i) Payments made immediately ii) Payments made later f) Receipts from Customers g) Other Expenditure i) Revenue Expenditure ii) Capital Expenditure iii) Petty Cash iv) Payroll Expenditure h) Accounting Adjustments Example j) Manual Accounting Systems – Flow Chart Chapter 9 ................................................................................................... 70 More Examples—Manual Accounting System a) Credit purchases i) Purchases Taken Into Stock ii) Purchases of Goods Sold Directly b) Payments to Creditors c) Cash Purchases d) Sales e) Credit Notes f) Other Expenditure i) Overheads ii) Payroll Costs (Salaries & Wages) iii) Capital Expenditure and Depreciation g) Petty Cash h) Journal Entries

Learning Accountancy: The Novel Way

ix

Chapter 10 ................................................................................................. 90 Computerised Accounting Systems A Introduction B Buying and ‘Setting Up’ a Computerised System The Hardware The Accounting Software ‘Setting up’ the System Testing the System C Outline of Computerised Procedures a) Credit Purchases (Goods Purchased or Overhead Expenditure) i) Data Preparation ii) Data Input (Via Keyboard) iii) Data Output b) Credit Sales c) Cash Purchases d) Cash Sales e) Purchase Ledger Payments i) Data Input ii) Data Output f) Sales Ledger Receipts i) Data Preparation ii) Data Input iii) Data Output g) Petty Cash h) Payroll Expenditure i) Setting up the System ii) Company or Business Information iii) Government Information iv) Employee Information – Standard and Variable i) Journal Entries Chapter 11 ............................................................................................... 102 Comprehensive Example—Computerised Accounting System A Goods Purchased on Credit a) Batched and Keyed In b) Computer Printouts (Output Reports) i) Stock Report – Showing Movements ii) Nominal Ledger Accounts Affected iii) Purchase Ledger Accounts Affected

x

Table of Contents

B Overhead Expenditure (On Credit) a) Batched and Keyed In b) Computer Print-outs i) Nominal Ledger Accounts Affected ii) Purchase Ledger Accounts Affected C Sales (On Credit) a) Batched and Keyed In b) Computer Print-outs i) Stock Report - Items Affected ii) Nominal Ledger Accounts Affected iii) Sales Ledger Accounts Affected D Payments to Creditors a) Amount Paid Keyed In b) Computer Print-outs i) Nominal Ledger Accounts Affected ii) Purchase Ledger Accounts Affected E Receipts from Debtors a) Amount Received Batched, and Keyed In b) Computer Print-outs i) Nominal Ledger Accounts Affected ii) Sales Ledger Accounts Affected F Capital Expenditure (On Credit) a) Batched and Keyed in Invoice Details b) Computer Print-outs i) Nominal Ledger Accounts Affected ii) Purchase Ledger Accounts Affected G Petty Cash a) Batched and Keyed In b) Nominal Ledger Accounts Affected H Payment of VAT I Payroll (Computerised) a) Information Previously Entered b) Information Entered in January c) Computer Print-outs i) Payroll Analysis for January ii) Payslips iii) Nominal Ledger Accounts Affected J Journal Entries K Trial Balance, Profit and Loss Account, Balance Sheet L Creditors and Debtors Balances Outstanding M Summary

Learning Accountancy: The Novel Way

xi

Chapter 12 ............................................................................................... 127 Examples of 10 Complex Transactions Chapter 13 ............................................................................................... 152 Control Accounts and Nominal Ledger Reconciliations A Control Accounts a) Bank Account i) Cash Book ii) Nominal Ledger b) Petty Cash Account i) Petty Cash Book ii) Nominal Ledger c) Stock Account i) Stock Ledger ii) Nominal Ledger d) Fixed Assets Account i) Asset Register ii) Nominal Ledger B Nominal Ledger Reconciliations a) Bought and Sales Ledger Balances b) Bank Account c) Petty Cash d) Stock e) Fixed Assets f) Other Nominal Ledger Reconciliations i) Staff Advances ii) Prepayments iii) Accruals iv) PAYE, National Insurance and Pension Contributions C Summary Chapter 14 ............................................................................................... 170 Management Information A Introduction B Review of Information Categories a) Budget and Long-Term Plan b) Essential Monthly Information Profit and Loss Account Cash Flow Statement Balance Sheet c) Recommended Monthly Information

Table of Contents

xii

d) -

Profit and Loss Account Forecast Cash Flow Forecast Average Period of Credit Accounting Ratios Other ‘Ad Hoc’ information Revenue Analysis Expense Analysis Departmental Analysis Aged Debtors Analysis

Chapter 15 .............................................................................................. 191 Website Access and Creation Chapter 16 ............................................................................................... 196 Internal Control Systems A Revenue Controls - Goods Despatched - Services Rendered B Cost Controls - Goods Received - Services Received - Petty Cash Expenditure - Payroll Expenditure C Physical Verification of Assets - Fixed Assets - Stocks - Petty Cash Balance - Bank Balance - Other Assets D Audits Chapter 17 ............................................................................................... 207 Types of Accounts A Purpose of Accounts a) Managements Accounts b) Statutory Accounts B Type of Business C Structure of the Business a) Sole Traders b) Partnerships c) Companies Conclusion

CHAPTER 1 INTRODUCTION

Many books on accounting have been written over the years ranging from elementary bookkeeping to advanced accountancy, depending upon the needs and aspirations of the prospective readers. The question then is why write yet another book? There are two basic reasons why this book has been written. Firstly, it does not follow the traditional approach of introducing double entry bookkeeping principles almost at the outset and then expounding those principles with the help of examples. In this book, no mention is made of double entry until Chapter 5. We start by examining three main financial statements which reflect our financial position: the Cash Flow Statement, the Profit and Loss Account, and the Balance Sheet. Then, with the help of examples, we see how business transactions affect those statements which in turn show how our financial position has changed. By following this approach, a number of problems of definition and concept can be ironed out at the outset. To take a simple example, while we all understand the concept of cash flow which is money received and spent, many of us are unclear about what profit or loss actually means and how precisely it differs from cash flow. That is why we fully examine, as early as Chapter 3, a number of fundamental differences between cash flow and profit or loss. There have been some well known cases of businesses going to the wall owing to severe cash flow problems despite the fact that they were trading profitably. Once we fully understand fundamental accounting concepts such as this, the logic of double entry can be quickly grasped and the endless heartache of waiting for “the penny to drop” avoided. Secondly, this book endeavours to do more than merely impart a clear understanding of accounting rules and principles. It covers a wide range of topics, many of them concentrating on very practical issues. For instance, in view of today’s increasingly computerised world, a strong emphasis is placed on computerised accounting systems and records. Another important practical feature is an insight into accounting controls and management

2

Chapter 1

information systems within a typical accounts department or office, knowledge of which would be invaluable to the novice as well as to anyone with some accounting experience. Finally, in this second recently-updated edition, a new chapter 15 entitled ‘Website access and creation’ has been added to summarize the invaluable help that websites give us these days to enable us to access information that we need. Furthermore, many individuals and businesses create their own websites as an essential marketing tool to provide information to potential customers about the products and services on offer. In summary, this book does not attempt to transform a newcomer to the world of accounting into a full-fledged accountant! It does, however, set out to explain the principles of bookkeeping by following a clear, logical approach and then to provide an insight into the practical aspects of accounting. To the layman, this book offers a rapid introduction to the theory and practice of accountancy. For the student, it provides a valuable basis for deepening his or her knowledge and understanding of the subject.

CHAPTER 2 SOME BASIC ACCOUNTING TERMS AND CONCEPTS

In order to understand how transactions affect our financial position let us start by examining the terms “transaction” and “financial position”. A transaction is a piece of business based on an agreement to exchange goods or services for money. If, for instance, you buy a bar of chocolate for 50 pence, then a transaction has taken place between yourself and the shopkeeper whereby you give him 50 pence in exchange for a bar of chocolate. “Financial position” refers to the wealth or capital of an individual or a business. In accounting terms our financial position is represented by a statement called the “Balance Sheet”. We can all prepare our own Balance Sheets which summarise our wealth. The following is a simple example of a Balance Sheet showing assets, liabilities and capital: Assets 3 bedroom house Bank Account Furniture, Jewellery, etc.

£ 150,000 20,000 15,000 ______ 185,000

Liabilities Mortgage outstanding Bank Loan

Capital (Assets minus Liabilities)

50,000 5,000 _____ 55,000 130,000

Assets are items owned by ourselves and liabilities are amounts owed to others. The difference is our net assets or net wealth or capital.

Chapter 2

4

We have seen what is meant by a transaction and how our financial position is represented by the Balance Sheet. Let us now look at the way in which our financial position is altered by entering into transactions. Let us suppose Mr. Austin starts the month with the above Balance Sheet and a number of transactions are entered into during the month, summarised as follows: Salary received Expenses incurred

£ 1,500 (1,300) _____ 200

(Salary received for services rendered to an employer is just as much a transaction, in the accounting sense, as money received for goods sold or payments for food, gas, electricity, telephone, etc.) At the end of the month Mr. Austin’s wealth has increased by £200 to £130,200 and his Balance Sheet at the end of the month would appear as follows: £ Assets 3 bedroom house Bank Account Furniture, Jewellery, etc.

Liabilities Mortgage outstanding Bank Loan

Capital (Assets minus Liabilities)

150,000 20,200 15,000 ______ 185,200 50,000 5,000 _____ 55,000 130,200

We can see that there are two ways in which Mr. Austin’s financial situation has altered. First, there has been an increase in his bank account balance by £200. Second, there has been an increase in his capital by £200. Changes in the bank account balance are described as “cash flow”, and a change in capital as “profit” or “loss”. An increase in capital represents a profit, and a decrease in capital represents a loss.

Some Basic Accounting Terms and Concepts

5

As we will see in the next chapter, cash flow and profit (or loss) are not necessarily one and the same thing. We will see how, in fact, cash flow is often quite different from profit (or loss) during the same accounting period. We will also see how ‘income’ and ‘expenditure’ which determine profit or loss, are quite different in the accounting sense from ‘receipts’ and ‘payments’ which determine cash flow. In our simple example, however, cash flow and profit increase by the same amount, £200, since ‘income’ happens to be the same as ‘receipts’ and ‘expenditure’ the same as ‘payments’. The movement in cash flow is itemised in a record one would normally call the “Cash Book”, which is a detailed cash flow statement, and the change in capital recorded in a statement called the “Profit and Loss Account”. Let us see how the details for the month might appear in Mr Austin’s Cash Book: £ Salary received Expenses incurred: Food Household Gas Electricity Telephone Mortgage interest* Other Surplus

£

1,500

200 150 120 70 50 500 210

1,300 ____ 200

(* In practice, part of the £500 mortgage repayment might relate to the capital element and therefore slightly reduce the amount of the mortgage outstanding shown on the Balance Sheet. However, in this example, the mortgage has been treated as an interest-only mortgage.)

The details in the Profit and Loss Account would be exactly the same as in the Cash Book, except that the £200 excess of income over expenditure would be described as a profit in the Profit and Loss Account and as a cash surplus in the Cash Book. Using our simple example of monthly income and expenses, we have seen how transactions affect an individual’s wealth or financial position and how those changes are reflected in the Cash Book, the Profit and Loss Account and the Balance Sheet.

6

Chapter 2

Now let us summarise the terms and concepts we have dealt with so far: A transaction is a piece of business based on an agreement to exchange goods or services for money. Financial position refers to the wealth of an individual or a business and is represented by the Balance Sheet, which is a statement showing assets, liabilities and capital. The excess of assets over liabilities is the capital. Cash flow refers to the increase or decrease in cash and bank balances. A Cash Book or Cash Flow Statement shows the starting balance at the bank, details of receipts and payments during the accounting period, and the closing balance at the bank. Profit is the excess of income over expenditure during an accounting period, resulting in an increase in capital. Loss is the excess of expenditure over income, resulting in a decrease in capital. A Profit and Loss Account is a statement that shows details of income and expenditure during an accounting period, and the resultant profit or loss. An accounting period is the period during which the change in financial position is assessed. The financial position at the start of an accounting period is represented by the “opening” Balance Sheet. The details making up the change in financial position during the accounting period are shown in the Cash Book and the Profit and Loss Account. The financial position at the end of the accounting period is represented by the “closing” Balance Sheet.

CHAPTER 3 CASH FLOW, PROFIT AND LOSS ACCOUNT AND BALANCE SHEET

We have examined some basic accounting terms and concepts and seen how relevant they are even in everyday life. Once the fundamentals have been thoroughly grasped, the most complicated transactions, business or private, can be dealt with relatively quickly and without much difficulty, as we shall see in later chapters. a)

Cash Flow and Profit or Loss

We will now examine the difference between cash flow, on the one hand, and profit or loss, on the other. There are several differences, but let us start with a simple example. Supposing all I possess is £10,000, which lies in my bank account. My Balance Sheet will be as follows: Bank Account

£ 10,000

Capital

10,000

Suppose I decide to buy a second-hand car for £6,000. My Balance Sheet will then alter as follows: Bank Account Car

Capital

£ 4,000 6,000 _____ 10,000 10,000

Notice that my bank balance has altered; it has been reduced by £6,000, but my capital is exactly the same as before. The reason for this is that

8

Chapter 3

although my wealth is held in a different form, the total remains unchanged. Instead of all my wealth existing in a bank account, £4,000 is now held in a bank account and £6,000 in the form of a motor car - my capital remaining unchanged at £10,000. So we can see that, whilst there has been a movement in cash flow as a result of this transaction and a change in the form in which the capital is held, there has been no change in total capital, and therefore no profit or loss has arisen. This very simple example highlights the difference in concept between cash flow and profit. Let us now define cash flow and profit or loss more explicitly by making a clear distinction between income and expenditure on the one hand and receipts and payments on the other. In accounting terms, income does not mean the same as receipts, and expenditure does not mean the same as payments. Firstly, profit or loss is arrived at by taking into account income and expenditure. Income results in an increase in capital, and expenditure results in a decrease in capital. Cash flow, on the other hand, is arrived at by taking into account receipts and payments. Receipts, in the accounting sense, do not necessarily increase capital nor do payments necessarily decrease capital. We saw, in our example, how the purchase of a car resulted in a cash payment but not in a reduction in capital. Secondly, income and expenditure are in respect of amounts relating to a particular accounting period, whether or not they are actually received or actually paid during that accounting period. Receipts and payments, on the other hand, are in respect of amounts actually received or actually paid in an accounting period, whether or not they relate to the accounting period. For example, if an item is sold for £100 in month 1, but the money is received in month 2, then the £100 sale which relates to month 1 is treated as income in month 1, but as a receipt in month 2. Similarly, a £300 electricity invoice relating to month 1 is treated as expenditure in month 1, but as a payment in month 2 (or later) when the payment is actually made. Now let us illustrate the various ways in which differences between cash flow and profit or loss can arise, highlighting, with examples, the differences between income and expenditure on the one hand and receipts and payments on the other.

Cash Flow, Profit and Loss Account and Balance Sheet

1.

9

Where cash flow is affected but profit or loss is not We have seen in our earlier example how cash flow is affected by the purchase of a car, but profit (or loss) is not.

2.

Where profit or loss is affected but cash flow is not a)

Continuing with that example, supposing I buy the car at the beginning of the month, we must provide for wear and tear, i.e. depreciation, since cars, like most other assets, depreciate or lose value over a period of time. If we assume that my car is likely to be worth nothing at the end of four years, the depreciation for each month will be 1/48 (i.e. spread over 48 months) of £6,000 or £125 per month. At the end of the month my Balance Sheet will be: £ Bank Account

£ 4,000

Motor car: Cost Depreciation

6,000 (125) ____

5,875 ____ 9,875

Capital: Beginning of the month Loss (depreciation)

10,000 (125) _____

____ 9,875

As we can see, depreciation is a form of expenditure since it represents a loss of value of my car and hence results in a reduction of my profit, i.e. my wealth or capital. Whilst the value of my car is reduced by depreciation which is treated as expenditure, my bank balance is entirely unaffected. (In real life, depreciation would be highest soon after the car’s purchase, and lowest towards the end of its useful life.)

Chapter 3

10

b)

Supposing I work as a freelance consultant and send my client an invoice for £1,500 for services rendered during the month but am not paid until the following month, then my Balance Sheet at the end of the month will be: £

£

Bank Account

£ 4,000

Motor car: Cost Depreciation

6,000 (125)

Amount owing to me for services rendered

5,875 1,500 11,375

Capital Beginning of month Profit during the month: Depreciation Consultancy services

10,000

(125) 1,500 1,375

End of the month

_____ 11,375

In this case my profit, and hence my wealth, has increased even though there has been no increase in my bank balance. It has increased because I have sent out an invoice amounting to £1,500 for consulting services rendered. Even though I have not actually received the £1,500, it nevertheless relates to the current month and is therefore treated as income this month, resulting in an increase in my profit. At the same time my client becomes a debtor for £1,500. (Note: a debtor is a person who owes money to another, and a creditor is a person to whom money is owed.) c)

Suppose I receive my telephone bill for the current month, amounting to £70, but I do not pay the bill until the following month. My Balance Sheet will alter as follows:

Cash Flow, Profit and Loss Account and Balance Sheet £

£

Bank Account Motor car: Cost Depreciation

6,000 (125) ____

Amount owing to me for services rendered

11 £ 4,000

5,875 1,500

Telephone bill payable by me

(70) _____ 11,305

Capital: Beginning of month Profit during the month: Depreciation Consultancy services Telephone bill End of the month

10,000

(125) 1,500 (70) _____

1,305 ______

_____ 11,305

In this case, although I have not yet paid my £70 telephone bill, it relates to the current month and is therefore expenditure in the current month, thereby reducing my profit by that amount. My bank account is still unaffected since I do not pay the bill until the following month. The telephone company becomes my creditor for £70 until I actually pay the bill. 3. Where both profit or loss and cash flow are affected, but by different amounts Continuing with the above example, supposing I receive a rates bill of £600 for the year and I pay it in advance. This means that although I pay £600 right at the beginning of the year, only 1/12 or £50 relates to each month. So my expenditure for the current month is £50, reducing my profit by £50 even though I have actually paid £600. The rating authorities will, at the first month end, in an accounting sense ‘owe’ me £550 (£600-£50) for the amount paid in advance. At the end of the second month they will owe £500, at the end of the third £450, and so on.

Chapter 3

12

My Balance Sheet will alter as follows, at the end of the first month: £

£

Bank Account (£4,000-£600) Motor car: Cost Depreciation

6,000 (125) ____

Amount owing to me for services rendered Rates prepaid by me Telephone bill payable by me

£ 3,400

5,875 1,500 550 (70) _____ 11,255

Capital: Beginning of month Profit during the month Depreciation Consultancy services Telephone bill Rates

10,000

(125) 1,500 (70) (50) _____

End of the month

1,255 _____

_____ 11,255

We have seen the various ways in which cash flow and profit or loss can be very different for the same accounting period. Let us now prepare a summary of cash flow and profit or loss based on the above transactions which began with the purchase of a car:

Purchase of car Depreciation Consultancy services Telephone bill Rates Movement in the month Balance at the beginning of the month Balance at the end of the month

Cash Flow £ (6,000) (600) _____ (6,600) 10,000 _____ 3,400

Profit or Loss £ (125) 1,500 (70) (50) ____ 1,255 ____ 1,255

Cash Flow, Profit and Loss Account and Balance Sheet

13

In our example, while there has been a profit of £1,255 in the month, there has been a reduction of £6,600 in the bank balance during the same month, clearly demonstrating the distinction between cash flow and profit or loss. Let us, finally, take another example which shows how, despite good trading results, a business can end up facing a cash flow crisis. XYZ Limited starts the year with the following Balance Sheet as at 1/1/2014: Assets: - Premises, Fixtures and Fittings, Car etc. - Bank Account

Capital: - Beginning of the month - Accumulated profits

£

£ 100,000 5,000 ______ 105,000

80,000 25,000

______ 105,000

During the first three months of 2014, XYZ Limited expands its business rapidly, but at the same time there are long delays in payment by the customers. At 31/3/2014, the Balance Sheet is as follows: Assets: -

£

Premises, Fixtures etc. Amount owing by customers Bank Overdraft

£ 100,000 40,000 (15,000) ______ 125,000

Capital: -

Beginning of the month Accumulated profits

80,000 45,000

______ 125,000

The deadline set by the bank for a drastic reduction of the overdraft passes in April 2014. The management of XYZ Limited is unable, despite strenuous efforts, to obtain sufficient funds from customers who owe money. In June, the bank concerned starts liquidation proceedings against the company.

Chapter 3

14

This is a very simple example that illustrates how a business can go to the wall even though it has been trading profitably right up to the very end. b)

Balance Sheet

Having examined the differences between cash flow and profit or loss, let us now turn to the Balance Sheet and its main features. In Chapter 2 we defined a Balance Sheet as a statement reflecting the financial position or wealth of an individual or a business. We saw that a Balance Sheet is made up of assets (items owned) and liabilities (amounts owed), the excess of assets over liabilities being the capital of the individual or the business. There are two further points of fundamental importance in relation to a Balance Sheet, which should be clearly understood. Firstly, a Balance Sheet, as the name suggests, must always balance. By that we mean that the value of assets minus the value of liabilities must always equal the amount shown as capital. The same equation can be expressed as follows: Assets - Liabilities = Capital or Assets = Liabilities + Capital If, therefore, having prepared a Balance Sheet at the end of an accounting period it is found that the total of assets does not equal the total of liabilities plus capital, we can then immediately conclude that there has been some error in the accounting process leading up to the preparation of the Balance Sheet. Of course it is possible to have negative capital, i.e. where liabilities exceed assets, for example, where losses have occurred which exceed the original capital. In such cases, the assets minus liabilities would be negative and would equal the negative capital. Here again, the Balance Sheet would still balance. Secondly, every transaction must always affect the Balance Sheet, even though it may or may not affect cash flow or profit or loss. Let us examine both these fundamentals by reviewing the example shown earlier in the section on profit or loss and cash flow, and demonstrate the impact of those transactions on the Balance Sheet.

Cash Flow, Profit and Loss Account and Balance Sheet

15

Impact on the Balance Sheet Assets

Capital/Liabilities £

1. Purchase of a car

2. Depreciation 3. Consultancy services

4. £70 telephone bill

5. £500 rates bill

Total of changes

+ 6,000 | - 6,000 | | Car - 125 | | Amount owing | to me + 1,500 | | | | | Amount owing | to me (prepayment) + 550 | Bank account - 600 | _____ | +1,325 |

£

Car Bank A/c

Capital

- 125

Capital

+1,500

Amounts owing by me Capital

+ 70 - 70

Capital

- 50 _____ +1,325

The overall effect of the above transactions is that the total of assets increases by £1,325 and the total of capital plus liabilities by the same amount, represented by the equation: Assets (+£l, 325) = Capital (+£1,255) + Liabilities (+£70) We can see that each of the above transactions has two sides to it, one side balancing the other, so that the balance between assets on the one hand and capital and liabilities on the other is always maintained. Hence, for instance, as a result of purchasing the car, the bank balance is reduced by £6,000 but is replaced by another asset in the form of a car worth £6,000; therefore, assets continue to equal capital + liabilities. Again, for instance, as a result of one month’s depreciation, the assets side is reduced by £125 and the capital plus liabilities side is also reduced by the same amount; once more, assets continue to equal capital plus liabilities. Even where, as quite often happens in practice, a single transaction affects more than two items on the Balance Sheet, the effect of the transaction on the Balance Sheet must be such that the equation, Assets = Capital + Liabilities, always holds good.

16

Chapter 3

In summary, whether or not a transaction affects cash flow or profit or loss, it must always affect the Balance Sheet, and the Balance Sheet must always balance after the recording of each transaction.

CHAPTER 4 RECORDING BUSINESS TRANSACTIONS— JOHN SMITH EXAMPLE

We have so far seen how transactions we enter into in our ordinary day-today lives affect our financial position in terms of cash flow, profit or loss and the Balance Sheet. The basic terms and concepts we have already examined in some detail are just the same when applied to a business as they are when applied to our private affairs, even though business transactions are normally far more numerous and complex. Let us now move on from private finances to a business situation with an example in which John Smith starts a business on 1st January. To reinforce our understanding of the concepts dealt with so far, we will look at each transaction, one at a time, and see how it affects the Balance Sheet, the Profit and Loss Account and the Cash Book. Remember: every transaction must affect the Balance Sheet, but not necessarily the Profit and Loss Account or the Cash Book. Also, the Balance Sheet must always balance. 1.

On 1st January John Smith starts a furniture business with £10,000 capital which he deposits in his bank account Effect on the Cash Book and the Balance Sheet:

Cash Book | Balance Sheet ____________________________________|____________________________________ | | | | | | Receipts | Payments | Assets | Capital & liabilities £ | £ | £ | £ | | | Capital invested 10,000 | | Bank Account 10,000 | Capital 10,000

18

Chapter 4

There is no effect on the Profit and Loss Account since he has yet to start trading (i.e. generating income and incurring expenditure). 2.

On 4th January some furniture is bought and a purchase invoice for £5,000 received. £500 is paid immediately on account. (The furniture is for resale – not for his office use). Effect on the Cash Book and the Balance Sheet:

Cash Book | Balance Sheet ____________________________________|_____________________________________ | | | Receipts | Payments | Assets |Capital & Liabilities £ | £ | £ | £ | | | Capital invested 10,000 | Payment on | Bank Account 9,500 | Creditor 4,500 | account 500 | (10,000-500) | (5,000-500) | | | _____ | Balance 9,500 | Stock 5,000 | Capital 10,000 10,000 | 10,000 | 14,500 | 14,500

Although goods have been purchased, the cost of those goods is treated as stock, an asset, and not as expenditure, since the goods have not yet been sold. There has been some movement in the bank account, and the Balance Sheet now includes stock and a creditor for unpaid goods. It is only when the goods are sold that a profit or loss will arise, as the next transaction will show. 3.

On 10th January £4,000 worth of furniture in stock is sold for £5,800 on credit (i.e. none of the £5800 is received immediately). Effect on the Profit and Loss Account and the Balance Sheet:

Recording Business Transactions—John Smith Example

19

Profit and Loss Account Balance Sheet ___________________________________________________________________________ | | | Expenditure | Income | Assets | Capital & Liabilities £ | £ | £ | £ £ | | | Cost of sales 4,000 | Sales 5,800 | Bank Account 9,500 | Creditor 4,500 | | | Profit to date 1,800 | | Stock 1,000 | Capital 10,000 | | (5,000-4,000) | ____ | ____ | | Profit to 5,800 | 5,800 | Debtor 5,800 | date 1,800 11,800 _____ | _____ 16,300 | 16,300

In this case there is no cash flow, but the Profit and Loss Account is affected following the sale of goods. Income of £5,800 is generated and expenditure of £4,000 incurred in the form of cost of goods sold. The difference of £1,800 (£5,800 - £4,000) is the profit arising from the transaction. The original stock costing £5,000 is reduced by £4,000 to £1,000. The customer who has not yet paid for the goods sold to him becomes a debtor for the £5,800 owing by him. 4.

On 12th January Mr. Smith pays the creditor the £4,500 owing to him and the debtor settles the £5,800 owing by him to Mr. Smith. Effect on the Cash Book and the Balance Sheet:

Cash Book Balance Sheet ______________________________________________________________________________________ | | | Receipts | Payments | Assets | Capital & Liabilities £ | £ | £ | £ £ | | | Capital 10,000| Payment on | Bank Account | Capital 10,000 invested | account 500| (9,500- 4,500 | | | +5,800) 10,800| Received from | Final Payment | | Debtor 5,800| to creditor 4,500| | Profit | | Stock 1,000| to date 1,800 11,800 | Balance 10,800| | _____| _____| _____| _____ 15,800| 15,800| 11,800| 11,800

Chapter 4

20

There is no effect on the Profit and Loss Account since there is no income or expenditure, but as a result of the cash settlements there is no longer a debtor or a creditor on the Balance Sheet. 5.

On 15th January, expenditure is incurred on the following items: Stationery (£300); Postage (£200); Travel (£50); Entertainment (£70). The total expenditure is £620. Effect on the Cash Book, the Profit and Loss Account and the Balance Sheet:

Cash Book Profit & Loss Account ___________________________________________________________________________ | | | Receipts | Payments | Expenditure | Income £ | £ | £ | £ | | | Capital invested 10,000 | Payment on | Cost of | Sales 5,800 | account 500 | sales 4,000 | Received from | | | debtor 5,800 | Final Payment | *Various | | to creditor 4,500 | Expenses 620 | | | | | *Various | Profit to | | Expenses 620 | date 1,180 | | | | _____ | Balance 10,180 | ____ | ____ 15,800 | 15,800 | 5,800 | 5,800

(* These expenses would, in practice, be shown separately in the Cash Book and the Profit and loss Account) Balance Sheet

Assets Bank account (10,800-620) Stock

£ 10,180

1,000 _____ 11,180

| | | | | | | | |

Capital and Liabilities £ Capital Profit to date

£

10,000 1,180

11,180 _____ 11,180

Recording Business Transactions—John Smith Example

21

In this case, both the Cash Book and the Profit and Loss Account are affected since there is an outflow of cash as well as expenditure incurred, which results in a reduction of profit. 6.

On 25th January three months’ rent amounting to £1,800 is paid. Of the £1,800, two months’ rent (£l,200) is paid in advance.

Cash Book Profit & Loss Account _____________________________________________________________________________ | | | Receipts | Payments | Expenditure | Income £ | £ | £ | £ | | | Capital invested 10,000 | Payment on | Cost of | Sales 5,800 | account 500 | sales 4,000 | Received from | | | debtor 5,800 | Final Payment | *Various | | to creditor 4,500 | Expenses 620 | | | | | *Various | | | Expenses 620 | Rent (1 month) 600 | | | | | Rent | Profit to | | (3 months) 1,800 | date 580 | | | | ____ _ | Balance 8,380 | ____ | ____ 15,800 | 15,800 | 5,800 | 5,800 Balance Sheet

Assets Bank account (10,180-1,800) Stock Debtor (rent prepaid)

£ 8,380

1,000 1,200 _____ 10,580

| | | | | | | | | | |

Capital and Liabilities £ Capital Profit to date

£

10,000 580

10,580

_____ 10,580

22

Chapter 4

Here again, the Cash Book and the Profit and Loss Account are affected, but by different amounts. Since the £1,800 rent is paid in advance, only the proportion relating to the current month, which is 1/3 x £1,800 = £600, is ‘charged’ (i.e. shown as an expense) to the Profit and Loss Account, while the whole of the £1,800 is shown as an outflow in the Cash Book. Let us now summarise the impact of the above transactions. Cash Book | Profit & Loss Account Receipts |Payments | Expenditure | Income £ | £ | £ | £ 1. £10,000 | | | deposited in | | | bank 10,000 | | | | | | 2. Furniture | | | bought for | | | £5,000; £500 | | | paid on account | 500 | | | | | 3. Furniture sold | | | for a profit of | | | £1,800 | | 4,000 | 5,800 | | | 4. Creditor is paid | 4,500 | | and debtor | | | pays amount | | | owing 5,800 | | | | | | 5. Expenditure | | | totalling £620 | | | incurred on | | | various items | 620 | 620 | | | | 6. 3 months rent | | | (£1,800) paid | 1,800 | | in advance | | 600 | | | | | | | | 7,420 | 5,220 | Cash balance/ Profit | 8,380 | 580 | | | | | | | 15,800 | 15,800 | 5,800 | 5,800 | | |

| Balance Sheet | Assets | Capital/Liabilities | £ | £ £ | | | | | 10,000(a)| 10,000 | | | | | | | 5,000(b)| 4,500(c) | (500)(a)| | | | | | 5,800(d) | |(4,000)(b)| 1,800 | | |(4,500)(a)| (4,500) (c) | | | 5,800(a) | |(5,800)(d)| | | | | | | | | | (620)(a)| (620) | | | | |(1,800)(a)| | 1,200(d) | (600) | | | | | | | | | | | | | 10,580 | 10,580 | |

Key to assets and liabilities movements: (a) = Bank Account; (b) = Stock; (c) = Creditor; (d) = Debtor

Recording Business Transactions—John Smith Example

23

The above summary gives a ‘snap shot’ of the impact of each transaction on the Cash Book, the Profit and Loss Account and the Balance Sheet. We can see at a glance which items affect the Cash Book and which items affect the Profit and Loss Account. We see how every transaction affects the Balance Sheet, and that the effect of each transaction is such that the equation Assets = Capital + Liabilities always holds good. Finally, we can reconcile the profit for the month with the cash balance at the end of the month as follows: £ Profit for the month Differences between Profit or Loss and cash flow: Money tied up as: - Stock - Debtor (prepayment)

£ 580

(1,000) (1,200) (2,200) ______ (1,620)

Opening bank balance Closing bank balance

10,000 _____ 8,380

Now that the concepts of cash flow, profit and loss and the Balance Sheet have been thoroughly explored and understood, let us move on to the system of “Double entry bookkeeping” which is based on very much the same concepts as those we have already examined and illustrated with examples.

CHAPTER 5 DOUBLE ENTRY BOOKKEEPING

Double entry is a tried and tested method of bookkeeping based on a system of ‘debits’ and ‘credits’ which help to ensure accuracy of recording and processing transactions. It applies the same concepts and principles which we have already examined with the help of examples, but it is based on a certain set of rules. The advantage of having understood those concepts at the outset is that the rules of double entry can now be grasped and applied much more easily than would otherwise have been the case. We have seen how transactions and accounting adjustments affect the Cash Book, the Profit and Loss Account, and the Balance Sheet. We shall shortly see how, by solving the John Smith example (Chapter 4) by the rules of double entry, the Cash Book, the Profit and Loss Account and the Balance Sheet are affected in very much the same way as shown in earlier examples. Before stating the rules, let us first examine the terms ‘debit’ and ‘credit’. As we know, every transaction has two sides to it, each side being equal and opposite to the other so as to ensure that the equation Assets = Capital + Liabilities always holds good. The ‘debits’ and ‘credits’ in double entry are simply mechanisms which make sure that Assets = Capital + Liabilities and that the Balance Sheet therefore always balances. The ‘debits’ and ‘credits’, by applying the rules of double entry, also ensure that transactions correctly appear as: -

Receipts or payments in the Cash Book;

-

Income or expenditure in the Profit and Loss Account.

Finally, it should be noted that, whilst receipts and payments are recorded in the Cash Book, transactions affecting income and expenditure are not recorded directly in the Profit and Loss Account, nor are transactions

Double Entry Bookkeeping

25

affecting assets, liabilities or capital recorded directly in the Balance Sheet. This is because transactions which affect the Profit and Loss Account and the Balance Sheet are first recorded in ‘primary’ books of account before being transferred or ‘posted’ ultimately to the Profit and Loss Account and the Balance Sheet. a)

Rules of Double Entry Let us now turn to the rules of double entry which will first be stated and then explained later with examples. There are three fundamental rules, as follows: 1.

Debit what comes in; credit what goes out.

2.

