Financial Accounting

Question 1

What is accounting?

Answer 1

The process of identifying, measuring and communicating financial information about a business entity

Question 2

3 types of business entity

Answer 2

• Sole trader = a person who is the exclusive owner of a business, entitled to keep all profits after tax has been paid but liable for all losses.
• Company
• Partnership

Question 3

Matching

To calculate financial performance in a period…

Answer 3

To calculate financial performance in a period, all income due must be matched with all expense incurred to generate the income

Question 4

The financial statement which shows ___________ ___________ over a ________ of _____ is called an ________ _____________ or ________ and _____ account

Answer 4

The financial statement which shows financial performance over a period of time is called an Income Statement or Profit and loss account

Question 5

Gross profit equation

Answer 5

Gross profit = sales revenue - purchase cost

Question 6

Net profit equation

Answer 6

Net profit = Sales revenue - total cost

Question 7

Income Statement

Answer 7

Summarises all income and expenditure over a period of time (usually 12 months)

= Its purpose is to show amount of
profit (where income > expenses) or
loss (where income < expenses)

Question 8

Title Convention examples

Answer 8

“for the year ending 2023”
“Balance sheet as at November 25 2023”

Question 9

What do brackets mean?

Answer 9

Means a minus

Question 10

Income Statement can also be known as (2)

Answer 10

• Trading and profit and loss account or
• Profit and loss account

Question 11

Financial Position of the Business

Answer 11

• Cash?
• Amounts owed to him?
• Amounts owed by him?
• Profit or loss?

Question 12

Separate Entity Concept

Answer 12

The activities of the business should be kept separate from the owner’s business

Question 13

Separate Entity Concept - why?

Answer 13

• To understand how the business is operating in its own right
• The Government - HMRC
• Customers
• Finance providers - Banks, Venture capitalists

Question 14

Balance Sheet

Answer 14

The financial statement which shows financial position at a specific point in time

A snapshot of assets, liabilities and capital at a single moment

Question 15

The Accounting Equation

Answer 15

Assets = Liabilities+ Capital

Question 16

Asset definition

Answer 16

Resources owned/controlled by the business to give future economic benefit
- Cash in bank, stock, machinery

Question 17

Liability

Answer 17

What the business owes to third parties (debts, obligations)
- Bank overdraft, money owed to supplier

Question 18

Capital (owed to the owner/s)

Answer 18

• Investment by the owner
• Money introduced, retained profit

Question 19

If a sole trader pays himself a wage it is called ________ and it will count as ________ but if it is a company then it is an _________

Answer 19

If a sole trader pays himself a wage it is called drawings and it will count as capital but if it is a company then it is an expense

Question 20

What are non-current assets and current assets?

Answer 20

Non-current assets = things that bring income in more than 12 months

Current assets = things that bring income in less than 12 months

Question 21

Income/ Revenue/ Turnover

Answer 21

• Transaction or event which causes an increase in the ownership interest

Question 22

Expenditure (Revenue or Capital)

Answer 22

Transaction or event which causes a decrease in the ownership interest

Question 23

Revenue expenditure

Answer 23

Expense used in period or matched with revenue for the period

Question 24

Capital Expenditure

Answer 24

Expenditure on items used in this and future periods

Question 25

Where will revenue expenditure be and where will be capital expenditure be?

Answer 25

Revenue expenditure will be on the income statement whereas capital expenditure will be on the balance sheet

Question 26

Balance Sheet

Answer 26

Shows the financial position of a business at a specific point in time

Question 27

Income Statement

Answer 27

Summarises the income and expenditure of a business = profit or loss

Question 28

Three main principles

Answer 28

1. Dual effect
2. Separate entity concept
3. Accounting equation

Question 29

Dual effect principle and car scenario

Answer 29

Every transaction will have at least TWO effects

one asset goes up, one asset goes down

Business buys a car
Business sells goods for cash
Business sells goods on credit

Question 30

Separate entity concept

Answer 30

A business entity is separate from its owner(s)
The activities of the business should be kept separate from the activities of the owner(s)

Question 31

Ledger

Answer 31

A ledger is just a book and a ledger account is just a page in that book

Question 32

The Nominal Ledger

Answer 32

• (aka general ledger) has a page (an account) for every item that appears on the Balance Sheet or Income Statement (Profit and Loss account).
• Each page (account) has two columns: a debit side on the left and a credit side on the right. Each page is often referred to as a “T” account

Question 33

Debits and Credits

Every transaction is recorded twice in the nominal ledger

The way to remember what goes where is?

Answer 33

DEADCLIC

Debit if increase in…
Expense
Asset
Drawings

Credit if increase in…
Liability
Income
Capital

Question 34

The accounting equation and the dual effect

Answer 34

Every transaction has two effects on the accounting equation

If assets increase, then liabilities or capital must increase or another asset must fall.

Question 35

Sally invests £3,000 in the business, what will increase?

Answer 35

Assets and Capital will increase by £3000

Question 36

Sally buys £2,600 (from the £3000) of cooking utensils, what is the result?

Answer 36

Cash asset falls by £2600 so its now £400
Other assets increase by £2600

Assets = Liabilities + Capital

Cash 400
Utensils 2600
Total 3000 = 0 + 3000

Question 37

Sally makes a profit of £200. What is the result?

Answer 37

Profit made is £200 so capital increases by 200

Question 38

Sally takes £150 cash for herself from the business bank account. What is the result?

Answer 38

Cash and capital fall by £150
It is classed as Drawings

Question 39

What is the accounting equation and what does each part mean

Answer 39

Assets = Liabilities + Capital

Assets = Something the business owns

Liabilities = Something the business owes to a third party

Capital = Something the business owes to the owner

Question 40

If a business makes it a loss, it comes off..?

Answer 40

Both assets and capital

Question 41

Fill in the debits and credits

Answer 41

Question 42

Balancing an account (5 steps)

Answer 42

1. Add up debits and credits on an account
2. If one side is greater than the other, insert a ‘balancing’ figure on the lower side
3. Balancing figure called balance carried forward (c/f) or carried down (c/d)
4. Enter total figures on both columns
5. The c/f figure becomes the b/f figure for the next period. Enter this below the total
   on the opposite side

Question 43

The Trial Balance

A list of Dr and Cr balances taken from the nominal / general ledger.
What is the purpose of this? (3)

Answer 43

• Check to ensure Dr = Cr
• Errors can still exist even if Dr = Cr
• Useful stage in the preparation of final
  accounts

Question 44

Why could the trial balance not balance?

Book-keeping errors such as: (5)

Answer 44

• Only a Dr or Cr side of a transaction may be posted with
  the other half being omitted.
• A Dr or Cr entry may be made on the wrong side of the ‘T’
  account
• Different amounts may be posted to the Dr and Cr sides
  (eg transposition errors)
• The ‘T’ account may be added up incorrectly and an
  incorrect balance transferred to the trial balance
• A Dr balance is entered onto the trial balance as a Cr
  balance or vice versa

Question 45

Suspense account

If such an error has occurred, the trial balance will not balance so…

On preparing the year end accounts…

Answer 45

If such an error has occurred, the trial balance will not balance so…

• We make it balance by creating a suspense account

On preparing the year end accounts…

• the errors must be found and removed

Question 46

Accounting Adjustments

Accounting Adjustments are necessary… (2)

Answer 46

• If the trial balance does not balance
• To comply with the key accounting conventions and assumptions

Question 47

What is the IASB Framework

Answer 47

• Sets out the concepts which underlie the preparation of financial statements

Question 48

Key accounting assumptions

• Accruals or Matching…
• Going concern

Answer 48

Accruals or Matching

• Expenses/Income should be matched to the period they relate and to the income/expenses they generate

Going concern

• Assume entity will continue to trade for the foreseeable future

Question 49

IASB Framework

Other assumptions (8)

Answer 49

• Consistency
  Of accounting treatment or presentation
• Prudence
  Slow to recognise profits/gains, quick to anticipate losses
• Materiality
  Influence economic decision making of users
• Offsetting
  Report items separately
• Comparative information
  Disclose previous period
• Substance over form
  Report reality, not legal form
• Neutrality
  Free from bias
• Completeness
  No material omissions

Question 50

Other Important Concepts

Answer 50

• Business entity
  Separation of owner from the business
• Money Measurement
  Only deal with items to which a monetary value can be attributed
• Historical Cost
  Transactions recorded at cost when occurred
• Stable Monetary Unit
  Eg £ or $ - Assume value of unit is constant
• Realisation
  Recognise income and profits when realised
• Duality
  Every transaction has two effects

Question 51

Adjustments needed as a result of the key accounting concepts (why for each one)

• Accruals & Prepayments
• Inventory (stock) and the cost of sales
• Bad and doubtful debts
• Depreciation

Answer 51

• Accruals & Prepayments
  To match expenses to the period they relate
• Inventory (stock) and the cost of sales
  To match sales with actual cost of those sales
• Bad and doubtful debts
  To be prudent in recognising debts that may not be recoverable
• Depreciation
  To match cost of a non current asset over its useful economic life

Question 52

Profit and cash flow

Formula for cash flow vs profit

Definition of income and expenses

Point about profit and cash flow

Biggest difference

Answer 52

Cash flow = Cash in – Cash out
Profit = Income – Expenses

Income:

• Value of goods and services sold during a period

Expenses:

• value of goods and services consumed in generating income

Profit is not a measure of cashflow.

