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Business Management

Study Manuals

Certificate in

Business Management

INTRODUCTION TO

ACCOUNTING

The Association of Business Executives


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Certificate in Business Management

INTRODUCTION TO ACCOUNTING

Contents

Unit Title Page

Introduction to the Manual iii

Syllabus vii

1 Nature and Scope of Accounting 1

Purpose of Accounting 2Rules of Accounting (Accounting Standards) 7

Accounting Periods 14The Fundamental Concepts of Accountancy 14Case Study A: Global Holdings Ltd 17

2 Double-Entry Book-Keeping and the Ledger 19Principles of Double-Entry Book-Keeping 20Ledger Accounts 21The Accounting Equation 24Balancing Off 25Classification of Ledger Accounts 30

3 Cash and Bank Transactions 35Nature of the Cash Book 36Bank Reconciliation Statement 46Stale and Post-dated Cheques 49The Petty Cash Book 50

4 Recording Business Transactions 63The Journal 64Opening Statement of Assets and Liabilities 65Drawings 68

The Purchases Book 70The Sales Book 74Returns and Allowances Books 75

A Typical Transaction 79

5 The Trial Balance 91Introduction to the Trial Balance 92Errors in the Trial Balance 98Correction of Errors 106


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Unit Title Page

6 Final Accounts 1: The Trading Account 119Introduction to Final Accounts 120Trading Account 120Stock 121

7 Final Accounts 2: The Profit and Loss Account 129Nature of the Profit and Loss Account 130Bad Debts 132Discounts 135Depreciation 135Prepayments and Accruals 139

Allocation or Appropriation of Net Profit 144

8 Final Accounts 3: The Balance Sheet 153

Essentials of a Balance Sheet 154Assets 156Liabilities 159Distinction Between Capital and Revenue 162Preparation of a Balance Sheet 165

9 Final Accounts 4: Preparation 171Preparation from Given Trial Balance 172Depreciation and Final Accounts 180Preparation from an Incorrect Trial Balance 183

10 Control Accounts 199

Purpose of Control Accounts 200Debtors Control Account 201Creditors Control Account 204Sundry Journal Debits and Credits in both Debtors andCreditors Control Accounts 206

11 Partnerships 213Nature of Partnership 214Partnership Capital and Current Accounts 218Partnership Final Accounts 220

12 Limited Companies 235

Nature of Limited Companies 236Capital of a Company 239Other Sources of Company Finance 243Company Profit and Loss Account 245Company Balance Sheet 249

13 Cash Flow Statements 263Introduction 264Contents of the Cash Flow Statement 265Example 268Use of Cash Flow Statements 272Case Study A Global Holdings Ltd (cont'd) 275


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Unit Title Page

14 Budgets and Budgetary Control 287Overview of Budgets and Budgetary Control 288Budget Preparation 290Types of Budgets 294Budgetary Control Systems 295Case Study B: Crest Computers plc 299

15 Interpretation of Accounts 303Accounting Ratios 304Profitability Ratios 306Liquidity Ratios 308Capital Structure 312Investment Ratios 313Limitations of Historical Cost Reporting 315

16 Introduction to Costs and Management Accounting 321The Nature of Management Accounting 322Elements of Cost 324The Costing Process 326Costing Principles and Techniques 330Cost Behaviour Patterns 331Case Study C: Reducing the Costs of High Street Banking 334

17 Overheads and Absorption Costing 337Overheads 338Cost Allocation and Apportionment 339

Absorption Cost Accounting 344Treatment of Administration Overheads 348Treatment of Selling and Distribution Overheads 348

Activity Based Costing (ABC) 349

18 Labour and Material Costing 355Stock Control 356Stock Valuation Methods 359Labour Costing and Remuneration 365

19 Break-Even and Profit Volume Analysis 377Break-Even Analysis 378

Break- Even Chart 381Profit Volume Graph 384The Profit/Volume or Contribution/Sales Ratio 385Case Study D: Whizzo Ltd 390


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Introduction to the Study Manual

Welcome to this study manual for Introduction to Accounting.

The manual has been specially written to assist you in your studies for the ABE Certificate inBusiness Management and is designed to meet the learning outcomes specified for this

module in the syllabus. As such, it provides a thorough introduction to each subject area andguides you through the various topics which you will need to understand. However, it is notintended to "stand alone" as the only source of information in studying the module, and weset out below some guidance on additional resources which you should use to help inpreparing for the examination.

The syllabus for the module is set out on the following pages and you should read thiscarefully so that you understand the scope of the module and what you will be required toknow for the examination. Also included in the syllabus are details of the method ofassessment the examination and the books recommended as additional reading.

The main study material then follows in the form of a number of study units as shown in thecontents. Each of these units is concerned with one topic area and takes you through all thekey elements of that area, step by step. You should work carefully through each study unit inturn, tackling any questions or activities as they occur, and ensuring that you fully understandeverything that has been covered before moving on to the next unit. You will also find it veryhelpful to use the additional reading to develop your understanding of each topic area whenyou have completed the study unit.

Additional resources

ABE website www.abeuk.com. You should ensure that you refer to the MembersArea of the website from time to time for advice and guidance on studying andpreparing for the examination. We shall be publishing articles which provide generalguidance to all students and, where appropriate, also give specific information about

particular modules, including updates to the recommended reading and to the studyunits themselves.

Additional reading It is important you do not rely solely on this manual to gain theinformation needed for the examination on this module. You should, therefore, studysome other books to help develop your understanding of the topics underconsideration. The main books recommended to support this manual are included inthe syllabus which follows, but you should also refer to the ABE website for furtherdetails of additional reading which may be published from time to time.

Newspapers You should get into the habit of reading a good quality newspaper on aregular basis to ensure that you keep up to date with any developments which may berelevant to the subjects in this module.

Your college tutor If you are studying through a college, you should use your tutors tohelp with any areas of the syllabus with which you are having difficulty. That is whatthey are there for! Do not be afraid to approach your tutor for this module to seekclarification on any issue, as they will want you to succeed as much as you want to.

Your own personal experience The ABE examinations are not just about learning lotsof facts, concepts and ideas from the study manual and other books. They are alsoabout how these are applied in the real world and you should always think how thetopics under consideration relate to your own work and to the situation at your ownworkplace and others with which you are familiar. Using your own experience in thisway should help to develop your understanding by appreciating the practicalapplication and significance of what you read, and make your studies relevant to your

personal development at work. It should also provide you with examples which can beused in your examination answers.


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And finally

We hope you enjoy your studies and find them useful not just for preparing for theexamination, but also in understanding the modern world of business and in developing inyour own job. We wish you every success in your studies and in the examination for thismodule.

The Association of Business Executives

September 2008


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Unit Title: Introduction to Accounting Unit Code: IALevel: 3 Learning Hours: 100Learning Outcomes and Indicative Content:

Candidates will be able to:

1. Describe and explain briefly the nature and scope of accounting

1.1 Briefly explain and describe the purpose of financial andmanagement accounting

1.2 Briefly explain and describe who are the different users offinancial information

1.3 Explain and describe the essential differences between a soletrader, a partnership and a limited company

1.4 Briefly explain and describe the role and the function ofaccounting concepts, standards and principles and Statements

of Standard Accounting Practice (S.S.A.P.s) and FinancialReporting Standards (FRSs)

2. Describe, explain and accurately reflect double entry bookkeepingprinciples and adjustments from books of original entry such asday books to the trial balance stage

2.1 Explain, describe and accurately reflect bookkeeping entriesand adjustments in the books of a business

2.2 Explain, describe and accurately reflect the bookkeeping entries

necessary to complete a two or a three column cash book2.3 Accurately prepare control accounts and suspense accountsincluding any necessary adjustments

2.4 Accurately prepare a trial balance that reflects, as appropriate,any necessary adjustments in the books of a business

3. Prepare a set of final annual accounts, including any appropriateadjustments needed, for a sole trader, a partnership and a limitedcompany

3.1 Explain, describe and accurately prepare a trading account for a

sole trader, a partnership and a limited company3.2 Explain, describe and accurately prepare a profit and lossaccount for a sole trader, a partnership and a limited company

3.3 Explain, describe and accurately prepare an appropriationaccount for a partnership and a limited company

3.4 Explain, describe and accurately prepare a balance sheet for asole trader, a partnership and a limited company

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4. Understand the need for and complete accurately a cash flowstatement

