O1 - Fundamentals of Financial Accounting (Study Text)

Fundamentals of Financial Accounting (Study Text)

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or otherwise without prior written permission or the ICMA Pakistan’s
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Institute of Cost and Management Accountants of Pakistan

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Institute of Cost and Management Accountants of Pakistan

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First Edition 2014

Contents developed by a consortium lead by KAPLAN.
Second Edition 2020
Contents updated by the ICMA Pakistan.
Disclaimer
This document has been developed to serve as a comprehensive study and

reference guide to the faculty members, examiners and students. It is
neither intended to be exhaustive nor does it purport to be a legal document.
In case of any variance between what has been stated and that contained in
the relevant act, rules, regulations, policy statements etc., the latter shall
prevail. While utmost care has been taken in the preparation / updating of
this publication, it should not be relied upon as a substitute of legal advice.
Any deficiency found in the contents of study text can be reported to the
Education Department at [email protected]

CONTENTS
1 INTRODUCTION TO FINANCIAL ACCOUNTING 01
ACCOUNTING CONVENTIONS AND REGULATORY

2 FRAMEWORK
14
THE ACCOUNTING EQUATION

3 34
4 DOUBLE ENTRY BOOKKEEPING 45
5 BOOKS OF PRIME ENTRY AND CONTROL ACCOUNTS 68
6 ACCOUNTING FOR SALES TAX 88
7 ACCRUALS AND PREPAYMENTS 97
8 BAD DEBTS AND ALLOWANCES OR RECEIVABLES 110
9 INVENTORY 127

10 CONTROL ACCOUNT RECONCILIATIONS 149
11 BANK RECONCILIATIONS 159
12 NON-CURRENT ASSETS 171

428
13 PAYROLL ACCOUNTING 203
14 PAYABLES, PROVISIONS AND CONTINGENCIES 211
15 JOURNAL ENTRIES AND SUSPENSE ACCOUNTS 221
16 FROM TRIAL BALANCE TO FINANCIAL STATEMENTS 232
17 INCOMPLETE RECORDS 247
18 COMPANY ACCOUNTS 271

19 MANUFACTURING ACCOUNTS 300
20 INCOME AND EXPENDITURE ACCOUNT 312
21 STATEMENT OF CASH FLOWS 334
22 FINANCIAL RATIOS 358
405

HOW TO USE THE MATERIAL
The main body of the text is divided into a number of chapters, each of which is
organized on the following pattern:
400
 Detailed learning outcomes. You should assimilate these before beginning
detailed work on the chapter, so that you can appreciate where your studies
are leading.
 Step-by-step topic coverage. This is the heart of each chapter, containing

detailed explanatory text supported where appropriate by worked examples
and exercises. You should work carefully through this section, ensuring that
you understand the material being explained and can tackle the examples and
exercises successfully. Remember that in many cases knowledge is
cumulative; if you fail to digest earlier material thoroughly; you may struggle to
understand later chapters.
 Examples. Most chapters are illustrated by more practical elements, such as

relevant practical examples together with comments and questions designed
to stimulate discussion.
 Self Test question. The test of how well you have learned the material is your
ability to tackle standard questions. Make a serious attempt at producing your
own answers, but at this stage don’t be too concerned about attempting the
questions in exam conditions. In particular, it is more important to absorb the
material thoroughly by completing a full solution than to observe the time
limits that would apply in the actual exam.
 Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an

illusion to think that this provides the same benefits as you would gain from a
serious attempt of your own. However, if you are struggling to get started on a
question you should read the introductory guidance provided at the beginning
of the solution, and then make your own attempt before referring back to the
full solution.

STUDY SKILLS AND REVISION GUIDANCE
Planning
To begin with, formal planning is essential to get the best return from the time
you spend studying. Estimate how much time in total you are going to need
for each subject you are studying for the Managerial Level. Remember that
you need to allow time for revision as well as for initial study of the material.
This book will provide you with proven study techniques. Chapter by chapter it
covers the building blocks of successful learning and examination techniques.
This is the ultimate guide to passing your ICMA PAKISTAN written by a team
of developers and shows you how to earn all the marks you deserve, and
explains how to avoid the most common pitfalls.
With your study material before you, decide which chapters you are going to
study in each week, and which weeks you will devote revision and final
question practice.
Prepare a written schedule summarizing the above and stick to it.
It is essential to know your syllabus. As your studies progress you will become
more familiar with how long it takes to cover topics in sufficient depth. Your
timetable may need to be adapted to allocate enough time for the whole
syllabus.
Tips for effective studying
(1) Aim to find a quiet and undisturbed location for your study, and plan as
far as possible to use the same period of time each day. Getting into a
routine helps to avoid wasting time. Make sure that you have all the
materials you need before you begin so as to minimize interruptions.
(2) Store all your materials in one place, so that you do not waste time
searching for items around your accommodation. If you have to pack
everything away after each study period, keep them in a box or even a
suitcase, which will not be disturbed until the next time.
(3) Limit distractions. To make the most effective use of your study periods
you should be able to apply total concentration, so turn off all
entertainment equipment, set your phones to message mode and put
up your ‘do not disturb’ sign.

(4) Your timetable will tell you which topic to study. However, before
dividing in and becoming engrossed in the finer points, make sure you
have an overall picture of all the areas that need to be covered by the
end of that session. After an hour, allow yourself a short break and
move away from your study text. With experience. You will learn to
assess the pace you need to work at.
(5) Work carefully through a chapter, note imported points as you go.
When you have covered a suitable amount of material, very the
pattern by attempting a practice question. When you have finished
your attempt, make notes of any mistakes you make, or any areas that
you failed to cover or covered more briefly.

Fundamentals of Financial Accounting (Study Text) 1|Page
Chapter Learning Objectives
When you have completed this chapter you should be able to:
 Explain the objectives of financial accounting.

 Explain the objectives of management accounting.
 Distinguish between financial and management accounts.

1 Financial statements
1.1 Introduction
Accounting information can take many forms. A set of accounts produced by
a large limited company, for example, will contain narrative description of the
activities and progress of the company, tables of figures and ratios measuring
its performance and financial strength, and a number of financial statements
supported by explanatory notes and figures.
There are two main financial accounting statements:
 The statement of financial position – a statement of assets and

liabilities at a point in time (the statement of financial position date). Each
asset and liability is valued according to certain accounting conventions.
 The statement of profit or loss – this summarises income and

expenditure over a period of time; if income exceeds expenditure there is
a profit, if vice versa there is a loss. Note that again income and
expenditure are measured using accounting conventions.
 Note that the statement of financial position is a ‘position’ statement, i.e.

the financial position at a point in time. On the other hand, the statement
of profit or loss is a ‘period statement’, explaining changes over time.
1.2 Statement of financial position

There are two possible ways of setting out the statement of financial
position:
 double-sided (or horizontal) format
 vertical format.
Both formats will be shown here.

As an example, the statement of financial position of a sole trader using
the double-sided format might appear as follows:
Mr. Hasseb
Statement of financial position as at 31 December 20X6
Rs Rs
Capital account: Fixed assets:
Balance at Jan 20X6 5,200 Motor van 2,400
Add: Net profit 3,450 Current assets:
Stock 2,390
8,650 Debtors 1,840
Less: Drawings (2,960) Cash at bank 1,704
Cash in hand 56
Balance as at Dec 20X6 5,690
Current liabilities:
Creditor 2,700
8,390 8,390
The assets of the business are shown on the right-hand side; the capital and
liabilities of the business are shown on the left-hand side.

DEFINITION
The capital of a business entity is a special liability of the business. It is the

amount that the business owes back to the owner of the business.
This illustration is not as difficult as it looks. First of all, consider what

information the statement of financial position conveys.
The assets used in the business amount to Rs 8,390. The individual

amounts making up the Rs 8,390 are usually referred to as the book
values. It cannot be assumed that these assets could be sold in the
open market for Rs 8,390 – in fact this is very unlikely. The valuation is
on a ‘historical’ not a ‘market value’ basis.
As regards the listing of assets in the statement of financial position,

the least liquid assets are dealt with first, followed by the more liquid
assets. The term liquid assets refers to cash and those assets that are
easily convertible to cash.
Looking at assets and starting with the least liquid assets:
(i) The motor van is classified as a fixed asset. A fixed asset is any
asset, tangible or intangible, acquired for retention by an entity for
the purpose of providing a service to the business, and not held for
resale in the normal course of trading.
(ii) The remaining assets are classified as current assets. Current

assets comprise cash or other assets e.g. stock held for conversion
into cash in the normal course of trading in our example the current
assets are:
1 stock, i.e. goods held for resale. When the goods are eventually
sold, the business will receive in exchange cash or a claim to
cash (usually referred to as a debtor)
2 debtors, i.e. amounts owing from customers that will eventually
result in the receipt of cash
3 cash at bank,
4 cash in hand
DEFINITION
A fixed asset is any asset, tangible or intangible, acquired for retention

by an entity for the purpose of providing a service to the business and
not held for resale in the normal course of trading.
Current assets comprise cash and/or other assets held for conversion
to cash in the normal course of trading.
Liabilities are claims on the business by outsiders.

Longterm liabilities: A long-term liability, often called a non-
current liability, is an obligation that will not be paid off in the current
year or accounting period. In other words, its debt that is not due within
a year. Some common examples of long-term liabilities are notes
payable, bonds payable, mortgages, and leases.
Current liabilities are those liabilities that fall due for payment within
one year. Creditors are amounts owing in respect of goods and
services previously received.
Capital: The total of resources invested and left in a business by its

owner.
Expenditures: The value of all the assets that have been used up to
obtain revenues.
Capital Expenditure: When a business spends money to buy or add

value to a fixed asset.
Revenue Expenditure: Expenses needed for the day-to-day running

of the business.
Accounting Equation: Accounting equation describes that the total

value of assets of a business is always equal to its liabilities plus
owner's equity.
(a) At the beginning of the year the amount owing to the

proprietor was Rs.5,200. During the year the overall profit of
the business of Rs.3,450 increased the amount owing to the
proprietor, whereas the drawings (cash and goods taken by
the proprietor for his own purposes) reduced the amount
owing to him.
(b) It may not seem clear why the statement of financial position
shows the information regarding capital account. The reason
is one of convention: although its key figure is Rs 5,690
(balance at 31 December 20X6), it is useful to show Mr
Hasseb why his balance has increased from Rs 5,200 to Rs
5,690.
KEY POINT
The statement of financial position is a statement of the financial

position of an entity at a given date.
It is important to appreciate that the balance, i.e. the amount that is

added to the other balances on the statement of financial position is
Rs.5,690. The statement of financial position could be presented
without the disclosure of information as to the movements in capital
during the year as follows:

Mr Hasseb
Rs Rs
Fixed assets:
Capital account: 5,690 Motor van 2,400
Current liabilities: Current assets:
Creditors 2,700 Stock 2,390
Debtors 1,840
Cash at bank 1,704
Cash in hand 56 1
1
8,390 8,390
(c) The most important point of all is that the statement of financial position
shows the position of Mr Hasseb’s business at one point in time – in
this case at close of business on 31 December 20X6. A statement of
financial position must always satisfy the basic equation:
Assets = Liabilities + Proprietor’s capital
This is known as the accounting equation.
In the present example the respective totals are Rs 8,390.
(d) The next sub-section will deal with how a profit figure of Rs 3,450 is
arrived at. However, first, it is worth looking at the alternative, and more
popular, way of presenting the statement of financial position – the
vertical form approach.
The statement of financial position of the same sole trader using the
vertical format would appear as follows:

Mr Hasseb
Rs Rs
Fixed assets:
Motor van 2,400
Current assets:
Stock 2,390
Debtors 1,840
Cash at bank 1,704
Cash in hand 56 5,990
8,390
Capital account:
Balance at 1 January 20X6 5,200
Add: Net profit 3,450
8,650
Less: Drawings (2,960)
Current Liabilities:
Creditors 2,700
8,390
There are two points to note.
(i) Unless instructed otherwise, always use this vertical layout for the
statement of financial position.
(ii) The fact that the totals on the double-sided approach are Rs 8,390,
Both balance sheets satisfy the fundamental accounting equation
referred to earlier, following the equation:
Assets = Proprietor’s capital + Liabilities
1.3 Statement of profit or loss

Assume that Mr Hasseb is a retailer and makes his profit from selling
goods. In principle there are two steps in calculating his profit:
(a) deciding what his sales are for the year
(b) deducting from this figure:
 the cost of buying goods from his suppliers

 various expenses such as wages, rent and insurance.
Mr Hasseb’s statement of profit or loss might have looked like this:

Mr Hasseb
Statement of profit or loss for the year ended 31 December 20X6
Rs Rs
Sales 33,700
Opening stock 3,200
Purchases 24,490
27,690
Less: Closing stock (2,390)
Cost of sales 25,300
Gross profit 8,400
Less; operating expenses
Wages 3,385
Rent and rates 1,200
Sundry expenses 365
(4,950)
Net profit 3,450
The detailed preparation of statement of financial positions and statement of

comprehensive incomes will be considered later, but it is useful at this stage
to obtain an overall view.
(a) The first point, in direct contrast with the statement of financial position,
is that the profit and loss account summarises the trading activities of a
business over a period of time, usually twelve months.
(b) Secondly, the figure of Rs 33,700 for sales relates to goods sold during
the year, whether or not the cash was actually received during the year.
(c) Having arrived at a figure for sales, one must deduct the cost of buying
these goods. It is quite likely that some of the goods sold at the
beginning of the year were goods that were in stock at the previous
year-end. One must therefore add these onto goods that were actually
purchased during the year. However, some of this year’s purchases
were unsold at 31 December 20X6. These must be deducted from
purchases as they will be set off against next year’s sales.
(d) Sales less cost of sales gives gross profit. Net profit is arrived at by
deducting expenses from gross profit.
(e) Note that for convenience the statement of profit or loss is divided into
two parts. The part dealing with sales and cost of sales may be referred
to as the trading account, the remainder as the profit and loss
account.
KEY POINT
A statement of profit or loss summarises the transactions of a business entity
over a period of time.
(f) Finally, one must be very careful to distinguish between wages and
drawings. Wages relate to payments to third parties (employees) and
represent a deduction or charge in arriving at net profit. Amounts paid to

the proprietor (even if they are called a ‘salary’!) must be treated as
drawings. It would be wrong to treat drawings as a business expense as
the amounts drawn are not used to further a sale. They represent an
appropriation of profit earned by the business and are eventually
deducted from the proprietor’s capital account.
2 Users of accounts
2.1 The objective of financial statements is to provide information to users

of financial statements. Financial statements serve a wide variety of
user groups, who have different interests and also different levels of
financial sophistication. This makes it particularly difficult to produce
accounts that are intelligible to the layman but comprehensive for the
expert. It is therefore relevant to determine the needs of the users. A
classification of users into user groups with a summary of their needs
could be as follows.
KEY POINT
Financial statements serve a wide variety of user groups, who have

different interests and also different levels of financial sophistication.
This makes it particularly difficult to produce accounts that are
intelligible to the layman but comprehensive for the expert.
2.2 Management
Management will be interested in an analysis of revenues and

expenses that will provide information that is useful when plans are
formulated and decisions made. Once the budget for a business is
complete, the accountant can produce figures for what actually
happens as the budget period unfolds, so that they can be compared
with the budget. Management will also need to know the cost
consequences of a particular course of action to aid their decision-
making.
2.3 Shareholders and potential shareholders
This group includes the investing public at large and the stockbrokers
and commentators who advise them. The shareholders should be
informed of the manner in which management has used their funds that
have been invested in the business. This is known as the stewardship
of funds. It is a matter of reporting on past events. However, both
current and potential shareholders are also interested in the future
performance of the business and use past figures as a guide to the
future if they have to vote on proposals or decide whether to disinvest.
Financial analysts advising investors such as insurance companies,
pension funds, unit trusts and investment trusts are among the most
sophisticated users of accounting information, and the company
contemplating a takeover bid is yet another type of potential
shareholder.

2.4 Employees and their trade union representatives
These use accounting information to assess the potential performance

of the business. This information is relevant to the employee, who
wishes to discover whether the company can offer them safe
employment and promotion through growth over a period of years, and
also to the trade unionist, who uses past profits and potential profits in
their calculations and claims for higher wages or better conditions. The
viability of different divisions of a company is of interest to this group.
2.5 Lenders
This group includes some who have financed the business over a long
period by lending money which is to be repaid at the end of a number
of years, as well as short-term creditors such as a bank which allows a
company to overdraw its bank account for a number of months, and
suppliers of raw materials, which permit a company to buy goods from
them and pay in, say, four to twelve weeks’ time.
Lenders are interested in the security of their loan, so they will look at
an accounting statement to ensure that the company will be able to
repay on the due date and meet the interest requirements before that
date. The amount of cash available and the value of assets that form a
security for the debt are of importance to this group. Credit-rating
agencies are interested in accounts for similar reasons.
2.6 Government agencies
These use accounting information, either when collecting statistical

information to reveal trends within the economy as a whole or, in the
case of the Inland Revenue, to assess the profit on which the
company’s tax liability is to be computed.
2.7 Customers
Customers of a business may use accounting data to assess the

viability of a company if a long-term contract is soon to be placed.
Competitors will also use the accounts for purposes of comparison.
2.8 The public
From time to time other groups not included above may have an
interest in the company, e.g. members of a local community where the
company operates, environmental pressure groups, and so on.
3 Characteristics of useful information
Introduction
The important aspects regarding useful information are summarised

below.
Fundamentals of Financial Accounting (Study Text) 10 | P a g e

Relevance
The information should be relevant to the needs of the users, so that it

helps them to evaluate the financial performance of the business and
to draw conclusions from it.
Problem – to identify these needs, given the variety of users.
Understandability
The information should be in a form that is understandable to user

groups.
Problems – users have very different levels of financial sophistication.

Also the very complexity of business transactions makes it difficult to
provide adequate disclosure whilst maintaining simplicity.
Reliability
The information should be of a standard that can be relied upon by

external users, so that it is free from error and can be depended upon
by users in their decisions.
Problem – the complexities of modern business makes reliability

difficult to achieve in all cases.
Reliable information should also have the following further qualities.

 Faithful representation of what it is supposed to represent or
could reasonably be expected to represent.
 Neutrality – freedom from bias.
 Free of material error – a material error is an error that is so
significant that it would have an effect on decisions taken by users
of the accounts.
 Completeness – all aspects of the business should be included.
 Prudence – the exercise of caution in the estimation of amounts
included in the accounts, such that assets and profits are not
overstated whilst liabilities and losses are not understated.
Comparability
Accounts should be comparable with those of other similar enterprises,

and from one period to the next.
Problem – the main problem has been the use of different accounting
policies by different enterprises. Mandatory accounting standards such
as International Financial Reporting Standards (IFRSs) or the local
Financial Reporting Standards (FRSs) have reduced, but not
eliminated this problem.

4. The differing functions of financial accounts, management accounts and
Cost accounts
4.1 Accounting
Accounting is defined as follows:
 the classification and recording of monetary transactions, and
 the presentation and interpretation of the results of those
transactions in order to assess performance over a period and the
financial position at a given date, and
 the monetary projection of future activities arising from alternative
planned courses of action.
There are two main types of accounting: financial accounting and

management accounting.
4.2 Financial accounting

Financial accounting is the classification and recording of the monetary
transactions of an entity in accordance with established concepts,
principles, accounting standards and legal requirements and their
presentation, by means of statement of profit or losss, statement of
financial positions and statement of cash flows, during and at the end of
an accounting period.
Financial accounting is mainly concerned with the production of financial
statements for users outside the business.
4.3 Management accounting

Management accounting is the application of the principles of accounting
and financial management to create, protect, preserve and increase value
so as to deliver that value to the stakeholders of profit and not-for-profit
enterprises, both public and private. In performing their job, managers will
need to know a great deal about the detailed workings of the business.
This knowledge must embrace production methods and the cost of
processes, products, etc. It is not the function of financial accounting to
provide such detail and therefore the managers require accounting
information geared to their own needs.
An integral part of management accounting is concerned with identifying,
presenting and interpreting information used for:
 formulation of strategy
 planning and controlling the activities
 decision taking
 optimising the use of resources.
4.4 Cost Accounting
Cost accounting aims to capture a company's costs of production by

assessing the input costs of each step of production as well as fixed costs
such as depreciation of capital equipment. Cost accounting will first
measure and record these costs individually, then compare input results
to output or actual results to aid company management in measuring
financial performance.
The main objectives of Cost Accounting are: (i) Ascertainment of cost, (ii)
Determination of selling price, (iii) Cost control and cost reduction, (iv)
Ascertaining the profit of each activity, (v) Assisting management in
decision-making.
4.5 Contrasting
Financial and management accounts can be contrasted as follows.
Financial accounts Management accounts

(i) In many instances (e.g. Records are not mandatory
companies) are required by
law.
(ii) Accordingly the cost of record The cost of record keeping is justified
keeping is a necessity
(iii) Objectives and uses of financial These can be defined by
accounts are vague and ill management
defined.
(iv) Are mainly concerned with profits. Are mainly concerned with business
managementgenerally
(v) Are mainly a historical record of Are mainly concerned with prediction
performance and position. of future performance and position
(vi) Information should be computed Information should be computed as
prudently, and accordance management requires the key
with legal and accounting criterion being relevance
requirements.
Summary
This opening chapter introduced the idea of accounting information with a
brief review of two important sources: the statement of financial position and
the statement of comprehensive income. Users of this information were
described, and the characteristics required that make information useful to
them.
Two contrasting types of accounting information were then examined:
financial accounts and management accounts. Ensure that you appreciate
why the users of these two types of accounts require a different style of
information.
Having completed your study of this chapter you should have achieved the
following learning outcomes.
 Identify the various user groups which need accounting information and
the characteristics of such information necessary to meet their
objectives
 Explain the function of and differences between financial and
management accounting systems
 Explain the concepts of capital and revenue, cash and profit, income
and expenditure and assets and liabilities.

Chapter learning objectives

dentify and explain the fundamental accounting concepts, bases and principles

xplain the historical cost convention and capital maintenance

dentify the basic methods of valuing assets on current cost, fair value and economic
value bases, and demonstrate their impact on profit measures and statement of
financial position values

xplain the influence of legislation (for example, Companies Act ) and accounting
standards on the production of published Accounting information for organizations

xplain capital and revenue, cash and profit, income and expenditure, and assets
and liabilities.

1 The need for regulation
1.1 Regulation ensures that accounts are sufficiently reliable and useful,
and prepared without unnecessary delay.
 Financial accounts are used as the starting point for calculating taxable
profits.
 The annual report and accounts is the main document used for reporting to
shareholders on the condition and performance of a company.
 The stock markets rely on the financial statements published by
companies.
 International investors prefer information to be presented in a similar and
comparable way, no matter where the company is based.
1.2 The role of accounting standards and the Companies Act 2017.
The accountancy profession and legislation provide guidance and law in

many areas to assist the formulation of properly drawn up accounts.
However, for the exam only a limited knowledge is needed of legislation or
accounting standards.
The International Accounting Standards Board (IASB) is responsible for

issuing International Financial Reporting Standards (IFRSs). Their role is
to promote good financial reporting.
They detail the four fundamental accounting concepts, the going concern
concept, the accruals (or matching) concept, the consistency concept
and the prudence concept.
Going concern concept
The going concern concept assumes that a business (or enterprise) will
continue in operational existence for the foreseeable future.
This definition means that the financial statements are drawn up on the
assumption that there is no intention or necessity to liquidate or curtail
significantly the scale of operation.
Circumstances where the going concern assumption would not be justified

include:
(a) Where there is a specific intention to liquidate the business in the

near future.

(b) Where there is a strong possibility that shortage of finance will force
the business into liquidation. This may be revealed by preparing a
cash flow forecast for the next twelve months where a month-by-
month comparison of expected cash inflows and outflows indicates
financing requirements that are unlikely to be satisfied.
(c) Where there is a strong possibility that shortage of finance will

result in the sale of a significant part of the business.
In the above circumstances the going concern assumption would

not be valid, and the financial statements would be prepared on a
basis that takes the likely consequences into account.
In most cases, however, financial statements will be prepared on a
going concern basis and the directors will be able to justify the idea
that such a basis is valid.
Accruals concept
The accruals concept is the principle that revenue and costs are
recognised as they are earned or incurred, are matched with one
another, and are dealt with in the profit and loss account of the
period to which they relate, irrespective of the period of receipt or
payment.
Revenue is usually recognised when it is realised. This is usually

taken to occur on the date of sale rather than on the date when the
cash relating to the sale is received.
The efforts of expenditure in the past have led to the revenues

accruing now. It is thus logical to match the costs or expenses of
earning revenue with the revenue reported in any particular period.
The operating profit determined in this way is supposed to indicate
how efficiently the resources of the business have been utilised.
Although the accruals or matching principle is conceptually simple,

it does run into practical difficulties.
For example, expenditure on fixed assets will provide benefits

extending over several accounting periods. When a fixed asset is
acquired it is necessary to estimate its useful life. The service
potential of a fixed asset will diminish over its useful life, and this
reduction is a cost or expense to be matched against the revenue
of each period and is called depreciation.

Consistency concept
The consistency concept is the principle that there is uniformity of

accounting treatment of like items, within each accounting period
and from one accounting period to the next.
As an example, in the case of depreciation of fixed assets, there is

more than one accepted accounting treatment. As far as the
consistency concept is concerned, once a business has selected a
method, it should use this method consistently for all assets in that
class and for all accounting periods. This ensures that the accounts
presented are comparable from one period to the next. Companies
are allowed to change their accounting policies if this will give a
fairer presentation of their results, but they must disclose the
change in their accounts.
Prudence concept
The prudence concept is the principle that revenue and profit are
not anticipated, but are included in the statement of profit or loss
only when realised in the form either of cash or of other assets.
Provision is made for all known liabilities (expenses and losses)
whether the amount of these is known with certainty or is the best
estimate in the light of the information available.
Profits are not reported and recognised in the financial statements

unless they are 'realised', i.e. when the likelihood of conversion to
cash is high. In most cases this means the date of sale.
Money measurement or measurability concept
Money Measurement Concept in accounting, also known as

Measurability Concept, means that only transactions and events
that are capable of being measured in monetary terms are
recognized in the financial statements.
All transactions and events recorded in the financial statements

must be reduced to a unit of monetary currency. Where it is not
possible to assign a reliable monetary value to a transaction or
event, it shall not be recorded in the financial statements.
1.3 The conflict between accruals and prudence concepts
The prudence concept often conflicts with the accruals concept when
considering costs and expenses. Examples include:
Stock

The accruals concept requires that purchased goods not yet sold should
be carried forward as stock i.e., the cost should be carried forward to
match against future sales.
If, however, there is some doubt that the items can be sold or they will be
sold for less than their cost they would only be carried forward up to the
amount of expected future sale proceeds (net of any further costs to make
the sale).
Thus if items bought for Rs 10,000 can only be sold as scrap for Rs 1,000
(net of delivery costs), the items would be stated at Rs 1,000 in closing
stock. The‘excess’ cost of Rs 9,000 is thus automatically charged against
gross profit.
Development costs
Businesses may undertake research and development work to make a
new or improved product. Costs of development can be considerable. If
there is an expectation that a saleable product can be developed, the
matching concept would require the costs to be carried forward.
However, the prudence concept would require a consideration of the
likelihood of profitable commercial production. If it is not reasonably
certain that profits will be made in a future period, the costs must be
written off in the period in which they are incurred.
1.4 Statutory accounting principles
The Companies Act 2017 affects the financial statements of companies in

a number of ways.
(a) The information must be prepared following certain accounting

principles.
(b) Prescribed formats for the statement of profit or loss and statement
of financial position are required.
(c) Detailed disclosures of information are required.
(d) The financial statements must show a ‘true and fair view’.
Items (b) and (d) are dealt with later. It is not required to know the
disclosures
in item (c). Item (a) is covered here.
1.5 Determination of value of each asset and liability separately
The standards require that in determining the aggregate amount of any

item, the amount of any individual asset or liability within that item shall be
determined separately.
For example, when stock is valued at the lower of cost and net realisable
value, the value must be determined for separate types of stock and then
aggregated. In this way anticipated losses on one type of stock will not be
offset against expected gains on another.

2 Other accounting conventions and terms
2.1 The business entity concept

Under the business entity concept, the entity is seen as being separate
from its owners, whatever its legal status.
Thus, a company is both legally and for accounting purposes a separate

entity distinct from its owners, the shareholders.
On the other hand, the business of a sole trader is not legally a separate
entity distinct from its proprietor; however, for accounting purposes, the
business is still regarded as being a separate entity and accounts are
drawn up for the business separately from the trader’s own personal
financial dealings.
2.2 Materiality convention

Financial statements should separately disclose items that are material.
Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the financial
statements. The significance of an item stems from its importance in the
overall context of the financial statements; what is and is not significant
will differ from organisation to organisation.
2.3 Assets and liabilities

Assets and liabilities are represented on the statement of financial position
. An asset is any tangible or intangible possession that has value to the
business. Assets are defined as ‘rights or other access to future economic
benefits controlled by an entity as a result of past transactions or events’.
Liabilities are the financial obligations of a business. Liabilities are defined

as ‘an obligations to transfer economic benefits as a result of past
transactions or events’.
2.4 Income and expenditure

Income and expenditure for a period of time is summarised in the
statement of profit or loss. However the term expenditure may also be
used for any purchases made by a business.
Examples of income are sales made by a trader and fees earned by a

person providing a service. A business may have income from more than
one source, e.g. dividends or interest received from investments or profits
on the sale of fixed assets.
Income should only be recognised in the statement of profit or loss if it

passes the test of realisation (see the prudence concept above).
Examples of expenditure are the purchase of fixed assets, stock for

resale, wages, rent and rates. All expenditure will eventually be charged
against income in the statement of profit or loss but not necessarily in the

accounting period in which the expenditure is incurred. The matching and
the prudence concepts are relevant in this decision.
2.5 Capital and revenue

Receipts and expenditure can be classified as capital and revenue. This
distinction is of more importance to expenditure and thus we concentrate
on the distinction from the expenditure point of view.
2.6 Distinction between capital and revenue expenditure

The life of a business extends over a long period of time. The problem is
that reports on the profitability of the business are needed at fairly regular
intervals, usually of twelve months. This requirement gives rise to certain
problems. For example, how should one treat Rs 5,000 expenditure on an
item of plant that is expected to be useful to the business for the next ten
years? This expenditure is referred to as capital expenditure because of
the long-term nature of the benefits that are expected to be received, thus
the capital expenditures are reported as an asset in Statement of financial
position at their book values and are depreciated at year end while the
revenue expenditures are reported as an expense in Income statement to
match with the revenues.
The distinction between capital expenditure and revenue expenditure

derives from the fact that, by convention, financial statements are
produced on an annual basis.
Examples
Category Types of expenditure included

Capital expenditure (a) Expenditure on the acquisition of fixed assets required
for use in the business and not for resale.
(b) Expenditure on existing fixed assets aimed at
increasing their earning capacity.
Revenue expenditure (a) Expenditure on current assets (stock).
(b) Expenditure relating to running the business
(administration, selling expenses).
(c) Expenditure on maintaining the earning capacity of
fixed assets (repairs and renewals).
2.7 Capital and revenue receipts
A capital receipt is one that relates to an item that would be regarded as

capital on the statement of financial position .
A capital receipt may be accounted for through the profit and loss account
but not necessarily so. If the receipt represents a profit or loss on the
disposal of a fixed asset it represents a gain or loss to the owners of the

business and thus should be shown in the statement of profit or loss(after
matching the receipt with the cost of the asset).
A capital receipt will also include additional cash invested in the business
by the owner(s) and the raising of a loan from a bank. As these receipts
represent sums that need to be paid back at some stage, they are not
reported through the profit and loss account, but included on the
statement of financial position as liabilities.
2.8 Profit and cash
In order for a business to prosper it must make profits and also have
sufficient cash to carry out its activities. The making of profits does not
necessarily mean that the business has sufficient cash to pay its debts.
The failure to understand the importance of cash as well as profits has
caused many businesses to cease trading.
A profit is made when an item is sold for more than the costs incurred by
the business in making the sale. If the sale is a credit sale then the
business has not actually received an equivalent cash receipt. If the
business is expanding it will need to buy more goods in order to make
further sales and it may find the creditors are demanding payment before
it has managed to collect sufficient cash receipts from its debtors. Unless
additional finance comes into the business (from the owner or a bank) the
business may run out of cash.
The relationship between profits and cash is examined in more detail

towards the end of this text when the preparation of cash flow statements
is considered.
2.9 Objectivity convention

Financial statements should be as objective as possible. Transactions are
to be recorded objectively as historical events.
This is the main basis of historical cost accounting. Certain aspects of

historical cost accounting do, however, represent departures from the
objectivity convention. For example, although the depreciation charge is
often based on the original cost of an asset (objective) it depends also on
the estimated useful life and estimated scrap value at the end of that
useful life (subjective).
2.10 Substance over form convention

The economic substance of a transaction should be reflected in the
accounts, rather than simply its legal form.
A good example is that of assets acquired on hire purchase terms.

Despite the fact that such assets are not owned by the user until the final
instalment has been paid, a fixed asset is recorded in their accounts at the

start of the hire purchase agreement. The substance of the transaction is
that the accounts should reflect the use of a fixed asset in a business.
It is also accepted practice for assets used under long-term leases to be

accounted for as if they were owned by the user. This is despite the fact
that for most long-term leases the user never becomes the legal owner of
the asset.
3 Asset valuation
3.1 Historical cost accounting convention
The historical cost accounting (HCA) system is a system of accounting in

which all values are based on the historical costs incurred (in other words,
the actual amount paid). It has several advantages.
Objectivity – historical costs are known with certainty, and there is no

scope for subjective judgement in their ascertainment.
Linkage with accounting records – the costs recorded in the records

follow directly through to the valuations, without adjustment.
Well-understood accounting model – since this is the accounting model

that has been in use since the beginning of large-scale commercial
enterprises, it is well understood, especially in the business/financial
community.
3.2 Alternative asset valuation methods
The historical cost convention has significant defects.
The historic cost may bear little relation to the value of an asset. In the
case of current assets, the distortion is worsened because only downward
movements in value are recognised under accounting rules.
The use of cost fails to recognise the effect of changing price levels either
of individual goods or because of general inflation.
Using historic cost in periods of rising prices generally overstates profits.
At various times, the accounting profession has been aware of the

shortcomings of the historical cost convention, and has sought an
alternative. Some of the main contenders are discussed below.
Replacement cost
Replacement cost is the cost of replacing an asset, as near as possible,
with an asset identical in terms of technical capacity, age and condition. It

may often be difficult to determine replacement cost where the product
has been subject to technical change, and a comparable product is no
longer available. This method could be used if the business wants to use
up-to-date market values in the statement of financial position . It provides
information on the estimated amount of finance that would be needed if
the asset were replaced.
Net realisable value

Net realisable value is the net amount a business would realise from the
disposal of an asset, i.e. the market value less any costs that would be
incurred to complete the sale.
The asset might be disposed of as it is, or combined in some final product.
There may be some costs of sale or preparing the asset for sale. This
method uses up-to-date market values in the statement of financial
position and provides information on the amount of finance that would be
raised if the asset were sold. This is useful if the business wants to
consider alternative uses for this finance.
Economic value
Economic value is the value of an asset’s future earnings discounted to
present value.
This is an especially important concept for fixed assets, since these are
bought not for resale, but for use in the business. The calculation of
economic value is difficult; it is the amount of the extra income the
business will receive as a result of possessing the asset, expressed in
terms of current money. This method gives the value in use of the asset
that is useful if the business is considering alternative strategies for the
asset, e.g. sell the asset or buy another asset.
Constant money (or real) cost

The constant money cost is the equivalent of the original cost, but
expressed in current money terms after allowing for the decline in the
value of money. The purpose of a constant money or real value is to
express the original cost of the asset after taking account of inflation or
general price changes since the date that the asset was acquired.
3.3 The impact on the statement of financial position values

If an alternative basis is used for the valuation of assets, the increase in
value is added to the historical cost of the asset in the statement of
financial position so the asset stands at its new value. This increase (or
decrease as may occasionally be the case) also has to be reflected in the
capital of the business as it is a type of profit (or loss).
Example

Adnan & Co
Statement of financial position
XX-X-20XX
Rs
Fixed asset 2,000
Cash 100
Net Assets 2,100
Capital account at 1 March 2,100
Adnan decides to include his fixed asset in his statement of financial position at
its current cost, its replacement cost of Rs 3,000.
Solution
Adnan & Co
XX-X-20XX
Rs
Fixed asset 3,000
Cash 100
Net Assets 3,100
Capital account At 1 March 2,100
Surplus on revaluation 1,000
3,100
Adnan’s statement of financial position now includes the fixed asset at its
replacement cost, and the capital of the business has increased by this ‘profit’
that has arisen merely from holding the asset. The effect on the statement of
financial position is to update it so that instead of the statement of financial
position showing the historical cost of the assets, it shows what the assets are
worth now. Many people would argue that this is more meaningful for users of
accounts. Of course, this revaluation exercise would have to be performed on a
regular basis if the current cost were to be reflected in the statement of financial
position in future.
3.4 The impact on profit measurement
In historical cost accounting an amount is charged in the profit and loss account
each year for the use of the fixed asset. It represents the portion of the cost
consumed during the period, and it is called depreciation. The amount charged
in the statement of profit or loss will depend upon the value of the asset. If
replacement cost is used as the valuation method, the depreciation charge will
charge a portion of the current cost in the statement of profit or loss.
If realisable value is used, the charge in the statement of profit or loss each year
will be the change in the value of the asset. Use of economic value would mean
the inclusion of changes in the present value of the future cash flows in the profit
and loss account.

Where stock is involved, its inclusion in the accounts at an alternative value will
have an effect on the amount of profit measured by the profit and loss account.
A statement of profit or loss could be drawn up under the historical cost
convention for a simple transaction, such as the sale of 10 items for Rs 20 each
that had originally been bought from a wholesaler for Rs 10 each:
Rs
Sales 200
Less: cost of sales (historical) 100
Profit 100
Inclusion of these items in the statement of profit or lossat other values would
have a significant effect on the profit. Let’s say that at the time of sale their
purchase price from the wholesaler had increased to Rs 15 each. Profit
measured by reference to the (current) cost would be reduced to Rs 50, as
follows:
Rs
Sales 200
Less: cost of sales (current) 150
Profit 50
This illustrates the drawback of historical cost accounting, namely that it tends to
overstate profits in times of rising prices; the historical cost profit here is higher
than the profit based on the current cost of the stock. The realisable value, the
market value in this case, is Rs 20 per item; if the stock were included at that
value in the profit and loss account, no profit would arise at all!
The true profit depends upon your point of view. Few companies would use
anything other than the historical cost of the stock in their profit and loss account
(although some do revalue the fixed assets in their statement of financial position
as a modification of historical cost accounting allowed under company
legislation). But this does not necessarily give the most meaningful measure of
profit if prices are rising. The problem comes when you look at the calculation of
profit in terms of capital maintenance.
DEFINITION
Profit for a period is the sum that can be withdrawn from the business by
the owner(s) but leaving capital at the same level as at the beginning of
the period.
3.5 Capital maintenance
This can be represented as:

Capital at start of period C0
Add: Profit +P
Less: Drawings -D
Capital at end of period C1
Profit for a period is the sum that can be withdrawn from the business by the
owner(s) but leaving capital at the same level as at the beginning of the
period.

If all profit is withdrawn, i.e. D = P, capital is maintained if C1 is equal to C0.
There are however different views as to the meaning of the term capital.
Capital can be defined in money terms (financial capital maintenance or in
physical terms (physical or operating capital maintenance). Financial capital
maintenance is the concept that profit is earned only if the financial (or
money) amount of the net assets at the end of the period exceeds the
financial (or money) amount of the net assets at the beginning of the period,
after excluding any distributions (e.g. drawings or dividend payments) to,
and contributions (e.g. share issues or increases in capital) from owners
during the period.
Conventional historical cost accounting is a method of financial capital
maintenance.
Physical or operating capital maintenance is the concept that profit is

earned only if the physical productive capacity (or operating capability) of
the enterprise … at the end of the period exceeds the physical productive
capacity at the beginning of the period, after excluding any distributions to,
and contributions from, owners during the period.
In this concept the net assets are viewed in physical terms, rather than
monetary units. Thus net assets consist of fixed assets, which are capable
of producing a certain amount of output, and working capital (stock, debtors,
creditors and cash) that can finance a certain amount of output. Profit is
regarded as the maximum amount that could be withdrawn from the
business without reducing the ability of the business to maintain its
operating capability.
Assume a company values stock on an historical cost basis. During a period
of inflation, the effect of this method is to overstate the real profit of a
business, since sales (in current terms) are matched with cost of sales (in
historical terms). If the company distributed the whole of its historical cost
profit, it would not be maintaining the capital of the business intact in real
terms.
Example
A business starts off on 1 January 20X7 with Rs 100,000 cash (contributed
by the proprietor). On the same day it purchased 50 motors at Rs 2,000
each. These are sold on 31 March 20X7 for proceeds of Rs 165,000. At this
date, the replacement cost of an identical motor is Rs 2,200.
Solution
Under HCA, the profit for the three months is Rs 65,000 (Rs 165,000 – Rs
100,000). If the proprietor withdraws this profit, the closing statement of
financial position at 31 March would show capital account Rs 100,000
represented by cash of Rs 100,000. Although capital has been maintained
intact in money terms (it was Rs 100,000 at 1 January), it has not been
maintained intact in real terms. At 31 March, Rs 100,000 cash will buy only
45 (approximately) machines. But what can be done about this? The profit
could be measured in a different way:

Rs
Proceeds of sale 165,000
Current (or replacement) cost at the date of sale 110,000
Current cost profit 55,000
If the proprietor withdrew Rs 55,000, the closing statement of financial

position would appear:
Rs
Capital account
Balance at 1.1.X7 100,000
165,000
Less: Drawings 55,000
110,000
Assets – cash 110,000
This cash is now sufficient to buy 50 machines at the new price of Rs

2,200 per machines. The trader can continue trading at the same level of
business – capital has been maintained intact in physical or operating
terms.
4. Company Law:
Means the repealed Companies Act, 1913 (VII of 1913), Companies Ordinance,
1984(XLVII of 1984) and Companies Ordinance, 2016 (VI of 2016).
4.1 Types of Companies:

Public Company:
Public company means a company which is not a private company.
Private Company:
Private company means a company which, by its articles- (a) restricts the
right to transfer its shares; (b) limits the number of its members to fifty not
including persons who are in the employment of the company; and (c)
prohibits any invitation to the public to subscribe for the shares, if any, or
debentures or redeemable capital of the company:
Provided that, where two or more persons hold one or more shares in a
company jointly, they shall, for the purposes of this definition, be treated
as a single member.
Listed Company:
Listed company means a public company, body corporate or any other
entity whose securities are listed on securities exchange.
Unlisted Company:
Unlimited company‖ means a company not having any limit on the liability
of its members.

Single Member Company:
Single member company‖ means a company which has only one member.
5 ICMA PAKISTAN
5.1 The Institute of Cost and Management Accountants of Pakistan was

established in 1951 and was granted statutory status under the Cost and
Management Accountants Act, 1966 for the regulation of the profession of
Cost and Management Accounting. The institute was established with the
name 'Pakistan Institute of Industrial Accountants (PIIA)' which was
changed to ICMA PAKISTAN in 1976. It is considered as the oldest
professional accountancy institute of Pakistan.
ICMA PAKISTAN is the sole provider of cost and management accounting

education, training and professional certification in Pakistan.
ICMA PAKISTAN has over 3000 members, who hold positions in trade,
commerce, industry and government in Pakistan and abroad. The active
registered students number around 15000, which makes ICMA PAKISTAN
one of the largest professional institutions in Pakistan. The institute has its
head office in Karachi.
The Institute is a member of the following international accounting bodies:
 International Federation of Accountants (IFAC)

 International Accounting Standards Board (IASB)
 Confederation of Asian and Pacific Accountants (CAPA)
 South Asian Federation of Accountants (SAFA)
6 ICAP
6.1 Institute of Chartered Accountants of Pakistan (ICAP) is a professional

accountancy body in Pakistan. As of now, it has 5,078 members working in
and outside Pakistan.[1] The institute was established on July 1, 1961 to
regulate the profession of accountancy in Pakistan. It is a statutory
autonomous body established under the Chartered Accountants Ordinance
1961. With the significant growth in the profession, the CA Ordinance and
Bye-Laws were revised in 1983.
The course of ICAP involves a blend of theoretical education and practical

training which run concurrently for a period of 3.5 years and equips a
student with knowledge, ability, skills and other qualities required of a
professional accountant.
The Institute is a member of the following international accounting bodies:
 International Federation of Accountants (IFAC)

 International Accounting Standards Board (IASB)
 Confederation of Asian and Pacific Accountants (CAPA)
 South Asian Federation of Accountants (SAFA)

IFRS :
International Financial Reporting Standards (IFRS) set common rules so

that financial statements can be consistent, transparent, and comparable
around the world. IFRS are issued by the International Accounting
Standards Board (IASB). They specify how companies must maintain and
report their accounts, defining types of transactions, and other events with
financial impact. IFRS were established to create a common accounting
language so that businesses and their financial statements can be
consistent and reliable from company to company and country to country.
Purpose of IFRS for Financial Reporting:
IFRS are designed to bring consistency to accounting language, practices

and statements, and to help businesses and investors make educated
financial analyses and decisions. The IFRS Foundation sets the standards
to “bring transparency, accountability and efficiency to financial markets
around the world… fostering trust, growth and long-term financial stability
in the global economy.” Companies benefit from the IFRS because
investors are more likely to put money into a company if the company's
business practices are transparent.
Summary
This chapter has introduced the idea of a conceptual framework; a set of
principles on which the legislation and accounting standards, which govern
and guide the preparation of accounting information, are built. In the context
of the examination, you only need to be aware of the broad reasons for the
existence of company ordinance and confine your knowledge of Accounting
Standards to the specific areas mentioned in this text. The most important
concepts are the four fundamental accounting concepts referred to earlier in
the chapter. Refer back to this chapter when these concepts are mentioned in
relation to topics in later chapters. Various other concepts and conventions
were also covered, including historical cost accounting which is the system
used by most business concerns. This system can be modified by revaluing
assets, and the implications of this for the statement of financial position and
the measurement of profit were examined. Having completed your study of
this chapter you should have achieved the following learning outcomes.
 Identify and explain the fundamental accounting concepts, bases and

policies
 Explain the concepts of capital and revenue, cash and profit, income
and expenditure and assets and liabilities
 Explain the historical cost convention

 Identify the basic methods of valuing assets on current cost, market
value and economic value bases, and demonstrate their impact on
profit measures and statement of financial position values
 Explain the influence of legislation (for example, Companies ordinance)
and accounting standards on the production of published accounting
information for organisation.
Self-test questions
Fundamental concepts of accounting

1 What does IASB stand for and what is its function? (1.2)
2 What is the going concern concept? (1.2)
3 What is the consistency concept? (1.2)
4 Which concept normally takes precedence if there is a conflict between
the accruals concept and the prudence concept? (1.3)
Other accounting conventions

5 What is the entity concept? (3.1)
6 What is the definition of an asset? (3.3)
Asset valuation
7 What are the advantages of historical cost accounting? (3.1)
8 What is meant by the term economic value with reference to an asset?
(3.2)
9 What is the idea behind operating capital maintenance? (3.5)
10 Explain the following accounting concepts:
Historical cost
(i) Net realizable value
(ii) Substance over form
11 Explain the meaning of the following accounting terms:

(a) Accrual basis
(b) Prudence
(c) Going concern
(d) Substance over form
12 Explain the meaning of the following accounting terms:

(a) Materiality
(b) Completeness
(c) True and fair view
(d) Air value
13 Which fundamental accounting concept best describes each situation below?

(a) Allocates expenses to revenue in the proper period.
(b) Indicates that changes in value subsequent to purchase are not
recorded in the accounts.
(c) Uniform accounting procedures are followed from year to year unless
a change is essential.
(d) Rationale why assets are not reported at liquidation value.
(e) Anticipates all losses, but reports gains only when specific
conditions are met.

Multiple Choice Questions
1 Which of the following is not a fundamental accounting concept?

A Accruals
B Prudence
C Consistency
D Materiality
2 Which two accounting concepts are viewed as the most important in FRS
18 Accounting policies?
A Going concern and Consistency
B Prudence and Accruals
C Going concern and Accruals
D Consistency and Prudence
3 Which of the following statements correctly describes the business entity
concept?
A A company must prepare accounts for each entity it owns
B A company is a separate legal entity from the shareholders
C A company and its shareholders are not separate entities
D A company must include information on its owners in the accounts
4 Which of the following expenditure would be classified as capital
expenditure?
A Purchase of stock for resale
B Payment for repairs to the delivery van
C Purchase of new building
D Payment for new stationery
Answers
10 (i) Historical cost:

Assets are recorded at the amount of cash or cash equivalents paid
or the fair value of the consideration given to acquire them at the
time of their acquisition. Liabilities are recorded at the amount of
proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash
or cash equivalents expected to be paid to satisfy the liability in the
normal course of business.
(ii) Net realizable value:
It is the estimated selling price in the ordinary course of business
less the estimated costs of completion and the estimated costs
necessary to make the sale.
(iii) Substance over form:
If information is to represent faithfully the transactions and other
events that it purports to represent, it is necessary that it is

accounted for and presented in accordance with their substance
and economic reality and not merely their legal form.
11 (a) Accrual basis:

In accrual, revenues are recorded when these are eared irrespective of
receipt of cash and expenses are recorded when these are incurred
irrespective of payment of cash. If an expense amounting to Rs. 10,000 is
incurred and it is not paid. It is necessary make adjustment in the
accounts for the expense incurred, if no adjustment is made the expenses
are understated by Rs. 10,000 and profit is over stated by Rs. 10,000 thus
it will not give true picture of the financial statements.
(b) Prudence:
Prudence is the inclusion of a degree of caution in the exercise of the
judgments needed in marking the estimates required under conditions of
uncertainty, such that assets or income are not observed and liabilities or
expenses are not understand. However, the exercise of prudence does
not allow the creation of hidden or expenses, because the financial
statements would not be neutral and therefore, not have quality of
reliability.
(c) Going concern:
When preparing financial statements, management shall make an
assessment of an entity’s ability to continue as a going concern. Financial
statements shall be prepared on a going concern basis unless
management either intends to liquidate the entity or to cease trading, or
has no realistic alternative but to do so. When management is aware, in
making its assessments, of material uncertainties related to events or
conditions that may cast significant doubt upon the entity’s ability to
continue as a going concern, those uncertainties shall be disclosed. When
financial statements are not prepared on a going concern basis, that fact
shall be disclosed, together with the basis on which the financial
statements are prepared and the reason why the entity is not regarded as
a going concern.
(d) Substance over form:
If information is to represent faithfully the transactions and other events
that it purports to represent, it is necessary that they are accounted for
and presented in accordance with their substance and economic reality
and not merely their legal form.
12 (a) Materiality:
Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the Financial
Statements. Materiality depends on the size of the item or error judged in
the particular circumstance of its omission or misstatement. Thus,
materiality provides a threshold or cut-off point rather than being a primary
qualitative characteristic which information must have if it is to be useful.
Amount of bad debts is an example of quantitative materiality whereas
increase in auditor’s remuneration is qualitative materiality.

(b) Completeness:
Means all the transactions have been recorded and accounted for which
have occurred during the period.
13 True and fair view:
Financial Statements shall present fairly the financial position, financial
performance and cash flows of an entity. True and fair presentation
requires the faithful representation of the effects of transactions, other
events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in the
framework.
(d) Fair value:
Is the amount for which an asset could be exchanged or liability settled
between knowledgeable willing parties in an firm’s length transaction.
(a) Accrual basis and / Matching concept.
(b) Historical cost
(c) Consistency concept
(d) Going concern assumption
(e) Prudence concept
MCQs
1 D
2 C
3 B
4 C

 Define accounting equation

1 The accounting equation in action
1.1 The linkage between the accounting statements
Statement of financial positions are pictures of the business at particular
points in time, while the statement of profit or loss show the activities of the
business in between those statement of financial position dates. Therefore
the linkage between the accounting statements can be seen as:
Statement of
financial position
at start ofperiod
Profit
(or - loss)
Movements of
cash to/from
proprietor
Statement of
Cash in financial position Cash out
at end of period
Thus, the statement of financial positions are not merely isolated statements;
they are linked over time by the profit (or loss) as analysed in the statement of
profit or loss, plus movements of cash with the proprietors.
1.2 The accounting equation and the double-entry concept
Any profit made by the business increases the net assets of the business and
thus the capital of the owner of the business.
The accounting equation emphasises the effect that any transaction has on
the statement of financial position of the business. The accounting equation is
a simple fact that at any point in time the assets of the business will be equal
to its liabilities plus the capital of the business. Each and every transaction
that the business makes or enters into has two aspects to it and has a double
effect on the business and the accounting equation. This is known as the dual
aspect of transactions.
So if a business buys some goods for cash the two aspects of the transaction are
that it has more goods but less cash. Equally if it sells some goods for cash the
effect is that cash has increased and a sale has been made on which there may
have been a profit made.

DEFINITION
Assets = Liabilities + Proprietor’s capital or
Assets – Liabilities = Proprietor’s capital.
Example
This example involves a series of transactions using the accounting equation to build
up a set of financial statements.
Day 1 Hamid commences in business introducing Rs 1,00 cash
Day 2 Buys a machine for Rs 400 cash
Day 3 Buys stock for Rs 200 cash
Day 4 Sells all the goods bought on Day 3 for Rs 300 cash
Day 5 Buys stock for Rs 400 on credit (stock acquired now with payment
later)
Day 6 Sells half of the goods bought on Day 5 on credit for Rs 250
Day 7 Pays Rs 200 to a trade creditor
Day 8 Receives Rs 100 from a debtor
Day 9 Proprietor draws Rs 75 in cash
Day 10 Pays rent of Rs 40 in cash
Day 11 Receives a loan of Rs 600 repayable in two years
Day 12 Pays cash of Rs 30 for insurance
Using the accounting equation a statement of financial position will be drawn up for
the end of each day (representing the cumulative effect of transactions to date) and
later a statement of profit or loss will be drawn up for the twelve-day period. For
simplicity, the distinction between cash at bank and cash in hand will be ignored.
Each day's statement of financial position is shown using the horizontal format.
Solution
Day 1: introduction of cash as capital.
Statement of financial position Day 1
Rs Rs
Cash 1,000 Capital 1,000
Note carefully that this transaction, like all others, has two aspects. The business has
Rs 1,000 of cash but also owes Rs 1,000 back to Hamid, the capital of the business.
Day 2: purchase of fixed asset for cash.
This is merely a change of the form in which the assets are held.