A profitable business may need an overdraft. A loss making business may have cash .

Income and expenses involve receivables and payables whereas cash is not about credit or what is owed, just what you have or have given out

Question 53

Matching/Accruals – Key accounting concept

What is the aim?
What is it about?
What should we remember?

Answer 53

The aim is to show expenditure in the period to which it belongs, and not to the period when payment is made.

• Many expenses ‘overhang’ more than one accounting period. Eg Rent, Rates, Insurance, Licence costs, Electricity, Telephone, accountancy/audit fees etc.
• Remember we should recognise an expense when the goods or services are consumed

Question 54

Matching/Accruals – Key accounting concept EXAMPLE

Accountancy fees

The accountant will prepare the accounts after the year end and therefore send their invoice after the year end.

However the expense is “_________” in the year and so
needs to be accounted for __ ____ _____.

Answer 54

The accountant will prepare the accounts after the year end and therefore send their invoice after the year end.

However the expense is “consumed” in the year and so
needs to be accounted for in the year.

Question 55

Accruals

What is it?
What do we need to recognise?

Answer 55

Expense incurred but not yet invoiced

We need to recognise the expense and also recognise the liability

Question 56

Rates - Example

Business rates are normally required to be paid annually in advance

If a business paid its business rates for the 12 month period to 31 March 2024 in April 2023 and had a year end of 30th June 2023 then 9 months of this payment relates to the next year

Answer 56

Question 57

Prepayments

When is the expense paid?
We need to…?

Answer 57

• Expense paid in advance
• We need to remove the prepaid expense and recognise the asset

Question 58

Balance sheet as at … (picture)

Answer 58

Question 59

Susan started to trade on 1 June 2023 and has prepared the following trial balance after her first 4 months as at 30 September 2023

• The £1,000 rates expense relates to the 10 months to 31st March 2024 (£100 pm)
• This expense covers 10 months to 31 March 2024 but we only want the 4 months to 30 September 2023

The £150 electric expense relates to the 3 months to 31st August 2023

Answer 59

• The £1,000 rates expense relates to the 10 months to 31st March 2024 (£100 pm)
• This expense covers 10 months to 31 March 2024 but we only want the 4 months to 30 September 2023
  Susan has prepaid

The £150 electric expense relates to the 3 months to 31st August 2023
This expense covers 3 months but we need 4 months to 30 September 2023
Susan needs an accrual for

Question 60

Answer 60

Question 61

Key Points, Accrual vs Prepayment

Answer 61

• Accrual
  • Increase the expenses in IS and recognise the liability in the BS
  • Dr Expense (IS), Cr Accruals (liability in BS)
• Prepayment
  • Decrease the expenses in IS and recognise the asset in the BS
  • Dr Prepayment (Asset in BS), Cr Expense (IS)

Question 62

Bad Debt

Some customers may never pay. They may go “bust”. In these circumstances: (3)

Answer 62

• The sales figure is not altered
• The loss is recognised as an expense in the IS
• A new type of expense appears in the IS alongside electricity, wages, insurance etc

Question 63

Prudence
What is prudence?
If a business believes a debtor will not pay what should they do?

What is bad debt?

What is doubtful debt?

Answer 63

Slow to recognise profits and gains, but swift to anticipate losses

If a business believes a debtor will not pay they should be prudent and recognise this in the accounts

Bad debt = debt that is definitely irrecoverable (eg debtor bankrupt

Doubtful debt = some chance of recovery, but also a chance of non-payment

Question 64

Doubtful Debts

• The accountant is being ______ in recognising the risk of ___-_______ and makes a charge to the __and some _________ to the value of ___________ in the __
• The adjustment may be against a _______ ________, or may be in the form of a _______ _________ set a percentage of total receivables

What would the Journal Entry look like?

Normally the same expense account is used as for bad debts in the IS, but separate accounts could be used

Answer 64

• The accountant is being prudent in recognising the risk of non-payment and makes a charge to the IS and some reduction to the value of receivables in the BS
• The adjustment may be against a specific debtor, or may be in the form of a general provision set a percentage of total receivables

Journal Entry

Dr Bad Debt expense (IS) 100
Cr Provision for Doubtful Debts (BS) 100

Question 65

Introduction to sales and receivables

• Sales are either __ ______ or for ____________ __________
• Receivables arise when a business makes a _______ sale

What are the two effects of a sale?

What are the two effects upon settlement?

Answer 65

• Sales are either on credit or for immediate payment
• Receivables arise when a business makes a credit sale

Sale:
Dr Receivables 300
Cr Sales 300

Upon settlement: (payment by debtor/receivable)
Dr Cash/Bank 300
Cr Receivable 300

Question 66

Provision in subsequent years

• If the provision is not used/needed it is
  ____________ ______ _____to the next year. It
  would appear in the __ as a ______entry.
• In the next year Heidi decides to increase the
  provision to £1,500:
• The balance sheet ___________ figure will be
  shown net of the £1,500

Answer 66

• If the provision is not used/needed it is automatically carried over to the next year. It would appear in the TB as a credit entry.
• In the next year Heidi decides to increase the provision to £1,500:
• The balance sheet receivables figure will be shown net of the £1,500

Question 67

Example – journal entries

Extract from the Trial Balance as at 31 October 2023

Cr£
Prov. for doubtful debts 1,500

Dr£
Receivables 75,000
Electric 2,200
Insurance 3,000

The following adjustments are to be made:

• A receivable of £2,500 has to be written off, and the general provision is to be adjusted to 3% of receivables.
• The last electric bill paid was for £600 and covered the three months to 30th September 2023
• The last insurance bill paid in the year was for £1,800 and covered the 12 months to 31st March 2024.

Write out the journal entries for the above

Prepare IS and BS extracts

Answer 67

1. Write off of Bad Debt
   Dr
   Cr
   Being the write off of the bad debt
2. Calculation of general provision:
   £75,000 - £2,500 = £72,500
   £72,500 @ 3% = £2,175
   £2,175 is the final provision needed. Already have £1,500 provision so increase by £675

Dr
Cr
Being the increase in the general provision

3. Electric Accrual
   Dr
   Cr
   Being the accrual for Oct 23 (£600 x 1/3)
4. Insurance Prepayment:
   Paid 12m to 31 March 2024
   Prepaid Nov, Dec, Jan, Feb, Mar
   Prepayment = £1,800 x 5/12 = £750
   Dr
   Cr
   Being the prepayment for Nov - March

Question 68

Extract from the Income Statement

Expenses

Bad Debt Expense (2,500 + 675) 3,175
Electric (2,200 + 200) 2,400

Insurance (3,000 – 750) 2,250
2,500 + 675

Answer 68

Extract from the Balance Sheet

Current Assets
Receivables 72,500 (75,000
– 2,500)
Less provision (2,175)
70,325
Prepayments 750

Current Liabilities

Accruals 200

Question 69

Adjustments needed as a result of the key accounting concepts (what is each ones purpose)

1. Accruals & Prepayments
2. Inventory (stock) and the cost of sales
3. Bad & doubtful debts
4. Depreciation

Answer 69

1. Accruals & Prepayments

• To match expenses to the period they relate

2. Inventory (stock) and the cost of sales

• To match sales with actual cost of those sales

3. Bad and doubtful debts

• To be prudent in recognising debts that may not be recoverable

4. Depreciation

• To match cost of a non current asset over its useful economic life

Question 70

What is the double entry of an accrual and a prepayment?

Answer 70

Accrual = Dr Expense
Cr Accrual

Prepayment = Dr Prepayments
Cr Expense

Question 71

Key accounting concept - Accruals

• The __________ recognised in the __________ ____________ are those related to the ______ recorded.

i.e. sales should be matched against the cost of those sales

Answer 71

• The expenses recognised in the income statement are those related to the sales recorded.

i.e. sales should be matched against the cost of those sales

Question 72

Cost of sales adjustment - Example

Jonny started to trade selling rugby balls. He bought 100 at £10 each and in the year sold 80 for £15 each
£
Sales (80 @ £15) 1,200
Less purchases (100 @ £10) (1,000)
Difference 200

Is this difference Jonny’s profit and why?

Answer 72

No because profit is not a measure of cashflow.