Debit expenses and losses; credit capital introduced, income and gains.

3.

Debit increases in debtors; credit increases in creditors. Conversely, debit decreases in creditors and credit decreases in debtors.

Note: It might well be asked why certain of the above items are debited and certain others credited. The answer is that it is merely a convention and there is no reason why the debits could not have been credits and the credits could not have been debits. The double entry system would have worked just as well the other way round. There are two further subsidiary rules of double entry: 4.

The debit side of each transaction must always equal the credit side. This ensures that the equation Assets = Liabilities + Capital always holds good.

5.

Debit entries should be recorded on the left hand side and credit entries on the right hand side. The only statement to which this rule does not apply is the Balance Sheet because debit or credit entries can affect either side of the Balance Sheet. Hence, for instance, the bank account which is an asset can be debited or credited, or the creditor account on the liability side can be debited or credited.

Chapter 5

26

It should be noted that one or more of the fundamental rules 1 to 3 can apply to a single transaction. Hence, for example, if £50 is paid for stationery, the transaction will be recorded as follows: Stationery is debited (Rule 2 - an expense) Bank account is credited (Rule 1- something ‘going out’) This is a simple example of a combination of the above rules applying to a single transaction. Before illustrating the rules of double entry with examples, let us examine two fundamental accounting records used in double entry bookkeeping. i) The Journal Entry: This is the basic way in which a transaction is recorded by double entry. Each Journal Entry must be accompanied (in brackets) by a ‘narrative’ or a short description of what the transaction is about. The above example of a £50 purchase of stationery would be journalised (i.e. recorded in the form of a Journal Entry) as follows with Debit (Dr) and Credit (Cr) headings: Dr £

Cr £

Stationery Account 50 Bank Account (Being the purchase of various items of stationery)

50

Note: The debit entry is on the left hand side and the credit entry on the right hand side.

ii) The Account: Details of each type of expense, receipt, asset or liability are summarised on a statement called an Account (or A/c in its abbreviated form). b)

Simple Examples Let now us take eight very simple examples to illustrate the rules of double entry:

Double Entry Bookkeeping Dr £

Cr £

27

Rule Number

Rule Description

1 1

Debit what comes in Credit what goes out

2 1

Debit expenses Credit what goes out

2 1

Debit losses Credit what goes out

2 1

Debit expenses Credit what goes out

1 2

Debit what comes in Credit income

2 1

Debit expenses Credit what goes out

Example 1 Goods are bought for £6,000 Journal Entry:

Stock A/c 6,000 Bank A/c 6,000 (Being goods bought for £6,000)

Example 2 £50 worth of stationery is bought Journal Entry:

Stationery A/c 50 Bank A/c 50 (Being £50 worth of stationery purchased)

Example 3 £200 worth of stock is pilfered Journal Entry:

Stock Pilferage A/c 200 Stock A/c 200 (Being £200 worth of stock pilfered)

Example 4 £700 worth of goods are sold in cash for £1,000 Journal Entries: a)

Cost of Goods Sold A/c 700 Stock A/c (Being the cost of goods sold out of stock)

700

b) Bank A/c 1,000 Sales A/c 1,000 (Being money received from the sale of goods)

Example 5 £4,000 worth of goods are sold on credit for £5,000 Journal Entries: a)

Cost of Goods Sold A/c 4,000 Stock A/c (Being the cost of goods sold out of stock)

4,000

Chapter 5

28 Dr £

Cr £

Rule Number

b) Debtors A/c 5,000 Sales A/c 5,000 (Being income from goods sold on credit)

Rule Description

3 Debit increase in debtors 2 Credit income

Example 6 The debtor (in Example 5) pays the £5,000 owing by him Journal Entry:

Bank A/c 5,000 Debtors A/c 5,000 (£5,000 received from the debtor)

1 Debit what comes in 3 Credit decrease in debtors

Example 7 Goods bought on credit for £2,000 Journal Entry:

Stock A/c 2,000 Creditors A/c 2,000 (£2,000 worth of goods bought on credit)

1 Debit what comes in 3 Credit increase in creditors

Example 8 The creditor (in Example 7) is paid the £2,000 owing to him Journal Entry:

c)

Creditors A/c 2,000 Bank A/c 2,000 (Payment of £2,000 to the creditor)

3 Debit decrease in creditors 1 Credit what goes out

John Smith Example Reworked Let us now rework the John Smith example by double entry. Transactions 1.

On 1st January, John Smith starts a furniture business with £10,000 capital and deposits the money in his bank.

2.

On the 4th, he is invoiced for £5000 worth of furniture purchased, and pays a deposit of £500.

3.

On the 10th he sells on credit £4,000 worth of furniture (from stock) for £5,800.

Double Entry Bookkeeping

29

4.

On the 12th, he pays the balance of £4,500 owing to the creditor, and receives £5,800 owing to him by the debtor.

5.

On the 15th, the following payments are made: £300 on stationery; £200 on postage; £50 on travel and £70 on entertainment: a total of £620.

6.

On the 25th, three months’ rent amounting to £1,800 is paid. Of the £1,800, two months rent (i.e. £1,200) is in advance.

Solution The example will be solved in the following sequence: 1.

Passing Journal Entries for the above transactions.

2.

Posting Journal Entries to the relevant Accounts.

3.

Preparing a Trial Balance, i.e. a list of debit and credit balances arising on the various accounts.

4.

Transferring balances from the Trial Balance to the Profit and Loss Account or the Balance Sheet.

5.

Transferring the profit or loss on the Profit and Loss Account to the Balance Sheet.

Chapter 5

30

Journal Entries Dr £ 1.

Cr £

Rule Number

Rule Description

1st January

Bank A/c Capital A/c

10,000 10,000

1 2

Debit what comes in Credit capital

500 4,500

1 1 3

Debit what comes in Credit what goes out Credit increases in creditors

4,000

2 1

Debit expenses Credit what goes out

5,800

3 2

Debit increases in debtors Credit income

4,500

3 1

Debit decreases in creditors Credit what goes out

5,800

1 3

Debit what comes in Credit decreases in debtors

(Capital introduced & deposited in bank) 2.

4th January

Stock A/c Bank A/c Creditors A/c

5,000

(Stock bought and deposit paid) 3.

10th January

Cost of Sales A/c Stock A/c

4,000

(Cost of stock sold) 4. Debtors A/c Sales A/c

5,800

(Sale of stock on credit) 5.

12th January

Creditors A/c Bank A/c

4,500

(Payment to creditor) 6. Bank A/c Debtors A/c (Receipt from debtor)

5,800

Double Entry Bookkeeping Dr £ 7.

31

Cr £

Rule Number

Rule Description

620

2 2 2 2 1

Debit expenses Debit expenses Debit expenses Debit expenses Credit what goes out

2 3

Debit expenses Debit increases in debtors (or prepayments) Credit what goes out

15th January

Stationery A/c Postage A/c Travel A/c Entertainment A/c Bank A/c

300 200 50 70

(Payment of expenses) 8.

25th January

Rent A/c Prepayments A/c

600 1,200

Bank A/c

1,800

1

(£1,800 paid for rent - £600 in respect of January, and £1,200 prepaid)

Note: The prepayment is treated as a debtor since at the end of January, the landlord, in an accounting sense, owes John Smith £1200 for the two months paid in advance. At the end of February there would be just one month’s rent (£600) prepaid, and at the end of March there would be no prepayment.

Accounts (Jnl = Journal) Bank A/c | Dr | Jnl No. £ | Jnl No | 1 10,000 | 2 6 5,800 | 5 | 7 | 8 | | Balance c/d _____ | 15,800 | | Balance b/d 8,380 | | |

Cr £ 500 4,500 620 1,800 8,380 _____ 15,800

| Capital A/c | | | Dr | | £ | Jnl No. | | | Balance c/d 10,000 | 1 _____| | | | | | Balance b/d | | | | | | | | | | | | | | | |

Cr £ 10,000 ______ 10,000

Chapter 5

32

Jnl No. 2

Balance b/d

Jnl No. 3

Balance b/d

Jnl No. 7

Balance b/d

Jnl No. 7

Balance b/d

Balance c/d

Stock A/c | Dr | £ | Jnl No. | 5,000 | 3 | Balance c/d ____ | 5,000 | | 1,000 | | Cost of Sales A/c | Dr | £ | | 4,000 | Balance c/d ____ | | 4,000 | | Stationery A/c | Dr | £ | | 300 | Balance c/d ___ | | 300 | | Travel A/c | Dr | £ | | 50 | Balance c/d __ | | 50 | | Sales A/c | Dr | £ | Jnl No. | 5,800 | 4 ____ | | | Balance b/d

Cr £ 4,000 1,000 ____ 5,000

Cr £ 4,000 ____

Cr £ 300 ___

Cr £ 50 __

Cr £ 5,800 ____ 5,800

| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |

Creditors A/c | Dr | Jnl No. £ | Jnl No. | 5 4,500 | 2 ____ | | | | | | Debtors A/c | Dr | Jnl No. £ | Jnl No. | 4 5,800 | 6 ____ | | | | Postage A/c | Dr | Jnl No. £ | | 7 200 | Balance c/d ___ | | Balance b/d 200 | | Entertainment A/c | Dr | Jnl No. £ | | 7 70 | Balance c/d __ | | Balance b/d 70 | | Rent A/c | Dr | Jnl No. £ | | 8 600 | Balance c/d ___ | | Balance b/d 600 |

Cr £ 4,500 ____

Cr £ 5,800 ____

Cr £ 200 ___

Cr £ 70 __

Cr £ 600 ___

Double Entry Bookkeeping

33

Prepayments A/c

Jnl No. 8

Balance b/d

Dr £ 1,200 ____ 1,200

| | | | Balance c/d | | |

Cr £ 1,200 ____

Note: Each of the above accounts with a balance outstanding shows a balance carried down (c/d) and a balance brought down (b/d). The balance carried down is merely a balancing figure which makes the totals of the debit and credit sides agree. The balance brought down is the same amount as the balance carried down but on the opposite side and reflects the debit or credit balance to be transferred to the Trial Balance.

Having followed the principles of double entry bookkeeping, we can now list all the balances on each account, debit or credit, and the two sides will add up to the same total. This is called a Trial Balance, which proves the arithmetical accuracy of recording transactions by the double entry system. In our example, the Trial Balance will be as follows: Trial Balance

Bank account Capital account Stock account Cost of sales account Stationery account Postage account Travel account Entertainment account Sales account Rent account Prepayments account

Dr £ 8,380

Cr £ 10,000

1,000 4,000 300 200 50 70 5,800 600 1,200 _____ 15,800

_____ 15,800

Chapter 5

34

Main Statements: The Cash Book, Profit and Loss Account, and Balance Sheet will appear as follows: Cash Book (for the month of January) Receipts

£

Capital invested Received from debtor

10,000 5,800

_____ 15,800

| | | | | | | | | | | |

Payments Payment on account to creditor Final payment to creditor Stationery Postage Travel Entertainment Rent (3 months) Balance

£ 500 4,500 300 200 50 70 1,800 8,380 _____ 15,800

Profit and Loss A/c for the month of January Expenditure

| £ | | Cost of sales 4,000 | Stationery 300 | Postage 200 | Travel 50 | Entertainment 70 | Rent 600 | Profit (transferred | to Balance Sheet) 580 | ____ | 5,800 |

| | Balance Sheet - End January | Income | Assets | Capital & Liabilities £ | £ | £ | | Sales 5,800 | Bank balance 8,380 | Capital 10,000 | Stock 1,000 | Profit 580 | Prepayments 1,200 | | _____ | _____ | 10,580 | 10,580 | | | ____ | 5,800 |

There is in essence little difference between the way in which the John Smith example was solved by logic and common sense in the last chapter and the way it has been solved by double entry in this chapter. The only differences have been in the use of Journal Entries, Accounts, and debits and credits, all of which are merely ‘tools’ of double entry. The reason for having a double entry system is simply that the rules ensure that transactions are recorded in a structured and disciplined way, which minimises errors and makes sure that those transactions have the correct ultimate impact on the Cash Book, the Profit and Loss Account, and the Balance Sheet. The concepts and logic applied in previous chapters are

Double Entry Bookkeeping

35

encompassed in the rules of double entry, which produce exactly the same results. We can now see how the understanding of those concepts at the outset (chapters 1 - 4) has enabled a rapid, smooth and logical progression to a sound grasp of the system of double entry.

CHAPTER 6 MORE ACCOUNTING TERMS AND CONCEPTS

We have now reached the stage where the logic and principles of the system of double entry have been fully examined. The emphasis so far has been on a thorough understanding of the basics, and that is why examples of transactions entered into have been relatively simple and straightforward. However, now that the principles have been firmly grasped, far more complex transactions can be tackled with greater ease than would otherwise have been the case. Let us first examine some of the more common terms and concepts, a few of which we have already come across. a)

Capital Capital is the amount of money brought in to start off a business. Further amounts may also be injected at a later stage. If it is banked, as in the John Smith example, the Balance Sheet will be: Assets Bank balance

| £ | 10,000 |

Capital and Liabilities Capital

£ 10,000

If, however, only £2,000 is banked, and £4,000 used to buy office equipment, £3,500 to buy office furniture, and the remaining £500 kept in the office as petty cash, the Balance Sheet will be: Assets Bank balance Office equipment Office furniture Petty cash

£ 2,000 4,000 3,500 500 _____ 10,000

| | | | | | | |

Capital and Liabilities Capital

£ 10,000

_____ 10,000

More Accounting Terms and Concepts

b)

37

Revenue Reserves Revenue reserves are profits less (minus) losses accumulated over the years. If, for example, a profit of £2,500 was made in year 1, a profit of £3,000 in year 2, a profit of £4,500 in year 3, a loss of £1,500 in year 4 and a profit of £3,500 in year 5, then the reserves (or accumulated profit) at the end of the fifth year would be £12,000.

c)

Current Liabilities Amounts owing by a business for short periods of time (normally up to one year) are known as current liabilities and normally comprise the following: Creditors Where a purchase invoice is received but not paid, then a creditor arises for the amount due but not paid. In the John Smith example, goods worth £5000 are received and invoiced, but only £500 is initially paid, giving rise to a creditor for £4,500. Accruals Where an amount is due during an accounting period but not invoiced, it becomes an accrual. An accrual is an amount owed which does not have to be paid until an invoice is received. Only when the invoice is received is the amount treated as a creditor, and must be paid within a certain period of time. In the John Smith example, had the £5,000 worth of goods received not been invoiced, the £4,500 owed would have been treated as an accrual and not as a creditor. Provisions Where an invoice is not received and the exact amount due is not known, a provision must be made for the approximate amount due. For example, if accounts are being prepared for the month of January and the electricity bill for January is not received, then a provision must be made for the amount expected to be paid subsequently in respect of January. This ensures that the Profit and

Chapter 6

38

Loss Account for January reflects the true financial position of the business. In all of the above three cases a) the expense relates to the period for which the accounts are being prepared and b) the payment in respect of that expense is made sometime after the end of that accounting period. d)

Debtors and Prepayments Debtors Where a sales invoice is sent out but not paid by the customer, a debtor arises for that amount. In the John Smith example goods worth £5,800 were sold and invoiced in January but payment was not received until after January. A debtor arises until the amount owed is subsequently received. Prepayment A prepayment is a payment in advance, the opposite of an accrual which is paid in arrears. In the John Smith example £1,800 was paid in January for rent but only £600 of that related to January. This means that £1,200 was paid in advance and is therefore treated as a debtor or a prepayment. In an accounting sense, the business is owed money for an amount which relates to a subsequent period. Bad and Doubtful Debts Where goods are bought and then sold, the value of goods sold is charged to the customer who as we know becomes a debtor until he has settled the amount owing by him. Suppose payment is not made by the end of the period of credit allowed, and it is uncertain whether or not the customer will ever honour his debt, then the amount owing is known as a doubtful debt and becomes a bad debt only when it is certain that the debt will not be recovered. The amount of the bad or doubtful debt will be shown as a cost in the Profit and Loss Account in the same way as any other expense. Note that a bad debt is a type of expense, not a reduction in sales. That amount will be deducted from the amount shown against ‘debtors’ in the Balance Sheet reducing the net asset value on the

More Accounting Terms and Concepts

39

assets side of the Balance Sheet and correspondingly reducing the profit or loss balance on the capital and liabilities side by the same amount. e)

Current Assets Where an item is bought with the intention of being sold, it is regarded as stock or stock-in-trade and becomes part of the current assets of the business. In our example, John Smith ran a furniture business and the furniture he bought was for resale and hence treated as stock. On the other hand, if John Smith were also to buy furniture not for the purpose of selling it but to equip his own offices, then such furniture would become a fixed asset (explained below). Other examples of current assets are bank balances and debtors. They are called current assets because a) they are assets or property belonging to the business and b) they are current in the sense that they are subject to frequent changes unlike fixed assets.

f)

Fixed Assets Where an item is bought, not for resale, but to be used for several years to help run the activities of the business, it is ‘capitalised’ and called a fixed asset. Examples are plant and machinery, furniture and fittings, office equipment, computer hardware and property. In practice, there is normally a low cut-off value below which assets are not capitalised but are written off as revenue expenditure. This is done in order to avoid complicating the accounting unnecessarily.

g)

Depreciation Although a fixed asset is bought with the object of being retained for a number of years, it nevertheless loses value over a period of time. For accounting purposes such loss of value, known as depreciation, must be taken into account in the Profit and Loss Account in the same way as any other expense. For example, let us assume that £5,000 worth of computer equipment is bought and has a useful life of 5 years. The loss (or cost) each year to the business is £1,000 which is the amount that needs to be depreciated annually. The Journal Entry for each year would be:

Chapter 6

40

Depreciation A/c Fixed asset A/c

Dr £ 1,000

Cr £ 1,000

The impact of the depreciation charge on the Profit and Loss Account and the Balance Sheet over five years would be: Profit and Loss Account | | Expenditure Income | Assets £ £ | £ | 5,000 1st year 1,000 |1st year end (1,000) | | 5,000 2nd year 1,000 |2nd year end (2,000) | | 5,000 3rd year 1,000 |3rd year end (3,000) | | 5,000 4th year 1,000 |4th year end (4,000) | | 5,000 5th year 1,000 |5th year end (5,000) | Total after | (5 years) 5,000 |

Balance Sheet

£ 4,000

3,000

2,000

1,000

-

| Capital and liabilities | £ | | | | | | | | | | | | | |

In the Balance Sheet, the purchase price or cost of the asset (£5,000) is called the gross book value and the depreciated value at the end of each year (£4,000, £3,000, etc.) is known as the net book value. h)

Goodwill Where another business is purchased for an amount that exceeds the value of assets purchased, then that excess is known as ‘goodwill’ and is shown as such on the assets side of the Balance Sheet. For example, if a business worth £90,000 is bought for £100,000, the impact on the Balance Sheet will be as follows:

More Accounting Terms and Concepts

41

Balance Sheet Assets Assets purchased Goodwill Bank balance

Capital and Liabilities £ 90,000 10,000 (100,000) -

| | | | |

Assets worth £90,000 are acquired, the bank balance is reduced by £100,000 and the difference is shown as goodwill. The amount of goodwill is treated as an asset since it represents some special qualities or reputation of the people or products of the business taken over for which the buyer is willing to pay an extra sum of money as a premium. These qualities are not tangible like property or furniture or office equipment. That is why, in practice, goodwill is shown in the Balance Sheet as an ‘intangible’ asset. i)

Capital Reserve Where, on the other hand, a business is purchased for an amount which is less than the value of assets purchased, the difference is shown as a ‘capital reserve’ on the capital and liabilities side of the Balance Sheet. If, for example, a business worth £90,000 is bought for £85,000, the impact on the Balance Sheet will be as follows: Balance Sheet Assets Assets purchased Bank balance

£ 90,000 (85,000) 5,000

| | | | |

Capital and Liabilities £ Capital Reserve 5,000 ____ 5,000

Capital reserve represents a profit on purchase of the business in the sense that the value of assets acquired is more than the amount paid for them. However, there is no way of being certain that the value of those assets shown in the books of the business acquired represents the value realisable in the open market. Hence, that ‘profit’ element is treated as a capital reserve or a reserve that cannot be drawn out of the business in the way one could withdraw part or all of the revenue reserve (i.e. the accumulated profits of the business).

CHAPTER 7 D. HARVEY EXAMPLE

Let us now see, with the help of the following example, how the various accounting terms and concepts discussed so far are applied in practice. D. Harvey has been running a business for some time and his Balance Sheet at 31/12/2013 was as follows: Assets £ Fixed Assets Leasehold property Office equipment Fixtures & fittings Motor car Gross book value Less: - Amortisation of Leasehold property - Depreciation of other fixed assets

65,000 20,000 15,000 10,000 110,000

(12,000) (8,000) (20,000)

Net book value Current assets Debtors Stock Bank balance

25,000 5,000 20,000

| | | | | | | | | | | | | | | | 90,000 | | | | | 50,000 | 140,000 | £

Capital and Liabilities £ £ Capital & Reserves Capital 100,000 Reserves (Profit & Loss A/c balance) 20,000 120,000

Current Liabilities Creditors Accruals

15,000 5,000

20,000

______ 140,000

During the month of January 2014, the following events took place. On the 2nd, D. Harvey bought £10,000 worth of goods, and paid for them immediately by cheque.

D. Harvey Example

43

On the 4th, he paid in advance 6 months’ rates amounting to £3,000. (He therefore charged 1/6 to the Profit and Loss Account for January). On the 5th, he received £20,000 from his debtors which at 31st December had amounted to £25,000. On the 8th, he paid off all his creditors (£15,000) outstanding at the end of December. On the 10th, he sold £8,000 of his stock for £12,000, and was paid by cheque immediately. On the 15th, he purchased for £6,000 a small business which had net assets of £5,000. On the 20th, he sent off cheques for the following: £50 for postage; £250 for stationery; £700 for car expenses. On the 23rd, he sold £4,000 worth of goods for £6,000, which was paid for immediately. On the 28th, he put through the following accounting adjustments: -

Accrued a £100 electricity bill for January, not paid until March.

-

Provided £70 for telephone charges for the month of January (he had not yet received the January-March quarter’s bill which was expected to amount to approximately £200).

-

Depreciated as follows: -

Office equipment Fixtures and fittings Car

£ 550 450 200

-

Amortised (or depreciated) the leasehold premises by £100 in January (the lease expires in approximately 44 years’ time).

-

Provided £1,500 for doubtful debts.

-

Wrote off £800 as bad debts.

Chapter 7

44

Let us now give effect to the above transactions and accounting adjustments. Solution Journal Entries Dr £ 1.

2nd January Stock A/c Bank A/c

Cr £

10,000 10,000

(Goods purchased and paid for immediately)

2.

4th January Rates A/c Prepayments A/c Bank A/c

500 2,500 3,000

(6 months’ rates paid, 5 months being prepaid)

3.

5th January Bank A/c Debtors A/c

20,000 20,000

(Of the £25,000 owed by debtors, £20,000 received)

4.

8th January Creditors A/c Bank A/c

15,000 15,000

(Payment to creditors outstanding at the end of December)

5.

10th January Cost of sales A/c Stock A/c

8,000 8,000

(Cost of goods sold) 6.

Bank A/c Sales A/c

12,000 12,000

(Sale of goods)

7.

15th January New business assets A/c Goodwill A/c Bank A/c

5,000 1,000 6,000

(Payment of £5,000 for assets of business purchased plus £1,000 for goodwill)

D. Harvey Example

45 Dr £

8.

20th January Postage A/c Stationery A/c Car expenses A/c Bank A/c

Cr £

50 250 700 1,000

(Payment of various expenses)

9.

23rd January Cost of sales A/c Stock A/c

4,000 4,000

(Cost of goods sold) 10.

Bank A/c Sales A/c

6,000 6,000

(Sale of goods)

11.

28th January Electricity A/c Accruals A/c

100 100

(Electricity for January accrued) 12.

Telephone A/c Provision A/c

70 70

(Estimated telephone charge provided for) 13.

Depreciation A/c - office equipment Depreciation A/c - fixtures and fittings Depreciation A/c - car Provision for depreciation A/c

550 450 200 1,200

(Depreciation provided on the above assets) 14.

Amortisation A/c - leasehold premises Provision for amortisation A/c

100 100

(Amortisation of Leasehold premises) 15.

16.

Doubtful debts A/c Provision for doubtful debts A/c (Provision for doubtful debts) Bad debts A/c Debtors A/c (Debtors reduced by bad debts of £800)

1,500 1,500

800 800

46

Chapter 7

Accounts Capital A/c | Summarised Profit & Loss (P&L) A/c Dr | Cr | Dr | Cr | | | £ | £ | £ | £ | | | Bal c/d 100,000|Opening bal 100,000| Bal c/d 20,730 | Opening bal 20,000 ______| ______| | Profit in | | _____ | January 730 | Bal b/d 100,000| 20,730 | 20,730 | | Bal b/d 20,730 | Stock A/c | Bank A/c Dr | Cr | Dr | Cr | | | Jnl £ |Jnl £ |Jnl £ |Jnl £ No. |No. |No. |No. | | | Opening bal 5,000|5 Cost of sales 8,000| Opening bal 20,000 |1 Goods purch. 10,000 1 Goods bought 10,000|9 From stock 4,000|3 Debtors 20,000|2 Rates - 6mths 3,000 | Bal c/d 3,000| 6 Goods sold 12,000 |4 Creditors 15,000 | |10 Goods sold 6,000|7 New business | | | purchase 6,000 | | |8 Expenses paid 1,000 | | | Bal c/d 23,000 _____| _____| _____| _____ 15,000| 15,000| 58,000 | 58,000 | | | Bal b/d 3,000| | Bal b/d 23,000 | | | Rates A/c | Prepayments A/c Dr | Cr | Dr | Cr | | | Jnl £ |Jnl £ |Jnl £ |Jnl £ No. |No. |No. |No. | | | 500|Tfr to P & L A/c 500|2 Rates | 2 Re: January | | prepaid 2,500|Bal c/d 2,500 _____| _____| _____| _____ | | | | | Bal b/d 2,500|

D. Harvey Example Creditors A/c | Dr | Cr | | | Jnl £ |Jnl £ |Jnl No. |No. |No. | | 4 Payment 15,000 |Opening bal 15,000| Bal c/d | | | | _____| _____| 15,000| 15,000| | | | | Bal b/d | | Cost of Sales A/c | Dr | Cr | | | Jnl £ |Jnl £ |Jnl No. |No. |No. | | 8,000|Tfr to |Tfr to 5 From stock 9 From stock 4,000|P & L A/c 12,000| P & L A/c _____| _____| 12,000| 12,000| | | New Business Assets A/c | Dr | Cr | | | Jnl £ |Jnl £ |Jnl No. |No. |No. | | 5,000|7 Re: New 7 Assets purch. 5,000| Bal c/d | | Business ____| ____| 5,000| 5,000| | | Bal b/d 5,000| | Bal b/d | | Postage A/c | Dr | Cr | | | Jnl £ |Jnl £ |Jnl No. |No. |No. | | 8 Payment 50|Tfr to P&L A/c 50|8 Payment __| __| 50| 50|

47 Debtors A/c Dr | | £ |Jnl |No. | 25,000 |3 Receipt |16 Bad Debts | Bal c/d _____| 25,000 | | 4,200 | | Sales A/c Dr | | £ |Jnl |No. | |6 Receipts 18,000 |10 Receipts _____| 18,000 | | Goodwill A/c Dr | | £ |Jnl |No. | | Bal c/d 1,000| ____ | 1,000 | | 1,000| | Stationery A/c Dr | | £ |Jnl |No. | 250|Tfr to P&L. A/c ___| 250|

Cr £

20,000 800 4,200 _____ 25,000

Cr £

12,000 6,000 _____ 18,000

Cr £

1,000 ____ 1,000

Cr £

250 ___ 250

Chapter 7

48

| Electricity A/c Cr | Dr | Cr | | Jnl £ |Jnl £ |Jnl £ No. |No. |No. 8 Payment 700|11 Jan. Accrual 100|Tfr to P&L A/c 100 ___| ___| ___ 700| 100| 100 | Accruals A/c | Telephone A/c Dr | Cr | Dr | Cr | | | Jnl £ |Jnl £ |Jnl £ |Jnl £ No. |No. |No. |No. | | | Bal c/d 5,100|Opening bal 5,000|12 Jan. Provn. 70|Tfr to P&L A/c 70 |11 Jan. - Elec. 100| | ____| ____| __| __ 5,100| 5,100| 70| 70 | | Bal b/d 5,100| | Depreciation A/c (Office Equipment) | Depreciation A/c (Fixtures & Fittings) Dr | Cr | Dr | Cr | | | Jnl £ |Jnl £ |Jnl £ |Jnl £ No. |No. |No. |No. | | | 13 January 550|Tfr to P&L A/c 550 |13 January 450|Tfr to P&L A/c 450 ___| ___| ___| ___ 550| 550| 450| 450 | Depreciation A/c (Car) | Provision for Depreciation A/c Dr | Cr | Dr | Cr | | | Jnl £ |Jnl £ |Jnl £ |Jnl £ No. |No. |No. |No. | | | 13 January 200|Tfr to P&L A/c 200| Bal c/d 9,200|Opening bal 8,000 | | |13 Jan. depn. 1,200 ___| ___| ____| ____ 200| 200| 9,200| 9,200 | | | | | Bal b/d 9,200 Car Expenses A/c Dr | | £ |Jnl |No. 700|Tfr to P&L A/c ___| 700|

D. Harvey Example | Provision for Doubtful Debts A/c Cr | Dr | Cr | | £ | £ |Jnl £ | |No. | | Bal c/d 70| Bal c/d 1,500|15 January 1,500 __| ____| ____ 70| 1,500| 1,500 | | 70| | Bal b/d 1,500 | Amortisation A/c (Leasehold Premises) | Provision for Amortisation A/c Dr | Cr | Dr | Cr | | | Jnl £ |Jnl £ |Jnl £ |Jnl £ No. | No. |No. |No. | | | 14 January 100|Tfr to P&L A/c 100| Bal c/d 12,100|Opening bal 12,000 | | |14 Jan. amortn 100 ___| ___| _____| _____ 100| 100| 12,000| 12,100 | | | | Bal b/d 12,100 | Doubtful Debts A/c | Bad Debts A/c Dr | Cr | Dr | Cr | | | Jnl £ |Jnl £ |Jnl £ |Jnl £ No. |No. |No. |No. | | | 15 January 1,500|Tfr to P&L A/c 1,500|16 January 800|Tfr to P&L A/c 800 ____ | ____| ___| ___ 1,500| 1,500| 800| 800 | | Leasehold Property A/c | Office Equipment A/c Dr | Cr | Dr | Cr | | | Jnl £ |Jnl £ |Jnl £ |Jnl £ No. |No. |No. |No. | | | 65,000|Opening bal 20,000 | Bal c/d 20,000 Opening bal 65,000| Bal c/d _____| _____| _____| _____ 65,000| 65,000| 20,000| 20,000 | | | Bal b/d 65,000| | Bal b/d 20,000 | Provision A/c Dr | | £ |Jnl |No. | 70|12 Jan. – Tel. __| 70| | |Bal b/d

49

50

Chapter 7

Fixtures and Fittings A/c | Motor Car A/c Dr | Cr | Dr | | | | Jnl £ |Jnl £ |Jnl £ |Jnl No. |No. |No. |No. | | | Opening bal 15,000 | Bal c/d 15,000|Opening Bal 10,000 | Bal c/d _____| _____| _____| 15,000| 15,000 | Bal b/d 10,000| | | | Bal b/d 15,000| | Bal b/d 10,000 |

Cr £

10,000 _____ 10,000

Opening and Closing Trial Balances Opening Trial Balance at 31/1/2014

Leasehold Property Office Equipment Fixtures and Fittings Car Capital Profit and Loss Account (Opening balance) Stock Bank Rates Prepayments Debtors Cost of Sales Sales New Business Assets Goodwill Postage Stationery Car Expenses Electricity Accruals Telephone Provision Depreciation - Office Equipment Depreciation - Fixtures and Fittings Depreciation - Car Provision for Depreciation Amortisation - Leasehold Premises Provision for Amortisation Doubtful Debts Bad Debts Provision for Doubtful Debts Total

Dr £ 65,000 20,000 15,000 10,000

Cr £

100,000 20,000 3,000 23,000 500 2,500 4,200 12,000 18,000 5,000 1,000 50 250 700 100 5,100 70 70 550 450 200 9,200 100 12,100 1,500 800 165,970

1,500 165,970

D. Harvey Example

51

Note: What we have just seen is known as the ‘opening’ Trial Balance, since all balances including those relating to the Profit and Loss Account (e.g. cost of sales) appear on the Trial Balance. It is only after the Profit and Loss Account items have been transferred to the summarised Profit and loss Account, that a ‘closing’ Trial Balance consisting of balances relating only to the Balance Sheet, is prepared as follows: Closing Trial Balance at 31/1/2014

Leasehold Property Office Equipment Fixtures and Fittings Car Capital Profit and Loss Account (Closing Balance) Stock Bank Prepayments Debtors New Business Assets Goodwill Accruals Provision Provision for Depreciation Provision for Amortisation Provision for Doubtful Debts

Dr £ 65,000 20,000 15,000 10,000

Cr £

100,000 20,730 3,000 23,000 2,500 4,200 5,000 1,000

148,700

5,100 70 9,200 12,100 1,500 148,700

Note: The above Profit and Loss Account (Closing Balance) is arrived at after all Profit and Loss Account items have been transferred to the summarised Profit and Loss Account. The Profit and Loss Account closing balance of £20,730 comprises the opening balance of £20,000 plus the £730 profit arrived at in the Profit and Loss Account shown below. The balances brought down and listed on the closing Trial Balance constitute the items appearing in the Balance Sheet, also shown below.