Rs Rs
Machine 400 Capital 1,000
Cash (Rs 1,000 – Rs 400) 600
1,000 1,000
The acquiring of an asset must lead to one of the following:
 reducing another asset by a corresponding amount (as above)
 incurring a corresponding liability (Day 5)
 increasing the capital contributed by the proprietor (Day 1).
Day 3: purchase of stock for cash.

Again this is merely a change in the form in which the assets are held. Rs 200 is
withdrawn from cash and invested in stock.

Rs Rs
Stock 200
Cash (Rs 600 – Rs 200) 400 1
1,000 1,000
Day 4: sale of stock at a profit.
This is an important new development. It is true that one asset (stock) is
being replaced by another (cash), but the amounts do not correspond.
DEFINITION
Excess price realized by the sale of goods and services is Profit. It is
calculated as the difference between purchase price and sale proceeds and it
belongs to the proprietor(s) of the business. It is an increase in the capital of
the business.
Rs
Cash acquired (sale proceeds) 300
Asset relinquished (stock) 200
Difference (= profit) 100
Thus total assets have increased by Rs 100. Since there are no liabilities involved, if
the fundamental equation is to remain valid the capital must increase by Rs 100.
Rs Rs Rs
introduced
Cash (Rs 400 + Rs 700 Add: Profit 100
300)
_______ 1,100
1,100 1,100
Day 5: purchase of stock on credit.

Assets can be increased by a corresponding increase in liabilities as follows:
Rs Rs Rs
introduced
Stock 400 Add: Profit 100
Cash 700 1,100
______ Creditors 400
1,500 1,500

Note that the creditors are acting in effect as a source of finance for the business.
Day 6: sale of part of the stock on credit terms.
This transaction introduces two new concepts:

(a) Sale on credit. Essentially this is the same as a sale for cash, except
that the asset increased is not cash, but debtors.
(b) Sale of part of the stock. In practice this is the normal situation. The
important accounting requirement is to separate:
(i) stock still held as an asset, from
(ii) cost of stock sold.
This is best viewed diagrammatically:

End Day 5 During Day 6 End Day 6
Debtors
Rs 250
Cost of stock sold Rs 200 + Rs 50 profit = Sale proceeds Rs 250
Stock
Rs 400
Cost of stock not yet sold Rs 200
Stock
Rs 200

Rs Rs Rs
introduced
Stock 200 Add: Profit to
date
Debtors 250 (Rs100 + Rs50) 150
Cash 700 1,150
_____ Creditors 400
1,550 1,550
Note that profit is recorded when the sale is made, not when the cash is received.
Thus the payment of the creditors (Day 7) or the receipt of cash from debtors (Day 8)
will not alter the total profit.

It would be useful at this stage to draw up a summary of the profit to date:
Statement of profit or loss for first six days of trading
Rs Rs
Sales: Cash 300
Credit 250
550
Purchases: Cash 200
Credit 400
Goods available for sale 600
Less: Goods not sold (closing stock) 200
Cost of goods sold 400
Gross profit 150
Notice that in this trading account the goods not sold, i.e. the closing stock, are
stated at their original purchase price. This is part of the traditional historical cost
convention of accounting.
The cost of goods sold is also known as the cost of sales.
Day 7: payment to trade creditor.
This is simply the reduction of one liability (creditors) and one asset (cash) by a
corresponding amount (Rs 200).
Rs Rs Rs
Machine 400 Capital introduced 1,000
Stock 200 Add: Profit to date 150
Debtors 250
Cash (Rs 700 – Rs 200) 500 1,150
_____ Creditors 200
1,350 1,350
Day 8: receipt of cash from debtor.
A change in the form in which assets are held:
Rs Rs Rs
Debtors (Rs 250 – Rs 100) 150
Cash (Rs 500 + Rs 100) 600 1,150
_____ Creditors 200
1,350 1,350
Day 9: cash withdrawal by the proprietor.
DEFINITION
Drawings are withdrawals of profits in anticipation.
This arises where the proprietor wishes to withdraw some of his interest in the business, i.e. his
original capital as increased by profits earned. This is shown on the statement
of financial position as a reduction of capital, and as a reduction of cash.

Rs Rs Rs
Debtors 150 1,150
Cash (Rs 600 – Rs 75) 525 Less: Drawings (75)
1,075
_____ Creditors 200
1275 1275
Day 10: payment of rent.

This is an example of a business expense. The payment of the expense reduces the
profit and reduces the cash.
Rs Rs Rs
Stock 200 Add: Profit to date
(Rs 150 – Rs 40) 110
Debtors 150 1,110
Cash (Rs 525 – Rs 40) 485 Less: Drawings (75)
1,035
_____ Creditors 200
1235 1235
Day 11: medium-term loan received of Rs 600.
This increases an asset (cash) and increases a liability (loan).

Rs Rs Rs
Debtors 150 1,110
Cash (Rs 485 – Rs 600) 1,085 Less: Drawings (75)
1,035
Creditors 200
_____ Loan 600
1,835 1,835
Day 12: payment of insurance.

Rs Rs Rs
Stock 200 Add: Profit to date
(Rs 110 – Rs 30) 80
Debtors 150 1,080
Cash (Rs 1,085 – Rs 30) 1,055 Less: Drawings (75)
1,005
Creditors 200
_____ Loan 600
1,805 1805
This is a further example of a business expense. The payment reduces both profit
and cash.

This marks the end of the transactions. The financial statements for the
twelve- day period can now be considered.
KEY POINT
After each transaction the accounting equation will always be equal, Assets =
Capital + Liabilities.
1.3 The financial statements
The trading and profit and loss account can be prepared by summarising all
the sales, purchases and expenses that have taken place in the 12 day
period, not forgetting the closing stock at the end of the period.
Both the statement of profit or loss and the statement of financial position are
presented in vertical form as follows:
Statement of profit or loss for the 12 days ended …..

Rs Rs
Sales: Cash 300
Credit 250
550
Cost of sales: Purchase: Cash 200
Credit 400
Goods available for sale 600
Less: Closing stock 200
Cost of goods sold (400)
Gross profit 150
Rent 40
Insurance 30
(70)
Net Profit 80
DEFINITION
Net profit is the gross profit less the expenses of the business.
Statement of Financial Position as at end of Day 12

Rs Rs
Fixed asset: Machine (at cost) 400
Current assets: Stock 200
Debtors 150
Cash 1,055
1,405
Less: Current liabilities: creditors (200)
1,205
1,605
Less: Long trem liability: Loan (600)
1,005
Capital account of Hamid: Capital 1,000
introduced
Net profit 80
1,080
Less: Drawings (75)
1,005

Notes:
(i) Although the alternative (double-sided) form of statement of financial position is

acceptable, the above vertical presentation is generally regarded as preferable.
(ii) Current liabilities are payable within twelve months of the statement of financial
position date and cannot therefore include a loan of Rs 600 repayable in two
years. Note the presentation of this loan as a long-term liability in the vertical
form statement of financial position.
(iii) The machine is stated in the statement of financial position at its original cost of
Rs 400. The important subject of depreciation will be considered at a later
stage.
1.4 Summary of the effect of each transaction
Capital and
Transaction Assets Reference
liabilities
Introduction of cash as capital +Cash +Capital Day 1
Purchase of asset for cash +Asset No effect Days 2 + 3
– Cash
Purchase of asset on credit + Asset +Liabilities Day 5
Sale of stock at a profit – for cash – Stock Capital Day 4
Sale of stock at a profit – on credit – Stock + Capital Day 6
+ Debtor
Payment of creditor – Cash – Liabilities Day 7
Receipt from debtor + Cash No effect Day 8
– Debtor
Drawings by proprietor – Cash – Capital Day 9
Sale of stock at a profit – on credit – Stock + Capital Day 6
Payment of expense in cash – Cash – Capital Days 10 + 12
Cash received as a loan + Cash + Liabilities Day 11
Note the following points:
 Every business transaction affects at least two items in the accounting

equation.
 The accounting equation must always balance: Assets = Capital + Liabilities,
or Assets – Liabilities = Capital.
 The net profit for the period is made up of the gross profit less business
expenses.
 The gross profit is recorded in the trading account and is calculated as sales
proceeds less the original cost of the goods sold.
KEY POINT
(a) Every business transaction affects at least two items in the accounting
equation.
(b) The accounting equation must always balance (Assets = Capital + Liabilities,
or Assets – Liabilities= Capital).
(c) The net profit for the period is made up of the gross profit less business
expenses.
(d) The gross profit is recorded in the trading account and is calculated as sales
proceeds less the original cost of the goods sold.

Summary
The accounting equation holds true no matter how complex a business
seems to be.
Every transaction or event of a business has two equal and opposite effects on
the business.
Self-test questions
The accounting equation in action
1 To whom does the profit of a business belong? (1.2)
2 What are drawings? (1.2)
3 What is the difference between gross profit and net profit? (1.3)
4 What are current liabilities? (1.3)
5 What effect does the cash receipt from a debtor have? (1.4)

1 Which of the following transactions would result in an increase in both assets
and liabilities?
A Purchase of stock for cash
B Drawings of cash by the owner
C Purchase of car on credit
D Payment of rent expense
2 What is the correct definition of the double entry concept?
A There are always two people involved in any transaction
B Every transaction will have two aspects to it
C The business has to keep two sets of its accounts
D The transactions have to be recorded twice in the books of
account

1. D
2. B

 explain the concept of double entry and the duality concept explain the debit
and credit principle
 prepare journal entries prepare nominal ledger accounts

1 The duality concept and double entry bookkeeping
1.1 Each transaction that a business enters into affects the financial
statements in two ways, e.g.
A business buys a non-current asset for cash.
The two effects on the financial statements are:

(1) There is an increase in non-current assets.
(2) There is a decrease in cash.
To follow the rules of double entry bookkeeping, each time a

transaction is recorded, both effects must be taken into account. these
two effects are equal and opposite such that the accounting equation
will always prove correct:
Assets – Liabilities = Capital
Traditionally, one effect is referred to as the debit side (abbreviated to Dr) and
the other as the credit side of the entry (abbreviated to Cr).
2 Ledger accounts
2.1 Ledger accounts

Each aspect is recorded in the relevant ledger account. Any business
of reasonable size will have a large number of ledger accounts. Each
account has two sides – the debit side and the credit side.
Ledger account
Rs Rs
Debit side (Dr) Credit side (Cr)
Remember that by tradition, debit is on the left-hand side, and

credit is on the right-hand side.
For each transaction it is now not only necessary to identify the two
effects of the transaction and therefore the two ledger accounts to be
used, but also to decide which ledger account has the debit entry and
which has the credit entry.
You might find the following table useful to help you learn which are the
debit entries and which are the credit entries.

DEBIT (DR) is a: CREDIT (CR) is a:
Increase in an asset Decrease in an asset
Increase in an expense Increase in income
Decrease in capital Increase in capital
Decrease in a liability Increase in a liability
2.2 Drawing up ledger accounts

In practising the following examples, provide plenty of space
between the ledger accounts so that the entries can be made. It
is essential that the examples be practised by opening ledger
accounts and writing down the entries. In this way the practice
and theory of double entry will be more quickly understood. Also
allow a full-page width for each ledger account. This will enable
narrative and figures to be clearly written and also emphasise
the ‘left-hand’ and ‘right- hand’ nature of the entries.
Example
To illustrate the rules of double entry, the example is used here

twelve separate transactions were considered which are as
follows:
Day 1 Hashim commences in business introducing Rs 1,000 cash
Day 2 Buys a machine for Rs 400 cash
Day 3 Buys stock for Rs 200 cash
Day 4 Sells all the goods bought on Day 3 for Rs 300 cash
Day 5 Buys stock for Rs 400 on credit
Day 6 Sells half of the goods bought on Day 5 on credit for Rs 250
Day 7 Pays Rs 200 to his trade creditor
Day 8 Receives Rs 100 from a debtor
Day 9 Proprietor draws Rs 75 in cash
Day 10 Pays rent of Rs 40 in cash
Day 11 Receives a loan of Rs 600 repayable in two years
Day 12 Pays cash of Rs 30 for insurance
Solution
Day 1: Hashim introduced cash of Rs 1,000 into the business. Cash
(an asset) is increased so this must be the debit entry. The claims of
the proprietor (their capital) are increased so this must be the credit
entry. Keep checking the table to make sure you are happy with the
debit and credit entries for each transaction.
As this is a new business we must open up ledger accounts for cash
and capital.
Cash account
Date Details Rs Date Details Rs
(1) Capital 1,000

Capital account
(1) Cash 1,000
Note that the items (1) refer to the date of the transaction. The details
refer to the other account that is being debited or credited.
KEY POINT
Whenever a business receives cash there is a debit entry made in the
cash account.
Day 2: on this day the business purchases a machine (which is a fixed

asset) for cash. The payment of cash is a credit in the cash account as
this has reduced the cash asset and the other side of the double entry
is a debit in the machine account as this is an increase in fixed assets.
Using the cash account already opened, the transaction appears as
follows:
Cash account
(1) Capital 1,000 (2) Machine 400
KEY POINT
Whenever a business pays out cash there is a credit entry made in the
cash account.
Machine account
(1) Cash 400
Day 3: the purchase of goods on Day 3 is a cash purchase and so the

cash account is credited as a decrease in the cash asset.
So which account is debited? it is the purchases account that is
debited as an increase in an expense.
Cash account
(3) Purchases 200
KEY POINT
An asset (or an increase in an asset) is always a debit entry.
Purchases account
(1) Cash 200

The purchases account contains items that are held for resale by the
business or are raw materials that will be used to manufacture goods.
Day 4: the sale of goods for cash involves a receipt of cash and thus a
debit to the cash account as an increase in the cash asset. What then
is credited? Again the answer is not stock but sales account as an
increase in income.
Cash account
(4) Sales 300 (3) Purchases 200
Sales account
(4) Cash 300
The sales account collects the sales that have been made by the
business during the period. Income to the business is always a credit
entry.
The effect of having separate sales and purchases accounts is that
profit is not computed when each sale is made as it was in the previous
example. As many sales are being made each day, it is not practical to
compute profit on each transaction. Profit is instead calculated at the
end of the period.
KEY POINT
Income to the business is always a credit entry.
Day 5: this produces a minor problem: cash is not involved! The

transaction involves a purchase of goods (as did the Day 3
transaction). Purchases account is therefore debited as an increase in
an expense. But what is credited? The answer is a creditor account for
the supplier of the goods. The credit on their account represents a
liability to them. A liability (or an increase in a liability) is always a credit
entry.
KEY POINT
A liability (or an increase in a liability) is always a credit entry.
Purchases account
(3) Cash 200
(5) Creditor 400
Creditors account
(5) Purchases 400

Day 6: a similar problem now arises. The transaction is a sale (like Day
4), so the sales account, representing all the sales taking place in the
period, is credited as an increase in income.
The debit side of the double entry goes to a debtors account as an

increase in an asset as debtors are assets. They represent amounts
owing to the business, i.e. promises to pay cash at some future date.
Sales account
(4) Cash 300
(6) Debtor 250
Debtors account
(6) Sales 250
The information about only half of the goods being sold does not
concern us at this stage. At the end of the period when the final
accounts (financial statements) are drawn up, account will be taken of
any closing stock (representing unsold goods).
Day 7: The payment of Rs 200 to the trade creditor firstly reduces the
asset cash (a credit) and, secondly, reduces liabilities or amounts
owing (debit to creditors' account).
Cash account
(7) Creditors 200
Creditors account
(7) Cash 200 (5) Purchases 400
Day 8: the receipt of Rs 100 from a debtor increases the asset cash
(debit cash) and reduces the asset debtors (credit debtors).
Cash account
(8) Debtors 100 (7) Creditors 200
Debtors account
(6) Sales 250 (8) Cash 100

Day 9: drawings of cash must clearly be credited to cash as a
decrease in the cash asset. The debit side of the double entry should
be taken to a drawings account as a decrease in capital.
Cash account
(9) Drawings 75
Drawings account
(9) Cash 75
Day 11: the loan represents a receipt of cash (debit cash). But the
business now owes Rs 600 to a third party (i.e. a liability). A loan
account must be credited.
Note that a separate account should be opened for each liability (i.e.
each third party).
Cash account
(11) Loan 600 (9) Drawings 75
Loan account
(11) Cash 75
Days 10 and 12: the payments of rent and insurance represent expenditure.
Cash is credited and the respective expense accounts debited.
Cash account
(10) Rent 40
(12) Insurance 30
Rent account
(10) Cash 75

Insurance account
(12) Cash 30
An expense account collects the costs of the various expenses of

running the business. Expenses of the business are always a debit
entry. These expenses eventually find their way to the profit and loss
account.
KEY POINT
Expenses of the business are always a debit entry.
2.3 Final ledger accounts

The final ledger accounts would appear as follows:
Note: the totals in brackets are there merely for convenience later in
the chapter. They form no part of the double entry.
Capital account
(1) Cash 1,000
Cash account
(10) Rent 40
(12) Insurance 30
(Total Rs (Total Rs 945)
2,000)
Machine account
(2) Cash 400
Purchases account
(3) Cash 200
(5) Creditors 400
(Total Rs 600)
Sales account
(4) Cash 300
(6) Debtors 250
(Total Rs550)

Creditors account (for each supplier)
(2) Cash 200 (5) Purchases 400
Debtors account (for each cusMs.Anumer)

(6) Sales 250 (8) Cash 100
Drawings account
(9) Cash 75
Rent account
(10) Cash 40
Loan account
(11) Cash 600
Insurance account
(12) Cash 30
2.4 Format of ledger accounts
In practice ledger accounts may take many forms depending on the type
of accounting system in operation. Possibilities include hand-written
ledger accounts or accounts produced by ledger-posting machines. In
the latter case the ledger account resembles a bank statement.
Accounts produced by computer are a further possibility, and are by far
the most important in practice. Nevertheless, whichever system is used,
the basic principles of double entry remain unchanged.
2.5 Usefulness of cash
Cash is defined as ‘Anything which is accepted by bank for deposit’. It

includes coins, currency (paper money), cheques, money orders and
money on hand, money deposit in a bank.
Only a combination of experience and thought will provide familiarity with

double-entry techniques. Even experienced accountants occasionally have
to ask which account is credited! It was clear in the previous illustration
how useful cash was in establishing one side of the double entry. If cash
was received, then cash account was debited and it was a question of
deciding what had to be credited. Conversely, a payment of cash involved

a credit to cash account and it was then a question of deciding in which
ledger account the debit was to appear.
3 The trial balance
3.1 Introduction
The large number of transactions recorded in ledger accounts means
that there is the possibility of errors occurring. Periodically some
assurance is required as to the accuracy of the procedures. This can
be done by taking out a trial balance. In the case of a moderate sized
business although final accounts will usually be prepared annually, a
trial balance will be extracted at more frequent intervals (say, monthly).
A trial balance is simply a memorandum listing of all the ledger
account balances. In an accounting context, memorandum means that
the listing is not part of the double entry system. If the double-entry
procedures have been carefully followed, then the trial balance should
show that the total of the debit balances agrees with the total of the
credit balances.
DEFINITION
A trial balance is simply a memorandum listing of all the ledger
account balances.
3.2 Balancing the ledger accounts

Before a trial balance can be drawn up the ledger accounts must be
balanced. Where there are several entries in a ledger account the
computation of the balance of the ledger account to go onto the trial
balance can be shown in the ledger account by carrying down and
bringing down a balance. The procedure is as follows:
Step 1
Add up the total debits and credits in the account and make a
(memorandum) note of the totals.
Step 2
Insert the higher total at the bottom of both the debits and credits,
leaving one line for the inclusion of a balance c/d (carried down). The
totals should be level with each other and underlined.
Step 3
Insert on the side that has the lower arithmetical total, the narrative
‘balance c/d’ and an amount that brings the arithmetical total to the
total that has been inserted under step 2 above.
Step 4
The same figure is shown on the other side of the ledger account but
underneath the totals. This is the balance b/d (brought down). The
balance c/d is known as the closing balance. The balance b/d is
known as the opening balance.
Example

The cash account from the example Hashim is reproduced below:
Cash account
(10) Rent 40
(12) Insurance 30
(Total Rs 2,000) (Total Rs 945)
Step 1
Add up the debits and credits and make a memorandum note of the totals
(shown in brackets).
Step 2
The higher total is inserted, Rs 2,000 on both sides.
Cash account
(10) Rent 40
(12) Insurance 30
_____ ____
2,000 2,000
Note that credits do not yet add up to Rs 2,000.

Step 3 & Step 4
Insert the balances b/d and c/d. The balance can be found from the
arithmetical totals Rs 2,000 – Rs 945 = Rs 1,055.
Cash account
(10) Rent 40
(12) Insurance 30
_____ Balance b/d 1055
2,000 2,000
Balance b/d 1055
The Rs 1,055 is known as a debit balance because the b/d figure is on

the debit side of the account, i.e. the debit entries in the account before
it was totalled must have exceeded the credit entries by that amount.
This balance means that there is Rs 1,055 cash left within the business
at the end of the period and also at the beginning of the next period.

The carrying down of balances causes problems to some students.
However, if the procedure is practised it soon becomes second
nature. It is helpful to have a clear mental picture of the form of a
ledger account when practising examples.
3.3 Drawing up the trial balance

Once the ledger accounts have all been balanced the trial balance can
be drawn up. This is done by listing each of the ledger account names
in the business's books showing against each name the balance on
that account and whether that balance is a debit or a credit balance
brought down. Note that it is the balance brought down which
determines whether the account is said to have a debit or a credit
balance.
Example
Continuing the example of Hashim the trial balance at the end of Day
12 would appear as follows:
Trial balance at the end of Day 12
Account Debit Credit

Rs Rs
Capital 1,000
Cash 1,055
Machine 400
Purchases 600
Sales 550
Creditors 200
Debtors 150
Drawings 75
Rent 40
Loan 600
Insurance 30
2,350 2,350
3.4 Errors
The fact that the two totals agree may be reassuring but it is not final
proof that the accounts are correct, It is possible for certain types of
error to occur and yet the overall effect is that the trial balance still
appears to balance.
Such errors include:
 Errors of omission where no entry of a transaction has been made

at all.
 Errors of commission where an amount has been correctly posted

but to the wrong account, although it is the right type of account,

e.g. A, pays Rs 50 by cheque which is debited to the cash account
and then in error posted to the credit of the account of B Although
there will have been a debit and a credit, nevertheless the account
of B shows a credit balance of Rs 50 higher than it should be, while
the account of A is also Rs 50 out.
DEFINITION
To ‘post’ amounts to a ledger account means to write the amount up in

the ledger accounts.
 Errors of principle. This occurs where an item is incorrectly

classified by the bookkeeper and posted to the wrong type of
account, e.g. the sale of surplus office equipment has been
classified as sales of goods.
 Errors of entry. This occurs where an incorrect amount is posted

to both the accounts in question, e.g. Rs 2.00 is misread as Rs 200
and so entered on both debit and credit sides of the correct
accounts. Some accountants refer to this error as an error of
original entry as it often arises due to the entry originally being
recorded in a daybook at the wrong amount.
 Compensating errors. These occur where two or more errors

cancel out each other. They are difficult to locate and fortunately
tend not to occur frequently.
4 Ledger accounts – further complications
4.1 Introduction
If a business has been in operation for a number of years then at the
beginning of any accounting period it will have assets and liabilities
such as cash, debtors, fixed assets and creditors left over from the
previous period. Such opening amounts are shown in the ledger
accounts as opening balances. Remember that assets are always
debits and therefore the opening balance on an asset account will be a
debit entry and as liabilities are credits the opening balance on liability
accounts will be credit entries.
Example
Bukhari makes up accounts to 31 December each year. The statement
of financial position at 31 December 20X8 showed the following
position:

Rs Rs
Fixed assets:
Freehold shop 17,600
Current assets:
Stock 5,343
Debtors 4,504
Cash 2,801
12,648
Less: Current
liabilities:
Creditors 5,430
7,218
Rs
Net current assets 24,818
Less Long-term
liability:
Loan account 8,000
16,818
Capital account:
Balance at 16,730
1 January 20X8
Net profit for 20X8 4,708
21,438
Drawings 4,620
Balance at 31 16,818
December 20X8
Notes
(a) Debtors consist
of:
Rs
E 2,600
F 987
G 536
H 381
4,504
(b) Creditors consist
of:
Rs
M 2,840
N 1,990
O 600
5,430
The following transactions took place during January 20X9:
3 January G settled their account in full

5 January Paid Rs 847 to N
8 January F returned as faulty, goods with an invoice value of Rs
264 and paid off the balance owing on their account
12 January Sold goods to G on credit, invoice value Rs 706
18 January Purchased goods from P on credit, invoice value Rs 746

19 January E paid their account subject to a discount of 2% for
prompt
payment
24 January Paid O subject to 1.5% discount for early settlement
28 January Bought goods from O on credit with invoice value Rs 203
31 January Returned goods to P, invoice value Rs 76 You are
required to prepare:
(a) Ledger accounts relating to all the above matters.

(b) Trial balance at 31 January 20X9.
Solution
Step 1
Open up all of the ledger accounts that have opening balances.
These are all of the accounts shown in the statement of financial
position at 31 December 20X8.
Capital account
Rs 20X9 Rs
1 Jan Balance b/d 16,818
Note that balance b/d is short for balance brought down from the
previous period. (Last year's ledger account would have shown all the
figures, including drawings of Rs 4,620, leading up to the final balance
of Rs16,818.) Thus the b/d figure records the fact that at the beginning
of the accounting period the credits on the capital account exceed the
debits by Rs 16,818.
Loan account
Rs 20X9 Rs
Freehold shop account

20X9 Rs Rs
Stock account
20X9 Rs Rs
Note: ledger accounts for stock are another special case that will be
discussed in detail later.
Cash account
20X9 Rs Rs

Debtor account - E
20X9 Rs Rs
Debtor account – F
20X9 Rs Rs
1 Jan Balance b/d 987
Debtor account – G
20X9 Rs Rs
Debtor account - H
20X9 Rs Rs
Creditor account – M
Rs 20X9 Rs
Creditor account – N
Rs 20X9 Rs
Creditor account – O
Rs 20X9 Rs
Step 2
Record the transactions for the period in the ledger accounts.
Note: Look carefully at the following items in particular.
8 January
Some of the goods sold to F were faulty so they were returned. When
the sale was originally made the double entry was to credit sales and
debit F's debtor account. When goods are returned the debtor's
account must be credited with the invoice amount of the goods as the
debtor is obviously not going to pay for the goods. The corresponding
debit entry is not to sales but instead to a sales returns or returns
inwards, account. Sales returns are goods returned by a
cusMs.Anumer because they are unsatisfactory.

DEFINITION
Sales returns are goods returned by a customer because they are
unsatisfactory, these are Contra Revenue entries and deducted from
Gross Sales in Income Statement
19 January
When the goods were originally sold to E the terms of the sale were
that if the account was paid by a certain date then they would be
entitled to a 2% discount for prompt payment. This is known as a cash
or settlement discount. E owes Rs 2,600 but the cash that Bukhari will
receive will be Rs 2,548 (98% of Rs2,600). This payment satisfies their
liability in full and therefore their debtor account must be cleared. This
is done by crediting it with Rs 52, the amount of the discount, and
debiting a discount allowed account. The discount allowed is an
expense of the business that will appear in the profit and loss account
as the business is sacrificing Rs 52 in order to receive the money
earlier.
DEFINITION
A cash discount allowed is a discount allowed to a customer if they pay
by a certain date.
24 January
This is an example of a discount received from a supplier. A cash
discount received is a discount received from a supplier if the business
pays its invoices by a certain date. Bukhari owes O Rs 600 but as he
is evidently paying the invoice early Bukhari needs only pay Rs 591
(98.5% of Rs 600). In order to clear the creditor account for O it must
be debited with the Rs 9 of the discount as well as with the cash
payment and the Rs 9 is then credited to a discount received account.
This Rs 9 will appear as income beneath gross profit in the profit and
loss account for the period.
DEFINITION
A cash discount received is a discount received from a supplier if the
business pays its invoices by a certain date.
31 January
This is an example of a purchase return. Purchases returns are goods
returned to a supplier because they are unsatisfactory. Goods
purchased from P are being returned and therefore P's creditor account
will be debited as the goods will not be paid for. The credit entry is to a
purchases returns, or returns outwards, account.
DEFINITION
Purchases returns are goods returned to a supplier because they are
unsatisfactory, these are Contra Cost accounts and are deducted from
Gross Purchases in Income Statement in Cost of Goods Sold

Cash account
20X9 Rs 20X9 Rs
1 Jan Balance b/d 2,801 5 Jan N 847
3 Jan G 536 24 Jan O 591
8 Jan F 723
19 Jan E 2,548 31 Jan Balance c/d 5,170
6,608 6,608
Balance b/d 5,170
Sales account
Rs 20X9 Rs
12 Jan G 706
Sales returns account

Rs 20X9 Rs
8 Jan F 264
Purchases account
20X9 Rs Rs
16 Jan P 746
28 Jan O 203 Balance 949
949 c/d 949
Balance b/d 949
Purchases returns account

Rs 20X9 Rs
31 Jan P 76
Discount allowed account

20X9 Rs Rs
19 Jan E 52
Discount recieved account

Rs 20X9 Rs
24 Jan O 9
E’s account
20X9 Rs 20X9 Rs
1 Jan Balance b/d 2,600 19 Jan 2,548
Cash (98%
(Rs2,600)
_____ Discount allowed 52
2,600 2,600

F’s account
20X9 Rs 20X9 Rs
1 Jan Balance b/d 987 8 Jan Sales return 264
____ Cash 723
987 987
G’s account
20X9 Rs 20X9 Rs
1 Jan Balance b/d 536 3 Jan Cash 536
12 Jan Sales 706 31 Jan 706
Balance b/d
1,242 1,242
Balance b/d 706
H’s account
20X9 Rs Rs
M’s account
Rs 20X9 Rs
N’s account
20X9 Rs 20X9 Rs
5 Jan Cash 847 1 Jan Balance b/d 1,990
31 Jan 1,143
Balance b/d
1,990 1,990
Balance b/d 1,143
O’s account
20X9 Rs 20X9 Rs
24 Jan 591 1 Jan Balance b/d 600
Cash (98%
(Rs600)
Discount received 9 28 Jan 203
Purchases
31 Jan 203
Balance b/d
803 803
Balance b/d 203

P’s account
20X9 Rs 20X9 Rs
28 Jan 76 18 Jan 746
Purchase Purchases
returns
31 Jan 670 28 Jan
Balance b/d Purchases
746 746
Balance b/d 670
Step 3
Balance off all of the accounts where necessary (see above).
Step 4
Prepare the trial balance.
Trial balance at 31 January 20X9

Rs Rs
(1) Capital 16,818
(2) Loan 8,000
(3) Freehold shop 17,600
(4) Stock 5,343
(5) Cash 5,170
(6) Sales 706
(7) Sales returns 264
(8) Purchases 949
(9) Purchases returns 76
(10) Discount allowed 52
(11) Discount received 9
(12) E –
(13) F –
(14) G 706
(15) H 381
(16) M 2,840
(17) N 1,143
(18) O 203
(19) P _____ 670
30,465 30,465
Summary
This has been a chapter in which you should have grasped the basics
of double-entry bookkeeping.
The key point is that every transaction or event has two effects on the
accounting of the business and that one of these effects is recorded as
a DEBIT entry in a ledger account and the other is recorded as a
CREDIT entry in a ledger account.

There are a number of helpful rules that can be learnt in order to assist
in finding the correct accounts to debit and credit for each transaction
but the key to double-entry bookkeeping is practice at writing up ledger
accounts.
Having completed your study of this chapter you should have achieved
the following learning outcomes.
 Prepare nominal ledger accounts; prepare journal entries;

prepare a trial balance.
 Explain the nature of errors and to be able to make accounting
entries for them.
Self-test questions
Ledger accounts
1 If cash is received by the business is that a debit or a credit
entry in the cash account? (2.2)
2 Are liabilities debit or credit entries in the liability accounts? (2.2)
3 Is an expense recorded as a debit or a credit entry in the
expense account? (2.2)
The trial balance

4 What is a trial balance? (3.1)
5 What is meant by the balance b/d on a ledger account? (3.2)
6 What is an error of commission? (3.4)
Ledger accounts – further complications

7 What is a return outwards? (4.1)
8 What is a cash discount allowed? (4.1)
9 What is the double entry for a discount received? (4.1)
10 What is the double entry for a sales return? (4.1)

1 Which of the following statements is correct?
A A debit is an increase in an asset and an increase in income
B A debit is a decrease in a liability and an increase in capital
C A debit is an increase in an expense and an increase in a
liability
D A debit is a decrease in capital and a decrease in income
2 Samina set up her business with Rs 1,000. She purchased a delivery

van for Rs 300 cash and stock for Rs 250 on credit. She received cash
of Rs 200 for her first sales and also had debtors owing her Rs 400.
Her sundry expenses amounted to Rs 50.

She paid for the stock in full less a 2% early settlement discount. After
these transactions took place, what is the closing balance on the cash
account?
A Rs 870
B Rs 655
C Rs 650
D Rs 605
3 Amir has a business that sells machine s. Which of the following should
be classified as a fixed asset?
A A machine displayed on the forecourt
B The balance on his business bank account
C A computer used in the office
D A trade debtor
4 Zain bought some machinery for Rs 10,000. The supplier offered a
discount of Rs 1,000 if payment was made within 2 weeks. Zain paid
Rs 9,000 but his payment was too late and he missed the early
payment discount. What are the correct entries to reflect this
transaction?
A DR Fixed assets Rs 10,000
CR Creditors Rs 1,000
CR Cash Rs 9,000
B DR Fixed assets Rs 10,000
CR Cash Rs 10,000
C DR Fixed assets Rs 9,000
DR Discount received Rs 1,000
CR Cash Rs 9,000
D DR Fixed assets Rs 9,000
5 Which of the following transactions would decrease both assets and

liabilities?
A A machine purchased for cash

B Payment of cash to a creditor
C Purchase of fixtures on credit
D Receipt of cash from a debtor
Answers to MCQs
1 D
2 D
3 C
4 A
5 B

 identify the main data sources and records in an accounting system
 describe the contents and purpose of different types of business
documentation
 Illustrate and describe different day books
 post day book totals to the ledger accounts
 explain the nature and purpose of control accounts for the accounts
receivable and accounts payable ledgers

1 Business documentation
1.1 The table below summarises the main types of business

documentation and sources of data for an accounting system,
together with their content and purpose.
Details Issue By/Sent to
Purchase Details of supplier, e.g. name Issued by supplier as request
invoice and address. for payment. Cross checked
Contains details of goods, with delivery note, and
e.g. quantity, price, value,
sales tax, terms of credit, purchase order. Statement
etc.
Statement Details of supplier, e.g. Issued by the supplier.
name and address. Has Checked with other
details of date, invoice documents to ensure that the
numbers and values, amount owing is correct.
payments made, refunds,
Credit note amount owing.
Details of supplier, e.g. Issued by the supplier.
name and address. Checked with documents
Contains details of goods regarding goods returned.
returned, e.g. quantity,
price, value, sales tax,
terms of credit, etc.
Debit note Details of the supplier. Issued by the company
Contains details of goods receiving the goods. Cross
returned, e.g. quantity,
referred to the credit note
price, value, sales tax,
terms of credit, etc. issued by the supplier.
Remittance Method of payment, invoice Sent to supplier with, or as

advice number, account number, notification of, payment.
date, etc.
Receipt Details of payment received. Issued by the selling
company indicating the
payment received.
Goods Details of goods received Issued by the recepient
Received from the supplier e.g company acknowledging
Note quantityand type of goods receipt of goods
received

2 Accounting records
DATA SOURCES
BOOKS OF PRIME ENTRY
LEDGER ACCOUNTS
TRIAL BALANCE
FINANCIAL STATEMENT
2.1 Books of prime entry
If ledgers were updated each time a transaction occurred, the ledger

accounts would quickly become cluttered and errors might be made.
To avoid this, all transactions are initially recorded in a book of prime
entry.
Several books of prime entry exist, each recording a different type of

transaction:
Book of prime entry Transaction type

Sales day book/Journal Credit sales
Purchases day book/Journal Credit purchases
Sales returns day book/Journal Returns of goods sold on credit
Purchases returns day Returns of goods bought on credit
book/Journal
Cash book All bank transactions
Petty cash book All small cash transactions
The General journal All transactions not recorded
elsewhere

- Entry of a transaction to a book of prime entry does not record the
double entry, except for the general journal, required for that
transaction.
- The book of prime entry is, however, the source for double entries to
the ledger accounts.
- The double entry arising from the book of prime entry will be recorded
periodically (daily, weekly, monthly) depending on the volume of
transactions.
3 Ledger accounts and the division of the ledger

3.1 In a manual system, ledgers can be thought of as books
containing the individual accounts:
- The general ledger/ nominal ledger contains all accounts or a

summary of all accounts necessary to produce the trial balance and
financial statements.
- The accounts receivable ledger contains an account for each credit
customer to show how much each one owes.
- An account to summarise this information, the receivables control
account, is normally contained within the general ledger.
- The accounts payable ledger contains an account for each credit
supplier to show how much they are owed.
- An account to summarise this information, the payables control
account, is normally contained within the general ledger.
Where there are individual accounts in a receivables or payables
ledger AND a control account in the general ledger, only one can form
part of the double entry system. The other exists for memorandum
purposes. It is normally the case that the control accounts form part of
the double entry.
4 Use of control accounts
4.1 Control account is a ledger account which collects the sum of the
postings into the individual accounts which it controls.
The sales ledger control account and purchase ledger control

account are ledger accounts that summarise all the debtors and
creditors transactions respectively. The use of these control
accounts means that we can:
- remove the individual debtors and creditors accounts from the

nominal ledger, although still maintaining them in similar form
- keep control over these accounts by maintaining an overall
debtors and creditors account in the nominal ledger.
DEFINITION
Control accounts, most notably debtors and creditors control accounts,
are ledger accounts that summarise a large number of transactions.

A control account is defined as a ledger account which collects the
sum of the postings into the individual accounts which it controls.
4.2 Sales ledger and sales ledger control account

The individual debtor accounts are kept outside the nominal ledger in a
sales ledger or debtors ledger. It is essential to remember that the
debtors accounts are still kept on an individual basis within the sales
ledger as the business needs a record of the individual debts owed to it
by customers. The use of a sales ledger control account however
means that the individual accounts are no longer part of the double
entry.
4.3 Purchase ledger and purchase ledger control account
The ledger in which the individual creditor accounts are kept is

alternatively known as the purchases ledger, the creditors ledger or the
bought ledger. The purchase ledger control account is a summary of
these individual creditor accounts.
5 Purchases day book
5.1 Purpose
The purchases day book is used to summarise the purchases made by

a business, and will list the invoices received.
This book is not part of the double entry. It is summarised periodically,

and the totals posted to the relevant accounts in the nominal ledger
(including the purchase ledger control account) and the creditors ledger
(which has now been removed from the double-entry system).
The creditors ledger is the ledger that contains the personal accounts
of the individual creditors. It is also known as the purchases ledger or
bought ledger.
Note in the example that follows that the purchases day book deals
with all types of purchases by a business – goods for resale, raw
materials to be processed into goods for sale, and expenses of running
the business. It therefore deals with items that will eventually find their
way into either the purchases account or the various expense
accounts. For this reason each different type of expense is analysed
into a separate column.
Example
During February 20X9 the purchases day book of a company appears
as follows:

Date Suplier Total Sale Purcha Lighting Repairs Tele Sundry
Leger ref. s ses & and phone Expen
Tax heating mainte ses
nance
Rs Rs Rs Rs Rs Rs Rs
5 Feb Telecom B1 188 28 160
8 Feb Zaffar S13 94 14 80
11 Feb Sunrise O17 211 31 180
14 Feb Elecricity E12 138 138
18 Feb Pink Ltd W4 23 3 20
21 Feb White Ltd G7 117 17 100
23 Feb Ahmad B13 164 24 140
25 Feb Black Ltd M1 47 7 40
982 124 500 138 40 160 20
Record the transactions in the appropriate ledgers.
Solution
(a) In the nominal ledger

The total of the invoices is posted to the purchase ledger control account as
this is the amount due to the creditors.
Sales Tax
20X9 Rs 20X9 Rs
Feb Purchases day book 124
Purchase ledger control

20X9 Rs 20X9 Rs
Feb Purchases day 982
book
Purchases
20X9 Rs 20X9 Rs
Lighting and heating

20X9 Rs 20X9 Rs
Repairs and maintenance

20X9 Rs 20X9 Rs
Telephone
20X9 Rs 20X9 Rs

Sundry expenses
20X9 Rs 20X9 Rs
These entries preserve double entry, the total debits equalling the total
credits.
(b) In the creditors ledger
This does not form part of the double entry.
Telecom (B1)
20X9 Rs 20X9 Rs
Ahmad (B13)
20X9 Rs 20X9 Rs
Electricity (E12)
20X9 Rs 20X9 Rs
White Ltd(G7)
20X9 Rs 20X9 Rs
Black Ltd (M1)
20X9 Rs 20X9 Rs
Sunrise (O17)
20X9 Rs 20X9 Rs
Zaffar (S13)
20X9 Rs 20X9 Rs
Pink Ltd (W4)

20X9 Rs 20X9 Rs
The total of these entries equals the credit entry in the purchase ledger
control account – a fact which will prove significant when we come on
to consider the reconciliation between the purchase ledger control
account and the list of balances (creditors ledger). This must be the
case as the entry in the purchase ledger control account was simply
the total amount owed to the creditors.

6 Other day books
6.1 Summary of treatment
The sales day book and the sales and purchases returns day books work in
similar fashion.
The use of all the day books is shown in summary in the following table.
Transaction Nominal ledger Creditors or debtors

Day book
dealt with
Debit Credit ledger
PURCHASES Invoices for e.g. Purchase ledger Entered on supplier’s
goods or purchases, control account personal account on
services lighting individual basis
purchased and
from suppliers heating,
SALES Invoices for Sales
telephone, e.g. sales, Entered on
goods to ledger
etc. sundry income, customer’s personal
customers control rental income account on individual
account basis
PURCHASES Credit notes Purchase Purchases Entered on supplier’s
RETURNS for goods ledger returns account on ‘debit’
returned to control side on individual
suppliers account basis
SALES Credit notes Sales Sales ledger Entered on
RETURNS for goods returns control account customer’s personal
returned by account on ‘credit’
customers side on individual
basis
For example, a sales day book may have headings as follows:
Date Customer Ledger ref Total Sales Tax Sales Sundry

income
6.2 Contras
On occasion there may be a set-off between accounts in the debtors ledger

and the creditors ledger. For instance, suppose a business both buys goods
from and sells goods to Hamalays. If at one time the creditors ledger shows
that the business owes Himalayas Rs 75 and the debtors ledger shows that
Himalayas owe Rs 50, there are two possible methods of approach:
- the business pays Himalayas Rs 75 and he pays the business Rs 50

- the business agrees with Himalayas to pay him Rs 25 and contra the
Rs 50 owing to it in the debtors ledger with Rs 50 of the Rs 75 owing to
them in the creditors ledger.
If the latter course is adopted the transactions should be recorded as follows:

(a) In the nominal ledger
Purchases ledger control
20X9 Rs 20X9 Rs
Sales ledger control account 50
Sales ledger control

20X9 Rs 20X9 Rs
Purchase ledger control account 50
Notice how the double entry is preserved.

(b) In the creditors ledger (also known as the purchases ledger)
Himalayas (T26)
20X9 Rs 20X9 Rs
Sales ledger contra 50 Balanced c/d 75
Balanced c/d 25 __
75 75
(c) In the debtors ledger (also known as the sales ledger)
Himalayas (T17)
20X9 Rs 20X9 Rs
Balanced c/d 50 Sales ledger contra 50
__
KEY POINT
If an amount is both owed to and from the same person it can be
removed by a debit to the purchase ledger control account and a credit
to the sales ledger control account. Such transactions must also be
mirrored in the purchase ledger and sales ledger.
The creditors ledger account now correctly shows the fact that we have
agreed to pay Himalayas only Rs 25 as a result of the contra
agreement. Clearly Himalayas themselves will make equivalent
adjustments in their own books.
7 The cash book
7.1 Introduction
The name 'cash book' is something of a misnomer, because the book

is used to summarise an organisation's bank transactions, a company's
transactions in cash being dealt with (in normal circumstances) through
the petty cash book (see later in the chapter).

Many enterprises have two distinct cash books - a cash payments
book and a cash receipts book, and this is the situation that will be
assumed here. Alternative names for the above books are to refer to
them as journals, e.g. a cash book is sometimes referred to as a cash
journal. The meaning of the word 'journal' in this context is a daily
record of transactions.
7.2 Cash payments book
In this book details will be given of all cheque payments made. The
book, which may or may not be part of the double entry, will be
summarised periodically, and the totals posted to the relevant accounts
in the nominal ledger.
The individual amounts are posted to the individual creditor accounts

within the creditors ledger. In some businesses the cash book is a day
book and part of the double entry. In this situation the bank column in
the example below forms the credit entry and the totals in the other
columns (except discount received) represent the debits to be posted
to the various accounts in the nominal ledger, e.g. Rs 357 to the
purchase ledger control account. In other businesses the cash book is
not part of the double entry. In this situation the total in the bank
column will become a credit entry in the bank account within the
nominal ledger.
Example
The following transactions are recorded in the cash payments book of

a company during February 20X9:
Purchase Sundr
Ledg Sale
Discount ledger Petty y
Date Detail No Cheque er Bank s Wages
received control cash expre
Ref. Tax
account ss
Rs Rs Rs Rs Rs Rs Rs Rs
2 Feb Wages 124507 - 1,052 1,052
5 Feb Zaffar 124508 S13 58 1 58
9 Feb Zaras 124509 - 141 21 120
16 Feb Cash 124510 - 150 150
23 Feb Green Ltd 124511 G7 80 6 80
24 Feb Sunrise 124512 G17 100 100
27 Feb Ahmad 124513 B13 119 2 119
1,700 21 9 357 1,052 150 120
Let's see how to record the above transactions in the relevant ledger
accounts.
7.3 Discounts
Before considering the double-entry bookkeeping procedures here it is

worth mentioning the discounts received column.

(a) It does not represent an amount paid in the period. The total of Rs
1,700 is made up of the analysed column totals excluding discount
received:
Rs
Sales Tax 21
Purchase ledger control 357
Wages 1,052
Petty cash 150
Sundry expenses 120
1,700
(b) It is included in the cash payments book to show whether any cash
discount has been taken for prompt payment and to facilitate its
recording in both the nominal ledger and the creditors ledger.
Note that only cash (prompt payment) discounts will be included

here, and not trade discounts. The distinction and different
treatments are explained by the following table:
Term Relates to Bookkeeping implications

Cash discount Discount for payment (i) Purchases are debited
before a stated date with the full invoice price
(ii) On payment of the
creditor, the difference
between cash paid and the
full invoice
price of the invoice paid
represents the cash
discount
Trade Favourable price for Purchases are recorded at
discount people in the same trade price (the lower price
trade involved). The amount of
the deduction
does not appear in the
ledger
accounts.
7.4 Sales Tax
Certain payments made through the cash book may involve Sales
Tax– sundry expenses above include a cash payment on which tax is
reclaimable. As regards purchase ledger payments Sales Tax is dealt
with in the purchases day book whilst the payment of wages and the
withdrawal of cash are not supplies and have no tax involved.

Solution
Returning to the example, at the end of February the transactions are
recorded as follows (it is assumed the cash book is not part of double
entry):
In the nominal ledger
SALES TAX
20X9 Rs 20X9 Rs
Feb Cash book 21
Bank
20X9 Rs 20X9 Rs
Feb Cash book 1,700
Discount received
20X9 Rs 20X9 Rs
Feb Cash book 9

20X9 Rs 20X9 Rs
Feb Cash book discount 9
Cash book 357
KEY POINT
The basic postings from the cash payments book are a credit to the
bank account and debits to purchase ledger control and expense
accounts.
Wages
20X9 Rs 20X9 Rs
Feb Cash book 1,052
Petty cash
20X9 Rs 20X9 Rs
Feb Cash book 150
Sundry expenses
20X9 Rs 20X9 Rs
Feb Cash book 120
Note: the discount is debited to purchase ledger control account

(reducing the amount owed to creditors) and credited to discount
received.

7.5 Cash receipts book
In this book details will be given of all items banked. The book, which
like the cash payments book may or may not be part of the double
entry, will be summarised periodically and the totals posted to the
relevant accounts in the nominal ledger, and the sales ledger (which
has been removed from the double- entry system).
KEY POINT
The postings from the cash receipts book are to debit the bank account
with the total and credit sales ledger control and income accounts.
Example
The following receipts are recorded in the cash receipts book of a company
during February 20X9:
Sales
Ledge Sales Discount ledger Cash Rental Sundry
Date Supplier Bank
r Ref. Tax allowed control sales Income Income
account
Rs Rs Rs Rs Rs Rs Rs Rs
2 Feb Cash 164 24 140
sales
5 Feb B. Ltd. B7 75 5 75
9 Feb C. Ltd. 5 5
16 Feb Cash 117 17 100
sales
23 Feb Brown B 16 1 16
Ltd.
24 Feb Hire-it 94 14 80
plc
27 Feb Z Ltd. P 5 5
476 55 6 96 240 80
The postings from the cash receipts book are to debit the bank account with
the total and credit sales ledger control and income accounts.
7.6 Discounts
Once again the treatment of discounts merits close scrutiny. The

discounts allowed column does not represent an amount received in
the period, but is included in the cash receipts book to show whether
any discount has been allowed and to facilitate its recording in both the
nominal ledger and the debtors ledger.
7.7 SALES TAX
Certain receipts may involve accounts for Sales Tax. On this occasion
it is assumed that the cash sales and rental income involve chargeable
supplies and that the sundry income does not. As regards sales ledger

receipts, Sales Tax is dealt with in the sales day book, i.e. it is
accounted for when an invoice is issued.
8 Sales Tax and discounts
8.1 Explanation
When a trader who is registered for Sales Tax issues an invoice and
offers a cash discount in the invoice, the amount of Sales Tax charged
on the invoice is calculated as if the customer will take advantage of
the cash discount. The amount of Sales Tax will not be changed even if
the customer does not take advantage of the discount.
Example
Black sells goods to Blue priced at Rs 1,000 plus Sales Tax. They offer
a 2% cash discount if the invoice is paid within 30 days. The invoice
would show:
Rs
Goods 1,000.00
Sales Tax 156.80
1,156.80
Sales Tax @ 16% x (98% x Rs1,000) = Rs 156.80.

Black would account for the transaction in their sales day book.
Date Customer Total Sales Tax Sales
Blue 1,156.80 156.80 1,000
If Blue takes advantage of the cash discount, the amount of Sales Tax they
pay remains at Rs 156.80. Blue calculates their discount on the Sales Tax
exclusive price,
i.e. 2% - Rs 1,000 = Rs 20.
Black would account for the cheque receipt in their cash book:
Discount
Date Customer Bank Sales Tax
allowed
Blue 1,136.80 20
Note that the sales tax column in the cash book is only relevant if a cash sale
has been made.
9 Petty cash accounting
9.1 Purpose of a petty cash system
The petty cash system is designed to deal with sundry small payments
in cash made by a business, e.g. paying the milkman, purchasing
biscuits, buying stationery or reimbursing travelling expenses.

9.2 Imprest system for petty cash
The best way of dealing with petty cash is by means of an imprest

system, which works as follows:
Step 1
To initiate the system, a round sum cheque is drawn. This will be dealt
with through the cash payments book, the eventual debit being to petty
cash and the credit to bank. This round sum amount will be referred to
as the ‘petty cash float’ or imprest amount.
Step 2
When a petty cash payment is made, a petty cash voucher is
completed, to which is attached any receipt or bill, in support of the
payment.
Step 3
At the end of the week or month a cheque is drawn to return the petty
cash to the exact amount of the original float. At this stage the
vouchers should be produced by the petty cashier to the cheque
signatory that will exactly equal the cheque required.
Step 4
The vouchers are used to record the payments in the petty cash book,
which is not part of the double-entry system. Alternatively, a petty cash
statement can be produced. Either of these is used to post to the
nominal ledger. This aspect of control is the essential feature of the
petty cash system. At any stage the float should be represented in the
petty cash box by the actual cash therein, plus any vouchers in support
of payments made since the last reimbursement.
Example
On 1 March 20X9 a petty cash float of Rs 100 is introduced by

Diamond Ltd. During March the following payments are made out of
petty cash:
Rs
2 March Biscuits 10.00
8 March Stationery 23.03 (includes Rs 3.43 Sales Tax)
11 March Bus fare 3.00
16 March Train fare 5.00
25 March Stationery 45.12 (includes Rs 6.72 Sales Tax)
On 1 April the cash is reimbursed. Write up the petty cash book for the
month.