A profitable business may need an overdraft. A loss making business may have cash

Question 73

Cost of sales adjustment - Example - Jonny continued

Sales should be matched with _____ __ _____

Sale proceeds from selling 80 balls should be matched with the ______ of _______ 80 balls

The 20 balls he has not sold should be removed from the ___________ ___________ and recognised as an ______ in the _________ ______

Answer 73

Sales should be matched with cost of sales

Sale proceeds from selling 80 balls should be matched with the cost of buying 80 balls

The 20 balls he has not sold should be removed from the income statement and recognised as an asset in the balance sheet

Question 74

Cost of sales adjustment

Jonny started to trade selling rugby balls. He bought 100 at £10 each and in the year sold 80 for £15 each

What should this look like?

Answer 74

Sales (80 @ £15) 1,200
Less cost of sales
purchases (100 @ £10) 1,000
Less closing inventory (20 @ £10) (200)
(800)
Gross Profit 400

Question 75

Cost of sales adjustment - Jonny year 2

Next year Jonny bought another 550 balls
At the year end he had 125 remaining.
How many has he sold in the year?

Answer 75

Opening inventory 20 balls
Bought in year (purchases) 550 balls
570 balls
Less Closing inventory (125 balls)
Balls sold in the year 445 balls

Question 76

Cost of sales formula

Answer 76

Cost of sales = (opening inventory + purchases) - closing inventory

Question 77

Cost of sales

• Do not confuse no of units with their value. The income statement contains _____ not units
• Cost of sale adjustment ensures we match the sales ________ _________ with the ______ of the goods which have been _____. Otherwise profit figures would be _________ or _________ depending on whether we had sold more inventory (stock) than we had purchased during the year or vice –versa.
• Closing inventory (stock) from one period is always the _________ inventory (stock) for the next period.
• The opening inventory figure (if there is any) will always appear as a ______ balance in the trial balance.
• Opening inventory is an ______ but goes on the _________ __________
• Closing inventory goes on the __ and __

Answer 77

• Do not confuse no of units with their value. The income statement contains values not units
• Cost of sale adjustment ensures we match the sales revenue gained with the costs of the goods which have been sold. Otherwise profit figures would be boosted or reduced depending on whether we had sold more inventory (stock) than we had purchased during the year or vice –versa.
• Closing inventory (stock) from one period is always the opening inventory (stock) for the next period.
• The opening inventory figure (if there is any) will always appear as a Debit balance in the trial balance.
• Opening inventory is an asset but goes on the income statement
• Closing inventory goes on the IS and BS

Question 78

Inventory: Valuation

• At the end of the accounting period there will be a stock take. (2 reasons why?)
• Inventory is valued at the lower of cost and Net Realisable Value (NRV) (what is NRV?)

Answer 78

• At the end of the accounting period there will be a stock take.

1. To count the actual quantity of each item
2. To note slow-moving items, damaged goods, obsolete items

• Inventory is valued at the lower of cost and Net Realisable Value (NRV)

  - NRV is the new value of an item and what you can sell it for

Question 79

Inventory is valued at the lower of cost and Net Realisable Value

What is cost?

• General accounting rule – use _______ cost rather than ________ cost but…
• Inventories may comprise _____________ products such as oil, gas, rugby balls etc.
• They may be purchased throughout the year at a ________ of _______.

Answer 79

• General accounting rule – use historic cost rather than current cost but…
• Inventories may comprise homogenous products such as oil, gas, rugby balls etc.
• They may be purchased throughout the year at a variety of prices.

Question 80

Possible costing solutions (3 and their definition)

Answer 80

FIFO: First in, First out

• Goods which arrive first are used first (particularly for perishable goods)

LIFO: Last in, First out (Disallowed under International Accounting Standards)

• Goods which arrive last are used first

WAC: Weighted average cost

• Goods are valued at the average price of the inventories held

Question 81

Which method should be used?

In financial accounting we can only use?
And what concept should we keep to?

What method can we use in management accounting?

Answer 81

Only FIFO or WAC may be used in financial accounting. The same method should be used every year = Consistency concept

Any method may be used in management accounting

Question 82

What is Net Realisable Value?

Answer 82

Estimated future selling price less all additional costs to be incurred before sale

Question 83

Mark-ups and margins

What are they calculated on?
What are they used for?

Answer 83

• Margin is calculated on sales (sales is the 100% figure)
• Mark-up is calculated on cost (cost is the 100% figure)

Profit margin = profit/sales

Sales = cost + gross profit

Margins and mark-ups can@ be used to establish costs and profits

Question 84

Depreciation

Definition?

Why do we need it?

Answer 84

Depreciation in the systematic allocation of a non-current asset over its useful economic life

We need it to spread the cost of a non current asset gradually over the years of its use and wearing out

Question 85

Imagine farmer John writes a cheque and buys a tractor for £20,000. He will use it for five years and at the end of that time it will have no further use or value.
Is this purchase an example of revenue or capital expenditure?

Answer 85

Capital

Question 86

John uses the bank a/c to buy a tractor for £20,000.
What is the double entry for this purchase?

The tractor is now in the _________ _______ as a ____ ________ ______

Each year we now need to take an element of this cost into the income statement as he is using the tractor to generate his _____

Answer 86

Dr Vehicles 20,000
Cr Bank 20,000

The tractor is now in the balance sheet as a non current asset

Each year we now need to take an element of this cost into the income statement as he is using the tractor to generate his sales

Question 87

Calculation of Depreciation
Two common methods:

Answer 87

Straight line method

Charge an equal amount of depreciation every year

Reducing balance method

Charge more depreciation in the earlier years of use, less in the later years

Question 88

Straight line method

What is the formula?

Example: An item costs £11,000, the residual value is £1,000 and the expected useful life is 4 years. What is the annual depreciation charge?

Answer 88

Annual Depreciation = Cost – Residual Value/
Estimated useful life

Annual Depreciation = 11,000 – 1,000/
4
= £2,500 p.a.

Question 89

To spread the decline in value we might take the total cost of £20,000 and spread over the five years. Ie the value of the tractor in the balance sheet will reduce by £4,000 each year

Answer 89

Opening BS value Depreciation taken to IS Closing BS value
Year 1 £20,000 £4,000 £16,000
Year 2 £16,000 £4,000 £12,000
Year 3 £12,000 £4,000 £8,000
Year 4 £8,000 £4,000 £4,000
Year 5 £4,000 £4,000 £NIL

Question 90

The Net Book Value (NBV) of a non current asset is its…

What do the terms in the formula mean?

Answer 90

The Net Book Value (NBV) of a non current asset is its historic cost minus all depreciation charged to date (accumulated depreciation) on that asset

Historic cost = original purchase price

Accumulated depreciation = total depreciation charged / taken to the Income Statement since purchase of the asset

Question 91

Reducing balance method

What is it?
Example?

Answer 91

Apply a constant % of the Net Book Value every year

Example: An item costs £12,000 and is to be depreciated at a rate of 25% reducing balance

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Question 92

Depreciation: Double Entry (what are the 2 effects)

What do we not do?

Answer 92

Dr Depreciation Charge (IS)
Cr Accumulated Depreciation (BS)

n.b we do NOT credit the non current asset directly

Question 93

Disposal of non-current assets

When an asset is sold, it needs deleting from the accounts

The relevant assets must…(2)

Anything more than the NBV is a _____
Anything less than the NBV is a _____

Answer 93

• Cost must be removed
• Accumulated depreciation must be removed

Anything more than the NBV is a profit
Anything less than the NBV is a loss

Question 94

Types of supply (3)

Answer 94

Standard Rated

• most goods and services
• rate of 20%

Zero Rated

• Taxable supplies but 0%
• eg. Food production, public transport, children’s clothes

Exempt

• Not taxable supplies
• eg. education, land

Question 95

Main principles of VAT (3)

Answer 95

• VAT registered traders are required to charge VAT on their sales
  
  • Output VAT
• VAT registered traders can generally reclaim any VAT they have suffered on purchases
  
  • Input VAT
• VAT registered traders pat over the difference to HMRC
  - Output - Input = payable to HMRC

Question 96

Accounting for VAT

• The double entry for a credit sale of 1000 plus VAT?
• The double entry for a purchase on credit of 600 plus VAT?

Answer 96

Dr Receivables 1200
Cr Sales = 1000
Cr VAT = 200 (liability to pay to HMRC)

Dr Purchases = 600
Cr Payables = 600
Cr VAT = 120 (asset as HMRC owe you)

Question 97

VAT and Discounts

Two types of discounts?

• VAT is always calculated…

Answer 97

• Trade discounts
• Early settlement discounts
• VAT is always calculated after all potential discounts and NO adjustment is made even if the discount is not taken up

Question 98

VAT and Non-current Assets

When a VAT registered business buys a non current asset to use in its trade it can recover the VAT it suffers on the purchase. (What is this called?

The non current asset is therefore stated net of VAT in the SoFP and depreciation is then calculated.

VAT however cannot be recovered when a VAT registered business buys a _______ ____. As a result the car is stated including VAT in SoFP and depreciation is then calculated.