Chapter 7

52

Main Statements Profit and Loss Account for the month of January Expenditure £ 500 12,000 50 250 700 100 70

Rates Cost of Sales Postage Stationery Car Expenses Electricity Telephone Depreciation - Office equipment - Fixtures and fittings - Car Amortisation Doubtful debts Bad debts Profit

550 450 200 100 1,500 800 730 18,000

| | | | | | | | | | | | | | | | | | |

Income £ 18,000

Sales

_____ 18,000

Balance Sheet - end January Asset £ Goodwill Fixed Assets at Cost: Leasehold property Office equipment Furniture & fittings Car

65,000 20,000 15,000 10,000 110,000

Less: Accumulated Depreciation/ Amortisation (21,300)

New Business Assets Current Assets £ Debtors 4,200 Doubtful Debts Provn. (1,500) Prepayments Stock Bank balance

2,700 2,500 3,000 23,000

| £ | 1,000 | | | | | | | | | | 88,700 | | | 5,000 | | | | | | | | 31,200 | 125,900 |

Capital and Liabilities £

Current Liabilities Creditors Accruals Provisions Capital & Reserves Capital Reserves (Profit & Loss A/c balance)

5,100 70

£

5,170

100,000 20,730

120,730

______ 125,900

D. Harvey Example

53

The profit in January was £730 but the bank balance increased by £3,000 to £23,000. The difference between profit and cash flow can be seen from the following Cash Flow Statement, which reconciles the profit made in January with the movement in the bank balance in January. Cash Flow Statement £ Profit in January Add Back: Depreciation : Amortisation -

-

-

Deduct: :

New business assets purchased Goodwill

Current Assets: - Add: Reduction in debtors/prepayments - Add: Reduction in stock Current Liabilities: - Deduct: Reduction in creditors - Add: Increase in accruals - Add: Increase in general provisions - Add: Provision for Doubtful Debts

£ 730

1,200 100

1,300

(5,000) (1,000)

(6,000)

18,300 2,000

20,300

(15,000) 100 70 1,500

(13,330) ______ 3,000 20,000 23,000

Increase in bank balance during January Bank balance - beginning of January Bank balance - end of January

The reconciliation comprises those items which are treated in the Profit and Loss Account differently from the Cash Book. For instance, depreciation is treated as a cost in the Profit and Loss Account but does not affect the Cash Book. The cash balance is consequently higher by that amount, which for reconciliation purposes is added to the profit figure to arrive at the bank balance at the end of January. Taking the reduction in debtors/prepayments as a more complicated example, the £18,300 is arrived at as follows: - amount received from debtors - reduction in profit but not cash flow owing to bad debts - prepayments (same as increase in debtors)

£ 20,000 800 (2,500) 18,300

Now that we have understood, in essence, the system of double entry and its underlying concepts, we are in a position to explore the more practical aspects of accountancy.

CHAPTER 8 MANUAL ACCOUNTING SYSTEM

So far we have examined a) the concepts and logic of accounting b) the application of those concepts to the system of double entry and c) the final impact on the three main statements: the Bank account, the Profit and Loss Account, and the Balance Sheet. In our examples, we have been through the following stages:

Transactions (e.g. rent paid) or Accounting adjustment (e.g. rent accrued) | | Journal Entries | | Accounts (including Bank account) | | Trial Balance | | | Profit & Loss Account

| Balance Sheet

1

2

3

4

In reality, however, a typical accounting system is more complex. The final stages 2, 3 and 4 are basically the same whatever the system. It is at stage 1 that a number of variations occur. We have until now recorded all transactions and accounting adjustments in the form of journal entries to demonstrate how the double entry system works. In practice, journal entries are not used for recording transactions but mainly to record accounting adjustments (e.g. accruals or prepayments) and for the correction of errors. Transactions, on the other hand, are processed

Manual Accounting System

55

differently, through either a manual or a computer-based system. In this chapter we will assume that a manual system is in operation. At this stage, for the sake of simplicity, we will ignore stock records by assuming that goods purchased are sold immediately and that there are therefore no stock holdings. Towards the end of this chapter we will work through a simple example which will clearly illustrate how transactions are processed through various stages right up to the Profit and Loss Account and the Balance Sheet. Let us now look at the main kinds of transactions and how they would typically be processed through a manual system. a)

Purchases

Purchase invoices received are processed through the following stages: Purchase invoices | | Recorded individually in the Purchase Day Book | | | Transferred or ‘posted’ to individual suppliers’ accounts in the Purchase Ledger | | | | | The total of individual balances posted to the Total Creditors account in the Purchase Ledger

| Transferred or posted in total to the Total Creditors account and individually to expense and/or asset accounts in the Nominal Ledger | | | Trial Balance | | __________|__________ | | Profit & Loss Account Balance Sheet

The purpose of the Purchase Day Book is to record details of each purchase invoice. The details include the name of the supplier, a brief description of goods purchased and the amount invoiced plus VAT. Each

Chapter 8

56

invoice total including VAT is posted individually to the Purchase Ledger. The Purchase Ledger is, therefore, a collection of accounts showing how much is owed to each supplier, and its purpose is to show the make up of the balance on the Total Creditors Account in the Nominal Ledger (explained below). In the previous examples, we have seen how accounts are written up for each type of asset and liability, revenue and expenditure. The book or ledger in which these accounts are written up is called the Nominal Ledger. As we have seen, the Trial Balance is prepared from the balances, debit or credit, remaining on accounts in the Nominal Ledger. It should be noted that a Cash or Bank Account, which is a summary of the Cash Book, is also one of the accounts in the Nominal ledger. Total Accounts (such as the Total Creditors Account which shows the total of balances outstanding on individual suppliers’ accounts in the Purchase Ledger) also form part of the Nominal Ledger. To take a very simple example, purchases of stationery (an expense) from J. Bloggs for £100 and of office equipment (an asset) from T. Short for £150, would be processed (without full details being shown) as follows: Purchase Day Book J. Bloggs T. Short

£ 100 150 250

Purchase Ledger Dr J. Bloggs A/c Cr | Dr T. Short A/c Cr £ £ | £ £ 100 | 150 | | Dr Total Creditors A/c Cr £ £ 250

Manual Accounting System

57

Nominal Ledger Dr Total Creditors A/c Cr | Dr Stationery A/c Cr £ £ | £ £ | 250 | 100 | | | Dr Office Equipment Cr | £ £ | | 150

Trial Balance Dr £ Total Creditors account Stationery Office equipment

100 150 250

Cr £ 250 ___ 250

Profit & Loss Account | | Income | £ | £ Stationery 100 | Loss to date 100 ___ | ___ 100 | 100 Note: The Loss to date is simply the balance shown in the Income column. Expenditure

Balance Sheet Assets

Office Equipment

£ 150 ___ 150

| Capital & Liabilities | | £ | Total Creditors 250 | Loss to date (100) | 150

Note that the expenditure on stationery is treated as an expense and is therefore shown as a loss in the Profit & Loss Account, whereas the expenditure on office equipment, an asset, is shown under Assets in the Balance Sheet. The above simple example gives a ‘bird’s eye’ view of the way in which a transaction is processed a) through the Purchase Ledger and b) through the Nominal Ledger right up to the Trial Balance, the Profit and Loss Account and the Balance Sheet.

Chapter 8

58

b)

Purchases Returns

Where goods are returned to the supplier, a credit note is received from the supplier for the value of goods returned. Credit notes are processed through the system in exactly the same way as purchase invoices, except that the debits and credits are reversed. In our example, if £20 worth of stationery were returned, then £20 would be posted to the debit of J Bloggs account and £20 to the credit of Stationery account. c)

Sales

Sales invoices issued for goods or services rendered are processed through the following stages: Sales invoices issued | | Recorded individually in the Sales Day Book | | | Posted to individual customers’ accounts in the Sales Ledger | | | | | The total of individual balances posted to the Total Debtors account in the Sales Ledger

| Posted in total to the Total Debtors account and to the Sales account in the Nominal Ledger | | | | Trial Balance | | __________|__________ | | Profit & Loss Account Balance Sheet

We can see that the above stages are much the same as for purchases except that a Sales Day Book and a Sales Ledger are involved instead of a Purchase Day Book and a Purchase Ledger.

Manual Accounting System

d)

59

Sales Returns

Where goods are returned by the customer, a credit note is issued to the customer for the value of goods returned. Except for the reversal of debits and credits, sales returns are processed through the same stages as sales. e)

Payments for Purchases

Payments for purchases of goods or services are made either immediately ‘in cash’, or some time later where goods are purchased ‘on credit’. i)

Payments made immediately

Cheques issued are processed through the following stages: Cheques issued | | Recorded individually in the Cash Book | | Posted individually to expense and/or asset accounts and in total to the Bank account in the Nominal ledger | | Trial balance ______________|________________ | | Profit and Loss Account Balance Sheet

Chapter 8

60

ii)

Payments Made Later

Cheques issued are processed through the following stages: Cheques issued | | | Posted to individual suppliers’ accounts in the Purchase Ledger | | The total of individual balances posted to the Total Creditors account in the Purchase Ledger

| Recorded individually in the Cash Book | | | Posted in total to the Total Creditors account and to the Bank account in the Nominal Ledger | | Trial Balance | | | | | Profit & Loss Balance Sheet Account

Continuing with our example, let us assume that J. Bloggs and T. Short are paid the £100 and £150 respectively owed to them. The accounting records would appear as follows: Purchase Day Book J. Bloggs T. Short

£ 100 150 250

Purchase Ledger Dr £ * 100

J. Bloggs A/c Cr | Dr T. Short A/c Cr £ | £ £ 100 | * 150 150 | | Dr Total Creditors A/c Cr £ £ * 250 250

Manual Accounting System

61

Nominal Ledger Dr £

Total Creditors A/c

* 250

Dr £ 100

Stationery A/c

Cr | Dr Bank A/c Cr £ | £ £ | 250 | * 250 | | Cr | Dr Office Equipment Cr £ | £ £ | 150 |

Trial Balance Dr £ Bank overdraft Stationery Office equipment

100 150 250

Cr £ 250 ___ 250

Profit & Loss Account Expenditure

Stationery

£ 100 ___ 100

| | Income | | | Loss to date | |

£ 100 ___ 100

Balance Sheet Assets

Office Equipment

£ 150 ___ 150

| Capital & Liabilities | | £ | Bank overdraft 250 | Loss to date (100) | 150

Note: 1. Items marked * refer to entries relating to payments. 2. The ultimate effect on the Balance Sheet of the payments to J. Bloggs and T. Short is that a bank overdraft of £250 takes the place of creditors amounting to £250.

Chapter 8

62

f)

Receipts from Customers

Receipts from customers go through exactly the same stages as payments for purchases except that a Sales Day Book and a Sales Ledger are involved instead of a Purchase Day Book and a Purchase Ledger. g)

Other Expenditure i)

Revenue Expenditure

We have reviewed the way in which goods or services purchased are processed. Where goods are bought for resale, they are described as purchases. Where expenses such as gas, electricity, rent, rates, telephone, travel, etc. are incurred, they are referred to as overheads. Both kinds of expenditure, purchases and overheads, are called ‘revenue’ expenditure. ii)

Capital Expenditure

Expenditure on items required to help run the business and to be used in the business for a long period of time, is called ‘capital’ expenditure. Such items become assets of the business. As we have seen, the annual cost of the asset to the business throughout the life of the asset is known as depreciation. Whilst purchase of an asset is capital expenditure, the depreciation charged to the Profit and Loss Account is revenue expenditure as depreciation is the proportionate cost of the asset in respect of the asset’s loss of value each year. So if, for example, a £100 charge is made for depreciation, then both the profit of the business and the value of the asset in the Balance Sheet are reduced by £100. iii)

Petty Cash

Petty cash expenditure relates to relatively small amounts paid in cash rather than by cheque. Petty cash payments are processed in basically the same way as purchases or overheads except that the expenses are first entered in the Petty Cash Book.

Manual Accounting System

63

Petty cash is processed through the following stages: Petty cash expenses paid | Recorded individually in the Petty Cash Book | Posted individually to expense accounts and in total to the Petty Cash account in the Nominal Ledger | Trial balance _________________|_________________ | | Profit and Loss Account Balance Sheet

iv)

Payroll Expenditure

The term payroll relates to the payment of wages (normally weekly) and salaries (normally monthly). Although wages and salaries are paid ‘net’ after deduction of tax, national insurance, etc., the cost to the business is the total amount comprising a) gross pay, which is net pay plus PAYE and other deductions, and b) the employer’s contributions for pensions and national insurance. Whilst the accounting treatment must take into account all the various elements of payroll expenditure, namely net pay, deductions and the employer’s contributions, the stages involved are basically the same as for other types of expenditure. Individual employees’ payroll details as well as the totals arrived at from the payroll records are then processed, as follows:

64

Chapter 8

Payroll records | ___________________|_____________________ | | Journal entry prepared from totals Payments made, normally by of net pay, deductions and cheque or direct bank employers’ contributions payable transfer, to individual | employees, Inland Revenue etc. | | | | | Totals entered in Cash Book | | | | | | Posted to the Nominal Ledger Posted to Net Pay, Inland Revenue | and other deductions accounts | and to the Bank account, in the | Nominal Ledger | | | | | | | | | Trial Balance | | | | | | Profit and Loss Account Balance Sheet Note: Payroll entries are shown in detail in an example in Chapter 9.

Manual Accounting System

h)

65

Accounting Adjustments

As we have seen, accounting adjustments for accruals, prepayments, depreciation, etc., or for correction of mis-postings, are journalised before passing through the usual stages as follows:

Accounting adjustments | | Recorded in the Journal | | Posted to the Nominal Ledger | | Trial balance | ________________|_____________________ | | Profit and Loss Account Balance Sheet

Let us now take a very simple example to illustrate how transactions are processed all the way through a basic accounting system from start to finish.

Chapter 8

66

Example Transactions in the Month of January Transaction Number Goods purchased from: (recorded in the Purchase Day Book)

1. 2. 3. 4.

A.B. C.D. E.F. G.H.

On credit £ 1,000 700

1,700

In Cash £

+

600 1,500 2,100

= £3,800

Sales made to: (recorded in the Sales Day Book)

5. 6. 7. 8.

I.J. K.L. M.N. O.P.

Payment (by cheque) to: 9.

C.D.

On credit £ 1,500 900 ____ 2,400 £ 700

Receipt (by cheque) from: 10.

I.J.

1,500

Expenditure (by cheque) on: 11.

Printing and Stationery

300

Accounting adjustment 12.

Accrual for gas (being 1/3 of the anticipated quarterly bill of approximately £600)

200

In Cash £

+

800 2,000 2,800

= £5,200

Manual Accounting System

67

Recording of transactions Bought Ledger Dr

A.B. A/c

Dr Payment Bal c/d

Cr | Dr £ | £ 1,000 | 700

C.D. A/c

Total Creditors A/c £ | 700 | Credit Purchases 1,000 | 1,700 |

Cr £ 700

Cr £ 1,700 ____ 1,700

Sales Ledger Dr £ 1,500

Dr

I.J. A/c

Cr | Dr £ | £ 1,500 | 900 |

Total Debtors A/c £ | Credit sales 2,400 | Receipt ____ | Bal c/d 2,400 |

K.L. A/c

Cr

Cr £ 1,500 900 2,400

Cash Book Receipts Cash Sales Sales Ledger receipt

| Payments £ | £ 2,800 |Cash Purchases 2,100 1,500 |Bought Ledger payment 700 |Printing & Stationery 300 ____ |Bal c/d 1,200 4,300 | 4,300

Chapter 8

68

Nominal Ledger (No transaction details have been shown in order to save space) Purchases A/c Dr £

Cr £

3,800

Total receipts

Bank A/c Dr £ 4,300 Total payments ____ Bal c/d 4,300

Cr £ 3,100 1,200 4,300

Bought Ledger Control A/c (Total Creditors)

Payment Bal c/d

Dr £ 700 Credit Purchases 1,000 1,700

Cr £ 1,700 ____ 1,700

Gas A/c Dr £ 200

Cr £

| Sales A/c | Dr Cr | £ £ | | 5,200 | | | Printing & Stationery A/c | Dr Cr | £ £ | 300 | | | | | Sales Ledger Control A/c | (Total Debtors) | | Dr Cr | £ £ | Credit Sales 2,400 Receipt 1,500 | Bal c/d 900 | 2,400 2,400 | | Accruals A/c | Dr Cr | £ £ | 200

Trial Balance Purchases Sales Bank Creditors Debtors Printing & Stationery Gas Accrual

Dr £ 3,800

Cr £ 5,200

1,200 1,000 900 300 200 ____ 6,400

200 6,400

Manual Accounting System

69

Profit and Loss Account Expenditure Purchases Printing & Stationery Gas Profit

£ 3,800 300 200 900 ____ 5,200

| | | | | | | |

Income Sales

£ 5,200

____ 5,200

Balance Sheet Assets £ Bank Debtors

1,200 900 ____ 2,100

| | | | | | | |

Capital & Liabilities £ Creditors Accrual Profit

1,000 200 900 ____ 2,100

We can now summarize the various stages of a very basic manual accounting system, in a chart showing a) the main types of transactions that take place in a small business and b) the records typically used in a manual accounting system to process those transactions. j)

Manual Accounting System - Flow chart Purchases/ Credit Notes | | Purchase Day Book

Sales/ Bank Credit Notes Payments | | | | Sales Cash Day Book Book

Bank Salaries Petty Accounting Receipts & Wages Cash Adjustments | | | | | | | | Cash Payroll Petty Book Records/ Cash Journal Cash Book Book /|\ /|\ |\ |\ | | | / | \ / | \ | \ | \ | | | / | \ | \ | \ | | | / | \ / | \ / | \ | \ | \ | | | / | \ / | \ | \ | \ | | | Stock | Purchase Stock | Sales | Purchase | Sales | | | Records | Ledger Records | Ledger | Ledger | Ledger | | | | | | | | | | | Nominal Ledger | Trial Balance ________________________|______________________________ | | Profit and Loss Account Balance Sheet

CHAPTER 9 MORE EXAMPLES— MANUAL ACCOUNTING SYSTEM

In the last chapter we examined a manual accounting system, taking at the end a very simple example to illustrate how transactions and accounting adjustments are recorded in manual books of account. In this chapter we will continue to illustrate with further examples and in greater detail how a manual accounting system operates. We will, for example, see how goods taken into stock require stock records in addition to the records examined so far. We will also see how payroll details are recorded in practice. Let us now examine, with examples, the following: a)

b) c) d) e) f)

g) h)

Credit purchases i) Into stock ii) Sold directly Payments to creditors Cash purchases Sales Credit notes Other expenditure i) Overheads ii) Payroll costs iii) Capital expenditure and depreciation Petty cash Journal entries

More Examples—Manual Accounting System

a)

71

Credit Purchases Let us take a simple example of an office furniture business, where just three items are bought and taken into stock, recorded initially in the Purchase Day Book. Purchase Day Book

Invoice Number 500 501 502

Name of Supplier Description C Tomkins S Hastings R Murray

Amount VAT Total £ £ £ 700.00 122.50 822.50 400.00 70.00 470.00 300.00 52.50 352.50 1,400.00 245.00 1,645.00

1 Table 1 Desk 2 Chairs

Postings to the Purchase Ledger Dr

C Tomkins A/c Inv No. 500

Cr

| | £ | | | 822.50 |

Dr Inv No. 501

S Hastings A/c

Cr

| | £ | | | 470.00 |

Dr

R Murray A/c

Cr

Inv No.

£

502

352.50

Postings to the Nominal Ledger Dr

Stock A/c

£ 1,400.00 Purchases

Cr

| Dr VAT A/c Cr | | £ | | 245.00 Re: Purchases

| Dr Total Cr | Creditors A/c | £ | | Goods Purchased 1,645.00

Trial Balance Dr £ Stock VAT Receivable Creditors

Cr £

1,400 245 1,645

1,645 1,645

Chapter 9

72

Balance Sheet Assets Stock VAT receivable

£ 1,400 245 ____ 1,645

| | | | | |

Capital & Liabilities Creditors

£ 1,645 ____ 1,645

Note: 1. There is no effect as yet on the Profit and Loss Account since the goods have been taken into stock but not sold. It is only when the sale takes place that the Profit and Loss Account is affected by ‘Cost of Sales’ for the cost of stock sold, and by ‘Sales’ for the amount invoiced to the customer. 2. The cost of the item purchased excluding VAT is posted to the debit of the expense or asset account, the VAT amount itself to the debit of the VAT account, and the total amount including VAT to the credit of the creditors account or the bank account. The VAT charged by the suppliers is recoverable from Her Majesty’s Customs & Excise (HMRC) and is therefore treated as a debtor. Conversely, VAT charged to customers is treated as a creditor and is subsequently payable to HMRC, after netting off the VAT recoverable.

It should be noted that purchases, whether on credit or in cash, can be made in two ways: i) Purchases taken into stock as in our example, and sold subsequently. ii) Purchases of goods sold directly to the customer. Let us look at the difference in accounting treatment. i)

Purchases Taken into Stock

When goods are purchased and taken into stock, entries are made in the Purchase Day Book and in the Stock Records. We have seen how the entries appear in the Purchase Day Book. The Stock Records give for each item in stock, details of amounts purchased and sold and the balance held. The details shown in the Stock Records will vary considerably according to the nature of the business. A simple format, using our example, would be as follows:

More Examples—Manual Accounting System

Purchase Invoice No.

Sales Invoice No.

In Units

500

1

501

1

502

2

Boardroom Tables | Out £ | Units | 700.00 | | Desks | 400.00 | | Chairs | 300.00 |

73

| Balance £ | Units £ | | 1 700.00 | | | | | |

1

400.00

2

300.00

Note: 1. The above stock records show the position before any sales are made from stock. 2.

The total value of purchases in stock at this stage is £1400.

3.

The goods purchased are posted from the Purchase Day Book to the Nominal Ledger Accounts for Stock, VAT and Total Creditors, and can be summarised by the following journal entries: Dr Cr £ £ Stock A/c 1,400 VAT A/c 245 Total Creditors A/c 1,645

4.

It is only when the goods are sold that postings are made from the stock records as follows: Dr Cr £ £ Cost of sales 1,400 Stock A/c 1,400

On sale, details would be entered in the ‘Out’ column of the Stock Records, and the ‘Balance’ column would be adjusted accordingly. ii)

Purchases of Goods Sold Directly

In this case, it is not necessary to enter details in the stock records. In our example, had the goods purchased been sold directly, the total of the Purchase Day Book would have been posted to the following accounts:

Chapter 9

74

Dr £ 1,400 245

Cost of Sales A/c VAT A/c Total Creditors A/c

Cr £

1,645

You will notice that when goods are first taken into stock and subsequently sold, the debit and credit entries on the Stock Account (for £1400) cancel out and the net result is as shown above for purchases of goods sold directly. In other words, the ultimate effect on the Profit and Loss Account and the Balance Sheet is exactly the same whether or not goods are sold directly or first taken into stock before being sold. b)

Payments to Creditors Continuing with our example where goods are taken into stock, let us assume the following payments are subsequently made: £ 700.00 470.00 352.50

C Tomkins S Hastings R Murray

Note: S Hastings and R Murray have been paid in full, but because of a small defect in the table, only £700 out of the total £822.50 owing has been paid to C Tomkins. (The difference of £122.50 being the same as the £122.50 VAT is purely coincidental).

Entries are made on the credit side of the Cash Book as follows: Cash Book Receipts

£

| | | | |

Payments

£

C Tomkins S Hastings R Murray

700.00 470.00 352.50

The debit side of the entries is posted to the suppliers’ accounts in the Purchase Ledger, as shown below.

More Examples—Manual Accounting System

75

Postings to the Purchase Ledger

Paymt. Bal c/d

C Tomkins A/c | Dr | Cr | £ | Inv £ | | No | | | 700.00 | 500 Purch. 822.50 | Paymt. 122.50 | | _____ | _____ | 822.50 | 822.50 |

Paymt.

S Hastings A/c Dr | Cr £ | Inv £ | No. | 470.00 | 501 Purch . 470.00

R Murray A/c Dr | £ | Inv | No | 352.50 | 502 Purch.

Cr £

352.50

Postings to the Nominal Ledger | Cr | £ | | | Re: purchases

Stock A/c Dr | £ | | Purchases 1,400.00 |

Payment to creditors

Bank A/c Dr | £ | | |

Cr £ 1,522.50

VAT A/c Dr | £ | | 245.00 |

| Total Creditors | (or Creditors Control) A/c | Dr | Cr | £ | £ | Payment 1,522.50 | Goods | Balance c/d 122.50 | purchased 1,645.00 | _______ | _______ | 1,645.00 | 1,645.00

Trial Balance

Stock VAT recoverable Bank Creditors

Cr £

Dr £ 1,400.00 245.00

_______ 1,645.00

Cr £

1,522.50 122.50 _______ 1,645.00

Chapter 9

76

Balance Sheet Assets Stock VAT recoverable

£ 1,400.00 245.00 _______ 1,645.00

| Capital & Liabilities | | Creditors | Bank overdraft | |

£ 122.50 1522.50 _______ 1,645.00

Note: There is no effect on the Profit and Loss Account until the goods are sold as demonstrated in section d) on Sales, below.

c)

Cash Purchases The only difference between cash and credit purchases is that in the case of cash purchases, payment is made immediately and there is therefore no need to post either to the Purchase Ledger or to the Total Creditors Account in the Nominal Ledger. The total shown in a separate column in the Purchase Day Book for cash purchases would be posted directly to the Cash Book and then to the Nominal Ledger, and the Balance Sheet would be as follows: Balance Sheet

Assets Stock VAT recoverable

£ 1,400.00 245.00 _______ 1,645.00

| Capital & Liabilities | | Bank overdraft | | |

£ 1645.50 _______ 1,645.00

Note that the overdraft is £1,645.00 instead of £1,522.50 as shown in the earlier Balance Sheet as it is assumed that the full amount has been paid immediately to C Tomkins. d)

Sales For accounting purposes, sales are the mirror image of purchases. When a sale is made, sales invoice details are first entered in a Sales Day Book and then posted to the Sales Ledger (in case of Credit Sales), or to the Cash Book (in case of Cash Sales), and then to the relevant accounts in the Nominal Ledger.

More Examples—Manual Accounting System

77

Continuing with our example, let us assume that all three items, the boardroom table, the desk and the two chairs are sold on credit. Soon after those items are delivered they are invoiced, and details on the sales invoice copies are entered in the Sales Day Book as follows: Sales Day Book Invoice Number

Customer Name

100 101 102

J Bloggs D Smith F Jones

Description 1 Table 1 Desk 2 Chairs

Amount £ 1000.00 650.00 400.00 2,050.00

VAT £ 175.00 113.75 70.00 358.75

Total £ 1,175.00 763.75 470.00 2,408.75

Postings are then made as follows: Postings to the Sales Ledger Dr

J Bloggs A/c

£

Cr | Dr D Smith A/c Cr | Dr F Jones A/c Cr | | | £ Inv No | £ Inv No | | Sales | 763.75 101 Sales | 470.00 102 Sales

Inv No

1,175.00 100

Postings to the Nominal Ledger i) Dr

From the Sales Day Book

Total Debtors A/c

£ 2,408.75

Sa1es

Cr | Dr | | | | Re:

VAT A/c

Sales

Cr | Dr | £ | | 358.75 |

Sales A/c

Cr £

Total

2,050.00

Chapter 9

78

ii)

From the Stock Records

Dr

Cost of Sales A/c Cr | Dr Stock A/c | | £ | £ | | | 1,400.00 Sales from stock | 1,400.00 Purchases | Cost of sales

Cr £ 1,400.00

Note: The stock records shown earlier will be completed by entering amounts under the ‘Out’ column, which will then result in nil balances throughout.

Following the purchases and payments to creditors, but prior to the sales, the Trial Balance is as follows: Stock VAT recoverable Bank overdraft Creditors

Dr £ 1,400.00 245.00

_______ 1,645.00

Cr £

1,522.50 122.50 _______ 1,645.00

The new Trial Balance following the sale (on credit) of items in stock will be:

Cost of sales VAT recoverable Bank overdraft Creditors Debtors VAT Payable Sales

Dr £ 1,400.00 245.00

Cr £

1,522.50 122.50 2,408.75

_______ 4,053.75

358.75 2,050.00 _______ 4,053.75

Note: 1. The Stock Account will now show a ‘nil’ balance. 2. £122.50 has not yet been paid to C Tomkins. 3. In practice, VAT recoverable and VAT payable would appear in the same account and, therefore, be netted together and shown as one amount. In our example, there would be net VAT payable of £113.75 (£358.75-£245) shown as a creditor.

More Examples—Manual Accounting System

79

The Profit and Loss Account and Balance Sheet will show: P&L Account Expenditure

£

Cost of sales 1,400.00 Profit 650.00

_______ 2,050.00

| Balance Sheet | |Income £ |Assets £ |Capital & Liabilities £ | | | |Sales 2,050.00 |Debtors 2,408.75 |Bank overdraft 1,522.50 | | |Creditors 122.50 | | |Net VAT payable 113.75 | | |(£358.75-£245.00) | | |Profit 650.00 | _______ | _______ | _______ | 2,050.00 | 2,408.75 | 2,408.75

When the debtors settle the amount due, and the creditor (C Tomkins) and VAT (to HMRC) are paid off, the Balance Sheet will simply be: Balance Sheet Assets Bank

e)

£ | Capital & Liabilities | 650 | Profit

£ 650

Credit Notes A credit note is raised when there is a mistake in either the purchase or the sales invoice or there is a return of goods. The credit note simply cancels part or all of the charge on the relevant purchase or sales invoice, and is processed through the system in exactly the same way as purchases or sales except that the double entry is reversed. If, for instance, goods worth £1000 are purchased and invoiced by the supplier, but £200 worth is returned subsequently for which a credit note is received, the entries will be: 1) On receipt of the goods and processing of the purchase invoice: Dr £ Stock A/C Suppliers A/C

Cr £

1000 1000

Chapter 9

80

2) On return of part of the goods and processing of the credit note: Dr £ Suppliers A/c Stock A/c

f)

Cr £

200 200

Other Expenditure The main activities of a business are to do with buying and selling of goods or services, and we have examined so far the books of account required to record Purchases and Sales. To run a business however, one has to incur, in addition to the purchase of goods, other kinds of expenditure, namely: i) ii) iii)

Overheads Payroll costs (i.e. salaries and wages) Capital Expenditure

i)

Overheads

The term overheads refers to all types of expenses (apart from the purchase of goods) for instance: Rent, Rates, Gas, Electricity, Water, Telephone, Travelling, Printing and Stationery, Postage, Depreciation. These are only some examples of overheads, but there are many others. Salaries and Wages or Payroll costs may also be considered overheads, but since they constitute a major area of costs involving special accounting treatment, we shall deal with payroll costs separately. As with purchases of goods, overheads invoices may be settled immediately or after some time in which case they are processed through the Purchase Ledger.

More Examples—Manual Accounting System

81

If, for example, rent of £1000 and Rates of £300 are paid immediately, postings from the Cash Book to the Nominal Ledger will be as follows: Dr

Rent A/c

Cr | Dr | | £ | | 300

£ 1,000

Paid

Rates A/c

Paid

Cr | Dr | | | |

Bank A/c

Rent Rates

Cr £ 1,000 300

The impact on the Profit & Loss Account and the Balance Sheet will be: P&L A/c Expenditure Rent Rates

ii)

£ 1,000 300 ____ 1,300

|Income | |Loss |to date | |

£

1,300 ____ 1,300

| Balance Sheet | | Assets £ |Capital & Liabilities £ | | | |Bank Overdraft 1,300 | |Loss to date (1,300) | ____ | ____ | 0 | 0

Payroll Costs (Salaries & Wages)

Payroll costs are a special type of cost in that they are not paid ‘gross’ but ‘net’ after certain deductions which are mainly in respect of Tax (Pay As You Earn or PAYE), National Insurance and Company Pension Contributions. Other deductions, for example those for repayment of loans, payment for medical insurance, charitable donations etc., may also be made. For the sake of simplicity, we will assume in the following example that only the three main types of deduction are made. It should also be remembered that the employer makes National Insurance and Pension Contributions on behalf of each employee in addition to the contributions made by those employees.

Chapter 9

82

Example: Payroll Records for the Month of May + Gross

| | | | | £ | | T Dobson 1,500| F Cole 1,700| B Austin 1,300| ____| 4,500| Pay

Deductions

| Net | Pay National Company | PAYE Insurance Pension | | £ £ £ | £ | 300 105 90 |1,005 340 119 102 |1,139 260 91 78 | 871 ___ ___ ___ |____ 900 315 270 |3,015

|Employers Contributions| *Total | | Payroll | National Company | Cost | Insurance Pension | | | | £ £ | £ | | | 130 90 | 1,720 | 150 102 | 1,952 | 115 78 | 1,493 | ___ ___ | ____ | 395 270 | 5,165

+ Gross Pay

= PAYE + Employees’ National Insurance and Pension Contributions + Net Pay * Total Payroll Cost = Gross Pay + Employer’s National Insurance and Pension Contributions Note: 1. The above deductions and contributions are fictitious. In practice, one would have to refer to Tax and National Insurance tables, with reference to each employee’s tax code issued by HMRC. Pension contributions would be based on percentage deductions laid down in the pension scheme rules. 2. Deductions made are paid over to the following third parties: -

PAYE & National Insurance

) )HMRC )

-

Company Pension Contributions

Company Pension Scheme (managed by Trustees)

More Examples—Manual Accounting System

83

The above payroll details are processed through the accounts in two stages, via the following journal entries: - Prior to net salary and deductions being paid: Dr £ Total payroll cost PAYE National Insurance (total) Company Pension (total) Net Pay

Cr £

5,165 900 710 540 3,015

- After payment of net salary, deductions and the employer’s contributions: Dr £ PAYE National Insurance (total) Company Pension (total) Net Pay Bank

Cr £

900 710 540 3,015 5,165

Note: In practice, net pay and the various deductions are not normally paid out at the same time.

After all the payments have been made, the impact on the Cash Book for the month of May will be as follows: Receipts

| | | | | |

Payments Net salaries paid PAYE National Insurance Pension contributions

£ 3,015 900 710 540 5,165

Chapter 9

84

Postings to the Nominal Ledger (after all payments have been made): Bank A/c Dr | £ | | | Total payroll | cost | PAYE A/c Dr | £ | | Payment 900 | Re: May Pension Contributions A/c Dr | £ | | Payment 540 | Re: May

| Net Pay A/c | Dr | Cr | £ | £ | | | Payment 3,015 | Re: May 3,015 5,165 | Cr £

| National Insurance A/c Cr | Dr | £ | £ | | | 900 | Payment 710 | Re: May | | Total Payroll Costs A/c Cr | Dr | £ | £ | | | 540 | Re: May 5,165 |

Cr £ 710

Cr £

Trial Balance - end May

Total Payroll Cost Bank

Dr £ 5,165 ____ 5,165

Cr £ 5,165 ____ 5,165

Impact on Profit and Loss Account and Balance Sheet: P&L A/c for the month of May

| Balance Sheet | Expenditure £ |Income £ | Assets £ |Capital & Liabilities £ | | | Total Payroll Cost 5,165 |Loss to date 5,165 |Bank (5,165) |Loss to date (5,165)

More Examples—Manual Accounting System

iii)

85

Capital Expenditure and Depreciation

As we know, when an asset is bought it is treated as capital expenditure, and the cost of the asset (in the form of depreciation) is charged to the Profit and Loss Account over a period of years. Details of each asset purchased are recorded within major categories in an Asset Register which shows the cost of each asset, the amount depreciated to date, and the net book value. Example: An asset is bought for £1000 and depreciated at £200 per annum over five years. Asset Register Date

Details

Asset Name: xxxx Cost Depreciation £ 1000

Purchased on xx/xx/xx Year 1 Year 2 Year 3 Year 4 Year 5

£ 200 200 200 200 200 1,000

Net Book Value (Year End) £ 800 600 400 200 -

Postings to the Nominal Ledger Dr £

Asset A/c

1,000

Details

Dr £ 200 200 200 200 200

Depreciation A/c

Yr.1 Depreciation Provn Yr.2 Depreciation Provn Yr.3 Depreciation Provn Yr.4 Depreciation Provn Yr.5 Depreciation Provn

Cr £

Cr £

| Dr Bank A/c | £ | | Description of Asset purchased

| Dr Provn. For Depreciation A/c | £ | | Yr. 1 Depreciation | Yr. 2 Depreciation | Yr. 3 Depreciation | Yr. 4 Depreciation | Yr. 5 Depreciation

Cr £ 1,000

Cr £ 200 200 200 200 200

Note: Postings to the Asset Account and the Bank Account are made from the Cash Book. Postings to the Depreciation Account and the provision for Depreciation Account are made from the Asset Register via the Journal.