Solution
Sales Sundry Travelling

Received Date Details Voucher Total Stationary
tax Expenses expenses
Rs. Rs Rs Rs Rs Rs
100.00 1 Mar Cash Book
2 Mar Biscuits 1 10.00 10.00
8 Mar Stationery 2 23.03 3.43 19.60
11 Mar Bus fares 3 3.00 3.00
16 Mar British Rail 4 5.00 5.00
25 Mar Stationery 5 45.12 6.72 38.40

86.15 10.15 58.00 10.00 8.00
(86.15)
13.85
86.15 1 Apr Cash book
100.00
9.3 Writing up the ledger accounts
No double-entry bookkeeping entries are made from the receipts side

of the petty cash book or statement - in a good system the only receipt
should be the reimbursement of the float and the double entry thereof
is dealt with in the posting of the cash payments book. The withdrawal
of cash does not involve Sales Tax.
As regards the payments, the double entry in the nominal ledger is
performed as follows:
SALES TAX
20X9 Rs 20X9 Rs
Mar Petty cash book 10.15
Petty Cash
20X9 Rs 20X9 Rs
Stationery
20X9 Rs 20X9 Rs

Sundry expenses
20X9 Rs 20X9 Rs
Travelling expenses
20X9 Rs 20X9 Rs
Some of the payments made through petty cash may involve Sales Tax –
stationery in this instance. Biscuits, bus and rail fares are zero rated and
hence no Sales Tax is involved.
10 The General Journal
10.1 The journal is a book of prime entry which records transactions

which are not routine (and not recorded in any other book of
prime entry), for example:
- year-end adjustments
- depreciation charge for the year
- irrecoverable debt write-off
- record movement in allowance for receivables
- accruals and prepayments
- closing inventory
- acquisitions and disposals of non-current assets
- opening balances for statement of financial position items
- correction of errors.
The journal is a clear and comprehensible way of setting out a

bookkeeping double entry that is to be made.
10.2 Presentation of a journal
A journal should be laid out in the following way:

Dr Non-current asset X
Cr Cash X
to record the purchase of a new non-current asset.
A brief narrative should be given to explain the entry.
Summary
In this chapter the operation of the system of books of prime entry or

day books has been studied. These are simply ways of summarising
the money transactions of a business at suitable points in time and
then posting these summaries to the relevant accounts in the nominal
ledger.
Allied to this system is the system of sales and purchase ledger control
accounts. These control accounts appear in the nominal ledger and
contain a summary of the transactions with debtors and creditors taken

from the books of prime entry. The individual accounts for each debtor
are held in the sales ledger and for each creditor in the purchase
ledger. The sales and purchase ledgers are for information purposes
only, they are not part of the double-entry system.
 Prepare cash and bank accounts; prepare bank reconciliation

statements
 Prepare petty cash statements under an imprest system
 Prepare accounts for sales and purchases including personal
accounts and control accounts
 Prepare nominal ledger accounts; prepare journal entries; prepare
a trial balance
Self-test questions
Ledgers and books of prime entry

1 What is a book of prime entry? (2.1)
2 What is a control account? (4.1)
3 What is the sales ledger? (4.2)
Purchases day book
4 What is the purchases day book? (5.1)
Other day books

5 What documents are used to write up the sales returns book?
(6.1)
6 What situation might cause a contra entry to take place? (6.2)
The cash book

7 Where is the total from the discount received column in the cash
payments book posted to? (7.3)
8 What is the difference between a cash discount and a trade
discount? (7.3)
Sales Tax and discounts

9 If a cash discount is offered how is the Sales Tax calculated? (8.1)
Petty cash accounting

10 What is the imprest system? (9.2)
Mutiple Choice Questions
1 Which of the following is not a book of prime entry:

A Cash book
B Journal
C Nominal ledger
D Sales day book

2 Discounts allowed to customers who pay in a given time period are:
A Trade discounts
B Bulk buying discounts
C Discount received
D Settlement discounts
3 Settlement discounts are recorded:

A In the sales day book
B In a memorandum column in the cash book
C In the purchase day book
D In the petty cash book as a sundry expense
4 Entries in the nominal ledger from the books of prime entry are:
A At total level
B At individual transaction level
C Not recorded at all
D Do not follow double entry
5 Large cash purchases of goods for resale are recorded in:

A The petty cash book
B Cash book
C Purchase day book
D Sales day book
Answerws to MCQs
1 C
2 D
3 B
4 A
5 B

 Explain the general principles of the operation of a sales tax

 Calculate sales tax on transactions correctly enter sales tax on sales and
purchases into the ledger accounts.

1 Principles of Sales Tax
1.1 Basic background
Sales Tax is a tax on consumer expenditure collected on business

transactions and imports. Sales Tax on inputs may be reclaimed or set
against output Sales Tax collected.
A typical trader registered for Sales Tax acts as an (unpaid) collection

agent for the government. Simply explained the position is that:
 there is Sales Tax on purchases (known as input tax)
 Sales Tax is charged on sales (known as output tax)
 if the output tax exceeds the input tax the excess is payable to the
government
 if the input tax exceeds the output tax the excess is repayable by
Government
1.2 Rate of SALES TAX and calculation thereof
The standard rate is 16% at present that can vary for different kind of
products. This means 16% is added to the cost of purchases
representing input Sales Tax, and 16% is added to the selling price of
goods sold representing output Sales Tax.
Example
A trader purchases goods for Rs 15,000 (net of Sales Tax) and sells
goods for Rs 20,000 (net of Sales Tax). Calculate the amount of Sales
Tax ultimately payable to Taxation Authorities
Solution
Rs
Output tax:
Sales (net of Sales Tax) 20,000
Sales Tax (16%) 3,200
Input tax:
Purchases (net of Sales Tax) 15,000
Sales Tax (16%) 2,400
Payable to Taxation Authorities:
Output tax – Input tax Rs(3,200 – 800
2,400)
You should also note that similar calculations can be performed if you
are given the gross sales and purchases figures. In this case the
calculation should be performed by calculating Sales Tax as 16/116 of
sales.

The fraction 16/116 is derived by making the Sales Tax rate the
numerator and 100 plus the Sales Tax rate the denominator.
2 Bookkeeping entries for Sales Tax
2.1 Introduction
The usual bookkeeping entries for purchases and sales are only
slightly amended by Sales Tax, the main addition being the introduction
of a Sales Tax account, which is quite simply a debtor or creditor
account with Taxation Authorities.
2.2 Sales Tax suffered on purchases

Debit Credit With
Purchases account Cost excluding SALES
SALES TAX SALES TAX
TAX account Individual creditor or cash a/c Cost including SALES
TAX
The purchases account does not include Sales Tax because the Sales Tax is
not an expense – it will be recovered. The creditor’s account does include
Sales Tax, as the creditor must be paid the full amount due.
2.3 Sales Tax charged on sales

Debit Credit With
Individual debtor or cash Sales price including
a/c Sales Tax
Sales account Sales price excluding
Sales Tax
Sales Tax account Sales Tax
The sales account does not include Sales Tax because Sales Tax is not
income – it will have to be paid to Taxation authorities. The debtor’s account
does include Sales Tax, as the debtor must pay the full amount due.
2.4 Payment to Taxation Authorities

Debit Credit With
SALES Cash account Amount owing
TAX account
If output tax exceeds input tax, a payment must be made to Taxation

Authorities.
KEY POINT
It is the purchase and sale of goods which give rise to entries in the
SALES TAX account, not the payments or receipts to or from creditors
and debtors.

2.5 Receipts from Taxation Authorities
Debit Credit With
Cash account Sales Tax account Amount received
If input tax exceeds output tax, there will be a receipt from Taxation
Authorities
Example
J Ltd purchases goods on credit for Rs 15,000 (net of Sales Tax) and
sells goods for Rs 20,000 (net of Sales Tax). At the end of his
accounting period it paid the amount of Sales Tax owing to Taxation
Authorities, whilst it has paid his creditors Rs 8,000 and his debtors
have paid him Rs 6,000. Write up the ledger accounts for the period.
KEY POINT
SALES TAX account, not the payments or receipts to or from creditors
and debtors.
Solution
Purchases
Rs Rs
Creditors 15,000 Trading and profit and 15,000
loss
Creditors
Rs Rs
Cash 8,000 Purchases 15,000
Balance c/d 9,400 Sales Tax 2,400
17,400 17,400
Balance b/d 9,400
Sales
Rs Rs
Trading and profit and loss 20,000 Debtors 20,000
Debtors
Rs Rs
Sales 20,000 Cash 6,000
Sales Tax 3,200 Balance c/d 17,200
23,200 23,200
Balance c/d 17,200
Sales Tax
Rs Rs
Creditors 2,400 Debtors 3,200
Cash 800
3,200 3,200

Sales Tax account, not the payments or receipts to or from creditors
and debtors.
Example
Ms. Sara provides you with the following information as regards the last
quarter of her financial year:
Rs
Taxable inputs 239,042
Taxable outputs 334,828
Both figures include Sales Tax at 16%. During this period she paid Rs
8,450 in settlement of the previous return. Draft the Sales Tax account
to record these transactions.
Sales Tax
Rs Rs
16 Balance c/d
Creditor ( x 239,042) 32,971 8,450
116
16
Cash 8,450 Debtors ( x 334,828) 46,183
116
Balance c/d 13,212 23,200
54,633 54,633
Balance c/d 13,212
Note: there is an opening credit balance on the account of Rs 8,450 as

this is the opening amount owing to Taxation Authorities. A debit
balance on the Sales Tax account would be shown as a debtor and a
credit balance as a creditor in the balance sheet.
3 Standard rated, zero rated and exempt supplies

3.1 Standard rated supplies
It has been assumed in the examples above that all the traders trade in
standard rated items. In this case they are charged Sales Tax on their
purchases and charge Sales Tax on their sales.Consequently Sales
Tax should have no effect on their profit and loss account, any balance
on Sales Tax account representing the amount payable to or
receivable from Taxation Authorities.
3.2 Zero rated supplies

Traders in zero rated supplies charge Sales Tax at 0% on their sales.
As they are making taxable supplies they can thus recover Sales Tax
suffered on their purchases. Once again Sales Tax should have no
effect on their profit and loss account, any balance on Sales Tax
representing the amount receivable from Taxation Authorities

Example
C Ltd makes zero-rated supplies. In his first month’s trading his sales
amounted to Rs 17,000, whilst Sales Tax suffered on his expenses
amounted to Rs 350.
During the month he was paid Rs 10,000 by his debtors, whilst no
receipts were received from Taxation Authorities. Write the relevant
ledger accounts for the month.
Solution
Sales
Rs Rs
Debtors
Rs Rs
Sales 17,000 Cash 10,000
______ Balance c/d 7,000
17,000 17,000
Balance c/d 7,000
Sales Tax
Rs Rs
Creditors 350 Balance c/d 350
Balance c/d 350
The Rs 350 balance on Sales Tax account is a current asset shown as a

debtor.
3.3 Exempt supplies

Traders in exempt supplies do not charge Sales Tax on their sales but
are not allowed (unlike the zero rated situation) to recover Sales Tax
on their purchases. In such cases the irrecoverable Sales Tax will be
added to the trader's costs, and there will be no Sales Tax account.
Example
Ms. Tabassum makes exempt supplies. In her first month's trading her
sales amounted to Rs 17,000, whilst her purchases totalled Rs 11,000
including Sales Tax of Rs 700. During the month she was paid Rs
10,000 by her debtors, whilst she paid her creditors Rs 6,000. Write up
the relevant ledger accounts.
Solution
Sales
Rs Rs

Debtors
Rs Rs
Sales 17,000 Cash 10,000
Balance c/d 7,000
17,000 17,000
Balance c/d 7,000
Purchases
Rs Rs
Creditors 11,000 Trading and 11,000
profit and loss
Creditors
Rs Rs
Cash 6,000 Purchases 11,000
Balance c/d 5,000
11,000 11,000
Balance c/d 5,000
Note in this instance the total absence of a Sales Tax account, the
Sales Tax suffered simply being included in the cost of purchases.
3.4 Sales Tax on motor vehicles

The Sales Tax payable on the purchase of a new motor vehicle is not
recoverable and would not be posted to the Sales Tax account. The
gross amount, inclusive of Sales Tax, paid for the vehicle is posted to
the fixed asset account. In contrast, Sales Tax on the purchase of plant
and machinery is recoverable, and the Sales Tax would be posted to
the Sales Tax account, the net value being posted to the plant account.
Summary
Sales tax is a much more complex topic than the previous sections
might appear to indicate. At this stage, however, you are required to
understand only the bookkeeping implications.
The key point to note is that the Sales Tax account is used to represent
the amount owing to or owed by Taxation Authorities. Thus if Sales Tax
appears on a trial balance it is a straightforward debtor or creditor and
should always be considered as such. In normal circumstances sales
and purchases are always shown net of Sales Tax in the trading
account. The only exceptions to this are if the trader deals in exempt
supplies when Sales Tax will be included in their purchases figure and
if a motor vehicle is purchased then the Sales Tax is included in the
motor vehicle account.
 Prepare accounts for indirect taxes (for example, Sales Tax)

Self-test questions
Principles of Sales Tax

1 Is Sales Tax a method of direct or indirect taxation? (1.1)
2 What is Sales Tax on sales known as? (1.1)
3 If sales are shown including Sales Tax at 16% how is the net of Sales
Tax figure calculated? (1.2)
Bookkeeping entries for SALES TAX

4 What is the double entry for Sales Tax on purchases? (2.2)
5 What is the double entry for a payment to Taxation Authorities? (2.4)
6 Where would a credit balance on the Sales Tax account appear in the
financial statements? (2.5)
Standard rated, zero rated and exempt supplies

7 If a trader sells goods with Sales Tax on them at 16% what type of
supplies are these? (3.1)
8 If a trader sells items that are zero-rated for Sales Tax purposes, is
Sales Tax included in their purchases figure in the trading account?
(3.2)
9 What are exempt supplies (3.3)
10 If a trader sells exempt supplies does the purchases figure in their
trading account include or exclude Sales Tax? (3.3)

1 Sales are recorded as follows:
A Debit sales account including SALES TAX

B Debit sales account excluding SALES TAX
C Credit sales account excluding SALES TAX
D Credit sales account including SALES TAX
2 A trader registered for SALES TAX at 17.5% has the following

transactions:
Sales Rs 30,000 net
Purchases Rs 20,143 gross
The opening balance on the SALES TAX control account was Rs 1,700 owing
to Taxation Authorities; this amount remains unpaid. What is the closing
credit balance?
A Rs 2,000
B Rs 1,700
C Rs 550
D Rs 3,950
Answers of MCQs
1 C
2 D
 Explain the need for adjustments for accruals and prepayments in preparing
 Illustrate the process of adjusting for accruals and prepayments in preparing

1 Accruals basis of accounting
1.1 Definition
Under this basis Income is considered as earned when goods are delivered or
services are performed whether cash is received or not and similarly expenses
are taken in consideration when they are incurred either paid or not.
The accrual concept is one of the fundamental accounting concepts. The

concept is that income and expenses should be matched together and dealt
with in the Statement of profit or loss for the period to which they relate
regardless of the period in which the cash was actually received or paid.
Therefore all of the expenses involved in making the sales for a period should
be matched with the sales income and dealt with in the period in which the
sales themselves are accounted for.
Examples
(a) Sales
The sales for an accounting period are included in the profit and loss account
when they are made. This means that when a sale is made on credit, it is
recognised in the Statement of profit or loss when the agreement is made and
the invoice is sent to the customer rather than waiting until the cash for the sale
is received. This is done by setting up a debtor in the Statement of financial
position for the amount of cash that is due from the sale (debit debtors and
credit sales).
(b) Cost of sales
The major cost involved in making sales in a period is the actual cost of the
goods that are being sold. As well as including purchases in the cost of goods
sold, the cost of any closing items of stock at the end of an accounting period
must be carried forward to the following period to be matched with the actual
sales of those items. Equally any items of stock that were not sold in the
previous period are brought forward as opening stock in the trading account to
be matched against their sale in the current period by adding their cost to the
cost of the purchases for the period.
(c) Expenses
The expenses of the period that the business has incurred in making its sales,
such as rent, electricity, telephone etc must also be matched with the sales for
the period. This means that the actual expense incurred in the period should be
included in the Statement of profit or loss, rather than simply the amount of the
expense that has been paid for in cash.

- If the rental due on a factory is Rs 5,000 every quarter then the annual
rental expense will be Rs 20,000 whatever the pattern of cash payments
for the rental is.
- If a business has an accounting year to 31 December 20X1 and during
that year has paid Rs 1,000 of electricity bills and has outstanding a bill
for the quarter from 1 October to 31 December 20X1 of Rs 300 then the
electricity expense incurred by the business is Rs 1,300 for the year to 31
December 20X1.
- If in the previous example the outstanding bill had been for the period
from 1 November 20X1 to 31 January 20X2 then an estimate of the
electricity expense for the period to 31 December 20X1 would be:
Rs 1,000 + (2/3 x 300) = Rs 1,200
- If a business with an accounting year end of 31 December 20X1 pays for

18 months of insurance on its buildings on 1 January 20X1 at a total cost
of Rs 3,000 then the insurance expense for the year to 31 December
20X1 would be:
12/18 x Rs 3,000 = Rs 2,000
2 Accrued expenses
2.1 Introduction
Accrued expenses are charges which are brought into the financial
statements at the end of a period because, although goods and services
have been provided, they have not yet been charged for by the suppliers.
In order to ensure that the full expenses of the period have been included
in the Statement of profit or loss the accountant must ensure that the
expense accounts include not only those items that have been paid for
during the period but any outstanding amounts due. In some instances a
bill or invoice will have been received for any outstanding amounts but in
other instances when the accounts are prepared any additional expense
items will need to be estimated from previous years and earlier bills or
invoices.
Example with no opening accrual

Ahmad’s business has an accounting year end of 31 December 20X1. He
rents factory space at a rental cost of Rs 5,000 per quarter payable in
arrears. During the year to 31 December 20X1 his cash payments of rent
have been as follows:
Rs
31 March (for quarter to 31 March 20X1) 5,000
29 June (for quarter to 30 June 20X1) 5,000
2 October (for quarter to 30 September 20X1) 5,000
The final payment due on 31 December 20X1 for the quarter to that date
was not paid until 4 January 20X2.

It should be quite clear that the rental expense for Ahmad’s business for
the year to 31 December 20X1 is Rs 20,000 even though the final
payment for the year was not made until after the year end. It should also
be noted that at 31 December 20X1 Ahmad’s business owes the landlord
Rs 5,000 of rental for the period from 1 October to 31 December 20X1.
Solution
Step 1
In order to account for this situation the cash payments would first be
entered into the Factory rent account.
Factory rent
20X1 Rs 20X1 Rs
31 Mar Cash 5,000
29 June Cash 5,000
2 Oct Cash 5,000
Step 2
The charge to the Statement of profit or loss that is required at 31
December 20X1 is Rs 20,000 and this is entered into the account on the
credit side (the debit is the expense in the Statement of profit or loss).
Factory rent
20X1 Rs 20X1 Rs
31 Mar Cash 5,000
29 June Cash 5,000
2 Oct Cash 5,000
Accrued Exp 5,00031 Dec P&L a/c 20,000
Accrued Expenses
Rs Rs
Factory Rent 5,000
Bal c/d 5,000
- By this method the correct expense has been charged to the profit and
loss account under the accruals concept, Rs 20,000, and the amount of
Rs 5,000 owed to the landlord has been recognised as a credit balance
on the account.
- This credit balance would be listed in the Statement of financial position
under the heading of current liabilities and described as an accrued
expense.
KEY POINT
The accounting treatment of an accrued expense is to debit the expense
account, thereby increasing the expense in the profit and loss account, and
carry this balance forward as a creditor, an accrued expense, in the balance
sheet.

Example with an opening accrual
During the year to 31 December 20X2 Ahmad’s rental charge remained the
same and his payments were as follows:
Rs
4 January (for quarter to 31 December 20X1) 5,000
28 March (for quarter to 31 March 20X2) 5,000
28 June (for quarter to 30 June 20X2) 5,000
4 October (for quarter to 30 September 20X2) 5,000
23 December (for quarter to 31 December 20X2) 5,000
The first step in accounting for these transactions is to enter the cash
payments in the Factory rent account. Note that there is already a
brought down balance on the account at 1 January 20X2 being the
accrued expense of Rs 5,000, a creditor and therefore a credit balance,
at 31 December 20X1.
Factory rent
20X2 Rs 20X2 Rs
4 Jan Cash 5,0001 Jan Bal b/d 5,000
28 March Cash 5,000
28 June 5,000
4 Oct Cash 5,000
23 Dec Cash 5,000
25,000
Even though Rs 25,000 has been paid in cash during the year the profit
and loss account expense is still only Rs 20,000 and if this transfer to the
Statement of profit or loss is made then the account will balance at 31
December 20X2 as there is no accrued expense to be carried forward
this year since the amount due for the final quarter of the year was paid
before the year end.
Factory rent
20X2 Rs 20X2 Rs
4 Jan Cash 5,0001 Jan Bal b/d 5,000
28 March Cash 5,000
28 June 5,000
4 Oct Cash 5,000
23 Dec Cash 5,00031 Dec P&L a/c (bal fig) 20,000
25,000 25,000
3 Prepaid expenses
3.1 Introduction
A prepaid expense is an item of expense that has been paid during the
current accounting period, but relates to the next accounting period. The
prepayments is defined as expenditure on goods or services for future

benefit which is to be charged to future operations, e.g. rentals paid in
advance. The accountant must ensure that no items of expense that
relate to future periods, but have already been paid for, are shown as
expenses of the current period.
Example with no opening prepayment
Ahmad also pays insurance on the factory that he rents and this is paid in
advance. His payments during 20X1 for this insurance were as follows:
Rs
1 January (for three months to 31 March 20X1) 800
28 March (for six months to 30 September 20X1) 1,800
2 October (for six months to 31 March 20X2) 1,800
The insurance expense for the year to 31 December 20X1 can be
calculated as follows:
Rs
1 January to 31 March 20X1 800
1 April to 30 September 20X1 1,800
1 October to 31 December 20X1 900
3,500
The remaining Rs 900 that was paid on 2 October which is not to be
charged to the Statement of profit or loss for the year to 31 December
20X1 is a prepaid expense. It has the characteristics of a debtor, the
insurance company effectively owing the Rs 900 back to Ahmad at 31
December 20X1.
Solution
Step 1
In order to account for the insurance expense again the cash payments
should be entered first into the Factory insurance account.
Factory rent
20X2 Rs20X2 Rs
1 Jan Cash 800
28 March Cash 1,800
2 Oct Cash 1,800
Step 2
Enter the Statement of profit or loss transfer and the closing prepayment.
- The charge to the Statement of profit or loss calculated above as Rs
3,500 is then entered in the account.
- In order for the account to balance a further credit entry of Rs 900 is
required. This is the prepayment that is to be carried down (the insurance
from 1 Jan 20X2 to 31 March 20X2) and will appear as a brought down
debit balance or debtor.
- The double entry is to credit the account above the total with Rs 900 and
put the debit entry in below the total at 1 Jan 20X2.

KEY POINT
The treatment of a prepaid expense is to credit the expense account with
the amount of the prepayment, thereby reducing the expense to be
charged to the profit and loss account, and to carry the balance forward
as a debtor, a prepayment, in the Statement of financial position.
Factory rent
20X1 Rs 20X1 Rs
1 Jan Cash 800
28 March Cash 1,800 31 Dec P&L a/c 3,500
2 Oct Cash 1,800 31 Dec Bal c/d 900
4,400 4,400
20X2
1 Jan Bal b/d 900
- This has given the correct charge to the Statement of profit or loss of
Rs 3,500 for the year to 31 December 20X1 and has recognised that
there is a debtor or prepayment of Rs 900 at 31 December 20X1.
- The Rs 900 balance will appear in the Statement of financial position
under the heading of prepayments or prepaid expenses.
Example with opening prepayment

In writing up expense accounts, care must be taken to remember to
include any opening balances on the account that were accruals or
prepayments at the end of the previous year. For example, Ahmad pays
his annual rates bill of Rs 4,000 in two equal instalments of Rs 2,000
each on 1 April and 1 October each year. His rates account for the year
to 31 December 20X1 would therefore look like this.
Factory rent
20X1 Rs 20X1 Rs
1 Jan Bal b/d (3/6 x 2,000) 1,000
1 April Cash 2,000 31 Dec P&L a/c (bal fig) 4,000
1 Oct Cash 2,000 31 Dec Bal c/d (3/6 x 2,000) 1,000
5,000 5,000
Note that at 1 January there is an opening debit balance on the account
of Rs 1,000. This is the three months’ rates from 1 January 20X1 to 31
March 20X1 that had been paid for on 1 October 20X0. You were not
specifically told this opening balance but would be expected to work it out
from the information given.
4 Examination standard problems

4.1 Introduction
Examination questions can be more complicated than the examples
given above with both brought down and carried down accruals and
prepayments. An example might use a telephone expense as the
telephone bill will tend to be made up of two elements. There will be a
charge for the rental of the lines that will normally be paid in advance,
and a further charge for the actual calls paid in arrears.

Example
The details of Ahmad’s telephone bills for 20X1 are as follows:
Rs
Quarterly rental payable in advance on 1 February, 1 May,
1 August and 1 November each year 60
Calls paid in arrears for previous three months
1 February 20X1 120
1 May 20X1 99
1 August 20X1 144
1 November 20X1 122
1 February 20X2 132
His telephone account for the year to 31 December 20X1 is to be written up.
Solution
Step 1
Any opening balances for accruals or prepayments at the beginning of the
year should be calculated and then entered into the account.
- The opening debit balance represents the prepayment of the rental at
31 December 20X0. On 1 November 20X0 a payment of Rs 60 would
have been made to cover the period from 1 November 20X0 to 31
January 20X1. The amount of the 20X1 expense paid in 20X0 is
therefore = Rs 20.
- The opening credit balance represents the calls made in November
and December 20X0 that were not paid for until 1 February 20X1.
This can be approximated as = Rs80.
Telephone
20X1 Rs20X1 Rs
1 Jan Bal b/d 20 1 Jan Bal b/d 80
The cash payments made during the year should be entered into the
account.
Telephone
20X1 Rs 20X1 Rs
1 Feb Cash – rental 60
1 Feb Cash – calls 120
1 May Cash – rental 60
1 May Cash – calls 99
1 Aug Cash – rental 60
1 Aug Cash – calls 144
1 Nov Cash – rental 60
1 Nov Cash – calls 122
Step 3
Any closing accruals and prepayments should be calculated and entered into
the account.
- There is a closing prepayment of telephone rental. Rs 60 was paid on 1
November 20X1 for the following three months rental. This covers

November and December 20X1 as well as January 20X2. The
prepayment is the amount that relates to January 20X2 = Rs 20.
- The accrued expense at 31 December 20X1 is for November and
December’s calls that will not be paid for until 1 February 20X2. These
can be estimated as 2
- Finally the Statement of profit or loss charge can be entered as the
balancing figure in the account.
Telephone
20X1 Rs 20X1 Rs
1 Feb Cash – rental 60
1 Feb Cash – calls 120
1 May Cash – rental 60
1 May Cash – calls 99
1 Aug Cash – rental 60
1 Aug Cash – calls 144
1 Nov Cash – rental 60
1 Nov Cash – calls 122 31 Dec P&L a/c 733
3
(bal fig)
31 Dec Bal c/d 88 31 Dec Bal c/d 20
(accrual) (prepayment)
3 833 833
20X2 20X2
Step 4
The Statement of profit or loss expense that was included in the account
as a balancing figure could be proved as follows.
Rs
Rental charge for 1 January to 31 December 20X1 (4 x 60) 240
Calls:
1 January to 31 January 20X1 (1/3 x 120) 40
1 February to 30 April 20X1 99
1 May to 31 July 20X1 144
1 August to 31 October 20X1 122
1 November to 31 December 20X1 (2/3 x 132) 88
733
5 Miscellaneous income
5.1 Introduction
So far all of the examples have concerned expenses of the business as

these are the most common areas for accruals and prepayments to
occur. However some organisations also have sources of miscellaneous
income that may also be prepaid or accrued.
Example
Ahmad sublets part of his factory space for a quarterly rental in advance
of Rs 900. The payments are due on 1 March, 1 June, 1 September and
1 December each year and are always paid on time. The rental

receivable account for the year to 31 December 20X1 will show both an
opening and a closing prepayment of rental of (2/3 x Rs 900) = Rs 600.
However the account is showing income (rather than an expense) and
therefore income received in advance is effectively a creditor. The
opening prepayment will therefore be a credit balance brought down and
the closing prepayment a debit balance carried down and credit balance
brought down on 1 January 20X2.
The cash entries are also cash receipts and therefore will be credit
entries in the rental income account (debit in the cash account). The
income that will be credited to the Statement of profit or loss (debit the
rental income account) will be Rs 3,600 (4 x Rs 900).
Rental income
20X1 Rs 20X1 Rs
1 Jan Bal b/d 600
1 Mar Cash 900
1 June Cash 900
31 Dec P&L a/c 3,600 1 Sept Cash 900
31 Dec Bal c/d 600 1 Dec Cash 900
4,200 4,200
20X2
1 Jan Bal b/d 600
The Rs 600 credit balance brought down at 31 December 20X1 would be
shown in the Statement of financial position as a creditor and described
as income received in advance or deferred income.
Summary
Adjustments for accruals and prepayments are necessary in order to

accord with the accounting concept of accruals or matching whereby
income and expenses of the business are matched and dealt with in the
accounting period to which they relate regardless of the accounting
period in which the related cash was received or paid. An accrued
expense, or accrual, is an expense of the period that has been incurred
but not paid for by the year end. The accrued expense will increase the
charge for the expense in the Statement of profit or loss and be shown as
a creditor in the Statement of financial position at the year end. A prepaid
expense, or prepayment, is an item of expense that has been paid for in
the current year but relates to the next accounting period. A prepayment
will reduce the expense for the year shown in the Statement of profit or
loss and will also be shown as a debtor in the Statement of financial
position at the year end. If an item of income is received in advance then
this will reduce the income credited to the Statement of profit or loss and
be shown as a creditor in the Statement of financial position as the
amount is effectively due back to the payer at the year end. If an item of
income due has not been received then this will increase the income to
be shown in the profit and loss account and be shown as a debtor in the

Statement of financial position at the year end. Having completed your
study of this chapter you should have achieved the following learning
outcome.
- Prepare accounts using accruals and prepayments
Self-test questions
The accruals concept
1 What is meant by the accruals or matching concept? (1.1)

2 When a sale is made on credit what is the other side of the double entry?
(1.1)
3 How is the cost of sales expense matched to the sales for the period?
(1.1)
Accrued expenses
4 What is the definition of an accrued expense? (2.1)

5 Will an accrual increase or decrease the expense in the Statement of
profit or loss for the period? (2.1)
Prepaid expenses
6 What is the definition of a prepaid expense? (3.1)

7 Will a prepayment increase or decrease the expense in the profit and loss
account for the period? (3.1)
Miscellaneous income
8 If income is received in advance will this be shown as a debtor or a

creditor in the Statement of financial position? (5.1)
9 If income is due but has not been received by the year end will this
increase or decrease the amount of income credited to the Statement of
profit or loss for the period? (5.1)

1 Mr. J pays Rs 1,500 for insurance from 1 July 20X0 for 15 months. What
will the adjustment be for the year ended 30 June 20X1?
A Accrual Rs 300
B Accrual Rs 600
C Prepayment Rs 600
D Prepayment Rs 300
2 Mr. R pays his telephone bill of Rs 150 for the quarter ended 30
September 20X0. The previous quarter’s bills were of a similar amount.
What will the adjustment be for the year ended 31 December 20X0?
A Accrual Rs 150
B Prepayment Rs 150
C Cash payment Rs 150
D No adjustment
3 Mr. P pays rates on 1 February and 1 August 20X4 in advance of Rs
1,200 each. What will the adjustment be for the year ended 30
September 20X4?
A Accrual Rs 800
B Prepayment Rs 400
C Accrual Rs 400
D Prepayment Rs 800
4 Mr. B has an opening accrual of Rs 300 on his rent expense account.

During the year he pays Rs 300 in January, Rs 350 in March, Rs 350 in
June and Rs 350 in September. What is the rent expense in the
Statement of profit or loss for the year ended 31 December?
A Rs 1,650
B Rs 1,350
C Rs 1,400
D Rs 1,050
5 Ms. H receives sundry income on a quarterly basis. In 20X5, he received

Rs 4,000 in total. There was an opening prepayment of Rs 1,000. At the
year end of December, there was Rs 2,000 income owing to him. How
much sundry income should be included in the Statement of profit or loss
for the year to December?
A Rs7,000
B Rs6,000
C Rs5,000
D Rs4,000
6 Ms .Z paid Rs 150 for 15 months phone rental in advance on 1 January

20X8. During the year she paid for her calls on a quarterly basis paying
Rs 60 for the March quarter, Rs 80 for June and Rs 70 for September.
She estimates that her final bill for the December quarter will be Rs 90.
What net adjustment is required in the accounts for the year ended 31
December 20X8 in respect of these transactions?
A Rs 30 prepayment
B Rs 60 accrual
C Rs 60 prepayment
D Rs 90 accrual
Answers of MCQs
1 D
2 A
3 D
4 C
5 A
6 B

 accounting concepts relevant to un-collectability of debts

 record an irrecoverable debt recovered
 identify the impact of irrecoverable debts on the income statement and
statement of financial position
 illustrate how to include movements in the allowance for receivables in the
income statement and how the closing balance of the allowance should
appear in the statement of financial position.

1 Sales and accounting concepts
1.1 Introduction
If a sale is for cash, the customer pays for the goods immediately that the sale
is made and will probably take the goods away or arrange for them to be
delivered. If the sale is on credit terms, the customer will not pay for the goods
at that time. Instead he will be given or sent an invoice detailing the goods
and their price and the normal payment terms. This will tell him when he is
expected to pay for those goods.
1.2 Accruals or matching concept
Under the accruals or matching concept a sale is included in the ledger

accounts at the time that it is made. For a cash sale this will be when the cash
or cheque is paid by the customer and the double entry will be:
Dr Cash account
Cr Sales account
For a sale on credit, the sale is made at the time that the invoice is sent to the
customer and therefore the accounting entries are made at that time as
follows:
Dr Debtor account
Cr Sales account
When the customer eventually settles the invoice the double entry will be:
Dr Cash account
Cr Debtor account
This then clears out the balance on the debtors account.
1.3 Realisation concept
The realisation concept requires gains or profits, such as those made on

sales, to be recognised and accounted for at the time that the transaction is
made if the receipt of cash from that transaction is reasonably certain.
Therefore under the realisation concept there is no necessity to wait until the
cash from a credit sale is received before the sale is recognised and the
double entry shown above, setting up a debtor at the time that the invoice is
sent out, is appropriate.
1.4 Collectability of debts
The problem that businesses face with credit sales is that of the collectability
of the amounts owing on sales invoices. If a customer is fraudulent and
disappears without trace before payment of the amount due then it is unlikely
that such amounts will ever be recovered. If a customer is declared bankrupt
then again it is unlikely they will be able to pay the amounts due. If a customer
is having financial difficulties or is in liquidation then there is likely to be some
doubt as to their eventual ability to pay.
If a business is faced with a situation where it is highly unlikely that the
amount owing by a debtor will be received then this debt is known as a bad

debt and as it will probably never be received it is written off by writing it out of
the ledger accounts completely.
If the eventual receipt of cash from a debtor is possible but there is some doubt
about the reliability of the debtor then such a debt is known as a doubtful debt. It
is still hoped that such a debt will be received and therefore it will remain in the
ledger accounts.
However in order to be prudent such a debt will be provided against. This

means that the possible loss from not receiving the cash will be accounted for
immediately whilst the amount of the original debt will still remain in the ledger
account just in case the debtor does eventually pay.
2 Bad debts
2.1 Introduction
If a debt is considered to be uncollectable then it would be prudent to remove

it totally from the accounts and to charge the amount as an expense to the
Statement of profit or loss. The original sale remains in the accounts as this
did actually take place. The debtor is, however, removed as it is now
considered that the debt will never be paid and an expense is charged to the
Statement of profit or loss for bad debts.
The double entry required to achieve these effects is:

Dr Bad debts expense account
Cr Debtors account
DEFINITION
A bad debt is a debt which is, or is considered to be, uncollectible and is,
therefore, written off as a charge to the profit and loss account.
Example
Ahmad & Co have total debtors at the end of their accounting period of Rs
45,000. Of these it is discovered that one, Mr Suhail who owes Rs 790, has
been declared bankrupt and another who gave his name as Mr. Tariq has
totally disappeared owing Ahmad & Co Rs 1,240.
Solution
Step 1
Enter the opening balance in the debtors account. As debtors are an asset
then this will be on the debit side of the ledger account.
Debtors
20XX Rs 20XX Rs
Opening balance 45,000
Step 2
As the two debts are considered to be irrecoverable then they must be
removed from debtors by a credit entry to the debtors account and a
corresponding debit entry to a bad debts expense account.

Debtors
20XX Rs 20XX Rs
Opening balance 45,000 Bad debts expense – Suhail 790
Bad debts expense – Tariq 1,240
Bad debts expense
20XX Rs 20XX Rs
Debtors – Suhail 790
Debtors – Tariq 1,240
Step 3
The debtors account must now be balanced and the closing balance would
appear in the Statement of financial position as the debtors figure at the end
of the period.
Debtors
20XX Rs 20XX Rs
Opening balance 45,000 Bad debts expense – 790
Suhail
Bad debts expense – 1,240
Tariq
_____ Balance c/d 42,970
45,000 45,000
Balance b/d 42,970
Rs 42,970 would appear in the Statement of financial position as the figure for
debtors under current assets at the end of the accounting period.
Step 4
Finally the bad debts expense account should be balanced and the balance
written off to the Statement of profit or loss as an expense of the period.
Bad debts expense
20XX Rs 20XX Rs
Debtors – Suhail 790 P&L a/c 2,030
Debtors – Tariq 1,240
2,030 2,030
Note that the sales account has not been altered and the original sales of Rs
790 to Suhail and Rs 1,240 to Tariq remain. This is because these sales
actually took place and it is only after the sale that the expense of not being
able to collect these debts has occurred.
KEY POINT
When a debt is considered to be bad then it is written out of the accounts
completely by removing it from debtors and charging the amount as an
expense to the Statement of profit or loss in the period in which the debt was
determined as bad.

3 Doubtful debts
3.1 Introduction
A doubtful debt is one about which there is some cause for concern but which
is not yet definitely irrecoverable. Therefore although it is prudent immediately
to recognise the possible expense of not collecting the debt in the profit and
loss account it would also be wise to keep the original debt in the accounts in
case the debtor does in fact pay up.
This is achieved by the following double entry:

Cr Provision for doubtful debts account
Although the expense is written off in the bad debts expense account, the
debt is not removed from debtors. Instead a provision is set up which is a
credit balance. This is charged against profit and netted off against debtors in
the Statement of financial position to give a net figure for debtors that are
probably recoverable.
DEFINITION
A doubtful debts provision is an amount charged against profit and deducted
from debtors to allow for the estimated non-recovery of a proportion of the
debts.
3.2 Types of doubtful debt
There are two types of amount that are likely to be considered as doubtful
debts in an organisation’s accounts.
 There will be some specific debts where the debtor is known to be
in financial difficulties and therefore the amount owing from that
debtor may not be recoverable. The provision to be made against
such a debtor is known as a specific provision.
 The past experience and history of a business will indicate that not
all of its debts will be recoverable in full. It may not be possible to
indicate the precise debtors that will not pay but an estimate may be
made that a certain percentage of debtors is likely not to pay its
debts. The provision made against this percentage of debtors is
known as a general provision.
Example – general provision for doubtful debts
On 31 December 20X1 Panorama Ltd had debtors of Rs 10,000. From past

experience it estimated that 3% of these debtors were likely never to pay their
debts and it therefore wished to make a general doubtful debt provision
against this amount.
During 20X2 Panorama made sales on credit totalling Rs 100,000 and
received cash from her debtors of Rs 94,000. It still considered that 3% of the
closing debtors were doubtful and should be provided against. During 20X3
Panorama made sales of Rs 95,000 and collected Rs 96,000 from her
debtors. At 31 December 20X3 it still considered that 3% of her debtors were
doubtful and should be provided against.
Solution
Step 1
Enter the balance on the debtors account at 31 December 20X1.
Debtors
20X1 Rs 20X1 Rs
31 Dec 10,000
Step 2
Set up a provision against 3% of Rs 10,000, Rs 300, by debiting the bad debts
expense account and crediting the provision for doubtful debts account.
Bad debts expense

20X1 Rs 20X1 Rs
31 Dec Provision for 300
doubtful debts
Provision for doubtful debts

20X1 Rs 20X1 Rs
31 Dec Bad debts
expense 300
Step 3
Balance off the three accounts.
Debtors
20X1 Rs 20X1 Rs
31 Dec 10,000 31 Dec Bal c/d 10,000
10,000 10,000
20X2
1 Jan Bal b/d 10,000
This balance of Rs 10,000 will appear in the Statement of financial position
under current assets as the debtors at 31 December 20X1.
Bad debts expense

20X1 Rs 20X1 Rs
31 Dec Provision for P&L a/c
doubtful debts 300 300
300 300
This is the expense for the period to be included in the Statement of profit or
loss.

20X1 Rs 20X1 Rs
31 Dec Bal c/d 31 Dec Provision
for
300 doubtful debts 300
300 300
20X2
1 Jan Bal b/d 300
This credit balance of Rs 300 is included in the Statement of financial position
under current assets and netted off against the debtors at the end of 20X1 in
order to indicate the amount of debtors that are doubtful.
An extract from the Statement of financial position would be as follows.

Rs Rs
Current assets
Debtors 10,000
Less:
Provision for
doubtful debts (300)
9,700
Step 4
Write up the debtors account for 20X2 and balance it off to find the debtors
figure at 31 December 20X2.
Debtors
20X2 Rs 20X2 Rs
1 Jan Bal b/d 10,000 31 Dec Cash 94,000
31 Dec Sales 100,000 31 Dec Bal c/d 16,000
110,000 110,000
20X3
Step 5
Set up the provision required of 3% of Rs 16,000, Rs 480. Remember that
there is already an opening balance on the provision account of Rs 300.
Therefore in order to end 20X2 with a total balance on the provision account
of Rs 480 only a further Rs 180 will need to be charged to the bad debts
expense account for the period and thus to the Statement of profit or loss.
Bad debts expense
20X2 Rs 20X2 Rs
31 Dec Provision for 31 Dec P&L a/c
doubtful debts 180 180
180 180

20X2 Rs 20X2 Rs
1 Jan Bal b/d 300
31 Dec Bal c/d 31 Dec Bad debts
480 expense 180
480 480
20X3
1 Jan Bal b/d 480
Step 6
The extract from the Statement of financial position at 31 December 20X2
would be as follows:
Rs Rs
Current assets
Debtors 16,000
Less: Provision for doubtful debts (480)
15,520
KEY POINT
When a provision for doubtful debts is first set up then the full amount of the
provision is charged to the profit and loss account for the period. In
subsequent years if the provision required increases then it is only necessary
to charge the increase in the provision over the period to the Statement of
profit or loss.
Step 7
Write up the debtors account for 20X3. Balance off the account to find the
debtors at 31 December 20X3.
Debtors
20X3 Rs 20X3 Rs
1 Jan Bal b/d 16,000 31 Dec Cash 96,000
31 Dec Sales 95,000 31 Dec Bal c/d 15,000
111,000 111,000
Step 8
Set up the provision required at 31 December 20X3 of 3% of Rs 15,000, Rs
450. This time there is already an opening balance on the provision for
doubtful debts account of Rs 480.
The provision is to be reduced and this is done by debiting the provision
account with the amount of the decrease required (Rs 480 – Rs 450 = Rs 30)
and crediting the bad debts expense account. The credit on the bad debts
expense account is transferred to the profit and loss account for the period as
a negative expense and is described as ‘decrease in doubtful debts provision’.

20X3 Rs 20X3 Rs
31 Dec Bad debts 1 Jan Bal b/d 480
expense 30
31 Dec Bal c/d 450
480 480
20X3
1 Jan Bal b/d 450
Bad debts expense
20X3 Rs 20X3 Rs
31 Dec P & L a/c 31 Dec provision for
30 doubtful debts 30
30 30
Step 9
The extract from the Statement of financial position at 31 December 20X3
would be as follows:
Rs Rs
Debtors 15,000
Less: Provision for doubtful (450)
debts
14,550
KEY POINT
If the provision for doubtful debts is to be decreased from one period end to
another then the provision for doubtful debts account will be debited with the
amount of the decrease and the bad debts expense account will be credited.
Example – specific provision for doubtful debts

SS has debtors of Rs 11,200 at her year end of 31 May 20X4. of these she
decides that there is some doubt as to whether or not she will receive a sum
of Rs 500 from Mr.Zubair and she also wishes to provide against the
possibility of not receiving 2% of her remaining debtors. At 1 June 20X3 SS
had a balance on her provision for doubtful debts account of Rs 230.
Solution
Step 1
Calculate the provision for doubtful debts required at 31 May 20X4.
Rs
Specific provision against Mr.Zubair’s debt 500
General provision against remaining debtors ((Rs 11,200 – 500) x 214
2%)
Total provision required 714

Step 2
Write up the provision for doubtful debts account putting in the opening balance
of Rs 230 and the closing balance required of Rs 714. The difference, the
increase in provision required, is the expense to the bad debts expense account
and subsequently to the Statement of profit or loss.

20X3/4 Rs 20X3/4 Rs
1 June Bal b/d 230
31 May Bad debts
31 May Bal c/d 714 Expense 484
714 714
20X4/X5
1 June Bal b/d 714
Bad debts expense
20X3/4 Rs 20X3/4 Rs
31 May Provision for
doubtful debts 484
____ 31 May P&L a/c 484
484 484
4 Bad debt recovered
4.1 Introduction
There is a possible situation where a debt is written off as bad in one

accounting period, perhaps because the debtor has been declared bankrupt,
and the money, or part of the money, due is then unexpectedly received in a
subsequent accounting period.
4.2 Double entry
When a debt is written off the double entry is:

Dr Bad debts expense account (an expense in the Statement of profit or
loss)
Cr Debtors account (removing the debtor from the accounts)
The full double entry for the cash being received from that debtor in a
subsequent accounting period is:
Dr Debtors account (to reinstate the debtor that had been cancelled when
the debt was written off)
Cr Bad debts expense account (unexpected sundry income to the
Statement of profit or loss) and
Dr Cash account
Cr Debtors account

Summary
Having studied this chapter you should now understand the reason for
considering the collectability of debts. The accounting concepts that are
relevant to this area are matching, realisation and prudence.
A bad debt is a debt that is considered irrecoverable and the double entry for
writing off a bad debt is:
Cr Debtors account
A provision for doubtful debts is set up when there is some doubt as to
whether all of the debts of the business will be recovered in full. This may be a
specific provision if certain specific debts are known to be in doubt or a
general provision based upon a certain percentage of debtors at the year end.
Unlike a bad debt write off, the double entry for a provision for doubtful debts
does not entail removing the debtor from the debtors account. Instead the
double entry is:
Cr Provision for doubtful debts account
When the provision is first set up then the entries in the bad debts expense
account and the provision account are for the full amount of the provision.
Thereafter the provision should reflect any opening balance on the provision
account. If the provision required is an increase over the opening balance
then the difference is credited to the provision account and debited to the bad
debts expense account. However if the required provision is less than the
opening balance on the provision account then the double entry is to debit the
provision account and credit the bad debts expense account with the
difference between the opening and closing balances on the provision
account. The balance on the provision account is netted off against the
balance on the debtors account in the Statement of financial position at the
end of the accounting period under the heading of current assets.
Finally you should be able to account for cash received from a debt that had
already been written off in a previous accounting period. This is done by
reinstating the debtor and cancelling the previous bad debt expense:
Dr Debtors account
Cr Bad debts expense account and then accounting for the receipt of
cash from the reinstated debtor:
Dr Cash account
Cr Debtors account
following learning outcome.
 Explain the difference between and prepare accounts for bad debts
and provisions for doubtful debts.

Self-test questions
Sales and accounting concepts

1 What is the double entry for a sale on credit? (1.2)
2 How is the realisation concept relevant to the accounting for credit sales?
(1.3)
3 Which accounting concept would require a provision for doubtful debts to be
set up? (1.4)
Bad debts
4 What is the definition of a bad debt? (2.1)
5 What is the double entry for writing off a bad debt? (2.1)
Doubtful debts
6 What is a provision for doubtful debts? (3.1)
7 What is the double entry required when a provision for doubtful debts is
initially set up? (3.1)
8 What is a specific provision for doubtful debts? (3.2)
9 If there is to be a decrease in the provision for doubtful debts over a period will this
result in a debit or a credit entry in the Statement of profit or loss? (3.2)
Bad debts recovered

10 What is the full double entry required to account for cash received from a debt that
had been written off in a previous accounting period? (4.2)
11 A portion of a trial balance of AB Ltd. is given.

AB Ltd.
Trial Balance
As on 31st December, 1995
Dr. (Rs.) Cr. (Rs.)

Debtors 40,000
Provision for doubtful debts 22,000
Bad debts 1,000
(i) Provide 5 per cent on debtors for further bad and doubtful debts.
(ii) Included in the debtors is an amount of Rs.100 in respect of insolvent
whose estate is expected to realise not more than 50 paise in the
rupee.
(iii) Included in debtors is an amount of Rs.400 due from K. who was our
creditor also of Rs. 600.
(iv) Bills received included dishonoured bills of Rs. 650. Out of these bills,
there was a bill of Rs.100, which was due from a certain debtor who
was expected to pay a dividend of 25 paisa in the rupee.
(v) Sales made on approval basis of Rs.600 are still pending. The profit
included in such goods was at 20 % on sales.
(vi) Sundry debtors included an item of Rs. 2,500 for goods supplied to the
proprietor. Rate of profit was the same, i.e. 20 % on sale.
You are required to show what amount will appear in profit and loss account,
on account of provision for doubtful debts.

The following information relates to questions 1, 2 and 3.

Hasham is finalising his accounts and reviewing his bad debt position. He has
Rs 20,500 of debtors at the year end. Of these debtors, the following are
doubtful:
S Rs 2,500
K Rs 750
J Rs 1,200
Hasham wishes to provide for all of S and K’s debts and half of J’s. He then
wishes to make a general provision of 2% of debtors.
1 What should Hasham’s specific provision amount to?
A Rs 3,250
B Rs 3,700
C Rs 3,850
D Rs 4,450
2 What should Hasham’s general provision amount to?
A Rs 410
B Rs 321
C Rs 333
D Rs 345
3 If Hasham’s opening provision for doubtful debts is Rs 3,500, what
would be the charge to the bad debt expense for the year?
A Rs 671
B Rs 3,500
C Rs 4,171
D Rs 7,671
4 What is the double entry for the cash received from a doubtful debt?
A Dr Cash Cr Bad debt expense
B Dr Cash Cr Debtors
C Dr Debtors Cr Cash
D Dr Bad debt expense Cr Debtors
5 Asim has a debtors balance of Rs 32,000 after writing off a bad debt of
Rs 1,000. He has decided that the bad debt provision should amount to
4% of debtors. The opening bad debt provision is Rs 1,000. What is the
effect on profit of adjusting the bad debt provision?
A Rs 1,280 decrease
B Rs 280 decrease
C Rs 1,280 increase
D Rs 280 increase
6 Which of the following items would be a debit to the bad debts expense
account?
A Write off of a bad debt as not recoverable
B Cash receipt of a debt previously written off
C Cash receipt of cash from a debtor that is provided for
D Decrease in bad debt provision

Answers
11
ACCOUNTING
PROVISION FOR BAD DEBTS
(a) Calculation of debtors balance:
Rs. Rs.
Total debts as per trial balance 40,000
Less: Goods supplied to the proprietor 2,500
Goods on approval basis 600 3,100
36,900
(b) Calculation of debts which are definitely good:
i) 50 paise in a rupee from an insolvent (this is likely to

be received and hence good) 50
ii) Amount due from K., since he is our creditor also, the
amount is definitely good 400
iii) 25 paise in a rupee calculated on a bill of Rs.100
(treated as good) 25
475
(c) Calculation of bad debts:
i) 50 paise in a rupee due from insolvent 50

ii) 75 paisa in a rupee on a bill of Rs.100 75
125
(d) Calculation of debtors for the purpose of provision:
Total debtors as per (a) above 36,900

Less: Definitely good (b) 475
Definitely doubtful (c) 125 600
36,300
(e) Amount to be shown in Profit and Loss Account
i) 5 % on Rs. 36,300 1,815

ii) Add Total amount of doubtful debt 125
Total amount of provision for doubtful debt 1,940
Less: Bad debts recovered 1,000
Amount of provision to be shown in P&L A/c 940

MCQs
1 C
2 B
3 A
4 B
5 B
6 A

 Explain, calculate and prepare accounts for stock

 Prepare Statement of profit or loss, appropriation of profit and Statement of
financial positions from trial balance
 define the cost and net realisable value of closing inventory
 discuss alternative methods of valuing inventory
 explain and demonstrate how to calculate the value of closing inventory from
given movements in inventory levels, using FIFO (first in first out) and AVCO
(average cost)

1 Stock and work-in-progress
1.1 Introduction
In order to arrive at the valuation placed on closing stock:

 the existence of the stock, and the quantities thereof, have to be
ascertained by means of a stock taking, and
 following on from this a valuation has to be placed on the stock which, as
will be seen, may differ according to which accounting policy a company
adopts.
1.2 What is stock?
At any point in time most manufacturing and retailing enterprises will hold
several categories of stock including:
 goods purchased for resale
 consumable stores (such as oil)
 raw materials and components (used in the production process)
 partly-finished goods (usually called work-in-progress)
 finished goods (which have been manufactured by the enterprise).
The amount at which stock should be stated in the Statement of financial
position is the lower of cost and net realisable value.
1.3 What is cost?
Cost is the amount of expenditure (actual or notional) incurred on, or

attributable to, a specified item or activity. For stock this includes:
 cost of purchase – material costs, import duties, freight
 cost of conversion – this includes direct costs, production overheads and
other overheads attributable in the particular circumstances of the
business to bringing the product or service to its present location and
condition.
Example
Golden Ltd is a small furniture manufacturing company. All of its timber is
imported from Scandinavia and there are only three basic products – a dining
table, a cupboard and a bookcase. At the end of the year the company has
200 completed bookcases in stock. For final accounts purposes, these will be
stated at the lower of cost and net realisable value. How is ‘cost’ arrived at?
Solution:
'Cost' will include several elements:
(a) Cost of purchase. First of all we must identify the timber used in the
manufacture of bookcases (as opposed to dining tables and
cupboards). The relevant costs will include the Rs sterling cost of the
timber, the import duty and all the insurance and freight expenses
associated with transporting the timber from Scandinavia to the factory.

(b) Cost of conversion. This will include costs that can be linked to the
bookcases produced during the year. This includes labour costs 'booked'
and sundry material costs (e.g. hinges and screws).
(c) Production overheads present particular problems. Costs such as

factory heat and light, salaries of supervisors and depreciation of
equipment are likely to relate to the three product ranges. These costs
must be allocated to these product ranges on a reasonable basis
based upon the normal level of activity.
These two groups of cost must relate to either:
 bookcases sold during the year, or
 bookcases in stock at the year end (i.e. 200 bookcases).
Definition
Cost of conversion comprises: costs which are specifically attributable to units

of production, e.g. direct labour, direct expenses and sub-contracted work;
production overheads; and other overheads, if any, attributable in the
particular circumstances of the business to bringing the product or service to
its present location and condition.
1.4 What is net realisable value (NRV)?
Net realisable value is the amount for which any asset could be disposed, less
any direct selling costs. Each individual item or each group of similar items of
stock should be stated in financial statements at the lower of cost and net
realisable value. At the balance sheet date it is necessary to make a
reasonable estimate of NRV.
1.5 Methods of stock valuation
With the exception of the unit cost method, the techniques mentioned below
are not designed to ascertain the identity of individual items of stock, but
make assumptions as to which items are deemed to be in closing stock:
(a) Unit cost
Unit cost is the actual cost of purchasing identifiable units of stock. This
method is only likely to be used in situations where stock items are of high
value and individually distinguishable. Examples would include jewellery
retailers and art dealers, where in each case the proprietors would need to
value each item individually.
(b) FIFO: first-in-first-out
FIFO is the principle that the oldest items or costs are the first to be used.
Every time a sale is made the cost of goods sold is identified as representing
the cost of the oldest goods remaining in stock. Closing stock is therefore
generally valued at relatively current costs.

