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Introduction To Financial Accounting Notes - Lecture notes,

lectures 1 - 10 - part 1, compleet
Introduction to Financial Accounting (University of Sheffield)

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Introduction to financial accounting

(132)
So what is it?
Businesses must maintain accounts not just by law, but to enable to see their
income/expenditures in order to assess their businesses financial position.
They may need to report these financial results to its owners. And also to act
as a basis for computing tax.
The balance sheet is also known as “statement of financial position” (SOFP)
and can simply be explained as:
Assets Liabilities
House Mortgage
Bank Loan
Cash Overdraft
Clothes Gas bill
Total Total

Accounting equation is as follows:

Assets = liabilities + capital OR liabilities = assets – capital
At the end of the financial year
Total asset = total sources of finance
- A balance sheet lists what a business owns and owes
- It shows assets and how they are financed
- Assets are financed by owners, long term liabilities and short term
liabilities
- Vertical format calculates owners equity as:
Fixed assets
+ current assets
-current liabilities
-non current liabilities
=net assets

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Balance sheet layout

Fixed assets XXX
+ current assets XXX
= total assets XXX

Capital XXX
Less current liabilities (XXX)
= total equity XXX

These must balance

Leasing may also be a source of finance as it spreads the cost over a period of
time
Start End Change
Assets 2000 7150 5150
Less liabilities 0 3950 3950
= Capital 2000 3200 1200

If there is no transactions with owner then any profit/loss = change in capital

So the following formula would suffice:
Closing capital – opening capital = profit/loss
3200 – 2000 = 1200
If there are transactions with owner then we must allow for these when
calculating profit:
Opening capital + capital introduced – drawings + profit/loss = closing capital
So suppose £1000 capital was introduced and £750 withdrawn
£2000 + 1000 – 750 = 2250 closing capital
Deduct this from closing capital figure to work out profit/loss (if not given)
3200 – 2250 = 950

So…
Capital at start 2000

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+ capital introduced 1000

-Drawings (750)
+ profit (worked 950
out)
= closing capital 3200

Each transaction changes 2 things on the balance sheet in order for it to

balance. The balance sheet only records cost of assets and not value.
Income statements
The layout for this financial statement would be as follows:
Sales 291,000
Less cost of sales
Opening stock 5000
+Purchases 207000
-Closing Stock (18000) (194000)
Gross Profit 97000
Add discounts received 1000
Total Gross Profit 98000
Less expenses
Selling and distribution 6000
Administration 7500
Wages and salaries 18000
Rent and rates 12000
Deprecation of fixtures 2500
Bank loan interest 2000 (48000)
Net profit 50000

Recording transactions
These must be maintained for 6 years by law of HMRC. The transactions are
classified according to type to be recorded ‘accounts’. Recorded in ledgers
such nominal, debtors, creditors.

Cash transactions are recorded in a cash book due to Corporate Government

Companies Act 2006 and must be held for 6 years.
Using the double entry bookkeeping system
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For every transaction you make, there must be two entries in the relevant
accounts.
Example
A man opens his business putting £5000 into the business account.
He then purchases a van for £4000
He pays for 1 month of his rent costing £100
He then purchases goods for resale for £900
And receives £500 cash for the sale of goods
He then withdraws £110 for personal use
He buys goods on credit from AB Suppliers PLC costing £800
And sells goods on credit for CD Products LTD costing £900
He pays AB suppliers £600 in part payment
And CD Products LTD pays £850 in full payment
Produce all the relevant accounts for these transactions.

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Trial balance to final accounts for sole traders

For this we will be making adjustments to the trial balance before moving onto
the S.O.F.P. when doing this we must apply the accruals concept.
Errors which may not be visible in the trial balance
- Error of principle
- Error of duplication
- Error of omission
- Compensating errors
- Error of original entry
Suspense account – this is an account for when you are unsure which ledger a
transaction goes into. It has to be cleared out every year end.
Types of adjustments we are going to cover
- Correction of errors
- Closing stock
- Depreciation
- Fixed assets
- Bad and doubtful debts
- Prepaids
- Accruals

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Fixed assets and depreciation

Fixed assets are held for long term use by the business. Typically they are used
to assist production, administration, selling and rental purposes. To be
recognised in the balance sheet they must be owned by the reporting entity as
a result of past transactions or activities and be expected to give rise to future
economic benefits.
Measuring fixed assets
They are recorded at cost in the SOFP, and would be subject to the adjustment
for depreciation. Same are revalued (land a buildings and investments). They
may also be subject to “impairment reviews” and may result in the value
decreasing in the balance sheet, as for the implementation of the revaluation
reserve which companies and directors dislike.

Depreciation
This applies to accruals concept and can be estimated by using: straight line
method, reducing balance method and expected method.
Straight line = NBV x % = dep
Reducing balance = NBV- dep x % = dep
Expected = cost – residual value / years

We would debit the depreciation expense a/c and credit the accumulated
depreciation a/c.