Chapter 9

86

Impact on Profit and Loss Account and Balance Sheet Dr

Profit & Loss A/c

£

Year 1 200 Depreciation

Year 2 200 Depreciation

Year 3 200 Depreciation

Year 4 200 Depreciation

Year 5 200 Depreciation

| | | | | | | | | | | | | | | | | | | | | | | | | | |

Cr | | £ | Asset | | |Year 1 end Loss 200 |Asset nbv |Bank | | |Year 2 end Loss 200 |Asset nbv |Bank | | |Year 3 end Loss 200 |Asset nbv |Bank | | |Year 4 end Loss 200 |Asset nbv |Yr.4 Bank | | |Year 5 end Loss 200 |End Asset nbv |Bank |

Balance sheet £ | Capital & £ | Liabilities | | 800 | (1,000) |Loss to date (200) (200) | (200) | | 600 | (1,000) |Loss to date (400) (400) | (400) | | 400 | (1,000) |Loss to date (600) (600) | (600) | | 200 | (1,000) |Loss to date (800) (800) | (800) | | - | (1,000) |Loss to date (1,000) (1,000) | (1,000)

Note: 1. nbv (net book value) = cost of asset minus accumulated depreciation. 2. The impact of depreciation of the asset is shown for each of the five years in the above Profit and Loss Account and the Balance Sheet.

In practice, when an asset is sold, the difference between the sales proceeds and the net book value is treated as profit or loss on sale. In our example, if the asset is sold for £250 at the end of year 4, when its net book value is £200, then there is a profit on sale of £50, which would be shown on the credit side of the Profit and Loss Account.

More Examples—Manual Accounting System

g)

87

Petty Cash Although petty cash expenditure forms part of business overheads, it is treated rather differently since payments are made in cash and not by cheque. Petty cash is the money that is kept physically on the business premises because there are certain types of expenses, for example taxi fares that can only be paid in cash. Petty cash normally operates on what is known as an ‘Imprest’ system whereby a certain amount, a ‘float’, is drawn from the bank to start with and is kept securely locked in a petty cash box which should in turn be retained in a safe. From time to time, cash is paid out of the petty cash box in return for a duly authorised petty cash voucher backed by a receipt from the third party. When the ‘float’ drops to a certain level, normally every few weeks, there needs to be a reimbursement from the bank to bring the balance of cash in the petty cash box back to the level of the ‘float’. The accounting treatment for petty cash is much the same as for overheads except that petty cash expenditure is recorded in the Petty Cash Book instead of the Cash Book. Example: There is a ‘float’ of £1,000. Petty cash expenditure of £700 is made over a period of three weeks after which there is a reimbursement from the bank to bring the float back to £1,000. The entries are recorded in three stages: i)

Starting with a float of £1,000 An entry is made on the credit side of the Cash Book and posted to the following accounts in the Nominal Ledger:

Dr £ 1,000

Petty Cash A/c Float

Cr | Dr £ | £ |

Bank A/c Petty Cash float

Cr £ 1,000

Chapter 9

88

ii)

£700 spent out of petty cash Entries are made in the Petty Cash Book and posted to the relevant Nominal Ledger accounts, say

Dr £ 250

Travel A/c

Cr | Dr £ | £ | 450

Petty Cash

Petty Cash A/c Dr | £ | 1,000 |

Float

Subsistence A/c

Cr £

Petty Cash

Payments

Cr £ 700

Note: In practice there would of course be many more expenditure accounts involved. It should also be noted that expenditure whether by petty cash or by cheque is posted to just the same account for that item of expenditure; so the Travel Account, for instance, would have on the debit side petty cash payments and/or payments by cheque.

iii)

Reimbursement of petty cash £700 is transferred from the bank to petty cash and an entry for £700 is made on the credit side of the Bank Account and the debit side of the Petty Cash Account, bringing the balance on the Petty Cash Account back up to £1,000: Petty Cash A/c Dr £

Float 1,000 Reimbursement 700 ____ 1,700 Balance b/d

1,000

| Cr | Dr £ | £ | Payments 700 | Balance c/d 1,000 | ____ | 1,700 | | |

Bank A/c Cr £ Petty Cash Float Petty Cash reimbursement

1,000 700 1,700

More Examples—Manual Accounting System

h)

89

Journal Entries As mentioned earlier, a Journal is used mainly to record (a) an accounting adjustment, such as an accrual, a prepayment or a charge for depreciation, and (b) a correction of an accounting error. Each Journal Entry is posted to the relevant Nominal Ledger Accounts which then form part of the Trial Balance and eventually the Profit and Loss Account and Balance Sheet.

Examples: a) An accrual for January of £500 is made for Rent. b) £300 was posted in error to the debit of the Travel Account instead of the Subsistence Account. Journal Dr £ 1.

2.

Rent A/c Accrual A/c (Rent accrued for the month of January)

Cr £

500 500

Subsistence A/c 300 Travel A/c 300 (Incorrect posting to Travel Account now transferred to Subsistence Account).

It is important to remember the ‘narrative’ or brief description at the end of every journal entry. We have now come to the end of this chapter in which we have seen, using examples, how a typical manual accounting system operates. In today’s world, however, most businesses use computerised systems, and in the next chapter the advantages of a computerised system will be highlighted and the basic method of operation reviewed. It should always be borne in mind that the rules of Double Entry apply just the same, regardless of the system in use.

CHAPTER 10 COMPUTERISED ACCOUNTING SYSTEMS

A

Introduction In the last chapter we saw, using examples, how a typical manual accounting system works on the basis of the various books of account and records maintained. We also saw how transactions pass through various stages and finally end up in the Profit and Loss Account and the Balance Sheet. In this chapter we will look at a simple but typical computerised accounting system. We will see that, in principle, transactions are dealt with in exactly the same way in a computerised system as in a manual system. However, a computerised system has some important advantages over a manual system, which are as follows: a)

No books of account are required in a computerised system and information for each transaction is entered or ‘keyed in’ only once into the system from the original document. The transaction details are then processed electronically through the system without any manual intervention right up to the Profit and Loss Account and the Balance Sheet. In a manual system there are several transfers, postings and manual calculations, all of which, of course, take a great deal more time and effort.

b)

A computerised system minimises the risk of human error because once information is entered accurately from the original document, it is processed automatically through the system. As a result, subsequent computer print-outs of the Nominal Ledger, the Purchase Ledger, the Sales Ledger, the Payroll, the Profit and Loss Account and the Balance Sheet, are all produced automatically and with total accuracy, with

Computerised Accounting Systems

91

the sole proviso that the information is entered accurately from the original document. c)

B

Once the data has been processed through the computer system, up-to-date information can be called up on the screen or can be printed out within seconds, whereas in a manual system information retrieval can be extremely timeconsuming.

Buying and ‘Setting Up’ a Computerised System Deciding upon the most appropriate accounting system for a particular business is not easy, and considerable time and care should be taken to ensure that the most suitable system is purchased. If one does not have much experience of computerbased systems it might well be advisable to employ an external computer consultant to help make the right choice. The consultancy cost entailed could well save a great deal of time and money in the long run. The two main decisions which need to be made concern a) the computer hardware and b) the accounting software. The Hardware The term hardware relates to that part of the computer system which is tangible and solid and comprises mainly:

-

-

the visual display unit (VDU): the screen which displays information on the screen.

-

the keyboard: like a typewriter keyboard, through which information (or data) is entered (or ‘input’ or ‘keyed in’).

-

the processor: the brain of the computer which does the calculations and stores in its memory the data entered. the printer: which prints out relevant information.

The type and model of hardware required depends upon the amount of information to be stored in memory, the speed and complexity of calculations required and compatibility (or the ability to act in coordination) with the software. It is always best to select reliable

Chapter 10

92

hardware manufactured by a reputable manufacturer even if it means paying rather more for it. The Accounting Software The term software relates to the intangible part of the system which drives the hardware or makes it go through the various routines and calculations that are required. The software is in the form of a specific program (note UK spelling) which is bought from the manufacturer of the software system and then installed in the hardware. An accountancy program or ‘package’ has built into it all the rules of double entry and the precise way in which the double entry system is required to produce the information eventually to be printed out or accessed by the user. It is possible that the original software purchased from the manufacturer, although it may be the best on the market, does not quite meet all the requirements of the user. In that case, it is normally possible, at a cost, to ‘modify’ the software to enable it to function in the required manner. Once the decision has been made about the most appropriate hardware and software system to be purchased, the next step is to start doing a considerable amount of preparatory or ‘set-up’ work. ‘Setting Up’ the System At the very outset, preparatory work or systems set-up needs to be done by the user mainly in the following respects. a)

Setting up Account numbers. It is much easier and saves much time for both the user and for the software programmer to have a system of numbers or ‘codes’ for: -

Nominal Ledger Accounts (for rent, rates etc.) Purchase Ledger Accounts (for each supplier) Sales Ledger Accounts (for each customer) Employees (for each member of staff)

Computerised Accounting Systems

93

Nowadays, most accounting packages come with a standard chart of Accounts which can be adapted to suit the needs of the business. Furthermore, where goods are taken into stock or information is required about various categories of goods bought and sold, stock numbers are given to each category. There may likewise be a need for asset numbers and department numbers where information is required about each type of asset or department or division in the business. Having bought the hardware system and the software package, code numbers together with corresponding details (e.g. 110 = Rent etc) are entered into the system. Subsequently, transaction details are entered by keying in the code numbers which represent for instance, a type of product, a type of expense, a supplier’s details, a customer’s details or an employee’s details. The details for a supplier, a customer or an employee would include name and address and any other information required to be stored in the computer and viewed on the screen or printed out later. b)

Designing documentation, for instance sales invoices. Most accounting software allows flexibility in designing documentation to suit the needs of a business. A specific ‘menu’ or section of the software program allows for the sales invoice format, for instance, to be laid out in a specific manner so that information is printed on the invoice in the correct locations.

Testing the System Once the system has been set up, it is imperative that it should be tested thoroughly by using a simple, fictitious example of the kinds of transactions that would occur in the business. System testing has two major advantages: a)

It verifies that the software system works properly and meets the accounting needs of the business. It is at this stage that all problems should be sorted out by the dealer, and any changes

Chapter 10

94

or modifications to the software package carried out as necessary. b)

C

It is a very good way to learn how the system works. One can also iron out any problems in advance of the system going ‘live’, which means the system starting to be used to process the actual transactions of the business. (A ‘dummy run’ on the other hand, is one where actual or fictitious data is used for testing purposes prior to the system going ‘live’.)

Outline of Computerised Procedures Let us now examine the procedures that would typically be carried out in a computer-based system. For simplicity, it is assumed that goods purchased are sold immediately, and there is therefore no need for stock records. a)

Credit Purchases i) Data Preparation Purchase Invoices received | Batched (i.e. bundled together – say 25 invoices per batch) | The following main details entered on Batch Sheets: | - Date - Purchase Invoice No. - Supplier’s A/c No. - Nominal Ledger A/c No. - Brief description or narrative - Amount (excl. VAT) - VAT amount (or VAT code) - Amount (incl. VAT – this may be calculated automatically) | Amounts on batch sheets totalled manually (using a calculator)

Computerised Accounting Systems

95

It should be noted that if goods go into stock before being sold, further details including stock number and quantity will need to be entered. ii) Data Input (via Keyboard) Batch Sheet details keyed in | Computer print-out for each batch sheet produced after details keyed in | Print-out totals checked against manual batch sheet totals to ensure accuracy of input Note: After each day’s data entry, (sometimes more frequently), the information keyed in should be ‘backed up’ or ‘saved’ onto disks, which should be stored in a secure place such as a fireproof safe. Information back-up should always be done regularly so that if there is a computer break-down, owing to power failure for instance, the data can always be subsequently ‘restored’ from the back-up disk.

iii) Data Output We have seen under ‘Data Input’ the importance of checking computer print-out totals against manually totalled batch sheets, to ensure that ‘Data Output’ is entirely accurate. The power of a computer is fully demonstrated at the ‘Data Output’ stage where information keyed in is automatically and instantaneously processed, and then by means of a few key strokes either called up on screen, or printed out on the following reports (relating to ‘Purchases’ in this instance): -

Various Cost Accounts and Total Creditors Account in the Nominal Ledger Suppliers Accounts in the Purchase Ledger Trial Balance Profit and Loss Account Balance Sheet

Chapter 10

96

It should be noted that the Accounts in the Nominal Ledger will give brief details entered from each purchase invoice. Therefore, there is often no need to go back to the original invoice when details of the expense are required. b)

Credit Sales

The procedures for Data Preparation and Data Input of Credit Sales are much the same as for Credit Purchases, except that there will be no sales invoice number until the sales invoice is produced. Sales invoices can be manually or computer produced. Where they are computer produced, the prices, product codes and VAT codes are keyed in at the initial ‘set up’ stage as permanent data to be altered only as and when required. Hence, only quantities are entered as variable data and multiplied automatically by ‘built in’ prices to arrive at amounts chargeable. Also, there are different VAT codes to signify whether the items are chargeable for VAT or zero-rated or exempt etc; VAT is automatically calculated (where applicable) by the computer system and added to the amount excluding VAT, to arrive at the amount including VAT. c)

Cash Purchases

The procedures are the same as for Credit Purchases, except that no supplier details are entered on batch sheets. Consequently, the Bank Account instead of the Purchase Ledger is affected. d)

Cash Sales

The procedures are the same as for Credit Sales, except that no customer details are entered on batch sheets. Consequently, the Bank Account instead of the Sales Ledger is affected. e)

Purchase Ledger Payments

Once the procedures relating to Credit Purchases have been completed, the following procedures should be followed for payment of part or all of the balance outstanding to suppliers.

Computerised Accounting Systems

i)

97

Data Input Print out of Purchase Ledger balances | Balance outstanding (or a lower amount in case of a dispute) together with Supplier’s A/c No. keyed in | Print-out of payments checked against: a) Print-out of Purchase Ledger balances b) Total of cheques produced

Note: There is no ‘Data Preparation’ since the starting point is the Purchase Ledger balances print-out that is already available following entry of purchase invoice details. ii) Data Output The records automatically updated by the computer system are: - Bank Account and Total Creditors Account in the Nominal Ledger - Suppliers’ Accounts in the Purchase Ledger - Trial Balance - Balance Sheet (The Profit and Loss Account is not affected by Purchase Ledger payments). f)

Sales Ledger Receipts i)

Data Preparation

Cheques (and cash) received | Batched | Amount received and Customer’s A/c No. entered on Batch Sheets | Amounts on Batch Sheets manually totalled

Chapter 10

98

ii) Data Input Batch Sheets details keyed in | Print-out produced for each batch sheet after details keyed in | Print-out totals checked against batch sheet totals iii) Data Output The records automatically updated by the computer system are: - Bank Account and Total Debtors Account in the Nominal Ledger - Customers’ Accounts in the Sales Ledger - Trial Balance - Balance Sheet (As in the case of Purchase Ledger payments, the Profit and Loss Account is not affected). g)

Petty Cash

Payment of petty cash expenditure is processed in the same way as payments for goods purchased or for overheads except that the starting point is petty cash vouchers instead of invoices for purchases or overheads. h)

Payroll Expenditure

The following are the main points to be borne in mind in relation to a computerised payroll system: i)

Setting Up the System Earlier in this chapter we saw how a computerised accounting system needs to be ‘set up’ at the outset. A payroll system needs to be set up similarly whereby information to be stored permanently is keyed in initially (and altered only when required), as follows:

Computerised Accounting Systems

99

ii) Company or Business Information - Name and Address - Bank Details - Department Names, each given a code number - Pension contribution (%) - employers and employees iii) Governmental Information - the prevailing PAYE bands and rates - the prevailing NI bands and rates iv) Employee Information Standard - Name and Address - Date of Birth - Male or Female - Date joined - PAYE Code - NI Code and Number (* see note below) - Bank details - Basic salary - Overtime and Shift Pay rates Variable - Overtime and Shift hours - Backlog pay - Sick pay - Maternity Leave pay - Holiday pay in advance - Bonus payment - Deductions, including: - Loan repayment - Medical insurance - Donations/covenants etc. * The NI (National Insurance) code signifies among other things, whether the employee is ‘Contracted In’ or ‘Contracted Out’ of the State pension scheme. Where any of the employees are ‘Contracted In’ it means that they do not belong to the company or an externally approved

100

Chapter 10

Pension Scheme and must therefore contribute more in National Insurance so that they receive a Basic plus an Additional Pension from the State on their retirement. If they are ‘Contracted Out’, (i.e. they contribute to the Company or an approved Pension Scheme) they then make a lower National Insurance contribution and receive the company pension plus only the Basic State pension on their retirement. The two main advantages of an automated payroll system are: - All permanent information is keyed in only once until it is required to be updated. For instance, the basic salary is the same each month until the next salary review, and does not therefore have to be entered repeatedly each month. - Calculations of PAYE, NI and company Pension deductions are carried out automatically by the payroll program. These calculations are always correct, whereas in a manual system errors are likely to occur from time to time. However, an internal control system is needed to ensure that both permanent and variable data keyed in are correct and properly authorised. At the end of each payroll period (normally a month), the following information is printed out: - Details of Gross Pay, Employer’s contributions, Deductions (analysed separately) and Net Pay - for the month and the tax year to date. (The tax year starts on 6th April). - Payslips in duplicate for each employee showing Gross Pay, Deductions (in detail) and Net Pay. The top copy of the payslip is handed to the employee and the bottom copy retained by the Accounts Department. - Cheques to be handed to each employee, or a schedule showing net pay for each employee to be sent or electronically transferred to the company’s bank which

Computerised Accounting Systems

101

will arrange transfers of net pay directly to each employee’s own bank account. The practice of paying wages in cash is now uncommon. At the end of the tax or fiscal year, payroll information for that year needs to be sent to HMRC with respect to PAYE and National Insurance to enable them to check that those deductions have been correctly made. The information is sent on pre-printed forms (P35s and P60s). i)

Journal Entries

Finally, there will almost always be a need for a Journal Entry: a) b)

to correct items which have been wrongly recorded or posted; to raise accruals or prepayments.

These days it is more common to pass Journal Entries on loose leaf Journal Vouchers rather than in a bound Journal. The Journal Entries are keyed in at least once a month to the Nominal Ledger and, where relevant, to the Purchase or Sales Ledgers. Now that we have seen how a computerised accounting system functions in practice, we are ready to tackle in the next chapter a comprehensive example based on a ‘real life’ situation.

CHAPTER 11 COMPREHENSIVE EXAMPLE— COMPUTERISED ACCOUNTING SYSTEM

N Hutchinson runs a business buying and selling sports equipment. His accounting system is computerised, and on 1/1/2014 the Balance Sheet was as follows: | |

Assets Fixed Assets – nbv* Leasehold premises Furniture & Fittings Office Equipment Car

Current assets Balance at bank Petty Cash Debtors

£ £ 50,000.00 10,000.00 15,000.00 5,000.00 80,000.00

| | | | | | | | | 75,000.00 | 200.00 | 12,500.00 87,700.00 | _________ | 167,700.00 |

Capital and Liabilities Long-term creditors Bank Loan Current Liabilities Creditors Accruals Provisions

£

£ 20,000.00

12,000.00 200.00 500.00 12,700.00

Capital & Reserves Capital 50,000.00 Reserves 85,000.00 135,000.00 _________ 167,700.00

* nbv = net book value.

Transactions during January The following transactions and data for January are designed as far as possible to reflect the variety and complexities of a ‘real life’ situation, although the actual number of transactions is, of course, much lower than would be encountered in practice. Each group of transactions is batched and keyed in. This is followed immediately by the ‘output’ in the form of print-outs. At the end of the

Comprehensive Example—Computerised Accounting System

103

month, the Trial Balance, Profit and Loss Account, and Balance Sheet are produced.

A

Goods Purchased on Credit Taken into Stock, and some items Returned a) Batched and Keyed in: Purchase Invoice Details Supplier’s Stock Number Number Quantity 017 082 029 045 073 121 009 058 113 037

2 147 17 84 61 176 39 114 197 8

Cost £ 15,000.00 7,000.00 4,500.00 5,000.00 4,000.00 6,000.00 7,500.00 4,500.00 6,000.00 12,500.00 72,000.00

150 1,000 300 500 200 1,500 300 450 1200 100

VAT Total (17.5%) £ £ 2,625.00 17,625.00 1,225.00 8,225.00 787.50 5,287.50 875.00 5,875.00 700.00 4,700.00 1,050.00 7,050.00 1,312.50 8,812.50 787.50 5,287.50 1,050.00 7,050.00 2,187.50 14,687.50 12,600.00 84,600.00

Credit Note Details (goods returned) 082 121

147 176

800 500

5,600.00 2,000.00 7,600.00

980.00 350.00 1,330.00

6,580.00 2,350.00 8,930.00

b) Computer Print-outs (Output Reports) i) Stock Number 2 147 17 84 61 176 39 114 197 8

Stock Report – Showing Movements Movements in January Balance in hand In Out Quantity Cost (Excl VAT) £ 150 1,000 300 500 200 1,500 300 450 1,200 100

800

500

150 200 300 500 200 1,000 300 450 1,200 100

15,000.00 1,400.00 4,500.00 5,000.00 4,000.00 4,000.00 7,500.00 4,500.00 6,000.00 12,500.00 64,400.00

Chapter 11

104

ii)

Nominal Ledger Accounts Affected (Nominal ledger code shown in brackets)

Stock A/c (1020) | VAT A/c (1030) | Total Creditors A/c (1015) Details Dr Cr | Details Dr Cr | Details Dr Cr £ £ | £ £ | £ £ Purchases 72,000.00 |Purchases 12,600.00 |Opening bal 12,000.00 Returns 7,600.00|Returns 1,330.00|Purchases 84,600.00 Bal c/d 64,400.00|Bal c/d 11,270.00|Returns 8,930.00 | |Bal c/d 87,670.00 _______ ________| ________ ________| ________ ________ 96,600.00 96,600.00 72,000.00 72,000.00| 12,600.00 12,600.00| | | Bal b/d 64,400.00 |Bal b/d 11,270.00 |Bal b/d 87,670.00

iii) A/c No. 017 Dr £ Purchases Bal c/d 17,625.00 ________ 17,625.00 Details

Bal b/d A/c No. 045 Dr £ Purchases Bal c/d 5,875.00 _______ 5,875.00 Details

Bal b/d A/c No. 009 Dr £ Purchases Bal c/d 8,812.50 _______ 8,812.50 Details

Bal b/d

Purchase Ledger Accounts Affected

| A/c No 082 Cr | Details Dr £ | £ 17,625.00|Purchases |Returns 6,580.00 ________|Bal c/d 1,645.00 17,625.00| 8,225.00 | 17,625.00 |Bal b/d | | A/c No 073 Cr | Details Dr £ | £ 5,875.00|Purchases |Bal c/d 4,700.00 _______| _______ 5,875.00| 4,700.00 | 5,875.00|Bal b/d | | A/c No 058 Cr | Details Dr £ | £ 8,812.50|Purchases |Bal c/d 5,287.50 _______| _______ 8,812.50| 5,287.50 | 8,812.50|Bal b/d

| A/c No 029 Cr | Details Dr Cr £ | £ £ 8,225.00|Purchases 5,287.50 |Bal c/d 5,287.50 _______| _______ _______ 8,225.00| 5,287.50 5,287.50 | 1,645.00|Bal b/d 5,287.50 | | A/c No 121 Cr | Details Dr Cr £ | £ £ 4,700.00|Purchases 7,050.00 |Returns 2,350.00 _______|Bal c/d 4,700.00 _______ 4,700.00| 7,050.00 7,050.00 | 4,700.00|Bal b/d 4,700.00 | | A/c No 113 Cr | Details Dr Cr £ | £ £ 5,287.50|Purchases 7,050.00 |Bal c/d 7,050.00 _______| _______ _______ 5,287.50| 7,050.00 7,050.00 | 5,287.50|Bal b/d 7,050.00

Comprehensive Example—Computerised Accounting System

Details

A/c No 037 Dr £

Purchases Bal c/d 14,687.50 ________ 14,687.50 Bal b/d

105

Cr £ 14,687.50 ________ 14,687.50 14,687.50

Note: 1. In order to save space the following information normally shown on print-outs has been omitted: - dates - stock description and supplier names 2. To conform with normal practice in computerised systems, the print-out heading “Details Dr Cr” will be shown in future, rather than the ‘T’ account format used in many manual systems. 3. As discussed earlier, after keying in details of invoices shown on each batch sheet, print-out totals must be checked against batch sheet totals. 4. The up-to-date ‘real-time’ position on the Stock report, the Nominal Ledger reports and the Purchase Ledger reports, can be displayed on the Visual Display Unit (VDU) screen or printed out whenever it is required.

B

Overhead Expenditure (On Credit) a) Batched and Keyed in: Purchase invoice details

Supplier’s Number

Expense

020 035 090 016 077 005 003 010

Stationery Postage Travel Petrol Cleaning Electricity Telephone *Rent

Nominal Ledger No. or Code 0500 0510 0520 0550 0535 0570 1010 1050

Description

Cost VAT £ £ 600 envelopes 80.00 14.00 Franking machine 70.00 12.25 Mini cab account 40.00 7.00 Re: January 50.00 8.75 Floors/windows 30.00 5.25 Re: January 150.00 26.25 Re: Oct-Dec ’09 200.00 35.00 Re: Jan-Mar ’10 500.00 _______ _____ 1,120.00 108.50

Total £ 94.00 82.25 47.00 58.75 35.25 176.25 235.00 500.00 _______ 1,228.50

(*No VAT is payable on rent.)

Note: 1. Since the £200 telephone bill relates to the previous quarter, it is posted to the debit of Accruals account (thereby cancelling the opening credit balance on the Accruals account), and to the credit of the Creditors account as part of the

Chapter 11

106

£1,228.50 total posted. What was first an accrual has, since the receipt of the £200 invoice, become a creditor which will subsequently be cleared when the payment is made. Note that the Telephone account itself is not affected by this payment since we are preparing accounts for January 2014, whilst the £200 invoice refers to October-December 2013. 2. On receipt of the £500 rent invoice, it is posted to the debit of Prepayments account (since the invoice is received in advance) and to the credit of Creditors account as part of the £1,228.50 total posted. The prepayments account is extinguished over 3 months by crediting it with £166.67 (£166.66 in one of the three months) each month from January to March, and debiting Rent account with the same amount in each of those months. The creditor for £500 will subsequently be cleared when the bill is paid. The Rent account is debited with £166.67 in January by way of a Journal Entry shown later in this example.

b) Computer Print-outs i)

Nominal Ledger Accounts Affected

Stationery A/c (0500) Details Dr Cr £ £ 600 envelopes 80.00 Charged to P&L A/c 80.00 ____ ____ 80.00 80.00 Petrol A/c (0550) Dr Cr £ £ Re: January 50.00 Charged to P&L A/c 50.00 ____ ____ 50.00 50.00 Details

Accruals A/c (1010) Details Dr Cr £ £ Opening balance 200.00 Telephone 200.00

| Postage A/c (0510) | Details Dr Cr | £ £ |Franking m/c 70.00 |Charged to P&L A/c 70.00 | ____ ____ | 70.00 70.00 | | Office Cleaning (0535) | Details Dr Cr | £ £ |Floors/windows 30.00 |Charged to P&L A/c 30.00 | ____ ____ | 30.00 30.00 | | Prepayments A/c (1050) | Details Dr Cr | £ £ |Rent (quarter) 500.00 |Bal c/d 500.00 |

| _____ _____ | 200.00 200.00 | | |Bal b/d

| Travel A/c (0520) | Details Dr Cr | £ £ |Mini cab a/c 40.00 |Charged to P&L A/c 40.00 | ____ ____ | 40.00 40.00 | | Electricity A/c (0570) | Details Dr Cr | £ £ |Re: January 150.00 |Charged to P&L A/c 150.00 | _____ _____ | 150.00 150.00 | | VAT A/c (1030) | Details Dr Cr | £ £ |Purchases 12,600.00 |Returns 1,330.00 |Overheads 108.50 |Bal c/d 11,378.50 _____ _____ | _______ ________ 500.00 500.00 | 12,708.50 12,708.50 | 500.00 |Bal b/d 11,378.50

Comprehensive Example—Computerised Accounting System Total Creditors A/c (1015) Dr £ Opening balance Purchases (stock) Returns 8,930.00 Purchases (Overheads) Bal c/d 88,898.50 _______ 97,828.50

________ 97,828.50

Bal b/d

88,898.50

Details

ii) Details

A/c 020 Dr £

A/c 016 Dr £

Purchases

Details Purchases

Cr £ 12,000.00 84,600.00 1,228.50

Purchase Ledger Accounts Affected

Purchases

Details

107

A/c 003 Dr £

| Cr | Details £ | 94.00 |Purchases | | Cr | Details £ | 58.75 |Purchases | | Cr | Details £ | 235.00 |Purchases

A/c 035 Dr £

A/c 077 Dr £

A/c 010 Dr £

| Cr | Details £ | 82.25 |Purchases | | Cr | Details £ | 35.25 |Purchases | | Cr | £ | 500.00 |

A/c 090 Dr £

A/c 005 Dr £

Cr £ 47.00

Cr £ 176.25

Note: In practice, a short description of items shown on each invoice is keyed in. As a result, brief details of any invoice appearing on the relevant Nominal Ledger account can be displayed on the screen or printed out at any time. This often saves considerable time and trouble not having to look up the original invoices for detailed information.