(c) LIFO: last-in-first-out
LIFO is a little-used method, not allowed by IAS 2, of pricing the issue of

material using the purchase price of the latest unit of stock. Thus every time a
sale is made the cost of goods sold are the most recent purchases leaving
closing stock as the earliest purchases
.
(d) Average cost
Stock is valued at the average price of stock on hand, calculated by dividing

the total cost of units by the total number of such units. This calculation can
be carried out periodically, or continuously after every purchase.
Example
A business is commenced on 1 January and purchases are made as follows:

Month No of units Unit price Value
Rs Rs
Jan 380 2.00 760
Feb 400 2.50 1,000
Mar 350 2.50 875
Apr 420 2.75 1,155
May 430 3.00 1,290
Jun 440 3.25 1,430
2,420 6,510
During this period, 1,420 articles were sold for Rs 7,000.
(a) Compute the cost of stock on hand at 30 June using the following
methods:
(i) FIFO
(ii) LIFO
(iii) Average cost.
(b) Show the effect of each method on the trading results for the six
months.
Solution
(a) Stock valuation (stock in hand 2,420 – 1,420 = 1,000 units)

(i) FIFO – stock valued at earliest purchase prices
Rs
440 articles at Rs 3.25 1,430.00
430 articles at Rs 3.00 1,290.00
130 (balance) articles at Rs 2.75 375.50
1,000 3,077.50

(ii) LIFO – stock valued at latest purchase prices
Rs
380 articles at Rs 2.00 760
400 articles at Rs 2.50 1,000
220 (balance) articles at Rs 2.50 550
1,000 2,310
(iii) Average cost i.e stock valued at average purchase price
Total value/Total no of articles = Rs 6,510/2,420 = Rs 2.69 per unit
∴ 1,000 articles at Rs 2.69 = Rs 2,690.
(b) Effect of different methods of computing cost of stock in hand on

trading results
No of
(i) FIFO (ii) LIFO (iii) Average
units
Rs Rs Rs Rs Rs Rs
Sales 1,420 7,000.00 7,000 7,000
Purchases 2,420 6,510.00 6,510 6,510
Less: Closing 1,000 3,077.50 2,310 2,690
stock
Cost of goods 1,420 3,432.50 4,200 3,820
sold
Gross profit 3,567.50 2,800 3,180
As this example shows, FIFO, LIFO and average cost are a means of
determining the cost of closing stock. They each give rise to different gross
profits. It is therefore vital that the method of stock valuation chosen be
adhered to from one period to the next, so as to give a meaningful trend of
trading results (i.e. the consistency concept).
1.6 Detailed stock records
In the previous example the precise dates, or the months in which the goods
are sold, are not given. What difference would it make if the date of sale of the
articles were known? Some accountants would state that it would not make
any difference. They match the purchases and sales of stock on an
accounting period basis. Other accountants would require a precise as
possible matching of purchases and sales.

Example
Purchases and prices of purchases are in the previous illustration. More

information on sales is now supplied:
No. of units
sold
January 200
February 350
March 100
April 500
June 270
1,420
The sales are made at the end of each month. Compute the cost of stock on
hand using the following methods.
(a) FIFO
(b) LIFO
(c) Weighted average.
Solution
(a) FIFO
The additional information makes no difference to the stock valuation. The

value of items remaining in stock will always be the items last purchased up to
the number of units counted by the physical stock count.
(b) LIFO
In April the 420 units most recently purchased are sold plus 80 of the next
most recently purchased units to make up sales of 500 units.
Receipts Issues Balance

No. of No. of No. of
units units units
Jan 380 (200) 180
Feb 400 (350) 50
Mar 350 (100)
April (80) 170
April 420 (420) -
May 430 430
June 440 (270) 170
1,000

Closing stock valuation
Rs
180 Articles at Rs 2.00 360.00
430 Articles at Rs 3.00 1,290.00
1,000 2,752.50
(d) Weighted average
Each time a consignment is received a weighted average price is calculated

as: Stock value + Receipt value/Quantity in stock received In the solution the
price is calculated to the nearest penny.
–––––––– Receipts –––––– –––––––– Issues –––––––– ––– Balance –––

No. of Unit Value No. of Unit Value No. of Value
units price units price units
Rs Rs Rs Rs Rs
January 380 2.00 760 380 760.00
200 2.00 400 180 360.00
February 400 2.50 1,000 580 1,360.00
350 2.34* 819 230 541.00
March 350 2.50 875 580 1,416.00
100 2.44 244 480 1,172.00
April 420 2.75 1,155 900 2,327.00
500 2.59 1,295
400 1,032.00
May 430 3.00 1,290 830 2,322.00
June 440 3.25 1,430 1,270 3,752.00
270 2.95 796.50 1,000 2,955.50
Notes
The January issues must be at the average price at that date = Rs 2.00
 The issue price (Rs 2.34) is found by dividing the balance value in
the previous line with the number of units in stock before the issue
(ie, Rs 1,360/ 580). The issue price is then deducted to give the
balance carried forward.
At the end of the period, the number of units in stock must be as before (2,420
– 1,420 = 1,000 units). The value, however, has changed from Rs 2,690 to Rs
2,955.50. The total value of stock issued represents the total cost of goods
sold.

Which method to use in the exam
Use the most precise method possible, given the information in the
examination question, unless the question states otherwise.
2 Accounting for stocks – closing stock

2.1 Introduction
In order to be able to prepare a set of financial statements it is firstly

necessary to learn how to account for any items of stock at the end of the
year i.e. closing stock.
Example
A trader starts in business and by the end of the first year, has purchased
goods costing Rs 21,000 and has made sales totalling Rs 25,000. Goods that
cost Rs 3,000 have not been sold by the end of the year. What profit has been
made in the year?
Solution
The unsold goods are referred to as closing stock. This stock is deducted
from purchases in the trading account section of the Statement of profit or
loss. Gross profit is thus:
Rs Rs
Sales 25,000
Purchases 21,000
Gross profit 7,000
Closing stock appears on the Statement of financial position as an asset. The
situation becomes slightly more complicated when the business has been in
existence for more than one year as will now be seen.
Example
A wholesaler buys goods from a manufacturer at Rs 2 per unit and sells them
on credit terms to various retailers at Rs 3 per unit. The transactions for 20X7
are summarised as follows:
Units
Opening stock (1 January 500
20X7)
Purchases 6,200 (Cost at Rs 2 = Rs 12,400)
Sales 5,900 (Proceeds at Rs 3 = Rs 17,700)
Closing stock (31 December 800
20X7)

How is the gross profit to be calculated?
Solution
Gross profit is sales less cost of sales. This brings us to the idea of accruals
or matching. Against the revenue from the 5,900 units sold, we must 'match'
what it cost to buy those goods in the first place. The purchases figure does
not give the answer, since clearly some of the goods sold during the year
come from the goods the wholesaler started off with at the beginning of the
year (last year's closing stock) and some from the goods bought during the
year (purchases). When comparing sales and cost of sales, it is important to
make sure that one is comparing like with like. In the example assume that
both opening and closing stock are valued for accounts purposes at Rs 2 per
unit, giving stock figures of Rs 1,000 and Rs 1,600 respectively.
Gross profit can be calculated as follows:
Rs Rs
Sales 17,700
Opening stock (at cost) (500 x 2) 1,000
Purchases (at cost) 12,400
13,400
Less: Closing stock (at cost) (800 x (1600)
Rs 2)
Gross profit 5,900
The closing stock is shown on the Statement of financial position as an asset

at the end of the year. The opening stock would have been shown as stock on
the Statement of financial position for the previous year.
3 Ledger accounts for stock

3.1 Trading A/c and Statement of profit or loss
Initially it is critical to appreciate that the trading A/c and Statement of profit or
loss is part of the double-entry bookkeeping system, whereas the Statement
of financial position is not.
Do not be put off by the fact that the trading and Statement of profit or loss is
set out in vertical form whereas other ledger accounts are set out in 'T'
account form.
The Statement of financial position is an ordered list of all the ledger account
balances remaining after the trading A/c and Statement of profit or loss has
been completed. It is not itself part of the double entry system.

Example
From previous example we arrived at a gross profit of Rs 5,900. Let us

examine the relevant ledger accounts. We will consider the accounts at two
separate points in time:
 immediately before extracting a trial
balance at 31 December 20X7.
 immediately after the financial statements
have been prepared and the various accounts ruled off.
Solution
Ledger accounts before extracting a trial balance

Stock account
20X7 Rs Rs
The stock is an asset and therefore is a debit entry in the stock account.
Purchases account
20X7 Rs Rs
Various creditors 12,400
Sales account
Rs Rs
Various debtors
17,700
Points to note:
The balance of Rs 1,000 in stock account originated from last year's balance
sheet when it appeared as closing stock. Remember that last year's closing
stock is this year's opening stock. This figure remains unchanged in the stock
account until the very end of the year when closing stock at 31 December
20X7 is considered.
The closing stock figure (which is known to be Rs 1,600) is not usually
provided to us until after we have extracted the trial balance at 31 December
20X7.
The purchases and sales figures have been built up over the year and
represent the year's accumulated transactions.
KEY POINT
When the closing stock is entered into the stock account at the end of a year,
it remains there untouched until the end of the following year when it has
become the opening stock for the year.

Ledger accounts after financial statements have been prepared
Assume that we are told that closing stock for accounts purposes has been
valued at Rs 1,600. What adjustments are required?
KEY POINT
The opening stock, sales and purchase are transferred to the trading and
profit and loss account. Closing stock is entered into the stock account and
the trading and profit and loss account. The balance on the stock account
remains at the end of the period and is listed in the Statement of financial
position under current assets as stock. The trading account is balanced to
show the gross profit figure carried down and brought down.
Step 1
Transfer the opening stock, purchases and sales to the trading and profit and
loss account.
Stock account
20X7 Rs 20X7 Rs
1 Jan Balance b/d 1,000 31 Dec Trading and 1,000
P&L a/c
Purchases account
20X7 Rs 20X7 Rs
Various creditors 12,400 31 Dec Trading and 12,400
P&L a/c
Sales account
20X7 Rs 20X7 Rs
31 Dec Trading and P&L 17,700 Various debtors 17,700
a/c
Trading account (‘T’ form)

20X7 Rs 20X7 Rs
31 Dec Purchases 12,400 31 Dec Sales 17,700
Stock 1,000
Step 2
Enter closing stock into the books.
The double entry for this is to debit the stock account with the value of the
closing stock (this is an asset that will appear on the Statement of financial
position) and credit the trading and profit and loss account.

Stock account
20X7 Rs 20X7 Rs
1 Jan Balance b/d 1,000 31 Dec T and P&L 1,000
a/c
31 Dec T and P&L 1,600
a/c
Step 3
The trading account is balanced to show the gross profit figure carried down
and brought down.
Trading and profit and loss A/c
20X7 Rs 20X7 Rs
31 Dec Purchases 12,400 31 Dec Sales 17,700
Stock (opening) 1,000 Stock (closing) 1,600
Gross profit c/d 5,900
19,300 19,300
Gross profit b/d 5,900
The above layout of the trading account is not particularly useful but it assists
the appreciation of the actual double-entry processes and the realisation that
the trading and Statement of profit or loss is part of the double entry.
A more familiar layout of the trading and Statement of profit or loss is:
Rs Rs
Sales 17,700
Opening stock 1,000
Add: Purchases 12,400
13,400
Gross profit 5,900
3.3 Stock account
After the financial statements have been completed, it is usual to balance the
various ledger accounts. Note particularly the treatment of the stock account.
Entries are only ever made to the stock account at the end of the accounting
period when the opening stock is transferred to the trading and profit and loss
account and the closing stock is entered into the stock account.
The balance carried down (c/d) is a balance at the end of the year that will be
entered on the Statement of financial position representing closing stock. This
is brought down (b/d) at the beginning of the following year, representing the
opening stock for the next accounting period. This illustrates two key features
in bookkeeping:

 any balance carried down at the end of an accounting period
should be included on the Statement of financial position.
 any balance carried down at the end of an accounting period, will

become the opening balance thereon at the beginning of the next
accounting period.
KEY POINT
Entries are only ever made to the stock account at the end of the accounting
period when the opening stock is transferred to the trading and profit and loss
account and the closing stock is entered into the stock account.
4. Physical Count
At the end of a year, every company stops its production process and
physically counts its inventory of Raw Material, Work in Process, Finished
Goods and Stores & Spares. These counted numbers are then used to
measure the amount of inventory accounted for while Financial statement.
Generally the count is done by the staff of the company and it is observed by
the external auditor.
Stock Taking Problem
As discussed earlier, closing stock is recorded at the end of year. But it value
is not available in double entry books. It is only possible if it is physically
counted at the end of the year
Sometimes due to some limitation stock taking (counting) cannot be

performed at reporting date (at year end e.g: 31 December) rather it is
performed at any later date. (e.g: 15 January). To calculate stock value at
reporting date from stock value actually counted at later date sales and
purchases of “in-between” period are adjusted as follows:
Stock at reporting date = Stock value at later date

– Purchases of in-between period
+ Cost of sales of in-between period.
In questions, these figures “stock value at later date”, “purchases of in-

between period” and “cost of sales in-between period” may also require some
adjustments/corrections. Followings are the examples of such
adjustments/corrections:

Stock Value (at later date):
Add: stock at Branch and consignment (at cost)

Add: stock sold at approval/return basis (at cost)
Add: under casting in stock sheet
Add: goods in transit
Less: stock held on consignment basis or on behalf of 3rd party (at
cost)
Less: overcasting in stock sheet
Less: NRV loss (if any)
Less: Purchases (From year end to stock take date):
Often following adjustments need to be made in purchase figure:

Less: purchase return
Less: Purchases of before year end OR after stock take date
erroneously included in purchases.
Less: goods received on consignment basis wrongly included in
purchases
Less: fixed asset purchased wrongly added to purchases
Less: purchase day book overcastted
Add: purchase day book under casted
Add: Sales (at cost) (From year end to stock take date):
Often following adjustments need to be made in sales figure:

Less: sales return
Less: stock delivered before year end OR after stock take date
Less: stock sent on consignment basis or to Branch
Less: fixed assets disposal wrongly added to sales
Less: sales day book over casted
Add: sales day book under casted
= Stock at year end
Similarly, if stock take is performed at any date earlier the reporting date (e.g:
Stock take is performed at 10th December and year end is 31 December) the
working to calculate stock value at reporting date would be as follows:
Stock at reporting date = Stock value at earlier date

+ Purchases of in-between period
- Cost of sales of in-between period.

5 Statement of profit or loss and Statement of financial positions from trial
balance
5.1 The preparation of final accounts

The information contained in the previous example may be given in the
form of a trial balance.
Trial balance as at 31 December 20X7 – extract

Rs Rs
Sales 17,700
Stock 1,000
Purchases 12,400
Additional information would be given as follows:
Stock has been valued at 31 December 20X7 as Rs 1,600.
Remember that the stock shown on the trial balance is last year's stock as
profit has not yet been computed by transferring sales and purchases to the
profit and loss account.
This fact should be reinforced by the additional information given concerning

closing stock (which is not on the trial balance).
Final accounts can be prepared straight from the information given:
Statement of profit or loss for the year ended 31 December

20X7 (extract)
Rs Rs
Sales (from TB) 17,700
Opening stock (from TB) 1,000
Purchases (from TB) 12,400
13,400
Closing stock (from additional information) (1,600)
Cost of sales (11,800)
Gross profit 5,900

Example
The trial balance of E Ltd at 31 December 20X8 is as follows:

Dr Cr
Rs Rs
Capital account 8,602
Stock 2,700
Sales 21,417
Purchases 9,856
Rates 1,490
Drawings 4,206
Electricity 379
Freehold shop 7,605
Debtors 2,742
Creditors 3,617
Cash at bank 1,212
Cash in hand 66
Sundry expenses 2,100
Wages and 3,704
salaries
34,848 34,848
In addition, E Ltd calculates that closing stock should be valued for

accounts purposes at Rs 3,060.
You are required to prepare a Statement of profit or loss for the year
ended 31 December 20X8 and a Statement of financial position at that
date.
Solution
Step 1
Stock figures can be inserted into the final accounts without a working.
Stock on the trial balance is opening stock and goes to the trading
account. Stock not on the trial balance is closing stock that goes to the
trading account and the Statement of financial position.
Step 2
Deal with the other items on the trial balance. In the case of tradingA/c
and Statement of profit or loss items, this entails debiting the relevant
accounts and crediting trading A/c and Statement of profit or loss (in
the case of income) and debiting trading A/c and Statement of profit or
loss and crediting the relevant accounts (in the case of expenses).
However, as the ledger accounts are not required the items will simply
be put into the tradingA/c and Statement of profit or loss The remaining
balances are Statement of financial position items.

Step 3
Prepare the Statement of profit or loss.
Statement of profit or loss for the year ended

31 December 20X8
Rs Rs
Sales 21,417
Opening stock 2,700
Purchases 9,856
12,556
Closing stock (3,060)
Gross profit 11,921
Rates 1,490
Electricity 379
Wages and salaries 3,704
(7,673)
Net profit 4,248
Step 4
Prepare the Statement of financial position.

Rs Rs Rs
Fixed assets:
Freehold shop 7,605
Current assets:
Stock 3,060
Debtors 2,742
Cash in hand 66
5,868
Less: Current liabilities
Creditors 3,617
Bank overdraft 1,212
(4,829)
8,644
Capital account:
Balance at 1 January 8,602
20X8
Net profit 4,248
12,850
8,644
Note: remember that the closing stock in the Statement of financial
position must agree with the closing stock in the trading account.
Note that the balance on the trial balance for cash at bank is a credit
balance, a liability, and therefore an overdraft.
Summary
This chapter examined the way that the value of stock is found for
inclusion in the accounts, and the accounting entries performed at the
period end to achieve this. Having completed your study of this chapter
you should have achieved the following learning outcomes.
 Explain, calculate and prepare accounts for stock

 Prepare Statement of profit or loss, appropriation of profit and
Statement of financial positions from trial balance
 define the cost and net realisable value of closing inventory
Self-test questions
Stock and work-in-progress
1 What is the general rule for the amount at which stock should be valued?
(1.2)
2 What is the net realisable value of an item of stock? (1.4)
3 State three methods of stock valuation. (1.5)
4 How is the weighted average price of stock calculated? (1.6)
Accounting for stocks – closing stock
5 Which accounting concept influences the calculation of gross profit?

(2.1)
Ledger accounts for stock
6 Is it the trading and Statement of profit or loss or the Statement of financial

position that is an account in the double-entry accounting system?
(3.1)
7 Is opening stock a debit or a credit balance on the stock account?
(3.2)
8 What is the double entry for closing stock? (3.3)
Statement of profit or losss and Statement of financial positions from trial

balance
9 Is an overdraft an asset or a liability? (4.1)

10 The closing stock of ABC Ltd. As at September 30, 20X8 was Rs. 750,000.
There were doubts regarding its condition and realizable value. It was found
that:
 80% was in good condition and was expected to realize a gross
margin of 25%.
 15% was slightly damaged and required and additional expenditure
of 15% of cost to make it saleable at normal price.
 5% was damaged and would fetch only 40% of the normal sale
price.
Required: Calculate the revised value of stock as of September 30, 20X8
11 The financial year of S. Enterprise ends on March 31, 20X6 but the stock
on hand was physically verified on April 8, 1996. You are required to
determine the value of closing stock at cost as on March 31, 20X6 from
the following information.
The Gross Profit is 25% on sales.
(a) Goods received during March 20X6 of Rs. 50,000, invoice of

which had not been received upto the date of stocktaking.
(b) Purchases register have been maintained on the basis of receipt
of purchase invoices irrespective of receipt of goods.
(c) Purchases as per purchase register during the period from April
1, 1996 to April 7, 20X6 amounted to Rs. 58,000 of which
purchase of Rs. 15,000 had not been received upto the date of
physical verification of stock and purchases of Rs. 20,000 had
been received before the year end.
(d) Sales have been entered in the sales register only after the
dispatch of goods to the customers & sales returns only after the
receipt of goods from customers.
(e) Sales as per sales register during the period from April 1, 20X6
to April 7, 1996 amounted to Rs. 68,800 of which sale value of
Rs. 12,000 had not been delivered upto the date of physical
verification.
(f) The stock (as physically verified) on April 7, 20X6 was
Rs. 154,000 at cost.
1 Stock is valued at the lower of:
A Cost and selling price

B Cost and mark up
C Cost and net realisable value
D Net realisable value and selling price
2 The cost of stock is made up of:

A Selling price – cost of purchase
B Cost of purchase + costs of conversion
C Cost of purchase – costs of conversion
D Selling price + costs of conversion
3 Net realisable value is calculated as:
A Selling price – profit

B Cost of purchase + selling price
C Selling price – cost of purchase
D Selling price – further costs
4 What value would be included in the Statement of financial

position for stock with the following details:
Cost of materials Rs 5,000

Selling price anticipated Rs 8,000
Labour and conversion costs incurred Rs 3,000
Distribution costs to be incurred Rs 1,000
A Rs5,000
B Rs8,000
C Rs4,000
D Rs7,000
5 Gohr has opening stock of Rs 5,000, purchases of Rs 16,000

and closing stock of Rs 2,000. He discovers that he has omitted
some stock form his stock take and that closing stock should be
Rs 3,000. What is the effect on profit of this error?
A Rs 1,000 decrease in profit

B Rs 1,000 increase in profit
C Rs 2,000 decrease in profit
D Rs 2,000 increase in profit
Answers
10.
ABC Ltd.
Revised Value of Closing Stock
As at 30 September 20X8
Rs.
Value as given 750,000
Adjustment of damaged stock requiring additional
expenditure (W-1) –
Less: Cost of damaged stock (5% of Rs. 750,000) 37,500
712,500
Add: Net realisable value of the above stock
(40% of Rs. 37,500 x 100/75) 20,000
Revised value 732,500
Working notes
(W-1)

Value of slightly damaged stock:
Cost (15% of Rs. 750,000) 112,500
Selling price of the above (Rs. 112,500 x 100/75) 150,000
Less: Additional expenditure required (Rs. 112,500 x 15%) 16,875
Net realisable value 133,125
Stock will be valued at the lower of the cost and net realisable value.
Therefore, no adjustment is required.
11.
S -ENTERPRISE
Value of closing stock at cost as on March 31, 20X6
Rs. Rs.
Physically verified stock as on April 7, 20X6 (at cost) 154,000
Less: Purchases from April 1 to April 7 58,000
Not yet received (15,000)
Received before year end (20,000) 23,000
131,000
Add: Sales as per sales register 68,800
Less: Not yet delivered (12,000)
56,800
Cost = (56,800 X 75) 42,600
100 ______
Value of closing stock at cost on Mar 31, 20X6 173,600
Note: No effect of item No.2.
MCQs
1 C
2 B
3 D
4 D
5 C

 prepare, reconcile and understand the purpose of supplier statements.

 identify errors which would be highlighted by performing a control account
reconciliation.
 perform basic control account reconciliations for receivables and payables,
identifying and correcting errors in control accounts and ledgers.

1 Control account reconciliation
1.1 Introduction
In many organisations control accounts for debtors and creditors are

maintained as part of the double-entry bookkeeping system, whilst
individual debtors and creditors personal accounts are maintained in
debtors and creditors ledgers, which are not part of the double-entry
system. The control account and the related ledger act as a check on
each other as both use the same day books as a source of information,
but the control account uses the totals from the day books whereas the
ledger uses the individual entries within the day books. As the sum of the
individual entries in the daybooks should equal the totals, the individual
debtor/creditor accounts should sum to the same balance as in the
control accounts.
KEY POINT
A regular reconciliation between the control accounts and the ledgers is an
important control on the efficiency of the double-entry bookkeeping and
the maintenance of the ledgers.
 the balance on the sales ledger control account (or debtors ledger
control account) should equal the total of the balances in the
debtors ledger and
 the balance on the purchase ledger control account (or creditors
ledger control account) should equal the total of the balances in the
creditors ledger
1.2 Reconciling items

In practice, the balance on the control account may not agree with the
total of the ledger accounts, and in such an instance the causes of the
difference must be identified and adjustments made where necessary.
Such differences may be caused by:

 errors in the sales or purchase ledger control accounts. In such a
case it must always be borne in mind that the control account is part
of the double-entry bookkeeping system. An error in the sales
ledger control account may well affect another double-entry
account.
 errors in the debtors or creditors ledger. Such ledgers are not part
of the double-entry bookkeeping system, so no double entry will be
necessary.
 errors in both the control accounts and the ledger accounts.
Example
The following example illustrates the type of problems which can arise.
Full explanations of the amendments are given - these are not normally
necessary in an examination question.

Star Ltd’s purchase ledger control account is an integral part of the
double-entry system. Individual ledger account balances are listed and
totalled on a monthly basis, and reconciled to the control account
balance. Information for the month of March is as follows:
(a) Individual ledger account balances at 31 March have been listed

out and totalled as follows:
Rs
Total of debit 1,012
balance
s
Total of credit 20,778
balance
s
(b) The purchase ledger control account balance at 31 March is Rs

21,832 (net). Net means credit balances less debit balances).
(c) On further examination the following errors are discovered:
(i) The total of discounts received for the month, amounting to

Rs 1,715, has not been entered in the control account.
(ii) On listing-out, an individual credit balance of Rs 205 has
been incorrectly treated as a debit.
(iii) A petty cash payment to a supplier amounting to Rs 63 has
been correctly treated in the control account, but no entry
has been made in the supplier’s individual ledger account.
(iv) The purchases daybook total for March has been under
cast (understated) by Rs 2,000.
(v) Contras (set-offs) with the sales ledger, amounting in total
to Rs 2,004, have been correctly treated in the individual
ledger accounts, but no entry has been made in the control
account.
Required:
(a) prepare the purchase ledger control account reflecting the
above information.
(b) prepare a statement reconciling the original total of the individual
balances with the corrected balance on the control account.
Solution
The way to approach the question is to consider each of the above five
points in turn and ask to what extent they affect (a) the purchase ledger
control account and (b) the listing of creditors ledger balances.
Step 1
The total of discounts received in the cash book is dealt with by
debiting purchase ledger control account and crediting discount
received. Thus, if the posting has not been entered in either double-
entry account it clearly should be. As the individual ledger accounts in

the creditors ledger are posted individually from the cash payments
book, the total of discounts received will not feature in any postings to
the creditors ledger; hence no amendment is required.
Step 2
Individual credit balances are extracted from the creditors ledger.
Here, this error affects the totals of the debit and credit balances of the
ledger account balances. No adjustment is required to the control
accounts.
Step 3
The question clearly states that the error has been made in the
individual ledger accounts. Amendments should be made to the list of
balances. Again, no amendment is required to the control accounts.
Step 4
The total of the purchases day book is posted by debiting purchases
and crediting purchase ledger control account. If the total is
understated the following bookkeeping entry must be made, posting
the Rs 2,000 understatement:
Dr Purchases
Cr Purchase ledger control
As the individual ledger accounts in the creditors ledger are posted
individually from the purchases day book, the total of the day book
being understated will not affect the listing of the balances in the
creditors ledger.
Step 5
Here it is clear that the error affects the control account, not the
creditors ledger. Correction should be made by the bookkeeping entry:
Dr Purchase ledger control
Cr Sales ledger control
Reconciliation of individual balances with control account balance
Purchase ledger control account
Rs Rs
Discount received (S1) 1,715 31 Mar Balance 21,832
(net)
Sales ledger control (S5) 2,004 Purchase (S4) 2,000
Balance c/d 20,113 ______
23,832 23,832
Reconciliation of individual balances with control account balance

Dr Cr
Rs Rs
Balances as extracted 1,012 20,778
Credit balance incorrectly treated 2 x Rs 205 (S2) 410
Petty cash payment (S3) 63 _____
1,075 21,188
(1,075)
Net total agreeing with control account 20,113

Summary
In this chapter the reasons why control account balances should be
equal to the list of individual balances in the relevant ledger were
considered as were the reasons why these two totals are very often not
equal. If the totals are not equal then the reasons for the difference
must be discovered and the control account and list of individual
balances amended accordingly. Having completed your study of this
chapter you should have achieved the following learning outcome.
 Prepare accounts for sales and purchases including personal

accounts and control accounts
Self-test questions
Control account reconciliation
1 Why should the balance on the purchase ledger control account equal
the total of the balances in the creditors ledger?
(1.1)
2 What is an alternative name for the sales ledger control account? (1.1)
3 What three types of difference may cause control account reconciliation
problems? (1.2)
4 Would the miscasting of the sales daybook affect the sales ledger
balances? (1.2)
5 Is the opening balance on the purchase ledger control account a debit or
a credit balance? (1.2)
6 What is the double entry for a discount received that has not been
entered in the accounts?
(1.2)
7 If a credit balance on a creditor’s account had been included in the list of
balances as a debit balance what amendment would be required?
(1.2)
8 Is the entry in a creditor’s individual account for a payment to them out of
petty cash a debit or a credit entry? (1.2)
9 If the purchases daybook were under-cast what would be the double
entry to amend this?
(1.2)
10 What is the double entry for a contra? (1.2)
11 The assistant accountant of Badshah Limited has prepared a Sales

Ledger Control account at December 31, 1999 to reconcile the same
with the list of Sales Ledger balances at that date. The control account
balances are:
Debit balances: Rs. 226,415 Credit balances: Rs. 1,250
The list of balances extracted from the sales ledger totals Rs. 225,575.
You discover the following:

(i) The credit balances have been included on the list of debtors as
debit balances.
(ii) A sales invoice of Rs. 6,400 has been recorded in the sales
daybook as Rs. 4,600, it has been correctly entered in the Sales
Ledger.
(iii) Cash discounts allowed amounted to Rs. 840 and cash
discounts received amounted to Rs. 560; the only entry in the
control account for discounts is a debit for cash discounts
received.
(iv) A dishonored cheque for Rs. 450 from customer has been
recorded correctly in the control account, but no entry has been
made in the debtor's personal account.
(v) A contra entry between the sales and purchase ledgers of Rs.
750 has been omitted from the control account.
(vi) The control account contains receipts from cash sales of Rs.
860 but does not contain the invoices to which these receipts
refer; no entries have been made in the sales ledger for these
invoices or receipts.
(vii) No entries have been made in the control account for bad debts
written off Rs. 2,150 and provision for doubtful debts Rs. 2,400.
Required:
(a) Correct the sales ledger control account.
Reconcile the listing of the individual balances to the revised
sales ledger control account balances.
12 The total balances as at March 31, 1995 of the individual accounts in

the Purchase Ledger of Furqan Limited, furniture distributors,
amounted to:
Rs.
Credit balances 19,493
Debit balances 761
The above amounts agreed with the purchase ledger control account
as at March 31, 1995. The following information relates to the
company’s activities during the year ended March 31, 1996.
a) Credit purchases totaled, at list price Rs. 246,000
b) Credit purchases returned to suppliers, totaled, at list price Rs.
2,584.
c) Payments totaling Rs. 187,316 settled outstanding debts of
Rs.190,416.
d) In addition to the payments mentioned in (c) above, Furqan
Limited paid Khan Printer Limited in February 1996 Rs. 3,000 as
a deposit for a supply of specially constructed arms chairs. The
manufacture of these chairs will commence in May 1996. The
payment to Khan Printer Limited is the first and only transaction
with that company on or before March 31, 1996.

e) On March 31, 1996, a cheque for Rs.416, paid by the company
to Bahadur Zaheer was returned for the date shown of March
20, 1996 to be corrected.
All goods purchased by Furqan Limited during the year ended March
31, 1996 are subject to a trade discount of 25% off list prices.
Early in March 1996, it was discovered that both the purchase ledger &
sales ledger included in account for the same person, Hakeem. The
purchase ledger account as at March 31, 1996 showed a credit
balance of Rs.540 and the sales ledger account at the same date, a
debit balance of Rs.5,250. It was decided to set-off one balance
against the other as at March 31, 1996.
At March 31, 1996, the following accounts in the purchase ledger had
debit balances as indicated below:
Rs.
Saeed 200
Sohail Aamir 210
A payment of Rs.100 in May 1995 to Rashid, a creditor had been
debited in the purchases account; before the discovery of the
accounting treatment of this payment, the balance at March 31, 1996
on Rashid’s account in the purchase ledger was Rs.100 credit.
There are no accounts with debit balances as at March 31, 1996 in the
purchase ledger other than those referred to above.
Required:
a) The purchase ledger control account for the year ended March
31, 1996.
b) The journal entry for the necessary adjustment to the accounts
of Mr. Hakeem.
1 A mistake in totalling the sales day book will require an adjustment in:
A The control account only

B The list of debtor balances only
C Both the control account and the list of debtor balances
D No adjustment required
2 A contra will be recorded as follows:
A In the individual accounts only

B In the control accounts only
C In the control accounts and individual accounts
D Neither as they cancel each other out

3 An invoice for cash purchases has been recorded in the purchase day
book. The adjustment required is:
A To the control account only

B Both control account and individual account
C The individual account only
D No adjustment
4 Mr. A is reconciling the purchases ledger with the purchase ledger

control account. What is the effect of an error in the casting of the
purchases day book?
A The list of balances will need adjusting

B The control account will need adjusting
C Neither will need adjusting
D Both will require adjusting
Answers
11
(i) SALES LEDGER CONTROL ACCOUNT
Rs. Rs.
31.12.99 b/d 226,415 31.12.99 b/d 1,250
Sales (less recorded)(ii) 1,800 Discount received
(6,400 – 4,600) (wrongly recorded) (iii) 560
Cash Sales Discount allowed (iii) 840
(wrongly recorded) (vi) 860 Creditors set off (v) 750
Bad debts (vii) 2,150
_____ c/d 223,525
229,075 229,075
(ii) RECONCILIATION STATEMENT
Rs.
Balance as per Sales Ledger (DR) 225,575
Less: Credit balance listed as debit balance (1,250 x 2) (i) (2,500)
223,075
Add: Cheques dishonoured (iv) 450
Adjusted balance as per sales ledger agreed with net
balance of sales ledger
control A/C (DR) (224,775 – 1,250) 223,525

12
a) FURQAN LIMITED
PURCHASE LEDGER CONTROL ACCOUNT
Rs. Rs.
1995 1995
Apr.01 Balance b/d 761 Apr.01 Balance b/d 19,493
Apr.01 Purchase returns (b) 1938 Apr.01 Purchases (a) 184,500
to (less trade discount) (less 25% trade discount)
1996 1996
Mar.31 Cash (c) 187,316 Mar.31 Balance c/d
(Rs.200+210+3,000) 3,410
Discount (c) 3,100
Cash paid to Khan
Printers (d) 3,000
Sales ledger control A/c
- Hakeem's balance
transferred 540
Purchases - Rashid's
balance adjusted 100
Balance c/d 10,648 _______
207,403 207,403
b) JOURNAL ENTRY
There are two accounts of Mr. Hakeem. One is in Sales Ledger and other one
is in Purchase Ledger.
Mr. Hakeem’s account in Purchase Ledger will be debited and his account will
be credited in Sales Ledger.
Journal entry in general ledger will be:
1996 Dr. Cr.

March 31 Purchase Ledger Control Account 540
To Sales Ledger Control A/c 540
MCQs
1 A
2 C
3 B
4 B

 describe the purpose of bank reconciliations

 identify the main differences between the cash book and the bank statement
 correct cash book errors or omissions prepare bank reconciliation statements

1 The bank reconciliation
1.1 The objective of a bank reconciliation is to reconcile the difference

between:
 the cash book balance, i.e. the business’ record of their bank
account,and
 the bank statement balance, i.e. the bank’s records of the bank
account.
Note that debits and credits are reversed in bank statements because
the bank will be recording the transaction from its point of view, in
accordance with the business entity concept.
1.2 Reasons to prepare a bank reconciliation statement
Nature and purpose of a bank reconciliation statement.
The cash book records all transactions with the bank. The bank
statement records all the bank’s transactions with the business.
The contents of the cash book should be exactly the same as the
record provided by the bank in the form of a bank statement, and
therefore our records should correspond with the bank statement.
This is in fact so, but with three important provisos:
(1) The ledger account maintained by the bank is the opposite way
round to the cash book. This is because the bank records the
balance in favour of an individual as a credit balance, i.e. a liability
of the bank to the individual. From the individual’s point of view it is,
of course, an asset, i.e. a debit balance in his cash book.
(2) Timing differences must inevitably occur. A cheque payment is

recorded in the cash book when the cheque is despatched. The
bank only records such a cheque when it is paid by the bank, which
may be several days later.
(3) Items such as interest may appear on the bank statement but are
not recorded in the cash book as the cashier is unaware that they
have arisen.
The existence of the bank statement provides an important check on the
most vulnerable of a company’s assets – cash. However, the differences
referred to above make it essential to reconcile the balance on the ledger
account with that of the bank statement.
The reconciliation is carried out frequently, usually at monthly intervals.

2 Differences between the bank statement and the cash book
2.1 When attempting to reconcile the cash book with the bank statement,
there are three differences between the cash book and bank
statement:
 unrecorded items
 timing differences
 errors
2.2 Cash book adjustments
Unrecorded items
These are items which arise in the bank statements before they are
recorded in the cash book. Such ‘unrecorded items’ may include:
 Interest
 bank charges
 dishonoured cheques.
They are not recorded in the cash book simply because the business
does not know that these items have arisen until they see the bank
statement.
The cash book must be adjusted to reflect these items:
Example
On which side of the cash book should the following unrecorded items
be posted?
 bank charges
 direct debits/standing orders
 direct credits
 dishonoured cheques
 bank interest.
Ans:
Cash book
Rs Rs
Bank interest X Bank charges X
Direct credits X Direct debits/ standing X
orders
Dishonoured cheques X
2.3 Bank reconciliation adjustments

Timing differences
These items have been recorded in the cash book, but due to the bank
clearing process have not yet been recorded in the bank statement:
 Outstanding/unpresented cheques (cheques sent to suppliers

but not yet cleared by the bank).

 Outstanding/uncleared lodgements (cheques received by the
business but not yet cleared by the bank).
The bank statement balance needs to be adjusted for these items:
Rs
Balance per bank statement X
Less: Outstanding/unpresented cheques (X)
Add: Outstanding/uncleared lodgements X
Balance per cash book (revised) X
2.4 Errors in the cash book
The business may make a mistake in their cash book. The cash book
balance will need to be adjusted for these items.
2.5 Errors in the bank statement
The bank may make a mistake, e.g. record a transaction relating to a

different person within our business’ bank statement. The bank
statement balance will need to be adjusted for these items.
3 Outstanding payments and receipts
3.1 Outstanding or unpresented cheques

Suppose a cheque relating to a payment to a supplier of Poorboy is
written, signed and posted on 29 March. It is also entered in the cash
book on the same day. By the time the supplier has received the
cheque and paid it into his bank account, and by the time his bank has
gone through the clearing system, the cheque does not appear on
Poorboy’s statement until, say, 6 April. Poorboy would regard the
payment as being made on 29 March and its cash book balance as
reflecting the true position at that date.
3.2 Outstanding deposits

In a similar way, a trader may receive cheques by post on 31 March,
enter them in the cash book and pay them into the bank on the same
day. Nevertheless, the cheques may not appear on the bank statement
until 2 April. Again the cash book would be regarded as showing the
true position. Outstanding deposits are also known as outstanding
lodgements.
3.3 Dishonoured cheques

Consider an example. Suppose that for the past two months
Diamonde's ledger balance has shown an amount owing to you of Rs
28. They send you a cheque for Rs 28 on 3 June that you promptly
enter in the cash book and pay into the bank. This increases cash and
reduces debtors by Rs 28. A week later the bank returns the cheque
marked R/D (return to drawer), i.e. it has been dishonoured. Since

Diamond's bank account is heavily overdrawn, their own bank has
refused to honour the cheque. What effect does this have? There are
two points to consider:
(a) The overall effect on your bank statement is nil. The receipt of Rs
28 shown earlier on the bank statement will be cancelled out by the
subsequent reversing entry by the bank (shown on the payments
side of the bank statement and marked as 'dishonoured cheque' or
'item advised').
(b) Diamond still owes Rs 28 – the earlier cheque was a worthless
piece of paper. The receipt of the cheque will have been recorded
in the cash receipts book in the usual way, and it will be included in
the total posted by debiting bank and crediting sales ledger control
account at the end of the month. This must now be corrected by
debiting sales ledger control account and crediting bank.
Diamond's account in the debtors ledger will appear as follows:

Diamond
Rs Rs
Balance b/d 28 Cash 28
Dishonoured 28 Balance c/d 28
cheque
56 56
4 Proforma bank reconciliation

Cash book
Rs Rs
Bal b/f X Bal b/f X
Adjustments X Adjustments X
Revised bal c/f X Revised bal c/f rX
_____ _____
X X
Revised bal b/f X Revised bal b/ X
Bank reconciliation statement as at

Rs
Balance per bank statement X
Outstanding cheques (X)
Outstanding lodgements X
Other adjustments to the bank X/(X)
statement
Balance per cash book (revised) X
 Beware of overdrawn balances on the bank statement.
 Beware of debits/credits to bank statements.
 Beware of aggregation of deposits in a bank statement.
 Note that the bank balance on the statement of financial position is
always the balance per the revised cash book.

Example
On 31 July 20X7 Sun Ltd's bank ledger account showed a balance in hand
of Rs 52 compared with a balance of Rs 134 shown by the bank
statement. The following was discovered:
(a) Cheques drawn by Sun Ltd during July, amounting to Rs 356, Rs
1,732 and Rs 196, had been entered in the cash book but had not
been presented at the bank by the end of the month.
(b) Sun Ltd had forgotten to enter in the cash book a standing order of
Rs 50 relating to a trade subscription.
(c) The bank had incorrectly credited Sun Ltd's account with a
dividend receipt of Rs 25 relating to another customer.
(d) Bank charges of Rs 105 shown on the bank statement had not yet
been entered in the cash book.
(e) Cheques received from customers amounting to Rs 1,211 were
entered in the cash book on 31 July but were not credited on the
bank statement until 3 August.
(f) Direct credits from customers of Rs 180 and Rs 31 had been paid
direct into the bank, but no entry had been made in the cash book.
(g) The payments side of the cash book for July had been undercast
by Rs 1,000 (this means that the total of the payments side is
understated by Rs 1,000).
(h) The statement shows an item 'return cheque Rs 72'. This has not
yet been accounted for in the cash book.
You are required to show adjustments to the bank account and to

prepare the bank reconciliation statement at 31 July 20X7.
Solution
Step 1
Identify those items that have yet to be entered in the cash book.
These include (b), (d), (f) and (h). The error by the bookkeeper (g) must
be corrected through the cash book since the unadjusted balance of Rs
52 has been affected by the addition error.
Step 2
Identify those items which appear in the cash book but not in the
statement: these include (a) and (e). These will appear on the bank
reconciliation statement.
Step 3
The error by the bank (c) will be adjusted on the face of the bank
reconciliation statement.

Cash at bank account
20X7 Rs. 20X7 Rs.
31 Jul Balance b/d 52 (b) Subscriptions 50
(f) Direct credit 180 (d) Bank charges 105
(f) Direct credit 31 (g) Cash book 1,000
(h) Dis1honoured 72
cheque
263
Corrected balance 964
c/d
1227 1227
Corrected balance 964
b/d (overdrawn)
Bank reconciliation statement at 31 July 20X7

Rs. Rs.
Balance per statement 134
Correction of error by bank- amount (25)
wrongly credited (c)
109
Unpresented cheques:
(a) 356
(b) 1,732
(a) 196
(2,284)
(2,175) O/D
Outstanding deposits (e) 1,211
Balance per cash book (overdrawn) (964) O/D
Notes: the bank reconciliation statement is rather complicated because it

starts with a balance in hand and ends up with an overdraft balance (O/D).
The logic is as follows:
(a) If the Rs 25 had been credited to the correct customer, Sun Ltd's
balance would have been only Rs109 (in hand).
(b) The three unpresented cheques are regarded as payments for July.
Had they appeared in the bank statement in July, they would have
had the effect of turning a Rs109 balance in hand into an overdraft of
Rs 2,175 (be careful with the arithmetic!).
(c) Operating in the opposite direction, if the deposits of Rs 1,211 had
been included in the bank statement in the same month as the cash
book, the overdraft would have been reduced from Rs 2,175 to Rs
964.

(d) This illustration shows how important it is to understand the processes
rather than to memorise a layout.
The bank account and the bank statement balance have now been
reconciled. A Statement of financial position at 31 July 20X7 would show a
bank overdraft of Rs 964 under the heading of current liabilities.
Self-test questions
Bank reconciliations
1 Why does the bank statement appear to be the opposite way round to a
ledger account? (1.1)
2 What types of items might appear on the bank statement but not be in the
cash book? (1.3)
3 What are the two types of timing difference that might cause there to be a
difference between the cash account and the bank statement? (1.4)
4 What is another name for an outstanding deposit? (1.4)
5 What does a cheque marked R/D mean? (1.6)
6 What is the double entry for a dishonoured cheque? (1.6)
7 What would be the treatment of bank charges omitted from the cash
book?
(1.6)
8 What is the treatment of direct credits, paid into the bank from customers,
in the cash account? (1.6)
9 A business had a bank balance of Rs. 12.5 million at the start of the
month. During the following month, it paid for materials invoiced at Rs,
18.0 million less trade discount of 25% and cash discount of 20%. It
received a cheque from a debtor in respect of an invoice for Rs. 12.0
million, subject to cash discount of 10%.
Required: What was the balance at the bank at the end of the
month? Please show calculations to Support your answer.
10 As at 30 June, 1998 Mr. Sarfraz’s cash book of current account shows

a debit balance of Rs. 300; his bank statement shows an
overdraft of Rs. 100. He notes the following points:
a) A cheque for Rs. 60 drawn by Mr. Aslam was incorrectly cleared
by bank through this account.
b) The bank statement does not show receipts of 30 June, 1998
amounting to Rs. 724.
c) A cheque for Rs. 76 from a debtor was dishonoured.
d) Mr. Sarfraz had brought forward a total of Rs. 2,154 on the
receipt side of the cash book as Rs. 1,254.
e) Mr. Sarfraz had omitted standing orders for payments totaling
Rs. 175 and bank charges of Rs. 7 from his cash book.
f) Mr. Sarfraz had transferred Rs. 500 from his deposit account to
his current account, the bank had performed the reverse
transfer.
g) Outstanding cheques, excluding those written back, totaled Rs.
750.

h) In the previous month, Mr. Sarfraz has written back old cheques
totaling Rs.34 without telling the bank that these were to be
cancelled. One of these cheques, for Rs. 8, was presented for
payment and appeared on the bank Statement.
Required: Show the adjustments to be made to the cash book and;

produce a bank reconciliation statement as at 30 June, 1998.
1 Bank charges for the period on the bank statement which are not in the
cash book would be adjusted as follows:
A Add them back to the statement balance
B Dr Cash book Cr Bank charges
C Dr Bank charges Cr Cash book
D Unpresented item in bank reconciliation
2 What should be the balance on the cash book when the statement
balance is Rs.2,789.31 Dr, there are uncleared lodgements of
Rs.138.14 and unpresented cheques of Rs.839.19?
A Rs 3,766.64
B Rs 2,088.26 overdrawn
C Rs 2,088.26
D Rs 3,490.36 overdrawn
3 Khuldun’s cash book has a balance of Rs.4,656 CR. On the bank
statement he finds unpresented cheques of Rs.2,322, uncleared
lodgements of Rs.567 and unrecorded bank charges of Rs.50. What is
the bank statement balance?
A Rs 2,851
B Rs 2,951 overdrawn
C Rs 2,951
D Rs 6,461 overdrawn
4 The purpose of a bank reconciliation is:
A To check that the business has enough cash to survive
B To enable the company to prepare a cash flow statement
C To make sure that the double entry system is working
D To make sure that the balance in the bank agrees with the cash
book balance
5 Ms. Sara reconciled the bank statement and found the following
unrecorded items:
(1) A cheque receipt of Rs 120 had been referred to drawer
(2) Debit interest of Rs 35
Tick the box to state the correct adjustment in the cash book for these
items:
DR CR
A Dishonoured cheque
B Interest - -
- -

6 The bank statement of Ms. Aleena shows a credit balance of Rs 100
and credit interest of Rs 40 and a standing order of Rs 75, which have
not been recorded in the cash book. There are unpresented cheques
amounting to Rs 245 and uncleared lodgements of Rs 60. What is the
cash book balance?
A Rs 65
B Rs 85 overdrawn
C Rs 120 overdrawn
D Rs 200 overdrawn
Answers
9.
Rs. Rs.
Balance at bank at start of the month 12,500,000
Add: Received cheque from a debtor 12,000,000
Cash discount 12,000,000 x 10% (1,200,000) 10,800,000
23,300,000
Less: Payment for materials 18,000,000
Trade discount (18,000,000 x 25%)(4,500,000)
13,500,000
Cash discount (13,500,000 x 20%)(2,700,000)
10,800,000
_________
Balance at the end of the month 12,500,000
10.
MR. SARFRAZ
CASH BOOK OF CURRENT ACCOUNT
Rs. Rs.
June 30 June 30
1988 1988
To Balance b/f 300 By Debtors A/c, -
To Surplus A/c. - Cheque dishonoured ( c) 76
amount less brought By Expenses - Standing order
forward (d) 900 payments (e) 175
By Bank charges (e) 7
By Deposit A/c.-
By creditors A/c. (h) 8
_____ By Balance 934
1,200 1,200

MR. SARFRAZ
BANK RECONCILIATION STATEMENT
AS ON JUNE 30, 1998
Rs.
Balance as per cash book (Adjusted) 934 DR.
Less: Amounts debited but not credited by the bank (724)
Amount wrongly debited by bank (a) 60
Amount wrongly debited by bank 500
Un-credited amount 500
(850) CR
Add: Un-presented cheques 750
Balance as per Bank Statement (overdraft) 100 DR.
MCQs
1 C
2 D
3 B
4 D
5 The dishonoured cheque is a credit as the cash has not been received
(previously the receipt would have been a debit in the cash book) The
interest is a debit on the bank statement, therefore a credit in the cash
book – this is an interest expense
6 B

 define non-current assets
 explain the function and purpose of an asset register
 explain and illustrate the ledger entries to record the acquisition and disposal
of non-current assets
 define and explain the purpose of depreciation
 make the necessary adjustments if changes are made in the estimated useful
life/residual value of a non-current asset
 define intangible assets
 accounting treatment of intangible assets
 Accounting treatment of research and development costs

1 Non-current assets
1.1 Non-current assets are distinguished from current assets by the

following characteristics:
they:
 are long-term in nature
 are not normally acquired for resale
 are could be tangible or intangible
 are used to generate income directly or indirectly for a business
 are not normally liquid assets (i.e. not easily and quickly
converted into cash without a significant loss in value).
1.2 Classification of Non-Current Assets in Statement of Financial

Position
As per the requirements of Companies Ordinance 1984 Non-Current

assets shoud be classified as follows:
Property, Plant and Equipment ( Main Head)
a) Land (distinguishing between free hold and lease hold);

b) Buildings (distinguishing between building on free hold land and
those on leasehold land);
c) Plant and machinery.
d) Furniture and fittings.
e) Vehicles.
f) Office equipment.
g) Capital work in progress indicating significant item wise details;
h) Development of property; and
i) Others to be identified.
2 Cost
2.1 An item of property, plant and equipment is initially recorded at its cost,
the cost of an asset:
• include all costs involved in bringing the asset into working

condition
• include in this initial cost capital costs such as the cost of site
preparation, delivery costs, installation costs.
• revenue costs should be written off as incurred

Example
Noor Limited imported a machinery with following details:
Rs. ‘000’
Invoice value 1,000
Custom duty 150
Central excise duty 50
Value determined by the authority for customs 1,300
Non-refundable sales tax 225
Income tax – adjustable against final liability 100
Carriage 40
Cost of restoring the site 90
Administration expenses 20
Required:
Compute cost of property, plant and equipment.
Solution
Rs’000
Invoice value 1,000
Customs 150
Central excise duty 50
Non-Refundable sales tax 225
Carriage 40
Cost of restoring the site 90
Cost of machinery 1,555
3 Depreciation
3.1 What is depreciation?
When a fixed asset is purchased by a business, the double entry is to

debit a fixed asset account and credit either cash or a creditor account.
The asset then remains in the balance sheet of the business until it is
disposed of. There are however two problems with this: Firstly the fixed
asset is earning revenue for the business that will be recognised in the
profit and loss account, but no part of the cost of the fixed asset is
being charged to the profit and loss account.
Secondly the fixed asset remains in the balance sheet at its original
cost until it is disposed of. However, it is highly unlikely that the fixed
asset's value will remain that of its original cost over the years; it is
likely to decrease in value as it is used.
DEFINITION
Depreciation is the measure of the cost or revalued amount of the

economic benefits of the tangible fixed asset that have been consumed
during the period.

The provision of depreciation deals with both of these problems.
Depreciation is defined as the measure of the cost or revalued amount
of the economic benefits of the tangible fixed asset that have been
consumed during the period. Depreciation is a method of charging a
proportion of a fixed asset's original cost to the profit and loss account
each year to match with the revenues that the asset earns. The
depreciation charge for each year also creates a provision account that
is used to net off against the original cost of the asset in the balance
sheet.
Depreciation may arise from:
 use, e.g. plant and machinery or motor vehicles;

 passing of time, e.g. a ten year lease of property;
 obsolescence through technology and market changes, e.g.
plant and machinery of a specialised nature;
 depletion, e.g. the extraction of material from a quarry.
KEY POINT
Depreciation is a method of applying the matching or accruals concept
to the cost of fixed assets. It is not a method of providing for, or saving
up for, replacement fixed assets.
3.2 Accruals concept
Assume a business has an item of plant that costs Rs 5,000 and that it
has a nil scrap value at the end of ten years. Since expenditure on the
asset will benefit the revenues of the next ten years, the accruals (or
matching) concept requires us to match the Rs 5,000 costs against all
of those revenues. The simplest way is to use the straight-line method
(discussed below) and charge one-tenth (i.e. Rs 500) against the
revenue of each year. Under historical cost accounting the purpose of
depreciation is to allocate the cost of Rs 5,000 over the expected life of
the asset of ten years. The profit and loss account for each year is
charged with part of the cost of the asset.
3.3 Purpose of depreciation
Note that the provision of depreciation is not intended to provide a fund

for the replacement of the asset. It is simply a method of allocating the
cost of the asset over the periods estimated to benefit from its use. In
our example it is unlikely that an equivalent replacement asset will cost
Rs 5,000 in ten years' time, due to inflation, and in any event
depreciation does not provide the funds to replace it.