4.1 Outline and describe the requirements for a cash flow statement4.2 Complete accurately a cash flow statement (under the

requirements of FRS 1) using either the direct (ie cash) methodor the indirect (ie accruals) method

4.3 Understand and describe the uses of a cash flow statement

5. Undertake some financial ratio analysis of a companys accountsand make reasoned judgements and comments on companyperformance based on their figures

5.1 Accurately calculate a range of financial and accounting ratiosprincipally the following: return on capital employed (ROCE);gross profit and net profit to sales ratio; asset turnover; workingcapital ratio, acid test ratio; debtor days; creditor days; capitalgearing ratio

5.2 Describe and explain accurately the results of any ratiocalculations

6. Describe, explain and calculate accurately different elements ofcosts

6.1 Describe and explain the nature, purpose and objectives of costand management accounting

6.2 Describe, explain and understand the following cost terms;direct and indirect cost; overhead cost, fixed and variable cost

7. Describe, explain and calculate labour and material costs

7.1 Calculate material costs using the following three methods ofmaterial (stock) valuation:FIFO (first in first out); LIFO (last in first out); AVCO (averagecost)

7.2 Calculate labour costs, given a range of figures on wage andpayroll rates and labour hours

8. Describe and explain the essential concepts and principles ofbreak-even analysis and undertake calculations accurately todemonstrate their overall understanding and knowledge

8.1 Describe and explain the essential concepts and principles ofthe break-even point and break-even analysis

8.2 Use the concepts of break-even analysis to calculate the break-even point for a given level of profit and accurately account forchanges in either the fixed or variable cost level

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9. Describe and explain the concepts and principles of budgetingand the essential factors behind budgetary control

9.1 Describe and explain the main purposes and benefits of budgetsto a business

9.2 Describe and explain the different timescales for budgets andthe main steps in the preparation of a budget

9.3 Describe and explain the different styles and types of budgets9.4 Accurately prepare a budget from a given set of simple figures

Assessment Criteria:

Assessment method: written examination

Length of examination: three hours

Candidates should answer four questions from a choice of eight, each

question carrying equal marks

Recommended Reading

ABE, ABE Study Manual Introduction to Accounting, ABE

Wood F, Sangster A Business Accounting 1 (2005), Pearson HigherEducationISBN: 0273681494

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Study Unit 1

Nature and Scope of Accounting

Contents Page

A. Purpose of Accounting 2

Financial and Management Accounting 2

The World of Accounting and Finance 2

Business Functions 3

Money as the Common Denominator 4

The Concept of the Business Entity 5

Users of Accounting Information 5

B. Rules of Accounting (Accounting Standards) 7

Development of Accounting Standards 7

Current Standards Setting Structure 8

Statements of Standard Accounting Practice 9

Financial Reporting Standards 1-7 11

International Accounting Standards 12

C. Accounting Periods 14

D. The Fundamental Concepts of Accountancy 14

The Four Fundamental Concepts 15

Other Concepts of Accountancy 15

Case Study A: Global Holdings Ltd 17

Background 17

Part 1 Energy Saving Products 17


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2 Nature and Scope of Accounting

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A. PURPOSE OF ACCOUNTING

A business proprietor normally runs a business to make money. He or she needs informationto know whether the business is doing well. The following questions might be asked by theowner of a business:

How much profit or loss has the business made?

How much money do I owe?

Will I have sufficient funds to meet my commitments?

The purpose of conventional business accounting is to provide the answers to suchquestions by presenting a summary of the transactions of the business in a standard form.

Financial and Management Accounting

Accounting may be split into financial accounting and management accounting.

(a) Financial accounting

Financial accounting comprises two stages:

book-keeping, which is the recording of day-to-day business transactions; and

preparation of accounts, which is the preparation of statements from the book-keeping records; these statements summarise the performance of the business usually over the period of one year.

(b) Management accounting

Management accounting is defined by the Chartered Institute of ManagementAccountants as:

"The application of professional knowledge and skill in the preparation and

presentation of accounting information in such a way as to assistmanagement in the formulation of policies and in the planning and controlof the operations of the undertaking".

Management accounting, therefore, seeks to provide information which will be used fordecision-making purposes (e.g. pricing, investment), for planning and control.

The World of Accounting and Finance

In everyday speech, the terms "data" and "information" are often used interchangeably.However, in the context of accounting systems, the terms have distinct meanings data israw facts, such as a group of figures, a list of names and such like, whereas information isdata which has been processed in such a way as to be meaningful to the person who

receives it. The difference might be summarised as follows:

Data + Meaning = Information

For example, the string of numbers 060463-413283-110985 does not have any meaning toyou as you read this sentence for the first time. It is data. This data can be given meaning ifyou are told that employee 413283 was born on 6th April 1963 and started work with theorganisation on 11th September 1985. It has now become information.

Similarly, the numbers 9180, 17689 and 9800 are, without further embellishment, data. If youare told that they are actually the list prices of the three company cars in your department,required by the Inland Revenue for tax purposes, they become information.

Today, the vast majority of organisations operate computerised bookkeeping and accountingsystems. These systems take data from the various activities of the business and turn thatdata into meaningful financial information. The basis on which this transformation from data


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Nature and Scope of Accounting 3

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to information takes place are the rules, principles and practices of accounting which we shallexamine in this course.

You should note that, whilst most financial information is obtained from computerisedsystems, it is most important that these rules, principles and practices are fully understood sothat you are able to acquire the right information and interpret it correctly. Indeed, there

remain many managers and employees who face major problems in obtaining coherent andcomprehensive information they need from these systems.

Business Functions

Having explained the purpose of accounting and the difference between "data" and"information", it is important to understand the nature of the different business functions in anorganisation and the information they produce.

Wages control and accounting

A paramount feature of all business enterprises is the necessity to employ andremunerate a workforce. The workforce usually comprises people with a wide of skills

manual, technical and managerial all of whom must be paid. It is necessary tomaintain a record for each employee containing full and absolutely accurate details ofpay items. This record must be kept up-to-date in terms of amendments as well as theupdating of totals-to-date.

Sales control and accounting

Customer order control entails procedures for ensuring that orders fromcustomers/clients are received, recorded and acknowledged in an efficient organisedmanner. At a later stage, order control is necessary to ensure that orders are actuallyfulfilled, i.e. customers receive the correct goods on time and at the right destination.The purpose of sales analysis is to forecast future sales demands and to planmarketing activities.

Purchases control and accounting

Purchasing involves the procedures for ensuring that all the materials, components,tools, equipment and other items needed by the company are made available at theright time, right place and right price. The precise nature of the purchasing functiondepends upon the type of items purchased. It is beneficial to analyse the company'spurchases in various ways for example, in order to measure the effectiveness ofsuppliers, to ascertain the efficiency of the company in handling materials and reducingwaste, etc.

Stock control

Stock control involves the maintenance of records relating to stock levels, issues,

outstanding orders, reorder levels, and so on. From the accounting informationviewpoint, an important requirement is stock valuation i.e. the book value of all stock-in-hand at a certain time. These figures should be accurate, and allow for stock losses,deterioration and enhanced value since these contribute to the firm's balance sheet.

Production control

Production planning covers what to make and how many to make, whilst productioncontrol ensures that the plans are achieved. The information required for productioncontrol purposes includes material requirements for each time period, quantities ofcomponents and subassemblies to be made by each period, the amounts of equipmentand machines, etc. needed for each stage, the amount of each labour category neededduring each period, and the progress of each job and reasons for delays.


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Marketing function

The marketing function is concerned with researching the business potential of themarket and for developing the right products and services to satisfy the needs ofcustomers. Accounting records are a vital source of information concerning customers

they show buying patterns, types of products bought, etc.

Customer services function

Generating new customers is very important for any successful business. However,customer retention is also vital if a company is going to continue to grow and develop.Therefore, the customer services function is responsible for liasing with the customerand providing added valued services, such as where a garage would provide acourtesy car, etc.

Human resources function

This function is responsible for satisfying the personnel needs of the organisation. Thisinvolves recruiting and training the right type of people. The HR function also dealswith staff appraisal, disciplinary procedures, grievances and the legal aspects of

employing staff.

Information systems function

In a large organisation the information technology and accounting functions must workin close harmony to produce systems capable of providing the financial informationneeded by the different business functions.