Answer 98

When a VAT registered business buys a non current asset to use in its trade it can recover the VAT it suffers on the purchase (Input VAT)

The non current asset is therefore stated net of VAT in the SoFP and depreciation is then calculated.

VAT however cannot be recovered when a VAT registered business buys a motor car. As a result the car is stated including VAT in SoFP and depreciation is then calculated.

Question 99

Key Points

• VAT is a ___ on most goods and services
• VAT is charged by VAT ___________ _________
• The final burden typically falls on the ____ ___________
• Businesses are ___________ of VAT for the ______________
• Every ________ business pays difference between output VAT and input VAT
• Figures in the Income Statement generally ________ VAT
• Figures in the SoFP generally ________ VAT

Answer 99

• VAT is a tax on most goods and services
• VAT is charged by VAT registered businesses
• The final burden typically falls on the final consumer
• Businesses are collectors of VAT for the government
• Every quarter business pays difference between output VAT and input VAT
• Figures in the Income Statement generally exclude VAT
• Figures in the SoFP generally include VAT

Question 100

Recap of types of profit-focussed business entity (3 types)

Answer 100

Sole traders:

• Personally liable for debts of the business
• People who work for themselves
• Usually small but could employ many

Partnerships:

• Usually personally liable for debts of the business
• Two or more people trading with a view to making a profit
• Risks and rewards are shared

Limited liability companies:

• Personally liability normally limited to amount paid for shares
• Legal entity formed by registration under Companies Act

Question 101

Accounting and the business entity

• The accounting process of inputting transactions and producing financial statements is the same for all business entities
• May be differences in ________ and ___________ of transactions

Key differences are in the __________ and ___________ requirements

Answer 101

• The accounting process of inputting transactions and producing financial statements is the same for all business entities
• May be differences in volume and complexity of transactions

Key differences are in the presentation and regulation requirements

Question 102

Company basics

A legal entity formed by registration under Companies Act 2006
Four types:

Answer 102

• Liability is limited by shares

       - Public (plc) – can offer securities (shares, loan stock) for sale to general public on a listed stock market; requires minimum net assets of £12,500
       - Private (Ltd)  – not allowed to offer shares for sale to general public so cannot be listed on a stock market; no minimum net assets required

• Unlimited liability
• Liability is limited by guarantee
• Liability is limited by shares and guarantee

Question 103

Key features of a company

Answer 103

• Legal nature
• Perpetual life
• Limited Liability
• Legal Safeguards

Question 104

Features: i. Legal Nature (3/2)

Answer 104

• A separate legal entity in the eyes of the law

       - Contrast with sole trader
       - Memorandum and Articles of Association

• Incorporated by registration on the Registry of Companies
• Owners = members or shareholders (may be 1 or many)

Question 105

Features: ii. Perpetual life (3/1,1,1)

Answer 105

Continues on death of shareholder(s)

• The shares will pass to the beneficiary of his/her estate

Shareholders

• can choose to end the company

The Courts

• can force the winding up of a company

Question 106

Features: iii. Limited Liability (3/1,2)

Answer 106

Shareholders liability is limited

• Owners only lose the amount they invest and any unpaid share capital

Creditors/Payables

• Can not sue the owners directly (veil of incorporation)
• They must sue the company

The company itself has unlimited liability for its debts

Question 107

Features: iv. Legal safeguards (3/1,1,2)

Answer 107

Limited liability indicated in the name

• Creditors/payables trade with a limited company at their own risk – credit checks advisable

Restrictions

• on withdrawal of equity by shareholders

Financial statements

• filed with Companies House
• publicly available

Question 108

Sole trader v Company – pros and cons

Advantages, disadvantages and both?

Answer 108

Advantages of Co.:

• Shareholder limited liability
• Transfer of ownership
• Tax
• Kudos / Status

Disadvantages of Co.:

• Higher costs – formation, annual
• Compliance with legislation - CA2006
• Duties of directors

Advantages/disadvantages of Co.:

• Transparency
• Separation of ownership and management

Question 109

Sole trader v Company – key differences

Ownership interests?
Forms of debt capital?
Profit withdrawn by owners?
Tax on profits?

Answer 109

Ownership interests?

Sole trader
- Capital account

Company
- Equity - Share capital and reserves

Forms of debt capital?

Sole trader
- Bank Loans

Company
- Range of securities

Profit withdrawn by owners?

Sole trader
- Drawings

Company
- Bonus if employee
- Dividends

Tax on profits?

Sole trader
- Liability of sole trader, not the business

Company
- Corporation tax on company profits

Question 110

Equity

Answer 110

• Term used to include all owners’ capital
• Share capital, shown at nominal value in statements
• Reserves (any other amount attributable to owners)

    - Retained earnings
    - Share premium reserve
    - Revaluation reserve
    - Other reserves

Reserves are not a spare pot of money!

Question 111

Share capital

Answer 111

• On the date of incorporation, a company will issue ordinary (aka equity) shares to its owners
• Each share has a named value shown on the share certificate

      - Nominal value or Par value

• It can be any value: 1p, 2p, 5p, 10p, 25p, 50p, £1 etc.
• Issued (or allotted) share capital – par value of the shares issued to shareholders
• Called up share capital – amount the company has requested to be paid (company may request payment in instalments)
• Paid up capital – the amount actually paid

Question 112

Share capital - Presentation in the financial statements

Answer 112

• Shown within equity on the statement of financial position (SOFP aka balance sheet)
• Normally the issued share capital is fully called up and has been fully paid for – figure in SOFP is the issued = called up share capital
• If the share capital has not been fully called up then the figure for share capital in the SOFP is the called up share capital
• If not all the called up share capital has been paid by the shareholders then the share capital in the SOFP will be the total called up share capital and any unpaid capital is shown as an other receivable within current assets of the SOFP

Question 113

How do you calculate the number of shares in issue?

Answer 113

divide the share capital figure from the ‘Statement of Financial Position’ by the nominal or par value
If a company has share capital of £200,000 and has shares with a nominal or par value of 50p, then it has 400,000 shares in issue

Quantity of shares X Share’s par value = Share capital

Question 114

Preference shares

Answer 114

A company can issue preference shares - another form of finance for a company

• These entitle the owner to be paid preference dividends out of company profits before equity shareholders are entitled to any equity dividends

Irredeemable preference shares:

• Company not entitled to buy back (redeem); treat as part of equity

Redeemable preference shares:

• Company is entitled to buy back (redeem); treat as debt

Question 115

Equity v preference shares

Answer 115

Equity shares:

• Entitled to vote
• Volatile dividends
• Rank last in winding up (risk v reward)

Preference shares

• Normally not entitled to vote
• Fixed dividend
• Rank higher than equity shares in winding up (less risky)

Question 116

Key points from lecture 2

Answer 116

• Limited companies are a separate legal entity (veil of incorporation)
• Limited companies are owned by their shareholders
• The shareholders have limited liability (contrast with sole traders) therefore more regulation needed to protect investors and creditors
• Equity (share capital and reserves) theoretical amount due to owners
• Various types of shares (ordinary, preference) with various rights
• Shares are issued at a nominal or par value – issued v called v paid

Question 117

Retained Earnings

What does it represent?
When profits are made what are the two options?

What does it represent since the company started trading?

Answer 117

• Represents accumulated retained earnings. When profits are made, they can either be paid out as dividends (after tax) or reinvested in the business
• It represents all profits
  less all losses
  less all dividend payments

since the company began trading

Question 118

Retained Earnings

What is it most similar to?
What should we note?
What cannot happen to the account and what effect does that have?

Answer 118

MOST similar to sole trader’s capital account

Note: Company Law does not allow dividends to be paid which exceed accumulated profit reserve.

This account cannot go overdrawn which is protection for creditors

Question 119

Revaluation Reserve

Answer 119

• Non-current assets (NCA) are normally carried in the ‘Statement of Financial Position’ at historical cost less accumulated depreciation
• NCA may be revalued to market value
• Most often done for land and buildings as property values can rise steeply over time

Question 120

Share Premium Reserve

Answer 120

• A company may require more finance and decide to issue more shares
• The market value of these shares may be significantly different from the nominal/par value
• Any such difference should be shown in the share premium reserve
  • Shares can be issued for more than the nominal or par value (a premium), but never less than it
  • Restrictions on use of the share premium reserve (maintain capital)

Question 121

Rights issues vs Bonus issues

What are they? (2,3)

Answer 121

Rights Issues

• Issuing shares to new shareholders risky and expensive
• Rights issues allows existing shareholders to buy shares at discount to market value

Bonus issues Aka capitalisation issue or scrip issue

• An issue of shares to existing owners free of charge in proportion to existing holding
• Adjusts companies’ capital structures by utilising share premium and/or accumulated profit reserves – no cash involved

Question 122

Equity dividends

How is the amount decided?

Where are dividends paid out of?