4 Methods of calculating depreciation
4.1 Introduction
There are several possible methods of calculating depreciation. The
methods specified in the syllabus are:
 straight line method
 reducing balance method (also known as the declining balance
method)
 revaluation method.
Examiners will normally specify which method is to be used. If they do not,
the straight-line method should be adopted.
4.2 Straight line method

This is the simplest and most popular method of calculating depreciation.
Under this method the depreciation charge is constant over the life of the
asset. To calculate the depreciation charge we require three pieces of
information:
 the original (historical) cost of the asset

 an estimate of its useful life to the business
 an estimate of its residual value at the end of its useful life.
The depreciation charge is calculated as follows:
Original cost - Residual value

Annualdepreciation charge 
Estimatedusefullife
Example – Straight line method
Munawwar is a sole trader with a 31 December year end. He

purchased a car on 1 January at a cost of Rs 1,200,000. He estimates
that its useful life is four years, after which he will trade it in for Rs
240,000. The annual depreciation charge is to be calculated using the
straight line method.
Solution – Straight line method
Depreciation charge = (Rs 1,200,000 - Rs 240,000)/4 = Rs 240,000 pa.

Notes
(i) Depreciation is often expressed as a percentage of original cost,
so that straight line depreciation over four years would
alternatively be described as straight line depreciation at 25%
pa.
(ii) If the car had been purchased on 30 September 20X3, strictly

speaking we should only charge three months depreciation in
20X3. The depreciation charged each year would be:

Rs in ‘000
20X3 (240 × 3/12) 60
20X4 240
20X5 240
20X6 240
20X7 (240 × 9/12) 180
You should follow this approach unless the question specifies that a full
year's depreciation should be charged in the year of purchase
irrespective of the date of purchase.
(iii) Frequently residual value is not specified, in which case you

should assume it to be zero and the whole original cost will be
written off over the life of the asset.
4.3 Reducing (declining) balance method
Under this method the depreciation charge is higher in the earlier years
of the life of the asset. If examiners require this method, they will
usually give you a percentage to apply. In the first year the percentage
is applied to cost but in subsequent years it is applied to the asset's net
book value (alternatively known as written down value). The net
book value (NBV) or written down value (WDV) of a fixed asset is the
historical cost less any accumulated depreciation.
DEFINITION
The net book value (NBV) or written down value (WDV) of a fixed asset
is the historical cost less any accumulated depreciation.
Example – Reducing balance method
A trader purchased an item of plant for Rs 1,000,000. The depreciation

charge for each of the first five years is to be calculated, assuming the
depreciation rate on the reducing balance to be 20% pa.
Solution – Reducing balance method
Year % - NBV = Depreciation Depreciation Cumulative

charge charge depreciation
Rs in ‘000 Rs in ‘000
1 20% x Rs 1,000 200 200
2 20% x Rs (1,000 – 200) 160 360
3 20% x Rs (1,000 – 360) 128 488
4 20% x Rs (1,000 – 488) 102 590
5 20% x Rs (1,000 – 590) 82 672

Notice how this method results in higher depreciation charges in earlier
years and also that a much higher annual rate is required than for the
straight line method if the asset is to be written off over the same
period.
5 Accounting for depreciation

5.1 Ledger accounts
Whichever of the two methods is used, the bookkeeping remains the
same.
(a) On acquisition of the fixed asset:

Debit Credit With
Fixed asset – Cash a/c Cost of the asset
cost a/c
(b) At the end of each year make the adjustment for depreciation:
Debit Credit With
Depreciation expense Fixed asset – Depreciation charge
– profit and loss a/c accumulated
depreciation a/c
(c) In the balance sheet the amount for fixed assets consists of the original
cost less the accumulated depreciation.
Example
The example of the straight line method introduced earlier is

reproduced below. Munawwar is a sole trader with a 31 December year
end. He purchased a car on 1 January at a cost of Rs 1,200,000. He
estimates that its useful life is four years, after which he will trade it in
for Rs 240,000. The annual depreciation charge is to be calculated
using the straight line method. A full year’s depreciation expense will
be charged in the year of purchase.
Show the ledger accounts for the first three years, together with the
effect on the financial statements.
Solution
Step 1
Set up a 'Motor car – cost account' and a 'Motor car – accumulated
depreciation account' (the provision for depreciation account).
Step 2
Account for the purchase of the car by debiting the Motor car – cost
account with Rs 1,200,000 on 1 January 20X3.

Step 3
At 31 December 20X3 carry down the cost of the car on the motor car
cost account.
Step 4
At 31 December 20X3 account for the first year’s depreciation charge
of Rs 240,000 by debiting the profit and loss account and crediting the
Motor car – accumulated depreciation account. Carry down the
balance on the Motor car – accumulated depreciation account.
Step 5
Repeat steps 3 and 4 at 31 December 20X4 and 20X5. Note how the
balance on the Motor car – accumulated depreciation account
increases each year as this is the total of the depreciation charged to
date on that motor car.
Motor car – cost account

20X3 Rs in 20X3 Rs in ‘000
‘000
1 Jan Cash 1,200 31 Dec Balance 1,200
c/d
20X4 20X4
1 Jan Balance b/d 1,200 31 Dec Balance 1,200
c/d
20X5 20X5
1 Jan Balance b/d 1,200 31 Dec Balance 1,200
c/d
20X6
Motor car – accumulated depreciation account

20X3 Rs in ‘000 20X3 Rs in ‘000
31 Dec Balance 240 31 Dec P&L a/c 240
c/d
20X4 20X4
c/d
480 480
20X5 20X5
c/d
720 720
20X6

Alternative solution
An alternative approach, which is normally used in more complex

situations, is to open an additional account for depreciation expense.
The overall effect will be exactly the same, as can be shown if we
consider the year 20X3 in the example above.

20X3 Rs in 20X3 Rs in ‘000
‘000
1 Jan Cash 1,200 31 Dec Balance 1,200
c/d
20X4 20X4
1 Jan Balance b/d 1,200 1,200
The depreciation expense account is a 'holding account' that holds the

depreciation expenses that will then be written off to profit and loss
account. It is used when there are many assets being depreciated and
saves multiple transfers of depreciation to the profit and loss account.
Motor car – accumulated depreciation account

20X3 Rs in ‘000 20X3 Rs in ‘000
Dec Balance c/d 240 31 Dec
Depreciation
expense 240
20X4
Depreciation expense account
20X3 Rs in 20X3 Rs in ‘000
‘000
31 Dec Motor car 240 31 Dec P&L a/c 240
accumulated
depreciation
KEY POINT
The annual charge for depreciation is made by debiting either a
depreciation expense account or the profit and loss account directly,
and crediting the accumulated depreciation account.
5.2 Effect on financial statements
The balance on the accumulated depreciation account is netted off

against the cost of the fixed asset in the balance sheet each year to
give the NBV of the fixed asset.

The fixed asset will be shown in Munawwar's financial statements as
follows:
(a) Profit and loss account

Year Depreciation
charge
Rs in ‘000
20X3 240
20X4 240
20X5 240
(b) Balance sheet

20X3 20X4 20X5
Rs in ‘000 Rs in ‘000 Rs in ‘000
Fixed asset:
Motor car: Cost 1,200 1,200 1,200
Depreciation cost 240 480 720
Net book value 960 720 480
KEY POINT
against the cost of the fixed asset in the balance sheet each year to
give the net book value of the fixed asset.
5.3 Summary of the effect of depreciation
(a) Without depreciation the full cost of the asset would appear on
the balance sheet each year.
(b) With depreciation the value of the asset on the balance sheet is
reduced by the amount of the cumulative annual depreciation
charges.
(c) The annual depreciation charge appears in the profit and loss
account each year thereby charging the profit and loss account
with a proportion of the cost of the fixed asset each year in
accordance with the matching or accruals concept.
6 Acquisition of a non-current asset
A non-current asset register is maintained in order to control non-current

assets and keep track of what is owned and where it is kept.
It is periodically reconciled to the non-current asset accounts maintained in

the general ledger.

The cost of a non-current asset is any amount incurred to acquire the
asset and bring it into working condition
 The correct double entry to record the purchase is:

Dr Non-current asset X
Cr Bank/Cash/Payables X
 A separate cost account should be kept for each category of non-
current asset, e.g. motor vehicles, fixtures and fittings.
6.1 Subsequent Expenditure
Subsequent expenditure on the non-current asset can only be recorded

as part of the cost (or capitalised), if it enhances the benefits of the
asset, i.e. increases the revenues capable of being generated by the
asset.
An example of subsequent expenditure which meets this criterion, and

so can be capitalised, is an extension to a shop building which provides
extra selling space.
An example of subsequent expenditure which does not meet this

criterion is repair work. Any repair costs must be debited to the income
statement, i.e. expensed.
7 Sale of fixed assets

7.1 Introduction
When a fixed asset is sold, the cost of that asset together with the
related accumulated depreciation should be transferred to a fixed asset
disposals account. The profit or loss on disposal is calculated by
comparing:
 the net book value of the asset at the date of sale (i.e.
cost less depreciation provision), and
 the proceeds of sale.
7.2 Ledger account entries
The purpose of the ledger account entries is to remove the asset being
sold from the ledger accounts and to account for any profit or loss on
the sale. This is all done in a disposals ledger account.

Ref Debit Credit With
1 Disposals account Fixed asset – cost Original cost of asset
account
2 Fixed asset – Disposals account Accumulated
accumulated depreciation up to the
depreciation date of disposal
3 Cash Disposals account Proceeds of sale
4A Disposals account Profit and loss Profit on sale
(balancing figure)
or
4B Profit and loss Disposals account Loss on sale
(balancing figure)
Summary of the bookkeeping entries:
Example
The motor car used in the previous example was sold on 1 January
20X6 for proceeds of Rs 510,000. It had been bought for Rs 1,200,000
and the accumulated depreciation on 1 January 20X6 was Rs 720,000.
Show the entries in the relevant ledger accounts.
Solution
Step 1
The profit on sale can be calculated arithmetically or derived from the
use of the disposals account. The arithmetic computation is:
Rs in ‘000
Proceeds of sale 510
Less: Net book value at date of sale 480
Rs(1,200,000 – 720,000)
Profit on sale 30
Step 2
Write up the ledger accounts.
20X6 Rs in ‘000 20X6 Rs in ‘000
1 Jan 1,200 7 Jan (1) 1,200
Balance b/d Disposals
Motor car – depreciation provision

20X6 Rs in ‘000 20X6 Rs in ‘000
7 Jan (2) 720 1 Jan 720
Disposals Balance b/d

Motor car – disposals account
20X6 Rs in ‘000 20X6 Rs in
‘000
7 Jan (1) Motor car – cost 1,200 7 Jan (2) 720
Depreciation
31 Dec (4A) Profit and loss (bal 30 (3) Cash 510
fig)
1,230 1,230
(Numbers in brackets refer to the reference numbers in the summary

chart above).
KEY POINT
When a fixed asset is sold, the cost and accumulated depreciation are
cleared to the disposal account and compared with the sale proceeds.
This will give a profit/loss on sale or over/under depreciation provided.
7.3 Presentation
A final point – how should the Rs 30 be presented in the profit and loss
account? There are two possibilities:
 show the profit on sale of Rs 30 as a separate item of

miscellaneous income below gross profit or as a negative
expense.
 describe the Rs 30 as depreciation over-provided and deduct it
from the total depreciation charge for the year.
Both these presentations are acceptable, though the first is probably

easier and clearer.
8 Revaluation of fixed assets

8.1 Reasons for revaluation
During a period of inflation, the current monetary value of fixed assets
such as freehold land and buildings may be much in excess of their net
book value (historical cost less depreciation). A business may wish to
reflect the current worth of such assets on its balance sheet. This is
particularly the case with large companies who wish to show to the
users of their financial statements the current worth of significant
assets in the company.
The difference between the revalued amount and the net book value
(usually a surplus) needs to be credited to an account separate from
the profit and loss account as the gain is not realised (i.e. there is no
intention of turning the asset into cash by selling it). The account is
known as a revaluation reserve.

8.2 Depreciation of a revalued asset
When a fixed asset has been revalued, the charge for depreciation
should be based on the revalued amounts and the remaining useful
economic life of the asset. Therefore because of the revaluation, the
depreciation is higher than previously. This may appear strange; an
upward revaluation has resulted in a higher depreciation charge to the
profit and loss account. However, it should be remembered that the
prime function of depreciation is to write off the 'cost' of an asset over
its expected life. If the 'cost' is increased therefore the depreciation to
be charged increases.
The accounting treatment of fixed asset revaluations can be seen in

the following example.
Example
A company revalues its buildings and decides to incorporate the

revaluation into the books of account. The following information is
relevant (all figures are in Rs '000s).
(a) Extract from the balance sheet at 31 December 20X7

Rs’000
Buildings:
Cost 1,500
Depreciation 450
1,050
(b) Depreciation has been provided at 2% per annum on a straight
line basis over the 50 year life of the building. At 31 December
20X7 the building is 15 years old.
(c) The building is revalued at 30 June 20X8 at Rs 1,380,000. There
is no change in its remaining estimated future life.
You are required to show the relevant extracts from the final accounts
at 31 December 20X8.
Solution
There are two important points to appreciate. Firstly, depreciation must

continue to be charged on original cost until the date of the revaluation.
Secondly, the accumulated depreciation on the old cost is effectively
'cleared out' when the gain is transferred to the revaluation reserve.
Thus accumulated depreciation at the year end only consists of the
depreciation charged on the revalued amount.

Profit and loss account – depreciation charge
Rs’000
Based on original cost for half year 15
(W1)
Based on valuation for half year (W2) 20
Total 35
KEY POINT
Depreciation must continue to be charged on original cost until the date
of the revaluation. Secondly, the accumulated depreciation on the old
cost is effectively ‘cleared out’ when the gain is transferred to the
revaluation reserve. Thus accumulated depreciation at the year end
only consists of the depreciation charged on the revalued amount.
Balance sheet
Rs’000
Buildings
Valuation 30 June 20X8 1,380
Accumulated depreciation (W2) 20
1,360
Workings
(W1)
Buildings account (NBV)
20X8 Rs 20X8 Rs
1 Jan Balance b/d 1,050 30 Jun P&L a/c Depreciation
first half year (1,500 x 0.02 x
½) 15
30 June Revaluation
surplus (bal fig) 345
30 June Balance c/d
(revalued amount) 1,380
1,395 1,395
30 June Balance b/d 1,380 31 Dec P&L a/c
depreciation second half
year (W2) 20
31 Dec Balance c/d 1,360
1,380 1,380
(W2) Depreciation for second half of year

Rs’000
Second half year = 0.5 x 1,380/34.5 years 20
9 Special Situations Relating assets

9.1 Introduction

Accounting standard for Tangible Fixed Assets, covers all areas of
accounting for tangible fixed assets. It does not make a preference for
any particular method of depreciation, but states that individual
businesses must decide which is the most appropriate.
It hen covers special situations including:
 revision of useful lives

 change in method of depreciation
 land and buildings
 Each of these is covered below.
9.2 Revision of useful lives
The useful economic lives of assets should be reviewed at each year

end and, when necessary, revised. When, as a result of experience or
of changed circumstances, it is considered that the original estimate of
the useful economic life of an asset requires revision, the effect of the
change in estimate on the profit and loss account needs to be
considered. The net book amount is written off over the revised
remaining useful economic life.
Example
An asset was purchased for Rs 100,000 on 1 January 2005, straight

line depreciation of Rs 20,000 pa was charged (five year life, no
residual value). A general review of asset lives is undertaken and for
this particular asset, the remaining useful life as at 31 December 2007
is seven years.
The accounts for the year ended 31 December 2007 are being
prepared. The calculations are:
Rs 60,000
Remaining years useful life 8 years
Annual depreciation charge (Rs 60,000 / 8 years) Rs 7,500
Note that the estimated remaining life is seven years from 31

December 2007, but this information is used to compute the current
year's charge as well. In the ledgers, cost remains at Rs 100,000 and
accumulated depreciation at 31 December 2007 is Rs 47,500 (40,000
+ 7,500) giving a net book value of Rs 52,500.
9.3 Change in method of depreciation
A change from one method of providing depreciation to another is

permissible only on the grounds that the new method will give a fairer
presentation. The net book amount should be written off over the
remaining useful economic life, commencing with the period in which
the change is made.

9.4 Land and buildings
Freehold land does not normally require a provision for depreciation,

unless its value is subject to depletion by, for example, the extraction of
minerals. However, the value of freehold land may be adversely
affected by considerations such as changes in the desirability of its
location and in these circumstances it should be written down.
Buildings are no different from other fixed assets in that they have a
limited useful economic life, albeit usually significantly longer than that
of other types of assets. They should, therefore, be depreciated having
regard to the same criteria.
10 Fixed asset registers

10.1 Introduction
Fixed assets are often the most significant items in value terms in a
business. It is therefore important that controls exist to ensure that
fixed assets do not 'disappear' through theft or by not being utilised
properly. An essential first step in maintaining control is full information
on the assets owned by a business.A fixed asset register is a means of
providing the information.
10.2 Fixed asset register
Any business with more than a few fixed assets needs to maintain a
record of the assets it owns so that:
 checks can be made of the continuing existence and conditions

of the assets
 depreciation rates can be reviewed
 checks can be made as to whether the asset is being used as
efficiently as originally envisaged.
The form in which this register is kept can vary. Computerised registers
allow data to be extracted in a variety of ways depending upon the use to
be made of the information. Depreciation calculations can be automatically
performed. The register will typically contain the following details. An
example is shown on the next page.
 date of purchase
 cost of asset
 supplier details
 asset description
 code number
 location
 estimated useful life
 estimated residual value
 depreciation method
 depreciation to date/book value.
Ideally the register should reconcile to the cost and depreciation figures
that appear in the financial accounting ledger accounts at the end of
the accounting period.
10.3 Recording entries in the fixed asset register
Information relating to a fixed asset should be recorded in the fixed

asset register when the asset is purchased. Accumulated depreciation
and disposal information should be added at the appropriate time. . If
the information on the fixed asset changes then the new information
must be recorded in the fixed asset register. The business will normally
have procedures that ensure the accounting department is made
aware of any of these changes, to allow the updating of the fixed asset
register.
Example of a fixed asset register

Fixed asset register
Class/Group of assets: plant and machinery
Register prepared as at close of business: 31 December 20X6
Asset: 1 2 3 4 Total
Acq date: 16.2.X2 1.1.X3 30.6.X6
Description Compressor Scrivemor Excelsior
XT 1 Z2Y
Location: Lahore Gujrat Chunian
Estimated Life (yrs): 5 5 5
Estimated residual 1,000 1,000 Nil
value (Rs):
Depreciation method: S/L S/L S/L
Cost (Rs): 5,600 11,600 7,000
Dep’n b/d (Rs): 3,680 6,360 –
Period Dep’n (Rs): 920 – 1,400
Disposal date: 30.6.X6
[if sold]
Proceeds (Rs): 2,800
[if sold]
P/L on sale (Rs): (2,440)
Totals c/d 5,600 – 7,000 12,600
– Cost: 4,600 – 1,400 6,000
– Acc dep’n:
[All figures to be
recorded to the nearest Rs.]
Example: Recording entries in the fixed asset register

The assets detailed below were purchased by XYZ Ltd.
An IBM computer (asset number 13465), to be used in Accounts, from
Computer Supplies Ltd for Rs 1,500,000 on 30 November 20X0. The machine
has a useful life of three years and an estimated scrap value of Rs 300,000. It
is to be depreciated on a straight line basis. A mixing machine (asset number
24536) from Industrial Supplies Ltd to be used in Factory 1, for Rs 4,000,000.
This has a useful life of five years and will be written off using the reducing
balance method. The machine was purchased on 4 October 20X0 and is not
expected to have any value at the end of its useful life.
Record this information in the fixed asset register.
Solution: Recording entries in the fixed asset register
Fixed asset register

Us
Asset Des Loca Suppli Purcha Dep
e Cost Scrap
numb criptio tion er ref se ref metho
ful Rs value
er n Purch d
life
ase
13465 IBM Accoun CS Ltd 30/11/X 3 SL 1,500,0 300,0
compu ts 0 00 00
tr
24536 Mixing Fact 1 IS Ltd 4/11/X0 5 RB 4,000,0 Nil
Machi 00
ne
Acc Date of Dis

Dep for
dep NBV Rs dis posal pro
year
Rs posal ceeds Rs
Note that manual fixed asset registers often have a separate page for
each fixed asset so that information that changes annually, such as
accumulated depreciation and net book value, may be updated.
10.4 Types of control
A business needs to exercise control over fixed assets in the following
areas.
(a) Authorisation procedures for purchasing

As capital items are not purchased frequently, procedures should
be established to ensure that only responsible officials purchase
fixed assets. Procedures may include obtaining more than one
quotation for an item and expenditure limits on any one item for
certain officials. Ideally, the person authorising the expenditure
should not be the same person who is using the asset.

(b) Physical check
There should be a regular physical check of the assets against the
register. The check should also include reports where appropriate on
the condition of the assets to enable a view to be taken of the accuracy
of the original estimates of useful life. The minimum check is usually
once a year.
(c) Disposal of fixed assets

Appropriate procedures are required to ensure that a fixed asset
cannot be easily sold by someone who might deprive the business of
the sale proceeds.
(d) Reconciliation of the fixed asset register to the nominal ledger
The same information in respect of the cost of a fixed asset is recorded
in the general ledger and the fixed asset register. In theory the total
cost on the register and the ledger should agree. However differences
will occur if one is not updated or if different figures are recorded in
each. To ensure the accuracy of the accounting information, a regular
reconciliation between the nominal ledger and fixed asset register
should take place.
Reconciling the general ledger and the fixed asset register is a matter
of balancing the fixed asset general ledger accounts for cost and
accumulated depreciation, adding up the cost and accumulated
depreciation columns in the register and comparing the sets of figures.
If the sets of figures agree then the general ledger and the fixed asset
register are probably accurate. If they do not agree however then some
investigative work is needed to track down the difference. This usually
involves checking every single entry made since the last reconciliation
in the ledger and the register, making sure entries in both have been
recorded identically.
11 Intangible fixed assets

11.1 Introduction
Intangible fixed assets are assets that do not have a physical

substance but have value to the business. In accounting terms they
most commonly arise when the business has paid money to acquire
them or has incurred expenditure that has created an intangible asset.
The two types of asset relevant to your exam are research and
development and goodwill.
Classification of Intangibles in Statement of Financial Position
As per Companies Ordinance 1984 Intangible fixed assets are

classified as follows:
Intangible: ( Main Head)
a) Goodwill;
b) Brand names;

c) Computer Software;
d) Licenses and franchises;
e) Patents, copyrights, trademarks and designs;
f) Intangible assets under development and
g) Others to be specified.
11.2 Research and development costs
There are three recognised categories of R & D expenditure:

 pure research is experimental or theoretical work undertaken
primarily to acquire new scientific or technical knowledge and
understanding. It is not primarily directed towards any specific
practical aim or application.
 applied research is original or critical investigation undertaken in
order to gain new scientific or technical knowledge and directed
towards a specific practical aim or objective.
 development is the use of scientific or technical knowledge in
order to produce new or substantially improved materials,
devices, products or services; to install new processes or
systems prior to the commencement of commercial production
or to improve substantially those already produced or installed.
DEFINITION
Pure (or basic) research:

Experimental or theoretical work undertaken primarily to acquire
new scientific or technical knowledge and understanding, not
primarily directed towards any specific practical aim or
application.
Applied research:
Original or critical investigation undertaken in order to gain new
scientific or technical knowledge and directed towards a specific
practical aim or objective.
Development is the use of scientific or technical knowledge in order to

produce new or substantially improved materials, devices, products or
services; to install new processes or systems prior to the commencement of
commercial production or to improve substantially those already produced or
installed.
11.3 Accounting treatment of research and development costs
There are two possible accounting treatments of research and

development costs:
 treat the expenditure as an expense, and charge it in the profit and

loss account
 treat the expenditure as creating a fixed asset, and 'amortise' it (this
term is used instead of 'depreciate' for intangible fixed assets) over

the period for which benefits from the R & D expenditure continue to
flow.
Example
ABC Ltd is developing a new product, the widget. This is expected to be

sold over a three-year period starting in 20X2. The data is as follows:
20X1 20X1 20X1 20X1

Rs’000 Rs’000 Rs’000 Rs’000
Net revenue from other activities 400 500 450 400
Net revenue from widgets - 450 600 400
Development costs of widgets (900)
Solution
Profit treating development costs as expenses when incurred

20X1 20X1 20X1 20X1
Rs’000 Rs’000 Rs’000 Rs’000
Other activities - Net revenue 400 500 450 400
Widgets - Net revenue - 450 600 400
Development costs (900) - - -
Net profit/(loss) (500) 950 1,050 800
Net profit amortising development cost over life of widgets

20X1 20X1 20X1 20X1
Rs’000 Rs’000 Rs’000 Rs’000
Other activities - Net revenue 400 500 450 400
Widgets - Net revenue - 450 600 400
Development costs of widgets
900,000 - 300 300 300
3
Net profit/(loss) 400 650 750 500
11.4 Goodwill
When a business changes hands, the price paid will commonly exceed
the net value of the tangible assets owned by the business (even when
these are valued at market prices). The difference is an intangible
asset referred to as 'goodwill'.
Thus goodwill may be seen as an intangible asset – the value of the

going concern element of the business.

DEFINITION
Purchased goodwill is the difference between the cost of an acquired

entity and the aggregate of the fair values of that entity’s identifiable
assets and liabilities.
11.5 Valuing goodwill
An accountant may be asked to value a business. The difficulty is that

there are no laid down rules to follow. Ultimately the value of goodwill is
what someone will pay for it.
11.6 Accounting treatment of goodwill
Goodwill is normally only recognised when the whole, or part, of a

business is sold. The accounting treatment of goodwill is governed by
IAS 38 intangible assets. This standard requires capitalisation of
goodwill and later on check for indicators of its impairment
Summary
Having completed this chapter you should understand the reasons for
the depreciation of fixed assets and the various methods of calculating
the annual depreciation charge. The depreciation charge is entered
into the accounts by debiting the profit and loss account and crediting
an accumulated depreciation account.
against the original cost of the fixed asset in the balance sheet each
year in order to arrive at the net book value of the asset. It is also
necessary to be able to account for the disposal of a fixed asset by
clearing out the cost and the accumulated depreciation to date on that
asset to the disposal account and comparing this net book value to the
proceeds of sale. This will give either a profit on sale that is effectively
an over-depreciation of the asset or a loss on sale that is an under-
depreciation of the asset. The profit or loss on sale can either be
shown as a separate item in the profit and loss account or included
with the depreciation charge for the year. A fixed asset register
facilitates the control of the fixed assets of the organisation. Finally, this
chapter looked at intangible fixed assets, in particular research and
development and goodwill, and their basic accounting treatment.

 Explain and calculate the methods of depreciation including
straight line, reducing balance and revaluation, and prepare
accounts using each method
 Prepare a fixed asset register
Self-test questions
Depreciation
1 What is the meaning of depreciation? (1.1)
Methods of calculating depreciation
2 What is the formula for calculating the annual depreciation charge using
the straight line method of depreciation?
(2.2)
3 What is the net book value of a fixed asset?
(2.3)
Accounting for depreciation
4 How should fixed assets be shown in the balance sheet of an

organisation?
(3.2)
Sale of fixed assets
5 What is the double entry required to account for the disposal of a fixed
asset?
(4.2)
Revaluation of fixed assets
6 How is depreciation calculated when an asset is revalued?

(5.2)
Fixed asset registers
7 What details are normally shown in a fixed asset register?

(7.2)
Intangible fixed assets
8 What is the definition of development expenditure?

(8.2)

9 What criteria must development expenditure satisfy if it is to be carried
forward as a fixed asset in the balance sheet? (8.4)
10 What is goodwill? (8.5)
11.
(a) Following is the data relating to import of machinery:
Rs.
 Letter of Credit opening charges 50,500
 Payment made to bank towards release of documents 2,560,000
 Import duty 690,000
 Income tax 195,000
 Octroi charges 24,500
 Demurrage charges 70,800
 Sundry expenses 5,600
 Clearing Agent fees 20,000
 Machinery transport charges to factory 31,500
Required: Calculate the amount of addition to Fixed Assets.
(b) A company replaced its old machinery with new machinery. List price
of new machinery is Rs. 1,800,000. Trade in allowance for used
machinery is Rs. 900,000. Cost of old machinery is Rs. 1,400,000 and
accumulated depreciation was Rs. 750,000. Fair value of old
machinery is Rs. 500,000.
Required: Calculate cost of new machinery to be recorded in

Company’s account, cash payment and profit / loss on trade
in of old machinery.
12 Unique Chemicals depreciated its assets by using the straight-line

method. Full year’s depreciation was charged in the year of purchase.
The useful life of each asset was reviewed in 1998 and it was decided
to revise the useful life of following assets effective from January 1,
1998.

Revised
Existing remaining Year of Cost
Category
useful life purchase (Rs.’000’)
useful life
Building 50 40 1996 10,000
Plant & 10 15 1996 20,000
Machinery
IT equipment 5 3 1997 3,000
Vehicles 4 5 1996 2,800
Furniture 10 7 1996 1,200
Office 10 5 1996 1,500
equipment
It was also decided to depreciate the carrying values as at January 1, 1998

over the remaining useful life of each asset.
You are required to calculate:

(a) Carrying values as at January 1, 1998.
(b) Depreciation for the year 1998.
13 Upon merger on January 1, 1999, Highest Ltd., took over assets and
liabilities of Smallest Ltd. The taken over assets include certain fixed
assets which are acquired at the book value. Details of certain fixed
assets in Smallest Ltd., are as under:
Item Month of purchase Useful life (Years) Purchase price (Rs.)

Motor Car March 1995 5 350,000
Jeep September 1996 5 650,000
Furniture December 1997 10 150,000
Computers August 1995 3 500,000
Depreciation is charged on straight-line basis at monthly rest from the

month of purchase by both companies.
Required:
(a) Written down value as at December 31, 1998 in the books of Smallest
Ltd., and
(b) Depreciation charge for the month of January 1999 of Highest Ltd.

Multiple-choice questions
1 Calculate the annual charge for depreciation on an asset that cost

Rs15,000 with a residual value of Rs 1,000 and a useful
economic life of 7 years. Use a straight line method assuming a
full charge in the year of purchase.
A Rs 2,143
B Rs 2,000
C Rs 2,286
D Rs 2,500
2 Using the reducing balance method, calculate the depreciation

charge for the third year of ownership of an asset costing
Rs12,000 with a residual value of Rs 2,000 using a rate of 20%.
Assume a full charge in the year of purchase.
A Rs 2,000
B Rs 2,400
C Rs 2,800
D Rs 1,536
3 What is the profit or loss on disposal of an asset which cost Rs

20,000, had accumulated depreciation to date of Rs 9,000 and
was part exchanged for a new asset costing Rs 25,000? A
cheque for Rs 17,000 was handed over to the vendor on
completion of the transaction.
A Profit Rs 6,000
B Loss Rs 3,000
C Loss Rs 5,000
D Profit Rs 3,000
4 Khawar bought land and buildings on the 1 January 20X6. The

land cost Rs 200,000 and the buildings cost Rs 300,000 with a
useful life of 30 years. What is the annual depreciation charge
using the straight line method?
A Rs 16,667
B Rs 10,000
C Rs 9,000
D Rs nil
5 What is the purpose of providing depreciation?

A To provide for the replacement of the asset
B To show how the value of the asset has decreased
C To allocate the cost of the asset over the periods it will be
used
D To show the current market value of the asset

6 M. Z purchased plant and machinery for Rs 35,000 on 1
December 20X4. Depreciation was charged at 25% per annum
on a reducing balance basis. On 30 September 20X6, the asset
was sold for Rs 24,000. Calculate the profit or loss on disposal.
A Rs 3,219 profit
B Rs 3,219 loss
C Rs 4,313 profit
D Rs 4,313 loss
7 Mr. J bought a machine on 1 July 20X0 for Rs 25,000. It is

depreciated at 15% reducing balance. What is the provision for
depreciation at 30 June 20X2?
A Rs 3,750
B Rs 3,188
C Rs 6,938
D Rs 18,062
8 Anna bought an asset for Rs 14,000 on 1 January 20X5 with an

estimated useful life of 10 years, depreciated on a straight line
basis. At 1 January 20X7, Anna decided that the remaining life
was only 5 years. What is the depreciation charge for the year
ended 31 December 20X7?
A Rs 2,000
B Rs 2,240
C Rs 2,520
D Rs 2,800
9 Munawar bought a building on 1 July 20X3 which had a useful

life of 40 years. It cost Rs 400,000 and was revalued to Rs
600,000 on 31 December 20X8. What is the gain on
revaluation?
A Rs 200,000
B Rs 250,000
C Rs 255,000
D Rs 260,000
Answers
11.
(a) CALCULATION OF AMOUNT OF ADDITION TO FIXED ASSETS.
Rs.
Letter of Credit opening Charges
50,500
Payment made to Bank towards release of Documents 2,560,000
Import duty
690,000

Octori
24,500
Sundry Expenses
5,600
Clearing Agent Fee
20,000
Machinery Transport to Factory
31,500
Value of addition to fixed assets
3,382,100
Note-1: It is assumed that all expenses have been incurred to bring the
asset into its working condition.
Note-2: Income tax has been considered as advance and

adjustable against final tax liability.
(b)
(i) Cost of New Machinery 1,800,000
(ii) Cash Payment:
List price of New Machinery

1,800,000
Less: Trade in allowance for used machinery 900,000
Cash payment of machinery 900,000
(iii) Profit / Loss on Trade in of old machinery:
Cost of old Machinery 1,400,000

Less: Accumulated Depreciation 750,000
Book value of old machinery 650,000
Less: Trade in allowance for used machinery 900,000
Profit on trade in of old machinery 250,000

12.
a) CALCULATION OF CARRYING VALUES AS AT JANUARY 1, 1998

(Rs. in 000)
Category Year of Cost on Useful life Accumulated * Carrying
Purchase 1.1.98 (years) Depreciation on amount on
1.1.98 1.1.98
Rs. Rs. Rs.
(1) (2) (3) (4) (5) (6) = (3–5)
Building 1996 10,000 50 400 9,600

Plant & Machinery 1996 20,000 10 4,000 16,000
IT equipment 1997 3,000 5 600 2,400
Vehicles 1996 2,800 4 1,400 1,400
Furniture 1996 1,200 10 240 960
Office equipment 1996 1,500 10 300 1,200
38,500 6,940 31,560
* Cost x No. of years used;

Useful life
e.g. Building = Rs. 10,000 x 2 = Rs. 400

50
b) DEPRECIATION FOR THE year 1998

(Rs. in 000)
Category Carrying amount Revised Depreciation
On 1.1.98 useful life for the year 1998
Rs. (Years) Rs.
Building 9,600 40 240

Plant 16,000 15 1,067
IT equipment 2,400 3 800
Vehicles 1,400 5 280
Furniture 960 7 137
Office equipment 1,200 5 240
31,560 2,764

13.
Smallest Ltd.
Written down Value
a) As at December 31, 1998
(All figures in Rs)
Purchase Month of Rate Total Used Accumulated
Price Purchase useful depreciation
Life
(months)
Motor Car 350,000 March, 20% 60 46 268,333
1995
Jeep 650,000 Sept., 20% 60 28 303,333
1996
Furniture 150,000 Dec., 10% 120 13 16,250
1997
Computers 500,000 Aug., 33% 36 41 500,000
1995
1,650,000 1,087,916
Accumulated Depreciation = Purchase Price x Months used

Useful life
Written down Value = Purchase Price – Accumulated Depreciation

= Rs. 1,650,000 – Rs.1,087,916
= 562,084
b) Depreciation charge for the month of January 1999:
Motor car 81,667 x 1/14 = 5,833

Jeep 346,667 x 1/32 = 10,833
Furniture 133,750 x 1/107 = 1,250
17,916
MCQs
1 B
2 D
3 B
4 B
5 C
6 A
7 C
8 B
9 C

 Prepare accounts for payroll

1 Wages and salaries
1.1 Introduction
So far we have considered the payment of wages and salaries to be

merely an expense to be entered on the profit and loss account.
However, the practical situation is more complex than this because of
two main factors:
 employees are not paid the full amount of their remuneration
- their pay packets are subject to various deductions
 employers are also required to pay certain amounts over and
above gross pay on behalf of their employees.
These complications are largely dealt with by the use of wages and
salaries books, which are further examples of books of prime entry.
1.2 The difference between the wages book and the salaries book
As regards accounting treatment there is no difference whatsoever.

The distinction is that wages are generally paid weekly, hence the
wages book is compiled weekly, whilst salaries are paid monthly,
hence the salaries book is compiled monthly.
The remainder of this chapter will concern itself with the wages book,
but the principles explained apply equally to the salaries book.
KEY POINT
From an employee’s gross pay there will almost always be deducted
Income Tax and EOBI contributions and in some cases also pension
and other deductions.
2 Wages from the employee’s viewpoint

2.1 Introduction
The key distinction for the employee is between gross pay (the total
amount they earn in any week) and take-home pay (the amount they
receive in their pay packet, or which is credited to their personal bank
account in any week). The difference between the two figures is often
referred to as deductions or stoppages.
There are a number of different deductions which can be made by the

employer.
(a) Income tax
The wages of all employees are liable to have income tax deducted
from them. The system that operates is graduated so that the lowest
paid pay no income tax, whilst the highest paid are liable at a higher

rate than the standard rate which applies to those who fall between the
two categories.
(b) Other deductions
These can take many forms, but can be divided into two main categories:
(i) voluntary – for instance, employees often subscribe a small
amount each week to belong to their firm’s social club
(ii)compulsory – for instance, an employee may have been ordered
by a court to pay off a fine in instalments out of their wages.
As regards the employer, these amounts will be deducted from gross

pay, voluntary deductions being used (in this instance) to offset the
cost of the social club, compulsory deductions being paid to the
relevant authority.
3 Accounting for payroll

3.1 Introduction
Here we are only concerned with the bookkeeping implications for the
employer. The full tax implications are very complex and even the
smallest of businesses is likely to use a computerised payroll package
in practice. This may not be integrated with the main accounts,
however, so it is important to know where to post the totals calculated
by the computer. The calculations will almost certainly be done through
a wages book, as a means of prime entry, but initially we need to
consider the essential entries.
3.2 Gross wages
Debit With
Credit
Wages Gross wages
account Bank account Amount payable to
Employees
Tax Payable control Income tax deducted
account contributions Employees’
Pension
Account contributions
e.g. Social club Social club voluntary
account Deductions
e.g. Magistrates’ order Compulsory deduction
a/c to
pay fine
3.3 Employer's contributions
Debit Credit With

Wages Total amount
account Pension contributions Employer’s
payable pension
Account fund
contributions
3.4 Nature of ledger accounts
The wages account records the total expense of the employees’
salaries, which will eventually be charged to the profit and loss
account. The Tax payable control account records the liability of the
employer to Taxation Authorities.The pension fund account records the
liability of the employer to the pension fund.
The social club account will either represent an amount payable to a

separate social club or will be used to offset expenditure incurred
thereon by the employer.
Accounts such as Tax payable control account, pension contribution

account or a 'Court Order' account are all similar. They represent
creditors accounts because all amounts included therein represent
amounts payable to the respective organisations. Thus these accounts
should be self clearing, in other words any amounts credited therein
should ultimately be paid out to, respectively, the Collector of Taxes,
the pension fund and the courts. An exception is, say, the social club
account, which may possibly be paid over to a separate organisation,
but which may be used to offset the company's cost of running the
social club.
KEY POINT
(a) The wages account records the total expense of the employees’
salaries, which will eventually be charged to profit and loss
account.
(b) The Withholding tax control account records the liability of the
employer to Taxation Authorities.
(c) The pension fund account records the liability of the employer to
the pension fund.
(d) The social club account will either represent an amount payable
to a separate social club or will be used to offset expenditure
incurred thereon by the employer.
4 The wages book

4.1 Example
We now need to see how all these entries may be incorporated into a
system involving a book of prime entry, on this occasion the wages
book (or payroll). WP Ltd, a company , has five employees whose
gross wages are as follows:
Mr. A Rs 140 per week
Mr. B Rs 160 per week
Mr. C Rs 180 per week
Mr. D Rs 200 per week
Mr. E Rs 220 per week

Let’s assume income tax is at a rate of 30% Each employee
additionally contributes 5% of their weekly wage to the Alfalah Pension
Fund, this payment not being an allowable deduction for tax purposes.
Mr. C, Mr. D and Mr. E are all members of the WP Social Club, and a
deduction of Re 1 a week is made for this purpose. WP Ltd pays 10%
of gross wages to the Alfalah Pension Fund.
Solution
The transactions from the wages book are recorded in the nominal
ledger, as are the employer's contributions, as follows:
Employee’s Gross Tax Pension Social Net pay

name wages (30%) Contribution Club
(5%)
Rs Rs Rs Rs
Mr. A 140 42 7 - 93
Mr. B 160 48 8 - 104
Mr. C 180 54 9 1 116
Mr. D 200 60 11 1 128
Mr. E 220 66 11 1 142
900 270 45 2 583
The transactions from the wages book are recorded in the nominal ledger, as
are the employer’s contributions, as follows:
Wages
Rs Rs
Wages book 900
Alfalah pension fund 10% . 90

Rs 900
Tax payable control
Rs Rs
Wages book 270
Alfalah pension fund
Rs Rs
Wages book 45
Wages 90
Social club
Rs Rs
Wages book 3
Bank
Rs Rs
Wages book 583

Summary
The wages book is another example of a book of prime entry. It is
important to realise that employers deduct several items from their
employee's gross pay and are responsible for handing them over to
Taxation Authorities, pension funds, social clubs and so on. . Having
completed your study of this chapter you should have achieved the
 Prepare accounts for payroll
Self-test questions
Wages and salaries
1 What is the difference between wages and salaries? (1.2)
Wages from the employee’s viewpoint
2 What is the name given to the difference between gross pay and
take-home pay? (2.1)
Accounting for payroll
3 What is the double entry required for an employee's gross wages?

(3.2)
4 What is the double entry for the employer's contributions?
(3.3)
Multiple Choice questions
1 Total wages cost is made up as follows:
A Gross wages + employee’s national insurance

B Gross wages + employer’s national insurance
C Net wages + tax + employee’s national insurance
D Net wages + tax + employer’s national insurance
2 More Ltd has the following opening balances payable:
Tax payable control Rs 3,000

Contributions payable control Rs 1,731
Wage details for the month are:
Gross wages Rs 82,319
Tax deducted Rs 21,037
Employer’s contribution Rs 9,003
Employee’s contribution Rs 8,791
Assuming that no payments were made during this month, what
is the total amount owing under Tax payable and contributions
payable control A/c at the end of the month?

A Rs 43,562
B Rs 17,794
C Rs 34,559
D Rs 34,771
3 Sami has the following detail regarding his wages:
Gross wages Rs350

Tax deducted Rs70
Social club deduction Rs10
Employer’s contribution Rs35
Employee’s contribution Rs25
What is Sami’s take-home pay?
A Rs 280
B Rs 270
C Rs 245
D Rs210
4 J Ltd has payroll records for the year as follows:
Rs
Gross wages 200,505
Employee’s special contribution 74,366
Employer’s contributions 22,689
Employee’s pension contributions 13,964
What is the payroll cost in the accounts for the year?
A Rs 112,175
B Rs 223,194
C Rs 297,560
D Rs 311,524
Answers of MCQs
1 B
2 A
3 C
4 B

Chapter Learning Objectives
 Classify items as current or Non-current Liabilities

 Define and Illustrate the different accounting treatments of provisions
and contingent liabilities and assets
 Calculate and record provisions and movement in provisions

1. Overview
Liabilities
Obligation to transfer economic benefit as a result of

past transactions or events
Current
vs non - Liabilities of uncertain Not probable or can’t
current timing and amount be measured
Provisions Contingent liabilities
2. Categorization of liabilities
Liabilities
LIABILITIES ARE CLAIMS

ON THE BUSINESS BY
OUTSIDERS
NON-CURRENT CURRENT LIABILITES

LIABILITES
Long term liabilities Those liabilities which

Payable more than 12 are payable within 12
months after the months of the
reporting date reporting date
e.g. e.g.
Long term payables, bank
loan overdraft loan (short-
term)

It is important to consider the time of settlement of a liability so that you can
ensure you allocate it to the correct category of the statement of financial
position. This can be significant to many multiple choice style questions, so
take care when making adjustments for liabilities.
3. Cash and credit purchases
3.1 If a purchase is for cash, the business pays for the goods/services at
the point of sale. The double entry for a cash purchase is:
Dr. Purchases / expenses
Cr. Cash
If the purchase is on credit terms the business will pay for the goods /
services after receiving them. Typically trading terms allow 30-60 days
to settle outstanding debts when purchasing goods and services on
credit.
Under the accrual concept, the purchase is recorded in the ledger

accounts when the expense has been incurred. That is usually the
point at which the goods / services are received / rendered. Therefore
when purchases are made on credit the cost is recorded with a
corresponding liability that represents the obligation to pay the supplier
of the goods / services. The liability is referred to as a ‘payable.’
The double entry is recorded as follows:

Dr. Purchases / expenses
Cr. Payables
When the payable liability is actually paid the double entry to reflect this
is:
Dr. Payables
Cr. Cash
4 Provisions
4.1 A provision can be defined as a liability of uncertain timing or amount.

For example; a business is facing legal action for breaching health and
safety law. The likely repercussion is that they will be fined. The timing
and severity of the fine will be decided by criminal court at some point
in the future. The key question is should the business attempt to reflect
this cost in their financial statements?
If we assume that the potential fine could be significant (it could even
lead to the closure of the business) should the potential consequences
be disclosed to the shareholders in some way? As the owners of the
business they are entitled to know about this potentially significant
issue that could damage the profits of the business and, therefore, their
own personal wealth.

4.2 Accounting for a provision
The first potential course of action management can take is to record a

provision in the accounts. This is done by estimating the potential cost
of the uncertain event and recognizing it immediately. As the amount
would be settled in the future a corresponding liability is recorded, as
follows:
Dr. Expenses
Cr. Provision liability
The provision liability will need to be categorized as either current or
non-current as befits the situation.
4.3 Criteria for recognizing a provision

Given the uncertainty surrounding provisions there is significant scope
for accounting error, or even fraudulent manipulation of provisions to
alter profits. To reduce this risk recognizing Provisions, Contingent
Liabilities and Contingent Assets provides three criteria that must be
met before a provision can be recorded.
 There must be a present obligation (legal or constructive) that
exists as the result of a past event.
 There must be a probable transfer of economic benefits.
 There must be a reliable estimate of the potential cost.
4.4 Movement in provisions
Provisions should be reviewed at each statement of financial position date

and adjusted to reflect the current best estimate.
Increase in provision: Dr Relevant expense account
Cr Provision
Decrease in provision: Dr Provision
Cr Relevant expense account
Example
The criteria referred to above mean that a provision can only be
recorded in an accounting period if a liability has been triggered at the
year-end.
For example; Hamid Ltd’s year-end is 31 December 20X7. In

November 20X7 they fire an employee. In February 20X8 a customer
slips on their premises and breaks their arm.
In March 20x8 both the employee and the injured customer Sue Hamid
Ltd; the former for unfair dismissal and the latter for compensation for
injuries suffered on Hamid’s premises. Is there an obligation at 31
December 20X7 for either of these lawsuits?

Solutions
There is a potential obligation at the year-end for the employee
claiming unfair dismissal. This is because the triggering event
happened in November 20X7, which is before the year-end.
There is no obligation to the injured customer at 31 December 20X7.

The event happened in the next accounting period and will be reflected
in that accounting period.
4.5 Obligations
Obligations can be triggered by either legally or constructively.
A legal obligation is an obligation that derives from:
 The terms of a contract
 legislation
 any other operation of law
A constructive obligation is an obligation that derives from an entity’s
actions where:
 The entity has in some way indicated that it will accept
certain responsibilities.
The entity has created an expectation on the part of other parties that it
will meet those responsibilities.
5. Contingent liabilities and assets

5.1 Contingent liabilities are also made with regard to liabilities of uncertain
timing or amount. However, unlike provisions, no accounting entries
are made with regard to contingent liabilities (i.e. no expense or liability
is recognized). When a contingent liability is necessary the business
will include a note in financial statements describing the potential
liability to the users.
A contingent liability is recognized when there is:

(1) a possible obligation that arises from past events; or
(2) a probable obligation that arises from past events but the
amount of the obligation cannot be measured with sufficient
reliability.
Examples of contingent liabilities include outstanding litigation where

the potential costs cannot be estimated with any degree of reliability or
when the likelihood of losing the litigation is only deemed possible.

A contingent asset is a possible asset that arises from past events and
whose existence will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not wholly within the
control of the enterprise.
An example of a contingent asset is when a business is claiming
compensation off either an individual or another business and the
outcome of the claim is uncertain at the reporting date.
5.2 Accounting for contingent liabilities and assets

The requirements as regards contingent liabilities and assets are
summarized in the following table:
Probability of Contingent Contingent assets

Occurrence liabilities
Virtually certain Provide Recognise
Probable Provide Disclose in note
Possible Disclose in note Ignore
Remote Ignore Ignore
 Note that the standards give no guidance as the meaning of the

terms in the left-hand column. One possible interpretation is as
follows:
Virtually certain > 95%

Probable 51% - 95%
Possible 5% - 50%
Remote < 5%
Example
A retail store has a policy of refunding purchases by dissatisfied
customers, even though it is under no legal obligation to do so. Its
policy of making refunds is generally known.
Should a provision be made at the year end?
Solution
The policy is well known and creates a valid expectation.
There is a constructive obligation.
It is probable some refunds will be made.
These can be measured using expected values.
Conclusion: A provision is required.

Chapter Summary
Liabilities
Obligation to transfer economic benefit as

a result of past transaction or events
Current (settled Liabilities of

within 12 months) uncertain timing
Vs and amount
Non-current
(settled after 12 (IAS 37)
months)
Provision: Not probable or can’t

- present obligation be measured
- probable transfer
- reliable estimate
Increase: Contingent liabilities:

Dr expenses - possible obligations
Cr provision - probable obligation
without reliable
The opposite estimate
entry is made
for a reduction Not recorded in So CI or
SoFP, Disclosed as a
supporting note to the
financial statements

Self Test Questions
1. What is Provision (4.1)

2. The draft financial statements of Madras, a limited liability company, for
the year ended 31 December 20X6 is currently under review. The
following points have been raised:
(i) An ex-employee has started an action against the company for

wrongful dismissal. The company’s legal team have stated that
the ex-employee is not likely to succeed. The following
estimates have been given by the lawyers relating to the case:
(a) Legal costs (to be incurred whether the claim is

successful for not) Rs 5,000
(b) Settlement of claim if successful Rs 15,000
Total Rs 20,000
Currently no provision has been made by the company in the
(ii) The company has a policy of refunding the cost of any goods
returned by dissatisfied customers, even though it is under no
legal obligation to do so. This policy of making refunds is
generally known. At the year-end returns totaling Rs 4,800 have
been made.
(iii) A claim has been made against a company for injury suffered by
a pedestrian in connection with building work by the company.
Legal advisers have confirmed that the company will probably
have to pay damages of Rs 100,000 but that a counterclaim
made against the building subcontractors for Rs 50,000 would
probably be successful.
State with reasons what adjustments, if any, should be made by the
company in the financial statements.
Answers
1 (i) A contingency is defined as an obligation or an asset that arises from

past events whose existence will be confirmed only by the occurrence
or non-occurrence of one or more uncertain future events not wholly
within the control of the enterprise. A provision should be made if:
(a) There is an obligation.

(b) A transfer is probable.
(c) There is a reliable estimate.
The legal cost of Rs 5,000 should therefore be provided for since they
will have to be paid whatever the outcome of the case. However, the
claim is not likely to succeed and so no provision should be made. A

disclosure note should be made. A disclosure note should be made for
the potential loss of Rs 15,000.
(i) An obligation can be legal or constructive. In this case the policy of
refunds has created a constructive obligation. A provision for Rs 4,800
should therefore be made.
(ii) As the success of the claim for damages of Rs 100,000 is probable, it
constitutes a present obligation as a result of a past obligating event,
and would therefore be accounted for as a provision. The success of
the counter-claim for Rs 50,000 is also considered probable and would
therefore need to be disclosed as a contingent asset (reimbursement).
Only if it were considered virtually certain would the counter-claim be
recognized as an asset in the statement of financial position.

Upon completion of this chapter you will be able to:
 describe the purpose of a suspense account

 prepare journal entries to correct errors and clear out a suspense account

1 Journal
1.1 Introduction
Thus far the impression given is that a senior accountant will actually
post the nominal ledger. In many organisations this will not in fact be
the casese; the accountant will instruct their staff to make postings by
means of a journal (so-called because it was traditionally in the form of
a book).
The journal is not part of the double entry. It is essentially a book of
prime entry for items that are not included in the daybooks and
cashbooks, such as year-end adjustments and correction of errors.
1.2 Presentation
Date/No. Details Ledger Dr Cr

folio
20X9 Rs Rs
6 Feb Van account V1
2,000
Motor expenses account M3 2,000
Purchase of van incorrectly debited
to motor expenses
DEFINITION
A suspense account is an account in which debits or credits are held
temporarily until sufficient information is available for them to be posted
to the correct accounts.
Notice particularly:
 in the ‘details’ column the names of the accounts to be debited and
credited should be entered
 the debit entries should be entered before the credit entries
 the names of the accounts to be credited are often inset slightly
from the names of the accounts to be debited
 the narrative explaining the journal should give a brief explanation
of the entry - unless a question specifically states that no narrative
is required. The narrative is included to aid comprehension if the
journal is reconsidered at a later date.
Example
Pass entries for following :
 motor expenses of Rs 200 incorrectly debited to heat and light
 telephone accrual Rs 58
 rates prepayment Rs 78.

