Ch08 Financial statements of a sole trader

					Chapter 8: Financial statements of a sole trader

    On completion of this topic you should be able to
       Differentiate between accruals and prepayments
       Calculate depreciation using the straight line method or
       reducing balance method
       Differentiate between bad debts and doubtful debts
       Construct financial statements with post trial balance
       adjustments
    Independent study
       Study Chapter 8
       Progress test and practice question(s) as set
The story so far…

                  Identify, measure and classify the
               economic transactions of the business

                      Record monetary values in
                        the ledger accounts

                  At the end of the accounting period,
           balance the accounts and construct a trial balance

                 Make post trial balance adjustments


                   Prepare the financial statements

                             Business Accounting                2
Post trial balance adjustments

     Although the records in the accounting system may
      be up to date, some last minute adjustments to the
      ledger accounts are always necessary at the end
      of the accounting period
        This means that some of the figures in the trial balance
        will need to be amended (‘post’ means ‘after’ in Latin,
        hence the term post trial balance adjustments)
     There are four main adjustments
        Stock
        Accruals and prepayments
        Depreciation of tangible fixed assets
        Doubtful debts
                             Business Accounting                   3
Exercise 1
Accounting principles revisited

     Post trial balance adjustments are guided by UK
      GAAP and in particular by the following accounting
      principles
        Historical cost concept
        Accruals concept
        Prudence concept
        Consistency concept
     Required
        Jot down a brief explanation of each principle


                             Business Accounting           4
Solution 1
Accounting principles revisited

  Historical cost concept – values of assets are based
   on their original acquisition cost, unadjusted for
   subsequent changes in price or value
  Accruals concept – revenue and costs are
   recognised as they are earned and incurred, and
   they are matched with one another and dealt with in
   the profit and loss account of the period to which
   they relate, irrespective of when cash is received or
   paid
                                              (Continued)

                        Business Accounting                 5
Solution 1 (continued)
Accounting principles revisited

   Prudence concept - revenue and profits are not
    anticipated, but are included in the profit and loss
    account only if there is reasonable certainty that
    they will be received. However, provision for all
    known expenses and losses must be made,
    whether the amount is known with certainty or is
    only a best estimate in the light of the information
    available
   Consistency concept - there is uniformity of
    accounting treatment of items of a similar nature
    within each period and from one period to the next
                         Business Accounting               6
Adjustments for stock (inventory)

     Stock refers to unsold goods
        In a manufacturing business, it includes raw
        materials, work-in-progress and finished goods
   Stocktaking is the process of counting the stock at
    the end of the accounting period to confirm the
    actual quantities support the figures recorded in the
    ledger accounts
   Under UK GAAP, stock must be shown at the lower
    of historical cost or net realisable value (NRV)
        NRV is the price the business expects to get for the
        stock, less any costs incurred in selling it

                           Business Accounting                 7
Closing stock and opening stock

  In a continuing business, the closing stock at the end
   of one accounting period is the opening stock at the
   beginning of the next
  The values of opening stock at the start of the period
   and closing stock at the end of the next are needed to
   calculate the cost of sales in the profit and loss
   account
     Closing stock is also shown under current assets
     in the balance sheet
     It is listed first, as it is the most permanent
     (it takes the longest to turn into cash)
                          Business Accounting           8
Accruals

  An accrual is ‘an estimate of a liability that is not
   supported by an invoice or a request for payment at
   the time when the accounts are prepared’ (Collis
   and Hussey, 2007, p. 136)
  It belongs to the financial period and must be added
   to the trial balance figure for that expense
     In the profit and loss account, show the expense
     (including the accrued amount)
     In the balance sheet, show total accruals under
     current liabilities


                          Business Accounting              9
Prepayments

  A prepayment is ‘revenue expenditure made in
   advance of the accounting period in which the
   goods or services will be received’ (Collis and
   Hussey, 2007, p. 137)
  It belongs to the next financial period and must be
   deducted from the trial balance figure for that
   expense
     In the profit and loss account, show the expense
     (excluding the prepaid amount)
     In the balance sheet, show total prepayments
     under current assets
                          Business Accounting            10
Depreciation of tangible fixed assets

     UK GAAP requires all tangible fixed assets with a
      finite life to be depreciated
        Tangible fixed assets are ‘non-monetary in nature and
        have a physical form’ (Collis and Hussey, 2007, p. 138)
     Depreciation is ‘the systematic allocation of the cost
      (or revalued amount) of a tangible fixed asset, less
      any residual value, over its useful economic life’
      (Collis and Hussey, 2007, p. 138)
        The residual value is an estimate of the net proceeds
        from the sale of the asset on disposal (ie the amount for
        which it can be sold less any costs of sale)

                            Business Accounting                     11
Calculating the annual provision for depreciation

     Straight-line method
                        Cost – Residual value
                          Useful economic life
        The useful economic life is an estimate of the number of
        years the asset is expected to provide economic benefits
     Reducing balance method
      Year 1: (Cost – Residual value)  Depreciation rate
      Subsequently: Net book value at start of year  Rate
       The net book value (NBV) is Cost  Depreciation to date