Chapter 11

108

Let us now start with the opening Trial Balance and then add on the entries recorded so far in January to arrive at an up-to-date Trial Balance. Opening Trial Balance | January entries | | (so far) | Dr Cr | Dr Cr | £ £ | £ £ | | | Leasehold premises 50,000.00 | | Furniture & Fittings 10,000.00 | | Equipment 15,000.00 | | Car 5,000.00 | | Debtors 12,500.00 | | Prepayments | 500.00 | Balance at bank 75,000.00 | | Petty cash 200.00 | | Bank loan 20,000.00 | | Creditors 12,000.00 | 76,898.50 | Accruals 200.00 | 200.00 | Provisions 500.00 | | Capital 50,000.00 | | Reserves 85,000.00 | | Stock |64,400.00 | VAT |11,378.50 | Stationery | 80.00 | Postage | 70.00 | Travel | 40.00 | Petrol | 50.00 | Office cleaning | 30.00 | Electricity | 150.00 | _________ _________ |________ _______ | 167,700.00 167,700.00 |76,898.50 76,898.50 |

C

Current Trial Balance Dr £

Cr £

50,000.00 10,000.00 15,000.00 5,000.00 12,500.00 500.00 75,000.00 200.00 20,000.00 88,898.50 500.00 50,000.00 85,000.00 64,400.00 11,378.50 80.00 70.00 40.00 50.00 30.00 150.00 _________ _________ 244,398.50 244,398.50

Sales (On Credit) a) Batched and Keyed in: Sales details

Customer’s Number 210 233 305 274 202 293 320

Stock Number 147 176 17 114 8 61 2

Quantity 200 800 200 300 75 150 100

Sales Value £ 1,600.00 4,000.00 4,000.00 3,600.00 11,250.00 3,750.00 12,000.00 ________ 40,200.00

VAT £ 280.00 700.00 700.00 630.00 1,968.75 656.25 2,100.00 _______ 7,035.00

Total £ 1,880.00 4,700.00 4,700.00 4,230.00 13,218.75 4,406.25 14,100.00 ________ 47,235.00

Comprehensive Example—Computerised Accounting System

109

Note: Most accounting systems are capable of producing sales invoices automatically. The information that has to be ‘programmed’ or keyed in at the outset is: - the sales invoice format - the sales price of each stock item - the capability of multiplying the sales price by the quantity to arrive at the sales value - a totalling capability where there is more than one stock item per invoice - the VAT rate and its application, so that the correct VAT amount and invoice total are calculated.

b) Computer Print-outs i)

Stock Report - Items Affected

Stock | Number | | | 2 | 147 | 17 | 84 | 61 | 176 | 39 | 114 | 197 | 8 |

Movements in January | Balance in hand In | Out | Quantity Cost | Quantity Cost | Quantity ** Cost £ | £ | £ 150 15,000.00 | 100 10,000.00 | 50 5,000.00 1,000 7,000.00 | *1,000 7,000.00 | 300 4,500.00 | 200 3,000.00 | 100 1,500.00 500 5,000.00 | - | 500 5,000.00 200 4,000.00 | 150 3,000.00 | 50 1,000.00 1,500 6,000.00 | *1,300 5,200.00 | 200 800.00 300 7,500.00 | - | 300 7,500.00 450 4,500.00 | 300 3,000.00 | 150 1,500.00 1,200 6,000.00 | - | 1,200 6,000.00 100 12,500.00 | 75 9,375.00 | 25 3,125.00 72,000.00 | 40,575.00 | 31,425.00 * (includes returns); ** (excluding VAT)

ii)

Nominal Ledger Accounts Affected

Stock A/c (1020) | Details Dr Cr | £ £ | Purchases 72,000.00 | Returns 7,600.00| Sales (at cost) 32,975.00| Bal c/d 31,425.00| ________ _______| 72,000.00 72,000.00| Bal b/d

31,425.00

Sales A/c No (0200) | Details Dr Cr | £ £ | Re: Jan 40,200.00| Credited to | P&L A/c 40,200.00 | | _______ _______ | 40,200.00 40,200.00|

Cost of Sales A/c (0300) Details Dr Cr £ £ Re: Jan 32,975.00 Charged to P&L A/c 32,975.00 ________ ________ 32,975.00 32,975.00

Chapter 11

110

Details Purchases Returns Overheads Sales Bal c/d

VAT A/c (1030) Dr Cr £ £ 12,600.00 1,330.00 108.50 7,035.00 4,343.50 ________ ________ 12,708.50 12,708.50

Bal b/d

4,343.50

| Debtors A/c (1100) |Details Dr Cr | £ £ | Opening bal. 12,500.00 | Sales 47,235.00 | Bal c/d 59,735.00 | | | ________ ________ | 59,735.00 59,735.00 | | Bal b/d 59,735.00

Note: 1. The ‘gross profit’, or the difference between total sales and cost of sales is £7,225 as follows: £ Sales 40,200 Cost of sales 32,975 (See note 3 below) Gross Profit

7,225

2. The Nominal Ledger entries in respect of the sales transactions are based on the following two journal entries:

a)

b)

Cost of Sales account Stock account Debtors account Sales account VAT account

Dr £ 32,975

Cr £ 32,975

47,235 40,200 7,035

3. The £7,225 gross profit, analysed by stock item, is arrived at as follows: Stock 147 176 17 114 8 61 2

Quantity 200 800 200 300 75 150 100

Sales £ 1,600 4,000 4,000 3,600 11,250 3,750 12,000 40,200

Cost of sales £ 1,400 3,200 3,000 3,000 9,375 3,000 10,000 32,975

Gross profit £ 200 800 1,000 600 1,875 750 2,000 7,225

Comprehensive Example—Computerised Accounting System

iii)

Sales Ledger Accounts Affected

A/c 210 Dr £ 1,880.00

Details Sales

A/c 274 Dr £ 4,230.00

Details Sales

A/c 320 Dr £ 14,100.00

Details Sales

111

| Cr | £ | | | | | Cr | £ | | | | | Cr | £ | |

Details Sales

Details Sales

A/c 233 Dr £ 4,700.00

| Cr | £ | | | | A/c 202 | Dr Cr | £ £ | 13,218.75 | | | | | | |

A/c 305 Dr £ 4,700.00

Details Sales

A/c 293 Details Sales Purchases

Dr £ 4,406.25

So far, all purchases and sales during January have been on credit. The next two sections deal with: - payments to creditors - receipts from debtors. D

Cr £

Payments to Creditors a) Amount Paid Keyed in

Supplier Number

Balance Owing

Amount Paid

Various (outstanding at 31.12.13) 017 082 029 045 073 037 020 090

£ 12,000.00 17,625.00 1,645.00 5,287.50 5,875.00 4,700.00 14,687.50 94.00 47.00

£ 9,500.00 17,625.00 1,645.00 5,287.50 5,875.00 4,700.00 14,687.50 94.00 47.00 ________ 59,461.00

Cr £

Chapter 11

112

Note: 1. The creditors outstanding at 31.12.13 have not been listed separately, though in practice they would be. 2. The above payments would be made on the basis of a print-out of amounts outstanding to date, and payments would be made to each supplier depending upon the period of credit allowed. Hence, all the creditors would not be paid immediately. ‘Period of Credit’ is the period between the date of invoice and the date by which payment must be made.

b)

Computer Print-outs i)

Nominal Ledger Accounts Affected

Creditors A/c (1015) Dr £ Opening balance Purchases (stock) Returns 8,930.00 Purchases (overheads) Payments 59,461.00 Bal c/d 29,437.50 ________ 97,828.50 Details

Bal b/d

| Cr | £ | 12,000.00 | 84,600.00 | | 1,228.50 | | | ________ | 97,828.50 | | 29,437.50 |

Bank A/c (1150) Dr £ Opening balance 75,000.00 Payments Bal c/d

Details

________ 75,000.00 Bal b/d

Cr £ 59,461.00 15,539.00

________ 75,000.00

15,539.00

Note: Since creditors are owed the full amount of their invoices, including VAT, payments are made inclusive of VAT. The Creditors account is debited with the full amount paid, including VAT, and the Bank account credited with the same amount. The VAT account is not affected until settlement is made with HMRC. The same principle applies to receipts from debtors.

ii)

Details

Purchase Ledger Accounts Affected

A/c 017 Dr £

Purchases Payment 17,625.00 ________ 17,625.00

| Cr | £ | 17,625.00 | | | ________ | 17,625.00 |

Details

A/c 082 Dr £

Purchases Returns 6,580.00 Payment 1,645.00 _______ 8,225.00

| A/c 029 Cr | Details Dr Cr £ | £ £ 8,225.00 |Purchases 5,287.50 |Payment 5,287.50 | _______ | _______ _______ 8,225.00 | 5,287.50 5,287.50

Comprehensive Example—Computerised Accounting System A/c 045 Dr £

Details Purchases Payment

5,875.00 _______ 5,875.00 A/c 020 Dr £

Details Purchases Payment

94.00 ____ 94.00

E

| Cr | Details £ | 5,875.00|Purchases |Payment _______| 5,875.00| | | Cr | Details £ | 94.00|Purchases |Payment | ____| 94.00| | |

A/c 073 Dr £ 4,700.00 _______ 4,700.00 A/c 090 Dr £ 47.00 ____ 47.00

113

| A/c 037 Cr | Details Dr £ | £ 4,700.00|Purchases |Payment 14,687.50 _______| ________ 4,700.00| 14,687.50 | | Various Cr | Details Dr £ | £ 47.00|Opening bal |Payment 9,500.00 |Bal c/d 2,500.00 ____ | ________ 47.00| 12,000.00 | |Bal b/d

Cr £ 14,687.50 ________ 14,687.50

Cr £ 12,000.00

________ 12,000.00 2,500.00

Receipts from Debtors a) Amount Received, Batched, and Keyed in On receipt of cheques from certain of the debtors during January, they are batched and keyed in as follows: Customer Number Various (outstanding at 31.12.13) 233 305 320

Amount Received (£) 10,000.00 4,700.00 4,700.00 14,100.00 33,500.00

b) Computer Print-outs (i)

Nominal Ledger Accounts Affected

Debtors A/c (1100) Dr £ Opening balance 12,500.00 Sales 47,235.00 Receipts Bal c/d ________ 59,735.00

Details

Bal b/d

26,235.00

| Bank A/c (1150) | Details Dr | £ |Opening balance 75,000.00 |Payments 33,500.00 |Receipts 33,500.00 26,235.00 |Bal c/d ________ | _________ 59,735.00| 108,500.00 Cr £

Bal b/d

49,039.00

Cr £ 59,461.00 49,039.00 _________ 108,500.00

Chapter 11

114

(ii)

Sales Ledger Accounts Affected A/c 233 Dr £ 4,700.00

Details Sales Receipt

_______ 4,700.00 A/c 320 Dr £ 14,100.00

Details Sales Receipts

_______ 14,100.00

F

| | Details | |Sales 4,700.00 |Receipt _______ | 4,700.00 | | | Cr | Details £ | |Opening bal 14,100.00 |Receipts |Bal c/d ________ | 14,100.00 | | |Bal b/d Cr £

A/c 305 Dr £ 4,700.00 _______ 4,700.00 Various Dr £ 12,500.00

________ 12,500.00

Cr £ 4,700.00 _______ 4,700.00

Cr £ 10,000.00 2,500.00 ________ 12,500.00

2,500.00

Capital Expenditure (On Credit) a) Batched and Keyed in Invoice Details

Supplier’s Capital Number Expenditure 150 183

Office Equipment Furniture

Nominal Ledger Code Description 1200 1210

Cost VAT Total £ £ £ PCs etc 6,000.00 1,050.00 7,050.00 Desk & chairs 800.00 140.00 940.00 _______ ______ _______ 6,800.00 1,190.00 7,990.00

b) Computer Prints-outs i)

Nominal Ledger Accounts Affected

Office Equipment A/c (1200) | Furniture A/c (1210) Dr Cr |Details Dr £ £ | £ Opening balance 15,000.00 |Opening balance 10,000.00 PCs etc 6,000.00 |Desk & chairs 800.00 Bal c/d 21,000.00 |Bal c/d ________ ________ | ________ 21,000.00 21,000.00 | 10,800.00 | Bal b/d 21,000.00 |Bal b/d 10,800.00 Details

Cr £

10,800.00 ________ 10,800.00

Comprehensive Example—Computerised Accounting System VAT A/c (1030) Dr £ Purchases (stock) 12,600.00 Returns Purchases (overheads) 108.50 Sales Purchases (cap. exp.) 1,190.00 Bal c/d

Details

_______ 13,898.50 Bal b/d

5,533.50

ii)

Purchases Bal c/d

7,050.00 _______ 7,050.00

Bal b/d

G

Cr £ 12,000.00 84,600.00 1,228.50 7,990.00 _________ 105,818.50 37,427.50

Purchase Ledger Accounts Affected A/c 150 Dr £

Details

| Creditors A/c (1015) |Details Dr | £ |Opening balance 1,330.00|Purchases (stock) |Returns 8,930.00 7,035.00|Purchases (overheads) |Payment 59,461.00 5,533.50|Purchases (cap. exp.) | Bal c/d 37,427.50 ________| _________ 13,898.50| 105,818.50 | |Bal b/d Cr £

115

| Cr |Details £ | 7,050.00|Purchases |Bal c/d _______| 7,050.00| | 7,050.00|Bal b/d

A/c 183 Dr £

Cr £ 940.00

940.00 _____ 940.00

_____ 940.00 940.00

Petty cash a) Batched and Keyed in

Voucher Expense Number 75 76 77 78 79 80 81 82 83

Nominal Ledger Description Code

Stationery 0500 Cash book Stationery 0500 Box of pencils Postage 0510 20 stamps Travel 0520 Taxi fare Postage 0510 5 stamps Stationery 0500 20 pads Travel 0520 Taxi fare Travel 0520 Taxi fare Stationery* 0500 150 envelopes (* Mis-posted to Postage account)

Cost £ 20.00 2.00 4.00 5.00 1.00 2.00 7.00 4.00 16.00 ____ 61.00

VAT £ 3.50 0.35 0.35 2.80 ___ 7.00

Total £ 23.50 2.35 4.00 5.00 1.00 2.35 7.00 4.00 18.80 ____ 68.00

Note: There are certain items, as seen above, on which VAT is not charged under current legislation.

Chapter 11

116

b) Nominal Ledger Accounts Affected Stationery A/c (0500) | Postage A/c No (0510) | Travel A/c (0520) Details Dr Cr |Details Dr Cr |Details Dr £ £ | £ £ | £ 600 envelopes 80.00 |Franking M/c 70.00 |Mini cab a/c 40.00 Cash book 20.00 |20 stamps 4.00 |Taxi fare 5.00 Box of pencils 2.00 |5 stamps 1.00 |Taxi fare 7.00 20 pads 2.00 |150 envelopes 16.00 |Taxi fare 4.00 Charged to P&L A/c 104.00 |Charged to P&L A/c 91.00|Charged to P&L A/c _____ _____ | _____ ____| ____ 104.00 104.00 | 91.00 91.00| 56.00 VAT A/c (1030) | Petty cash A/c (1300) Dr Cr |Details Dr £ £ | £ Purchase (Stock) 12,600.00 |Opening balance 200.00 Returns 1,330.00|Purchase Purchase (Overheads) 108.50 |Bal c/d Sales 7,035.00| Purchase (cap. expend.) 1,190.00 | Purchase (petty cash) 7.00 | Bal c/d 5,540.50| | _____ 13,905.50 13,905.50| 200.00 | Bal b/d 5,540.50 |Bal b/d 132.00 Details

Cr £ 68.00 132.00

_____ 200.00

Note: We have already seen in Chapter 9 that petty cash procedures are normally based on an ‘imprest’ system.

H

Payment of VAT VAT is either paid over or received from HMRC (Her Majesty’s Revenue & Customs) depending upon the circumstances. We have seen that VAT is charged on invoices received from suppliers and is charged by the business on invoices sent to customers. Where the total VAT on suppliers’ invoices (‘input’ VAT) is in excess of the total VAT on invoices despatched to customers (‘output’ VAT), the difference is recovered from HMRC; and vice versa. Thus, the business neither gains nor loses on account of VAT charged by suppliers or charged to customers. In our example, there is a debit balance of £5,540.50 which means that Customs & Excise is a debtor for that amount. On receipt of the £5,540.50 from HMRC, the VAT account would show a nil balance as follows:-

Cr £

56.00 ____ 56.00

Comprehensive Example—Computerised Accounting System

117

VAT A/c (1030) Details Purchases (stock) Returns Purchases (overheads) Sales Purchases (capital expenditure) Purchases (petty cash) Bank receipt

Dr £ 12,600.00

Cr £ 1,330.00

108.50 7,035.00 1,190.00 7.00 5,540.50 ________ 13,905.50

________ 13,905.50

It should be noted that VAT is settled periodically with HMRC, following the completion and submission to them of a simple form giving brief details of input and output VAT and the balance payable or recoverable. Settlement is normally made each quarter. I

Payroll (computerised) a) Information Previously Entered Basic Monthly Salary (£) Mr. Hutchinson Secretary

4,000.00 2,400.00 6,400.00

b) Information Entered in January Overtime (£) Secretary

200.00

c) Computer Print-outs i)

Payroll Analysis for January Employer’s Contributions

| | | Total | Gross Pay NI Pension Payroll | (incl. overtime) Cost | (a) (b) (c) (a)+(b)+(c) | £ £ £ £ | Mr. Hutchinson 4,000.00 360.00 400.00 4,760.00 | Secretary 2,600.00 200.00 260.00 3,060.00 | _______ ______ ______ _______ | 6,600.00 560.00 660.00 7,820.00 |

Employees’ Contributions

N.I.

Pension

(d) £ 270.00 160.00 ______ 430.00

(e) £ 188.00 122.00 ______ 310.00

| | | | PAYE | Net pay | (f) | (a)-(d)-(e)-(f) £ | £ 800.00 | 2,742.00 400.00 | 1,918.00 _______| _______ 1,200.00| 4,660.00

Chapter 11

118

Note: 1. For the purpose of our example, National Insurance contributions are assumed amounts. The actual contributions required of employers and employers would in practice be calculated by the computer program, the calculations being based on Inland Revenue National Insurance tables. 2. Pension contributions have been assumed to be 10% of gross pay for employers and ca. 4.7% of gross pay for employees, and are calculated by the computer program automatically. 3. PAYE (‘Pay as you earn’) taxation deductions are also assumed amounts, but in practice are based on Inland Revenue PAYE tables and are calculated by the computer program automatically. It should be noted that PAYE is calculated on gross taxable pay, which is gross pay minus tax allowances to which each of the employees is entitled under legislation prevailing at the time. 4. Total payroll cost is gross pay plus the employer’s contributions for National Insurance and Pensions. It is the total payroll cost which is charged to the Profit and Loss Account as the overall cost of salary payments. 5. In April 2014, after the end of the 2013/14 tax or fiscal year, a copy of the printout for the fiscal year together with other relevant information would be sent to the Inland Revenue.

ii)

Payslips

A payslip is produced automatically for each employee and has the same basic information as that shown on the computer print-out, showing for the month and year to date the employee’s gross pay and the various deductions. iii)

Details

Nominal Ledger Accounts Affected Total Payroll Cost A/c (0700) Dr Cr £ £ 6,600.00

Gross Pay Employer’s - NI - Pension Charged to P&L A/c

560.00 660.00

_______ 7,820.00

| NI Contributions | Pension Contributions | A/c No (1400) | A/c (1410) |Details Dr Cr |Details Dr Cr | £ £ | £ £ | Re: January | Re: January | - Employers 560.00 | - Employers 660.00 | - Employees’ 430.00 | - Employees’ 310.00 | | | Bal c/d 990.00 | Bal c/d 970.00 7,820.00| | _______| _____ _____ | _____ _____ 7,820.00| 990.00 990.00 | 970.00 970.00 | | | Bal b/d 990.00 | Bal b/d 970.00

Comprehensive Example—Computerised Accounting System PAYE A/c (1420) Dr £

Details Re: January Bal c/d

Cr £ 1,200.00

1,200.00

_______ 1,200.00 Bal b/d

_______ 1,200.00 1,200.00

119

| Bank A/c (1150) |Details Dr Cr | £ £ |Opening balance 75,000.00 |Payments 59,461.00 |Receipts 33,500.00 |Net Pay 4,660.00 |Bal c/d 44,379.00 | ________ _________ | 108,500.00 108,500.00 | |Bal b/d 44,379.00

Note: 1. The above payroll entries posted to the relevant Nominal Ledger accounts are based on the following Journal Entry: Dr Cr £ £ Expenditure debited to ( Gross pay 6,600.00 the Profit & Loss Account ( Employer’s NI contribution 560.00 ( Employer’s Pension contribution 660.00 ( Total NI contributions Creditors and amounts paid ( Total Pension contributions shown in the Balance Sheet ( PAYE deductions ( Bank (net pay)

990.00 970.00 1,200.00 4,660.00

2. The credit balance on the National Insurance account (£990) and on the PAYE account (£1,200) will be paid over to the Inland Revenue by a certain date in the following month. The credit balance on the Pension Contributions account (£970) will be paid over to the Pension Scheme. Normally, such transfers to the Pension Scheme are also made monthly.

J

Journal Entries Transactions, come across in our example so far, which will require month-end Journal Entries are: a) The £500 Rent invoice for the quarter January - March 2014. b) Charges for depreciation on office equipment and furniture purchased in January and on various fixed assets purchased previously. c) Correction of £16 worth of envelopes misposted to Postage account instead of Stationery account.

Chapter 11

120

Let us also assume that: d) In addition to the £500 opening provision, a further £500 is needed for the estimated cost of office redecoration to be carried out in a few months’ time. e) The Telephone bill for January is expected to be exceptionally high at around £300. Journal Entries in January for the above are: a)

Rent A/c Prepayments A/c

Dr £ 167

Cr £ 167

(One-third of £500 charged to Rent A/c and credited to Prepayments A/c monthly over 3 months) b)

Leasehold premises amortisation A/c 100 Depreciation account - Furniture and fittings 300 - Office equipment 550 - Car 120 Provision for Amortisation A/c 100 Provision for Depreciation A/c - Furniture and fittings 300 - Office equipment 550 - Car 120 (Amortisation of leasehold premises over about 42 years, and depreciation of other assets over 3 to 3½ years) Note: Depreciation on assets bought in January is included above. c)

Stationery A/c 16 Postage A/c 16 (Correction of posting to Postage A/c instead of Stationery A/c)

d)

Office redecoration A/c 500 Provision A/c (Increase in provision set aside for office redecoration)

e)

Telephone A/c Accruals A/c (Estimated telephone cost relating to January)

500

300 300

Comprehensive Example—Computerised Accounting System

121

Note: Until the actual telephone bill is received, the accrual for each month is estimated. However, once the invoice is received, the required adjustment is made. For example, let us suppose that £300 is the estimated telephone charge for the month of January, and that at the end of March the actual first quarter bill for, say, £550 is received. The charge for February and March would then be £250. Assuming that £150 was the accrual in the February accounts, that would then leave £100 (£550 - £300 - £150) to be charged to the Profit and Loss Account in March.

Effect of the above Journal Entries on the Nominal Ledger Accounts: Rent A/c (0580) Dr Cr £ £ January 167.00 Charged to P & L A/c 167.00

Details

_____ 167.00

_____ 167.00

Amortisation A/c (0650) Dr Cr £ £ January 100.00 Charged to P & L A/c 100.00 Details

_____ 100.00

_____ 100.00

Provision for Amortisation A/c (1500) Details Dr Cr £ £ January 100.00 Bal c/d 100.00

_____ 100.00 Bal b/d

_____ 100.00 100.00

| Prepayments A/c (1050) |Details Dr Cr | £ £ |Rent invoice 500.00 |Rent for January 167.00 |Bal c/d 333.00 | _____ _____ | 500.00 500.00 | |Bal b/d 333.00 | | Depreciation A/c (0660) |Details Dr Cr | £ £ |January |- Furniture & Fittings 300.00 |- Office Equipment 550.00 |- Car 120.00 |Charged to P & L A/c 970.00 | _____ _____ | 970.00 970.00 | | Provision for Depreciation A/c (1510) |Details Dr Cr | £ £ |January |- Furniture & Fittings 300.00 |- Office Equipment 550.00 |- Car 120.00 |Bal c/d 970.00 | _____ _____ | 970.00 970.00 | |Bal b/d 970.00

122

Chapter 11

Stationery A/c (0500) | Postage A/c (0510) Dr Cr |Details Dr £ £ | £ Balance (previous) 104.00 |Balance (previous) 91.00 Correction 16.00 |Correction Charged to P & L A/c 120.00 |Charged to P & L A/c _____ _____ | ____ 120.00 120.00 | 91.00 | Office redecoration A/c (0590) | Provision A/c (1040) Details Dr Cr |Details Dr £ £ | £ Increase in provision 500.00 |Bal b/d Charged to P & L A/c 500.00 |Office redecoration |Bal c/d 1,000.00 _____ _____ | _______ 500.00 500.00 | 1,000.00 | |Bal b/d | Telephone A/c (0600) | Accruals A/c (1010) Details Dr Cr |Details Dr £ £ | £ Re: January 300.00 |Balance (opening) Charged to P & L A/c 300.00 |Telephone invoice 200.00 |Telephone accrual (Jan ’10) |Bal c/d 300.00 _____ _____ | _____ 300.00 300.00 | 500.00 | |Bal b/d Details

Cr £ 16.00 75.00 ____ 91.00

Cr £ 500.00 500.00 _______ 1,000.00 1,000.00

Cr £ 200.00 300.00 _____ 500.00 300.00

Comprehensive Example—Computerised Accounting System

K

123

Trial Balance, Profit & Loss Account, Balance Sheet We have seen how the transactions in our example affect all aspects of a computer-based accounting system, how print-outs can be produced and upto- date information called up on the screen or printed out at any point in time. Let us now look at the opening and closing Trial Balance, then the Profit and Loss Account and finally the Balance Sheet. Trial Balances (£)

Nominal Opening Trial Balance | Transactions in January | Ledger | | Code Dr Cr | Dr Cr | 1220 Premises 50,000.00 | | 1210 Furniture 10,000.00 | 800.00 | 1200 Off. Equip. 15,000.00 | 6,000.00 | 1230 Car 5,000.00 | | 30,621.00 | 1150 Bank balance 75,000.00 | 1300 Petty cash 200.00 | 68.00 | 1100 Debtors 12,500.00 | 13,735.00 | 1060 Bank Loan 20,000.00 | | 1015 Creditors 12,000.00 | 25,427.50 | 1010 Accruals 200.00 | 200.00 300.00 | 1040 Provisions 500.00 | 500.00 | 1070 Capital 50,000.00 | | 1080 Reserves 85,000.00 | | 1020 Stock | 31,425.00 | 1030 VAT | 5,540.50 | 0500 Stationery | 120.00 | 0510 Postage | 75.00 | 0520 Travel | 56.00 | 0550 Petrol | 50.00 | 0535 Cleaning | 30.00 | 0570 Electricity | 150.00 | 1050 Prepayments | 333.00 | 40,200.00 | 0200 Sales | 0300 Cost of Sales | 32,975.00 | 0700 Payroll Cost | 7,820.00 | 1400 NI Contrib. | 990.00 | 1410 Pens. Contrib. | 970.00 | 1420 PAYE | 1,200.00 | 0580 Rent | 167.00 | 0650 Amortisation | 100.00 | 0660 Depreciation | 970.00 | 1500 Prov. for amortisation | 100.00 | 1510 Prov. for depreciation | 970.00 | 0590 Office redecoration | 500.00 | 0600 Telephone | 300.00 | Loss in January | | _________ _________ | _________ _________ | 167,700.00 167,700.00 | 101,346.50 101,346.50 |

Closing Trial Balance Dr 50,000.00 10,800.00 21,000.00 5,000.00 44,379.00 132.00 26,235.00

Cr

20,000.00 37,427.50 300.00 1,000.00 50,000.00 85,000.00 31,425.00 5,540.50

333.00

990.00 970.00 1,200.00

100.00 970.00

3,113.00 _________ 197,957.50

_________ 197,957.50

Chapter 11

124

Note: 1. The Profit and Loss Account items are not shown individually in the Closing Trial Balance, instead only the £3,113 loss in January is shown since it represents the net of all Profit and Loss Account items shown below. 2. The debit balance of £5,540.50 at the end of January for VAT is cancelled on recovery of that amount from HMRC in April (i.e. at the end of the first quarter). 3. In the Balance Sheet (overleaf), provisions for depreciation and amortisation are not shown separately but are ‘netted off’ in fixed assets which are shown at net book value. Profit & Loss Account for the month of January 2014 Dr £ Sales Cost of Sales

32,975.00 ________

Gross Profit Overheads: Payroll cost Stationery Postage Travel Petrol Office cleaning Electricity Telephone Rent Amortisation Depreciation Office redecoration

Cr £ 40,200.00 ________ 7,225.00

7,820.00 120.00 75.00 56.00 50.00 30.00 150.00 300.00 167.00 100.00 970.00 500.00

Loss in January ________ 10,338.00

3,113.00 ________ 10,338.00

Comprehensive Example—Computerised Accounting System

125

Balance Sheet as at 31/1/14 Assets £ Fixed Assets - nbv Leasehold Premises Furniture & Fittings Office Equipment Car

Current assets Balance at bank Petty cash Debtors Prepayments Stock VAT recoverable

49,900.00 10,500.00 20,450.00 4,880.00

44,379.00 132.00 26,235.00 333.00 31,425.00 5,540.50 ________

| | £ | | | | | | | 85,730.00 | | | | | | | | | | | | 108,044.50 | _________ | 193,774.50 |

Capital & Liabilities £ Long - Term creditors Bank Loan

Current Liabilities Creditors Accruals Provisions Payroll deductions

£ 20,000.00

37,427.50 300.00 1,000.00 3,160.00 _______ 41,887.50

Capital & Reserves Capital 50,000.00 Reserves 81,887.00 _______ 131,887.00

_________ 193,774.50

Note: 1. Fixed assets are shown at net book value. 2. It is assumed in this example that the bank loan is repaid by instalments with interest each December. Interest is charged to the Profit and Loss Account in the month in which it is paid. 3. Payroll deductions will be paid over to the Pension Scheme and to the Inland Revenue in February.

Chapter 11

126

L

Creditors and Debtors Balances Outstanding Print-out of Creditors’ Balances Outstanding Purchase Ledger Account Number *Various 121 009 058 113 035 016 077 005 003 010 150 183

Balance Outstanding £ 2,500.00 4,700.00 8,812.50 5,287.50 7,050.00 82.25 58.75 35.25 176.25 235.00 500.00 7,050.00 940.00 37,427.50

* Relates to pre-January creditors

Print-out of Debtors’ Balances Outstanding Sales Ledger Account Number **Various 210 274 202 293

Balance Outstanding £ 2,500.00 1,880.00 4,230.00 13,218.75 4,406.25 26,235.00

** Relates to pre-January debtors.

M

Summary We have now come to the end of our comprehensive example and gained an insight into a ‘real life’ situation. We have seen how the month’s results can be printed out automatically (using set key strokes) to produce a Trial Balance, Profit and Loss Account, Balance Sheet, debtors balances outstanding and creditors balances outstanding. Even though the rules and principles of accounting are always the same, the systems of recording can vary greatly. Our example, although greatly simplified in relation to ‘real life’ situations, serves to demonstrate how a basic computer-based accounting system works.

CHAPTER 12 EXAMPLES OF 10 COMPLEX TRANSACTIONS

Now that we are fully acquainted with the principles and application of double entry, we can tackle transactions and accounting adjustments which are far more complex than those dealt with so far. The secret of dealing with complicated transactions is to break those transactions down into their constituent parts and to journalise each of those parts separately. Thus, you could find a complex transaction requiring several Journal Entries or just one long Journal Entry. As we know, in practice most transactions are not journalised but posted directly or via Day Books to the Nominal Ledger. In this chapter we will show that in order to ensure correct treatment of a complicated transaction it should first be journalised before it is processed through the relevant books of accounts. Let us now take some examples of complex transactions and prepare Journal Entries, Nominal Ledger accounts and a Trial Balance for each example. Example 1 A business is started with the following assets, with the help of a bank loan: Leasehold property Furniture Computer equipment Company car Bank balance Bank Loan Capital

£ 50,000 10,000 6,000 9,000 10,000 85,000 (30,000) 55,000

Chapter 12

128 Journal Entry

Leasehold property A/c Furniture A/c Computer equipment A/c Company car A/c Bank A/c Bank loan A/c Capital A/c

Dr £ 50,000 10,000 6,000 9,000 10,000

Cr £

30,000 55,000

Note: This is an example of several transactions being recorded in the form of one Journal Entry, since they refer to the same event, namely, the start of a business. Nominal Ledger accounts affected Leasehold property A/c Details Dr Cr £ £ 50,000

| Furniture A/c | Details Dr | £ | 10,000 | Company car A/c | Bank A/c Details Dr Cr | Details Dr £ £ | £ 9,000 | 10,000 | Capital A/c | Details Dr Cr | £ £ | 55,000 |

| Computer equipment A/c Cr | Details Dr Cr £ | £ £ | 6,000 | | Bank Loan A/c Cr | Details Dr Cr £ | £ £ | 30,000 |

Trial Balance Leasehold property Furniture Computer equipment Company car Bank Bank loan Capital

Dr £ 50,000 10,000 6,000 9,000 10,000

_____ 85,000

Note: All the above are Balance Sheet accounts.

Cr £

30,000 55,000 _____ 85,000

Examples of 10 Complex Transactions

129

Example 2 A 2% cash discount is received on £30,000 worth of purchases because of prompt payment within 7 days. £2,000 worth of goods are returned because they are sub-standard. The supplier is subsequently paid. Journal Entries Dr £ 30,000

a) Stock A/c Supplier A/c (Receipt of goods)

Cr £ 30,000

b) Supplier A/c Stock A/c (Goods returned)

2,000 2,000

c) Supplier A/c Cash discount A/c (2% of £28,000 = £560)

560 560

d) Supplier A/c Bank A/c (Payment to supplier)

27,440 27,440

Nominal Ledger Accounts affected Details a) b) Balance c/d

Stock A/c Dr £ 30,000

2,000 28,000 _____ 30,000

Bal b/d

Details a)

Cr £

_____ 30,000

28,000 Cash discount A/c Dr £

Cr £ 560

| | | | | | | | | | | | | | | |

Details a) b) c) d)

Details d)

Supplier A/c Dr £ 2,000 560 27,440 _____ 30,000

Bank A/c Dr £

Cr £ 30,000

_____ 30,000

Cr £ 27,440

Chapter 12

130 Trial Balance

Stock Cash discount Bank

Dr £ 28,000

_____ 28,000

Cr £ 560 27,440 _____ 28,000

Affects Balance Sheet Profit & Loss A/c Balance Sheet

Note: The £560 Cash discount is credited to the Profit & Loss A/c. Eventually, of course, it would be transferred as part of the Profit & Loss A/c balance to the Balance Sheet.

Example 3 £25,000 worth of goods are sold for £32,000. The customer receives a quantity discount of 3%. A further cash discount of 2% on the £32,000 is allowed to the customer for making payment within 2 weeks. Journal Entries Dr £ a) Cost of sales A/c Supplier A/c (Cost of goods sold)

25,000

b) Debtor A/c Sales A/c (Gross value of sales)

32,000

c) Quantity discount A/c Debtor A/c (3% of £32,000)

960

d) Cash discount A/c Debtor A/c (2% of £32,000)

640

e) Bank A/c Debtor A/c (Receipt from debtor)

Cr £

25,000

32,000

960

640

30,400 30,400

Examples of 10 Complex Transactions

131

Nominal Ledger Accounts affected Cost of Sales A/c Details Dr Cr £ £ a) 25,000

Details b)

Details e)

| Supplier A/c | Details Dr Cr | £ £ | a) 25,000 | | | | | | Sales A/c | Quantity discount A/c Dr Cr | Details Dr Cr £ £ | £ £ 32,000 | c) 960 | Bank A/c | Dr Cr | £ £ | 30,400 |

| Debtor A/c | Details Dr Cr | £ £ | b) 32,000 | c) 960 | d) 640 | e) 30,400 | _____ _____ | 32,000 32,000 | | Cash discount A/c | Details Dr Cr | £ £ | d) 640 |

Trial Balance

Cost of sales Supplier Sales Quantity discount Cash discount Bank

Dr £ 25,000

Cr £ 25,000 32,000

960 640 30,400 _____ 57,000

Affects Profit & Loss A/c Balance Sheet Profit & Loss A/c Profit & Loss A/c Profit & Loss A/c Balance Sheet

_____ 57,000

Example 4 An advance of £200 in sterling from petty cash and £300 worth of (fictitious) foreign currency cents (10 cents = £1) from the bank is made to H. Tracy for a short business trip overseas. On return from his trip he presents expense vouchers totalling 500 cents for travel and 3,700 cents for subsistence. He returns 500 cents and £20 sterling, both of which are banked. The total bank charge is £15.

Chapter 12

132

Before proceeding with the Journal Entries, it is advisable to analyse the various elements of the above transactions, which helps one to arrive at the profit or loss on exchange as follows: Advance

-

from petty cash from bank

Expenses

-

Travel Subsistence

Returned

-

500 cents in sterling

Loss on exchange

£ 200 300 ___ 500 (50) (370) ___ 80 (50) (20) ___ 10

(in sterling) (in cents)

(500 cents) (3,700 cents)

(at 10 cents = £1)

Note: Of the £180 sterling (£200 advanced - £20 returned) that H. Tracy exchanged when he was abroad, he must have received just 1,700 cents instead of 1,800 cents, resulting in a £10 loss on exchange. Journal Entries Dr £ a) H. Tracey Advance A/c Petty cash A/c Bank A/c (Advance given for business trip)

500

b) Travel A/c Subsistence A/c H. Tracey Advance A/c (Expenses incurred on trip)

50 370

Cr £

200 300

420

c) Bank A/c H. Tracey Advance A/c (Money returned)

70

d) Loss on Exchange A/c H. Tracey Advance A/c (Loss on exchange)

10

e) Bank Charges A/c Bank A/c (Bank charges)

15

70

10

15

Examples of 10 Complex Transactions

133

Nominal Ledger Accounts affected H. Tracy Advance A/c Details Dr Cr £ £ a) 500 b) 420 c) 70 d) 10 ___ ___ 500 500

Details b)

Travel A/c Dr £ 50

Cr £

Bank Charges A/c Details Dr Cr £ £ e) 15

| Petty Cash A/c | Bank A/c | Details Dr Cr | Details Dr Cr | £ £ | £ £ | a) 200 | a) 300 | | c) 70 | | e) 15 | | Bal c/d 245 | | ___ ___ | | 315 315 | | | Subsistence A/c | Loss on exchange A/c | Details Dr Cr | Details Dr Cr | £ £ | £ £ | b) 370 | d) 10 | | | | | |

Trial Balance Dr £ Petty cash Bank Travel Subsistence Loss on exchange Bank charges

50 370 10 15 ___ 445

Cr £ 200 245

Affects Balance Sheet Balance Sheet Profit & Loss A/c Profit & Loss A/c Profit & Loss A/c Profit & Loss A/c

___ 445

Example 5 A bank loan of £30,000 is received, repayable over 5 years at the end of each year, at 10% per annum compound interest. Let us examine the accounting entries in each of the 5 years until the loan is repaid at the end of the fifth year.