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Reducing balance charges higher prices in the earlier years and is also not liked
by directors and accountants.
As for the consistency concept you have to stick to the same method every
year.

Clarabel
5. motor van (4 years with no residual value)
Cost - note 9 = NBV
42000-6000=36000÷4 years = 9000 dep

Office furniture and fittings (20% using straight line)

Cost x %
18,000 x 20% = 3600 dep

6. computer equipment (40% using reducing balance)

Year 1 = 28000 x 40% - 11,200
Year 2 = 28000-11,200=16,800 x 40% = 6720 (but we don’t use this one)

Disposal of a fixed asset ( note 9)

Credit disposal a/c debit bank with sale proceeds
Debit dispoal a/c credit fixed asset with its costs
Credit disposal a/c debit acc dep a/c with acc dep
A disposal will always result in either a profit or a loss.

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How are fixed assets shown in the balance sheet?

Fixed assets Cost£ Dep£ NBV£
Office fixtures and fittings 18,000 3600 14,400
Motor van 36,000 9000 27,000
Computer equipment 28,000 11,200 16,800
82,000 23,800 58,200

How would we calculate depreciation for year 2

This is purely just an example of how to calculate subsequent years. These
would not be entered into this year’s balance sheet; they would go in next
years. For this we would assumed there were no additions or disposals during
the year.
Office fixtures and fittings (straight line) 18,000x20%= 3600
Motor van (straight line) 36,000x25%= 9000
Computer equipment (reducing balance) (28,000-11,200) x 40%= 6720
Total depreciation expenses = £19,320
So the balance sheet at the end of year 2 would look as follows:
Fixed assets Cost£ Acc Dep£ NBV£
Office fixtures and fittings 18,000 7200 10,800
Motor van 36,000 18,000 18,000
Computer equipment 28,000 17,920 10,080
82,000 43,120 38,880
Bad debts and doubtful debts
Some debtors will not pay (BAD) and have to be written off (usually over 6
months) to record as a loss.
Others may not pay (DOUBTFUL) and we consider a provision for estimated
loss.
We would use the prudence concept to record expected losses from these
debtors who are expected to not pay.
If bad debts are already written off:
- Bad debt a/c in the income statement

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- Debtors are adjusted

If bad debts are to be written off:
- Debit bad debt a/c expense in the income statement
- Credit debtor a/c reduce debtors in balance sheet

Prepayments
Some expenses are paid in advance: and we apply accruals concept and
charged in the income statement.
Debit expense a/c in balance sheet under current assets
Credit expense a/c in income statement

Accruals
This is when you are owing an expense and will apply the accruals concept.
Debit expense a/c and increase expense in income statement
Credit bal b/d in expense a/c and under current liabilities in the balance sheet

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Income statement (using the information from the t-bars and trial balance)
Sales 345,000
Opening Stock -----
+ Purchases 132,000
Less closing stock (14,000)
Cost of goods sold (118,000)
Gross profit 227,000
Add discount received 900
Gross profit 227,900
Expenses
Wages and salaries 76,000
Rent and rates 24,000
Administration 15,000
Heat, light and power 13,000
Discount allowed 1200
Selling and distribution 10,000
Loan interest 3000
Repairs and maintenance 17,000
Bad debts 2000
Provision for doubtful debts 600 2600
Depreciation:
Office fixtures and fittings 3600
Motor van 9000
Computer equipment 11,200 23,800
Loss on disposal 3700
(189,300)
NET PROFIT 38,600
Incomplete records
This when we are not provided with a trial balance, income statement or
statement of financial position. These generally occur with early start up sole
traders or partnerships.
Denston example
Here we have to work through this example step by step so we can work out
all the relevant figures needed to complete the income statement and
statement of financial position. We will need to calculate the following:
- Capital

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- Bank
- Sales
- Purchases
- Expenses
- Fixed asset
- Drawings
Once we have calculated all these we are then able to compile the required
accounts.

Step 1 – calculating the capital (capital = assets – liabilities)

Fixed assets 2200

Current Assets
Stock 2141
Debtors 3219
Prepaids 100
Bank 821
8481
Current liabilities
Creditors 1842
Accruals 31
(1873)
Opening capital 6608

Step 2 – calculating how much there is in the bank at the end of the year. This
is given in the question and shows as £1030 bank overdraft.
Step 3 – calculating purchases from creditor figures
Creditors a/c
Bank 18,624 Bal b/d 1842
Bal c/d 8,191 Purchases 18,673
20,515 20,515

Step 4 – calculating sales from debtor figures

Debtors a/c
Bal b/d 3219 Bank 24,264
Sales 24,433 Bal c/d 3388

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27,652 27,652

Step 5 – calculating all the expense accounts

Heating and Lighting expense a/c Rent and rate expense a/c
Bank 168 Bal b/d 31 Bal b/d 100 I.S 804
Bal c/d 42 I.S 179 Bank 824 Bal c/d 120
210 210 924 924

General Expenses a/c Salaries expenses a/c

Bank 1581 Drawings 2469 Bank 2249 I.S 2249
Bank 2669 I.S 1781
4250 4250
This had a note attached to it