The information required will not only vary between functions, it will also vary betweendifferent levels within an organisation. For example, what is perceived as informationat the operational levels will invariably be viewed as raw data by middle and seniormanagers. The systems must, therefore, be capable of converting data into a variety ofinformation forms in order to allow managers at different levels to make effective

business decisions.

Money as the Common Denominator

Accounting is concerned only with information which can be given a monetary value. Weput money values on items such as land, machinery and stock, and this is necessary forcomparison purposes. For example, it is not very helpful to say: "Last year we had fourmachines and 60 items of stock, and this year we have five machines and 45 items ofstock.". It is the money values which are useful to us.

Whilst we are concerned with money, we should note that there are limitations to the use ofmoney as the unit of measurement.

(a) Human asset and social responsibility accounting

We have seen that accounting includes financial accounting and managementaccounting. Both of these make use of money measurement. However, we may wantfurther information about a business:

Are industrial relations good or bad?

Is staff morale high?

Is the management team effective?

What is the employment policy?

Is there a responsible ecology policy?


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These questions will not be answered by conventional business accounting in moneyterms but by "human asset accounting" and "social responsibility accounting". Thesesubjects have not yet been fully developed and are outside the scope of your syllabus.

(b) Devaluation

The value of money does not remain constant, and there is normally some degree of

inflation in the economy. We will look at the steps that have been taken to attempt toadjust accounting statements to the changing value of money later in the course.

The Concept of the Business Entity

The business as accounting entity refers to the separate identities of the business and itsowners.

(a) Sole trader

There must always be a clear distinction between the owner of the business and thebusiness itself. For example, if Mr X owns a biscuit factory, we are concerned withrecording the transactions of the factory. We are not concerned with what Mr X spends

on food and clothes. If Mrs Y, works at home, setting aside a room in her house, anapportionment may have to be made.

(b) Partnership

Similarly, the partners in a business must keep the transactions of the businessseparate from their own personal affairs.

(c) Companies

In law, a company has a distinct "legal personality". This means that a company maysue or be sued in its own right. The affairs of the shareholders must be distinguishedfrom the business of the company. The proprietor of a limited company is thereforedistinct from the company itself.

Users of Accounting Information

We need to prepare accounts in order to "provide a statement that will meet the needs of theuser, subject to the requirements of statute and case law and the accounting bodies, andaided by the experience of the reception of past reports".

So if we prepare accounts to meet the needs of the user, who is the user?

The main users of financial accounts are:

Equity investors (shareholders, proprietors, buyers)

Loan creditors (banks and other lenders)

Employees

Analysts/advisers

Business contacts (creditors and debtors, competitors)

The government (The Inland Revenue)

The public

Management (board of directors)

Users can learn a lot about the running of a company from the examination of its accounts,but each category of user will have its own special perspective. We need to look at some ofthese in more detail.


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Proprietor

The perspective of the business proprietor is explained above (but see below for theinterests of shareholders).

Inland Revenue

The Inland Revenue will use the accounts to determine the liability of the business fortaxation.

Banks and other lending institutes

These require to know if the business is likely to be able to repay loans and to pay theinterest charged. But often the final accounts of a business do not tell the lender whathe or she wishes to know. They may be several months old and so not show the up-to-date position. Under these circumstances, the lender will ask for cash flow forecasts toshow what is likely to happen in the business. This illustrates why accountingtechniques have to be flexible and adaptable to meet users' needs.

Creditors and debtors

These will often keep a close eye on the financial information provided by companieswith which they have direct contact through buying and selling, to ensure that their ownbusinesses will not be adversely affected by the financial failure of another. Anindicator of trouble in this area is often information withheld at the proper time, thoughrequired by law. Usually, the longer the silence, the worse the problem becomes.

Competitors

Competitors will compare their own results with those of other companies. A companywould not wish to disclose information which would be harmful to its own business:equally, it would not wish to hide anything which would put it above its competitors.

Board of Directors

The board of directors will want up-to-date, in-depth information so that it can draw upplans for the long term, the medium term and the short term, and compare results withits past decisions and forecasts. The board's information will be much more detailedthan that which is published.

Shareholders

Shareholders have invested money in the company and as such are the owners of thebusiness. Normally, the company will be run by a team of managers and theshareholders require the managers to account for their "stewardship" of the business,i.e. the use they have made of the shareholders' funds.

Employees

Employees of the company look for, among other things, security of employment.

Prospective buyers

A prospective buyer of a business will want to see such information as will satisfy himor her that the asking price is a good investment.

The users of accounting information can also be viewed as stakeholders. This is becausethey all have a vested interest in how well the organisation performs. The board of directors'prime focus of attention must be on satisfying the requirements of the shareholders.However, when developing the company's long-term strategy, the interests of the otherstakeholders must be taken into consideration for example, the board of directors mustensure that the company is run efficiently and effectively as possible as there may be a need

to raise finance from outside parties (such as the bank, potential investors, etc).


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B. RULES OF ACCOUNTING (ACCOUNTING STANDARDS)

As different businesses use different methods of recording transactions, the result might bethat financial accounts for different businesses would be very different in form and context.However, various standards for the preparation of accounts have been developed over the

years. We shall be looking at the layout of financial accounts later on in the course. Withregard to companies, various rules have been incorporated into legislation (Companies Acts).Companies whose shares are listed on the Stock Exchange are subject to Stock Exchangerules. There are also "Statements of Standard Accounting Practice" (SSAPs) and FinancialReporting Statements (FRSs) which are issued by the main professional accounting bodiesthrough the Accounting Standards Board (ASB). In addition, international standards arebecoming increasingly important.

Development of Accounting Standards

In 1942, the Institute of Chartered Accountants in England and Wales began to makerecommendations about accounting practices, and over time issued a series of 29

Recommendations, in order to codify the best practice to be used in particular circumstances.Unfortunately, these recommendations did not reduce the diversity of accounting methods.

(a) The Accounting Standards Committee

In the late 1960s, there was a lot of public criticism of financial reporting methods andthe accounting profession responded to the criticism by establishing the AccountingStandards Committee (ASC) in 1970. The ASC was set up with the object ofdeveloping definitive standards for financial reporting. A statement of intent producedin the 1970s identified the following objectives:

To narrow the areas of difference in accounting practice

To ensure disclosure of information on departures from definitive standards

To provide a wide exposure for new accounting standards

To maintain a continuing programme for improving accounting standards.

(b) Statements of Standard Accounting Practice (SSAP)

The ASC comprised representatives of all the six major accounting bodies, i.e. theChartered Accountants of England and Wales, of Scotland, and of Ireland, the Certified

Accountants, the Cost and Management Accountants, and the Chartered Institute ofPublic Finance and Accountancy. The procedure was for the Committee to produce anexposure drafton a specific topic, for comment by accountants and other users ofaccounting information. A formal statement was then drawn up, taking account ofcomments received, and issued as a Statement of Standard Accounting Practice

(SSAP). Once a statement had been adopted by the accountancy profession, anymaterial departures by a company from the standard practice had to be disclosed innotes to the Annual Financial Accounts.

(c) The Dearing Report

Although the ASC had much success during its period of operation and issued 25SSAPs as well as a number of exposure drafts (EDs), Statements of Intent (SOI), andStatements of Recommended Practice (SORP), there were many serious criticisms ofits work, leading to its eventual demise.

In July 1987, the Consultative Committee of Accountancy Bodies (CCAB) set up areview of the standard-setting process under the chairmanship of Sir Ron Dearing. TheDearing Reportsubsequently made a number of very important recommendations.The government accepted all but one of them and in August 1990 a new standardsetting structure was set up.


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Current Standards Setting Structure

The system is centred around the Accounting Standards Board, and the structure, asrecommended by the Dearing Report, is shown in Figure 1.1.

Figure 1.1: Standard Setting Structure

The FRC acts as a policy-making body for accounting standard-setting.

(a) Financial Reporting Standards (FRS)

The ASB is more independent than the ASC was and can issue standards known asFinancial Reporting Standards (FRS). The ASB accepted the SSAPs then in force andthese remain effective until replaced by an FRS. The ASB develops its own exposuredrafts along similar lines to the ASC; these are known as FREDs (Financial ReportingExposure Drafts).

(b) Statements of Recommended Practice (SORP)

Although the ASB believed that Statements of Recommended Practice (SORPS) had arole to play, it did not adopt the SORPS already issued. Not wishing to be divertedfrom its central task of developing accounting standards, the Board has left thedevelopment of SORPS to bodies recognised by the Board.