Chapter 12

134 Journal Entries Dr £ First year a) Bank A/c 30,000.00 Bank loan A/c (Beginning of year 1)

b) Interest A/c 3,000.00 Bank Loan A/c (First year interest)

c) Bank Loan A/c 6,600.00 Bank A/c (First year end repayment)

Second year d) Interest A/c 2,640.00 Bank Loan A/c (Second year end interest)

e) Bank Loan A/c 7,260.00 Bank A/c (Second year end repayment)

Third year f) Interest A/c 2,178.00 Bank Loan A/c (Third year end interest)

g) Bank Loan A/c 7,986.00 Bank A/c (Third year end repayment)

Cr £

| | | | | 30,000.00| | | | | 3,000.00| | | | | | 6,600.00| | | | | | | 2,640.00| | | | | | 7,260.00| | | | | | | 2,178.00| | | | | 7,986.00| | | |

Calculation £

Loan

1st yr interest (10% of £30,000.00)

1st yr end repayment (£33,000.00 / 5)

2nd yr end interest (10% of £26,400.00)

2nd yr end repayment (£29,040.00 / 4)

3rd yr end interest (10% of £21,780.00)

3rd yr end repayment (£23,958.00 / 3)

30,000.00

3,000.00 ________ 33,000.00

(6,600.00) ________ 26,400.00

2,640.00 ________ 29,040.00

(7,260.00) ________ 21,780.00

2,178.00 ________ 23,958.00

(7,986.00) ________ 15,972.00

Examples of 10 Complex Transactions Dr £ Fourth year h) Interest A/c 1,597.20 Bank Loan A/c (Fourth year end interest)

i) Bank Loan A/c 8,784.60 Bank A/c (Fourth year end repayment)

Fifth year j) Interest A/c 878.46 Bank Loan A/c (Fifth year end interest)

k) Bank Loan A/c Bank A/c (Final repayment)

9,663.06

Cr £

| | | | | 1,597.20| | | | | 8,784.60| | | | | | | 878.46| | | | | | 9,663.06| | |

135 Calculation £

4th yr end interest (10% of £15,972.00)

4th yr end repayment (£17,569.20 / 2)

5th yr end interest (10% of £8,784.60)

1,597.20 ________ 17,569.20

(8,784.60) ________ 8,784.60

878.46 _______ 9,663.06

(9,663.06) ________

-

Note: Applying the above method, the annual repayments are not equal. However, with the use of computers or some electronic calculators, the repayments, including interest, can be arrived at in such a way that the repayments are the same each year.

Chapter 12

136 Nominal Ledger accounts affected Details 1st yr a)

Bank A/c Dr £ 30,000.00

c) 2nd yr e) 3rd yr g) 4th yr i) 5th yr k) Bal c/d 10,293.66 ________ 40,293.66 Bal b/d

| Bank Loan A/c | Interest A/c |Details Dr Cr | Details Dr | £ £ | £ |1st yr |1st yr | a) 30,000.00| b) 3,000.00 | b) 3,000.00| 6,600.00| c) 6,600.00 | | | |2nd yr |2nd yr | d) 2,640.00| d) 2,640.00 7,260.00| e) 7,260.00 | | | |3rd yr |3rd yr | f) 2,178.00| f) 2,178.00 7,986.00| g) 7,986.00 | | | |4th yr |4th yr | h) 1,597.20| h) 1,597.20 8,784.60| i) 8,784.60 | | | |5th yr |5th yr | j) 878.46 | j) 878.46 9,663.06| k) 9,663.06 | | |Bal c/d ________| ________ ________| ________ 40,293.66| 40,293.66 40,293.66| 10,293.66 | | 10,293.66| | Bal b/d 10,293.66 Cr £

Cr £

10,293.66 ________ 10,293.66

Note: 1. Balance c/d and balance b/d have not been shown at the end of each year. 2. The bank overdraft is exactly the same amount as the interest charged. Trial Balance Dr £ Bank Interest

10,293.66 10,293.66

Cr £ 10,293.66 _______ 10,293.66

Affects Balance Sheet Profit & Loss A/c

Examples of 10 Complex Transactions

137

Example 6 The payroll entries in respect of a member of staff, A. Marley, in month 1 are as follows:— Basic salary Overtime Bonus Total salary Deductions: -PAYE -Employees’ contributions: -National Insurance -Pension -Contribution to BUPA -Repayment of company loan Net pay

£ 1,500 300 120 ____ 1,920 (400) (120) (90) (80) (120) ____ 1,110

The total payroll cost is as follows:Total salary Employer’s contributions: -National Insurance -Pension Total payroll cost

£ 1,920 160 180 ____ 2,260

In month 2, the amounts deducted are paid to the relevant third parties. Note: Since total payroll cost is normally shown as one item in the Profit and Loss Account, just one Nominal Ledger account will normally be set up for total payroll cost which includes basic salary, overtime, bonus, etc. plus the employer’s contributions for pension and National Insurance.

Chapter 12

138 Journal Entries

Dr £

Month 1 ( Basic salary A/c Total ( Overtime A/c Payroll ( Bonus A/c A/c ( Employer’s N. I. A/c ( Employer’s Pension A/c PAYE A/c National Insurance A/c Pension A/c BUPA A/c Loan A/c Net Pay A/c

Cr £

1,500 300 120 160 180 400 280 270 80 120 1,110

(Payroll cost, deductions and net pay) Month 2 PAYE A/c National Insurance A/c Pension A/c BUPA A/c Loan A/c Net pay A/c Bank A/c (Payment of deductions and net pay)

400 280 270 80 120 1,110 2,260

Examples of 10 Complex Transactions Nominal Ledger Accounts affected Total Payroll Cost A/c Details Dr Cr £ £ Month 1 2260 Journal Entry

Pension A/c Dr £ Month 1 Journal Entry Details

Month 2 Payment to Pension scheme

Details

270 270

Net pay A/c Dr £

Month 1 Journal Entry

Month 2 Payment to A. Marley

1,110 1,110

| Paye A/c | National Insurance A/c | Details Dr Cr | Details Dr Cr | £ £ | £ £ | Month 1 400| Month 1 280 | Journal Entry | Journal Entry | | | Month 2 | Month 2 | Payment to | Payment to | HMRC 400 ___| HMRC 280 ___ | 400 400| 280 280 | | | BUPA A/c | Loan A/c Cr | Details Dr Cr | Details Dr Cr £ | £ £ | £ £ | Month 1 | Month 1 270| Journal Entry 80| Journal Entry 120 | | | Month 2 | Month 2 | Payment to | Payment of ___| BUPA 80 __| instalment 120 ___ 270| 80 80| 120 120 | | | Bank A/c | Cr | Details Dr Cr | £ | £ £ | | Month 2 | 1,110| Payment to | | various parties 2,260| | | | | | | ____ | | 1,110| |

139

Chapter 12

140 Trial Balances Dr £ Month 1 Total payroll Cost PAYE National Insurance Pension BUPA Loan Net pay

2,260

____ 2,260 Month 2 PAYE National Insurance Pension BUPA Loan Net pay Bank

Cr £

400 280 270 80 120 1,110 ____ 2,260

400 280 270 80 120 1,110 ____ 2,260

2,260 ____ 2,260

Affects

Profit & Loss A/c ) ) ) Balance sheet ) ) )

) ) ) ) Balance sheet ) ) )

Examples of 10 Complex Transactions

141

Example 7 A photocopier is purchased for £5,100 and an invoice is subsequently received for the photocopier plus a charge of £500 covering the first 3 years’ maintenance, less a cash discount of 2% for both the photocopier and the maintenance charge on account of early payment. The photocopier is depreciated over 3 years. Journal Entries Dr £

Cr £

First year a)

Photocopier A/c 5,100 Cash discount A/c Bank A/c (Payment for photocopier less 2% cash discount)

102 4,998

b)

Maintenance A/c 500 Cash discount A/c 10 Bank A/c 490 (Payment for 3 years’ maintenance less 2% cash discount)

c)

Depreciation A/c Photocopier A/c (First year depreciation)

1,700 1,700

Second year d)

Depreciation A/c Photocopier A/c (Second year depreciation)

1,700 1,700

Third year e)

Depreciation A/c Photocopier A/c (Third year depreciation)

1,700 1,700

142

Chapter 12

Nominal Ledger Accounts affected Photocopier A/c | Cash discount A/c | Bank A/c Details Dr Cr | Details Dr Cr | Details Dr £ £ | £ £ | £ Year 1 | Year 1 | Year 1 Purchase 5,100 | Re: photocopier 102| Photocopier Depreciation 1,700| Re: maintenance 10| maintenance Balance c/d 3,400| Credited to | Month 2 | P&L A/c 112 | Bal c/d 5,488 ____ ____ | ___ ___| ____ 5,100 5,100| 112 112| 5,488 | | | |Balance b/d Year 2 | | Balance b/d 3,400 | | Depreciation 1,700| Maintenance A/c | Depreciation A/c Bal c/d 1,700| Details Dr Cr | Details Dr ____ ____| £ £ | £ 3,400 3,400| Year 1 | Year 1 | Payment 500 | Re: Photocopier 1,700 | Charged to 500| Charged to P&L A/c | P&L A/c | Year 3 | ___ ___| ____ Balance b/d 1,700 | 500 500| 1,700 Depreciation 1,700| | ____ ____| | Year 2 1,700 1,700| | Re: Photocopier 1,700 | | Charged to P&L A/c | | ____ | | 1,700 | | | | Year 3 | | Re: Photocopier 1,700 | | Charged to P&L A/c | | ____ | | 1,700

Cr £ 4,998 490

____ 5,488 5,488

Cr £

1,700 ____ 1,700

1,700 ____ 1,700

1,700 ____ 1,700

Examples of 10 Complex Transactions

143

Trial Balances Dr £

Cr £

Affects

End year 1 Photocopier (nbv) Cash discount Bank Maintenance Depreciation

3,400 *112 5,488 *500 *1,700 ____ 5,600

Balance Sheet Profit & Loss A/c Balance Sheet Profit & Loss A/c Profit & Loss A/c

____ 5,600

End year 2 Photocopier (nbv) 1,700 Depreciation *1,700 Bank Profit & loss A/c - debit balances (£500 + £1,700 - £112) *2,088 ____ 5,488

5,488

Balance Sheet Profit & Loss A/c Balance sheet Balance Sheet

____ 5,488

End year 3 Depreciation 1,700 Bank Profit & Loss A/c - debit balances (£500 + £3,400 - £112) 3,788 ____ 5,488

5,488

Profit & Loss A/c Balance Sheet Balance Sheet

____ 5,488

nbv = net book value * At the end of the second and third years the Trial Balances must include losses brought forward on the Profit and Loss Account, made up of costs less revenue relating to prior years.

Example 8 A computer system costing £5,100 is leased at £2,000 per annum over 3 years, the £2000 per annum payment to include an annual interest charge of £300. Depreciation is charged at £1,700 per annum over 3 years. (In the case of this particular kind of lease agreement the computer system is treated in the Accounts as if it has been bought, resulting in an annual depreciation charge.)

Chapter 12

144 Journal Entries

Dr £

Cr £

Year 1 a)

b)

c)

Leased computer A/c Leasing company A/c (Purchase of leased computer)

5,100

Depreciation A/c Leased computer A/c (First year depreciation)

1,700

Leasing company A/c Leasing interest A/c Bank A/c (First year repayment with interest)

1,700 300

Depreciation A/c Leased computer A/c (Second year depreciation)

1,700

5,100

1,700

2,000

Year 2 d)

e)

1,700

Leasing company A/c 1,700 Leasing interest A/c 300 Bank A/c (Second year repayment with interest)

2,000

Year 3 f)

g)

Depreciation A/c Leased computer A/c (Third year depreciation)

1,700

Leasing company A/c Leasing interest A/c Bank A/c (Third year repayment with interest)

1,700 300

1,700

2,000

Note: Of the £2000 per annum paid to the leasing company, £1700 relates to the capital element which reduces each year the amount owing to the leasing company. The remaining £300 per annum is the interest charge which is debited each year to the Profit & Loss Account.

Examples of 10 Complex Transactions

145

Nominal Ledger Accounts affected Leased Computer A/c | Leasing Company A/c | Depreciation A/c Details Dr Cr | Details Dr Cr | Details Dr £ £ | £ £ | £ Year 1 | Year 1 | Year 1 a) 5,100 | a) 5,100| b) 1,700 b) 1,700| c) 1,700 |Charged to P&L A/c Bal c/d 3,400| Bal c/d 3,400 | ____ ____ | ____ ____ | ____ 1,700 5,100 5,100| 5,100 5,100| | | Year 2 | Year 2 | Year 2 Bal b/d 3,400 | Bal b/d 3,400| d) 1,700 d) 1,700| e) 1,700 |Charged to P&L A/c Bal c/d 1,700|Bal c/d 1,700 | ____ ____ | ____ ____ | ____ 3,400 3,400| 3,400 3,400| 1,700 | | Year 3 | Year 3 | Year 3 Bal b/d 1,700 | Bal b/d 1,700| f) 1,700 f) 1,700| g) 1,700 |Charged to P&L A/c ____ ____ | ____ ____ | ____ 1,700 1,700| 1,700 1,700| 1,700 | Leasing interest A/c | Bank A/c Details Dr Cr | Details Dr Cr £ £ | £ £ Year 1 | Year 1 c) 300 | c) 2,000 Charged to P&L A/c 300| Bal c/d 2,000 ___ ___| ____ ____ 300 300| 2,000 2,000 | Year 2 | Year 2 | Bal b/d 2,000 e) 300 | e) 2,000 Charged to P&L A/c 300| Bal c/d 4,000 ___ ___| ____ ____ 300 300| 4,000 4,000 | Year 3 | Year 3 | Bal b/d 4,000 g) 300 | g) 2,000 Charged to P&L A/c 300| Bal c/d 6,000 ___ ___| ____ ____ 300 300| 6,000 6,000 | | Bal b/d 6,000

Cr £

1,700 ____ 1,700

1,700 ____ 1,700

1,700 ____ 1,700

Chapter 12

146 Trial Balances

Dr £ End year 1 Leased computer (nbv) Leasing company Depreciation Leasing interest Bank A/c

Cr £

Affects

3,400 3,400 1,700 300 ____ 5,400

End year 2 Leased computer (nbv) 1,700 Leasing company Depreciation 1,700 Leasing interest 300 Bank Profit & Loss A/c - debit balances 2,000 (£1,700 + £300) ____ 5,700 End year 3 Depreciation 1,700 Leasing interest 300 Bank Profit & Loss A/c - debit balances 4,000 (£3,400 + £600) ____ 6,000

2,000 ____ 5,400

1,700

4,000

Balance Sheet Balance Sheet Profit & Loss A/c Profit & Loss A/c Balance Sheet

Balance Sheet Balance Sheet Profit & Loss A/c Profit & Loss A/c Balance Sheet Balance Sheet

____ 5,700

6,000

Profit & Loss A/c Profit & Loss A/c Balance Sheet Balance Sheet

____ 6,000

nbv = net book value

Example 9 A rates bill for £3,000 in respect of the year April 2013 to March 2014 is received in April 2013 and paid the following month. Journal Entries April 2013

a)

b)

Rates prepaid A/c Local County Council A/c (Receipt of Rates invoice) Rates A/c Rates prepaid A/c (1/12 of £3,000 accrued for April)

Dr £ 3,000

Cr £ 3,000

250 250

Examples of 10 Complex Transactions

147

Note: Although rates are not actually paid in advance until the following month (May), for accounting purposes since the £3,000 invoice is received in April it is debited in April to the Rates Prepaid Account and credited to the Local County Council, and £250 (1/12 of £3,000) debited to the Rates Account in April. May 2010

c)

d)

Rates A/c Rates prepaid A/c (1/12 of £3,000 accrued for May) Local County Council A/c Bank A/c (Payment of rates to the Council)

Dr £ 250

Dr £ 250

3,000 3,000

Nominal Ledger Accounts affected Details April b) May c)

Rates A/c Dr £ 250

250

Local County Council A/c Details April a) May d)

Dr £

3,000

| Cr | £ | | | | | | | | | | | | | | | | | | Cr | £ | | 3,000 | | ____ |

Details April a) b) Bal c/d

Rates prepaid A/c Dr £ 3,000

____ 3,000 May Bal b/d c) Bal c/d

250 2,750 ____ 3,000

2,750

____ 2,750 Bal b/d

Cr £

250 2,500 ____ 2,750

2,500 Bank A/c

Details

May d)

Dr £

Cr £

3,000

Chapter 12

148 Trial Balances Dr £

Cr £

Affects

End April Rates Rates prepaid Local County Council

250 2,750 ____ 3,000

3,000 ____ 3,000

Profit & Loss A/c Balance Sheet Balance Sheet

End May Rates 250 Rates prepaid 2,500 Bank P & L A/c debit balance (re April rates) 250 ____ 3,000

3,000

Profit & Loss A/c Balance Sheet Balance Sheet Balance Sheet

____ 3,000

Example 10 £10,000 worth of raw materials is purchased and paid for in month 1 for the manufacture of certain goods. In month 2, three men work full-time and produce finished goods the cost of which comprises £7,000 worth of raw materials and £2,500 in labour cost. On the remaining £3,000 worth of raw materials they spend £1,000 worth of their time, resulting in partfinished goods or work-in-progress amounting to £4,000 (£3,000 raw materials plus £1,000 labour). In month 3, they finish manufacturing all the items by spending another £1,000 worth of their time on the manufacturing process. At the end of month 3 they sell all the goods for £20,000. The total cost of sales is analysed as follows:

Month 1 Month 2 Month 3

Raw Material’s £ 10,000 _____ 10,000

Labour £ 3,500 1,000 ____ 4,500

Total £ 10,000 3,500 1,000 _____ 14,500

Examples of 10 Complex Transactions

149

Journal Entries Dr £

Cr £

Month 1 a)

Raw materials A/c Bank A/c (Payment for raw materials)

10,000 10,000

Month 2 b)

Finished goods A/c 9,500 Work-in-progress A/c 4,000 Raw materials A/c 10,000 3,500 Added value A/c (Production of finished goods and work-in-progress)

Note: At this stage, the £3,500 labour element is shown in the Profit & Loss Account on the credit side as ‘added value’, offsetting the equivalent cost of labour also shown in the Profit & Loss Account on the debit side. Month 3 c)

Finished goods A/c Work-in-progress A/c Added value A/c (Remaining finished goods produced)

5,000 4,000 1,000

After sale d)

e)

f)

Cost of sales A/c Finished goods A/c (Cost of goods sold)

14,500

Bank A/c Sales A/c (Receipt from sales)

20,000

14,500

20,000

Added value A/c Cost of sales A/c (Cost of sales reduced by added value)

4,500 4,500

Note: The profit on sale is: Sales value Cost of sales Gross profit

£ 20,000 10,000 10,000

The £4,500 labour costs are not journalised in this example as they are assumed to be part of the total labour costs.

Chapter 12

150 Nominal Ledger Accounts affected Raw materials A/c | Dr Cr | £ £ | Month 1 | a) 10,000 | Bal c/d 10,000 | | _____ _____| 10,000 10,000 | | Month 2 | Bal b/d 10,000 | b) 10,000 | | _____ _____ | 10,000 10,000 | | | | Added Value A/c | Details Dr Cr | £ £ | Month 2 | b) 3,500| Bal c/d 3,500 | | | ____ ____ | 3,500 3,500| | Month 3 | Bal b/d 3,500| c) 1,000| f) 4,500 | ____ ____ | 4,500 4,500| | | | Details

| Cr | £ | Month 1 | a) 10,000 | Bal c/d 10,000 | | _____ _____| 10,000 10,000| | Month 3 | Bal b/d 10,000 | e) 20,000 | Bal c/d 10,000 | _____ _____| 20,000 20,000 | | Bal b/d 10,000 | | Work-in-progress A/c | Details Dr Cr | £ £ | Month 2 | b) 4,000 | Bal c/d 4,000| | | ____ ____ | 4,000 4,000| | Month 3 | Bal b/d 4,000 | c) 4,000| | ____ ____ | 4,000 4,000| | | | Details

Bank A/c Dr £

Finished goods A/c Details Dr Cr £ £ Month 2 b) 9,500 Bal c/d 9,500 ____ 9,500 Month 3 Bal b/d c) d)

____ 9,500

9,500 5,000 _____ 14,500

14,500 _____ 14,500

Cost of Sales A/c Details Dr Cr £ £ Month 3 d) 14,500 f) 4,500 Charged to P&L A/c 10,000 _____ _____ 14,500 14.500

Details

Sales A/c Dr £

Month 3 e) Credited to P&L A/c 20,000 _____ 20,000

Cr £ 20,000

_____ 20,000

Examples of 10 Complex Transactions

151

Trial Balances Dr £

Cr £

Affects

Month 1 end Raw materials Bank

10,000 10,000

10,000 10,000

Balance Sheet Balance Sheet

Month 2 end Finished goods Added value Work-in-progress Bank

9,500 3,500 4,000 13,500

10,000 13,500

Balance Sheet Balance Sheet Balance Sheet Balance Sheet

Month 3 end Cost of sales Sales Bank

10,000 20,000 10,000 20,000

Profit & Loss A/c Profit & Loss A/c Balance Sheet

20,000

We have come to the end of our examples and seen that the basic principles of double entry apply no matter how complicated the transaction might be. To repeat what was said at the beginning of this chapter, it is advisable for a complex transaction to be broken down in logical sequence into its constituent parts, and then each part journalised separately. In that way we find that the transaction, however complex, can be processed without difficulty through the relevant books of Accounts.

CHAPTER 13 CONTROL ACCOUNTS AND NOMINAL LEDGER RECONCILIATIONS A

Control Accounts

We are already quite familiar with Control accounts such as Sales Ledger (or Total Debtors) or Bought Ledger (or Total Creditors) accounts. As we know, the main purpose of Control (or ‘Total’) accounts is to avoid having more accounts and detailed information than is necessary within the Nominal Ledger. This can be illustrated by the following simple example: Trial Balance at 1/2/14 Dr £ Leasehold property 179,500 Furniture & fittings 2,360 Office equipment 3,500 Total debtors 15,000 Staff advances 4,500 Prepayrnents 500 Bank balance 10,000 Petty cash 200 Total creditors Accruals PAYE National insurance Pension contributions Capital Reserves ______ 215,560

| | Cr | £ | | | | | | | | | 12,200 | 1,000| 2,200| 1,000| 800| 150,000| 48,360| ______| 215,560|

Bought Ledger balances

A Bailey C Denver E Frawley G Hicks I Jackson

| | | £ | 500| 6,400| 2,900| 1,500| 900| _____| 12,200|

Sales Ledger balances

K Lawson M Norris O Parry R Smith T Wilson

£ 3,200 6,000 1,400 2,700 1,700 _____ 15,000

The Trial Balance which is extracted from the Nominal Ledger shows only one amount for Total Creditors (£12,200) and one for Total Debtors (£15,000). The individual balances which comprise the Total Creditors and Total Debtors accounts are shown separately in the Bought and Sales Ledgers.

Control Accounts and Nominal Ledger Reconciliations

153

This is because in real life situations the number of individual creditors and debtors accounts are so numerous that separate Bought and Sales Ledgers, or ‘personal’ ledgers, need to be maintained in addition to the Nominal Ledger. Apart from the Purchase and Sales Ledgers there are other Control accounts, the main ones being: a) b) c) d)

Bank account Petty cash account Stock account Fixed assets accounts

Details contained in the Cash Book the Petty Cash Book the Stock Ledger the Assets Register

Note: 1. There is also normally a Control Account for VAT receivable and payable. 2. Instead of a Petty Cash Book there may simply be a file of petty cash vouchers. Let us illustrate each of cases A to D with examples. a)

Bank Account i)

Cash Book

Receipts £ | | | Feb ’10 Opening balance 10,000| 2/2 Cash sales 3,000| 4/2 Cash sales 2,500| 8/2 Receipts from debtors 5,300| 13/2 Cash sales 1,700| 14/2 Receipts from debtors 4,200| 19/2 Receipts from debtors 2,900| 24/2 Receipts from debtors 3,400| 27/2 Cash sales 1,300| _____| 34,300| | March Opening balance 13,100|

Payments £

2/2 4/2 5/2 7/2 10/2 12/2 17/2 21/2 Feb

Cheque Supplier Number Number xxxx xxx xxxx xxx xxxx xxx xxxx xxx xxxx xxx xxxx xxx xxxx xxx xxxx xxx Closing balance

Stock Purchase 10,000 Petrol 50 Electricity 120 Rent 700 Rates (business) 2,500 Stock purchase 3,530 Telephone 300 Stock purchase 4,000 13,100 _____ 34,300

Chapter 13

154

ii) Nominal Ledger Bank A/c Date

Details

Feb

Opening balance Receipts Payments Closing balance

Dr £ 10,000 24,300

_____ 34,300 March

Opening balance

Cr £

21,200 13,100 _____ 34,300

13,100

Note: The balance on the Bank Account in the Nominal Ledger at the beginning and end of February agree exactly with the opening and closing balances in the Cash Book. In practice, of course, as with all other examples throughout this book, there would be many more transactions involved. Also, in a manual system, there is no certainty of agreement between the Cash Book balance and the Bank balance in the Nominal Ledger.

b)

Petty Cash Account i)

Petty Cash Book (or file of petty cash vouchers) Voucher No.

Feb 2nd 4th 9th 15th 21st 23rd 25th

27th

March

xxx xxx xxx xxx xxx xxx xxx

Expense

£

Opening balance Taxis Taxis Stationery Stamps Stamps Entertainment Stationery

5 15 27 15 18 38 12

Reimbursement from bank Opening balance

£ 200

(130) ___ 70 130 ___ 200

Note: In a computerised system, petty cash vouchers are sequentially numbered, and postings to the Nominal ledger are made directly from the vouchers which are filed in numerical order; hence there is no need to maintain a separate Petty Cash Book.

Control Accounts and Nominal Ledger Reconciliations

ii)

155

Nominal Ledger Petty Cash A/c Date

Details

Feb

Opening balance

Dr £ 200 Payments Reimbursement from bank Closing balance

March

c)

1/2/14 5/2/14 End February

130 130 ___ 330

200 330

200

Stock Account i)

Date

Opening balance

Cr £

Stock Ledger

Supplier A D Bailey

3/2/14 7/2/14 15/2/14 End February

E Field

6/2/14 20/2/14 End February

M North

| Customer| | | C Day | | | | | | G Hunt | I Jones | | | | | | P Riley | | | |

Item X In No.

| | | 20 2,000 | | | | Item Y | | 300 4,500 | | | | | Item Z | | 50 2,500 | | | | | £

Out No.

15

150 100

50

| Balance £ | No. £ (at Cost)| | 1,500| | | 5 500 | | | 2,250| 1,500| | | 50 750 | | | 2,500| | | | 1,250

Chapter 13

156

ii)

Nominal Ledger Date

Details

February Purchases Cost of sales Closing balance

Stock A/c Dr £ 9,000

Cr £ 7,750 1,250 ____ 9,000

____ 9,000 March

d)

Opening balance

1,250

Fixed Assets Accounts i)

Asset Register

Leasehold property (50 year Lease) | Cost | Monthly | Date Details | |Depreciation | | £ | £ | 31/12/93 Kensington, London | 300,000 | | | monthly amortization | | 500 | | | | | | | | | | | | | | | | | | | | | End 2013 | | | Jan 2013 Amortization | | 500 |

Net book Value £

180,000 179,500

Furniture & Fittings (depreciated over 5 years) 1992 onwards Various (itemised separately, and fully depreciated) 2/1/13 Tables, chairs, cabinets Jan ’13 Depreciation

| | | |

2,400

| | | |

40

| | | |

0 2,400 2,360

| | | |

0 3,600 3,500

Computer & office equipment (depreciated over 3 years) 1992 onwards Various (itemised separately, and fully depreciated) 4/1/14 3 PCs Jan ’14 Depreciation

| | | |

3,600

| | | |

100

Note: The cost of each asset is written off by being depreciated (or amortized in the case of property) each month over the expected useful life of the asset.

Control Accounts and Nominal Ledger Reconciliations

ii)

157

Nominal Ledger Leasehold property A/c Date 1/1/14 Jan ’14 31/1/14

Details Net book value brought forward Amortisation Net book value carried forward

Dr £ 180,000

______ 180,000 1/2/14

Net book value brought forward

Cr £ 500 179,500 ______ 180,000

179,500

Furniture & fittings A/c Date 1/1/14 2/1/14 Jan ’14 31/1/14

Details Net book value brought forward Tables, chairs, cabinets Depreciation Net book value carried forward

Dr £ 0 2,400

____ 2,400 1/2/14

Net book value brought forward

Cr £

40 2,360 ____ 2,400

2,360

Computer & office equipment A/c Date 1/1/14 4/1/14 Jan ’14 31/1/14

Details Net book value brought forward 3 PCs Depreciation Net book value carried forward

Dr £ 0 3,600

____ 3,600 1/2/14

Net book value brought forward

Cr £

100 3,500 ____ 3,600

3,500

Note: 1. In this example, cost and depreciation are shown within the same account so that the balance outstanding is the net book value. However, it is quite common to have separate cost and depreciation provision accounts for the same asset category in which case it is the difference between the balances outstanding on the two accounts, which represents the net book value. 2. In all the above examples, we have assumed that the balances in the Cash Book, Petty Cash Book etc agree with the corresponding balances on the Control Accounts in the Nominal Ledger, which is very likely but not inevitable in a computerized system.

Chapter 13

158

B

Nominal Ledger Reconciliations

We have examined with illustrations the purpose and function of Control accounts, and can now move on to the subject of Nominal Ledger reconciliations, which is concerned with ensuring the accuracy of Control account balances. A Nominal Ledger reconciliation is a reconciliation of a balance on an account in the Nominal Ledger with the total of corresponding individual items or balances recorded separately. Let us take for example the Bought Ledger balances shown at the beginning of this chapter. We saw that the Bought Ledger control total of £12,200 in the Trial Balance extracted from the Nominal Ledger equalled exactly, as it should, the total of individual suppliers’ balances in the Bought Ledger. It is this examination of a Control account balance in the Nominal Ledger and ensuring that it agrees with the total of corresponding individual balances, which is known as a Nominal Ledger reconciliation. Where, however, there happens to be a difference between the Control account total and the total of individual balances, then the reason or reasons for that difference must be ascertained and corrected. Let us again take our Bought Ledger balances example, assuming that the system is computerised. Under a computerised system, after the purchase invoices and payments to suppliers have been posted to individual accounts in the Bought Ledger, the computer system automatically adds up the purchase invoice and payment totals and posts those totals to the Bought Ledger control in the Nominal Ledger. In that way, a difference between the Bought Ledger and the Nominal Ledger should never arise. So how then can a difference arise in practice within a computerised system? Apart from the remote possibility of a computer software or hardware malfunction, one way in which a difference can arise is where a Journal Entry is passed erroneously, for example, as follows:-

Travel account Bought Ledger account

Dr £ 500

Cr £ 500

Let us suppose that the £500 should not have been credited to the Bought Ledger account but to the Postage account in the Nominal Ledger. In that case, in our example on page 152 the balance would not have been a credit of £12,200 in the Nominal Ledger (summarised in the Trial Balance) but £12,700 (£12,200 + £500). However, the total of individual balances would have correctly been £12,200 in the Bought Ledger.

Control Accounts and Nominal Ledger Reconciliations

159

Having discovered that there is a difference of £500, how then does one go about ascertaining how that difference arose and rectifying it through the accounting system? There are no hard and fast rules for discovering such differences. With practice and experience one is able to ascertain the areas where such differences are most likely to arise. Furthermore, the more regularly such reconciliations are carried out, preferably once a month, the easier it is to track down any differences. In the above example, we have seen how a Journal Entry, which affects the Nominal Ledger but not the Bought Ledger, results in a discrepancy that can be easily rectified by passing the following Journal Entry: Bought Ledger account Postage account

Dr £ 500

Cr £ 500

In a manual (non-computerised) system, there is a much greater chance of discrepancies arising, for example, as a result of an error in posting the wrong total from the Purchase Day book to the Nominal Ledger, or an error in posting the wrong amount from the Day Book or the Cash Book to an individual supplier’s account in the Bought Ledger, and so on. We can see, once more, the advantage that a computerised system has over a manual system in the way it reduces substantially the likelihood of discrepancies. Let us now look at the various ways in which discrepancies can arise and the consequent need for Nominal Ledger reconciliations. a)

Bought and Sales Ledger Balances We have seen above how discrepancies can arise between the balance on the Bought Ledger Control account in the Nominal Ledger and the total of balances on suppliers’ accounts in the Bought Ledger. The same issues that relate to the Bought Ledger apply equally to the Sales Ledger.

b)

Bank Account

The reconciliations relating to the Bank account are more complex in that there are three separate balances involved namely:a) b) c)

the Bank account balance in the Cash Book the Bank account balance in the Nominal Ledger the Bank account balance on bank statements received from the bank.

Chapter 13

160

The first two balances a) and b) should normally agree in a computerised system. In a manual system discrepancies can arise, as we know, through human error. In a computerised system, a common source of error is once again the Journal Entry, for example:

Bank account Accrual account

Dr £ 800

Cr £ 800

Let us suppose the Bank account was debited in error instead of the Telephone account. Then in the example on page 152 the balance in the Nominal Ledger would have been £10,800 (£10,000 + £800) while the balance in the cash book would have been £10,000. The rectification entry would be:

Telephone account Bank account

Dr £ 800

Cr £ 800

But what about the balance c) above on the bank statement? While the bank balance in the Nominal Ledger will normally agree with the balance in the Cash Book, the balance on the bank statement at the end of a particular month is very unlikely to agree with the balance in the Nominal Ledger and the Cash Book at the end of that month. There are several reasons for the disagreement between the bank statement balance and the Cash Book balance, including the following:

- cheques drawn and entered in the cash book but not cleared by the bank until the following month or later. - cash and cheques received and entered in the cash book at the end of the current month, but not paid into the bank until early in the following month. - bank charges and interest appearing in the current month’s bank statement, but not entered in the Cash Book until the following month.