What is recorded in the financial statements?

Extra fact?

Answer 122

Equity dividends

• Amount is decided by the board of directors, usually quoted in terms of the pence amount each share receives

     - E.g. a company has 10,000 £1 equity shares in issues and during the year paid a dividend of 5p per share. Total paid = £500 Dividend paid out of the retained earnings reserve

• Dividend paid out of the retained earnings reserve
• Only the amount of equity dividend paid in a year is recorded in the financial statements (in the statement of change in equity)
• No accrual is made for proposed equity dividends at the year end

Question 123

Preference Dividends

What is it usually expressed as?

What do you do to work it out?

What do you do with irredeemable and redeemable preference dividends?

Answer 123

• Usually expressed as a fixed percentage and paid ahead of equity dividends
• A 7% preference share with a par value of 50p will receive a dividend of 3.5p per year
• Record the dividend due for the period, making accrual if required
• Irredeemable preference dividends – paid from retained earnings reserve (just as equity dividends).
• Redeemable preference dividends – treated as a finance cost (like interest) and deducted through Income Statement

Question 124

Forms of debt capital

What does a company have access to?

What do these securities have?

What happens to interest?

What are a form of debt capital?

What is it accounted for under?

Answer 124

• A company has access to bank loans and can also borrow in the form of debt securities (eg loan stock, debentures)
• These securities often have a par value, interest payments and a redemption date
• Interest (paid and accrued) is a finance cost in Income Statement
• Redeemable preference shares are a form of debt capital
• Accounted for under IFRS9 Financial Instruments

Question 125

Forms of debt capital 2

What are loan stocks and debentures?

When is interest paid?

What can it be? (2)

Answer 125

• Loan stock and debentures (aka corporate bonds) are effectively loans to the company that carry a fixed rate of
  interest based on the nominal value and usually repayable at some future date.
• Interest paid ahead of dividends
• Can be secured (fixed charge on specific asset or floating charge on group of assets) or unsecured.
• Can be convertible (at the option of the holder) into equity shares at some point in the future

Question 126

Tax

A company is a…

What is tax therefore?

As tax liability is finalised after the year end…?

Double entry for this?

Any under/over provisions are…

During year….

Answer 126

• A company is a separate legal entity and is liable to pay corporation tax on its profits
• Tax is therefore another expense in the Income Statement
• As the tax liability is finalised after the year end, estimated tax liabilities are calculated and included within current liabilities

     - Dr tax charge (IS), Cr tax payable (SOFP) with estimated liability

• Any under/over provisions are corrected in the following year

   - During year, record tax paid and record year end estimated liability

Question 127

Tax - 2 methods?

Answer 127

Method 1:

• Post tax paid in year to the tax liability and adjust for any under or over provision in the previous year (Dr tax payable Cr Tax charge/expense if over provision, Dr tax charge/expense Cr tax payable if under provision)

Method 2:

• Clear the opening tax liability to the tax charge/expense account (Dr tax liability, Cr tax charge/expense). Post tax paid to the tax charge/expense account (Dr tax charge/expense Cr Bank). Post estimated year end liability (Dr tax charge/expense Cr tax liability).
• In this method you don’t have to calculate the under or over provision as it automatically comes through in the tax charge account

Question 128

Key points (9)

Answer 128

• Companies are owned by their shareholders who hold shares
• Various types of shares (ordinary, preference) with rights
• Equity (capital and reserves) theoretical amount due to owners
• Owners entitled to share of profits in the form of dividends
• Shares are issued at a nominal or par value
• Shares may be issued at a premium (but never a discount) to par
• Non-current assets may get revalued
• Companies have access to debt capital as a form of finance
• Companies are liable to and must account for corporation tax

Question 129

Equity

Answer 129

Term used to include all owners’ capital

• Share capital, shown at nominal value in statements
• Reserves (any other amount attributable to owners)

         - Retained earnings
         - Share premium reserve
         - Revaluation reserve
         - Other reserves

Question 130

Regulation of company financial statements

Why is this needed? (3/1,1,1)

Answer 130

• Separation of control from ownership

    - Directors need to account for their stewardship over the year

• Limited liability of shareholders

     - Creditors need protection in addition to limited liability warning

• Social justice

    - Large companies have extensive economic power. If they fail, many people are usually adversely affected

Question 131

Where do these rules and regulations come from?

Answer 131

Legislation – The Companies Act 2006

Rules:

• Accounting Profession – Accounting Standards
• Stock exchange listing rules

Question 132

Legislation – Companies Act 2006

What must all UK limited liability companies do?

What must their statements do?

What must they be prepared in accordance with?

Where must these statements be approved?

Answer 132

• All UK limited liability companies must prepare and publish financial statements annually (audited if large company)
• The statements must give a true and fair view of the performance and position of the company
• They must be prepared in accordance with either UK GAAP (Generally Accepted Accounting Practice) or IFRS Standards
• These statements must be approved by the shareholders at a general meeting and then filed with Registrar of Companies where open to inspection for a nominal fee.

Question 133

Accounting Standards

In business…?

When is professional judgement required?

Historically?

As business and investment became…?

Answer 133

• In business, different people may interpret the same situation in a different way.
• Professional judgement is often required creating subjectivity and accounting standards were developed to try to limit this to allow comparability between different organisations
• Historically many countries developed their own accounting standards
• As business and investment became increasingly global, clear need developed for harmonisation of standards

Question 134

Accounting Standards in the UK and Ireland

Difference between listed and unlisted companies?

Answer 134

• Listed companies are required to apply IFRS Standards
• Unlisted can choose either IFRS or UK GAAP

Question 135

UK GAAP (generally accepted accounting practice)

Who mostly abides by this?
Differences (4)

It’s a ….?
Some differences between UK GAAP and IFRS in terms of…?

Answer 135

• Financial statements are prepared under UK GAAP for most private unlisted companies
• UK GAAP: The rules, from whatever source, that govern accounting and financial reporting in the UK.

   - Company law (CA2006)
   - UK accounting standards (FRS100-105) set by Financial Reporting Council (FRC)
   - Effects of stock exchange listing requirements
   - Effects of IFRS standards

• It’s a dynamic changing concept, not always easy to define
• Some differences between UK GAAP and IFRS in terms of treatment, presentation and terminology

Question 136

Harmonization of global accounting standards

Generally jurisdictions around the world are moving towards harmonizing global standards
Why?
Any drawbacks to harmonization?
Any drawbacks to financial statements?

Answer 136

Generally jurisdictions around the world are moving towards harmonizing global standards
Why?

• Allows comparability, easier fund raising, reduces costs, provides legitimacy

Any drawbacks to harmonization?

• Threat to national identity & culture, lack of flexibility, costly to change, still need local standards as inappropriate for SME

Any drawbacks to financial statements?

• Too general, lack non financial information, largely historical

Question 137

Elements of financial statements (Define)

• Asset
• Liability
• Equity
• Income
• Expense

Answer 137

Asset

• Present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits

Liability

• A present obligation of an entity to transfer an economic resource as a result of past events. An obligation is a duty or responsibility that an entity has no practical ability to avoid.

Equity

• Residual interests in the assets of an entity after deducting all its liabilities

Income

• Increases in assets or decreases in liabilities that result in increases in equity other than those relating to contributions from holders of equity claims

Expense

• Decreases in assets or increases in liabilities that result in decreases in equity other than those relating to distributions to holders of equity claims

Question 138

Corporate Social Responsibility (CSR)

What does CSR describe?
What can it include?
What does it help?
What does it have accusations of?
What are more favoured now?

Answer 138

• CSR describes how entities adopt/integrate social and environmental concerns in their business operations to benefit stakeholders
• Could include policies on local communities, employees, customers, the environment, general ethical code
• Help recruitment and retention of employees, good risk management, build brand and reputation, may reduce costs
• Accusations of greenwashing and just a marketing ploy
• Sustainability and ESG (environmental, social and governance) more favoured now

Question 139

Sustainability standards

• In 2021 the International Sustainability Standards Board (ISSB) was formed by the IFRS Foundation

What was the aim?
Why?
How?