The SORPS issued by the ASC from 1986 differed from SSAPs in that SSAPs had tobe followed unless there were substantive reasons to prove otherwise, and non-compliance had to be clearly stated in the notes to the final accounts. A SORP simplysets out best practice on a particular topic for which a SSAP was not appropriate.However, the later SORPs are mandatory and cover a topic of limited application to aspecific industry (e.g. local authorities, charities, housing associations). These SORPSdo not deviate from the basic principles of the various SSAPs and FRSs currently in

issue.(c) Urgent Issues Task Force (UITF)

This is an offshoot of the ASB which tackles urgent matters not covered by existingstandards or those which, if covered, were causing diversity of interpretation. In thesecircumstances, the UITF issues a "Consensus Pronouncement" in order to detectwhether or not accounts give a true and fair view.

(d) Financial Reporting Review Panel

This examines contentious departures from accounting standards by large companies.The panel has the power to apply to the court for an order requiring a company'sdirectors to revise their accounts.

Apart from the UK Accounting Standards, there are also standards issued by theInternational Accounting Standards Committee (IASC) which was established in 1973.

The Review Panel

The Financial Reporting Council (FRC)

The Urgent Issues Task Force (UITF)

The Accounting Standards Board (ASB)


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Representatives from the United Kingdom sit on this Committee with those of other countries.The need for the IASC arose because of international investment, the growth of multinationalfirms and the desire to have common standards worldwide. In the United Kingdom, our ownstandards take precedence over the IASC, but most of the provisions of IASs are alreadycontained in existing SSAPs or FRSs. Where there is non-compliance with an IAS, this isdisclosed in the UK standard.

We look at international standards in a little more detail in a later section here.

Statements of Standard Accounting Practice

A detailed knowledge of all the current SSAPs and FRSs is notrequired by your examiners,but you should be aware of what they cover. However, some of the more importantstandards are dealt with in the main body of this course material under their own topicheadings.

SSAP 1: Accounting for Associated Companies

Where one company has invested in another company and can significantly influence

the affairs of that company, then rather than simply show dividends received as ameasure of income, the full share of the profits of that company should be shown in theinvesting company's accounts.

SSAP 2: Disclosure of Accounting Practice

This standard requires disclosure if the accounts are prepared on the basis ofassumptions which differ materially from the generally accepted fundamentalaccounting concepts.

The position must be disclosed as a note to the accounts. (Accounting concepts aremore fully covered later on in this study unit.)

SSAP 3: Earnings Per Share

This SSAP defines how earnings per share is calculated and is covered in more detaillater in the course.

SSAP 4: Accounting for Government Grants

Grants should be recognised in the profit and loss account so as to match theexpenditure to which they relate. Capital grants relating to capital expenditure shouldbe credited to revenue over the expected useful economic life of the asset.

SSAP 5: Accounting for Value Added Tax

This aims to achieve uniformity of accounting treatment of VAT in financial statements.

SSAPS 6 and 7

These have been withdrawn.

SSAP 8: Treatment of Tax Under the Imputation System in Accounts ofCompanies

This establishes a standard treatment of taxation in company accounts with particularreference to advance and mainstream corporation tax.

SSAP 9: Stocks and Long-term Contracts

Stocks should be valued at the lower of cost or net realisable value. With long-termcontracts the accounts should not recognise profit in advance but should accountimmediately for any anticipated losses (covered later in the course).

SSAPs 10 and 11SSAP 10 has been superseded by FRS 1 and SSAP 11 has been withdrawn.


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SSAP 12: Accounting for Depreciation

This SSAP applies to all fixed assets except investment properties, goodwill,development costs and investments. All assets with a finite life should be depreciatedby allocating cost less residual value to the revenue account, over their economic lives.The SSAP recognises several different methods but does not insist on which method

should be used; the method applied, however, should be consistent. (Covered later inthe course.)

SSAP 13: Accounting for Research and Development

Expenditure on pure (basic) or applied research can be regarded as ongoing tomaintain a company's business. Expenditure on developing new and improvedproducts is normally undertaken to secure future benefits, but should still also bewritten off in the year of expenditure unless it complies with stringent conditions, e.g.the project is commercially viable.

SSAP 14

SSAP 14 has been superseded by FRS 2.

SSAP 15: Accounting for Deferred Tax

This covers the treatment of taxation attributable to timing differences between profitscomputed for tax purposes and profits as stated in financial statements. Timingdifferences originating in one period are likely to be reversed in a subsequent period.

SSAP 16

SSAP 16 has been withdrawn.

SSAP 17: Accounting for Post Balance Sheet Events

Any event occurring up to balance sheet date will have affected the balance sheet, butnormally it is impossible to alter the accounts after approval by the directors. However,

between these two dates some types of events can be adjusted for, e.g. discovery oferrors or frauds which show that the financial statements were incorrect.

SSAP 18: Accounting for Contingencies

A contingency is a situation that exists at the balance sheet date, the outcome of whichis uncertain. Contingent losses must be taken into account and the contingent gainsleft out. Material contingent losses can be disclosed in the notes to the balance sheet.

SSAP 19: Accounting for Investment Properties

This standard requires investment properties to be included in the balance sheet atopen market value. Where investment properties represent a substantial proportion ofthe total assets the valuation should be carried out by a recognised professional

person, and by an external valuer at least every five years.

SSAP 20: Foreign Currency Translation

This deals with the translation of foreign currency transactions from overseas branchesor subsidiaries into sterling. The method used should be disclosed as a note to thefinal accounts.

SSAP 21: Accounting for Leases and Hire Purchase Contracts

This requires that a finance lease (where the lessee takes on the risks and rewards ofownership) should be accounted for by the lessee as if the asset had been purchased.In other words, substance over form.


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SSAP 22: Accounting for Goodwill

Goodwill purchased should reflect the difference between the price paid for a businessand the fair value of the net assets acquired. Goodwill should not include any value forintangible items; these should be included under the heading of intangible assets in thebalance sheet. Purchased goodwill should not remain as a permanent item in the

balance sheet. It must either be written off immediately on acquisition againstreserves, or amortised against profit and loss on ordinary activities over its usefuleconomic life. (This is covered in more detail later in the course.)

SSAP 23: Accounting for Acquisitions and Mergers

This deals with the different accounting methods for acquisitions or mergers. (See alsoFRS 6 later in this Study Unit.)

SSAP 24: Accounting for Pension Costs

An employer should recognise the cost of providing pensions on an equitable basis inrelation to the period over which he derives benefit from services rendered byemployees.

SSAP 25: Segmental Reporting

Information in accounts should be broken down by class of business andgeographically (covered later in the course).

Financial Reporting Standards 1-7

FRS 1: Cash Flow Statements

Cash flow statements replace the source and application of funds statement, so thatthe emphasis is now on what cash has flowed in or out of the business during theaccounting period rather than on how the components of working capital have changedin the year. (We shall look at these in detail in a later unit.)

FRS 2: Accounting for Subsidiary Undertakings

This deals with preparing accounts for parent and subsidiary companies.

FRS 3: Reporting Financial Performance

This covers the treatment of extraordinary and exceptional items in financialstatements, and requires a statement of total recognised gains and losses to beprepared. (Covered later.)

FRS 4: Accounting of Capital Instruments

This standard supersedes the Urgent Issues Task Force's (UITF) Abstract 1"Convertible Bonds" and Abstract 8 "Repurchase of own debt". The subject matter

involved is to do with raising finance.

FRS 5: Reporting the Substance of Transactions

This standard, issued 14 April 1994, ensures that financial statements report thesubstance of transactions and not merely their legal form. (Covered later.)

FRS 6: Accounting for Business Combinations (Acquisitions and Mergers)

This standard limits the ability of a company to use merger accounting in accordancewith SSAP 23 by setting out a number of conditions which must first be satisfied beforemerger accounting can be adopted. FRS 6 in conjunction with FRS 7 (see nextparagraph) are mandatoryfor accounting periods commencing on or after 23December 1994.


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FRS 7: Fair Values in Acquisition Accounting

All business combinations that do not qualify as a merger in accordance with FRS 6must therefore adopt acquisition accounting. This Standard ensures that all the assetsand liabilities of the acquired company at the date of acquisition are recorded at "fairvalues" in the financial records of the acquiring company.