Control Accounts and Nominal Ledger Reconciliations

161

- direct debits appearing on the bank statements in the current month, not entered in the cash book until the following month. Let us take the following simple example. The details are in respect of January 2014, and it is assumed that there was no balance at the bank at the beginning of January. | |

Cash Book Receipts Date 2014 £ 1/1 15/1 22/1 29/1

9,400 10,000 5,300 11,460

______ 36,160

| | | | | | | | | | | | | | | | | | | | | | | |

Payments Date Cheque 2014 Number 2/1 4/1 4/1 4/1 7/1 8/1 11/1 12/1 13/1 19/1 19/1 23/1 23/1 25/1 27/1 28/1 29/1 29/1 Bal c/d

211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228

£

300 570 2,100 3,500 1,400 120 70 5,300 630 770 960 1,240 6,470 210 520 170 1,350 480 10,000 36,160

Bank Statements

| |Receipts| Payments | Date Cheque | | | 2014 Number| £ | £ | 1/1 | 9,400 | | 5/1 211 | | 300 | 7/1 212 | | 570 | 7/1 213 | | 2,100 | 8/1 214 | | 3,500 | 10/1 215 | | 1,400 | 12/1 216 | | 120 | 14/1 217 | | 70 | 15/1 219 | | 630 | 16/1 |10,000 | | 24/1 221 | | 960 | 23/1 | 5,300 | | 27/1 222 | | 1,240 | 27/1 223 | | 6,470 | 28/1 224 | | 210 | 29/1 Interest | | | received | 150 | | | | | | | | |

|Balance | | £ | | | | | | 1,530 | | | 710 | 10,710 | | 15,050 | | | | | 7,280 | |

Whilst the bank balance as at the end of January per the cash book is £10,000, the balance per the bank statements is £7,280. The difference is reconciled by drawing up a statement known as a ‘bank reconciliation statement’ which in our example would be constructed typically as follows:

Chapter 13

162

Bank reconciliation statement as at 31/1/14 £ 10,000

Balance per cash book as at 31/1/14 Add:

Cheques drawn but not presented until after January: Cheque No. 218 220 225 226 227 228

Less:

Add:

£ 5,300 770 520 170 1,350 480

Cheques and cash received but not deposited until after January Interest credited by bank but not entered in Cash Book until after January

Balance per bank statement as at 31/1/14

8,590

(11,460)

150 ____ 7,280

The bank reconciliation technique is based simply on identifying items appearing in the Cash Book and not on the bank statement, as well as those appearing in the bank statement but not in the Cash Book. Those items then account for or reconcile the difference between the Cash Book and the bank statement balances, as shown in the above reconciliation. c)

Petty Cash

These days it is unusual to maintain a Petty Cash Book, so all that is required is batching and filing of petty cash vouchers after the information has been keyed in. Any discrepancies that might arise would be between the balance on the Petty Cash account in the Nominal Ledger and the amount of cash in the petty cash box. There are several ways in which such discrepancies can arise, for instance: a) the petty cash is miscounted at the end of the month. b) an amount shown on the petty cash voucher is keyed in wrongly. c) the wrong amount is given to the person presenting the voucher for instance say £5 handed over in error when the voucher is only for £3. d) loss or pilferage of money in the petty cash box.

Control Accounts and Nominal Ledger Reconciliations

163

Where the discrepancy is due to a) or b), the discrepancy should be discovered after diligent investigation. Discrepancies c) and d) on the other hand would be difficult to account for, which is why three important points must be borne in mind. First, great care must be taken in handing over the correct amount of petty cash against the expense voucher presented. Secondly, the petty cash box should be stored in a secure safe. Finally, there should as far as possible be just one person in charge of petty cash, that person being responsible for accounting for the correct amount of cash at the end of each month. Where on the rare occasion a discrepancy cannot be resolved, the difference between the balance on the Petty Cash account in the Nominal Ledger and the amount of cash in the petty cash box must be ‘written off’ to the Profit and Loss account. As an example of such a write-off, supposing the Petty Cash account balance in the Nominal Ledger is £200 but the actual amount in the petty cash box is £190, then the £10 difference will be written off by the following Journal Entry:

Sundries account Petty cash account (Being a shortfall in Petty Cash)

Dr £ 10

Cr £ 10

As a result, the Petty Cash account balance in the Nominal Ledger will be reduced to £190, equalling the amount in the petty cash box. If the Petty Cash balance in the Nominal Ledger were lower than the actual amount in the petty cash box, then the rectification entry would, of course, be the reverse of the one shown above. d)

Stock

If the Stock Ledger is computerised, there ought to be little scope for differences from the Stock account in the Nominal Ledger. However, as in the case of computerised Bought and Sales Ledger systems, a Journal Entry that erroneously debits or credits the Stock account would create a discrepancy. If the Stock Ledger is kept on a manual basis, then, of course, any human error in recording entries in the Stock Ledger would result in a discrepancy which would be identified only by a close scrutiny of the Stock Ledger.

Chapter 13

164

e)

Fixed Assets

As in the case of computerised Bought, Sales and Stock Ledger systems, there is little scope (apart from erroneous Journal Entries) for there to be differences between the Fixed Asset Register and the Fixed Asset account balances in the Nominal Ledger. Manual Fixed Asset Registers could, as we know, result in differences resulting from human error and would need to be carefully examined to enable those differences to be located and rectified. f)

Other Nominal Ledger Reconciliations

We have seen how balances on Control accounts in the Nominal Ledger need to be agreed or reconciled regularly with the total of individual balances which are separately recorded or which exist physically on the premises as in the case of Petty Cash. However, Control accounts are not the only accounts to require Nominal Ledger reconciliations. In fact every account in the Nominal Ledger needs to be scrutinised and where necessary reconciled and corrected. Let us go back to the Trial Balance on page 152 and scrutinise the other balances namely:

i) Staff advances ii) Prepayments

£ 4,500 (Dr) 500 (Dr)

iii) Accruals

1,000 (Cr)

(PAYE iv) (National insurance (Pension contributions

2,200 (Cr) 1,000 (Cr) 800 (Cr)

In each case we need to know what these balances represent, and whether or not they are correct.

Control Accounts and Nominal Ledger Reconciliations

i)

165

Staff Advances - £4,500 Dr A separate manual record is maintained of advances made to the following staff who have not yet paid back the amount they owe: S G A

£ 1,200 2,150 1,170 4,520

Tomlinson Fraser Monks

Note that the total of advances owing is £4,520 compared with £4,500 outstanding on the Staff Advances account in the Nominal Ledger. On further investigation, it is found that a £20 credit note for stationery returned has been credited in error to Staff Advances account instead of stationery account. The rectification entry is:

Staff advances account Stationery

Dr £ 20

Cr £ 20

This brings the balance on the Staff Advances account in the Nominal Ledger up to £4,520, in line with the total of advances recorded separately. One can see clearly that it is only by scrutinising Nominal Ledger accounts as regularly as possible (i.e. carrying out frequent Nominal Ledger reconciliations) that one is able to pick up errors which would otherwise go undetected, and result in the production of an inaccurate set of accounts. ii)

Prepayments - £500 Dr By inspecting the Prepayments account in the Nominal Ledger one can see that there is, let us say, only the Rates account involved. The £500 prepayment is the debit balance outstanding at the end of January 2014 in respect of a rates bill of £3,000 for the period 1/4/13 - 31/3/14 paid on 1/4/13. We check that the £500 debit balance at 31/1/14 is correct, as follows: - the £3,000 prepayment made on 1/4/13 is reduced each month by 3,000/12 = £250.

Chapter 13

166

- after 10 months, i.e. on 31/1/14, the prepayment is reduced by £250 x 10 = £2,500. - the prepayment outstanding at 31/1/14 is therefore £500, i.e. £3,000 - £2,500. For further clarification, let us look at the entries in the relevant accounts in the Nominal Ledger, assuming that the accounting year is 1/4/13 - 31/3/14. Prepayments A/c Details Dr Cr £ £ 2013 1st April 3,000 April 250 May 250 June 250 July 250 August 250 September 250 October 250 November 250 December 250 2014 January 250 Bal c/d 500

Bal b/d February March

____ 3,000 500

____ 3,000 250 250

___ 500

___ 500

| | | | | | | | | | | | | | | | | | | | | | | | | |

Details

Bank A/c Dr £

2013 1st April

2014 End January balance

End March balance

| Cr | £ | | 3,000 | | | | | | | | | | | | 3,000 | | ____ | 3,000 | 3,000 | | | | ____ | 3,000 |

Details

Rates A/c Dr £

Cr £

2013 April 250 May 250 June 250 July 250 August 250 September 250 October 250 November 250 December 250 2014 January 250 Charged to P&L A/c (to date) ____ 2,500 February 250 March 250 Charged to P&L A/c (Feb/March ’10) ___ 500

2,500 ____ 2,500

500 ___ 500

The Trial Balances as at the end of January 2014 and March 2014 would be as follows: End January ’14 | Dr Cr | £ £ | Prepayments 500 | Bank 3,000| Rates A/c - April ’13 to January ’14 2,500 | Rates A/c - February and March’14 | ____ ____ | 3,000 3,000|

End March ’14 Dr Cr £ £ 3,000 2,500 500 ____ ____ 3,000 3,000

Balance Sheet Balance Sheet P & L A/c P & L A/c

Control Accounts and Nominal Ledger Reconciliations

iii)

167

Accruals - £1,000 Cr Based on invoices received in respect of the first quarter of 2013, the charges expected to be received in April 2014 relating to the quarter 1/1/14 - 31/3/14 for the following costs are: £ 1,200 300 1,500 ____ 3,000

Gas Electricity Telephone

The Profit and Loss Account charge for each month, and the month end accruals, would be: January P&L Month charge end accrual £ £ Gas 400 400 Electricity 100 100 Telephone 500 500 ____ ____ 1,000 1,000

| | | | | | | | |

February P&L Month charge end accrual £ £ 400 800 100 200 500 1,000 ____ ____ 1,000 2,000

| | | | | | | | |

March P&L Month charge end accrual £ £ 400 1,200 100 300 500 1,500 ____ ____ 1,000 3,000

| | | | | | | | |

End March Dr Cr £ £ 1,200 300 1,500 3,000 ____ ____ 3,000 3,000

The Trial Balances would be: End January Dr Cr £ £ Gas 400 Electricity 100 Telephone 500 Accruals 1,000 ____ ____ 1,000 1,000

| | | | | | | | |

End February Dr Cr £ £ 800 200 1,000 2,000 ____ ____ 2,000 2,000

When carrying out Nominal Ledger reconciliations one should check that: a)

the charges for each of the expense items, gas, electricity and telephone, are reasonable based on previous experience.

Chapter 13

168

b)

iv)

the accruals at the end of each month are correct as analysed above.

PAYE - £2,200 Cr National Insurance - £1,000 Cr Pension Contributions - £800 Cr In order to check whether or not the above payroll credit balances are correct we need to refer to the payroll records. In a computerised system the relevant print-out would include the following main headings: Gross Pay

Employer’s Contributions National Insurance Pensions

PAYE Employees’ Contributions Net National Pay Insurance Pensions

Suppose for the month of January the total shown in the payroll records for PAYE is £2,200, national insurance (employer’s and employees’) is £1,000 and pension contributions (employer’s and employees’) is £800, then we can see from the print-out that they are the totals of individual amounts shown against each employee. If one or more of the above totals for January do not agree with the credit balances on the Trial Balance, then it could well be that the Trial Balance figures include the total for December (checked against payroll records) which has not yet been paid over to the relevant government departments (in the case of PAYE and national insurance), or to the pension scheme (in the case of pension contributions). Suppose one found, however, that the Trial Balance at the end of January showed correct credit balances for national insurance contributions of £1,000 and for pension contributions of £800, but an incorrect credit balance of £2,200 instead of £2,100 in respect of PAYE. We know that the national insurance and pension balances are correct, but that there is something wrong with the PAYE balance. One obvious possibility is that there might have been a mis-posting to the PAYE account in the Nominal Ledger wrongly crediting that account with £100 as a result of which the PAYE account balance is £2,200 Cr instead of £2,100 Cr. A rectification entry would reduce the credit balance to £2,100 bringing it in line with the January total of PAYE shown in

Control Accounts and Nominal Ledger Reconciliations

169

the payroll records. Another possibility in a manual system is that £2,200 instead of £2,100 was posted from the payroll records. In this case, the Trial Balance would not balance (not possible in a computerised system), the total on the credit side being £100 more than the total on the debit side. It is only by carefully rechecking the postings to the Nominal Ledger that one would discover the £100 posting error and proceed to rectify it. C

Summary We have seen how regular scrutiny of Nominal Ledger accounts is a crucial function of the accounts department. In most fully computerised systems it is, in theory, impossible for a Trial Balance not to balance because of the way the software program is written. However, that certainly does not suggest that the balances are correct. For instance, if an amount were posted to the wrong account both sides of the Trial Balance would still agree. There is, therefore, no short-cut to discovering such errors and ensuring that balances in the Nominal Ledger are correct. The only way to ensure that the balances are correct is to scrutinise and reconcile as regularly as possible the balances on all accounts in the Nominal Ledger.

CHAPTER 14 MANAGEMENT INFORMATION

A

Introduction

We have so far concentrated on systems and procedures for processing transactions and accounting adjustments through accounting systems - manual or computerised. Whilst one of the basic objectives of accounting is the recording of financial information, another equally important objective is to use that information for management purposes. Every business or organisation, without exception, must have rapid access to accurate and relevant management information to help it to succeed. It is difficult to make the right decisions where reliable and up-to-date information is not quickly available. One of the very important advantages of a good computerised system is that the software package enables a great deal of management information to be produced automatically with a few keystrokes, based on data that has already been entered. Let us summarise the management information which would typically be required by a business: a)

Budget and long-term plan

b) Essential monthly information: - Profit and Loss Account, - Cash flow statement - Balance Sheet c)

Recommended monthly information including: - Profit & loss forecast - Cash flow forecast - Average period of credit - Accounting ratios

Management Information

171

d) Other ‘ad hoc’ information (i.e. produced as and when required) -

Revenue analysis - by product - by customer - by region - by salesman

-

Expense analysis

-

Departmental analysis

-

Aged debtors analysis

There are various ways in which information can be stored and accessed, including the following: 1) Accounting systems Much of the information listed above can be extracted automatically from accounting systems into which financial data for purchases, sales, etc is initially entered. These are systems sold by a number of major software companies and give users a very wide choice depending on their individual requirements. 2) Spreadsheets Another popular method for storing and accessing information is in the form of spreadsheets. Information is either entered manually into spreadsheets or ‘downloaded’ (i.e. transferred electronically) from the accounting system into spreadsheets. Spreadsheets are a very powerful tool enabling data entered or downloaded to be manipulated in many different ways with the help of builtin formulas or computer programs, to allow management to receive information in the format required. A great deal of very valuable information, in addition to the reports listed above, can be produced quickly and accurately on spreadsheets once the spreadsheets have been correctly constructed with relevant tables and formulas and supported where necessary by codes written by the user, for example, in Visual Basic, which is the Microsoft programming language.

172

Chapter 14

3) Database systems There are a number of database systems on the market, which are chiefly designed to store and manipulate large volumes of data that may be more efficiently handled through this medium than in the form of spreadsheets. B

Review of Information Categories a) Budget and Long-term Plan Towards the end of each year it is essential that a budget or financial target should be set for the next year together with a longterm plan for the following three to five years. The budget for the next year should show for each month and the year as a whole a detailed Profit and Loss Account and, preferably in addition, a cash flow statement and a Balance Sheet. The long-term plan should have at least an abbreviated Profit and Loss Account for each year. Both the budget and the plan should be accompanied by detailed commentaries on how the short-term and long-term targets are to be achieved. b) Essential Monthly Information Let us now prepare, as an example, a Profit and Loss Account and a cash flow statement with budget comparatives, of T. Pratt’s printing business for the month of January 2014, and a Balance Sheet as at the end of January 2014.

Management Information

173

Profit and Loss Account for the month of January 2014

Revenue Books - hardback - paperback Magazines Journals Direct Costs Labour Paper Ink Machine repairs Machine depreciation

Gross profit Overheads Labour Postage Office stationery Travel Car expenses Subsistence Entertaining Insurance premium Office cleaning Gas Electricity Telephone Rent Rates Bank charges Audit fees Other professional fees Depreciation - Furniture and fittings - Office equipment - Computer equipment - Car Temporary staff Sundries

Net profit

Actual £

Budget £

21,000 11,500 5,300 4,100 41,900

18,000 12,000 6,000 3,600 39,600

B W W B B

3,000 500 700 500 2,300

14,100 1,350 100 205 2,400 18,155

13,800 1,200 90 210 2,400 17,700

W W W B W

300 150 10 5 455

23,745

21,900

B

1,845

12,650 270 340 210 135 210 225 90 45 180 132 210 1,200 180 15 240 -

12,600 240 360 180 120 240 180 90 48 180 126 210 1,200 180 24 240 48

W W B W W B W

B

50 30 20 30 15 30 45 3 6 9 48

300 150 240 180 50 70 17,322

300 150 240 180 120 90 17,346

B B B

70 20 24

6,423

4,554

B

1,869

* Variance signs: B = better than budget; W = worse than budget

*Variance £

B W

B

Chapter 14

174

Note: Budget amounts have been taken as actual in the case of depreciation and certain other accrued expenses such as insurance premium, gas, etc. where invoices have not yet been received. When invoices are received in future months, the actual amounts for depreciation and other expenses are then substituted for the accruals, resulting in variances against budget. Cash Flow Statement for the month of January 2014

Profit in January

Actual £ 6,423

Budget £ 4,554

B

Variance £ 1,869

Add: Less:

Depreciation Capital Expenditure

870 (4,500)

870 (3,200)

W

1,300

Add:

Increase in creditors Decrease in debtors Increase in debtors

750 (900) ____ 2,643

1,200 500 ____ 3,924

Less:

Cash inflow in January

W W W W

450 500 900 ____ 1,281

Note: 1. Although the actual profit is higher than the budgeted profit in January, the budgeted inflow of cash is higher than actual, as analysed above. 2. The figures in the actual column for profit and depreciation are taken straight from the Profit and Loss Account. The figures for the other items are arrived at by taking the difference between the assumed opening and closing Trial Balances, as follows:

- Fixed assets (total of gross book values) - Creditors - Debtors

Extracts from Trial Balances at 1/1/14 31/1/14 £ £ 55,000 (Dr) 59,500 (Dr) 50,000 (Cr) 50,750 (Cr) 65,000 (Dr) 65,900 (Dr)

Movement in January £ (4,500) 750 (900)

The above assumed amounts are extracted from the ‘actual’ Trial Balances; the same procedure is followed to arrive at budgeted cash flows. The following debit and credit entries, although not actually journalized, illustrate the impact on cash flow:

Management Information

175

Dr £ 4,500

a) Fixed assets account Bank account (Purchase of fixed assets)

Cr £ 4,500

b) Bank account Creditors account (Increase in creditors)

750

c) Debtors account Bank account (Increase in debtors)

900

750

900

After January, the Profit and Loss Account and the cash flow statement will be produced not only for each succeeding month but cumulatively as well. Hence, for instance, the cumulative Profit and Loss Account for March will include totals of each of the items for January, February and March, and show the profit or loss for the three months put together. The Balance Sheet at 31/1/14 of T. Pratt’s business is as follows: Balance Sheet as at 31/1/14 Net Assets £ Fixed assets (net book value) Current assets Stock Debtors Balance at bank (£10,000 at 1/1/14)

1,000 65,900 12,643

£ 34,000

79,543

______ 113,543

| Capital & Liabilities | £ £ | Current Liabilities | Creditors 50,750 | Accruals 1,370 52,120 | | | Capital and Profit & Loss | Account accumulated balance | (£55,000 at 1/1/14) 61,423 | ______ | 113,543

Note: In practice, the Balance Sheet does not show budget comparatives; these are normally shown only in the Profit and Loss Account and Cash flow statement.

Chapter 14

176

c)

Recommended Monthly Information Profit and Loss Account Forecast In management information terms, a forecast is not the same as a budget. Forecasts are made in addition to the budget. Whilst budgets are drawn up once a year, forecasts are made several times during the course of the financial year to which they relate, either at the end of each month or each quarter. Hence whilst the budget for 2014 will have been prepared and finished during the latter part of 2013, forecasts for the remainder of 2014 will be made, for instance, at the end of March 2014, June 2014 and September 2014. Forecasts, in other words, give the most up-to-date view of the expected results for the current year, while the budget is prepared only once and will be somewhat out of date by the time the forecasts are made. To take just the revenue sections of our printing business, supposing we wish to make a forecast at the end of March 2014 and the position at 31.3.14 is as follows: 1/1/14 to 31/3/14 Actual Budget £ £ Books - hardback 60,000 56,000 - paperback 34,000 35,000 Magazines 16,500 18,500 Journals 12,000 10,500 ______ ______ 122,500 120,000

| | | | | | | | | |

1/4/14 to 31/12/14 Budget £ 170,000 102,000 55,000 32,000 ______ 359,000

| | | | | | | | | |

2014 Total Budget £ 226,000 137,000 73,500 42,500 ______ 479,000

In order to prepare a forecast at the end of March 2014, two main factors must be taken into account. i) Actual performance during the quarter ended 31/3/14. ii) Likely performance during the remainder of the year, bearing in mind the budgeted performance for the remainder of the year. The performance during the March quarter tells us that there has been a £2,500 improvement on budgeted revenue, which will therefore help the results for the year as a whole. The March quarter results give an idea of the current trend which coupled with

Management Information

177

up-to-date information about the remaining months of the year will enable a forecast to be made, perhaps as follows:

Books - hardback - paperback Magazines Journals

1/1/14 to 31/3/14 Actual £ 60,000 34,000 16,500 12,000 ______ 122,500

1/4/14 to 31/12/14 Forecast £ 165,000 105,000 50,000 37,000 ______ 357,000

2014 Total Forecast £ 225,000 139,000 66,500 49,000 ______ 479,500

Paperback books and journals are expected to perform better than budget during the remainder of the year. Hardback books and magazines, on the other hand, are expected to show a revenue shortfall owing to a general downturn in the economy resulting in a cut-back in demand for the more expensive hardbacks and for certain magazines. The overall revenue for 2014 as a whole is, therefore, expected to be just £500 ahead of budget despite a first quarter improvement of £2,500. The forecast shown in our example covers the nine months from 1/4/14 to 31/12/14. In practice, there would be ‘rolling’ forecasts for each future quarter if not each month from April to December. Also, the forecasts would cover the whole of the Profit and Loss Account including each item of cost. Cash Flow Forecast The procedure used for cash flow forecasting is normally the same as that used for forecasting the Profit and Loss Account. However, the factors involved in forecasting cash flow items are in most cases quite different. Let us examine each of the major cash flow items in turn. i) Profit or loss: this figure is, of course, taken straight from the Profit and Loss Account forecast.

178

Chapter 14

ii) Depreciation: this figure, again, is taken from the Profit and Loss Account forecast. iii) Capital expenditure: this is one of the easiest of cash flow items to forecast since the amount of capital expenditure to be incurred during the remainder of the year is a management decision and fully under managerial control. The items to be purchased, their price after discount, and the month or months in which they are to be purchased, can all be forecast with a high degree of accuracy. These forecasts can, however, still go wrong where, for instance, trading results have taken an unexpected turn for the worse, consequently requiring last minute cut-backs in capital expenditure. The alternative might be higher bank borrowings which may not be management’s preferred option. iv) Future movement in creditors, which depends mainly upon: - the forecast level of trading, hence the volume of purchases; - the pressure from creditors to pay sooner rather than later; - how healthy or otherwise the bank balance is. So far as the first factor is concerned, the higher the amount of purchases forecast in the Profit and Loss Account, the higher the likely level of creditors. The pressure from creditors for earlier payment depends upon the state of the economy and the business’s relationship with them. Often there are warning signs in the form of frequent telephone calls from certain suppliers. Where such calls happen to come from a number of the major suppliers, it could signal the need for earlier payments, but the amount eventually paid to creditors will also depend upon how healthy or otherwise the business’s bank balance is. v) Future movement in debtors, which depends mainly upon: - the forecast level of trading, hence the volume of sales. - the pressure to be put on customers to pay sooner rather than later.

Management Information

179

As with creditors, the movement in debtors depends upon the forecast level of trading reflected in the sales forecast in the Profit and Loss Account. The greater the value of sales, the higher is the likely level of debtors. The second factor determining the future level of debtors is the extent of pressure to be put on customers to settle their accounts sooner than they have in the past. Unless a significant deterioration in trading conditions is forecast, there is normally no need to change one’s attitude towards customers’ payment patterns. It could be, however, that certain customers who are traditionally poor payers should be asked to pay more promptly in future. Or management could decide that the average period of credit extended to customers is too long, and give instructions to the credit controller to reduce the average period of credit, thereby improving cash flow. Management must, however, bear in mind that they could lose some of their customers by putting too much pressure on them for earlier settlement of their debts. Average Period of Credit As mentioned above, ‘period of credit’ which is part of the ‘terms of settlement’, is the commonly used term for the length of time allowed to customers for settlement of their debts. The most common period of credit allowed to customers is one month. However, whilst the terms of settlement are specified in the contract, and/or pre-printed on sales invoices, a number of customers do not, in practice, settle on time. Hence, if the stipulated period of credit is say one month, the period of credit taken by some customers may be five, six, seven weeks or more. As a result, the average period of credit for debtors as a whole would often be in excess of one month. There are various ways of calculating the average period of credit, but the following is a simple example of the way the average period of credit is calculated. Customer

A B C D

Sales during 1/1/14 - 31/3/14 £ 4,000 5,500 3,200 8,400 21,100

Amount outstanding at 31/3/14 £ 2,000 3,000 1,500 4,500 11,000

Chapter 14

180

Average period of credit calculation: - The period 1/1/10 - 31/3/14 consists of about 13 weeks - 11,000 x 13 (weeks) = 6.8 21,100 6.8 weeks is the average period of credit. Supposing management had in the past put greater pressure on customers so that average period credit had been 5.8 weeks instead of 6.8 weeks. The amount outstanding at 31/3/14 would then have been: 5.8 (weeks) x £21,100 = £9,414 13 (weeks) As a result, the bank balance would have been £1,586 (£11,000 – £9,414) higher. This example clearly shows that the lower the average period of credit allowed to customers, the higher the bank balance will be. However, as mentioned earlier, management must bear in mind the risk of losing some of those customers by putting pressure on them. If customers are lost then, at least in the short-term, there will be a reduction in profits and consequently a reduction in the inflow of cash. Accounting Ratios Accounting ratios are among the various tools of management, which enable it to measure business performance month by month. Let us take our printing business to illustrate some of the common ratios and percentages used in business. i) Gross Profit as a Percentage of Turnover This percentage is also known as the gross margin, and tells us about the profitability of products sold before taking into account the overhead costs of the business. The gross margin concentrates on the profitability of products as well as the profitability of the business as a whole. In our example, the actual gross profit

Management Information

181

percentage is 56.7% (23,745/41,900 x 100) compared with a budgeted 55.3% (21,900/39,600 x 100). In addition to a comparison with budget it is also important to compare the 56.7% overall percentage with the percentage relating to each product and with the average for other printing businesses. Where a product yields a gross margin well below 56% then the strategy in respect of that product should be carefully reviewed. ii) Net Profit as a Percentage of Turnover This percentage is also known as the net margin. In our example, net profit as a percentage of turnover is 15.3% (6,423/41,900 x 100) compared with a budget of 11.5% (4,554/39,600 x 100). This is one of the most important and commonly used business ratios that can be compared with the net margin of other printing businesses simply by referring to their audited accounts. iii) Return on Capital Employed (ROCE) This is another very important ratio which refers to the net profit of the business as a percentage of capital plus reserves. In our example, it is 10.5% (6,423/61,423 x 100), and as with the net margin it should be compared with the ROCE of other similar businesses. The return on capital employed is the same as the return on net assets (RONA) since capital plus reserves = net assets (assets minus liabilities). iv) Period of Credit In our printing business example, the period of credit at 31/1/14 is as follows:

Debtors - 31/1/14 Sales in January (4.4 wks) Period of credit: 65,900 x 4.4 weeks = 41,900

Actual £ 65,900 41,900

6.9 weeks

Chapter 14

182

Another way of calculating period of credit is to take into account the sales of the previous month, December 2013. Supposing the sales in December were £35,000, the period of credit would be calculated as follows:

Revenue in December Revenue in January

£ 35,000 41,900 76,900

Period of credit: £65,900 (Debtors) / £76,900 (Dec/Jan sales) x 8.8* weeks = 7.5 weeks. * Number of weeks in December & January By the second calculation the period of credit is 7.5 weeks. The second method is preferable since it does not rely on just one month’s sales. However, whichever method one uses, the important thing is to be consistent, so that one can accurately assess the monthly trend in the period of credit and take whatever action is considered necessary. v) Liquidity Ratios A liquidity ratio is one which assesses the potential for converting current assets less current liabilities into cash. The higher the ratio the more comfort, in a sense, it gives one that extra cash can be generated quite quickly, by reducing current assets or increasing current liabilities. The liquidity ratio that is commonly used is current assets/current liabilities. In our example, this ratio would be: 79,543 = 1.5 52,120 The 1.5 ratio suggests that there is scope for reducing that ratio through a reduction in current assets or an increase in current liabilities or both. A comparison of this ratio with that of similar

Management Information

183

businesses would help to assess the appropriateness of the 1.5 ratio in our example. If the ratio is much higher than the norm, it could suggest that too high a proportion of the funds of the business is tied up in current assets. vi) Interest Cover Although there is no bank loan in our example, many businesses do have bank loans or overdrafts on which the interest payable is charged to the Profit and Loss Account. Interest cover is the ratio: Net profit/Interest. The higher the ratio the stronger the business’s financial position since there is more room for further borrowings should there be a requirement for additional funds for investment or any other purpose. vii) Price Earnings Ratio In the case of companies which are quoted on the stock exchange, shares are bought and sold at prices which are constantly changing. In order to gauge whether a company’s share price is high or low in relation to its recent annual earnings, a ratio called the price earnings ratio (PER or PE ratio) is calculated and published in some national newspapers. The PE ratio is: Total market value of shares The latest annual net profit If, for instance, the share price of a company on a given day is £2 and the total number of shares issued is 400 million then the total market value of the shares or the ‘market capitalisation’ is £800 million. If the net profit (after tax) for the most recent accounting year is say £60 million, then the PE ratio is: £800 million (total market value) = 13.3 £60 million (annual net profit) If the average PER in the relevant industry is say 12, then the shares of the company in our example are valued at a slight premium. In other words, those who trade in that company’s shares

Chapter 14

184

on the stock market think rather more of the company’s current financial position and future prospects than they do of the average performance and prospects of other quoted companies in the same industry. The above ratios and percentages are among the common ones used to evaluate the trading performance and financial position of a business. They help a potential investor or supplier or a bank to decide whether or not to go ahead with an investment, a supply of goods or services, or a bank loan. d) Other ‘Ad Hoc’ Information Revenue Analysis There are various ways in which sales can be analysed, and the main methods with typical print-out formats are shown below: Jan £ Product analysis Product

Customer analysis Customer

Feb £

March £

1st quarter £

April £

etc.

a b c etc.

a b c etc.

Regional analysis Southern Western etc. Analysis by salesman a Salesman b c etc.

In addition to sales analysis, one can have gross profit analysis as well. One of the most useful analyses of gross profit is by product or product category. This enables management to decide upon its

Management Information

185

future product strategy, which means deciding on the product ranges which should be continued or expanded and those which should be contracted or discontinued. Expense Analysis As mentioned before, one of the main advantages of a computer system is the ability to call up on the screen or to print out an analysis of any particular type of expenditure. Let us suppose that in the month of March, the expenditure on travel has been exceptionally high. One can quickly see the reason for this by running off a print-out of the Travel account, which might look like the following: Travel account Date 2014

Invoice Ref

3/1 14/1 25/1

7241 1564 3289

7/2 18/2

4/3 12/3 17/3 29/3

Details

Amount £

VAT £

Total £

T. Phillips - New York S. Andrews - Aberdeen P. Norton - Southampton

700.00 120.00 45.00 865.00

0.00 0.00 0.00 0.00

700.00 120.00 45.00 865.00

0172 8914

F. Bradshaw - Brighton N. Jones - Liverpool

6.00 75.00 81.00

0.00 0.00 0.00

6.00 75.00 81.00

2498 7632 4891 5583

N. Young - Manchester O. Peterson - Sydney, Australia R. Harvey - New York H. Smith - Southampton

70.00 3,000.00 700.00 45.00 3,815.00

0.00 0.00 0.00 0.00 0.00

70.00 3,000.00 700.00 45.00 3,815.00

Note: VAT is not chargeable on travel costs.

By printing out the Travel account as shown above, one can see straight away that O. Peterson’s trip to Australia accounts for the exceptionally high cost of travel in March. In practice, there would be far more items involved and the print-out which could run into several pages, would need to be carefully scrutinised in order to obtain the explanation one is looking for.

Chapter 14

186

Departmental Analysis Most businesses above a certain size have a number of departments which enable the businesses to be run more efficiently than if there were no departmental structure. The departments one would commonly come across are: - Production - Selling - Administration In practice, especially in larger organisations, separate Profit and Loss Accounts are often produced for each sector or product category, within each of which one might have sub-departments for production, selling and administration. In our printing business example, one might well have separate Profit and Loss Accounts for hardback books, paperback books, magazines and journals and within each of these there could be sub-departments for production, selling and administration. It might be that certain categories of overhead expenditure are not capable of being allocated to any one or more of the products sold, in which case there would need to be a further ‘department’ which relates to overhead expenditure which cannot be allocated to individual products. For the purpose of demonstrating a departmental analysis, let us assume, taking our printing business example, that there are only three departments: production, selling and administration. The revenue and costs shown in the overall Profit and Loss Account would be broken down departmentally as follows:

Management Information

187

Production department Actual £ 14,100 1,350 100 205 2,400 _____ 18,155

Labour Paper Ink Machine - repairs - depreciation

Budget % 33.7 3.2 0.2 0.5 5.7 ___ 43.3

£ 13,800 1,200 90 210 2,400 _____ 17,700

% 34.9 3.0 0.2 0.5 6.1 ___ 44.7

Note: % = percentage of total revenue

The percentage column is usually a truer reflection of efficiency than the actual costs, as the percentages are related to differences in production volumes. Hence, although the total actual cost is higher than budget, the percentage is lower suggesting that actual efficiency is greater than budget especially in the cost of labour. It should be noted that the lower actual percentages could also be the result of differences in pricing. The best measure of cost efficiency is ‘cost per unit sold’ which is not distorted by variations in revenue resulting from pricing differences. Selling department

Books - hardback - paperback Magazines Journals

Actual £ 21,000 11,500 5,300 4,100 _____ 41,900

Budget £ 18,000 12,000 6,000 3,600 _____ 39,600

Variance £ B 3,000 W 500 W 700 B 500 ____ B 2,300

The £2,300 improvement is the result of differences in a) pricing and b) volume. Let us assume that the revenue and gross profit for hardback books is arrived at as follows: Volume sold Price Volume x price = Total cost Gross Profit

Actual 1,500 £14 £21,000 £12,000 £9,000

Budget 1,200 £15 £18,000 £10,800 £7,200

188

Chapter 14

One can see that although each book has been sold at £1 less than budget, the actual numbers sold have exceeded budget by 300. Although the increased volumes have required additional resources in the form of labour, paper, etc., the actual gross profit is in excess of budget, confirming that management made the right decision to cut the price and increase volumes. Furthermore, the actual cost per unit of hardback books is £8, i.e. 12,000 ÷ 1,500, compared with a budgeted cost per unit of £9, i.e. 10,800 ÷ 1,200, showing that hardback books have been produced more efficiently than had been anticipated when the budget was drawn up. Administration department

Labour Postage Office stationery Travel Car expenses Subsistence Entertaining Insurance premium Office cleaning Gas Electricity Telephone Rent Rates Bank charges Audit fees Other professional fees Depreciation - Furniture and fittings - Office equipment - Computer equipment - Car Temporary staff Sundries

Actual £

Budget £

Variance £

12,650 270 340 210 135 210 225 90 45 180 132 210 1,200 180 15 240 -

12,600 240 360 180 120 240 180 90 48 180 126 210 1,200 180 24 240 48

W W B W W B W

300 150 240 180 50 70 _____ 17,322

300 150 240 80 120 90 _____ 17,346

B W

B B

B B B

50 30 20 30 15 30 45 3 6 9 48 70 20 __ 24

It is the responsibility of the manager or director in charge of administration to scrutinise the variances, especially those that are unfavourable as in the case of labour, postage and entertaining, among others. Sometimes variances are merely to do with timing,

Management Information

189

which means that the actual expenditure was incurred in a different month from the one in which it was budgeted to occur. Aged Debtors Analysis This is a detailed listing of debtors’ balances outstanding showing the length of time each debtor’s balance has been outstanding. In our example, the Balance Sheet at the end of January showed £65,900 worth of debtors outstanding. The aged debtors analysis might have the following details on it: Debtors Name

ABC DEF GHI JKL MNO PQR STU VWX

Balance outstanding

1 month old

2 months old

3 months old

£ 20,000 1,700 12,500 4,350 16,500 2,870 3,180 4,800 _____ 65,900

£ 12,000 1,500 8,700 3,500 12,300 2,870 3,000 1,000 _____ 44,870

£ 7,000 100 2,000 400 3,150 3,800 _____ 16,450

£ 500 1,200 450 400 ____ 2,550

Over 3 months old £ 500 100 600 650 180 ____ 2,030

In our example, the revenue in January 2014 was £41,900, and assuming it was £35,000 in December 2013, the average period of credit would be 6.9 weeks or 7.5 weeks depending on which method one applied. The age profile of the balance outstanding (£65,900) as analysed in the above age debtors analysis does not affect the average period of credit calculation. What the age debtors analysis does do is highlight the long outstanding debts especially those that are more than 3 months old, some of which might soon start to become doubtful and eventually have to be written off as bad debts. It is also an excellent tool to enable the credit control department to concentrate on those debts that have been outstanding the longest. We have now completed our examination of a typical basic management information system comprising monthly accounts prepared for each month and cumulatively, and some useful accounting ratios. Information which is needed from time to time on an ‘ad hoc’ basis is also very much a part of the

190

Chapter 14

management information system. In practice, management information systems will vary in detail between businesses and industries according to the requirements of each management team but will include in one form or another much of the essential information outlined in this chapter.