                             Business Accounting                 12
Depreciation

    In the profit and loss account, the provision for
     depreciation is shown under expenses
       Straight-line method spreads charge evenly over the
       period the asset is used
       Reducing balance method gives a lower charge in later
       years, which offsets higher maintenance costs as the
       asset ages, so the overall cost is smoothed
    In the balance sheet, the accumulated depreciation
     is shown as a deduction from cost to give the net
     book value (NBV) under fixed assets
       NBV represents the remaining proportion of the cost

                            Business Accounting                13
Doubtful debts

  A doubtful debt is ‘money owed to an organization,
   which it is unlikely to receive. A provision for
   doubtful debts may be created, which may be
   based on specific debts or on the general
   assumption that a certain percentage of debtors’
   amounts are doubtful’ (Hussey, 1999, p. 138).
  Do not confuse them with bad debts, which are ‘an
   amount owed by debtors that is considered to be
   irrecoverable’ (Collis and Hussey, 2007, p. 141)
   that are written off immediately as
   an expense in the profit and loss account
                       Business Accounting              14
Adjustments for doubtful debts

    In the profit and loss account
       Year 1: Show the provision for doubtful debts under
       expenses
       In subsequent years, show only the increase or decrease
       in the provision (last year’s provision less this year’s
       provision) under expenses
    In the balance sheet
       Show the provision for the current year as a separate
       deduction from debtors under current assets
       In the profit and loss account for Year 1, show the
       provision for doubtful debts under expenses

                            Business Accounting                   15
Exercise 2
Post trial balance adjustments

  Cotswold Coolers’ bookkeeper has drawn up the
   following trial balance from the records at 30 June
   2006
  However, you can see that Ros has provided some
   additional year-end information regarding expenses
   which is not reflected in the trial balance
  Required
     Using the relevant figures from the trial balance and the
     additional information provided, draw up a final list of all
     the expenses for the year showing the adjusted amounts
Exercise 2 Cotswold Coolers
Trial balance at 30 June 2006
                                £          £        Additional information
 Sales                                38,500        Stock at 30 June 2006 £10,000
 Purchases                  29,000                  Accruals
 Vehicles (at cost)          5,000                    Electricity                £300
 Trade debtors               6,800                    General expenses            £50
 Trade creditors                        9,100       Prepayments
 Bank                       15,100                    Rent and rates             £240
 Cash                          350                  Provision for depreciation on
 Rent and rates              2,400                  vehicles will be 25% of cost
 Electricity                 1,500                  Provision for doubtful debts will
 Drawings                    7,000                  be 10% of trade debtors
 General expenses              600
 Interest receivable                  150
 Capital at start of year   _____ 20,000
                            67,750 67,750           Tip: Tick each item as you use it


                                     Business Accounting                                17
Solution 1           Cotswold Coolers
              Post trial balance adjustments

                                                                 £
  Rent and rates (2,400 – 240)                               2,160
  Electricity (1,500 + 300)                                  1,800
  General expenses (600 + 50)                                  650
  Provision for depreciation on vehicles (5,000  25%)       1,250
  Provision for doubtful debts (6,800  10%)                   680
   Notes
   - Total prepayments are £240 and total accruals are £350
   - There are also the two new expenses in the form of the
     provisions for depreciation (£1,250) and doubtful debts (£680)
   - Overall, these adjustments increase expenses by £2,040
   We are now ready to look at the final version of the financial
    statements for Cotswold Coolers …
                             Business Accounting                      18
                   Cotswold Coolers
Profit and loss account for the year ending 30 June 2006

                                                               £        £
           Sales                                                   38,500
           Cost of sales
             Purchases                                    29,000
             Closing stock                               (10,000) (19,000)
           Gross profit                                            19,500
           Interest received                                          150
                                                                   19,650
           Expenses
             Rent and rates (2,400 - 240)                  2,160
             Electricity (1,500 + 300)                     1,800
             General expenses (600 + 50)                     650
             Provision for depreciation on vehicles        1,250
             Provision for doubtful debts                    680   (6,540)
           Net profit                                              13,110

                                   Business Accounting                       19
       Cotswold Coolers
Balance sheet as at 30 June 2006
                                                 £             £        £
Fixed assets                                Cost     Depreciation    NBV
  Vehicles                                 5,000           1,250     3,750
Current assets
  Stock                                                   10,000
  Trade debtors                            6,800

  Provision for doubtful debts              (680)          6,120
  Prepayments                                                240
  Bank                                                    15,100
  Cash                                                       350
                                                          31,450
Creditors: amounts due within one year
  Trade creditors                                          9,100
  Accruals (300 + 50)                                        350
                                                          (9,450)

Net current assets                                                  22,360
Total net assets                                                    26,110   (Continued)


                           Business Accounting                                             20
            Cotswold Coolers
Balance sheet as at 30 June 2006 (continued)


                                       £           £     £
      Capital and reserves
      Capital at start of year      20,000
      Net profit                    13,110     33,110
      Drawings                                (7,000)   26,110




                             Business Accounting                 21
Conclusions

    Post trial balance adjustments are necessary to
     deal with outstanding matters at the end of the
     accounting period
       In exercises and exams these adjustments are provided
       as ‘additional information’ to the trial balance
       If you tick every item as you use it in the financial
       statements you will have one tick against every item in
       the trial balance and two ticks against each adjustment,
       because these are shown once in the profit and loss
       account and once in the balance sheet

				
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