Answer 139

In 2021 the International Sustainability Standards Board (ISSB) was formed by the IFRS Foundation

Aim? To provide users with information to understand the entity’s environmental, social and governance risks and responses to them

Why? Users increasingly interested in sustainability issues

How? Develop IFRS Sustainability Standards to provide consistency in disclosure
Initial two standards issued in 2023 (IFRS S1 and IFRS S2) designed to set a global baseline about sustainability related risks and opportunities useful for investor decision making – effective reporting periods beginning from 1 January 2024

Question 140

Sustainability standards

IFRS S1 – General requirements for disclosure of sustainability related financial information

• Disclosure requirements to enable companies to _______________ to __________ about sustainability related risks and opportunities over the short, medium and long term
• How it manages its sustainability related risks and opportunities

IFRS S2 – Climate related disclosures

• Specific climate related disclosures designed to be used with IFRS __

Answer 140

IFRS S1 – General requirements for disclosure of sustainability related financial information

• Disclosure requirements to enable companies to communicate to investors about sustainability related risks and opportunities over the short, medium and long term
• How it manages its sustainability related risks and opportunities

IFRS S2 – Climate related disclosures

• Specific climate related disclosures designed to be used with IFRS S1

Question 141

Ethical considerations

What and who was it issued by?
Who does is apply to?
Based on…?
Members must?(3)

Answer 141

• Code of Ethics issued by International Federation of Accountants (IFAC) in 2005
• Applies to all members of professional accountancy bodies
• Based on 5 fundamental principles, the spirit of which must be complied with at all times
  Members must

    - Identify threats
    - Evaluate the significance of a threat
    - Implement safeguards to eliminate / reduce threats

Question 142

Code of Ethics (3/5,5,2)

Answer 142

Fundamental Principles

• Integrity
• Objectivity
• Professional competence and due care
• Professional behaviour
• Confidentiality

Threats

• Self-interest
• Self-review
• Advocacy
• Familiarity
• Intimidation

Safeguards

• Profession, legislation or regulation
• Work environment

Question 143

Function of the Annual Report (3)

Answer 143

• Fulfil legal obligations to shareholders
• Allows the directors to explain what has happened during the year and also provide an outline of the strategy going forwards
• Used to help persuade

Question 144

Typical contents of Annual Reports (3/6,4,4)

Answer 144

Strategic Information

• Overall review
• Strategy
• Chairman’s report
• Risk analysis
• Key performance indicators
• CSR reports

Directors Information

• Directors report
• Governance report
• Audit committee
• Directors remuneration and responsibilities

Financial Information

• Auditors report
• Financial statements
• Notes to the accounts
• 5/10 year summary

Question 145

IAS1 – presenting profit or loss

IAS1 requires the presentation of both realised and unrealised profit and loss in a period

These can either be:

Answer 145

• combined into one statement – “statement of comprehensive income”
• or split into two, one showing the profit and loss for a period, the other showing the other comprehensive income for the period

Question 146

Typical classification of expenses

Cost of sales
Distribution costs
Administration expenses
Finance costs

Answer 146

Cost of sales:

• Opening inventory (raw materials, - WIP, finished goods)
• Carriage inwards
• Purchases
• Manufacturing expenses
• Closing inventory (raw materials, WIP, finished goods)

Distribution costs:

• Advertising
• Carriage outwards
• Delivery vehicle expenses
• Expenses relating to warehousing of finished goods ready to be sold
• Selling costs

Administration expenses

• Auditor fees
• Irrecoverable receivables
• Discount received
• Directors remuneration
• Office costs

Finance costs:

• Bank overdraft/loan interest
• Debenture interest
• Loan stock interest
• Redeemable preference share dividends
• Discount allowed

Question 147

Statement of financial position

Answer 147

• IAS1 provides recommended formats but they are not mandatory
• Specifies that certain items must be shown in the statement, other items can be shown in the notes
• Must separate current from non current assets and liabilities

Question 148

Non current assets

Answer 148

Property, Plant and Equipment

• Tangible non current assets
• The face of the SoFP should contain the overall carrying value (net book value).

IAS16, Property, plant & equipment requires a note showing the reconciliation of movements in each class of asset

IAS 16 PPE – PPE includes assets held for use in the production or supply of goods or services, or administrative purposes, and are expected to be used during more than one period

Question 149

What is the cost of a non-current asset?

Include vs exclude?

Answer 149

Include:

• Purchase price
• Delivery costs
• Installation costs
• Professional fees (e.g. architect)
• Subsequent capital expenditure

Exclude:

• Administration costs
• Staff training costs
• General overhead costs
• Repairs and maintenance costs

Question 150

Intangible non current assets

What are they?
3 examples?

Answer 150

IAS 38 – Intangible assets are “identifiable non-monetary assets without physical substance”

Examples:

• Goodwill (Difference between the amount paid for an investment and its net assets)
• Patents, copyrights, trademarks
• Development costs (Costs spent on developing a new product with commercial viability e.g. software, drugs development)

Question 151

Statement of Changes in Equity (SOCIE)

Answer 151

• The statement of changes in equity explains how the equity section of the statement of financial position has changed in the reporting period.ie it reconciles the opening and closing position.
• The SOCIE uses the information already contained in the statement of profit or loss and the statement of financial position to explain how equity has changed in the period.
• You need to use the information relating to transactions and balances already recorded in order to prepare the statement of changes in equity.

Question 152

..to make decisions and provide advice but for whom? (3,4)

Answer 152

The users of financial statements

Per Conceptual Framework

• Investors (existing and potential)
• Lenders
• Other creditors

But also

• Customers,
• employees,
• general public,
• Government etc

Question 153

Needs and objectives of users

Three general areas of interest: (what are they and what questions do they raise/answer)

Answer 153

Performance

• What is the profitability?
• How well have assets been used to generate profits

Financial position

• Can immediate debts be paid? How well is working capital being managed? - Can the business survive?

Investment / Risk

• Returns for shareholders and company

Question 154

Benchmarks are needed

Comparison against (for example) (4)

Answer 154

The previous period

• Is current year better or worse

Budgeted figures

• Has current activity matched expectations?

Competitors & The industry average

• Is our business performing as well as another (or the industry?

Question 155

How do we interpret financial statements? (4 steps)

Answer 155

1. Start with information directly in the statements
2. Calculate ratio’s from figures within the statements
3. Compare and contrast to expectations, competitors, industry averages etc
4. Use the above to make sense of the story

Question 156

Financial analysis terminology

What is Vertical (3) and Horizonal (2) analysis

Answer 156

Vertical analysis

• Within one time period
• Shows relative size of an account compared to a total
• Eg. cost of sales were x% of turnover

Horizontal analysis

• Shows percentage change over time
• Eg sales revenue grew by x% in the year

Question 157

Example of what you can learn from a statement of profit or loss (4)

Answer 157

• Both companies are profitable in 20X2
• Dougal generates approximately 2.5x the revenue of Ted but less than 1.5x the operating profit
• Dougal incurs high distribution costs compared to Ted (4x)
• Dougal incurs high finance costs compared to Ted (17x)

Question 158

Example of what you can learn from a Statement of financial position (5)

Answer 158

• Dougal is better than Ted in using its PPE to generate revenue
• Both companies have positive equity
• Inventory and payables in Dougal high compared to Ted
• Ted has large cash balance. Dougal has a large bank overdraft – can expect high interest costs
• Dougal has high long term borrowings – can expect high interest costs

Question 159

Example of what you can learn from a Statement of cash flows

Answer 159

• Both generate cash inflows from operations
• Ted has decreased cash in the year but has invested in NCA and repaid borrowings. Both these should improve future profits and cash flow
• Dougal has increased cash balances but has issued more equity and debt which will decrease future retained earnings

Question 160

Use of ratios to understand a business (4)

Answer 160

• There are many ratio’s that could be calculated, and for some, different ways of calculating them.
• Each user will select ratio’s, and the method of their calculation, that would be useful to them.
• Important to know how the ratio’s are calculated and what they tell us.
• Important to note that ratio’s in isolation do not give a full picture. They should be compared to other relevant benchmarks.

Question 161

Capital Terminology

Assets?

Equity?

Total capital?

Total capital?

Capital employed?

Working capital?

Answer 161

Assets = Liabilities + Equity

Equity = total owner investment + reserves = total capital

Total capital = Total assets – Total liabilities

Total capital = NCA + CA – CL – NCL

Capital employed = NCA + CA – CL

Working capital = CA – CL

Question 162

Financial ratio’s

We can categorise them into the three general areas of interest: (3/5,6,5)

Answer 162

Performance

• Gross profit %
• Operating profit margin
• Return on capital employed
• Asset turnover
• Non current asset turnover

Financial position

• Inventory turnover
• Inventory days
• Receivable days
• Payable days
• Current ratio
• Quick ratio

Investment / risk

• Capital gearing
• Dividend cover
• Interest cover
• Earnings per share
• Price earnings ratio

Question 163

Performance ratios - their formulas and use? (5)

Answer 163

Gross profit

• (𝑮𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕)/𝑹𝒆𝒗𝒆𝒏𝒖𝒆 x 100%
• Effectively shows the percentage of revenue that’s generated from the main trade of the organisation.
  Very industry specific.

Operating profit margin

• (𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕)/𝑹𝒆𝒗𝒆𝒏𝒖𝒆 x 100%
• Shows a measure of profit that is generated per £1 of revenue that can contribute towards tax and finance costs. Very industry specific.