CHAPTER 15 WEBSITE ACCESS AND CREATION

Introduction We live in an age where access to information on the internet is indispensable to people in all walks of life. For those in the world of finance, involving students and businessmen for example, it is essential to have access to the internet to be able to obtain help and information on a very wide variety of topics. In the last chapter on page 171, we see that spreadsheets are among the most popular and useful ways of storing and accessing information. The spreadsheet application that is most commonly used is Microsoft Excel, which is often backed up by the Microsoft programming language, Visual Basic, which adds considerably more power and functionality to Excel. In this chapter we look at ways in which such spreadsheet applications are accessed on the internet by selecting websites that are likely to be the most suitable for providing the help or information that is required.

Accessing help and information There are broadly two reasons why websites providing management information are accessed. Firstly, those who already have their own spreadsheet systems may require some help to enable them to solve some technical problem that they come across when creating or upgrading a spreadsheet of their own to help them meet certain management information requirements. Secondly, even those who have not set up their own spreadsheets to provide certain information that they require, may be able to find and ‘download’ into their system a comprehensive spreadsheet solution in one of the websites that they have found by browsing through the internet. The question then is how one goes about finding on the internet the help or solution that is needed. The answer lies in, first of all, selecting a ‘search

192

Chapter 15

engine’ through which help or information is received. There are many search engines on the internet, of which one of the most popular is ‘Google’. These days the word google is often used as a verb to mean searching for help or information on the internet. Once a search engine such as Google or Yahoo, for example, is selected, the next step is to enter what are known as keywords in a panel on the front or ‘home’ page of the search engine.

Keyword selection To find the most suitable information that one is looking for, it is most important to enter what are known as ‘keywords’ that are the most likely to bring up a list of websites, one or more of which can provide the help or information that is being sought. Let us now look at examples of the two main types of enquiries we might wish to make by entering keywords into the chosen search engine. a) Keyword examples for model templates or solutions: Supposing we wish to obtain models or examples or templates of a basic monthly accounting system, the following are examples of keywords we might choose to enter: - Monthly accounting templates - Monthly accounting models - Spreadsheet-based monthly accounting - Excel spreadsheet monthly accounts models The above are just a small selection of a number of possible options for finding websites with the monthly accounting system that would most suit one’s individual requirements.

b) Keyword examples for receiving technical help or suggestions: Supposing we find ourselves facing a technical problem while creating or modifying a spreadsheet that already exists in our system. Once again, we need to decide upon keywords that are most likely to bring up websites that will enable us to solve our problem. If, for example, we wish to consolidate a number of tables by using a very useful and powerful tool in Excel called pivot tables, we can simply enter the keywords ‘consolidation of multiple tables using a pivot table’. If those keywords do not bring up websites that offer the solution that we are looking for, we can then simply key in some other keywords and by entering a

Website Access and Creation

193

variety of keywords find the website or websites that come up with the right solution.

Website selection Once we enter our keywords that bring up the front page of the service provider’s website listings, we then have to select the website that is the most likely to provide the solution or technical guidance we are looking for. But how do we do that? Often, the website listings are shown across several pages and occasionally we need to go from page to page to locate the website that looks the most promising for our purposes. It is, however, worth bearing in mind that generally the website most likely to satisfy our needs will be on the first page or one of the early pages. That is how the service provider’s so-called ‘search engine optimization’ (SEO) system tends to work. The other thing to bear in mind is that below each website listing there is a short description normally comprising a couple of lines explaining briefly the information each website offers. A brief glance at each of the website descriptions is often enough to enable us to decide which website to click on to obtain the help or information we are looking for.

Website creation So far we have looked at ways in which we can avail ourselves of the help and information given by websites that already exist on the internet. These are websites that have been constructed by other individuals or businesses. But if we have our own business then in this day and age a website is almost imperative to help publicize the services or products that our business offers. There are basically two ways to go about constructing a website. The first and often the cheapest way is to build our own website. There are several websites that explain how to build do-it-yourself websites for a modest fee. However, most businesses need professionally-built sophisticated websites, which are best left to professionals to construct on our behalf. A well-constructed website can make all the difference between successful marketing of one’s offerings and failure to attract sufficient attention to our products and/or services. Whichever route each individual or business chooses to take, a number of basic decisions need to be made. These include, in particular, setting up a

194

Chapter 15

domain name and selecting a web hosting service provider. The domain name refers to the name given to our website. The name should reflect as closely as possible the type of product or service we provide. Also, it should be a name that is not used elsewhere on the internet. A web hosting service is a type of internet hosting service that allows individuals and organizations to make their website accessible via the World Wide Web. Web hosts are companies that provide space on a server owned or leased for use by clients. Finally, the website should not only look attractive but be made as marketable as possible. One important way to make it most likely for potential customers to locate the website is through ‘search engine optimization’ (SEO). This involves using techniques whereby, for example, certain keywords entered by potential customers are most likely to bring up our website. The greater the range of keywords bringing up the website the more successful our website is likely to be in marketing our products or services. Other ways to market the website are regular inclusion of ‘blogs’ or commentaries on relevant topics, and building links between our website and other similar websites, which is to everyone’s advantage. Some websites even have videos demonstrating the products or services on offer.

An example of a good management information website The author, in conjunction with his internet marketing partner, has set up a website: accountancytemplates.com, which provides a number of useful templates and user tips, as well as consultancy services. a) Templates The purpose of these Excel Accounting templates is to save many hours, even days of work setting up from scratch management information or financial control systems based on Excel spreadsheets. There are around a dozen templates offered in this website. The most popular is the management accounts template, which is a basic model of a spreadsheet-based monthly or quarterly accounts system that can be easily adapted to suit individual requirements. b) User Tips The User Tips mainly complement the Helpline in Excel or on the internet where a particular routine or technique is not always

Website Access and Creation

195

readily available on the Helpline. There are about thirty User Tips offered in this website and they serve as a useful reference library. c) Consultancy services The website offers a consultancy service that aims at building ready-made spreadsheet-based solutions entirely to the potential customer’s specifications for a highly competitive fee. The size of each assignment can vary greatly, ranging from a few hours to a month or more. d) ‘Blogs’ or commentaries The purpose of blogs is to give potential customers useful information from time to time to help them keep abreast of the latest developments in the website or simply to offer tips that customers may find particularly useful. The following are blogs that have appeared on this website: ‘Most popular template updated’: this refers to the management accounts template that has been updated to make the template even more user-friendly than before. ‘Run a macro by simply selecting a cell’: this tells us how a computer program or macro can be run simply by selecting a cell rather than by first clicking on a macro button. Over a period of time earlier blogs are removed from the website and new blogs added in order to keep the website looking as fresh and as appealing as possible. e) Links Many websites have links to other websites that are related or relevant in some way. In this website there is a link to this book ‘Learning Accountancy: The Novel Way’. The reason for this link is that those persons who are interested in the offerings of this website are likely to find the contents of the book also of interest. In summary, this chapter is merely a brief account of the benefits and functioning of websites, but there is no substitute for practice in searching or browsing as many websites of interest as possible.

CHAPTER 16 INTERNAL CONTROL SYSTEMS

In chapter 13, we examined Control accounts and Nominal Ledger Reconciliations which are an essential part of an accounting system in that they are designed to ensure that accounting records are accurate and accounts and statements produced from them entirely correct. Those controls are essentially accounting controls. In this chapter, we will deal with financial rather than accounting controls. Whilst accounting controls ensure the accuracy of accounts, financial controls are designed to protect the finances and property of the business. They are also known as internal controls which are formalised normally in the form of a written set of rules that make up an internal control system. Internal control systems vary from business to business, but some of the important ingredients of a good internal control system are summarised below. It is assumed that the accounting system is computerised. A

Revenue Controls Revenue controls are designed to ensure that all money receivable for goods despatched or services rendered, is actually received. This is done by making sure that all goods and services rendered are invoiced, and the amounts due are ultimately paid by the customers. The following is an example of a typical internal control system for revenue receivable. Goods Despatched a)

On delivery of the goods, the customer signs a copy of the delivery note, which is retained as proof of delivery.

Internal Control Systems

197

b)

The signed copy of the delivery note is sent to the accounts department which then produces or ‘raises’ the invoice. We will assume that the invoice is raised manually although in many cases it will be produced automatically by the computer program on the basis of the sales details keyed in.

c)

The top copy of the invoice, which like the delivery note is sequentially numbered, is sent to the customer.

d)

The details on each invoice should be checked against the corresponding despatch note ideally by someone other than the person who entered the invoice details into the computer system. Where the invoice is produced automatically by the computer, the computer program will ensure that all calculations are done automatically and correctly, which means that there is no need to check the calculations manually.

e)

A print-out is produced at each month end of despatch note numbers and invoice numbers in numerical sequence. Where there are missing despatch note numbers on the print-out, this should be followed up with the despatch department ensuring that the missing notes are found and ultimately invoiced. Where invoice numbers are missing, the accounts copies of the missing invoices should be located and relevant details on those invoices keyed in. These checks should ensure that all goods despatched have been invoiced. (Of course, fraud can still occur where goods are pilfered from the stock room or where deliveries are made by an unscrupulous member of staff to an associate without delivery notes being prepared. Far more sophisticated control systems would be needed to cover such eventualities).

f)

Once the system has ensured that all goods despatched have been followed by corresponding sales invoices, it is then up to the credit control department to take over and ensure that the amounts charged are ultimately received from the debtors. Credit control procedures basically run along the following lines:

Chapter 16

198

- telephone calls are made to customers who have not paid by the due date of settlement. - if the money is still not forthcoming a letter is sent requesting payment followed, where necessary, by one or two more strongly worded letters demanding payment. - if payment is still not made, senior management must then decide whether or not to ask their lawyers to threaten legal action. Services Rendered Where instead of goods being despatched, services are rendered as, for instance, in the case of accountants, solicitors or computer consultants, the internal control procedures for revenue receivable could be along the following lines: a)

Diary sheets are retained by each member of staff involved in consultancy work, describing briefly the work done and time spent on behalf of each client.

b)

The details noted in the diary sheets are then keyed into the computer system.

c)

Invoices would then be produced manually or automatically on the basis of hourly rates entered into the system at the outset. The total time charged out per the invoices should equal the total time spent by staff on consultancy work.

Credit control procedures for services rendered would follow the same lines as procedures for goods despatched. B

Cost Controls Cost controls are designed to ensure that all charges received are correct and legitimate, and payments are made only in respect of legitimate charges and none other. A typical system of controls could be as follows:

Internal Control Systems

199

Goods Received a)

A copy of the supplier’s goods received note is signed by the employee who receives the goods after checking that the details on the note agree with the quantity and quality of goods received.

b)

The goods received note is sent to the accounts department where the details are first checked against orders raised in writing and are then entered in the Stock Register. The notes are then filed temporarily pending receipt of the purchase invoice.

c)

On receipt of the purchase invoice, the corresponding goods received note is appended to the invoice and details on the invoice checked against the goods received note.

d)

The invoice together with the appended goods received note is sent to the relevant senior member of staff who, as an authorized signatory, signs the invoice and returns it together with the goods received note to the accounts department.

e)

On receipt of the authorized invoice, details are keyed into the computer system.

f)

On a periodic basis, normally monthly, a print-out of balances owing to suppliers is run.

g)

The authorized invoices are batched and sent (with the goods received notes appended) together with a cheque which then needs to be signed by normally two authorized signatories. After being signed, the cheque is returned together with documents appended, to the accounts department. In a number of larger organizations, payments are made in bulk to several suppliers electronically from the payer’s bank account directly to the recipients’ bank accounts, based on systems such as BACS (Bankers' Automated Clearing Services). The authorised signatories would sign the printout of bulk payments instead of cheques individually. One of the advantages of such a system is that there is no need to raise cheques.

Chapter 16

200

h)

On receipt by the accounts department of the duly signed cheque (with invoice and goods received note attached), the cheque is posted to the supplier concerned.

Services Received Where items or services, other than goods bought and sold, are received, the control systems in the initial stages are different from those that are required for the receipt of goods. Examples of items or services received are postage, stationery, travel and subsistence, gas, electricity, etc. In such cases, the initial stages of a control system would be along the following lines: a)

The department in charge of the service required, raises a written order whenever possible (not, of course required in the case of gas, electricity and similar public services) and despatches the top copy to the supplier, the bottom copy being retained by the department concerned.

b)

On receipt of items such as stationery, the items received are checked against the order. In the case of a service such as repairs of office equipment, on satisfactory completion of the repair a note is made to that effect on the written order.

c)

On receipt of the purchase invoice, it is sent to the relevant department which checks it against the written order where one has been raised. Where an order has not been raised, checks are carried out for example as follows: - gas, electricity, water rates: checked against meter readings; - telephone: quarterly bills should normally not vary greatly - any major variation should be investigated; - travel and subsistence: travel invoices should be checked by the person who has made the journey, against the travel company’s written quotations. Similarly, hotel bills should be checked against the hotel’s written quotation, ensuring that the correct number of nights has been charged.

Internal Control Systems

201

The above are just a few examples of the checks that can be carried out to verify the accuracy of suppliers’ charges for services rendered. Once the invoice for items or services received is checked it is authorised by the senior member of staff concerned, and the controls procedure from that point onwards is the same as that for goods received. Petty Cash Expenditure The controls on expenditure discussed above relate to items that are paid by cheque. Let us now examine a typical petty cash control system. a)

To reclaim petty cash expenditure incurred on behalf of the business, the member of staff concerned must have an external invoice or voucher authorised by a senior member of staff whenever possible, as proof of payment. In some cases, for instance train journeys, it may be difficult to obtain a voucher, but in most cases there should be little difficulty.

b)

The person wishing to be reimbursed must present the properly authorised invoice or voucher to the petty cashier who enters brief details on a sequentially numbered internal petty cash docket which the recipient of the petty cash signs as confirmation that he or she has been reimbursed.

c)

The dockets, with the external vouchers attached, are batched, and the amount together with brief details are entered from each docket into the computer system.

d)

A print-out of sequential petty cash docket numbers is run, and any missing numbers are investigated (a docket may have been cancelled, for instance).

e)

Periodically, normally at the end of the month, a count is carried out of the petty cash in the petty cash box which should be kept locked in a safe.

f)

The petty cashier should ensure that the amount of petty cash in the petty cash box exactly equals the balance on the petty cash account in the Nominal Ledger. If there is a difference

Chapter 16

202

and assuming that the check for missing dockets has been completed, the amount shown on every docket entered should be checked carefully against the corresponding item on the print-out of petty cash expenditure. This exercise would help to identify any items which were incorrectly entered. If the discrepancy persists, there should be a second petty cash count by someone other than the petty cashier. If the discrepancy is still not resolved, then all recent recipients of petty cash should be asked whether they might have received the wrong amount. If none of these checks is successful, there is no option but to write-off or write-back the difference to a Sundries account in the Nominal Ledger. Payroll Expenditure In chapter 13 we examined the accounting controls required to check the accuracy of Nominal Ledger accounts relating to payroll expenditure. However, in addition to the need for payroll expenditure to be correctly recorded, there is also a need for a system of internal controls which ensures that payroll expenditure is correctly and properly authorised. An internal control system for payroll expenditure should be based on periodic checks by a person not normally involved in payroll work, typically the internal auditor of a large concern. The checks and controls should include the following: a) Letters of appointment which confirm starting salaries and letters in subsequent years offering salary increases should be written by properly authorised senior members of staff. b) The payroll data for each employee should be in line with 1) the letter of appointment, 2) the letter authorising salary increases and 3) the internal rules laid down in the business manual. The payroll data to be checked should include: -

gross pay overtime rates shift pay rates bonus payments deductions (including PAYE, National Insurance, etc.)

Internal Control Systems

203

c) Gross pay should be checked against letters of appointment or letters authorising the most recent salary increases. d) Overtime and shift work hours and rates per hour should be checked against properly authorised sheets compiled for each employee who is entitled to overtime and shift work payments. e) Bonus payments should be checked against letters written by properly authorised senior members of staff. f) Statutory Sick Pay (SSP) and Statutory Maternity Pay (SMP) should be checked against detailed records of sickness and maternity leave. The procedure adopted for reclaiming SSP and SMP from the State should be carefully checked. g) The names of employees listed on the payroll print-outs should be checked to ensure that they are authentic members of staff and not fictitious names, which would allow misappropriation of funds of the business. Special care needs to be taken in the case of casual or temporary staff whose hours worked and rates of pay should also be properly authorised. h) The date of termination of employment shown in the payroll records, as well as the final salary including any Holiday Pay due, should be checked with heads of department and/or the head of personnel to ensure that there have been no over (or under) payments. i) It should be ensured that all deductions have been correctly paid over to third parties concerned, for instance: - PAYE/ National insurance payments to HMRC. - Pension payments to the Pension Scheme. - Insurance premiums to the insurance company concerned. C

Physical Verification of Assets We have discussed so far the controls required to ensure the accuracy of amounts receivable and payable. However, there are further controls which are needed to ensure that assets of the business which ought to exist, do actually exist. Let us look at some

Chapter 16

204

of the main items that require systems of control designed to verify the existence of those items. Fixed Assets A Fixed Asset Register should be maintained with the following details for each asset category: - Date purchased - Brief description of the asset, including an asset number if required - Purchase price of the asset - Depreciation since: - the beginning of the accounting year - the date of purchase - Net book value (purchase price minus accumulated depreciation) The amount charged to the Profit and Loss Account for the accounting year should be the total depreciation since the beginning of the accounting year. The net book value of fixed assets in the Balance Sheet should agree with the total of net book values in the Asset Register. Reconciling the Asset Register with the Profit and Loss Account and the Balance Sheet is part of the system of accounting controls. However, at regular intervals (at least once a year), there should be a physical verification of all the assets in the Asset Register. This is done by locating each asset and identifying it in the Asset Register. At the end of the exercise, every item in the Asset Register should have been identified physically, thus verifying the existence of all assets shown in the Asset Register. Stocks As we have seen, a Stock Register should be maintained showing details of all goods bought and sold. Again, at regular intervals (at least once a year) , there should be a stock count during which the number of items physically in stock should be checked against the number of corresponding items in the Stock Register. The stock count is very similar, in principle, to a fixed asset count. The main difference, however, is that whilst fixed assets are large expense

Internal Control Systems

205

items that are expected to be accounted for in full, items of stock are generally of lower value and far more numerous. As a result, it is very likely that a small percentage of stock items will be missing through occasional miscounting (especially where large numbers of items are received and despatched) or pilferage or loss through damage or normal wear and tear. Where items are missing, they should be shown as losses in the Stock Register, which should be adjusted to come in line with the actual quantities in existence. The cost price of missing items should then be written off as a stock loss in the Nominal Ledger. Petty Cash Balance We have discussed earlier in this chapter the system of petty cash accounting and the procedures and controls involved. As with fixed assets and stocks, the amount of petty cash must be counted at the end of each monthly or four-weekly accounting period. The total amount of cash in the petty cash box should agree with the balance on the Petty Cash account in the Nominal Ledger. If there is a disagreement, then the reconciliation procedure outlined at paragraph f) on page 196 should be followed. If the discrepancy still cannot be resolved, it should be written off as a loss (in case of a cash shortfall) or written back as a profit (in case of a cash surplus) to the Profit and Loss Account. Bank Balance We have already dealt in chapter 13 with the bank reconciliation which verifies that a) the balance per the Cash Book is correct and b) the balance at bank is what it should be. In other words, a bank reconciliation acts both as an accounting control (ensuring the accuracy of the Cash Book) and as a financial control by verifying the existence of the correct amount of money in the bank with reference to the bank statements. Other Assets The existence and ownership of all other assets should be verified from time to time. For instance, leasehold and freehold property should be backed by legally binding deeds and land registry certificates; ownership of motor vehicles should be backed by

Chapter 16

206

registration (log) books; the value of outstanding debts is normally verified by auditors at the time of the statutory audit when letters are sent to a random selection of debtors who are asked to confirm the amount owing to them. D

Audits The term ‘audit’ in an accounting context, refers to checking and reporting on the accuracy of accounting records and the appropriateness of systems and controls. Those who carry out audits fall into two main categories: ‘external’ auditors, and ‘internal’ auditors who are employees of the business. External auditors are members of professional accounting firms which conduct two kinds of audits, a) the ‘statutory’ or ‘year end’ audit and b) the ‘systems’ audit. The statutory (or legally obligatory) audit is carried out some time after the end of the accounting year, and the external auditors must at the end of their audit declare in the form of a short report whether or not the Profit and Loss Account for the accounting year and the Balance Sheet as at that year end, present a ‘true and fair view’ of the trading performance and the financial position respectively, of the business. A systems audit is one which involves a thorough examination of the systems and controls of a business. Whilst external auditors may or may not carry out a systems audit in addition to the statutory audit, internal auditors are only concerned with carrying out systems audits. The controls examined include all accounting controls dealt with in chapter 13 and internal controls discussed in this chapter. At the end of the systems audit, the auditors prepare a report which includes a summary of areas of weakness and a detailed list of recommendations designed to strengthen control mechanisms in those areas.

Having come to the end of our chapter on internal controls, we can now well appreciate how important it is not only to have accounting controls which ensure the accuracy of accounts, but also to have a sound internal control system which safeguards the finances and property of the business.

CHAPTER 16 TYPES OF ACCOUNTS

Throughout this book we have examined at length, accounting concepts, principles and procedures which have been demonstrated with examples of typical accounting systems. Although all systems are based on the same basic concepts and principles of double entry, there are many differences in practice in the format of accounts. Differences in format can be categorised according to: A

The purpose of the accounts, namely: a)

To provide regular information to senior management in the form of management accounts.

b)

To present, in the form of statutory accounts, a true and fair view of the trading results of the business for the past accounting year and its financial position as at the year end.

B

The type of business.

C

The structure of the business, depending upon whether it is: a)

Run by a ‘sole trader’

b)

Run by a ‘partnership’

c)

Formed as a ‘company’.

Let us now examine each category in turn.

Chapter 16

208

A

Purpose of Accounts a)

Management Accounts Management accounts have already been dealt with at length in Chapter 14 on Management Information. The purpose of management accounts, as we know, is to provide senior management with regular as well as ‘ad hoc’ information. Whilst the principles of double entry must always be applied, the content and format of management accounts can vary greatly according to the nature of the business and the longterm strategy of senior management.

b)

Statutory Accounts The purpose of statutory (or ‘Year End’) accounts is different from that of management accounts. Statutory accounts are produced only annually soon after the end of each accounting year. They must be produced compulsorily each year for certain businesses above a certain size according to prevailing law and within a certain period from the end of the accounting year. Whilst management accounts are produced mainly for the benefit of senior management, statutory accounts are produced and published also for the benefit of third parties which include shareholders, investment analysts, banks and other financial institutions, creditors and prospective buyers of the business. Statutory accounts must follow guidelines which prescribe in broad terms the format and contents of those accounts. Where the year end accounts are subject to an audit, the auditors will also need to ensure that certain accounting conventions are observed. These conventions vary from country to country, but in the UK are encompassed in a publication of Accounting Standards prepared and published by the Institute of Chartered Accountants in England and Wales. Accounting conventions are not part of the rules of Double Entry, but are necessary in cases where some flexibility is

Types of Accounts

209

required in the application of those rules. Let us assume, for instance, that at the end of the accounting year the balance on the Stock account in the Nominal Ledger which agrees with the balance of stock in the Stock Register, is £25,000. Let us also suppose that the items in the Stock Register would sell for less than £25,000 in the open market. Which value should one then include in the Balance Sheet, the higher or the lower one? The answer lies in the Statement of Accounting Standards regarding the treatment of stocks and work-inprogress. The statement says that stocks and work-inprogress should be valued at cost or at net realisable value (less the expenses of sale), whichever is the lower. Net realisable value is the amount that stocks or work-in-progress would realise if sold in the open market. Going back to our example, supposing the net realisable value of all the stock, including items valued at less than cost, is say £23,000. The value of stock to be included in the Balance Sheet should then be £23,000 and not the £25,000 shown in the Nominal Ledger and the Stock Register. This means that there is a stock loss of £2000 which must be written off to the Profit and Loss Account by passing the following Journal Entry: Dr £ Stock Loss A/c Stock A/c

Cr £

2,000 2,000

Affects

Profit & loss Account Balance Sheet

There are various statements of standard accounting practice in the Accounting Standards publication, for instance on depreciation, research and development expenditure, and goodwill, among many others. Although these standards do not necessarily carry the force of law, the external auditors’ report will normally state that the year end accounts present a ‘true and fair view’ only if the standards have been correctly followed. In addition to following a number of conventions concerning the treatment of certain items of revenue and expenditure, statutory accounts must also be presented in a format which is largely standardised.

Chapter 16

210

The following is a summary of the main items that would be included in a typical set of statutory accounts: - Chairman’s Statement - Directors’ Report - Auditors’ Report - Financial highlights - Profit and Loss Account - Balance Sheet - Statement of Sources and Application of Funds - Notes on the Accounts Note: The Statement of Sources and Application of Funds is basically a Cash Flow Statement, but one which groups items relating to the inflow of funds separately from items relating to the outflow of funds. An example of a typical company Profit and Loss Account, Balance Sheet, and Statement of Sources and Application of Funds is given at the end of this chapter under section c). B

Type of Business As mentioned earlier, while statutory accounts are both brief and standardised, management accounts can vary greatly according to the business or industry concerned and according to the emphasis that senior management places on certain aspects of the business. Moreover, in the case of certain kinds of businesses and professions, accounts are required to be prepared and presented in a certain manner. For instance, in the case of accounts of a firm of solicitors, it is necessary to maintain an entirely separate account for money received from clients and money spent on their behalf. Those accounts must, in other words, ensure that funds belonging to the firm of solicitors are kept and recorded quite separately from funds belonging to its clients.

C

Structure of the Business a)

Sole Traders A number of small to medium-sized businesses are run by sole traders or sole owners. They may well have a number of employees who are paid salaries but the capital plus

Types of Accounts

211

accumulated profits (or assets less liabilities) of the business belong to the sole proprietor. All the examples dealt with so far have assumed that the businesses have been run by sole traders. b)

Partnerships Although most small businesses are run by sole traders, a significant proportion are established on a partnership basis, which means that there are two or more owners who share the capital and profits (or losses) of the business. The management accounts of a business are very much the same whether the business happens to be run by a sole trader or as a partnership. The main difference lies in the treatment of profits or losses in the Profit and Loss Account and the Balance Sheet, and in the allocation of capital in the Balance Sheet. To take a simple example, let us suppose that A, B and C started a business on 1/1/13, investing as capital £50,000, £65,000 and £45,000 respectively. Taking into account the capital sums invested as well as the business expertise of each of the partners, the partnership agreement stipulates that the partners will share profits and losses as follows: A : 30%; B : 45%; C : 25%. Their Balance Sheet as at 1/1/14 is: Assets £

Fixed Assets n.b.v. Freehold Property Furniture and Fittings Office Equipment Motor Vehicles

170,000 10,000 18,000 17,000

Current Assets Debtors Balance at bank Petty cash

20,000 15,000 1,000

| | | Liabilities | | Creditors | Provisions | Bank Loan 215,000 | | | Capital | A | B | C 36,000 | | Reserves | A | B | C 251,000 | £

Capital and Liabilities £ £

12,000 4,000 25,000

41,000

50,000 65,000 45,000

160,000

15,000 22,500 12,500

50,000 251,000

Chapter 16

212

The business makes a profit of £4,000 during the month of January, and the profit allocated or ‘appropriated’ to the partners is as follows: Profit and Loss Account (abbreviated) for the month of January 2014 £ 20,000

Revenue (analysed in detail) Expenditure (analysed in detail)

16,000 _____ 4,000

Profit in January

Profit and Loss Appropriation Account for the month of January 2014 £ 4,000

Profit in January Allocation to partners: A: 30% share B: 45% share C: 25% share

1,200 1,800 1,000 ____ 4,000

Their Balance Sheet at 31/1/14 will be: Assets £ Fixed Assets n.b.v. Freehold Property Furniture and Fittings Office Equipment Motor Vehicles

169,500 9,800 17,700 16,700

Current Assets Debtors Balance at bank Petty cash

18,000 13,000 1,000

| | | | | | | 213,700 | | | | | | 32,000 | | | | | | | ______ | 245,700 |

Capital and Liabilities £

£

£

Liabilities Creditors Provisions Bank Loan

12,500 3,700 15,500

31,700

50,000 65,000 45,000

160,000

Capital A B C Reserves A B C

16,200 24,300 13,500

54,000 ______ 245,700

Types of Accounts

213

Note: The profit in January has been added to the opening reserves in the Balance Sheet, increasing the total to £54,000. Each partner’s reserves have been increased according to his or her agreed share of profits. The values of the various items in the Balance Sheet have been changed arbitrarily since the beginning of the month on the basis of a number of assumed transactions during the month including, for example, a bank Loan repayment of £9,500.

c)

Companies As mentioned earlier, year end accounts of certain companies above a certain size must follow guidelines set out by statute and by the Statement of Accounting Standards. An example of a company Profit and Loss Account, Balance Sheet and Statement of Sources and Application of Funds is set out on the following pages. Note that the Balance Sheet is presented in a vertical format which is the one commonly used, as compared with the horizontal format used in previous examples. XYZ Limited Profit and Loss Account for the year ended 31 December 2013 Notes

2013 £000

2012 £000

Turnover Trading profit Interest payable

1 2 3

25,000 2,700 (400)

23,000 2,400 (450)

Profit before taxation Taxation

4

2,300 (700)

1,950 (600)

1,600

1,350

Profit after taxation Minority interests Extraordinary items

5 6

(100) (50)

(90) (20)

Profit available to shareholders Dividend

7

1,450 (900)

1,240 (750)

550 8,990

490 8,500

9,540

8,990

Retained profits Retained profits at the commencement of the year Retained profits at the end of the year

16

Chapter 16

214

It should be noted that: i) The Profit and Loss Account is in summarised form and in vertical format, and no debits and credits are shown. ii) Comparatives for the previous year, ‘2012’ in our example, are shown. iii) The numbers shown under the ‘Notes’ column refer to explanatory notes (not set out in this chapter) which come after the main statements in the published accounts. The Balance Sheet has references to explanatory notes in the same way. iv) ‘Extraordinary’ items, as the term suggests, relate to transactions or events which are outside the ordinary activities of the business. v) Minority interests relate to the share in the profits and assets of the business attributable to third parties and not to the shareholders. XYZ Limited Balance Sheet as at 31 December 2013 Notes

2013 £000

2012 £000

8 9

11,800 200 _____ 12,000

11,350 150 _____ 11,500

Current Assets: Stocks and work-in-progress Debtors Cash at bank and in hand

10 11 12

4,500 3,500 500 ____ 8,500

4,300 3,350 550 ____ 8,200

Current Liabilities: Creditors Provisions

13 14

(2,800) (200) _____ (3,000)

(2,750) (150) _____ (2,900)

5,500

5,300

(930) _____ 16,570

(880) _____ 15,920

6,500 9,540 530 _____ 16,570

6,500 8,990 430 _____ 15,920

Fixed Assets: Tangible Intangible

Net Current Assets Long-term Liabilities: Bank Loan

15

Net Assets Capital and Reserves: Capital Reserves Minority Interest

16 5

Types of Accounts

215

Note: a) Fixed Assets are often summarised as ‘Tangible’ and ‘Intangible’ (for example, Goodwill) analysed in detail in the notes to the accounts. b) The Bank Loan is shown under Long-term Liabilities on the basis that it is not repayable within one year. XYZ Limited Statement of Sources and Application of Funds for the Year Ended 31 December 2013 2013 £000 Sources of Funds Retained profits Depreciation Bank Loan increase Increase in Minority Interest Total Sources Application of Funds Capital Expenditure (including intangibles) Additional working capital: Stocks and work-in-progress Debtors - (Increase) Creditors - Increase Provisions - Increase Total Applications Decrease in cash at bank and in hand

2012 £000

£000

£000

550 2,500 50 100 3,200

490 2,350 70 90 3,000

(3,000)

(2,870)

(200) (150) 50 50

(150) (170) 30 (250) (3,250)

(290) (3,160)

(50)

(160)

Note: The figures shown for 2013 are extracted from the Profit and Loss Account for 2013 and the decrease in cash holding of £50,000 arrived at above exactly equals, as it should, the cash movement in the Balance Sheet (£550,000-£500,000). The figures shown for 2012 are, however, assumed since we do not know what the Balance Sheet looks like as at the end of 2011.

Conclusion We have now come to the end of this chapter and to the end of the book. As with all reading material that requires careful analysis and memorising, it is advisable to read this book again in the not too distant future, concentrating on those aspects that one is particularly interested in or feels least confident about. There is, of course, no substitute for practical training and experience, but it is more than likely that with the help of this book, progress in the theory and practice of accounting will be made with much greater ease and speed than might otherwise be the case.