Solution
Date/No. Details Dr Rs Cr Rs
1 Motor expenses 200

Heat and light 200
Invoice for motor expenses
incorrectly
charged to heat and light.
2 Telephone expense 58
Accruals 58
Accrual for telephone bills.
3 Prepayments 78
Rates expense 78
Prepayment of rates.
2 Suspense accounts
2.1 Introduction
A suspense account is an account in which debits or credits are held

temporarily until sufficient information is available for them to be posted
to the correct accounts.
Suspense accounts are often encountered and must be dealt with
according to the usual rules of double-entry bookkeeping.
2.2 Creation of suspense accounts
There are two main reasons why suspense accounts may be created:
 on the extraction of a trial balance the debits are not equal to the
credits and the difference is put to a suspense account.
 when a bookkeeper performing double entry is not sure where to
post one side of an entry they may debit or credit a suspense
account.
2.3 Differences on trial balances
Before opening a suspense account the accountant will try to ascertain

the reason the trial balance does not balance. This may be the result of
either:
 errors in the double-entry bookkeeping such as a single entry or
an account incorrectly cast
 an error in the extraction of the trial balance.
If the error is not discovered immediately, he may set up a suspense
account so as to balance the trial balance.
2.4 Clearing suspense accounts
A suspense account should not remain in the books of account, but as

it forms a ‘T’ account it should be cleared by means of normal
bookkeeping procedures. Not all errors affect the trial balance. If no
entry has been made at all for a transaction, then the trial balance still
balances.
Example
On extracting a trial balance the accountant of ETT discovered a

suspense account with a debit balance of Rs 1,075 included therein; he
also found that the debits exceeded the credits by Rs 957. The amount
needed to make the trial balance equal was entered into the suspense
account and then the situation was investigated.
They discovered:
(a) A debit balance of Rs 75 on the postages account had been
incorrectly extracted on the trial balance as Rs 750 debit
(b) A payment of Rs 500 to a creditor, X, had been correctly entered
in the bank account, but no entry had been made in the
creditor's account
(c) When a motor vehicle had been purchased during the year the
bookkeeper did not know what to do with the debit entry so
made the entry Dr Suspense, Cr Bank Rs 1,575
(d) A credit balance of Rs 81 in the sundry income account had
been incorrectly extracted on the trial balance as a debit balance
(e) A receipt of Rs 5 from a debtor, Y, had been correctly posted to
the debtors account but had been entered in the cash account
as Rs 625
(f) The bookkeeper was not able to deal with the receipt of Rs 500
from the owner's own bank account, and made the entry Dr
Bank and Cr Suspense
(g) No entry has been made for a cheque of Rs 120 received from a
debtor M
(h) A receipt of Rs 50 from a debtor, N, had been entered into their
account as Rs 5 and into the cash account as Rs 5.
Solution
Step 1
The Rs 1,075 debit balance is already included in the books, whilst the
Rs 957 is entered on the credit side of the suspense account because
the trial balance, as extracted, shows debits exceeding credits by Rs
957. Although the two amounts arose in different ways they are both
removed from suspense by the application of double entry.
Step 2
The incorrect extraction is corrected by amending the balance on the
trial balance and debiting the suspense account with Rs 675. In this
case the ‘credit’ entry is only on the trial balance, as the postages
account itself shows the correct balance, the error coming in putting
that balance on the trial balance.

Step 3
The non-entry of the Rs 500 to the debit of X’s account causes the
account to be incorrectly stated and the trial balance to be unbalanced.
To correct matters Dr Creditors, Cr Suspense, amending both the
creditors ledger account and the trial balance.
Step 4
The suspense entry here arose from adherence to double-entry
procedures, rather than a numerical error. In this case the bookkeeper
should have Dr Fixed asset – cost, Cr Bank instead of Dr Suspense, Cr
Bank, so to correct matters the entry Dr Fixed asset – cost, Cr
Suspense is made.
Step 5
Is similar to Step 2, but note that the incorrect extraction of a credit
balance as a debit balance means that twice the amount involved has
to be amended on the trial balance and debited to suspense account,
therefore Rs 162.
Step 6
Is similar to Step 3 – on this occasion Dr Suspense, Cr Cash with Rs
620 and amend the cash account balance on the trial balance.
Step 7
Is similar to Step 4. The bookkeeper should have Dr Bank, Cr Capital,
but instead has Dr Bank, Cr Suspense, so to correct matters Dr
Suspense, Cr Capital.
Step 8
Item (g) does not appear in the suspense account as the error does not
affect the imbalance of the trial balance. As no entry has been made
for the cheque, the correcting entry is:
Rs Rs
Dr Cash account 120
Cr Debtors account 120
KEY POINT
Once a suspense account has been created it should be cleared by the
application of double- entry principles. Not all errors affect the
suspense account. If no entry has been made at all for a transaction,
then the trial balance still balances.
Step 9
Item (h) also does not appear in the suspense account. Although an
entry has been made in the books that was wrong, the entry was
incorrect for both the debit and credit entry. The correcting entry is:
Rs Rs
Dr Cash account 45
Cr Debtors account 45

Rs Rs
Balance b/d (S1) 1,075 Trial balance – 957
difference (S1)
Postages (trial 675 X (S3) 500
balance only) (S2)
Sundry income (trial 162 Fixed asset- cost 1,575
balance only) (S5) (S4)
Cash (S6) 620
Capital account – 500 ____
ETT (S7)
3,032 3,032
2.5 Transposition errors

Though not encountered in the example above, a common cause of
bookkeeping error is through the transposition of digits, i.e. Rs 527 is
recorded as Rs 725, (the 5 and 7 have been transposed). The
difference the error creates is always divisible by 9.
Summary
In order to put through many items of double-entry bookkeeping and to
correct errors journals must often be drafted. Errors or omissions in the
double-entry bookkeeping system will often lead to the temporary
creation of a suspense account. The reasons for the creation of this
suspense account must be investigated and the balance cleared by
correcting the error by applying double-entry principles.
the following
learning outcome.
 Prepare journal entries; prepare a trial balance
Self-test questions
Journal
1 What is a journal? (1.1)

2 How should a journal entry be set out? (1.2)
3 Why is a narrative required for a journal? (1.2)
4 What is the journal required for an accrual? (1.2)
Suspense account
5 What is a suspense account? (2.1)

6 What are the two ways in which a suspense account may be
created? (2.2)
7 If the debits in a trial balance exceed the credits will the suspense
account balance be a debit or a credit? (2.4)
8 If an entry is omitted from the ledger entirely will a suspense
account be created? (2.4)
9 If a credit balance is extracted on the trial balance as a debit
balance what will be the amending entry in the suspense
account? (2.4)
10 What is a transposition error? (2.5)
11 Messrs Modern Chemicals were unable to agree the trial

balance on June 30, 2001 and have raised a 'Suspense
Account' for the difference. Later the following errors were
discovered and rectified and the ‘Suspense Account' was
balanced:
(a) The addition of the sundry purchases in the purchase
journal was short by Rs. 1500.
(b) Goods valuing of Rs. 1050 returned by Mr. Farooq, a
customer, had been posted to the debit of 'Accounts
Receivables' and also to sales returns.
(c) Sundry items of furniture sold for Rs. 30,000 had been
entered in the sales day book, the total of which had been
posted to sales.
(d) An amount of Rs. 6,000 due from Mr. Mahmood, a
customer, had been omitted from the schedule of sundry
debtors.
(e) Discount amounting to Rs. 300 allowed to customer had
been posted in his account, but not posted in the discount
account.
(f) Insurance premium of Rs. 4,500 paid on June 30, 2000
for the year ended June 30, 2001 had not been brought
forward.
Required:
(i) Pass journal entries to rectify the above mistakes.

(ji) Draw up the 'Suspense Account'.
(iii) Show how the above mistakes affect the profit for the
year ended June 30,2001.
12 You are required to rectify the following errors:

(a) Goods purchased for Rs. 10,000 on credit which were not
received till the closing of year end, could not be
recorded.

(b) A debit balance of Rs. 4,500 pertaining to Mr. Khan was
omitted from the subsidiary ledger of Debtors.
(c) Obsolete machinery was sold for Rs. 15,000 but was
recorded through sales book.
(d) A customer returned the goods amounting to Rs. 7,000,
which were taken, into stock but no entry was made in
the books.
13.
(a) On March 17, 1998 a business received Rs. 20,000 in
cash through the mail. It is accompanied only by a note
which reads “Please find enclosed towards my bill”. No
identification of the sender is available.
(b) On March 27, it is discovered that the money was in fact

received from Mr. Saleem, a credit customer. Mr. Saleem
owed the business Rs. 26,000 at March 1, and was
invoiced a further Rs. 12,000 on March 14.
Required:
i) Record the receipt of March 17, 1998 in the double entry
system
ii) Relevant journal entry on March 27
iii) Suspense account
iv) Mr. Saleem’s account
1 Suspense accounts are used to:
A Hide entries you are unsure of

B Hold a temporary balance to balance a trial balance
C Hold money in suspense until it is paid out
D Record errors and imbalances after reconciliations
2 A trial balance has debits totalling Rs97,032.97 and credits totalling

Rs98,218.34.
What will be the balance on the suspense account?

A Rs 2,370.74 debit
B Rs 2,370.74 credit
C Rs 1,185.37 credit
D Rs 1,185.37 debit

3 Ideally a suspense account:
A Should have a credit balance

B Should have a debit balance
C Should be used regularly
D Should have no balance
4 Which of the following errors would cause the trial balance to be out of
balance?
A A receipt from a debtor was incorrectly recorded as Rs45 and
not Rs55 in the cash book and the debtor’s ledger
B Repairs of the building have been classified as capital
expenditure
C A purchase invoice has been omitted from the accounting
records
D The rent expenses account has been incorrectly extracted from
the trial balance as Rs 450 rather than Rs 540.
5 Mr. Moon has extracted his trial balance and found that it is out of
balance. The following two errors have been discovered:
(a) A purchase invoice was entered in the accounts incorrectly as

Rs ,200 rather than Rs 120.
(b) The rental income received has been entered into the cash book
as Rs 50 rather than Rs 500.
What was the difference on the trial balance?
A Credits Rs 450 higher than debits

B Debits Rs 450 higher than credits
C Credits Rs 630 higher than debits
D Debits Rs 630 higher than credits
Answers
11
(i) RECTIFIED JOURNAL ENTRIES
Particulars Debit Credit

Rs. Rs.
a) Purchases 1,500
To Suspense 1,500
(Rectification of purchase journal under casted).
b) Suspense 2,100
To Accounts receivable 2,100
(Rectification of sales return of Rs. 1,050 wrongly debited)

12
RECTIFIED JOURNAL ENTRIES
Date Particulars L.F. Debit Credit

Rs. Rs.
(a) Goods in Transit Account 10,000
To Creditors Account 10,000
(Purchased goods but not received till year-end)
(b) No entry
(Balance will be included in subsidiary ledger)
(c) Sales Account 15,000

To Machinery Account 15,000
(Correction of sale of machinery, which was wrongly recorded through sale book)
(d) Sales Return Account 7,000

To Debtors Account 7,000
(Goods returned back by customers)
13
DR. CR.
1998 Rs. Rs.
I. March 17, Cash 20,000
To Suspense A/c. 20,000
1998
II. March 27, Suspense A/c. 20,000
To Mr. Saleem 20,000
III. SUSPENSE ACCOUNT
1998 Rs. 1998 Rs.

March 27, To Mr. Saleem 20,000 March 17, By Cash 20,000
IV. MR. SALEEM’S ACCOUNT
1998 Rs. 1998 Rs.

March 01, To Balance b/d 26,000 March 27, By Suspense A/c.20,000
“ 14, Sales 12,000 “ 31, By Balance c/d 18,000
38,000 38,000
MCQs
1 B
2 D
3 D
4 D
5 A

 Prepare trading accounts, statement of profit or loss, and statement of

financial position from trial balance

Trial Balance:
Basically, it is an account that lists the closing balance of each account on the
respective debit or credit side. One of the main objectives of the trial balance
is to ensure that the total of all debits equals the total of all the credits.
Objectives of Trial Balance
The following are the important objectives of trial balance
1. To Check the Arithmetical Accuracy
Trial balance is based on the double-entry principle of debit equals credit or

credit equals debit. As a result, the debit and credit columns of trial balance
must always be equal. If they do, it is assumed that the recordings of financial
transactions are accurate. Conversely, if they do not, it is assumed that they
are not arithmetically accurate. Therefore, one important purpose of preparing
trial balance is to provide a check on the arithmetical accuracy of the
recordings of the financial transactions.
2. To Help Locate Accounting Errors
Since the trial balance indicates if there is any error committed in the journal
and the ledger, it helps the accountant to locate the error because the starting
point of locating errors is trial balance itself.
3. To Summarize the Financial Transactions
A business performs several numbers of financial transactions during a

certain period of time. The transactions themselves cannot portray any picture
of the financial affairs of the business. For that purpose, a summary of the
transactions has to be drawn. The trial balance is prepared with a view to
summarize all the financial transactions of the business.
4. To Provide the Basis for Preparing Final Accounts
Final accounts are prepared to show profit and loss and the financial position
of the business at the end of an accounting period. These accounts are
prepared by using the debit and credit of all ledger accounts. Therefore, since
the trial balance is a statement of the debit and credit balances of the ledger
accounts, it provides the basis for the preparation of the final accounts.

1 Trial balance example
1.1 The trial balance of Time Ltd at 31 May 20X6 is as follows:
Rs Rs
Capital account 15,258
Drawings 3,970
Purchases 73,010
Returns inwards 1,076
Returns outwards 3,720
Discounts 1,870 965
Credit sales 96,520
Cash sales 30,296
Customs duty 11,760
Carriage inwards 2,930
Carriage outwards 1,762
Salesman’s commission 711
Salesman’s salary 3,970
Office salaries 7,207
Bank charges 980
Loan interest 450
Light and heat 2,653
Printing and postage 2,103
Advertising 1,044
Bad debts 1,791
Doubtful debts provision 437
Stock 7,650
Debtors 10,760
Creditors 7,411
Cash at bank 2,634
Cash in hand 75
New Machines(less trade-in) 2,200
Motor expenses 986
Furniture and equipment:
Cost 8,000
Depreciation at 1 June 20X5 2,400
Old machine:
Cost 2,000
Depreciation at 1 June 20X5 1,000
Loan account at 9% (repayable in five ______ 5,000
years)
163,007 163,007

You ascertain the following information:
(a) Closing stock has been valued for accounts purposes at Rs

8,490.
(b) The Machine was sold on 31 August 20X5 and traded in against
the cost of a new one. The trade-in price was Rs 1,000 and the
cost of the new one was Rs 3,200.
(c) Depreciation on the straight-line basis is to be provided at the
following annual rates:
Machine 25%
Furniture and equipment 10%
(d) 5% of the closing debtors total is estimated to be doubtful.

(e) An accrual of Rs 372 is required in respect of light and heat.
(f) A quarter’s rent to 30 June 20X6 amounting to Rs 900 was paid
on 2 April 20X6. Rates for the year to 31 March 20X7 amounting
to Rs 1,680 were paid on 16 April 20X6.
Required:
(a) a trading A/c and Statement of profit or loss for the year ended
31 May 20X6
(b) a statement of financial position as at 31 May 20X6.
Solution
Step 1: Stock
The closing stock figure of Rs 8,490 is identified for the final accounts.
No working is required.
Step 2: Fixed assets and depreciation
This is the most difficult part of the question. Considering the motor
vehicles initially, the approach should be in three stages.
(a) depreciation on the old vehicle up to the point of sale: 25% x

3/12 x Rs 2,000 = Rs 125
(b) dealing with the trade-in: the way to approach this is to treat the
sale and the purchase as two separate transactions. Effectively
the old machine is treated as sold to the dealer for Rs 1,000 and
the new one is treated as being purchased from the dealer for
Rs 3,200
(c) depreciation on the new machine from the date of purchase to
the year end: 25% x 9/12 x Rs 3,200 = Rs 600.

‘T’ accounts should clearly be used:
Old Machines– accumulated depreciation

Rs Rs
Old Machines– 1,125 Per trial balance 1,000
disposal
_____ Depreciation expense 125
1,125 1,125
Old Machines– disposal

Rs Rs
Old Machines– cost (per 2,000 Old Machines–
TB)
accumulated
depreciation 1,125
Profit on disposal (profit and 125 New machine – cost 1,000
loss)
_____ _____
2,125 2,125
Note: the trade in value of Rs 1,000 is effectively the sales proceeds from the
sale of the old machine.
New Machines– cost

Rs Rs
Per trial balance 2,200 Balance c/d 3,200
Old Machines– disposal _____
1,000
3,200 3,200
Note: the disposal ‘proceeds’ on the old Machines are treated as reducing the
cost of the new Machines in practice. To reflect this in the books the following
entry is made:
Dr New Machines– cost Rs1,000

Cr Old Machines– disposal Rs1,000
This ensures that the disposal proceeds are correctly reflected in the disposal
account and that the new machine is shown at its full cost for accounts
purposes.

New Machines– accumulated depreciation
Rs Rs
Balance c/d 600 Depreciation 600
expense
Depreciation expense – machines

Rs Rs
Old Machines– 125 Old Machines– (over 125
accumulated provision or profit on disposal)
depreciation account
New Machines–
accumulated
depreciation account 600 Profit and loss 600
725 725
Tutorial note: a separate account for depreciation expense on machines has

been used. Alternatively, the depreciation could have been shown as Rs 725
with the gain on disposal at Rs 125, either treatment being acceptable.
Depreciation on the furniture and equipment is much more straightforward:
Furniture and equipment – accumulated depreciation

Rs Rs
Balance c/d 3,200 Per trial balance 2,400
____ Depreciation expense (Rs 8,000 x 800
10%)
3,200 3,200
Step 3: Bad debts

Careful scrutiny of the trial balance will reveal two accounts of
importance here:
(a) bad debts – a debit balance of Rs 1,791 representing bad debts
already written off in the year
(b) doubtful debts provision – a credit balance of Rs 437 representing the
current provision against doubtful debts.
KEY POINT
The increase in the doubtful debts provision is charged to the profit and
loss account through the bad debts account.
The increase in the doubtful debts provision is charged to the profit and
loss account through the bad debts account.

Doubtful debts provision
Rs Rs
Balance c/d (5% x Rs 538 Per trial balance 437
10,760)
____ Bad debts (bal fig) 101
538 538
Bad debts
Rs Rs
Per trial balance 1,791 Profit and loss 1,892
Doubtful debts provision 101 _____
1,892 1,892
Step 4: Light and heat

A straightforward accrual which increases the expense shown in the
profit and loss account and will also appear in the statement of financial
position as a current liability.
KEY POINT
The accrual increases the expense shown in the profit and loss
account and will also appear in the statement of financial position as a
current liability.
Light and heat

Rs Rs
Per trial balance 2,653 Profit and loss 3,025
Balance c/d 372 _____
3,025 3,025
Step 5: Rent and rates

The prepayment of rent and rates reduces the expense to the profit
and loss account and will appear in the statement of financial position
as a current asset.
Rs
(a) Rent prepaid (1/3 x Rs 900) 300
(b) Rates prepaid (10/12 x Rs 1,680) 1,400
1,700
KEY POINT
The prepayment of rent and rates reduces the expense to the profit
and loss account and will appear in the balance sheet as a current
asset.

Rent and rates
Rs Rs
Per trial balance 7,315 Profit and loss (bal 5,615
fig)
_____ Balance c/d 1,700
7,315 7,315
Step 6
Prepare the trading A/c and Statement of profit or loss and statement
of financial position.
The answers are shown on the next two pages.
(a)
Trading A/c and Statement of profit or loss for the year ended 31 May 20X6
Rs Rs Rs
Sales:
Credit 96,520
Cash 30,296
126,816
Less: Sales returns (1,076)
125,740
Opening stock 7,650
Purchases 73,010
Less: Purchase returns (3,720)
69,290
Customs duty 11,760
83,980
91,630

Trading A/c and Statement of profit or lossfor the year ended 31 May 20X6
Rs Rs Rs
Gross profit 42,600
Discount received 965
43,565
Less: Expenses:
Depreciation:
Machine (Step 2) 600
Equipment (Step 2) 800
Bad debts (Step 3) 1,892
Light and heat (Step 4) 3,025
Rent and rates (Step 5) 5,615
Discount allowed 1,870
Carriage outwards 1,762
Salesman’s commission 711
Salesman’s salary 3,970
Office salary 7,207
Bank charges 980
Loan interest 450
Printing and postage 2,103
Advertising 1,044
Motor expenses 986
(35,115)
Net profit 8,450
(b) Statement of financial position as at 31 May 20X6

Fixed assets: Cost Rs Acc depn NBV Rs
Rs
Machines 3,200 600 2,600
Furniture and equipment 8,000 3200 4800
11,200 3800 7,400

Current assets:
Stock 8,490
Debtors 10,760
Less: Provision for
doubtful debts ______ (538)
10,222
Prepayments (rent and 1,700
rates)
Cash at bank 2,634
Cash in hand 75
23,121

Rs Rs Rs
Less: Current liabilities:
Trade creditors 7,411
Accrued expenses (light and 372
heat)
______ (7,783)
15,338
22,738
Less: Long-term liability:
Loan account (5,000)
17,738
Capital account:
Balance at 1 June 20X5 15,258
Net profit 8,450
23,708
17,738
1.1 Notes on presentation
(a) The trading account includes all expenditure incurred in bringing

the goods to their present location and condition. This includes:
(i) purchase cost including import duty

(ii) carriage inwards and freight costs
‘Carriage’ means transport costs. ‘Inwards’ refers to the cost of

bringing in raw materials from suppliers. Carriage outwards is
delivery charges incurred in supplying goods to customers. It is
treated as an expense of selling and is included with all the
other expenses. Note that both carriage inwards and carriage
outwards are debits (i.e. expenses).
(c) ‘Returns’ often causes difficulties. Returns inwards are the same
as sales returns. Since sales are credits, sales returns are
debits. For presentation purposes, sales returns are deducted
from sales. In the same way purchase returns are deducted
from purchases.
(d) The discounts are shown as one line in the trial balance with
both a debit and a credit balance. Remember that expenses are
debit balances and income, credit balances. Therefore the
discount allowed is the debit balance and the discount received
the credit balance.
2 Chart of Account
2.1 A chart of accounts (COA) is a financial organizational tool that provides

a complete listing of every account in an accounting system. An

account is a unique record for each type of asset, liability, equity,
revenue and expense.
A COA, which lists the names of the accounts that a company has
identified and made available for recording transactions in its general
ledger, establishes the level of detail tracked in a record-keeping
system. Typically, a COA contains the accounts’ names, brief
descriptions and identification codes.
In practice, the COA serves as the foundation for a company’s financial

record keeping system. It provides a logical structure that facilitates the
addition of new accounts and deletion of old accounts.
Within the COA, accounts will be typically listed in order of their

appearance in the financial statements. Typically, Balance sheet
accounts are listed first followed by the income statement accounts
An important purpose of a COA is to segregate expenditures, revenue,

assets and liabilities so that it can quickly give a sense of a company’s
financial health. A well-designed COA not only meets the information
needs of management, it also helps a business to comply with financial
reporting standards. A company has the flexibility to tailor its chart of
accounts to best suit its needs. Within the categories of operating
revenues and operating expenses, for instance, accounts might be
further organized by business function and/or by company divisions.
A chart of accounts will likely be as large and as complex as the

company itself. An international corporation with several divisions may
need thousands of accounts, whereas a small local retailer may need
as few as one hundred accounts.
Summary
The purpose of this chapter was to illustrate the approach necessary
with a more complex example where a trial balance is given and a
number of adjustments have to be made before the financial
statements can be prepared. The illustration should have brought
together all of the basic double entry that has been studied piecemeal
in the earlier chapters of this text.
A number of new items were also introduced such as carriage inwards
and outwards, customs duties and the trade in of an old fixed asset in
part exchange for a new fixed asset.
 Prepare nominal ledger accounts; prepare journal entries; prepare

a trial balance.

 Prepare trading accounts, statement of profit or loss, appropriation
of profit and statement of financial positions from trial balance.
Self-test questions
Trial balance example
1 Is opening stock a debit or a credit balance in the trial balance? (1)

2 Where a fixed asset is part exchanged for another fixed asset should
the cost of the new fixed asset be net of the trade in value or include
the trade in value? (1 Step 2)
3 What is the double entry necessary to ensure that the trade in value of
an old fixed asset is correctly reflected in the accounts? (1 Step 2)
4 If the provision for doubtful debts is increased is this a debit or a credit
to the profit and loss account? (1 Step 3)
5 Does a prepayment increase or decrease the expense shown in the
profit and loss account? (1 Step 5)
6 Are discounts allowed a debit or a credit balance? (1.1)
7 What are returns inwards? (1.1)
8 How are returns inwards presented in the financial statements?
(1.1)
9 What is the correct treatment for carriage inwards in the trading and
profit and loss account? (1.1)
10 What is carriage outwards? (1.1)
Practice questions
The following information relates to questions 1 to 6.

The following is the trial balance extracted from the books of Delta Ltd
at 31 December 20X9:
Rs Rs
Capital at 1 Jan 20X9 20,000
Loan account, Omega 2,000
Drawings 1,750
Freehold premises 8,000
Furniture and fittings 500
Plant and machinery 5,500
Stock at 1 Jan 8,000
Cash at bank 650
Provision for doubtful debts 740
Purchases 86,046
Sales 124,450
Bad debts 256

Bad debts recovered 45
Trade debtors 20,280
Bank charges 120
Rent 2,000
Returns inwards 186
Returns outwards 135
Salaries 3,500
Wages 8,250
Travelling expenses 1,040
Carriage inwards 156
Discounts allowed 48
Discounts received 138
General expenses 2,056
Carriage outwards 546
Gas, electricity and water 2,560
Travellers’ salaries and 5,480
commission
Printing and stationery 640 0
157,564 157,564
The following information is relevant:
(a) stock at 31 December 20X9 Rs 7,550

(b) interest on the loan at 5% pa had not been paid at 31 December
(c) rent includes Rs 250 for premises paid in advance to 31 March
next year
(d) depreciate plant and machinery by 10% pa depreciate furniture
and fittings by 5% pa
(e) adjust the provision for doubtful debts to 5% of trade debtors
(f) show wages as part of cost of sales.
MCQ’s
1 What is the gross profit for the year?

A Rs 24,497
B Rs 41,497
C Rs 32,455
D Rs 38,291
2 What is the rental expense for the year?

A Rs 2,097
B Rs 4,497
C Rs 3250
D Rs 1,750
3 What is the bad debt expense for the year?

A Rs 297

B Rs 197
C Rs 320
D Rs 485
4 What is the net book value of furniture and fittings?

A Rs 297
B Rs 197
C Rs 320
D Rs 475
5 What is the net book value of plant and machinery?

A Rs 2,097
B Rs 4,950
C Rs 3250
D Rs 1,750
6 What is the interest expense for the year?

A Rs 297
B Rs 100
C Rs 320
D Rs 475
Answers of MCQs
1 A
2 B
3 D
4 D
5 B
6 C

 explain and illustrate the calculation of profit or loss as the difference
between opening and closing net assets
 explain techniques used in incomplete record situations:
 calculation of opening capital
 use of ledger total accounts to calculate missing figures.
 use of given gross profit percentage to calculate missing figures.

1 Incomplete records: basic approach
When you are preparing a set of accounts, it is likely that you may not have
all of the information available to you to complete a set of financial
statements.
It is likely that you may have an incomplete ledger or control accounts
system.
If this is the case, you will have to use the best information that is available to
you and 'guestimate' any missing figures.
There are a number of different ways which we can use to calculate missing
figures and balances, such as:
 Opening capital calculations
 Cash and Bank transactions
 Ratios – mark up and margin
1.1 Calculating profit from capital
The most basic incomplete records situation of all is where one is

required to calculate net profit, given details only of a sole trader's
capital at the beginning and end of the year and of his drawings.
Example
A sole trader's capital position is as follows:
31 December
20X6 20X7
Rs in ‘000 Rs in ‘000
Motor vehicle:
Cost 2,000 2,000
Depreciation (800) (1,200)
1,200 800
Stock 2,040 2,960
Debtors 865 1,072
Bank 1,017 1,964
Cash 351 86
5,473 6,882
Creditors 1,706 1,905
Net assets 3,767 4,977
Estimated drawings for the year are Rs 3,000,000. An estimate of the

net profit for the year is required.
Solution
From the basic statement of financial position equation capital equals
assets less liabilities. Hence the opening and closing capital account

balances are Rs 3,767,000 and Rs 4,977,000 respectively. His net
profit may be calculated by completing the capital account.
Capital Account
20X7 Rs in ‘000 20X7 Rs in ‘000
Drawings 3,000 1 Jan Balance 3,767
b/d
31 Dec Balance 4,977 Net profit (bal fig) 4,210
c/d
7,977 7,977
20X8
1 Jan Balance 4,977
b/d
Note that the net profit figure is very much an estimate and depends on
the reliability of the drawings and the opening and closing net asset
positions. It also assumes that no new capital has been introduced by
the owner during the year.
1.2 Alternative method
An alternative method of calculation is:
Rs in ‘000
Net assets this year end 4,977
Net assets last year end 3,767
Increase in net assets 1,210
Less: Capital introduced by owner –
Add: Drawings 3,000
Profit for the year 4,210
KEY POINT
Profit for the year = Increase in net assets – Capital introduced +
Drawings.
The alternative method emphasises that profit represents an increase
in the net assets of the business unless it is withdrawn by the owner.
2 Cash and bank transactions

2.1 Introduction
In the first example above no details were given of transactions taking

place during the year. If basic information regarding receipts and
payments is provided, it is possible to build up to a statement of
financial position and statement of profit or loss, although some
important assumptions may well need to be made.

2.2 Basic procedure for incomplete records
The procedure suggested below is a full procedure suitable for a wide

range of incomplete records questions and may be set out in basic
steps.
Step 1
Set aside a sheet for the trading account and statement of profit or loss
and a sheet for the statement of financial position. Some information
can be inserted straight into the final
Step 2
Prepare the opening statement of financial position from information on
assets and liabilities. The opening capital account balance can be
calculated as a balancing figure (capital = assets less liabilities).
KEY POINT
The opening capital account balance can be calculated as a balancing
figure (capital = assets less liabilities)
Step 3
Insert the opening balances in ‘T’ accounts. For example:
Balance Account
Cash at bank Cash at bank (bank)
Cash in hand Cash in hand (cash)
Debtors Sales control account
Creditors Purchases control account
Accrued expenses Separate account for each expense category
Prepayments Separate account for each expense category
Purchases control account and Sales control account have a similar
layout to control accounts in a double-entry system. The difference is
that their key objective in incomplete records is often to calculate
purchases and sales made in the accounting period that will be
transferred to the statement of profit or loss Alternative names given to
these accounts in incomplete records are:
Sales control = Total sales account, or Total debtors account

Purchases control = Total purchases account, or Total creditors
account.
Step 4
Information is almost certain to be given as regards cash and bank
transactions. Accordingly the cash and bank accounts can be
prepared, making use of double- entry principles and completing the
entries by debiting and crediting whichever accounts are appropriate.
Notes
(a) Cash withdrawn is cash taken out of the bank (Cr bank) and
into cash in hand (Dr cash).
(b) Cash banked operates in the opposite direction – it is a
reduction of cash (Cr Cash) and an increase in money at bank
(Dr Bank). Depending on the degree of incompleteness, cash is
likely to contain one or two missing items of information. This
aspect of the problem will be receiving more attention later.
Step 5
Insert into the accounts the closing balances provided in the question
in respect of debtors, creditors, accrued expenses and prepayments. In
simple questions the respective transfers to profit and loss may be
calculated as balancing items.
Sales control account

Rs Rs
Opening debtors b/d X Cash X
Sales (bal fig) X Closing debtors c/d X
X X
Purchases control account
Rs Rs
Cash X Opening debtors b/d X
Bank X Purchases (bal fig) X
Closing trade creditors c/d X
X X
Rates account (assuming paid in advance)

Rs Rs
Opening prepayment b/d X Profit and loss (bal X
fig)
Bank X Closing prepayment X
c/d
____ ___
X X
Step 6
Carry out any further adjustments as required, such as dealing with
doubtful debts and depreciation.
Example
Y Ltd does not keep proper books of account. You ascertain that the bank
payments and receipts during the year to 31 December 20X8 were as
follows:
Bank account
Rs Rs
Balance 1 Jan 20X8 800 Cash withdrawn 200
Cheques for sales 2,500 Purchases 2,500
Cash banked 3,000 Expenses 800
Drawings 1,300
Machine (bought 1 Oct 1,000
20X8)
_____ Balance 31 Dec 20X8 500
6,300 6,300

From a cash notebook you ascertain that:
Rs
Cash in hand 1 January 20X8 70
Cash takings 5,200
Purchases paid in cash 400
Expenses paid in cash 500
Cash in hand 31 December 20X8 30
Drawings by proprietor in cash Unknown
You discover that assets and liabilities were as follows:
1 Jan 20X8 31 Dec 20X8
Rs Rs
Debtors 300 450
Trade creditors 800 900
Expense creditors 100 150
Stock on hand 1,400 1,700
Y Ltd says that there is no hope of receiving an amount of Rs 100 due
from one customer and that a provision of 10% of debtors would be
prudent. Depreciation on the machine is to be provided at the rate of
20% pa. You are required to prepare a trading account and statement
of profit or loss for the year to 31 December 20X8 and a statement of
financial position at that date.
Solution
Step 1
The sheets set aside for the final accounts can be inserted with main
headings and certain information such as opening and closing stock
can be inserted.
Step 2
Calculate opening capital. The preparation of the opening statement of
financial position is usually achieved by drawing up a statement of
opening capital using information given in the question about the
opening balances. A careful scrutiny of the question reveals:
Workings
(W1)
Statement of opening capital
Dr Cr
Rs Rs
Bank 800
Cash 70
Debtors 300
Trade creditors 800
Expense creditors 100
Stock 1,400 _____
2,570 900
(900)
1,670

Thus debits (assets) exceed credits (liabilities) by Rs 1,670.
Accordingly Y Ltd's business has net assets of Rs 1,670, represented
on the statement of financial position by the opening capital account.
Step 3
Insert the opening balances into T accounts if construction of the
accounts is required. Leave plenty of space between the ledger
accounts.
A ledger account for Bank is not required, because the question has
already provided this. Accounts for stock and capital are not required
as the information can be inserted immediately into the final accounts.
(W2)
Cash
Rs Rs
Balance b/d 70
(W3)
Rs Rs
Balance b/d 300
(W4)
Rs Rs
Balance b/d 800
(W5)
Creditors – expenses
Rs Rs
Balance b/d 100
Step 4
Prepare the cash account, and post the cash and bank entries to the
other accounts.
(W2)
Cash
Rs Rs
Balance b/d 70 Bank 3,000
Bank 200 Purchases control 400
account
Sales control account 5,200 Expenses 500
Drawings (bal fig) 1,540
______ Balance c/d 30
5,470 5,470

(W3)
Rs Rs
Cash 5,200
(W3)
Rs Rs
Cash 5,200
(W4)
Rs Rs
Bank 2,500 Balance b/d 100
Cash 400
(W5)
Creditors – Expenses
Rs Rs
Bank 800 Balance b/d 100
Cash 500
(W6)
Drawings
Rs Rs
Bank 1,300
Cash (W2) 1,540
(W7)
Machine cost
Rs Rs
Bank 1,000
The commentary above is designed to show what happens after each

step; in practice of course you would not write out each account on
more than one occasion.
Step 5
Insert the closing balances and calculate the transfers to profit and
loss.

(W4)
Rs Rs
Bank 2,500 Balance b/d 800
Cash 400 Trading and 3,000
profit and loss
(bal fig)
Balance b/d 900 _____
3,800 3,800
(W5)
Creditors – Expenses
Rs Rs
Bank 800 Balance b/d 100
Cash 500 Trading and 1,350
profit and loss
(bal fig)
Balance b/d 150 _____
1,450 1,450
The sales control account has not yet been closed, as there is an
adjustment for bad debts still to be made.
Step 6
Carry out any further adjustments. These will be familiar, and the
principles behind them are unchanged.
Bad debts
(W3)
Rs Rs
Trading and profit and loss 7,850 Cash 5,200
(bal fig)
Bad debts 100
_____ Balance c/d (Rs 450 – Rs 350
100)
8,150 8,150
(W8)
Bad debts
Rs Rs
Sales control account 100 Profit and loss 135
Provision for doubtful debts 35
____ ____
135 135

(W9)
Rs Rs
Balance c/d (10% x Rs 35 Balance b/d Nil
350)
Bad debts 35
____ ____
35 35
Depreciation
(W7)
Machine
Rs Rs
Bank 1,000 Balance c/d 1,000
____ ____
(W10)
Machine accumulated depreciation
Rs Rs
Balance c/d 50 Profit and loss 50
____ ____
Charge 20% x 3 months x Rs 1,000 = Rs 50
Drawings
(W6)
Drawings
Rs Rs
Bank 1,300 Capital 2,840
Cash 1,540 ____
2,840 2,840
The remaining figures can be inserted into the final accounts.
Y Ltd
Trading Account and Statement of profit or loss for year ended 31
December 20X8
Rs Rs
Sales (W3) 7,850
Cost of sales:
Opening stock 1,400
Purchases (W4) 3,000
4,400
(2,700)
Gross profit 5,150
Expenses (W5) 1,350

Bad debts (W8) 135
Depreciation of machine 50
(W10)
_______
(1,535)
Net profit 3,615
Y Ltd
Rs Rs Rs
Fixed assets:
Machine at cost (W7) 1,000
Depreciation to date (W10) (50)
950
Current assets:
Stocks 1,700
Debtors (W3) 350
Less: Provision for doubtful
debts (35)
315
Cash at bank 500
Cash in hand 30
2,545
Rs Rs Rs
Trade creditors (W4) 900
Expense creditors (W5) 150
(1,050)
1,495
2,445
Capital account:
Capital at 1 January 1,670
20X8 (W1)
Add: Profit for year 3,615
5,285
Less: Drawings in year (2,840)
(W6)
2,445
3 Using ratios and percentages

3.1 Introduction
In the example above, drawings was the only unknown in the cash
account. What happens if there are two unknowns in the cash account

– for example, drawings and takings? We can still construct the
financial statements provided we are given some additional
information.
DEFINITION
3.2 Gross profit percentages
Gross profit percentage = Gross profit/Sales x 100

For instance, if we know that sales total Rs 8,000 and the gross profit
percentage is 25%, the following can be deduced:
Rs %
Sales 8,000 (given) 100
Less:Cost of sales (6,000) (75)
–––––– ––––––
Gross profit 2,000 25 (given)
3.3 Margins and mark-ups
The gross profit percentage in the previous examples is also known as

the profit margin. The percentage of profit is given by reference to
sales. Alternatively information on the mark-up may be given.
DEFINITION
Mark-up percentage = Gross profit/Cost of sales x 100.
Thus if we know that cost of sales is Rs 6,000 and the mark-up is one
third, we can set out the following:
Rs Ratio
Sales
Cost of sales (given) 6,000 3
–––––– ––––––
Gross profit 1
The 'ratio' is an alternative to using percentages. One third is awkward

to work with in percentage terms. In ratio terms gross profit is one part
to three parts costs. Sales are therefore four parts (1 + 3), so total
sales = 4/3 x Rs 6,000 = Rs 8,000.
Rs Ratio
Sales 8,000 4
Cost of sales (6,000) 3
Gross profit 2,000 1

Example
Suppose we have been told that sales are Rs 60,000 and the mark-up
is 25%. The information given can be set out:
Rs %
Sales 60,000
Cost of sales 100
Gross profit 25
Solution
Laying out the information as above should show that gross profit and
cost of sales can still be worked out. In percentage terms sales are
125% (100 + 25). Profit is therefore 25/125 x Rs 60,000 = Rs 12,000.
Rs %
Sales 60,000 125
Cost of sales 48,000 100
Gross profit 12,000 25
Example
Mr. Khawar, a sole trader, has provided you with the following
information relating to the year ended 31 December 20X5:
 No note of drawings or of cash received has been made. The
following items were paid from takings prior to banking: Purchases
Rs 760 Sundry expenses Rs 400
 Mr. Khawar has estimated that the gross profit percentage is 20%.
 The summarised bank account was as follows:
20X5 Rs 20X5 Rs
1 Jan Balance 1,700 Rent 1,000
b/d
Bankings 16,940 Electricity 235
Purchases 16,140
Drawings 265
31 Dec Balance c/d 1,000
______ ______
18,640 18,640

 Assets and liabilities were as follows:
31 Dec 20X5 31 Dec 20X4

Rs Rs
Stock 4,800 5,600
Debtors 1,650 2,100
Creditors:
Goods 1,940
Electricity 65 1,640
Cash float 2,400 170
 Mr. Khawar started paying rent in 20X5. A year's rent was paid in
advance on 1 April 20X5.
Required:
(a) a trading account and statement of profit or loss for the year ended
31 December 20X5
(b) a statement of financial position at that date.
Solution
The final solution is below. This is explained in pages that follow.
(a) Trading Account and Statement of profit or loss for the year
ended 31 December 20X5
Rs Rs
Sales (W3) 22,500
Opening stock 5,600
Purchases (W1) 17,200
22,800
Closing stock 4,800
Cost of sales (W2) 18,000
Gross profit 4,500
Rent (1,000 – 250) 750
Electricity (235 + 65) 300
Sundry 400
1,450
Net profit 3,050

(b) Statement of financial position as at 31 December 20X5
Rs Rs
Current assets:
Stock 4,800
Debtors 1,650
Prepayment 250
Bank 1,000
Cash 2,400
10,100
Creditors:
Goods 1,940
Expenses 65
2,005
8,095

Rs `Rs
Capital account:
Opening capital 7,930
(W6)
10,980
Less: Drawings (W5) 2,885
8,095
Step 1
Sheets are reserved for the statement of profit or loss and statement of
financial position. In particular the trading account becomes a key
working in situations where a margin or mark-up is given. Insert the
opening and closing stock figures (if given) and also the margin
percentages.
Step 2
In earlier examples, Step 2 involved completing the opening statement
of financial position in order to derive the opening capital balance. You
may prefer to do this after the sales and purchases control accounts
have been completed as it only helps in finding one figure to go into the
final accounts. (See W6.)
Step 3
Insert the opening balances in ‘T’ accounts. In this case you need
accounts for purchases control (W1), sales control (W3), cash float
(W4) and drawings (W5).
Step 4
Deal with the information given as regards cash and bank transactions.
Note that the bank account is not included in the workings, full details
being given in the question. In addition, no ledger accounts have been

shown for the various expenses. Instead workings have been shown
on the face of the statement of profit or loss , e.g. rent. There is a rent
prepayment of Rs 250 (three months rent). The expense is therefore
Rs 750.
Step 5a
Insert the closing balances into the accounts. At this point the figure for
purchases can be calculated.
Step 5b
Having reached this far, a little more thought is now required. The
position as regards unknowns can be summarised as follows:
 Debtors – The figures for sales and receipts from debtors are
unknown. This is where the gross profit percentage is utilised:
see W2.
 Cash –The figures for drawings and receipts from debtors are
unknown.
Step 5c
Once the sales figure has been derived (W2) this leaves only one
unknown in the debtors account – receipts from debtors, which is
calculated as a balancing figure (W3).
Step 5d
The resulting double entry (Dr Cash Rs 22,950, Cr Debtors Rs 22,950)
means that there is now only one unknown in the cash account, the
drawings figure: see W4 and W5.
Workings
Descriptions such as '4’. Cash' indicate that the entry is made at Step 4.
(W1)
Purchases control
Rs Rs
4. Bank 16,140 3. Balance b/d 1,640
4. Cash 760 5a. Trading and profit
and loss (bal fig) 17,200
5a. Balance c/d 1,940
18,840 18,840
(W2)
Calculation of Sales (see step 5b)
Rs Rs %
Sales (Rs 18,000/80%) 22,500 100
Less: Cost of goods sold:
Opening stock 5,600
(given)
Purchases 17,200 (W1)
22,800
Less: Closing stock 4,800
(given)

18,000 80
Gross profit ( % given) 4,500 20
(W3)
Sales control
Rs Rs
3. Balance b/d 2,100 5c. Cash (bal fig) 22,950
5c. Trading and profit 23,500 5a. Balance c/d 1,650
and loss (W2)
24,600 24,600
(W4)
Cash float
Rs Rs
3. Balance b/d 170 4. Bank 16,940
5c. Debtors (W3) 22,950 4. Creditors – goods 760
4. Creditors –
expenses
5d. Drawings (bal fig)
5a. Balance c/d
23,120 23,120
(W5)
Drawings
Rs Rs
4. Bank 265 5d. Capital (bal fig) 2,885
5d. Cash (W4) 2,620
2,885 2,885
(W6)
Statement of opening capital
Dr Cr
Rs Rs
Bank 1,700
Stock 5,600
Debtors 2,100
Creditors – goods 1,640
Cash 170
9,570 (1,640)
9,570
Net 7,930
KEY POINT
The fact that all incomplete records questions are different means that
there is no universally correct way of attempting them. The key feature
is to remember that double-entry bookkeeping should be used to
prepare the required financial statements. Therefore you should
convert the incomplete records into suitable accounting form.

3.4 Variations on the theme
No two incomplete records questions are the same. Two examples of

common variations are:
(a) Suppose that stock was destroyed in a fire and that there was
enough information to calculate sales, purchases and opening
stock. The gross profit percentage would enable sales to be
converted to cost of sales. Closing stock could then be calculated
as a balancing figure.
(b) Suppose that a trader always received a rebate from the suppliers
amounting to 1% of purchases, and that in the current year the
rebate amounted to Rs 172. Clearly this tells us that purchases
were Rs 17,200. If cash paid to suppliers was unknown, it could be
calculated as a balancing figure.
The fact that all incomplete records questions are different means that
there is no universally correct way of attempting them. The key feature
is to remember that double entry bookkeeping should be used to
prepare the required financial statements. Therefore you should
convert the incomplete records into suitable accounting form.
Summary
In multiple choice and objective test questions you may only be asked
to perform a small part of the entire procedure, but that makes it all the
more vital that you understand the full process and how the steps fit
together – you'll need to know what stage has been reached and what
remains to be calculated. Having completed your study of this chapter
you should have achieved the following learning outcome.
 Prepare accounts from incomplete records

Self-test questions
Incomplete records: basic approach
1 How can the profit of a business be measured if opening and closing net
assets and drawings are known? (1.1)
Cash and bank transactions
2 What are the six basic steps for the approach to an incomplete records
question?
(2.2)
Using ratios and percentages
3 How is the gross profit percentage calculated? (3.2)

4 How is a mark-up percentage calculated? (3.3)

5 If stock was destroyed in a fire but sales, purchases and opening stock
could be calculated how would the figure for stock destroyed be
estimated? (3.4)
6 As at December 1, 1999 ABC Ltd. Company’s distribution expenses

account showed four months prepaid rent of Rs. 80,000 and
transporters accrued bill of Rs. 95,000. During December, the
outstanding bill was paid along with further bills of Rs. 245,000.
Transporters outstanding bills as at December 31, 1999 were Rs.
12,000.
Required: You are required to calculate the distribution expenses for

the month of December, 1999.
7 Malik was carrying on retail business of ready-made garments. He sold

his goods at a fixed margin of 15% above cost. The trial balance as at
January 1, 1999 was as under:
Rupees
Capital 600,000
Cash at Bank 118,000
Cash in hand 2,000

Creditors for supplies 150,000
Debtors 30,000
Furniture & Fixture 80,000
Stock 520,000
He had an assistant at a salary of Rs. 2,500 p.m. Malik paid the salary
on the last day of the month and took for personal use Rs. 5,000 on the
same day. Monthly expenses were Rs. 3,000 paid before the month
was over. On January 1, 1999
Malik fell ill seriously and could come to his shop only on 1st March
1999 when he found that the assistant did not turn up and he had
misappropriated entire available cash.
Malik gathered following information to ascertain the amount

embezzled:
Rupees
Creditors as at March 1, 1999 (according 140,000
to books)
Debtors as at March 1, 1999 56,000
Stocks as at March 1, 1999 (actual count) 400,000
Amount paid to Creditors by cheques 300,000
Cheques received from Debtors 80,000
(deposited into bank)
Cash sent to bank as per pass book 250,000

It was found that a bearer cheque for Rs. 15,000 received from a
debtor was en-cashed by the assistant. This information was
ascertained by getting the confirmations from the Debtors. The cheque
was not entered in the books at all. A cheque for Rs. 10,000 issued to
a creditor and not crossed by mistake, was also en-cashed by the
assistant. The cheque has been entered in the books. Stock records
revealed that goods costing Rs. 10,000 were missing.
You are required to:

a) Calculate the amount embezzled by the assistant.
b) Compute balance in bank as at March 1, 1999.
1 How would you calculate a profit figure with only statement of financial
position information?
A Profit = assets – liabilities + drawings
B Profit = closing net assets – opening net assets
C Profit = capital introduced – drawings
D Profit = closing net assets – opening net assets – capital
introduced + drawings
2 Mark ups are based on:

A Cost
B Sales
C Stock
D Profit
3 What is the link between all the control accounts in incomplete

records?
A Nominal ledger
B Sales
C Cash
D Purchases
4 Calculate closing stock using the following information:

Rs
Sales 200,000
Opening stock 18,000
Purchases 162,000
Mark up 20%.
A Rs 20,000
B Rs 13,333
C Rs 22,000
D Rs 16,667

5 Using the following information calculate closing stock.
Rs
Sales 500,000
Purchases 350,000
Gross margin 25%
A Rs 20,000
B Rs 55,000
C Rs 22,000
D Rs 16,000
Answers
DISTRIBUTION EXPENSE ACCOUNT

Rs. Rs.
Opening Balance Opening Balance (Accrued Bills) 95,000
(Prepaid Rent- 4 months) 80,000 Profit & Loss as Expense
Cash-Accrued Bills 95,000 (Balancing Figure) 277,000
Cash-Other Bills 245,000
Closing Balance Closing Balance
(Outstanding Bill) 12,000 (Prepaid Rent- 3 months) 60,000
432,000 432,000
Thus the distribution expenses for the month of December 1999 are Rs.
277,000
a) CALCULATION OF THE AMOUNT

EMBEZZLED BY THE ASSISTANT
Rs.
Amount received from debtors (bearer cheque) 15,000
Cheque issued to creditors en-cashed 10,000
Goods embezzled 10,000
Cash (W-1) 85,000
120,000

Working notes
(W-1)
Cash Account
Rs. Rs.
Balance b/d 2,000 Bank Deposits 250,000
Sales (W-2) 354,000 Salary of Assistant
(Rs. 2,500 x 2) 5,000
Drawings (Rs. 5,000 x2) 10,000
Office expenses (Rs. 3,000 x 2) 6,000
_______ Balance c/d 85,000
356,000 356,000
(W-2)
Cash Sale:

Add: Purchases (W-3) 290,000
810,000
Less: Closing stock (Physical + misappropriated) (410,000)
Add: Profit 15% on cost 60,000
Total sale 460,000
Less: Credit sale (W-4) (106,000)
Cash sales 354,000
(W-3)
Creditors’ Account
Rs. Rs.
Bank 300,000 Balance b/d 150,000
Embezzlement 10,000
Balance c/d
(140,000+10,000) 150,000 Purchases (Bal. Fig.) 290,000
450,000 450,000
(W-4)
Debtors Account
Rs. Rs.
Balance b/d 30,000 By Bank Receipts 80,000
Credit Sale (Bal. Fig.)106,000 By Embezzlement 15,000
By Balance c/d
______ (56,000–15,000) 41,000
136,000 136,000

BALANCE AT BANK
AS ON 01 MARCH 1999
Rs.
Opening balance 118,000
Add: Amount deposited
- Cheques from debtors 80,000
- Cash 250,000
448,000
Less: Cheques issued to creditors (300,000)
Cash at bank on 01 March 1999 148,000
MCQs
1 D
2 A
3 C
4 B
5 B

When you have completed this chapter you should be able to :
 explain the difference between a sole trader and a limited liability

company
 explain the capital structure of a limited liability company
 explain and illustrate the share premium account
 define a rights issue and dividends
 Book keeping of interim and final dividend
 define a bonus (capitalisation) issue
 explain and illustrate other reserves which may appear in a company
 explain why the heading, retained earnings, appears in a company

1 Types of limited company
1.1 Introduction
Most companies are limited by shares. This means that in the event of
the failure of a company, the amount the shareholders can lose is
restricted to the amount paid for their shares.
It is important to appreciate that not all limited companies are large –
they vary in size from the very small to the huge quoted company that
operates worldwide.
1.2 Key factors distinguishing companies
There are three key factors that distinguish companies from other
forms of business enterprise:
(a) The fundamental concept of the separate legal entity of the

company:
The company is a separate entity in law. From this flow (b) and (c)
below.
(b) The separation of the ownership (shareholders) from the
management (directors) of the company.
(c) The limited liability of shareholders for the debts of a company.
Generally speaking their liability will be limited to any portion of the
nominal value of shares that is unpaid.
1.3 Sole traders and companies compared
These three factors lead to differences between companies and sole

traders in the following respects:
 the form of the capital accounts

 the form of loans to the company
 the way in which profits are withdrawn by the proprietors
 the form in which retained funds are presented.
The differences may be summarised as follows:
1.4 Types of company
The various types of limited company may be categorised as follows:

(a) Private companies and public companies
Private company is a company which by its articles
i) restrict the right to transfer its shares
ii) limits its members to 50
iii) prohibits any invitation to the public to subscribe for the
shares, if any, or debentures of the company

A public company is a company that is not a private company:
(b) Quoted and unquoted companies
A quoted (or listed) company is a company the shares of which
are traded on the Stock Exchange. Clearly a quoted company
must, by definition, be a public company, though of course not
all public companies are quoted companies.
Unquoted (or unlisted) companies are those whose securities are not
traded on Stock Exchange.
DEFINITION
Listed in relation to securities, means securities which have been allowed

to be traded on a stock exchange;
Listed company means a company or a body corporate or other body

whose securities are listed
2 Company finance
2.1 Introduction
The way in which the assets of a company are financed will vary from
one company to another. Part of the finance may be provided by the
owners or proprietors of the company (referred to as shareholders),
while part may be provided by outsiders including trade creditors,
banks and other lenders of funds.
The principal sources of finance may be summarised as follows:

(a) Ordinary shares
(b) Preference shares Share capital
(c) Secured and unsecured loan stock (debentures)
(d) Convertible loan stock Liabilities
(e) Bank overdraft
(h) Trade creditors
2.2 Nominal value of share capital
Each share has a stated nominal (or par) value. This has little practical
significance except as a base line price below which further shares
may not generally be issued. The nominal value is also used as a
means of calculating dividends to shareholders. It is important to
appreciate that the market value of a share quoted on the Stock
Exchange has no direct relationship to the nominal value.
DEFINITION
A debenture is a written acknowledgement of a debt by a company,
usually given under its seal, and normally containing provisions as to
payment of interest and the terms of repayment of principal. A
debenture may be secured on some or all of the assets of the company
or its subsidiaries.