Return on capital employed (‘ROCE’)

• (𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙 𝒂𝒏𝒅 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕)/(𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔 𝒍𝒆𝒔𝒔 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔)

=

• (𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕)/(𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅) x 100%
• Indicates how efficiently and effectively a company has utilised its assets during a period in generating profit

Asset turnover

• 𝑹𝒆𝒗𝒆𝒏𝒖𝒆/(𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅)
• Expressed as a number of times per annum
• Effectively shows the sales revenue generated for every £1 of capital employed.
• Measure of the level of activity and productivity.

Non current asset turnover

• 𝑹𝒆𝒗𝒆𝒏𝒖𝒆/(𝑵𝒐𝒏 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔)
• Expressed as a number of times per annum
• Effectively shows the sales revenue generated for every £1 of non current asset.
• Measure of the level of activity and productivity.

Question 164

Financial position/ liquidity - their formulas and use? (6)

Answer 164

Inventory turnover

• (𝑪𝒐𝒔𝒕 𝒐𝒇 𝒔𝒂𝒍𝒆𝒔)/(𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚)
• How many times inventory is turned over in a year

Inventory days

• (𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚)/(𝑪𝒐𝒔𝒕 𝒐𝒇 𝒔𝒂𝒍𝒆𝒔) 𝑿 𝟑𝟔𝟓
• How long on average inventory is stored before it is sold

Receivables’ days

• (𝑻𝒓𝒂𝒅𝒆 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔)/(𝑪𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔) 𝒙 𝟑𝟔𝟓
• How long it takes on average to collect receivables

Payables’ days

• (𝑻𝒓𝒂𝒅𝒆 𝒑𝒂𝒚𝒂𝒃𝒍𝒆𝒔)/(𝑪𝒓𝒆𝒅𝒊𝒕 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔) 𝒙 𝟑𝟔𝟓
• How long it takes on average to pay payables

Current ratio

• (𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔)/(𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔)
• Measure of extent current liabilities are covered by current assets

Quick ratio

• (𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔 𝒍𝒆𝒔𝒔 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚)/(𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔)
• Measure of ability to cover liabilities with most liquid current assets

Question 165

Investment ratio’s - their formulas and use? (5)

Answer 165

Capital Gearing

• (𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝒍𝒐𝒂𝒏𝒔)/(𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅)
• Gearing or leverage is relationship between fixed interest capital (debt) and total capital (debt and equity).
• Measure of financial risk

Dividend Cover

• (𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙)/(𝑬𝒒𝒖𝒊𝒕𝒚 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅)
• Measure of ability of company to pay current dividend

Interest Cover

• (𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕)/(𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒄𝒐𝒔𝒕)
• Measure of ability of company to pay current interest

Earnings per share

• (𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙)/(𝑵𝒐. 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔)
• Useful for shareholders to evaluate performance over time

Price Earnings Ratio

• (𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆)/𝑬𝑷𝑺
• Reflects risk – effectively number of years taken to cover the cost of buying a share

Question 166

Limitations and warnings (2/4,1)

Answer 166

Are you comparing like-with-like?

• Accounting policies
• Exact competitors
• Environments of periods compared
• Time value of money

Appropriateness of ratios used

• Industry characteristics

Question 167

Profit and cash flow

What are the formulas for them?

Answer 167

Cash flow = Cash in – Cash out

Profit = Income – Expenses

Income = Value of goods and services sold during a period
Expenses = value of goods and services consumed in generating income

Profit is not a measure of cash flow and…
Cash flow is not a measure of profit

Question 168

Cash flow ≠ Profit

Some transactions involve profit only (no impact on cash flow)

Eg Depreciation for the year has been calculated at £16,000.

What is the double entry?

Answer 168

Some transactions involve cash only (no impact on profit)

E.g. a company issues 10,000 £1 ordinary shares for £3.50 each
What is the double entry?

Dr Bank 35,000
Cr Ordinary share capital 10,000
Cr Share premium reserve 25,000

Question 169

Cash flow ≠ Profit

Some transactions involve profit and cash but at different times

Eg a year end accrual for audit fees of £40,000.
What is the double entry at the year end?
What is the double entry when the fee is paid ?

Answer 169

What is the double entry at the year end?

Dr Audit (PoL – admin expense) 40,000
Cr Accruals Affects profit this period
40,000

What is the double entry when the fee is paid ?
Dr Accruals* 40,000
Cr Bank 40,000
Affects cash next period

Question 170

Cash flow ≠ Profit

Five transactions are listed below. For each, state the initial effect on profit and on cash flow (i.e. increase/decrease/no effect)

1. Purchase of new land for cash
2. Sale (£300) of inventory (cost £200) for cash
3. Obtain a bank loan
4. Buy purchases on credit
5. Write off an irrecoverable debt

Answer 170

1. Purchase of new land for cash

Profit = No effect
Cash Flow = Decrease

2. Sale (£300) of inventory (cost £200) for cash

Profit = Increase by £100
Cash Flow = Increase by £300

3. Obtain a bank loan

Profit = No effect
Cash Flow = Increase

4. Buy purchases on credit

Profit = No effect
Cash Flow = No effect

5. Write off an irrecoverable debt

Profit = Decrease
Cash Flow = No effect

Question 171

The importance of cash

Answer 171

Cash flow is vital for the survival of a company

• Allows growth as opportunities can be taken
• Good relationship with suppliers and customers

You can be highly profitable but still go bust
- Overtrading – business runs out of cash due to rapid growth and poor cash management

Cash more easily understood

Cash less easily manipulated

Question 172

Statement of cash flows – regulatory requirements

Answer 172

• IAS1 requires a statement of cash flows to be included in a set of financial statements for a company
• IAS7 sets out the presentation requirements
• The cash flow statement analyses
  changes in ‘cash and cash equivalents’ during a period.
• Direct and Indirect methods can be used – Indirect most common and used for ACC1010

Question 173

Statement of cash flows – value to users

Answer 173

• Statement of cash flows are needed to provide information about liquidity, viability and financial adaptability.
• They are prepared from the statement of financial position and the statement of profit or loss.
• Therefore not new information
• Highlights how the business has raised cash and paid out cash over the year
• To make more useful, breaks down cashflows arising from operating activities, investing activities and financing activities

Question 174

Cash flows from interest and dividends

• Per IAS7 cash flows from interest and dividends paid and received must be (3)
• In this module always treat as follows (3)

Answer 174

• Per IAS7 cash flows from interest and dividends paid and received must be

  - disclosed separately in a statement of cash flows
  - treated as either operating, investing or financing activities
   - classified in a consistent manner from one year to the next

• In this module always treat as follows

   - Interest paid and dividends paid on redeemable preference shares as an operating activity
  - Interest received and dividends received as an investing activity
  - Dividends paid on ordinary shares and irredeemable preference shares as a financing activity

Question 175

Cash flows from operating activities

Answer 175

• Shows users how much cash has been

  - Generated from normal trading activities
  - Paid in tax and interest

• Useful to users

  - Shows ability to generate sufficient cash to meet normal demands

Question 176

Cash flows from investing activities

Answer 176

• Shows users how much cash has been
  • invested in resources
  • received from past investments
• Useful to users
  • To predict future income and cash flow generation

Question 177

Cash flows from financing activities

Answer 177

• Shows users how much cash has been

   - Used to repay debt
   - Received from new finance

• Useful to users

   - To predict claims on future cash flow e.g. interest, dividends

Question 178

Where do the figures come from?

Answer 178

SOFP and PoL
BUT
Need actual cash flow so some adjustments may be needed

Question 179

Cash inflow from operations is…

Answer 179

Derived from a reconciliation

Question 180

WHY do we adjust for changes in working capital? (4)

Answer 180

• Accounts are prepared under the accruals basis following the matching principle
• Therefore statement of profit or loss shows revenue earned in a period, not the cash received from sales.
• Similarly, it shows the expenditure incurred in generating the revenue, not the cash actually paid
• he statement of cash flows ignores accruals and simply looks at cash in versus cash out

Question 181

HOW do we adjust for changes in working capital?

Increases in inventory or receivables: (3)

Increases in payables: (2)

Answer 181

Increases in inventory or receivables:

• Increase in inventory means more cash has been spent on buying inventory therefore the company has less cash
• Increase in receivables means more of the revenue in the PoL has not been collected therefore the company has less cash
• an increase in inventory or receivables must be subtracted from operating profit (cash OUTflow)

Increases in payables:

• Increase in payables means more of the purchases in the PoL have not been paid therefore the company has more cash
• an increase in payables is added to operating profit (cash INflow)

Question 182

HOW do we adjust for changes in working capital?

Increase during the year?
Decrease during the year?

Inventory
Receivables
Payables

Answer 182

Inventory

Increase during the year = Cash Outflow
Decrease during the year = Cash Inflow

Receivables

Increase during the year = Cash Outflow
Decrease during the year = Cash Inflow

Payables

Increase during the year = Cash Inflow
Decrease during the year = Cash Outflow

Question 183

Tax paid

Answer 183

• The tax charge in the statement of profit or loss represents the estimated liability for that year. *(Plus potentially any under/over provisions from previous year)
• It does not represent what was actually paid.
• To find the tax actually paid adjustments have to be made for the opening and closing tax payable (current liability)

Question 184

Cash paid to buy non current assets (NCA)

Answer 184

Not just the difference between the two Statement of Financial Position figures for non-current assets = purchases for the year:
because we have to allow for depreciation and disposals.