International Accounting Standards

(a) Historical Development

The International Accounting Standards Committee (IASC), established in 1973,was an independent private sector body and had no formal authority. It therefore hadto rely on persuasion and the professionalism of others to encourage adoption of theInternational Accounting Standards (IASs) that it issued. The IASC operated underthe umbrella of the International Federation of Accountants (IFAC), which is theworldwide organisation of accountancy bodies and is independent of any country'sgovernment. All members of IFAC were originally members of IASC.

In 1995 the IASC entered into an agreement with the International Organisation ofSecurities Commission (IOSCO) (the body representing stock exchanges throughoutthe world) to produce a core set of accounting standards. These standards were to beendorsed by IOSCO as an appropriate reporting regime for business entities in theglobal marketplace for the raising of finance.

The IASC became known as the International Accounting Standards Board (IASB)under a restructuring in 2000. It is now governed by a group of 19 individual trustees,known as the IASC Foundation, with diverse geographical and functional backgrounds.

The IASB's sole responsibility is to set International Financial Reporting Standards(IFRSs). As such it is at the forefront of harmonisation of accounting standards acrossthe world as it pushes for adoption of its standards with the help of IOSCO.

(b) Harmonisation

Within the UK this harmonisation process with IASs has already begun. As notedabove, most of the provisions of IASs are already contained in existing SSAPs orFRSs, and where there is non-compliance with an IAS, this is disclosed in the UKstandard.

The European Union, besides issuing Directives on company law (Fourth and SeventhDirectives), has also adopted the IASB standards for the preparation of financialstatements. Thus, for example, all stock exchange listed businesses within the EUhave to comply with IASs for the publication of their consolidated financial statementsfor accounting periods starting on or after 1 January 2005. The aim is to improve theefficiency of the capital market (stock exchanges) across the EU by improving thereliability and comparability of published financial information. Businesses not listed,which tend to form the majority, can still use the framework of standards established bytheir individual home country. However, within the EU, countries are converging theirhome standards with the international standards and this process is occurring in otherareas of the globe.

(c) The Standards

With the issuing by the IASB of new accounting standards (IFRSs), there are currentlyboth a number of IFRSs and IASs in force. You do not require a detailed knowledgeof all the current international standards, but it is useful to be aware of their range.Where necessary, though, because of their importance, broader details will be provided

later in the study manual (principally those units on limited companies and cash flowstatements).


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Current International Financial Reporting Standards

IFRS 1 First-time Adoption of International Financial Reporting Standards

IFRS 2 Share-based Payment

IFRS 3 Business Combinations

IFRS 4 Insurance Contracts

IFRS 5 Non-current Assets Held for Sale and Discontinued

IFRS 6 Exploration for and evaluation of Mineral

IFRS 7 Financial Instruments: Disclosures

IFRS 8 Operating Segments

Current International Accounting Standards

IAS 1 Presentation of Financial Statements

IAS 2 Inventories

IAS 7 Cash Flow Statements

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

IAS 10 Events After the Balance Sheet Date

IAS 11 Construction Contracts.

IAS 12 Income Taxes

IAS 16 Property, Plant and Equipment

IAS 17 Leases

IAS 18 Revenue

IAS 19 Employee Benefits

IAS 20 Accounting for Government Grants and Disclosure of GovernmentAssistance

IAS 21 The Effects of Changes in Foreign Exchange Rates

IAS 23 Borrowing Costs capitalised as part

IAS 24 Related Party Disclosures

IAS 26 Accounting and Reporting by Retirement Benefit Plans

IAS 27 Consolidated and Separate Financial Statements

IAS 28 Investments in Associates

IAS 29 Financial Reporting in Hyperinflationary Economies

IAS 31 Interests in Joint Ventures

IAS 32 Financial Instruments: Presentation

IAS 33 Earnings per Share

IAS 34 Interim Financial Reporting

IAS 36 Impairment of Assets

IAS 37 Provisions, Contingent Liabilities and Contingent Assets

IAS 38 Intangible Assets

IAS 39 Financial Instruments: Recognition and Measurement


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IAS 40 Investment Property

IAS 41 Agriculture

C. ACCOUNTING PERIODS

An owner of a business will require financial information at regular intervals. As we havenoted, he or she will want to be able to check periodically how well or badly the business isdoing. Financial accounts are normally prepared on an annual basis, e.g. twelve months tothe 31 March. Preparing accounts on an annual basis facilitates comparisons between oneyear and previous years and assists forecasting the next year. For example, there may beseasonal factors affecting the business, which will even out over the year. An ice-creamvendor will expect to make more sales in the summer months than in the winter months. Hewould not be able to tell if business is improving by looking at accounts for six months ended31 March 20XX and comparing them with accounts for the six months ended 30 September20XX. True comparison of profit/loss can be gained only when he examines his accounts forthe years (say) 31 March 20X1 and 31 March 20X2.

Accounts normally have to be prepared annually for tax purposes as tax is assessed onprofits of a 12-month accounting period. In the case of limited companies, accounts areprepared annually to the "accounting reference date". It is necessary to calculate annuallythe amount of profit available for distribution to shareholders by way of dividend.

D. THE FUNDAMENTAL CONCEPTS OF ACCOUNTANCY

The purpose of SSAP 2: Disclosure of Accounting Policies is to ensure that thefundamental bases on which the accounts of a company are prepared are disclosed in notesto the published accounts, thus enabling any person to understand and interpret them in thelight of the information disclosed.

The statement distinguishes between fundamental accounting concepts, accounting basesand accounting policies.

Accounting concepts

These are defined as broad basic assumptions which underline the periodic financialaccounts of business enterprises. Fourare singled out for special mention (seebelow). The Companies Act 1985 refers to these four accounting concepts as"fundamental principles", gives them statutory force and takes into account twoadditional principles, i.e. non-aggregation (assets must be valued individually) and set-off (assets or income cannot be set off against liabilities of expenditure or vice-versa).

Accounting basesThese are different methods that have been developed for expressing or applying thefundamental accounting concepts, e.g. calculation of depreciation, valuation of stocks.

Accounting policies

These are the specific accounting bases judged by business enterprises to be the mostappropriate to their circumstances and adopted by them for the purpose of preparingtheir financial accounts.


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The Four Fundamental Concepts

These are the fundamental principles referred to in SSAP2.

"Going concern" concept

The assumption is made that the business entity will continue in existence for the

foreseeable future. This is an important concept, as the value placed on the assets ofa continuing business is different from the value placed on the assets of a closingbusiness. Stock is normally valued at cost price but if the business were about tocease trading, then the resale value of the stock would be more relevant, as the ownerwill try to sell off the remaining stock. One obvious problem with this concept is that wecan never be entirely sure that the business will continue. The concept also applies tothe significant curtailment of any part of the business operation.

Consistency concept

Once a business has decided which accounting methods it is going to apply and how itis going to interpret the various rules of accounting, it should be consistent in thesematters from year to year. Consistency is necessary so that the results of the

business, as shown by the accounts, may be compared from year to year. Changesshould be adopted only if the old methods, for a good reason, can no longer apply.

Concept of prudence

The accountant should adopt procedures which do not overstate or anticipate profitsand do not understate losses but which do provide for all potential losses. Profit shouldbe included only when it is reasonably certain that cash will be received. Adopting theconcept of prudence is a measure against drawing money from the business out ofprofits which may not materialise, or when a loss arises which had not beenanticipated.

Accruals concept

Revenues and costs are recognised as they are earned or incurred, and not when themoney is received or paid. For example, if in year 1 a trader has only paid three of fourtelephone bills, and in year 2 pays the outstanding bill in addition to the four billsreceived in year 2, then the outstanding bill should be adjusted for ("accrued") in theaccounts of year 1, so that each year is charged with the appropriate telephone costsincurred, rather than with the amount actually paid.

Other Concepts of Accountancy

In addition to the four basic concepts of accounting, there exist various other conventions,which may be encountered in examinations. (You should note here that, sometimes, theterms accounting "rules", "concepts" and "conventions" are used interchangeably, so do be

prepared for this.)

Historical cost

Accounting information is quantitative information, recorded in monetary value at"historical cost". This means that transitions are recorded at their original price, e.g.purchases of stock are recorded at cost price.