Step 6 – calculate the fixed assets to

be entered into the SOFP Fixed Asset depreciation a/c
Fixed Asset a/c Provision 220 I.S 220
Bal c/d 2200

Provision for depreciation a/c

Dep a/c 220

We can now compile the income statement and the statement of financial
position:

Income statement for the year ending 31st December 2011

Sales 24,433
Opening Stock 2141
+ Purchases 18,673
Less closing stock (2648)
Cost of goods sold (18,166)
Gross profit 6267
Less Expenses

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Heating and lighting 179

Rent and rates 804
General expenses 1781
Salaries 2249
Provision for depreciation 220 (5233)
Net profit 1034

Statement of financial position as at 31st December 2011

Cost Dep NBV
Fixed Asset 2200 220 1980
Current Assets
Stock 2648
Debtors 3388
Prepaids 120
6156
Total Assets 8136
Current Liabilities
Creditors 1891
Accruals 42
Bank overdraft 1030
2963
Equity
Capital 6608
Less drawings (2469)
Add net profit 1034
5173
Total Capital and liabilities 8136
Accounting principles, concepts and stock valuation
Principles
Accounting convention- concerns the whole accounting process
- Entity: business is separate and distinct identity separate from the
owner
- Price measurement : items measured in financial terms
- Historical cost : use of original amount paid for goods, there are
exceptions

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- Periodity : accounts are prepared for a set period

Concepts
- Going concern – assume the business will continue trading
- Accruals – recognition of revenues and expenses in set period
- Consistency – items treated similarly from year to year
- Prudence – introduces caution but treats potential income differently to
potential liabilities
Policies
Business must describe the accounting policies used to prepare their financial
statements. They have a choice of policy such as fixed assets, goodwill, sales
and stock valuations.
Inventories
Inventories are owned assets of the company and will fall under the current
assets in the balance sheet. They are a result of past transactions of activities
and are expected to provide future economic benefits.
Measurement of stock
This can be done by cost or NRV. NRV is selling price less the cost of getting the
item ready for sale.
Going concern – the valuation of stock will be done by cost of NRV. It doesn’t
assume that there will be an enforced sale
Accruals (matching) – by carrying stock forward it ensures the cost or NRV will
be matched against income
Costing inventories
- Purchase price includes carriage in
- Direct cost of manufacture together with production overheads
Disclosure of policies
Lower of cost and NRV. But why?
- Specific requirements of accounting standards (SSAP 9 ) or (ISA 2)
- Long adopted approach
- Cost relatively objective
- Inventory is often a significant item
Implications
If cost if lower than NRV then- stock is valued at cost price to avoid unrealised
profits being recorded in the accounts. = profit

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If NRV is lower than cost then – stock is valued at NRC so that the expected
loss on sale is recorded in current year and stock is not overvalued = loss
For example:
Cost Exp SP Cost to NRV Lower Expected
sell
A 100 150 0 150 100 Profit
B 150 160 20 140 140 Loss
C 200 170 50 120 120 Loss
Total 450 360

Methods of stock valuation

FIFO – this assumes that the purchased items are used first, so closing stock is
valued at the latest price
LIFO – this assumes that the latest items are purchased first, so closing stock is
valued at the earliest and incurred
AVCO – this is based on the weighted average cost calculated each time stock
is recorded
RC (replacement cost) – cost of goods sold is based on cost of replacing stock.
The matching of current revenues with current costs.
Manto example
Jan buys 6 units at £15
Feb sells 4 units at £19
April buys 10 units at £16
June buys 7 units at £17
Nov sells 15 units at £22
Calculate using FIFO, LIFO and AVCO.
FIFO – 23 bought – 19 sold = 4 remaining
4 units x latest price of £17 = £68

Date Purchases Sales FIFO LIFO AVCO***

Jan 6 at £15 = £90 ---- 6 at £15 = £90 6 at £15 = £90 6 at £15 = £90
Feb ---- 4 at £19 = £76 6-4 = 2 2 at £15 = £30 2 at £15 = £30
2 at £15 = £30
Apr 10 at £16 = ---- 2 at £15 = £30 2 at £15 = £30 12 at £15.83
£160 +10 at £16 = +10 at £16 = = £190
£160 £160
= £190 = £190
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June 7 at £17 = £119 ---- 12 = £190 12 = £190 19 at £16.26

+ 7 at £17 = + 7 at £17 = = £309
£119 £119
= £309 = £309
Nov ---- 15 at £22 = 19-15 = 4 2 at £15 = £30 4 at £16.26 =
£330 4 at £17 = £68 + 2 at £16 = £32 £65
= £62
Total £369 for 23 £409 for 19 4 units left 4 units left 4 units left
units units

AVCO calculations:
2 at £ 15+10 at £ 16
April = 12 units
=£ 15.83 per unit

12 at £ 15 .83+7 at £ 17
June = 37 units
=£ 16.26 per unit

All of the different methods will give a different effect on profits.

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