Question 185

Cash received from sale of non current assets(NCA)

Answer 185

P/L sale of NCA = sale proceeds - CV
Sale proceeds = CV + profit on sale (Deduct if loss on sale)

Question 186

Key points

• Cash flow and profit are ___ the _____
• Cash is ____ – life blood of a business, easy to understand and more difficult to _______________
• Statement of cash flows
• required by ___ _ presentation details in ____ _
• provide information about the ___________, _________ and __________ ____________ of a company.
• Three cash flows identified – from ____________ activities, ___________ activities and ____________ activities
• A ___________________ of _________ ________ ____ to cash flows from operations must be shown

Answer 186

• Cash flow and profit are not the same
• Cash is vital – life blood of a business, easy to understand and more difficult to manipulate
• Statement of cash flows
• required by IAS 1, presentation details in IAS 7
• provide information about the liquidity, viability and financial adaptability of a company.
• Three cash flows identified – from operating activities, investing activities and financing activities
• A reconciliation of profit before tax to cash flows from operations must be shown

Question 187

Nature of a partnership

Definition
4 Features?

Answer 187

“The relationship which subsists between persons carrying on a business in common with a view of profit”
The Partnership Act, 1890

• Must be at least 2 partners
• Partners are jointly and severally liable with each other
• A partnership agreement or deed is usually in place
• A partner is equally and independently liable

Question 188

Partnership agreement

Agreements typically cover the following areas: (6)

Which of those 3 are used to work out overall profit split?

Answer 188

Bold are used to work out overall profit split

- Profit share ratio (PSR)
- Salaries and drawings
- Interest on capital and drawings
- Long term capital introduced by each partner
- Procedures to change the agreement
- Authority of partners to bind others

Question 189

Partnership agreement (5)

Answer 189

All partnerships should have an agreement which is usually in writing and referred to as a partnership deed

If not, provisions of the Partnership Act 1890 apply:

• Profits shared equally by partners
• No interest on capital or drawings
• No partners’ salaries
• Loans by partners attract interest at 5% pa

Question 190

Partnership financial statements (4)

What do they usually consist of?
Income statement?
What shows the split?
What is there?

Answer 190

• Usually consist of a balance sheet, income statement and an appropriation of profit statement
• Income statement - same as for a sole trader
• Appropriation of profit statement shows the split of the overall partnership profit to each partner
• In a partnership there is a current and capital account for each partners to represent owners equity within the balance sheet.

Question 191

Appropriation of profit

When does this go?
What does it show?
What can it contain information on (4)
Extra fact

Answer 191

• A further section is added to the income statement which is known as the appropriation statement.
• This shows the net profit for the period and the division of that profit according to the partnership agreement/deed.
• Remember the deed may contain information on salaries, interest on capital, interest on drawings, and profit share ratios.
• Salaries, interest on capital and interest on drawings do not go through the income statement. They are just an appropriation (allocation) of profit.

Question 192

Capital and Current accounts (2 differences)

Answer 192

Capital account

• For long term
• Few transactions – only capital introduced / withdrawn.

Current account
- For short term
- Regularly changes as profit share from appropriation account and drawings are entered here.

Question 193

Partnership loans

Answer 193

• Rather than injecting money into the partnership through a capital account a partner may make a loan to the partnership at an agreed rate of interest.
• This loan is shown in the balance sheet as a non current liability
  Dr Bank Cr Loan to partner (non current liability)
• and interest on the loan is allowed as a normal business expense in the income statement.
  Dr interest expense Cr Partners Current account

Question 194

Accounting System

Definition?
Can be simple?
Cloud?

Answer 194

• Process by which a business can record, process and store financial information
• Today nearly all accounting systems are computerised – but it is essential accountants understand the processes.
• Accounting software – can be as simple as a spreadsheet, or an off the shelf programme (eg Sage, Xero) or bespoke software
• Cloud computing (accounting) – service giving a business access to software (accounting) via the internet

Question 195

Remember - Garbage in, garbage out!

What can be challenging?
What needs to be entered?
What needs to be set up?
What needs to be determined?
Needs…

Answer 195

• Setting-up the computerised accounting system can be challenging
• Standing data (data that does not regularly change) needs to be entered correctly and be tightly controlled
• Account codes need to be set up in a logical fashion for all items that could appear in the financial statements
• Need to determine which source documents are input, when they are input and how they are input
• Need controls and checks in place and regular reviews

Question 196

Purpose of BOPE

What isn’t practical?
Instead?
Typically there are…?
Even though

Answer 196

• In a manual system its not practical to record transactions directly into the nominal/general ledger
• Instead, transactions are categorised and recorded in BOPE then transferred periodically into the nomial/general ledger
• Typically there are five BOPE, often referred to as the day books
• Even though manual systems are rarely used today, the terminology of the BOPE is still often used in computerised systems

Question 197

The 5 main BOPE

Answer 197

• Sales Day Book (SDB)

     - Record credit sales and returned sales

• Purchase Day Book (PDB)

  - Record credit purchases and returns

• Cash Book (CB)

   - Recording bank receipts and payments

• Petty Cash Book (PCB)

    - Record petty cash transactions

• Journal Book (JB)

   - Record unusual and period end adjustments

Question 198

Uses of the Journal

The Journal is a book of prime entry and is used for the following; (4)

Answer 198

The Journal is a book of prime entry and is used for the following;

• Recording entries to open a new set of ledger accounts
• Recording purchase and sale of non current assets on credit (if not entered in SDB or PDB)
• Recording year end adjustments
• Correcting errors

Question 199

Potential bookkeeping errors(4/1,2,2,1)

Answer 199

• Errors of omission

  - Transaction not recorded (both or one side missing)

• Errors of commission

    - Correct theory but error by bookkeeper
    - Post repairs to rent, addition or transposition error

• Errors of principle

  - Dr or Cr to completely wrong account
  - Drawings to wages, repairs to non current asset additions

• Compensating errors

  - Two unrelated errors which balance each other out

Question 200

The need for control accounts (4)

Answer 200

• Individual transactions are categorised and entered into the respective BOPE (SDB, PDB, CB etc)
• The BOPE are totalled and entered via double entry into the nominal ledger
• Problem – not clear how much is owed to individual creditors/payables or from individual debtors/receivables
• Solution – keep additional ledgers, one for all credit sales, one for all credit purchases

Question 201

Control Accounts

In the traditional manual accounting system there would be…
Debtors (2)
Creditors (2)

Answer 201

• In the traditional manual accounting system there would be three ledgers (general, sales and purchase)
• Debtors (receivables) in the general ledger should equal the total of all the individual debtors in the sales ledger

  - Debtors in the general ledger sometimes referred to as the sales ledger control account

• Creditors (payables) in the general ledger should equal the total of all the individual creditors in the purchase ledger

  - Creditors in the general ledgers sometimes referred to as the purchase ledger control account

Question 202

Reconciliations

What is it?

Answer 202

A reconciliation is a checking procedure, whereby two figures that should equal are compared and any differences are investigated.

Question 203

Bank reconciliations

The bank statements?

As a control measure we should?

The aim is?

They are performed to…?

Answer 203

• Bank statements (transaction list) provide an independent record of the bank balance.
• As a control measure we should be able to tie in the cash book balance to the bank statement / transaction balance.
• The aim of a bank reconciliation is to show that any differences are due to perfectly proper and explainable reasons.
• Bank reconciliations are performed to provide an independent check on the completeness, accuracy and validity of the cash book and ultimately the cash figure included on the balance sheet.

Question 204

Why should the cash book balance not equal the bank statement balance? (3/2,2,0)

Answer 204

• Timing differences

  - Unpresented cheques (cheques written but not appearing on bank statement) 
  - Unrecorded lodgements (money banked but not appearing on bank statement)

• Errors by the business

  - Omissions (eg direct debits, bank charges)   - Transposition (£521 entered instead of £512) 

• Errors by the bank

Question 205

A matter of perspective

Assuming there are funds in the account

• The bank account is an ________ and therefore a _______ ___________
• From the bank’s perspective the bank account is a _______ __________

Why? It is a __________ of the bank

Answer 205

Assuming there are funds in the account

• The bank account is an asset and therefore a debit balance
• From the bank’s perspective the bank account is a credit balance

Why? It is a liability of the bank

Question 206

Bank reconciliations - process (4)

Answer 206

• Tick off items appearing in cash book and bank statement / transaction listing
• Perform the reconciliation

  - Reconcile the balance per the cash book to the balance per the bank statement
  - Adjust for any errors or omissions