Materiality

If it would serve no useful purpose, i.e. it is not worthwhile to record an item in aparticular way, or to show an item separately in the accounts, then it should not bedone. If an item is "immaterial", it may be that the costs of recording it in a particularway outweigh any benefit of doing so. Each business must quantify "materiality"

individually as, for example, an item costing 50 might be material to a business with aturnover of 1,000 and a profit of 100, but not to a business with a turnover of 5m


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and a profit of 350,000. Also, other conventions may be ignored if the cost ofadopting them outweighs the benefit.

Matching

Income should be included in the accounts in the same accounting period as theexpenses relating to that income.

Realisation

Transactions are recorded when the customer incurs liability for the goods or services(normally, liability is incurred when the goods or services are actually received). Anyprofit on the transaction is not realised until that time.

This convention is in conflict with the economist's view that, if an asset has increased invalue, that increase should be recognised.

Dual aspect

Every transaction involves an act of giving and an act of receiving. For example, if Abuys a car from B for 2,500, then A receives a car and "gives" 2,500. It is from this

aspect of transactions that the double-entry system of book-keeping developed.


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CASE STUDY A: GLOBAL HOLDINGS LTD

Throughout the manual, we shall use a number of case studies of businesses to helpillustrate the topics under consideration, particularly through relating Review Questions (seebelow) to the circumstances of the case study.

The general background to the first such case study example is set out here. We shall buildon this in future units.

Background

Global Holdings Ltd is a UK based company, created in 1995 by the current ManagingDirector, Jim Baxter. He served an apprenticeship as a heating engineer and worked for anumber of large companies, but having been made redundant on two occasions, Jim decidedto start his own business in 1995. He started as a sole trader and did work for a limitednumber of customers. However, as his reputation for excellent workmanship spread, thedemand for his services rose dramatically.

Jim joined forces with Tom Watkins, a former work colleague, to form a partnership in 1997.Jim and Tom complemented each other and were able to exchange ideas and launch anambitious sales strategy which proved to be very successful. As the company's salescontinued to rise, Jim and Tom were able to branch out into other activities for example,they opened a showroom and began selling fitted bathrooms and bedrooms. Eventually, thebusiness was converted into a private limited company in 2000.

Part 1 Energy Saving Products

At this time, many of the company's customers were complaining about the cost of energy,and Jim and Tom spotted in a gap in the market for an energy saving device.

In early 2001, they launched their prototype product the Zephron which proved to be

very successful. Today, this product is available in three formats: the deluxe, the standardand the economy. These are bought by domestic and industrial customers and can beattached to any central heating system to save energy by identifying inefficiencies andreducing the amount of heating provided in rooms which have been vacated. They generateenergy savings per year of between 3% and 12% depending upon the brand (and format)which has been bought. Global Holdings sell all three formats in roughly equal proportions.


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Review Questions

At the end of each unit in this manual, the questions set out in this section will provide youwith an opportunity to consolidate the knowledge and understanding you have gained fromstudying the unit. They will be a mixture of straightforward questions about key principles or

elements of the topics under consideration, and other questions which challenge you to thinkabout the application or importance of these principles and elements (sometimes in relationto the case studies used in the manual). No answers are given, but you should satisfyyourself that you are able to answer them all adequately before moving on to the next unit.

Section A

1. Explain the differences between financial and management accounting.

2. Explain why, as a business grows, its affairs become more complicated.

3. For a large company, such as Marks and Spencers, identify four types of stakeholderand explain how their various interests in the organisation may conflict with oneanother.

Section B

1. Explain the main purpose of accounting standards.

2. Explain how FRS 6 and 7 might protect the interests of stakeholders when companiesare involved in mergers and takeovers.

Section C

1. Explain why a company interested in taking over a smaller rival would need to analyseits final accounts for the last three years.

2. How can seasonal influences distort a company's financial performance?

Section D1. What problems will a company interested in buying a smaller rival face when

attempting to calculate its current value based upon historical cost data?

2. When investigating fraud in an organisation explain why the concept of materiality isimportant?

Case Study A

1. At which point in its development does Global Holdings have a distinct "legalpersonality"?

2. Explain why, in the early stages of its development, Global Holdings may havestruggled to borrow money from a bank and obtain credit from suppliers?

3. At which point in its development would Global Holdings have been most affected bythe requirements of the accounting standards laid out in Section B?


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Study Unit 2

Double-Entry Book-Keeping and the Ledger

Contents Page

A. Principles of Double-Entry Book-Keeping 20

B. Ledger Accounts 21

Recording Transactions in the Ledger 21

Rules for Debits and Credits 23

C. The Accounting Equation 24

D. Balancing Off 25

Why Do We "Balance Off" Ledger Accounts? 25

Procedure for Balancing Off 25

Balancing Off Month by Month 27

E. Classification of Ledger Accounts 30

Answers to Questions for Practice 33


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A. PRINCIPLES OF DOUBLE-ENTRY BOOK-KEEPING

At the outset here we need to clear about a number of terms and concepts upon which arebuilt the system of double-entry book-keeping.

Dual aspect

You will recall from the last unit that the system of double-entry book-keeping is basedon the dual aspect of transactions, i.e. for every transaction there is a receivingand agiving. For example, if I buy a book and pay cash, I receive a book and give cash.

The ledger

We record the receiving and giving aspects of business transactions in a book ofaccounts which we call "the ledger". An account is opened in the ledger for eachreceiving person or "thing" and for each giving person or "thing". For example, if I amin business and I buy a car, paying by cheque, I would open an account in my ledgerfor "motor vehicles" and one for "bank". If I then buy a fax machine and pay cash, Iwould open an account for "office equipment" and one for "cash".

Debits and credits

We record the receiving aspect of transactions by debitingthe "receiving" account andcreditingthe "giving" account. If we look at the example in paragraph above, we cansee which accounts to debit and which accounts to credit. When I buy a car, paying bycheque, I debit the account for motor vehicles as the receiving account, and credit theaccount for bank as the giving account. When I buy a fax for cash, I debit the accountfor office equipment as the receiving account, and credit the account for cash as thegiving account.

Stock

It is worth mentioning at this stage that the account for stock is split into an account for

"purchases of stock" and an account for "sales of stock". When we purchase goods forresale (i.e. purchase stock) for cash, we debit the account for purchases as thereceiving account, and we credit the account for cash as the giving account. If we sellitems of stock to Mr X on credit, we debit the account for Mr X as the receiving accountand we credit the account for sales as the giving account.

Capital

The other account at which we should look at this stage, is the capital account. First,do remember that, in our ledger, we keep the accounts which reflect the transactions ofa business. In the capital account we record the amount which the proprietor of thebusiness personally pays into the business itself. For example, if Mrs Y starts abusiness by paying some of her own money into the business bank account, then we

debit the bank account as the receiving account, and we credit the capital account asthe giving account. If Mrs Y draws cash from the business for her own personal use,we open a drawings account, and we debit the drawings account as the receivingaccount, and credit the cash account as the giving account.


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B. LEDGER ACCOUNTS

Recording Transactions in the Ledger

Each account that we open in a ledger will be shown on a separate page. We shall show the

debit entries on the left-hand side of the page and the credit entries on the right-hand side.For example, we represent the bank account in our ledger as follows:

Dr Bank Cr

Date Details Amount Date Details Amount

Let us look at an example. Ms A starts in business on 1 January 20X0 by lodging 500 of herpersonal money into a business bank account. We would record the event in her books of

account in the following way.

Dr Bank Cr

20X0 20X0

Jan. 1 500

Dr Capital Cr

20X0 20X0

Jan. 1 500

When Ms A later looks at her ledger, she will see from the account for "Bank" that 500 hasbeen lodged on 1 January. She will also want to know where the 500 came from (bearing inmind that she may be recording a large number of transactions and is unlikely to rememberthe details of each one). Similarly, when Ms A looks at her "Capital" account, she will want toknow which account has "received" the 500 that she has paid into the business.

Therefore, when we enter a transaction in the ledger accounts, we enter, in the "details"column, the name of account in which we are entering the opposite entry.

In the example of Ms A, above, her two ledger accounts now appear as follows.

Dr Bank Cr

20X0 20X0

Jan. 1 Capital 500

Dr Capital Cr

20X0 20X0

Jan. 1 500 Bank


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Ms A can now see from her "Bank" account that the 500 lodged has come from capital, andfrom her "Capital" account that the 500 paid into the business has been lodged in the bank.