DEFINITION
Ordinary shares are the normal shares issued by a company. They
entitle the holders to the remaining divisible profits (and, in a
liquidation, the assets) after prior interests, e.g. creditors and prior
charge capital, have been satisfied.
DEFINITION
Preference shares are shares carrying a fixed rate of dividend, the
holders of which have a prior claim to any company profits available for
distribution.
2.3 Types of share capital

The share capital of a company may be divided into various classes.
The company’s internal regulations (the Articles of Association) define
the respective rights attached to the various shares, e.g. as regards
dividend entitlement or voting at company meetings. The various
classes of share capital are dealt with below. In practice it is usually
only larger companies that have different classes of share capital.
(a) Ordinary shares

Ordinary shares are the normal shares issued by a company. They
entitle the holders to the remaining divisible profits (and, in a
liquidation, the assets) after prior interests, e.g. creditors and prior
charge capital, have been satisfied.
The normal rights of ordinary shareholders are to vote at company

meetings and to receive dividends from profits.
Ordinary shares are often referred to as equity shares. A special
class of ordinary share is the redeemable ordinary share where the
terms of issue specify that it is repayable by the company.
Rights of Ordinary Shareholders

Whena person buys a share in a Company, he becomes a part of
owner of that Company. Under Company Ordinance 1984 this
ownership entitles you to certain rights.
Some of these rights relate to financial aspects of owning shares and

some relate to the communication between the company and the
shareholders. These right are as follows:
a) Right to the offer shares by the company at the time of

further issue of shares;
b) Right to receive dividends
c) Right to participate and vote in general meetings,
d) Right to elect and remove directors;
e) Right to contest election to the position of director;
f) Right to appoint auditors and fix their remuneration;
g) Right to receive residual assets at the time of winding up of

company;
h) Right to have different periodical reports; and
i) Right to have access to certain information of company.
(b) Preference shares

Preference shares are shares carrying a fixed rate of dividend, the
holders of which have a prior claim to any company profits available for
distribution.
The rights and advantages of the shares will be specified in the Articles
of Association. Preference shareholders may have a prior claim to the
repayment of capital on winding up, for example.
Special categories of preference shares include:
(i) Participating preference shares – shares which entitle the

holders to a fixed dividend and, in addition, to the right to
participate in any surplus profits after payment of agreed
levels of dividends to ordinary shareholders have been
made.
(ii) Redeemable preference shares – shares that are issued
on terms that may require them to be bought back by the
issuer at some future date, either at the discretion of the
issuer or of the holder.
(iii) Irredeemable preference shares- If preference shares are

not redeemable / convertible after a specific period of
time are called irredeemable preference shares
(iv) Cumulative preference shares - If the Company is not

able to pay preference dividend in one year, the arrears
of dividend are to be carried forward and paid out of the
profits of the subsequent years, such preference shares
are known as cumulative Preference shares
(v) Non cumulative preference shares - If unpaid dividend is

not carried forward but lapse then such shares are known
as non-cumulative preference shares
(vi) Convertible preference shares - Preference shares which

are convertible into any other shares of the Company
after a specified period of time or on occurrence of a
defined event are termed as convertible preference
shares

In summary:
Aspect Ordinary shares Preference shares
Voting power Carry a vote Do not carry a vote
Distribution of A dividend which may A fixed dividend (fixed

profits vary from one year to percentage of nominal
(dividends) the next after the value) in priority to
preference ordinary dividend
shareholders have
received their dividend
Liquidation of Entitled to surplus Priority of repayment

the assets on liquidation over ordinary shares
Company after liabilities and but not usually entitled
preference shares have to surplus assets on
been repaid liquidation
2.4 Debentures or loan stock
A debenture is a written acknowledgement of a debt by a company,

usually given under its seal, and normally containing provisions as to
payment of interest and the terms of repayment of principal.
A debenture may relate to a loan from one person. Debenture stock, on

the other hand, may be held by a large number of individuals.
Debentures are not part of a company’s share capital – they are third
party liabilities. Debenture interest is therefore a charge against profit
and must be paid whether or not the company makes a profit.
Debenture or loan stock may be secured on some or all of the assets

of the company or its subsidiaries. If a debenture is secured, the
debenture holder has the right to sell the company’s assets if it defaults
on its payment obligations. Both secured and unsecured loan stock are
usually redeemable at a specified future date.
DEFINITION
Convertible loan stock is a loan which gives the holder the right to
convert to other securities, normally ordinary shares, at a
predetermined price/rate and time.
2.5 Convertible loan stock

This is a hybrid, having characteristics both of loan stock and of
ordinary shares. On issue, the stock starts off with the characteristics of
loan stock. The conditions of issue state that at certain specified future
dates holders of the stock may, if they wish, convert their stock into a
specified number of ordinary shares.

3 Financial statements
3.1 Introduction
Two important considerations directly affect the financial statements of
a company:
(a) the Companies Ordinance 1984 contains detailed rules governing
the form and content of company accounts
(b) International Financial Reporting Standards (IFRSs)
3.2 Purpose of financial statements

A distinction must be made between:
 Financial statements that the Companies Ordinance require
to be presented to shareholders. These must comply with
the requirements of (a) and (b) above.
 Financial statements that are prepared for internal
purposes, e.g. for management. These statements need not
comply with legal and accountancy requirements.
At this stage you do not need to know any of the detailed requirements
of the Companies Ordinance or IFRSs beyond what is covered in this
text.

A vertical form Statement of financial position of a company is shown
on the next page: The profit and loss account balance represents the
retained profits of the company, i.e. those profits of the company that
have not yet been paid out by way of dividend to the shareholders.
Rs Rs
Fixed assets:
Tangible assets:
Freehold land and buildings 174,700
Plant and machinery 29,750
Investments 20,000
224,450
Current assets:
Stocks 59,670
Debtors 49,350
Cash at bank and in hand 4,645
113,665
Creditors: amounts falling due
within one year:
Taxation 26,735
Dividend payable 30,000
88,425
Total assets less current 249,690
liabilities

after more than one year:
8% Debenture 20X4 100,000
149,690
Capital and reserves:
Called up share capital – Rs 10
ordinary shares 75,000
Profit and loss account 74,690
149,690
3.4 Statement of Profit or Loss

There are two formats for the Statement of profit or loss; the most
common one which analyses expenses by function is shown below:
Rs
Turnover 256,788
Gross profit 120,791
Distribution costs (36,912)
Administration expenses (42,554)
Operating profit 41,325
Interest expense (10,217)
Profit before tax 31,108
Taxation (17,324)
Retained profit for the year 13,784
Retained profit b/fwd 60,906
Retained profit c/fwd 74,690
DEFINITION
A dividend is an amount payable to shareholders from profits or other
distributable reserves.
3.5 Dividends
A dividend is an amount payable to shareholders from profits or other
distributable reserves. Dividends can be stated as a percentage based
on the nominal value of the share or alternatively as an amount per
share, e.g. Rs 0.8 dividend on a Rs 10 share can be expressed either
as 8% or 80 paisa per share.
Dividends are declared by the company in general meeting. This can
only be done if the directors recommend payment of a dividend and it
cannot exceed the amount recommended by them. The directors on
their own responsibility can declare an interim dividend during the
accounting period on account of the total dividend for the year, if
allowable in the articles of the company.

KEY POINT
Both the interim and final dividends paid are shown in the notes to the
accounts. Any dividends declared by the year end are included in
creditors.
The bookkeeping for payment of an interim dividend is:
Debit Credit With

Profit and loss Cash Dividend
reserve
(appropriation of
profit)
Whilst the bookkeeping for a declared final dividend is:
Debit Credit With

Profit and loss Dividend Dividend
reserve creditor
(appropriation of (shown as
profit) current
liability on
The interim dividends Statement
paid and final
of dividends declared are not shown
on the face of statement of profit or loss. Instead, they are disclosed in
financial position)
a note to the accounts. If a dividend has been declared by the year
end, then it will be included in creditors as a current liability.
3.6 Corporation tax
There is a special cost to a company that is not a cost to a sole trader
business – corporation tax. Corporation tax is a tax levied on
companies as a percentage of their taxable profits. Certain adjustments
need to be made to adjust accounting profits to taxable profits but
knowledge of these adjustments is not required at this stage.
As it is a form of appropriation of profit (appropriated by the

Government rather than the shareholders), it is shown as a separate
cost after net profit before taxation. Corporation tax is payable in most
cases after the end of the accounting period. In order to agree the
corporation tax payable, the company must submit the accounts to the
Inland Revenue. Thus at the time of the preparation of the accounts the
corporation tax is an estimate of the liability. The entry is:
Debit Credit With
Profit and loss Tax creditor Estimate of
account account corporation
(shown as tax charge
current
liability on
Statement of
financial position)

3.7 Appropriation account
The term appropriation account is not often disclosed on the face of

statement of profit and loss today.
The account used to be regarded as separate from the profit and loss
account in the same way that a Trading account was separated from
the profit and loss account. Net profit was transferred into it and the
various appropriations were shown. The idea was that the net profit
earned by the company was calculated in the profit and loss account,
while the appropriation account showed how this net profit was divided
up between the stakeholders (e.g. dividends paid to shareholders).
Modern practice is to avoid the use of the term appropriation account

but some examiners may refer to it.
DEFINITION
The authorised share capital is the type, class, number and amount
of the shares that a company may issue, as empowered by its
memorandum of association. It represents the maximum number of
shares a company may issue.
DEFINITION
The issued share capital is the type, class, number and amount of the
shares held by shareholders, i.e. the actual number of shares in issue.
4 Issue of shares
4.1 Authorised and issued share capital
The authorised share capital is the type, class, number and amount of
the shares that a company may issue, as empowered by its
memorandum of association. It represents the maximum number of
shares a company may issue.
The issued share capital is the type, class, number and amount of the
shares held by shareholders, i.e. the actual number of shares in issue.
It is the issued share capital that appears on a company’s Statement of
financial position.
4.2 Issues of shares at nominal value
A company issues 200,000 Rs 10 ordinary shares at their nominal value.

Cash book
Rs Rs
Ordinary share 200,000
capital

Ordinary share capital account
Rs Rs
Cash 200,000
4.3 Issues at a value in excess of nominal value
In this case the amount by which the issue price exceeds the nominal
value must by law be transferred to a share premium account. A
company issues 200,000 Rs 10 ordinary shares at an issue price of Rs
15
Cash book
Rs Rs
Ordinary share 200,000
capital 100,000
Share premium
Ordinary share capital account

Rs Rs
Cash 200,000
Share premium account
Rs Rs
Cash 100,000
Statement of financial position extract
Rs
Called up share capital – Rs 10 200,000
ordinary shares
Share premium account 100,000
Profit and loss account X
The Companies Ordinance 1984 imposes certain legal restrictions on the

issue of shares at a discount – in other words at a value less than their
nominal value.
4.4 The share premium account
The share premium account may be used for the following purposes:
 financing the issue of fully paid bonus shares
 writing off preliminary expenses on the formation of a company
 writing off expenses, commission or discount on share or debenture
issues
 providing the premium payable on the redemption of debentures and in
certain cases on redeemable shares.
Note: the balance on share premium account is either a credit balance or nil
– never a debit balance.

4.5 Bonus, scrip or capitalisation issues
The issue of bonus shares (a bonus, scrip or capitalisation issue)

represents the issue of additional shares to existing shareholders in
proportion to their existing holdings.
No cash or other consideration is passed from shareholders to
the company. The bonus issue is financed internally by a
capitalisation of reserves.
Debit Credit With
Reserves Share capital Amount of bonus
issue
Any reserve may be used to finance the bonus issue. Clearly a reserve
which, by statute, cannot be distributed would be used in preference to
reserves that can be distributed.
The effects of a bonus issue are threefold:

 issued share capital is brought more into line with the fixed assets
employed in the company
 issued share capital is divided into a larger number of shares
 market price per share falls, although not necessarily pro rata to
the bonus issue. The stock market usually interprets a bonus issue
as a sign of strength.
The third effect is the main reason why bonus issues are made. It is felt
that if the market price per share becomes very high, investors are
more reluctant to purchase the shares. Of course, nothing has changed
to the real worth of the company – the effect is purely psychological.
DEFINITION
The issue of bonus shares (a bonus, scrip or capitalisation issue)
represents the issue of additional shares to existing shareholders in
proportion to their existing holdings.
4.6 Rights issues
A rights issue represents the raising of new capital by giving existing

shareholders the right to subscribe to new shares or debentures in
proportion to their current holdings. These shares are usually issued at
a discount to market price.
Unlike the bonus issue, the shareholders do not have to take up their
offer and have the alternative of selling their rights on the stock market.
Debit Credit With

Share capital Proceeds
Cash book Nominal value
Share premium Premium (if any)

A rights issue is the cheapest way a company can raise further finance
by the issue of shares.
DEFINITION
A rights issue represents the raising of new capital by giving existing
shareholders the right to subscribe to new shares or debentures in
proportion to their current holdings. These shares are usually issued at
a discount to market price
5 Reserves
5.1 Statutory reserves
These must be established in certain circumstances by law. They

include:
 share premium account (see above)
 capital redemption reserve (not within the syllabus)
 revaluation reserve (see an earlier chapter).
These reserves are sometimes referred to as capital reserves. They
represent amounts that cannot legally be paid out as dividends.
5.2 Revenue reserves
The profit for the year (after allowing for expenses and taxation) may
be dealt with as follows:
Profit after tax
1 2 3
Dividends paid Transfers to Unappropriated
and proposed specific named profit
reserves (profit and loss account)
Where profit is transferred to a named reserve, the directors are

indicating that these amounts are not available to support a dividend
payment (although there is nothing in law to prevent their distribution).
Examples of reserves given special names or titles include:
(a) Plant replacement reserve
During a period of rising prices the replacement cost of new plant will
be far greater than its original cost, and consequently the assets
representing the historical cost depreciation will fall short of the
required amount. Setting up a plant replacement reserve will help to
solve this problem.

Each year profit is reduced by a further amount (over and above
historical cost depreciation). The double entry each year is:
Debit Credit With
Profit and loss Plant Additional
account replacement Depreciation
(appropriation of reserve
profit)
(b) Stock replacement reserve
A similar problem arises with stock. During a period of increasing

prices, each successive unit of stock costs more. By reducing
distributable profits, amounts that might otherwise have been
distributed as dividends are retained within the business. The double
entry is:
Debit Credit With
Profit and loss Stock Additional
account replacement deduction
(appropriation of reserve relating to cost
profit) of
sales
(c) General reserve
Questions often state, for example, that ‘the directors wish to transfer
Rs 300,000 to a general reserve’ without indicating a specific purpose
for the reserve. The double entry is:
Debit Credit With

Profit and loss General Transfer to
account reserve general
(appropriation of reserve
profit)
5.3 Retained Earnings (reserve)
Any unappropriated profits remain in the profit and loss account. It is,
however, important to distinguish between:
 the ‘normal’ profit and loss account, for the year, which is made up
in a similar fashion to that of the sole trader, and
 Retained earnings (reserve), which is the total accumulated
unappropriated profit of the company to date – effectively, the
amount the company regards as distributable to shareholders. It is
this balance that appears in the Statement of financial position.
Note that there are detailed legal rules regarding distributable profits,
but these are beyond the scope of this text.
5.4 Statement of reserves
In order to cope with the double entry involved in and disclosure of the
transfers between various reserves, it is helpful to present the
movement in the various reserves in columnar format. This statement
can be put immediately below the profit and loss account for the year.
Example
ZZ Ltd’s summarised Statement of financial position at 31 December

20X7 showed:
Rs
Net assets 280,000
Capital and reserves
Called up share capital
– Rs 10 ordinary shares 75,000
– Rs 10 8% preference shares 60,000
Plant replacement reserve 30,000
Unappropriated profits 90,000
280,000
The net profit for the year to 31 December 20X8 has been computed as Rs
180,000.
The following additional information is available:

 corporation tax is estimated at Rs 70,000
 an interim dividend of 40 paisas has been paid on the ordinary
shares, and one half of the dividend on the preference shares
 it is proposed to pay the remaining dividend on the preference
shares and a final dividend of 100 paisas on the ordinary shares
 Rs 20,000 is to be transferred to the plant replacement reserve.
Required:
(a) to construct the Statement of profit and loss for the year
(b) to show the Statement of financial position at the end of the year
to the extent that information is available.
Solution
(a) Statement of Profit or Loss for the year ended 31 December 20X8
Rs Rs
Profit before taxation 180,000
Corporation tax 70,000
Retained profit for the 110,000
year

(a) Statement of financial position (extracts) as at 31 December
20X8
Rs
Creditors: amounts falling due within
one year
Corporation tax 70,000
Dividends (2,400 + 7,500) 9,900
Called up share capital
– Rs 10 ordinary shares 75,000
– Rs 10 8% preference shares 60,000
Plant replacement reserve 50,000
Unappropriated profits 164,700
374,700
Note: the total amount of capital and reserves (and thus the net
assets) has increased by the amount of retained profits of the
company, proved below.
Rs
Net assets last year 280,000
Retained profit (110,000 – 2,400 -
2,400 - 3,000 - 7,500) 94,700
Net assets this year 374,700
Statement of reserves
Profit and Plant Share

loss replacement premium
Rs Rs Rs
Balance at 1 January 20X8 90,000 30,000 25,000
Profit for the year 110,000
Dividends
Preference – paid (60,000 x (2,400)
4%)
– proposed (2,400)
Ordinary – paid (7,500 x 40 (3,000)
paisas)
– proposed (7,500 x Rs 1) (7,500)
Transfer (20,000) 20,000 ______
Balance at 31 December 164,700 50,000 25,000
20X8

5.5 Alternative presentation of profit or loss account
An alternative presentation of the profit and loss account is to show all

the appropriation and the opening and closing balances on the face of
the profit and loss account:
Profit and loss account for the year ended 31 December 20X8
Rs Rs
Profit retained for the year (as 94,700
before)
Transfer to plan replacement (20,000)
reserve
74,700
Balance brought forward 90,000
Balance carried forward 164,700
5.6 Reserves and provisions
These two terms are often confused. Essentially, the term provision
refers to:
 an amount written off or retained to provide for depreciation or
diminution in value of an asset (for example, a depreciation
provision or a doubtful debts provision), or
 an amount retained to provide for any known liability whose
amount cannot be determined with substantial accuracy. This does
not include outstanding invoices or accruals for electricity and
telephone (these can be determined with reasonable accuracy). An
example could be a provision for further pension costs.
The key distinction between reserves and provisions lies in their

accounting treatment:
 changes in a provision are an expense in arriving at net profit for a

period
 changes in a reserve are an appropriation of profits to another
reserve.
6 Financial statements of companies – full example

6.1 Introduction
How much information should the financial statements include? The
answer to this depends on for whom the statements are required. Users
may be divided into two groups:
 Internal users – directors and management require a detailed
Statement of profit or loss and Statement of financial position. For
the purpose of simplicity, it will be assumed that these are required
on an annual basis.
 External users – the Companies Ordinance requires shareholders
to be presented with a Statement of financial position and
Statement of comprehensive income. These statements are
normally made up on an annual basis and the Companies
Ordinance sets out minimum disclosure requirements. Published
accounts must also comply with the requirements of the relevant
accounting standards.
The following is an example of the preparation of financial statements

for internal use.
Example
You are provided with the following trial balance of Guard Ltd at 31 December
20X6:
Dr Cr
Rs Rs
Ordinary share capital (Rs 10 shares) 60,000
5% Preference share capital (Rs 10 20,000
shares)
Sales 80,000
Discount allowed 400
Debtors and creditors 10,000 2,000
Stock at 1 January 20X6 10,000
10% Debentures 20X9 50,000
Debenture interest paid 5,000
Fixed assets, at cost 230,000
Fixed assets, aggregate depreciation 100,000
Purchases 49,000
Administrative expenses 4,000
Salaries (excluding directors) 4,000
Preference dividend paid 1,000
Profit and loss account balance 8,000
Cash at bank 5,000 _______
320,200 320,200
Adjustments are required for:

 stock at 31 December 20X6, at cost Rs 15,000
 directors’ salaries not yet paid Rs 5,000
 \corporation tax for the year Rs 5,000
 proposed ordinary dividend 50 paisas per share
 depreciation charge for the year Rs 4,600
 accrued audit fee Rs 1,000
 creation of a plant replacement reserve of Rs 1,000.

You are required to prepare a Statement of financial position and
Statement of profit or loss in vertical form, suitable for presentation to
the directors.
Solution
Guard Ltd
Statement of profit or loss and appropriation account
for year ended 31 December 20X6
Rs Rs
Sales 80,000
Purchases 49,000
60,000
Gross profit 35,000
35,200
Discount allowed 400
Administrative expenses 4,000
Staff salaries 4,000
Directors’ salaries 5,000
Audit fee 1,000
Depreciation (W2) 4,600
Debenture interest 5,000
(24,800)
Net profit before tax 10,400
Corporation tax (5,000)
Net profit after tax 5,400
Transfer to plant replacement reserve 1,000
(W3)
Preference dividend of 5% (paid) 1,000
Ordinary dividend of 5% (proposed) 3,000
(W1)
(5,000)
Retained profit 400
Profit and loss account b/d 8,000
Profit and loss account c/d 8,400
Tutorial note:
1. Note that if these accounts were being prepared for external use, the
dividends could not be shown as an appropriation on the face of the

Statement of profit and loss as IFRS requires they are only disclosed
in a note to the accounts.
Guard Ltd
Rs Rs Rs
Fixed assets:
Tangible assets:
Freehold land and buildings
(Rs 230,000 – 104,600 (W2)) 125,400
Current assets:
Stock 15,000
Trade debtors 10,000
Cash at bank 5,000
30,000
Creditors – Amounts falling due
within
one year:
Current taxation 5,000
Dividend proposed (W1) 3,000
Accruals (Rs 5,000 + Rs 6,000
1,000)
(16,000)
Total assets less current liabilities 139,400
Creditors – Amounts falling due
after
more than one year:
10% debentures 20X9 (50,000)
89,400
Called up share capital:
Ordinary Rs 10 shares 60,000
5% preference shares 20,000
Plant replacement reserve (W3) 1,000
Profit and loss account 8,400
89,400

Workings
(W1) Proposed ordinary dividend

Note that the figure of 50 paisas per share relates to the number of shares in
issue (60,000/10= 6,000 shares) x 50 paisas = Rs 3,000. Thus:
Dividend payable
Rs Rs
Balance c/d 3,000 Profit and loss 3,000
appropriation
(W2) Depreciation
Fixed assets – Accumulated depreciation
Rs Rs
Balance b/d 100,000
104,600 104,600
(W3) Creation of plant replacement reserve

This is an appropriation of profit, and is accordingly shown on the profit and
loss account after the profit after taxation figure.
Plant replacement reserve
Rs Rs
Balance b/d 1,000 Profit and loss 1,000
appropriation
Summary
Limited companies are financed by a mixture of share capital and third

party liabilities. Profits are appropriated to the owners of the business
in the form of dividends, to the government in the form of taxes and
retained within the business by means of various reserves. Having
 Prepare trading accounts, Statement of profit or loss, appropriation
of profit and Statement of financial positions from trial balance
Self-test questions
Types of limited company
1 What are the three key factors that distinguish a company from a sole
trader?
(1.2)
2 Who are the owners of a company? (1.2)

3 Who are the managers of a company? (1.2)
4 What is the difference between a private and a public company?
(1.4)
Company finance
5 What is the relationship between the nominal value and the market value of
a company’s shares? (2.2)
6 What are preference shares? (2.3)
7 What are debentures? (2.4)
Financial statements
8 What is the double entry for a proposed final dividend? (3.4)
Issue of shares
9 How is an issue of shares at a price in excess of their nominal value

accounted for? (4.3)
10 Following figures were extracted from the books of Adam Sons as on

December 31,1998:
Rs.
Drawing account 129,600
Building 500,000
Office equipment 285,400
Furniture & fixture 25,000
Carriage-in 87,400
Wages 429,400
Salaries 93,400
Provision for bad debts 39,400
Sales 1,824,600
Sales return 35,200
Bank charges 2,800
Energies 14,400
Rates & taxes 16,800
Discount received 2,400
Purchases 800,000
Bills receivable 25,400
Trade expenses 39,800
Sundry debtors 756,000
Sundry creditors 243,400
Stock (Jan 1, 1998) 402,400
Insurance expense 9,800
Cash at bank 260,000
Cash in hand 12,800
Bad debts 4,200

Following adjustments are to be incorporated in the books:
a) Closing Stock as at December 31, 1998 – Rs. 587,800
b) Charge of depreciation at 5% on building, 20% on office
equipment and 10% on furniture & fixture.
c) Provision for bad debts at 5% of sundry debtors.
d) Sundry debtors include an item of Rs. 2,500 for goods supplied
to the proprietor and an item of Rs.6,000 due from a customer
who is in default. The expected recovery is 60% only.
e) Following payments were made on July 1, 1998 for the period
1998-99:
Insurance 6,600
Rates & Taxes 11,200
f) Allow 5% interest on capital
g) Goods valuing Rs. 10,000 were destroyed by fire and insurance

company has admitted the claim for Rs. 7,500.
Total of debit balance Rs. 3,929,800.
Required:
a) Statement of Comprehensive Income for the year ended
December 31, 1998
b) Calculate Capital A/c balance as on December 31, 1998
c) Statement of Financial Position as on December 31, 1998
1 The bottom half of a limited company Statement of financial position is

made up of:
A Capital + profit – drawings
B Share capital + profit – dividends
C Share capital + reserves
D Capital + reserves – dividends
2 The accumulated profits since the company commenced are referred
to as:
A Total dividends
B Retained profit for the year
C Unrealised profits
D Profit and loss reserve
3 Which expense has a separate line under the limited company
statutory format?
A Interest payable
B Depreciation
C Audit fee
D Salaries

4 What would be the total nominal value shown in a trial balance for
200,000 50p ordinary shares?
A Rs 200,000
B Rs 50,000
C Rs 100,000
D Rs 400,000
5 Which of the following is not a characteristic of an ordinary share?
A Carries a voting right
B Enables a fixed annual dividend to be paid
C Entitled to surplus assets on liquidation
D Receives dividends from profits after preference dividends are
paid
6 Which of the following is not a source of finance for a limited company?
A Debenture loans
B Trade creditors
C Ordinary shares
D Fixed assets
7 What is the correct treatment of dividends in the financial statements?
A All dividends must be recorded in the profit and loss account
B Only interim dividends must be recorded in the profit and loss
account
C Both interim and final dividends must be recorded in the profit
and loss account
D Both interim and final dividends must be disclosed in the notes
to the Accounts
Answers
10.
a) ADAM SONS
Statement of Comprehensive Income
FOR THE YEAR ENDED DECEMBER 31, 1998
(Rupees) (Rupees)
Sales 1,824,600
Less: Sales returns 35,200 1,789,400
Less: Cost of sales:
Purchases 800,000
Carriage-in 87,400
Wages 429,400
1,719,200
Less: Closing stock 587,800
Abnormal loss 10,000 1,121,400
Gross Profit 668,000
Less: Administrative expenses:

Salaries 93,400
Energies 14,400
Rates & Taxes (W-1) 11,200
Trade expenses (W-2) 39,800
Bank charges 2,800
Insurance (W-1) 6,500
Bad debts (W-3) 4,825
Depreciation (W-4) 84,580 257,505
Abnormal loss (W-5) 2,500
Interest on capital (W-6) 91,000
316,995
Add: Other income – Discount received 2,400
Net Profit 319,395
(b)
Capital Account Balances as on 31 December, 1998
Rs. Rs.
Capitals as per trial balance (W-6) 1,820,000
Add: Profit for the year 319,395
Interest on capital 91,000 2,230,395
Less: Drawings (as per trial balance) 129,600
Goods drawn 2,500
Capital on 31 December, 1998 2,098,295
(c) ADAM SONS
STATEMENT OF FINANCIAL POSITION

AS ON DECEMBER 31, 1998
(Rupees) (Rupees)
Fixed Assets (W-4) 725,820
Current Assets:
Stocks 587,800
Trade debts (W-3) 753,500
Less: Provision (W-3) 39,775
713,725
Bills receivable 25,400
Prepayments (W-1) 8,900
Insurance claim receivable 7,500
Cash at bank 260,000
Cash in hand 12,800
1,615,875
2,341,695
Capital (b) 2,098,295

Current Liabilities: Sundry creditors 243,400
2,341,695
Working notes
(W-1)
Rates & taxes and Insurance.
Rates & taxes Insurance Total
Rs. Rs. Rs.
As per trial balance 16,800 9,800
Less: Prepaid(Rs. 11,200 / 2) 5,600
(Rs. 6,600 / 2) _____ 3,300 8,900
Expense for the year 11,200 6,500
(W-2)
It is assumed that trade expenses are of administrative nature as their precise
nature is not apparent from the question.

(W-3)
Bad debts:
Provision for bad debts
Particulars Amount Particulars Amount

Rs Rs
Balance b/d 39,400
Balance c/d 40,025 Bad debts 625
40,025 40,025
Debtors
Particulars Amount Particulars Amount
Rs Rs
Balance b/d 756,000 Drawing 2,500
______ Balance c/d 753,500
756,000 756,000
Specific provision (6,000 x 40%) 2,400

General provision (747,500 x 5%) 37,375
Total provision 39,775
(W-4)
Depreciation:
As on Depreciation Book value
1.1.98 Rate For the year on 31.12.98
Rs. % Rs. Rs.
Building 500,000 5 25,000 475,000
Office equipment 285,400 20 57,080 228,320
Furniture & Fixtures 25,000 10 2,500 22,500
810,400 84,580 725,820
(W-5)
Abnormal Loss.
Value of goods destroyed 10,000

Less: Insurance claim 7,500
2,500

(W-6)
Capital and interest thereon.
Total of debit balances 3,929,800

Less: Credit balances
Provision for bad debts 39,400
Sales 1,824,600
Discount received 2,400
Sundry creditors 243,400 2,109,800
Capital 1,820,000
Interest @ 5% 91,000
MCQs
1 C
2 D
3 A
4 C
5 B
6 D
7 D

• Define factors of production

• Prepare manufacturing accounts
• Prepare trading accounts of manufacturing companies

1 Presentation of manufacturing accounts
1.1 Introduction
In presenting financial statements for a manufacturing business, it is

necessary to show the manufacturing account relating to the production
activity in a meaningful, informative way. The manufacturing account
accumulates the costs of production in a logical sequence and the cost of
finished production is then transferred to the trading account to be
incorporated in the computation of cost of sales and gross profit.
Example of presentation
Manufacturing, Statement of profit or loss for the year ended 31

December 20X6
Rs Rs
Direct materials consumed
Stock 1 January 20X6 7,100
Purchases 36,402
43,502
Stock 31 December 20X6 (8,450)
35,052
Direct labour 21,660
Prime cost 56,712
Factory overheads
Supervisory and managerial 5,600
labour
Repairs and maintenance 2,640
Power 4,050
Light and heat 870
Depreciation of plant and 31,00
machinery
Factory rent, rates and insurance 2,700 18,960
75,672
Manufacturing, Statement of profit or loss for the year ended 31

December 20X6
Rs Rs
Add: Work-in-progress at 1 2,740
January 20X6
78,412
Less: Work-in-progress at 31 (3,050)
December 20X6
Works cost of goods produced 75,362
Sales 120,000
Cost of finished goods sold
Stock 1 January 20X6 8,200
Cost of goods produced 75,362
83,562 ______
Less: Stock 31 December 20X6 (6,200) 77,362
Gross profit 42,638
Less: Expenses:
Salaries 10,100
Rent and rates 760
Depreciation of office equipment 300
Advertising 4,020
Carriage 3,100
(20,780)
Net profit 21,858
1.2 Direct materials

Direct materials are the materials consumed by the manufacturing
process during the accounting period. Purchases of materials must
therefore be adjusted for opening and closing stocks, to give the cost of
materials consumed in the period.
1.3 Direct labour and direct expenses

Direct labour includes all payroll expenses that can be identified
directly with units of production. Payroll costs which relate to production
generally but which cannot be identified with particular units of
production (for example the salary of the works manager) are regarded
as factory overheads (see below).
Direct expenses are expenses that can be identified directly with units
of production. A patent royalty paid in respect of each unit produced
would be classified as a direct expense.
1.4 Prime cost
Prime cost is the total of all of the direct costs of production but added
to this must be the indirect costs of production or factory overheads.
1.5 Factory overheads
Although these form part of production costs, factory overheads cannot

be identified with particular units of production. The overheads are
expense headings that are accounted for in the same ways as any
other expense accounts.
1.6 Works cost of goods produced
In order to calculate this figure we must adjust for opening and closing
work in progress. Closing WIP must be deducted since it relates to
expenditure on goods that are not completed this year. However
opening WIP does relate to expenditure on goods that are completed
this year, and must be added in.

1.7 Trading and profit and loss account
Thereafter the statement of profit or loss is produced in its normal

form, the significant thing to note being that the stock in this case is the
stock of finished goods.
Example
You are required for APF Ltd, a company that manufactures and sells
two products X and Y, to prepare in vertical and columnar form:
(a) Manufacturing, Statement of profit or loss for products X

and Y for the year ended 30 June 20X7
(b) An appropriation account for the year
(c) A statement of financial position as at 30 June 20X7.
The procedure for preparing the statements should be as follows:

Step 1
Mark each item in the trial balance with its destination, e.g. M, T, P, A
or B (standing for manufacturing a/c, trading a/c, profit and loss a/c,
appropriation a/c or statement of financial position).
Step 2
Calculate the adjustments as appropriate and mark the destination of
both sides of the entry as in Step 1.
Step 3
Prepare the statements in sequence, paying particular attention to
layout and format.
The trial balance of APF Ltd at 30 June 20X7 was as follows:

Rs’000 Rs’000
Ordinary shares of Rs 10, issued and
fully paid (authorised Rs 800,000) 800
6% preference shares of Rs 10, issued
and fully paid (authorised Rs200,000) 100
Share premium account 150
Retained profits, at 1 July 20X6 441
Fixed assets, at cost Rs 1,200,000 914
Stocks at 1 July 20X6:
Materials 80
Work-in-progress:
Product X 34
Product Y: 29
Finished products:
Product X 280
Product Y 150
Debtors and creditors 306 90

Bad debts provision, at 1 July 20X6 12
Sales: Product X (120,000 units) 1,200
Product Y (180,000 units) 1,200
Purchases of materials 720
Manufacturing wages: Product X 100
Manufacturing wages: Product Y 200
Manufacturing expenses 208
Creditor for royalties, at 1 July 20X6 62
Payments for royalties 391
Administration expenses 139
Selling and distribution expense 214
Cash at bank and in hand 290 _____
4,055 4,055
The following information is given:
(a) Depreciation is to be provided on fixed assets at the rate of 10% pa on

cost. Additions to fixed assets during the year amounted to Rs
100,000, purchased on 31 December 20X6. The annual depreciation
charge is to be apportioned among manufacturing, administration, and
selling and distribution in the proportions of 8:1:1.
(b) During the year the cost of materials consumed was Rs 300,000 for
product X and Rs 400,000 for product Y.
(c) Work-in-progress for both products was constant in quantity and value
at the beginning and end of the year.
(d) Stocks of finished products were:

1 July 20X6 in 30 June 20X7
units in units
Product X 40,000 20,000
Product Y 30,000 50,000
These stocks are to be valued at manufacturing cost (i.e. materials
consumed, manufacturing wages, royalties, manufacturing expenses and the
depreciation apportioned to manufacturing).
(e) Royalties of Rs 2 per unit for product X and Rs 1 per unit for product Y
are payable on the quantities of products completely manufactured.
(f) Manufacturing expenses, including the apportionment of depreciation,
are divided between the products in proportion to the number of
completed articles transferred from the factory to the finished product
stock. All products are transferred immediately on completion.
(g) Bad debts of Rs 6,000 are to be written off and the bad debts provision
is to be made equal to Rs 15,000. These items are a selling and
distribution expense.
(h) Administration expenses, including the proportion of depreciation, are
to be divided between the products in proportion to the number of
products sold.

(i) Selling and distribution expenses, including the proportion of
depreciation, bad debts written off and any increase or decrease in the
bad debts provision, are to be divided between the products in
proportion to sales values.
(j) Prepaid and accrued expenses at 30 June 20X7 were:

Prepaid Accrued
Rs Rs
Administration expenses 1,500 1,000
Selling and distribution expenses 1,500 7,000
(k) Provision is to be made for:
Rs
Corporation tax on the year’s profits 135,000
Preference dividend 6,000
Ordinary dividend 120,000
All amounts are to be shown to the nearest Rs 1,000.
Manufacturing account for the year ended 30 June 20X7

Product Product Total
X Y
Production units (W1) 100,000 200,000
Rs’000 Rs’000 Rs’000
Materials used (W2):
Opening stock 80
Purchases 720
Less: Closing stock (bal (100)
fig)
300 400 700
Manufacturing wages 100 200 300
Manufacturing expenses 100 200 300
(W3,
W4)
Royalties (W5) 200 200 200
WIP increase/decrease – –
Cost of finished goods 700 1,000 1,700
produced
Cost per unit (W1) Rs7 Rs5

Product X Product Y Total
Rs’000 Rs’000 Rs’000 Rs’000 Rs’000 Rs’000
Sales 1,200 1,200 2,400
Cost of finished
goods sold:
Opening stock 280 150 430
Cost of goods
produced
(from
manufacturing
account) 700 1,000 1,700
Less: Closing (140) (250) (390)
stock
(W6)
840 900 1,740

Gross profit 360 300 660
Deduct:
Administration 60 90 150
expenses
(W7)
Selling and 120 120 240 _____
distribution _
expenses (W8)
210 390
180
Profit before 180 90 270
taxation
(b)
Appropriation account for the year ended 30 June 20X7
Rs’000 Rs’000
Profit for the year before taxation 270
Corporation tax on the year’s profit 135
Profit after taxation 135
Preference dividend 6
Ordinary dividend 120
126
Retained profits for the year 9
Retained profits at 1 July 20X6 441
Retained profits at 30 June 20X7 450

(c)
Statement of financial position as at 30 June 20X7
Rs’000 Rs’000 Rs’000
Fixed assets
At cost 1,200
Less: Depreciation (W9) (401)
799
Current assets:
Stocks: Materials (see Man Acc) 100
Stocks: Work-in-progress (34 + 29) 63
Stocks: Finished products (W6) 390
553
Debtors 300
Less: Provision for bad debts (15)
285
Prepaid expenses 3
Cash at bank and in hand 290
1,131
within one year
Creditors 90
Royalties payable (W5) 71
Accrued expenses 8
Taxation 135
Dividends 126
(430)
Net current assets 701
Authorised Issued 1,500
Rs 10 ordinary shares fully paid 800 800
Rs 10 6% preference shares fully 200 100
paid
900
Share premium account 150
Profit and loss account 450
1,500
Workings
(W1) Production units = sales plus closing stock of finished product
less opening stock
of finished product
X: 120 + 20 - 40 = 100,000 units
Y: 180 + 50 - 30 = 200,000 units.
If data is available, it is informative to include production volume and
costs per unit as memorandum items in the manufacturing account.

(W2) Materials used
Opening stock and purchases of materials were given, together with the cost
of materials consumed, by product. Therefore the closing stock of materials is
the balancing figure.
(W3) Depreciation
Rs ’000
10% of 1,100 (cost at 1/7/X6) 110
10% of 100 (additions) for half year 5
115
Apportioned: Manufacturing (8/10) 92.0; Administration (1/10) 11.5; S and D
(1/10) 11.5.
(W4) Manufacturing expenses

Rs’000
Per trial balance 208
Depreciation 92
300
Apportioned on finished units (100 : 200) = X : 100; Y : 200.
(W5) Royalties
Rs 2 per unit of X and Rs 1 per unit of Y ((Rs 2 × 100) + (Rs 1 × 200))
= Rs 400. It is preferable to show royalties as a separate charge in the
manufacturing account.
Royalties account
Rs’000 Rs’000
Payments per TB 391 Balance b/d 62
Balance c/d (bal fig) 71 Manufacturing account 400
462 462
(W6) Finished goods stocks
X Y
Closing stock units 20,000 50,000
Manufacturing cost per unit Rs7 Rs5
Rs ’000 Rs ’000
Closing stock value (Rs’000) 140 250
(W7) Administration expenses

Rs ’000
Per trial balance 139.0
Depreciation 11.5
Accruals 1.0
Prepayments (1.5)
150.0
Apportioned on sales units (120 : 180) = X: 60; Y : 90.

(W8) Selling and distribution expenses
Rs ’000
Per trial balance 214.0
Depreciation 11.5
Bad debts written off 6.0
Increase in provision for doubtful debts 3.0
Accruals 7.0
Prepayments (1.5)
240.0
Apportioned on sales values (1,200 : 1,200) = X : 120; Y : 120.
(W9) Accumulated depreciation at 30 June 20X7

Rs’000
Cost 1,200
Net book value at 1 July 20X6 914
Accumulated depreciation at 1 July 286
20X6
Charge for the year (W3) 115
401
Summary
The manufacturing account simply gathers together all of the costs of the
factory. Having completed your study of this chapter you should have
achieved the following learning outcomes.
 Prepare manufacturing accounts
Self-test questions
Presentation of manufacturing accounts

1 Which part of the organisation does a manufacturing account
represent? (1.1)
2 How are direct materials consumed calculated? (1.2)
3 What are the costs included in direct labour? (1.3)
4 How is works cost of goods produced calculated? (1.6)
5 What type of stock is dealt with in the trading account? (1.7)
1 Prime cost is made up of:

A Direct costs + factory overheads
B Direct wages + work in progress
C Direct materials + direct wages + direct expenses
D Direct materials + work in progress + finished goods

2 If work in progress decreases over the period then,
A Factory cost will increase
B Factory cost will decrease
C Prime cost will increase
D Prime cost will decrease
3 A manufacturing company incurred the following costs:

Factory overheads Rs 10,000
Direct labour Rs 6,000
Raw materials consumed Rs 4,500
Direct expenses Rs 1,500
Prime cost is:
A Rs 22,000
B Rs 17,500
C Rs 20,500
D Rs 12,000
Answers of MCQs
1 C
2 A
3 D

 Prepare Income and Expenditure account

1 Format of income and expenditure account
1.1 Income and expenditure account
This is the equivalent of the profit and loss account for a sole trader. The only
difference between it and the profit and loss account is the way in which it is
presented.
Example
ABC Gardening Society
Income and expenditure account for the year ended 31 December 20X9
Rs Rs
Income:
Subscriptions 8,006
Donations 574
Bank interest 201
8,781
Expenditure:
Salaries 3,102
Telephone 804
Sundry expenses 796
(6,904)
Surplus of income over expenditure,
transferred to accumulated fund 1,877

Compared with that of a sole trader, the main difference lies in the
capital section. The capital account of a club is referred to either as an
accumulated fund or as a general fund.
Example
In the example above, suppose that the balance on accumulated fund
(represented by assets less liabilities) at 1 January 20X9 was Rs
8,304. The relevant statement of financial position extract at 31
December 20X9 would be:
Rs
Fixed assets, etc. X
Net assets 10,181
Accumulated fund:
Balance at 1 January 20X9 8,304
Surplus of income over expenditure for the year 1,877
Balance at 31 December 20X9 10,181

2 Preparation of income and expenditure accounts
2.1 Receipts and payments account
In some clubs a receipts and payments account is prepared. This is a

summary of the cash and bank transactions that have taken place during the
year. The difference between the receipts and payments account and the
income and expenditure account is the same as
the difference between a cash book and the profit and loss account in a
trading entity – the income and expenditure account and the profit and loss
account accrue for income and expenses. The receipts and payments
account for the ABC Gardening Society for the year ended 31 December
20X9 may have looked as follows:
Rs Rs
Receipts
Subscriptions 8,006
Donations 574
Bank interest 201
8,781
Payment s
Salaries 3,102
Telephone 700
Sundry expenses 750
(6,952)
1,829
Add: Balance at bank 1 January 2,100
20X9
Cash in hand 1 January 20X9 50
2,150
3,979
Comprising:
Balance at bank 31 December 3,700
20X9
Cash in hand 31 December 20X9 279 _____
3,979
Or it may be written up in a two-sided format similar to a ledger account:

Receipts Payments
20X9 Rs 20X9 Rs
1 Jan Cash in 50 Salaries 3,102
hand
Balance at bank 2,100 Telephone 700
Subscriptions 8,006 Rent and rates 2,400
Donations 574 Sundry expenses 750
Bank interest 201
31 Dec Cash in 279
hand
______ Balance at bank 3,700
10,931 10,931
2.2 Special fund-raising activities
Many organisations run separate fund-raising activities to supplement

their finances. These activities may be permanent or occasional.
Permanent activities
With permanent activities, e.g. and refreshments, it is usual to open a
separate trading account. Any profit will be transferred to the credit of
the income and expenditure account and any loss will be written off to
the debit of the income and expenditure account.
Occasional activities
With occasional activities, e.g. dances, parties, whist drives etc, any
expenses should be matched with the income arising. The balance is
taken to the appropriate side of the income and expenditure account
but there should be a note to the statement showing the gross income
and expenses.
2.3 Large legacies and donations
These are normally treated as capital and credited directly to the

accumulated fund (normally Dr Bank Cr Accumulated fund), the
receipts being disclosed on the face of the statement of financial
position.
2.4 Annual subscriptions
Members intending to leave a club often do so without formally handing

in a letter of resignation: they just stop attending. For this reason
annual subscriptions are often dealt with on a cash basis rather than an
accruals basis, and credited to the income and expenditure account in
the year of receipt.

In examination questions, however, you should pay attention to the
examiner’s requirements. Often you will be given information about
subscriptions in arrears. If this is so, subscriptions should be dealt with
on an accruals basis unless there is an instruction to the contrary.
In some cases members may pay subscriptions in advance. These

represent income of the following year and should be carried forward
as deferred income.
A proforma subscriptions account showing the full entries that would be

made during a year is shown below:
Subscriptions account
Rs Rs
Balance b/d Balance b/d

(subscriptions not paid (subscriptions paid in
last year) X advance last year) X
Income for year (credit Cash and bank
income and receipts during year
expenditure account) (from receipts and
(balancing figure) X payments account) X
Balance c/d Balance c/d
(subscriptions paid in (subscriptions not paid
advance this year) X this year) X
X X
The subscription income is thus a balancing figure in the above account.
2.5 Life membership fees
In theory these should be credited to the income and expenditure

account over the number of years of estimated remaining life of the
members concerned! Not surprisingly, this approach poses all sorts of
problems, and thus life membership fees are often credited over an
arbitrary number of years (e.g. five). Once again the examiner will
usually specify clearly the accounting treatment to be adopted.
The amount not credited to the income and expenditure account will be
carried forward as a credit balance on the statement of financial
position. This amount may be viewed as a liability as the club has to
provide future services to these members in return for the fees.
Often however the amount will not be included with other liabilities but
will have its own heading: Deferred income. The title recognises the
fact that it is income but is being deferred to later years' income and
expenditure accounts.

Example
Included in last year's statement of financial position was deferred

income: life subscriptions Rs 8,000. This represents the balance of life
subscriptions paid by twenty members since the club was founded six
years ago.
In the current year ten new life membership subscriptions were paid
totaling Rs 5,000. Life membership fees are spread over 20 years to
income. The amount payable for a life subscription has always been Rs
500.
What are the amounts appearing in the income and expenditure

account for the current year and statement of financial position as at
the end of the year?
Solution
Rs
Income and expenditure account
(extract)
Life subscriptions (W2) 750
Statement of financial position at end of
year (extract)
Deferred income
Life subscriptions 12,250
Workings
(W1)
Life subscriptions
Rs Rs
Income and 750 Balance b/d 8,000
expenditure
(W2)
Balance c/d 12,250 Cash 5,000
13,000 13,000
(W2) Life membership fee Rs 500
Annual transfer to income per member Rs500 ÷ Rs 25
20
Number of members 30
Annual transfer Rs 25 x 30 Rs 750
Note: the Rs 8,000 brought forward consists of varying amounts for

each member not yet transferred to income and expenditure depending
upon the year in which the fee was paid. However as the club was only
formed six years ago, no life subscription fee has been fully credited to
income and expenditure.

3 Special funds
3.1 Bookkeeping entries
Special funds may be set up for a specific purpose e.g. a prize fund or
a building fund. The entries required will depend on the circumstances:
(i) If the fund is set up by a specific gift or legacy:
Debit Credit With
Cash Special fund Amount received
(ii) If the fund is set up out of existing resources, as a result of a

management decision:
Debit Credit With
Accumulated fund Special fund Amount appropriated
It will also be necessary to allocate particular assets to the fund, so that

they are kept quite separate from the general assets of the club:
Debit Credit With
Special fund Assets allocated to
‘Ordinary’ assets
assets fund
The key feature is that the fund and its assets represent a mini balance
sheet within a statement of financial position. Thus the debit balances
on the asset accounts should equal the balance on the fund account.
3.2 Statement of financial position presentation
The special funds should be presented quite separately from the

accumulated (or general) fund. The assets representing the special
fund should also be kept separate, although occasionally in questions
the information given is not sufficient to do so.
3.3 Income and expenditure
The key point to remember is that the fund and its assets must be kept
in balance. Thus:
Debit Credit With

Special fund Special fund Income
cash received
And
Debit Credit With

Special fund Special fund Expenditure
cash

If expenses are paid other than out of special fund cash, a
compensating transfer will be required to keep the fund in balance.
Debit Credit With

Ordinary cash Special fund Amount
cash expended out
of ordinary
cash
Example
The treasurer of the Oxygen Cricket Club has produced the following
receipts and payments account for the year ended 31 December 20X8:
Receipts Payments
20X8 Rs 20X8 Rs
1 Jan Cash in hand 7 Grounds man’s wages 641
Balance at bank: Rent of ground 100
Current account 159 Repairs to pavilion 69
Deposit account 617 Cricket equipment 34
Members’ subscriptions 453 8% Government stock 455
takings 1,828 purchases 1,524
Surplus on dances 193 Sundry expenses 47
Bank deposit interest 28 Insurances 48
Donations 10 Cash in hand 15
31 Dec Balances at bank:
Current account 111
Deposit account 251
3,295 3,295
You have also been provided with the following additional information:
 The only fixed asset was the pavilion. This had a book value at 1
January 20X8 of Rs 1,450 (comprising cost Rs 3,200 and depreciation
Rs 1,750). Depreciation to be provided during the year amounts to Rs
150.
 Expenditure on cricket equipment is to be written off in the year in
which it is incurred.
 The other assets and liabilities were as follows:
31 December
20X7 Rs 20X8 Rs
stock (at cost) 131 110
Creditors for purchases 40 33
Creditors for sundry 15 17
expenses
Insurance paid in advance 12 8
Rent owing 5 6
 The club does not wish to take credit for outstanding subscriptions.
 On 18 December 20X8 the committee decided to set up a special fund
of Rs 455 to be referred to as the ABC Fund. This amount was
invested in government stock and it was intended that in each

subsequent year the interest on this stock should be paid to the person
considered to be the best all-rounder.
Required:
(a) a statement showing the accumulated fund as at 31 December
20X7
(b) the income and expenditure account for the year ended 31
December 20X8
(c) the statement of financial position as at 31 December 20X8.
Solution
(a) Accumulated fund as at 31 December 20X7
Rs Rs
Fixed asset:
Pavilion 1,450
Current assets:
stocks 131
Prepayment 12
Cash at bank:
Deposit account 617
Current account 159
Cash in hand 7
926
Creditors and accrued expenses (40 + 15 (60)
+ 5)
866
2,316
(b)Income and expenditure account for the year ended 31 December
20X8
Rs Rs
Income:
profit (see note) 290
Members’ subscriptions 453
Donations 10
Surplus on dances 193
Bank deposit interest 28
974
Expenditure:
Grounds man’s wages 641
Rent (100 – 5 + 6) 101
Pavilion:
Repairs 69
Depreciation 150
Renewal of cricket equipment 34
Insurance (48 + 12 – 8) 52
Sundry expenses (47 – 15 + 49
17)
(1,096)
Excess of expenditure over income (122)

Note to income and expenditure account
Rs Rs
Sales 1,828
Less: Cost of sales:
Opening stock 131
Purchases (1,524 – 40 + 33) 1,517
1,648
Less: Closing stock (110)
(1,538)
gross profit 290
(c)
Statement of financial position at 31 December 20X8
Cost Depreciation
Rs Rs Rs
Fixed asset:
Pavilion 3,200 1900 1300
Current assets:
stock 110
Prepayments 8
Cash at bank:
Deposit account 251
Current account 111
Cash in hand 15
495
Creditors and accrued expenses (33 + (56)
17 + 6)
439
1,739
Assets of ABC Fund:
8% Government stock 455
2,194
Accumulated fund:
Balance 1 January 20X8
Less: Excess of expenditure (122)
Transfer to ABC Fund (455)
(577)
1,739
ABC Fund:
Transfer from accumulated fund 455
2,194
Note: the workings are similar to any other incomplete records question. Bank
and cash transactions have already been written up (i.e. the receipts and
payments account). Sales and purchases control accounts may be required to
determine the sales and purchases of the trading part of the organisation,
This is as complex as an income and expenditure account can be. Remember
to apply the accruals concept to the receipts and payments account and to
deal with separate trading entities such as a as you would in a trading
account.