Worked example

Read through the following example and try to work out what the entries in the ledgeraccounts will be, before looking at the solution.

Mr Fisher started in business by lodging 10,000 of his own money into a business accounton 1 March 20X1. On 3 March, he bought a van, paying 3,000 for it by cheque. On 8March, he purchased goods for resale from Mr Hunter for 1,000 on credit. On 12 March hepaid 500 to Mr Hunter by cheque.

Let us decide which accounts to debit and which to credit. First, the bank account "receives"10,000 which is "given" by Mr Fisher personally. So the entries in the ledger accounts willbe:

Debit: Bank account 10,000

Credit: Capital account 10,000

Secondly, the motor vehicles account "receives" 3,000 and the bank account "gives"3,000. The entries will be:

Debit: Motor vehicles account 3,000

Credit: Bank account 3,000

Next, the purchases account "receives" 1,000 which is "given" by Mr Hunter. The entrieswill be:

Debit: Purchases account 1,000

Credit: Mr Hunter's account 1,000

Finally, Mr Hunter "receives" 500, "given" by the bank account. The entries will be:

Debit: Mr Hunter's account 500

Credit: Bank account 500

Mr Fisher's ledger accounts will appear as follows:

Dr Capital Cr

20X1 20X1

Mar 1 Bank 10,000

Dr Bank Cr

20X1 20X1

Mar 1 Capital 10,000 Mar 3 Motor vehicles 3,000

Mar 12 Mr Hunter 500

Dr Motor vehicles Cr

20X1 20X1

Mar 3 Bank 3,000


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Dr Purchases Cr

20X1 20X1

Mar 8 Mr Hunter 1,000

Dr Mr Hunter Cr

20X1 20X1

Mar 12 Bank 500 Mar 8 Purchases 1,000

Rules for Debits and Credits

The types of account which we require in the ledger fall into five categories:

Assets which are the resources possessed by the business: property; motorvehicles; bank balance; cash; debts owing to the business; etc.

Liabilities which are moneys owing by the business for goods supplied, for expenseitems and for amounts borrowed.

Capital which is the amount supplied by the proprietor to the business.

Income which is the revenue of the business. It may be sales; work done; feesearned; rents receivable; commission; etc.

Purchases and expenses which are items of expenditure "used up" by thebusiness. Purchases are of goods for resale. Expense items may include, forexample, wages, insurance, repairs, rent, etc.

Transactions are recorded in the ledger by debiting one account and crediting another. The

treatment of the debit and credit will depend on the type of account concerned in thetransaction. Table 2.1 sets out the rules.

Table 2.1: Rules for debits and credits for particular types of account

Debit Credit

Assets Increase Decrease

Liabilities Decrease Increase

Capital Decrease Increase

Income Decrease Increase

Purchases and expenses Increase Decrease

Let's think about each of the entries in the table in turn. One example of a ledger account foran asset is the bank account. If the bank account "receives", then the bank balance hasincreased so we debit the bank account. If the bank account "gives", then the bank balancehas decreased, so we credit the bank account.

An example of a ledger account for a liability is the account for a creditor say, Mr X. If Mr X"gives", the liability to pay him increases so we credit his account. If Mr X "receives", theliability to pay him decreases, so we debit his account. Similarly, if the capital account"gives", the liability to pay the proprietor increases, so we credit the capital account. If thecapital account "receives", then the liability to pay the proprietor decreases, so we debit the


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capital account. Let us use sales as our example of an income account. If sales "gives" (i.e.the business sells goods), sales have increased, so we credit the sales account. If sales"receives" (i.e. goods sold are returned), then sales have decreased, so we debit the salesaccount.

Stationery is an example of an expense account. If stationery "receives", the stock of

stationery has increased and we debit the stationery account. It stationery "gives" i.e.stationery is returned to the supplier the stock of stationery has decreased, and we creditthe stationery account.

Worked example

Let us go back now to our earlier example of Mr Fisher, and look at his transactions in termsof "increasing" and "decreasing".

First, Mr Fisher lodges 10,000 of his own money into the business bank account. The assetof bank has increased and the amount which the business owes to Mr Fisher personally hasalso increased so, we can see that the entries are:

Debit: Bank account (increase in an asset)

Credit: Capital account (increase in capital)

Second, he buys a van (an asset) and pays by cheque from his bank account (an asset). So,we can agree the entries as:

Debit: Motor vehicles account (increase in an asset)

Credit: Bank account (decrease in an asset)

Next, he purchases goods on credit from Mr Hunter, so the entries are:

Debit: Purchases (increase in purchases)

Credit: Mr Hunter (increase in a liability)

Finally, he pays a cheque to Mr Hunter, so the entries are:

Debit: Mr Hunter (decrease in a liability)

Credit: Bank (decrease in an asset)

C. THE ACCOUNTING EQUATION

The accounting equation states that:

Assets Liabilities Capital

This means that what the business owns is equal to what it owes (to any creditors, other

lenders and the proprietor).

Let us look at a simple example.

If I start in business by paying 500 of my own money into a business bank account, then Ihave an asset (bank) of 500 and capital of 500.

Asset (500) Liabilities (nil) Capital (500)

If I then buy a second-hand PC on credit for 150 from Mr W, then I have assets of 500

(bank) 150 (PC), I have a liability to pay Mr W 150, and I have capital of 500.

Assets (650) Liabilities (150) Capital (500)

We shall see the accounting equation in operation in the unit on balance sheets, later in thecourse.


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D. BALANCING OFF

Why Do We "Balance Off" Ledger Accounts?

We shall use an example to illustrate. Mrs P. Potter commenced in business on 1 January20X1. The bank account in her ledger appears as follows for the month of January 20X1.

Dr Bank Cr

20X1 20X1

Jan 1 Capital 2,000 Jan 2 Purchases 400

Jan 9 Sales 320 Jan 4 Motor vehicle 1,200

Jan 17 Sales 205 Jan 12 Insurance 110

Jan 23 Cash 190 Jan 20 Purchases 270

Jan 31 Sales 380 Jan 24 Motor expenses 90

We can tell from this account the amounts which P. Potter has lodged in the bank, and theamounts which she has drawn from the bank. We can tell from the narrative where eachlodgement has come from (e.g. sales, cash) and where each amount drawn has gone to(e.g. purchases, insurance).

What else do we want to know about the bank account? The bank balance.

To find how much P. Potter has in the bank at 31 January, we simply add the amounts which

she had lodged in the bank (2,000 320 205 190 380 3,095) and subtract the

amounts which she had paid out of the bank account (400 1,200 110 270 90

2,070). Her bank balance at 31 January was, therefore, 3,095 2,070 1,025.

In this case, P. Potter has a debit balance of 1,025, as the total of the amounts on the debitside of her bank account is greater that the total of the amounts on the credit side.

Procedure for Balancing Off

In the bank account of Mrs Potter's ledger we want to show that, at 31 January 20X1, thedebit side was greater than the credit side by 1,025. We do this by entering the balancingfigure on the credit side as follows, and totalling the two columns.

Dr Bank Cr

20X1 20X1






Jan 31 Balance c/d 1,025

3,095 3,095

"Balance c/d" means balance carried down to the next month. If P. Potter had 1,025 in thebank at the close of business on 31 January, then she also had 1,025 in the bank at the

start of business on 1 February. We want to show in the ledger account for bank thatP. Potter started off February with 1,025 in the bank.


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This is done as follows:

Dr Bank Cr

20X1 20X1

Jan 1 Capital 2,000 Jan 2 Purchases 400Jan 9 Sales 320 Jan 4 Motor vehicle 1,200





3,095 3,095

Feb 1 Balance b/d 1,025

"Balance b/d" means balance brought down from the previous month. Instead of saying thatP. Potter started February with debits of 3,095 and credits of 2,070 in her bank account,we say that she had a debit balance of 1,025.

The procedure for balancing off is as follows.

(a) Total both sides of the ledger account.

(b) Which side is "bigger"? Enter the balancing figure required on the "smaller" side.

(c) The total of both sides should now agree. Enter the totals and "rule off" (i.e. underline).

(d) Bring the balance down to the beginning of the following month.

N.B. Balancing off is normally done every month, though it may be done more, or less

frequently.One further point of procedure is worth mentioning. If there is only one entry in a particularledger account for the month, it is unnecessary to enter the totals.

For example, suppose that P. Potter had lodged 2,000 from capital into the bank accountand had made no further transactions during the month. Her bank account would appear asfollows.

Dr Bank Cr

20X1 20X1

Jan 1 Capital 2,000

If we followed stages (a) to (d) of our procedure list, the bank account would appear asfollows.

Dr Bank Cr

20X1 20X1

Jan 1 Capital 2,000 Jan 31 Balance c/d 2,000

2,000 2,000



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However, in this case we can omit stage (c) entering the totals. Instead we simply rule off,and the account will look as shown below.

Dr Bank Cr

20X1 20X1



Balancing Off Month by Month

Now let us suppose that, in our original example, P. Potter made the following transactions inFebruary 20X1:

Feb 6 Purchased goods for resale 400, paying by cheque.

Feb 18 Sold goods for 140, the money being banked immediately.

Feb 21 Paid 60 by cheque for stationery.

Feb 27 Received a cheque for 200 from D. Smith, a debtor.

Mrs Potter's bank account now appears as follows:

Dr Bank Cr

20X1 20X1







3,095 3,095

Feb 1 Balance b/d 1,025 Feb 6 Purchases 400

Feb 18 Sales 140 Feb 21 Stationery 60

Feb 27 D. Smith 200 Feb 28 Balance c/d 905

1,365 1,365

Mar 1 Balance b/d 905

Comprehensive example

Jean started in business on 1st January 20X1, as a computer consultant. Her transactionsfor her first two months of trading are listed below.

Jan 1 Transferred her car, value 8,400, to the business.

Jan 9 Purchased headed notepaper, business cards, etc. to the value of 135, oncredit from OK Paper Limited.

Jan 10 Received a consultancy fee of 400 by cheque from a client.

Jan 19 Paid motor expenses of 90 by cheque.

Jan 20 Drew 50 from the bank for business use.


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Feb 2 Invoiced W Watson 200 for work done.

Feb 9 Paid OK Paper Limited 20 cash.

Feb 22 Drew 40 from the bank for personal use.

Her ledger accounts at 1 March 20X1 will appear as follows.

Dr Motor Vehicle Cr

20X1 20X1


Feb 1 Balance b/d 8,400 Feb 28 Balance c/d 8,400

Mar 1 Balance b/d 8,400

Dr Capital Cr

20X1 20X1 Jan 31 Balance c/d 8,400 Jan 1 Motor vehicle 8,400

Feb 28 Balance c/d 8,400 Feb 28 Balance b/d 8,400

Mar 1 Balance b/d 8,400

Dr Stationery Cr

20X1 20X1

Jan 9 OK Paper Ltd 135 Jan 31 Balance c/d 135

Feb 1 Balance b/d 135 Feb 28 Balance c/d 135Mar 1 Balance b/d 135

Dr OK Paper Limited Cr

20X1 20X1

Jan 31 Balance c/d 135 Jan 9 Stationery 135

Feb 9 Cash 20 Feb 1 Balance b/d 135

Feb 28 Balance c/d 115

135 135Mar 1 Balance b/d 115


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Dr Bank Cr

20X1 20X1

Jan 10 Consultancy Fees 400 Jan 19 Motor expenses 90

Jan 20 Cash 50

Jan 31 Balance b/d 260

400 400

Feb 1 Balance b/d 260 Feb 22 Drawings 40

Feb 28 Balance c/d 220

260 260


Dr Consultancy Fees Cr

20X1 20X1

Jan 31 Balance c/d 400 Jan 10 Bank 400

Feb 1 Balance b/d 400

Feb 28 Balance c/d 600 Feb 2 W. Watson 200

600 600


Dr Motor Expenses Cr

20X1 20X1 Jan 19 Bank 90 Jan 31 Balance c/d 90

Feb 1 Balance b/d 90 Feb 28 Balance c/d 90


Dr Cash Cr

20X1 20X1

Jan 20 Bank 50 Jan 31 Balance c/d 50

Feb 1 Balance b/d 50 Feb 9 OK Paper Ltd 20Balance c/d 30

50 50


Dr W Watson Cr

20X1 20X1

Feb 2 Consultancy Fees 200 Feb 28 Balance c/d 200



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Dr Drawings Cr

20X1 20X1

Feb 22 40 Feb 28 Balance c/d 40


E. CLASSIFICATION OF LEDGER ACCOUNTS

The accounts which may appear in the ledger are commonly classified into the followinggroupings.

(a) Personal accounts

These are the accounts for each person to whom we sell on credit (i.e. our debtors)and from whom we purchase on credit (i.e. our creditors). The capital account is also apersonal account.

(b) Impersonal accounts

These are all the accounts which are not personal accounts, and they may besubdivided into:

real accounts these are our "property" accounts, for instance, vehicles,equipment and

nominal accounts these are the accounts for income, purchases andexpenses of the business.


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Questions for Practice

1. Mr Plum has been trading for many years. In April 20X2, he makes the followingtransactions:

(a) He buys goods on credit from Miss Peach for 300.

(b) He sells goods for cash 150.

(c) He pays insurance of 40 by cheque.

(d) He pays Miss Peach 150 by cheque.

(e) He lodges 50 cash in the bank.

Complete the following table with reference to the above transactions, by entering"debit" and "credit", as appropriate.

(a) ______________ Miss Peach ______________ Purchases

(b) ______________ Sales ______________ Cash

(c) ______________ Insurance ______________ Bank

(d) ______________ Miss Peach ______________ Bank

(e) ______________ Cash ______________ Bank

2. Debbie starts in business on 1 January 20X0 as a mobile hairdresser. Draw up herledger accounts and enter the following transactions.

Jan 6: Debbie pays 1,000 of her own money into a business bank account.

Jan 9: Debbie buys a small second-hand car for 600, paying by cheque.

Jan 2: Debbie draws 100 cash from bank, for business use.

Jan 13: Debbie buys hairdressing supplies for 60 cash.

Jan 16: Debbie buys petrol for 10 cash and sets off for her hairdressingappointments. She takes in 60 cash from these appointments.

Jan 17: More appointments 70 received in cheques, which Debbie banksimmediately.

Balance off all the accounts as at 31 January.

Now check your answers with those given at the end of the unit.


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Review Questions

Section A

1. Case Study A reveals how Jim started his business and was very successful in a veryshort space of time. Explain what might have happened had Jim taken too much cashout of his fledgling business in the form of drawings.

2. Explain how the double-entry bookkeeping helps to prevent fraudulent transactions.

Section B

1. Referring to Case Study A: When Jim Baxter started the business, he admitted that heknow literally nothing about bookkeeping. Explain how Jim would have been betterequipped to manage his business on a daily basis if he had been more knowledgeableabout ledger accounts.

2. Explain the benefits a business can gain by reducing its liabilities.

Section C

1. Referring to Case Study A: When Jim Baxter started Global Holdings, he found it verydifficult to borrow money from his local bank to finance his development plans. Jimcommented, "The bank refused to lend me any money because I had too manyliabilities". Explain the nature of any liabilities that could affect a person's ability toborrow money from a bank.

Section E

1. Explain the difference between personal and real accounts.


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ANSWERS TO QUESTIONS FOR PRACTICE

1. (a) credit, debit

(b) credit, debit

(c) debit, credit(d) debit, credit

(e) credit, debit

2. The accounts, balanced off at 31 January, are as follows.

Dr Capital Cr

20X0 20X0

Jan 31 Balance c/d 1,000 Jan 6 Bank 1,000


Dr Bank Cr

20X0 20X0

Jan 6 Capital 1,000 Jan 9 Motor vehicle 600

Jan 17 Work done 70 Jan 12 Cash 100

Jan 31 Balance c/d 370

1,070 1,070


Dr Motor Vehicle Cr

20X0 20X0

Jan 9 Bank 600 Jan 31 Balance c/d 600


Dr Cash Cr

20X0 20X0

Jan 12 Bank 100 Jan 13 Hairdressing supplies 60

Jan 16 Work done 60 Jan 16 Motor expenses 10

Jan 31 Balance c/d 90

160 160



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Dr Hairdressing Supplies Cr

20X0 20X0

Jan 13 Cash 60 Jan 31 Balance c/d 60


Dr Motor Expenses Cr

20X0 20X0

Jan 13 Cash 10 Jan 31 Balance c/d 10


Dr Work Don

03 Intro to Accounting Txt

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