Summary
The preparation of an income and expenditure account is a good test of a

student's understanding of the accruals concept as the approach is basically
to convert cash receipts and payments into accruals based statement, the
income and expenditure account. The main differences between this and
Statement of profit and loss is that any trading items such as profits are
shown on the face of the statement as the net profit from the activity and for
any other occasional activities the income and expenses are netted off and
the net amount is shown as either an item of income or expense.
The statement of financial position is very similar to that of a sole trader with
the exception of the capital account now becoming the accumulated fund.
 Prepare income and expenditure accounts

Self-test questions
Format of income and expenditure accounts
1 What is the equivalent to capital in a club or society's statement of

financial position? (1.2)
Preparation of income and expenditure accounts
2 How are the income and expenses of occasional activities such as a

dinner dance or raffle treated in an income and expenditure account?
(2.2)
3 How are legacies and donations treated in an income and expenditure
account? (2.3)
4 Are subscriptions in arrears at the beginning of the period a debit or a
credit balance? (2.4)
5 Are subscriptions in arrears at the end of the period a debit or a credit
balance? (2.4)
6 If the total amount of a life membership fee is not credited to the
income and expenditure account then where will the balance appear?
(2.5)
Special funds
7 What are special funds? (3.1)

8 How is a special fund treated in the statement of financial position?
(3.2)
9 Traders Association prepared the accounts for the year ended

Dec.31, 1999.
(i) The Association started the year with Rs 47, 000 in the bank.
(ii) They received subscription amounting to Rs.83,500, of which
Rs.2,500 represented arrears, Rs.76,000 current subscription and
Rs.5,000 in advance.
(iii) They received Rs.52,000 as donation to the general fund and
Rs.85,000 to the welfare fund, which had Rs.1500 in hand at
January 01, and out of which Rs.72,000 was paid for welfare
expenses. There was no separate bank account
(iv) They held Defence Saving Certificates on Jan.01, which amounted
to Rs. 200,000. Half were en-cashed for Rs. 125,000 and the
balance were valued at Rs. 120,000 at the end of the year. These
investments earned a profit of Rs. 3,500 during the year.
(v) Office premises were purchased during the year for Rs. 300,000
and a loan was arranged through housing Society for Rs. 150,000.
Legal expenses amounted to Rs. 10,500 and one installment of Rs.
8,000 was paid to the Society of which Rs. 4,500 was markup.
Alterations to the premises cost Rs. 57,000 of which Rs. 15,000 still
owed.

(vi) Office furniture was valued at Rs. 15,000 at January 01, Rs. 17,000
was paid for additions during the year and Rs. 7,000 was still
owing. Depreciation is to be charged @ 10%.
(vii) The only other receipt was Rs. 7,500 for sale of literature, cost Rs.
6,000.
(viii) Other payments were:
Salary Rs. 70,000 (of which Rs. 5,000 related to next

year)
Office Expenses Rs. 35,000
Rent & Rates Rs. 17,000 (Rs. 5,000 owing at Jan.01)
Meeting Expenses Rs. 16,500 (Rs. 3,000 for next year)
Stationery & Postage Rs. 15,000
Required: Prepare for the year ended December 31.1999:
(i) Receipt & Payment Account

(ii) Income & Expenditure Account
(10)
10 The Accountant of Gharib Charitable Hospital has prepared following

Receipts & Payment Account for the year ended on December 31,
1999:
Receipt & Payment Account

For the year ended on December 31, 1999
Rs. Rs.
Cash at bank and in hand 27,342 Medicines 49,131
OPD charges 59,673 X-Rays Film 25,000
X-Rays charges 40,440 Laboratory supplies 8,517
Laboratory charges 24,867 Consultant fees 156,500
In-patient billings 567,230 Salaries 298,450
Donations 345,200 Electricity 324,710
Cleaning & general 38,549
Stationery & supplies 19,825
Repairs & maintenance 25,221
Telephone charges 31,750
Equipment 54,000
________ Cash at bank and in hand 33,099
1,064,752 1,064,752
Following additional information is available:
a) Position of certain assets and liabilities as at December 31, 1999 and

1998 was as under:

1999 1998
Salaries due 22,520 26,780
X-Rays charges 2,780 1,600
In-patient billings 57,920 27,270
Laboratory charges 2,100 1,900
Stock of medicines 7,450 6,230
Stock of Laboratory supplies & X-Rays Films 3,980 4,170
Electricity bill due 30,100 24,200
Telephone bill due 2,720 2,100
Cleaning & General due 3,710 2,400
Consultants fees payable 15,500 12,000
Equipment 664,000 560,000
Furniture 100,000 100,000
Creditors for:
- Medicines 4,500 4,000
- X-rays films 3,500 4,000
- Lab supplies 1,300 1,200
b) Equipment as at December 31, 1999 includes an instrument

costing Rs. 50,000 placed free of charge by a supplier under
Laboratory Supplies Purchase agreement.
c) Both furniture and equipment as at December 31, 1998 were

purchased in 1997 when hospital started its operations.
d) It is hospital’s policy to charge depreciation @ 10% p.a.

irrespective of the date of purchase.
Required: You are required to prepare:
(a) Income & Expenditure Account for the year ended on December
31, 1999 and
(b) Balance Sheet as at that date.

1 The receipts and payments account is:
A The bank account
B The petty cash account
C A summary of cash and bank transactions
D A profit and loss account.
2 A difference between the receipts and payments account and the

income and expenditure account is:
A Cash expenses are only recorded in the receipts and payments
account
B The income and expenditure account takes into account
accruals and prepayments
C Subscriptions are only recorded in the income and expenditure
account
D There are no differences.

3 How are legacies and donations best dealt with?
A As capital
B As income
C As an expense
D As an asset.
4 Calculate an amount for subscriptions to be included in the income and

expenditure account for 20X8 using the following information:
20X7 20X8
Rs Rs
Subscriptions:
in advance 50 130
in arrears 200 80
Cash received 2,600
A Rs 2,800
B Rs 2,600
C Rs 2,500
D Rs 2,400
Answers
9.
i) TRADERS ASSOCIATION
RECEIPT AND PAYMENT ACCOUNT
Receipts Rs. Payments Rs.

b/d (Bank) 47,000 Welfare expenses 72,000
Subscription 83,500 Office premises 300,000
Donation to General Fund 52,000 Legal expenses 10,500
Donation to Welfare Fund 85,000 Loan 3,500
DSCs en-cashed 125,000 Mark-up 4,500 8,000
Loan 150,000 Addition to premises
(57,000 – 15,000) 42,000
Profit (Interest) on Investment 3,500 Office furniture 17,000
Sale of literature 7,500 Literature cost 6,000
Salary 70,000
Office expenses 35,000
Meeting expenses 16,500
c/d 55,500 Stationery and postage 15,000
609,000 609,000

(ii) TRADERS ASSOCIATION
INCOME AND EXPENDITURE ACCOUNT
Expenses Rs. Income Rs.
Salaries 70,000 Subscription 76,000
Less: Advance 5,000 65,000 Profit on encashment of DSC
Office expenses 35,000 (125,000 – 100,000) 25,000
Rent and rates 17,000 Interest on Investment 3,500
Less: Payable at
beginning 5,000 12,000 Profit on sale of literature
Meeting expenses 16,500 (7,500 – 6,000) 1,500
Less: Advance 3,000 13,500
Stationery and postage 15,000 Deficit 53,400
Depreciation of furniture (W-1) 3,900
Legal expenses 10,500
Mark-up 4,500 ______
159,400 159,400
Working notes
(W-1)
DEPRECIATION ON FURNITURE
Rs.
Furniture cost at January 01, 1999 15,000
Additions (17,000 + 7,000) 24,000
Cost at December 31, 1999 39,000
Depreciation 39,000 x 10% 3,900
Note: It is assumed that investments are recorded at cost. So appreciation of

Rs.20,000 in value of investment has not been accounted for.

10. (a) Gharib Charitable Hospital
Income & Expenditure account
For the year ended 31-12-1999.
Particulars (Rs.) Particulars (Rs.)
EXPENDITURE INCOME
OPD Charges 59,673
Donations 345,200
Consultant charges (W-4) 160,000 X-ray charges (W-2) 41,620
Lab Supp. & X.Ray Films(W- 33,307 In-Patient Billing (W-2) 597,880
3) 48,411 Laboratory charges 25,067
Medicine (W-3) 294,190 (W-2)
Salary Expense(W-4) 19,825
Stationary & Supplies 25,221
Repair & Maintenance 330,610
Electricity Bill (W-4) 32,370
Telephone Bill (W-4) 39,859
Clearing & Gen. Charges (W- 61,400
4) 10,000
Depreciation Equipment 14,247
Depreciation Furniture
Excess of Income over exp.
1,069,440 1,069,440
(b) Gharib Charitable Hospital

Balance Sheet as at 31-12-1999
Particular (Rs.) Particular (Rs.)
Rs. Equipment (W-6) 552,600

General Fund Furniture (W-6) 90,000
- Opening
balance (W-1)
651,832
Add: Excess of Income
Over Expense 666,079
14,247 Stock of Medicine
15,500 Stock of Lab Supplies &
Consultant Fee Payable 2,720 Films X-ray 7,450
Telephone Bill Payable 30,100 X-ray charges due
Electricity Bill Payable 3,710 In-Patient bill due 3,980
Clearing & Gen. Charges 22,520 Lab charges due 2,780
Payable 57,920
Salaries Payable 4,500 2,100
Creditors: (W-5) 3,500 Cash at bank and in
- Medicine 1,300 hand 33,099
- X-Ray Films
- Lab Supplies
749,929 749,929

Working notes
(W-1)
Balance Sheet as at 31-12-1998
Particular (Rs.) Particular (Rs.)
General Fund 651,832 Equipment 560,000
(Balancing Figure) Furniture 100,000
Salaries Payable 26,780 Stock of Medicine 6,230

Electricity Bill Payable 24,200 Stock of Lab Supp. &
Telephone Bill Payable 2,100 X-Ray Films 4,170
Clearing & Gen. Charges 2,400 X-Ray charges 1,600
Payable 12,000 Receivable 27,270
Consultants fee Payable In-Patient bill 1,900
Creditors: 4,000 Receivable
- Medicine 4,000 Lab charges
- X-Ray Films 1,200 Receivable
- Lab Supplies 27,342
Cash at bank and in
hand
728,512 728,512
(W-2)
Calculation of Incomes
X-Ray In. Patient
Laboratory
Balance c/d 2,780 57,920 2,100
Add: Receipts 40,440 567,230 24,867
43,220 625,150 26,967
Less: Balance b/d 1,600 27,270 1,900
Income for the year 41,620 597,880 25,067
(W-3)
Stock Accounts
Medicin Lab Supplies

Balance b/d 6,230 4,170
Add: Transfer from creditors (W-5) 49,631 24,500
______ 8,617
55,861 37,287
Less: Balance c/d 7,450 3,980
Expense for the year 48,411 33,307

(W-4)
Calculation of Expenses
Salary Electricity Telephone Clearing & Consultant
Bill Bill General Charges
Charges
Balance c/d 22,520 30,100 2,720 3,710 15,500
Add: Payments during
the year 298,450 324,710 31,750 38,549 156,500
320,970 354,810 34,470 42,259 172,000
Less: Balance b/d 26,780 24,200 2,100 2,400 12,000
Expense for the year 294,190 330,610 32,370 39,859 160,000
(W-5)
Creditors Accounts
Creditors for Medicine X-Ray Lab Supplies
Balance c/d 4,500 3,500 1,300
Add: Payment during the year 49,131 25,000 8,517
53,631 28,500 9,817
Less: Balance b/d 4,000 4,000 1,200
Purchases for the year (Transfer to Stock A/c's) 49,631 24,500 8,617
(W-6)
Fixed Assets Accounts
Equipment Furniture
Given balances 664,000 100,000
Less: Wrongly recorded Equipment* 50,000 --
614,000 100,000
Depreciation @ 10% 61,400 10,000
Balance c/d 552,600 90,000
* As the equipment is placed free of charge therefore it will not be recorded

as an asset of Hospital. Moreover it is also assumed that single effect of
this transaction has been previously recorded.
MCQs
1 C
2 B
3 A
4 D

When complete this chapter you should be able to:
 explain the inward and outward flows of cash in a typical company
 calculate cash flows from operating activities using the indirect method
 calculate cash flows from operating activities using the direct method
 calculate the cash flows from investing activities
 calculate the cash flows from financing activities

1 Statement of cash flows
1.1 Introduction
A statement of cash flows is a further means of presenting accounting
information. There are two types of statements:
 a statement of cash flows which is an historical record of
transactions presented as part of the financial accounts of a
business in addition to the profit and loss account and balance
sheet
 a cash budget or cash forecast which is an estimate of cash flows
in the future.
Cash budgets are dealt with in cost and management accounting. We
are concerned in this chapter with the preparation and presentation of
statement of cash flows in the financial accounts.
DEFINITIONS
Cash
Cash on hand (including overdrafts) and on demand deposits.
Cash equivalents
Short-term, highly liquid investments that are readily convertible into
known amounts of cash and are subject to an insignificant risk of
changes in value.
Bank overdrafts may be counted as a negative element in cash and

cash equivalents, though long-term bank borrowings are generally
considered to be financing activities.
The components of cash and cash equivalents should be disclosed in a

note to the statement of cash flows with a reconciliation to the
equivalent items in the statement of financial position.
Operating activities
are the principal revenue-producing activities of the entity and other
activities that are not investing or financing activities.
Investing activities
are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents.
Financing activities
are activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity

1.2 The benefits of a statement of cash flows
A statement of cash flows is needed as a consequence of the above

differences between profits and cash. It helps to:
 provide additional information on business activities
 assess the current liquidity of the business
 allow the user to see the major types of cash flows into and out of the
business
 estimate future cash flows
 determine cash flows generated from trading transactions rather than
other cash flows.
1.3 The drawbacks of a statement of cash flows
 The statement of cash flows is backward looking. Users of the

accounts are particularly interested in the future.
 No interpretation of the statement of cash flows is provided within the
accounts. Users are required to draw their own conclusions as to the
relevance of the figures contained within it.
 Non-cash transactions, e.g. a bonus issue of shares are not
highlighted on the face of the statement of cash flows (although they
are disclosed elsewhere within the accounts). These are of interest to
users as they will impact future cash flows.
2 Preparation of a statement of cash flows

2.1 Direct and indirect methods
Figures for the statement of cash flows will be derived either from the
accounting records or from the other financial accounting statements –
the statement of financial position for the current year end and the
previous period and the profit and loss account for the period.
The item requiring most work will often be the net cash flow from
operating activities. The two alternative methods of calculation are
shown below.
Direct method Indirect method
Rs ’000 Rs ’000
Cash received from 15,424 Operating profit 6,022
customers
Cash payments to (5,824) Depreciation charges 899
suppliers
Cash paid to and on behalf (2,200) Increase in stocks (194)
of employees
Increase in debtors (72)
Other cash payments (511) Increases in creditors 34
Net cash inflow from 6,889 6,889
operating activities

The direct method is so called because it records the gross trading
cash flows; the indirect method starts with profit and adjusts it to
remove accruals and other adjustments so that net cash flow from
operating activities remains.
Operating profit (profit from operating activities) is the starting point for
the indirect method. Operating profit is turnover less cost of sales and
operating expenses. It is profit before interest, investment income and
tax. It may or may not include profits or losses on disposal of fixed
assets.
The information for the direct method could be found in the accounting
records or derived from the other financial statements. The information
for the indirect method is more likely to be found from the other
Example of indirect method
The summarised statement of financial position of Grass Ltd at 31

December 20X4 and 20X5 were as follows:
20X4 20X5
Rs Rs
Plant and machinery, at cost 15,000 16,500
Less: Depreciation (8,000) (10,000)

7,000 6,500
Stock 20,000 23,500
Debtors 10,000 15,000
Cash 5,000 2,000
42,000 47,000
Share capital 20,000 20,000
Reserves 17,000 21,000
42,000 47,000
No fixed assets have been sold during the period under review.
Depreciation provided for the year amounted to Rs 2,000. There is no
interest paid, dividends paid or taxation paid. You are required to
prepare a statement of cash flows for the year ended 31 December
20X5.

Solution
Grass Ltd
Statement of cash flows for the year ended 31 December 20X5
Rs
Net cash outflow from operating activities (1,500)
(working)
Capital expenditure – purchase of fixed assets (1,500)
Decrease in cash (3,000)
Rs
Working
Profit for the year (21,000 – 17,000) 4,000
Depreciation (10,000 – 8,000) 2,000
Increase in stock (3,500)
Increase in debtors (5,000)
Increase in creditors 1,000
Net cash outflow from operating activities (1,500)
Tutorial note: as there is no tax and dividends, the movement in

reserves per the statement of financial position represents operating
profit for the year. The example shows the important information that
can be directly given by a statement of cash flows. Despite making a
profit of Rs 4,000 in the period, the business has suffered a Rs 3,000
reduction in cash. This is largely due to the amount of profit tied up in
increased working capital (stock, debtors, less creditors).
Due to the importance of the information revealed in the working
above, IFRS requires a reconciliation between the operating profit and
net cash flow from operating activities either adjacent to the statement
of cash flows or as a note. The reconciliation is presented in the same
format as the working above.
2.2 Relationship of profit to cash

The main categories of items in the profit and loss account and on a
balance sheet which form part of the reconciliation between operating
profit and net cash flow from operating activities are:
(a) Depreciation
Depreciation is a book write off of capital expenditure. Capital
expenditure will be recorded under ‘capital expenditure’ at the time of
the cash outflow. Depreciation therefore represents an addition to
operating profit in deriving cash inflow.
(b) Profit/loss on disposal of fixed asset

The cash inflow from a sale is recorded under ‘capital expenditure’. As
a consequence any profit or loss on disposal included within operating

profit needs to be removed. An alternative name for loss on sale is
‘depreciation under provided on disposal’. Thus, like depreciation, a
loss is added to operating profit. A profit on sale is a deduction from
operating profit.
(c) Balance sheet change in debtors

A sale creates income irrespective of the date of cash receipt. If the
cash has not been received by the balance sheet date however there is
no cash inflow from operating activities for the current accounting
period. Similarly opening debtors represent sales of a previous
accounting period most of which will be cash receipts in the current
period. The change between opening and closing debtors will thus
represent the adjustment required to move from operating profit to net
cash inflow.
(i) An increase in debtors is a deduction from operating profit.

(ii) A decrease in debtors is an addition to operating profit.
(d) Statement of financial position change in stocks
Stock at the statement of financial position date represents a purchase

that has not actually been charged against current operating profits. As
however cash was spent on its purchase or a creditor incurred, it does
represent an actual or potential cash outflow.
(e) Statement of financial position change in creditors
A purchase represents the incurring of expenditure. It does not

represent a cash outflow until paid.
(i) An increase in creditors between two statement of financial

position dates is an addition to operating profit.
(ii) A decrease in creditors is a deduction from operating profit.
Note that fixed asset creditors are not included as the purchase of a
fixed asset does not result in a charge to the profit and loss account in
the current year.

More detailed example
The statement of financial position of Ms. Sofia as at 30 June were as
follows
20X8 20X7
Rs Rs Rs Rs
Freehold property (as revalued) 22,000 12,000
Plant and machinery
Cost at beginning of year 5,000 5,000
Additions at cost 6,000
Less: Disposals at cost (1,000)
10,000
Accumulated depreciation (2,250) (2,000)
3,000
7,750
Trade investment at cost – 7,000
Stock 16,000 11,000
Debtors 9,950 2,700
Balance at bank – 1,300
55,700 3,700
Capital account
Balance at beginning of year 16,000 5,000
Net trading profit for year 16,000 15,000
Profit on sale of investment 4,000 –
Surplus on revaluation of _______
property 10,000
46,000 20,000
Less: Withdrawals (16,000
) (4,000)
30,000 16,000
Loan account 6,000 10,000
Bank overdraft 11,700 –
55,700
37,000
The machinery disposed of, which had a net book value of Rs 250, was sold
at the beginning of the year for Rs 350.
Sophia is upset, as she has received a rather critical letter from her bank
manager, despite the fact that her profits and capital account balance have
never been higher.
Interest paid on the overdraft was Rs 800.

You are required to draw up a statement(s) that explains in a meaningful way
the reason for the change in the balance at bank during the year.

Solution
Step 1
Allocate a page to the statement of cash flows so that easily identifiable
cash flows can be inserted. Provide room at the foot of the statement of
cash flows for the reconciliation of operating profit to net cash flow from
operating activities. Allocate a further page to workings.
Step 2
Go through the statement of financial position and take the
movements to the statement of cash flows, the reconciliation note or to
workings as appropriate. Tick off the information in the statement of
financial position once it has been used.
Step 3
Go through the additional information provided and deal with it as per
Step 2.
Step 4
The amounts transferred to workings can now be reconciled so that the
remaining cash flows can be inserted on the statement or in the profit
reconciliation note.
Step 5
The profit reconciliation note can now be added, the operating cash
flow transferred to the statement of cash flows and the statement of
cash flows totaled.
Rs Rs
Net cash inflow from operating 2,450
activities (note)
Returns on investments and servicing
of finance
Interest paid (800)
Drawings (16,000)
(16,800)
Capital expenditure and financial
investment
Payments to acquire tangible fixed assets (6,000)
Receipts from sales of tangible fixed 350
assets
Receipts from sales of investments 11,000
(7,000 + 4,000)
5,350
(9,000)
Financing
Part repayment of loan (4,000)
(4,000)
Decrease in cash (1,300 + 11,700) (13,000)
Note to the statement of cash flows
Reconciliation of operating profit to
net cash inflow from operating
activities

Rs
Operating profit (16,000 + 800 interest 16,800
paid)
Depreciation charges (W1) 1,000
Profit on sale of tangible fixed assets (100)
(W2)
Increase in stocks (16,000 – 11,000) (5,000)
Increase in debtors (9,950 – 2,700) (7,250)
Decrease in creditors (8,000 – 11,000) (3,000)
Net cash inflow from operating activities 2,450
Tutorial notes:
 Drawings have been included as a payment in respect of the finance
provided by the owner of the business. However, the owner may find it
useful to have a separate heading, ‘Drawings’, equivalent for a sole
trader of ‘Equity dividends paid’ for a shareholder of a company.
 The revaluation of the freehold property has been ignored as it does

not involve any change in cash.
Workings
(W1)
Fixed assets account Aggregate depreciation
Rs Rs
Depreciation: Disposals 750 Balance b/d 2,000
during year Rs(1,000 –
250)
Depreciation
Balance c/d 2,250 Provided for year (bal fig) 1,000
3,000 3,000
(W2)
Fixed assets disposal account
Rs Rs
Cost of disposals 1,000 Depreciation on 750
disposals
Over-provision for 100 Sale proceeds 350
depreciation
1,100 1,100
3 The direct method

3.1 Introduction
As previously stated, gross cash flows from operating activities can be

used to compute net cash flow from operating activities. The gross cash
flows can be derived:

(a) from the accounting records of the entity by totaling the cash receipts
and payments directly, or
(b) from the opening and closing statement of financial position and profit
and loss account for the year by constructing summary control
accounts for:
(i) sales (to derive cash received from customers)
(ii) purchases (to derive cash payments to suppliers)
(iii) wages (to derive cash paid to and on behalf of employees).
Example using control accounts
The statement of financial position of a business is:

Last year This year
Rs Rs
Fixed assets 153,364 149,364
Stocks – –
Debtors 265,840 346,000
Cash – 165,166
Creditors (219,204) (318,890)
200,000 341,640
Reserves – 141,640
200,000 341,640
Extracts from statement of profit or loss account for the year are:
Rs Rs
Sales 1,589,447
Cost of sales
Purchases (no stocks) 1,021,830
Wages and salaries 145,900
Depreciation 84,000
(1,251,730)
Administration
Purchases 96,077
Salaries 100,000
(196,077)
Operating profit and retained profit 141,640
for the year

Additional information
(a) Creditors consist of:
Rs Rs
(i) creditors from
purchases
Ledger
– re fixed assets 46,000
– other 210,564 258,240
(ii) Wages payable 8,640 14,650
(b) Purchase invoices relating to fixed assets totaling Rs 80,000 have

been posted to the purchases ledger during the year. Prepare the
statement of cash flows showing gross cash flow from operating
activities and a note reconciling operating profit to net cash inflow from
operating activities.
Solution
Step 1
Calculate the cash received from customers.
Sales ledger control
Rs Rs
Balance b/d Debtors 265,840 Cash receipts (bal 1,509,287
fig)
Sales 1,589,447 Balance c/d – 346,000
Debtors
1,855,287 1,855,287
Step 2
Calculate cash payments to suppliers. Information relating to fixed
assets is not included in the purchases ledger control account below in
order to compute cash paid to suppliers of operating costs.

Rs Rs
Balance b/d – 210,564
creditors
Cash paid (bal fig) 1,070,231 Purchases 1,117,907
(1,021,830 +
96,077)
Balance c/d - creditors 258,240 ________
1,328,471 1,328,471

Step 3
Calculate total payments in respect of wages including contributions
paid.
Wages control
Rs Rs
Net wages and Balance b/d
Contributions paid (bal 239,890 Cost of sales 145,900
fig)
Balance c/d
14,650 Administration 108,640
254,540 254,540
Step 4
Cash paid for fixed assets is 80,000 – 46,000 = Rs 34,000. The Rs
80,000 invoice agrees with the movement in fixed assets per the
statement of financial position.
Fixed assets (NBV)

Rs Rs
Balance b/d 153,364 Depreciation 84,000
charge
Addition (bal fig) 80,000 Balance c/d 149,364
233,364 233,364
Step 5
The statement of cash flows can now be prepared.
Statement of cash flows
Rs
Operating activities
Cash received from customers
1,509,287
Cash payments to suppliers (1,070,23
1)
Cash paid to and on behalf of employees (239,890)
Capital expenditure
Purchase of fixed assets (34,000)
Increase in cash 165,166
Tutorial note: if gross cash flows from operating activities had not been
requested, net cash inflow from operating activities could have been derived
from operating profit as follows:

Reconciliation of operating profit to net cash inflow from operating
activities
Rs
Operating profit 141,640
Depreciation charges 84,000
Increase in stock –
Increase in creditors (excluding fixed asset 53,686
creditors)
199,166
4 How to prepare statement of cash flows from financial statements

4.1 Information
The summarised financial statements of Tolls Ltd are as follows.
(a) Statement of financial position at 31 December

20X5 Rs 20X6 Rs
Fixed assets (net book value) 40,406 47,759
Stock 27,200 30,918
Debtors 15,132 18,363
Bank 4,016 2,124
86,754 99,164
Share premium 8,000 10,000
Profit and loss account 13,533 16,748
Debenture stock 10,000 –
Taxation 5,200 6,000
Proposed dividend 6,400 ______
86,754 99,164
(b) Statement of profit or loss for the year ended 31 December 20X6
Rs Rs
Trading profit (after charging 17,215
depreciation of Rs 2,363 and interest of
Rs 900)
Taxation 6,000
Profit after tax 11,215
Dividends
Paid 2,000
Proposed 6,000
8,000
Retained profit 3,215
Balance b/d 13,533
Balance c/d 16,748

An item of machinery with a net book value of Rs 1,195 was sold for Rs
1,614. The depreciation charge of Rs 2,363 does not include the profit/loss on
the sale of the fixed asset.
You are required to prepare a statement of cash flows for the year ended 31
December 20X6.
Solution
Reconciliation of operating profit to net cash inflow from operating
activities
Rs
Operating profit (17,215 + 900) 18,115
Depreciation charge 2,363
Profit on sale of fixed asset (W1) (419)
Increase in stocks (3,718)
Increase in creditors (10,416 – 3,621) 6,795
Statement of cash flows for the year ended 31 December 20X6

Rs Rs
Net cash inflow from operating 19,905
activities
Returns on investments and servicing
of
Finance
Interest paid (900)
Taxation (W2) (5,200)
Capital expenditure
Payments to acquire tangible fixed (10,911)
assets (W1)
Receipts from sales of tangible fixed 1,614
Assets (9,297)
Equity dividends paid (W3) (8,400)
(3,892)
Financing
Issue of ordinary share capital (10,000 + 12,000
2,000)
Redemption of debentures (10,000)
2,000
Decrease in cash (1,892)

Workings
(W1)
Fixed assets – NBV
Rs Rs
Balance b/d 40,406 Fixed assets disposal 1,195
Bank (bal fig) 10,911 Depreciation (profit 2,363
and loss)
______ Balance c/d 47,759
51,317 51,317
Tutorial note: the above account summarises the balances and transactions
relating to fixed assets during the year. The account is required in order to
derive the expenditure on fixed assets for the year.
Fixed assets disposal

Rs Rs
Fixed assets – NBV 1,195 Bank 1,614
Profit on sale (profit
and loss) 419 ______
1,614 1,614
(W2)
Taxation
Rs Rs
Bank (bal fig) 5,200 Balance b/d 5,200
11,200 11,200
Tutorial note: the taxation paid in the year was last year’s charge. Often
there will be a change from last year’s estimate and thus a ledger account will
derive the correct figure paid.
(W3)
Dividends
Rs Rs
Bank (bal fig) 8,400 Balance b/d 6,400
14,400 14,400

Tutorial notes
The dividends paid this year will be:

 last year’s proposed
 This year’s interim.
5 Uses of statement of cash flows
A statement of cash flows can provide information that is not available from
statement of financial position and profit and loss accounts.
(a) It may assist users of financial statements in making judgements on the

amount, timing and degree of certainty of future cash flows.
(b) It gives an indication of the relationship between profitability and cash
generating ability, and thus of the quality of the profit earned.
(c) Analysts and other users of financial information often develop models
to assess and compare the present value of the future cash flows of
entities. Historical cash flow information could be useful to check the
accuracy of past assessments.
(d) A statement of cash flows in conjunction with a statement of financial

position provides information on liquidity, viability and adaptability. The
balance sheet provides information about an entity’s financial position
at a particular point in time including assets, liabilities and equity and
their relationship with each other at the statement of financial position
date.
The statement of financial position is often used to obtain information

on liquidity, but the information is incomplete for this purpose as the
statement of financial positions drawn up at a particular point in time. It
should be stressed however that a historical statement of cash flows
does not provide complete information for assessing future cash flows.
Statement of cash flows should normally be used in conjunction with

statement of profit or loss and statement of financial position when
making an assessment of future cash flows.
The accruals accounting basis used in preparing profit and loss

accounts and balance sheets provides a better basis for projections.

6 Format of a statement of cash flows
6.1 Under Indirect Method
(Indirect method)
Statement of Cash Flows
For the year ended 31 December 20x5
20x5 20x4
Cash flow from operating activities Rs. Rs.
Profit before tax XXX XXX
Adjustment for:
Depreciation XXX XXX
Loss on sale of property XXX XXX
Profit on sale of investment (XXX) (XXX)
Investment Income (XXX) (XXX)
Interest expenses XXX XXX
Goodwill written off XXX XXX
Amortization of intangible assets XXX XXX
Operating profit before working capital changes XXX XXX
Changes in working capital

Increase in trade receivables (XXX) (XXX)
Decrease in inventories XXX XXX
Decrease in prepayments XXX XXX
Decrease in accrued expenses (XXX) (XXX)
Decrease in trade payables (XXX) (XXX)
Cash generated from operations XXX XXX
Interest paid (XXX) (XXX)
Income taxes paid (XXX) (XXX)
Net cash from operating activities (A) XXX XXX
Cash flow from investing activities

Acquisition of shares, debenture etc (XXX) (XXX)
Purchase of property, plant and equipment (XXX) (XXX)
Proceeds from sale of equipment XXX XXX
Interest received XXX XXX
Dividend received XXX XXX
Net cash from / (used in) investing activities (B) (XXX) (XXX)
Cash flow from financing activities

Proceeds from issuance of share capital XXX XXX
Proceeds form long-term borrowings XXX XXX
Payment of finance lease liabilities (XXX) (XXX)
Dividend paid* (XXX) (XXX)
Net cash from/(used in) financing activities (C) XXX XXX

Net increase/(decrease) in cash & cash equivalents XXX XXX
Cash & cash equivalents at the beginning of the period XXX XXX
Cash & cash equivalents at the end of period XXX XXX

*Dividend paid could also be shown as an operating cash flow.
Indirect method
The indirect method used above:
• begins with profit before tax from the income statement

• adjusts for interest to get back to profit from operations
• adjusts for noncash items
• adjusts for increases and decreases in working capital.
6.2 Under Direct Method
(Direct method)
Statement of Cash Flows
For the year ended 31 December 20x5
20x5 20x4
Cash flow from operating activities Rs. Rs.
Cash received from customers XXX XXX
Cash paid to suppliers (XXX) (XXX)
Expenses paid (XXX) (XXX)
Cash generated from operations XXX XXX
Interest paid (XXX) (XXX)
Income tax paid (XXX) (XXX)
Net cash from operating activities (A) XXX XXX
Cash flow from investing activities

Acquisition of shares, debenture etc (XXX) (XXX)
Purchase of property, plant and equipment (XXX) (XXX)
Proceeds from sale of equipment XXX XXX
Interest received XXX XXX
Dividend received XXX XXX
Net cash from/(used in) investing activities (B) (XXX) (XXX)
Cash flow from financing activities

Proceeds from issuance of share capital XXX XXX
Proceeds form long-term borrowings XXX XXX
Payment of finance lease liabilities (XXX) (XXX)
Dividend paid* (XXX) (XXX)
Net cash from/(used in) financing activities (C) XXX XXX
Net increase/(decrease) in Cash & Cash equivalents (A+B+C) XXX XXX

Cash & Cash equivalents at the beginning of the period XXX XXX
Cash & Cash equivalents at the end of period XXX XXX
*Dividend paid could also be shown as an operating cash flow.

Summary
The chapter has concentrated on the computational techniques involved in

the preparation of a statement of cash flows. Practice on the questions
that follow will result in the IFRS format becoming second nature. Having
 Prepare statement of cash flows
Self-test questions
1 What are the standard headings in a statement of cash flows? (1.2)
2 What is cash for statement of cash flows purposes? (1.2)
Preparation of a statement of cash flows

3 What are the main categories of items to adjust profit for in order to arrive at net
cash flow from operating activities? (2.2)
4 Is an increase in stocks a deduction from or addition to operating profit? (2.2)
5 Is a decrease in creditors a deduction from or addition to operating profit? (2.2)
6 Is a decrease in debtors a deduction from or addition to operating profit? (2.2)
7 How are receipts from the sale of fixed assets categorised? (2.2 Solution)
8 Is a surplus on the revaluation of property included in the statement of cash
flows? (2.2)
The direct method

9 Under the direct method do wages paid include withholding tax? (3.1)
Uses of statement of cash flows

10 Does a historical statement of cash flows provide complete information on
future cash flows? (5)
11 The balance sheets of Fazal Din at December 31, 2005 and 2006 are as
follows:
Particulars 2005 2006
Rs. Rs.
Cash in hand 200,000 300,000
Debtors – net 450,000 500,000
Stocks 400,000 650,000
Prepaid expenses 100,000 50,000
Fixed assets 1,150,000 1,650,000
Allowance for (75,000) (175,000)
depreciation 2,225,000 2,975,000
400,000 515,000
125,000 100,000
Creditors 300,000 785,000
Accrued expenses 1,400,000 1,575,000
Bank overdraft
2,225,000 2,975,000
Capital

Other information:
(i) Value of land included in fixed assets in 2005 amounted to Rs.
450,000.
(ii) Another plot of land was acquired during the year from a relative, at a
cost of Rs. 350,000.
(iii) Mr. Fazal Din withdrew Rs. 100,000 out of profits made during 2006.
(iv) Equipment costing Rs. 100,000 and having a book value of Rs. 40,000
was sold during the year for Rs. 60,000.
Required: A statement of cash flow for the year ended December 31, 2006.
Multiple Choice questions
1 Which expenses are adjusted in the reconciliation of operating

profit/loss to give the net cash inflow/outflow from operating activities
for the first line of the statement of cash flows?
A Depreciation
B Depreciation + audit fee
C Depreciation – proceeds from fixed asset sales
D Dividends + taxation
2 What is operating profit if retained profit for the year is Rs 75,000, tax is
Rs 12,000, dividends Rs 8,000, interest Rs 2,000 and audit fee Rs
1,000?
A Rs 98,000
B Rs 97,000
C Rs 96,000
D Rs 95,000
3 Capital expenditure in the statement of cash flows proforma

represents:
A Cash spent on raising capital
B All increases in fixed assets
C Cash paid for new fixed assets + cash received from sales of
fixed assets
D Cash paid for new fixed assets – cash received from sales of
fixed assets
4 Calculate the taxation paid to be included in a statement of cash flows
for 20X8 from the following information:
20X7 20X8
Rs Rs
Taxation creditor 20,000 25,000
P & L charge 77,000
A Rs 77,000
B Rs 82,000
C Rs 72,000
D Rs 75,000

5 Calculate the dividend paid for the year in 20X5 from the following
information:
20X4 20X5
Rs Rs
Dividend creditor 35,000 45,000
P & L charge:
- interim 20,000 25,000
- final 35,000 45,000
A Rs 35,000
B Rs 45,000
C Rs 60,000
D Rs 70,000
6 Why is a statement of cash flows useful?

A It provides information on the liquidity, viability and adaptability
of a company
B It enables the company to pay their debts as they fall due
C It allows management to see the profitability of the company
D It is used to forecast future cash inflows and outflows
7 From the following information, determine the cash movement for

20X7.
20X6 20X7
Rs Rs
Cash at bank 62,000 12,000
Bank overdraft 20,000 85,000
A Rs 31,000 decrease
B Rs 50,000 decrease
C Rs 115,000 decrease
D Rs 15,000 decrease
8 Under which heading in the statement of cash flows would the

purchase of current asset investments?
A Capital expenditure and financial investment
B Management of liquid resources
C Net cash flow from operating activities
D Financing

Answers
11.
Fazal Din
For the Year ended 31st December, 2006
Particulars Rs. Rs.
Cash Flow from operating activities:
Profit (W-1) 275,000
Adjustments:
Depreciation (W-2) 160,00
Gain on sale of equipment (W-3) 0 140,000
Profit before charges in working capital (20,000 415,000
Increase in debtors )
Increase in stock
Decrease in prepaid expenses (50,000
Increase in creditors )
Decrease in accrued expenses (250,00 (160,000)
Net cash generated from operating activities 0) 255,000
50,000
115,00
Cash Flow from Investing Activities: 0
(350,000)
Land bought (25,000
(250,000)
Equipment bought (W-4) )
60,000
Equipment disposal
(540,000)
Net cash used in Investing Activities
Cash Flow from Financing Activities: (100,000)

Drawings (100,000)
Net cash used in financing activities
(100,000)
Opening balance of cash & cash equivalents (W-5)
Net decrease in cash & cash equivalent (255,000- (385,500)
540,000-100,000)
(485,000)
Closing balance of cash & cash equivalent
Working notes
(W-1)
Opening capital + Profit – Drawings = Closing Capital
Profit = Closing capital + Drawings – Opening capital

= 1,575,000 + 100,000 – 1,400,000
= 275,000

(W-2)
Accumulated Depreciation
Rs. Rs.
Disposal 6,000 b/d 75,000
c/d 175,000 Depreciation 160,000
235,000 235,000
(W-3)
Disposal of Equipment
Rs. Rs.
Equipment 100,000 Accumulated dep. 60,000
Profit & Loss A/C 20,000 Cash 60,000
120,000 120,000
(W-4)
Fixed Assets
Rs. Rs.
b/d 1,150,000 Disposal of equip. 100,000
Land 350,000 c/d 1,650,000
Equipment (b/f) 250,000 _______
1,750,000 1,750,000
(W-5)
Cash & Cash Equivalents
Opening Closing
Rs. Rs.
Cash 200,000 300,000
Bank overdraft (300,000) (785,000)
(100,000) (485,000)
MCQs
1 A
2 B
3 D
4 C
5 C
6 A
7 C
8 B

 Understand the importance and purpose of analysis of financial statements

 Describe how the interpretation and analysis of financial statements is used in a
business environment
 Explain the purpose of the interpretation of ratios
 Calculate key accounting ratios
 Profitability
 Liquidity
 Efficiency
 Position
 Explain the interrelationships between ratios

1 Analysis of accounting statements and use of ratios
1.1 Basis for decision making
Up to this point only the preparation and underlying theory of financial
statements have been considered. However, many users of accounts
need to draw conclusions that will form the basis for decisions in the
future. Much of this information will be gathered by calculating ratios and
making comparisons with:
 the performance of the business in previous years

 the budgeted or planned performance in the current year
 the performance of similar businesses.
The ratios themselves do not tell one what to do, but they do help to point one
in the right direction. Ratios should, therefore, make it easier to make better
decisions.
1.2 What information does a user require?

The various users of financial statements require information for quite
different purposes. There are a large number of ratios, not all of which
will be relevant to a particular situation. It is therefore important to
determine the precise information needs of the user, and the decisions
that need to be taken after analysing the relevant information. The needs
of three particular users may be summarised:
User Required for

Management Control of costs, improved profitability
Lenders Borrowing and credit purposes
Shareholders and investment Investment decisions – buying and
analysts
selling shares
Ask yourself the questions ‘What decision is being made?’ and ‘What
information is relevant to that decision?’
1.3 Types of ratios

Ratios fall into several groups, the relevance of particular ratios
depending on the purpose for which they are required. The groups to be
considered here are:
 operating ratios
 short-term liquidity ratios
 working capital efficiency
 medium and long-term solvency ratios.
1.4 Illustration
The above ratios will be illustrated by reference to the following. Assume
that a limited company has a reasonably detailed trading and profit and

loss account (published accounts would rarely provide this amount of
detail).
Summarised statement of financial positions at 30 June

20X7 20X6
Rs’000 Rs’000 Rs’000 Rs’000
Fixed assets (net book value) 130 139
Current assets:
Stock 42 37
Debtors 29 23
Bank 3 5
74 65
Creditors:amounts falling due
within one year:
Taxation 10 10
(46) (65)
Net current assets 28

Total assets less current 158 139
liabilities
Creditors:amounts falling due
beyond one year:
5% secured loan stock (40) (40)
118 99
Ordinary share capital (Rs 10 35 35
shares)
8% Preference shares (Rs 10 25 25

shares)
Share premium account 17 17

Revaluation reserve 10 –
Profit and loss account 31 ¤ 22
118 99

Summarised statement of profit or loss for the year ended 30 June
20X7 20X6
Rs.’000 Rs.’000 Rs.’000 Rs.’000
Sales 209 196
Opening stock 37 29
Purchases 162 159
199 188
Closing stock (42) (37)
(157) (151)
Gross profit 52 45
Interest 2 2
Depreciation 9 9
Sundry expenses 14 11
(25) (22)
Net profit 27 23
Taxation (10) (10)
Net profit after 17 13
taxation
Dividends:
Ordinary shares 6 5
Preference 2 2
shares
(8) (7)
Retained profit 9 6
1.5 Operating ratios

There are several ratios that attempt to assess the profitability of a business.
These are more conveniently expressed in percentage form and include:
(a) The gross profit margin
Gross profit margin = (Gross profit ÷ Sales) –100

This is a very popular ratio and is used by even the smallest of businesses.
DEFINITION
Gross profit margin = (Gross profit ÷ Sales) – 100

20X7 20X6
52/209 – 100% = 24.9% 45/196 – 100% =
23.0%

What can be learned from these figures? Clearly, the gross profit
percentage has improved but it is not known why. Nor is it obvious
whether these figures are better or worse than those that would be
expected in a similar type of business. Before coming to definite
conclusions one would need further information. For example, most
businesses sell a wide range of products, usually with different gross
profit percentages (or profit margins). It may be that in 20X7 the sales
mix changed and that a larger proportion of items with a high profit
percentage were sold, thus increasing the overall gross profit percentage
of the business.
Percentage change in sales
It is relevant to consider the change in sales at this point. The

percentage growth in sales is:
((209 – 196) ÷ 196) - 100% = 6.6%
This is not a significant increase. A larger increase might have given
some evidence of the type of changes in trading conditions that may
have occurred.
DEFINITION
Net profit margin = (Net profit ÷ Sales) - 100%
(a) Net profit margin
Net profit margin = (Net profit ÷ Sales) x 100%

20X7 20X6
27/209 x 100 = 12.9% 23/196 x 100 = 11.7%
What conclusions can be drawn from this apparent improvement? Very
few! Since net profit equals gross profit less expenses, it would be useful
to tabulate, for each of the two years, the various expenses and express
them as a percentage of sales. These are known as costs to sales
ratios.
A suitable tabulation might be:
20X7 20X6
Rs.’000 % Rs.’000 %
Sales 209 100.0 196 100.0
Cost of sales 157 75.1 151 77.0
Gross profit 52 24.9 45 23.0
Interest (2) (1.0) (2) (1.1)
Depreciation (9) (4.3) (9) (4.6)
Sundry expenses (14) (6.7) (11) (5.6)
Net profit 27 12.9 23 11.7
Given a detailed trading and profit and loss account, the above type of
summary could be very useful. Care must be taken in interpreting the
results, particularly since sales (Rs.) are used as the denominator. An
increase in sales (Rs.) could be due to a combination of price and
quantity effects.
DEFINITION
(b) ROCE can be defined as:

(Profit before tax and interest x Average capital employed) x 100, where
average capital employed includes long-term finance but does not
include short- term finance such as bank overdrafts.
(c) Return on capital employed (ROCE)
ROCE can be defined as:
Average capital employed includes long-term finance but does not

include short-term finance such as bank overdrafts. On the balance
sheet, the figure you need to look for is total assets less current
liabilities.
This is an important ratio as it relates profit to the capital invested in a
business. Finance for a business is only available at a cost – loan stock
finance requires interest payments and further finance from shareholders
requires either the immediate payment of dividends or the expectation of
higher dividends in the future. Therefore a business needs to maximize
the profits per Rs. of capital employed.
Due to its importance the ROCE is sometimes referred to as the primary

ratio.
There are several ways of measuring ROCE, but the essential point is to
relate the profit figure used to its capital base. In this examination the
examiner proposes to use a formula based on total long-term capital.
Points to note in definition

 The interest referred to is the interest payable on the long-term
liabilities. Any interest on short-term liabilities such as a bank
overdraft is deducted from the profit, i.e. the numerator and the
denominator must be computed on a consistent basis.
 The examiner requires the calculation to be based on the average
capital employed during the accounting period. This is the
preferable basis of calculation as it relates profits made during a
period of time with capital employed during the same period. The
average is most commonly computed by averaging the capital
employed per the statement of financial positions at the beginning
and end of the accounting period.

If no statement of financial position has been provided at the beginning
of the accounting period, it is often possible to work back to the figure
required by adjusting reserves by the retained profits for the year.
1.6 Asset turnover ratio
Asset turnover ratio = (Sales ÷ operating assets) Asset turnover is a

measure of how well the assets of a business are being used to
generate sales.
Operating assets can be defined in various ways but the most sensible is
to use the same amount as computed for capital employed.
20X7 20X6
209/148.5 = 1.41 196/136 = 1.44
There is a slight decrease in 20X7 compared to 20X6. The asset

turnover ratio helps to explain the movements in the ROCE when used
in conjunction with the profitability ratios. This relationship is shown
below.
1.7 Structure of operating ratios

Operatingprofit
Roce 
Operatingassets
Operatingassets Sales Operatingassets

or
Sales Operatingassets Sales
Various cost elements Fixed assets Currentassets

Sales Sales Sales
Productioncosts
(e.g. Sales)
Stock Debtors Cash

Sales Sales Sales

1.8 Factors affecting return on capital employed
There are two factors affecting return on capital employed:

 profitability of sales
 rate of asset utilisation.
Note: that the product of these two gives the return on capital employed:
Operating profit/Sales x Sales/Operating assets = Operating
profit/Operating assets = ROCE
In the example for 20X7:
Operating profit/Sales = Rs.29,000/Rs.209,000 = 13.9%
Sales/Operating assets = Rs.209,000/Rs.148,500 = 1.41
Note:
(13.9% . 1.41 = 19.6%, i.e. ROCE subject to a rounding difference.)
1.9 Factors affecting operating profit/sales
This ratio may be subdivided as far as detail in our profit and loss
account permits, since:
Operating profit/Sales + Cost elements/Sales = 1
Cost elements may include production, marketing, distribution,
administration and so on.
KEY POINT
From the analysis it becomes clear that the subdivision of the key ratio,
return on capital employed, is limited only by the detail in the data
available. The important point to remember is that in each case the
ultimate result is directly related to each individual ratio by the pyramid,
i.e. there is an arithmetical relationship between all the pyramid ratios, so
it is possible to determine the effect that a change in one of the ratios will
have on the key ratio – return on capital employed.
1.10 Factors affecting operating assets/sales
In the first place, operating assets may be subdivided into fixed and
current assets, since:
Operating assets/Sales = Fixed assets/Sales + Current assets/Sales
Each of these may be appropriately subdivided, e.g.:
Fixed assets = plant and machinery + Freehold land + etc.
Current assets = stock + debtors + cash + etc.
From the analysis it becomes clear that the subdivision of the key ratio,
return on capital employed, is limited only by the detail in the data
available. The important point to remember is that in each case the
ultimate result is directly related to each individual ratio by the pyramid,

i.e. there is an arithmetical relationship between all the pyramid ratios, so
it is possible to determine the effect that a change in one of the ratios will
have on the key ratio – return on capital employed.
2 Liquidity, working capital and solvency

2.1 Short-term liquidity ratios
The two main ratios are:
(a) The current ratio

The current ratio = Current assets at end of period/Current liabilities at
end of period.
20X7 20X6
74/46 = 1.61 65/65 = 1.0
The current ratio is sometimes referred to as the working capital ratio.
DEFINITION
The current ratio = Current assets at end of period/Current liabilities at end
of period.
(b) The liquidity (or quick) ratio

Liquidity ratio = Current assets – stock at end of period/Current liabilities at
end of period.
20X7 20X6
32/46 = 0.7 28/65 = 0.43
Both of these ratios show a strengthening.

The extent of the change between the two years seems surprising and
would require further investigation.
It would also be useful to know how these ratios compare with those of a
similar business, since typical ratios for supermarkets are quite different
from those for heavy engineering firms.
What can be said is that in 20X7 the current liabilities were well covered
by current assets. Liabilities payable in the near future (creditors),
however, are only half covered by cash and debtors (a liquid asset, close
to cash).
Conventional wisdom has it that an ideal current ratio is 2 and an ideal

quick ratio is 1. It is very tempting to draw definite conclusions from
limited information or to say that the current ratio should be 2, or that the
liquidity ratio should be 1. However, this is not very meaningful without
taking into account the type of ratio expected in a similar business.
It should also be noted that a high current or liquidity ratio is not

necessarily a good thing. It may indicate that working capital is not being
used efficiently. The next group of ratios can help to identify whether or
not this is the case.

DEFINITION
Liquidity ratio = Current assets – stock at end of period/Current liabilities
at end of period.
2.2 Elements of working capital

It is necessary to consider three ratios concerned with current assets
and current liabilities:
DEFINITION
Stock turnover ratio = Cost of sales/Average stock in period.
DEFINITION
Equity gearing = Preference share capital plus loans/Ordinary share
capital and reserves.
(a) Stock turnover ratio

Stock turnover ratio = Cost of sales/Average stock in period.
Companies have to strike a balance between being able to satisfy
customers’ requirements out of stock and the cost of having too much
capital tied up in stock.
Using the example:

20X7 20X6
157/½ (37 + 42) = 4.0 times pa 151/½ (29 + 37) = 4.6 times pa
The stock turnover ratio has fallen.

Unless the nature of the business is known, it is not possible to say
whether either 4.6 or 4.0 is satisfactory or unsatisfactory. A jeweller will
have a low stock turnover ratio, but it is hoped that a fishmonger selling
fresh fish has a very high turnover ratio.
An alternative calculation of the stock turnover ratio is to show the result
in days. The calculation is:
Aver
accounting period)
20X7 20X6
½ (37 + 42)/157 x 365 = 92 days ½ (29 + 37)/151 x 365 = 80 days
DEFINITION
Formula to compute debt collection period = Average trade
debtors/Credit sales for year x 365.
(b) Debtors collection period (or debtors turnover)

Formula to compute debt collection period = Average trade
Businesses that sell goods on credit terms specify a credit period.

Failure to send out invoices on time or to follow up late payers will have
an adverse effect on the cash flow of the business.
The debt collection period relates average trade debts to the average
daily credit sales. Using the example, with the additional information that
debtors at 30 June 20X5 were Rs.21,000:
20X7 20X6
Credit sales per day Rs.209,000/365 = Rs.573 Rs.196,000/365 = Rs.537
Average trade debtors ½ (29 + 23) = Rs.26,000 ½ (23 + 21) = Rs.22,000
Debt collection period Rs.26,000/Rs.573 = 45.4 Rs.22,000/Rs.537 = 41.0

days days
Compared with 20X6 the debt collection period has worsened in 20X7. If
the average credit allowed to customers was, say, thirty days, then
something is clearly wrong. Further investigation might reveal delays in
sending out invoices or failure to ‘screen’ new customers. The quickest
way to compute the debt collection period is to use the formula:
20X7 20X6
26,000/209,000 x 365 = 45.4 days 22,000/196,000 x 365 = 41.0 days
(c) Average period of credit allowed by suppliers (or creditors’ time to pay)
Average period of credit = Average trade Average period of credit =
Average trade creditors/Credit purchases for year x 365
DEFINITION
Average period of credit = creditors/Credit purchases for year x 365
This relates average creditors to average daily credit purchases. Using

the example, with the additional information that creditors at 30 June
20X5 were Rs.57,000:
20X7 20X6
Credit purchases per day Rs.162,000/365 Rs.159,000/365
= Rs.444 = Rs.436
Average trade Creditors ½ (36 + 55) = ½ (55 + 57) =
Rs.45,500 Rs.56,000
Average period of credit Rs.45,500/Rs.44 Rs.56,000/Rs.43
allowed by suppliers 4 = 102.5 days 6 = 128.5 days
The average period of credit taken has fallen substantially from last year.
It is however, in absolute terms still a high figure.
Often, suppliers request payment within thirty days. The company is
taking nearly three months. Trade creditors are thus financing much of
the working capital requirements of the business. This is beneficial to the
company.

However, there are three potential disadvantages of extending the credit
period.
(i) Future supplies may be endangered.

(ii) Possibility of cash discounts is lost.
(iii) Suppliers may quote a higher price for the goods knowing the
extended credit taken by the company.
The quick calculation is:

20X7 20X6
45,500/162,000 x 365 = 102.5 days 56,000/159,000 x 365 = 128.5 days
3 Financial gearing
3.1 Medium and long-term solvency ratios
Consider the various forms of long-term finance. The table below lists
their priorities as regards the distribution of profits and repayment on
liquidation. These priorities will be specified in the articles of association:
Source of finance Priority in relation to Priority on liquidation
profit
Secured loan stock Interest must be paid Secured by a fixed or
(debentures) whether or not the floating charge – first
company makes a profit claim on assets
Unsecured loan stock Interest must be paid Rank equally with other
whether or not the unsecured liabilities such
company makes a profit as trade creditors
Convertible loan stock Interest must be paid If unconverted rank
whether or not the equally with other
company makes a profit unsecured liabilities. If
converted into ordinary
shares treat as other
ordinary shareholder.
Preference shares Fixed dividend has to be Priority of repayment
paid in priority to any over ordinary shares but
ordinary dividend not usually entitled to
surplus assets on
liquidation.
The various ratios can now be considered.
3.2 Capital gearing
Gearing is one of the most widely-used terms in accounting.

Unfortunately it can be defined and calculated in several different ways.
It is essential to state the definition used.
Gearing is relevant to the long-term financial stability of a business. Two
possible definitions will be considered, both based on book values of
assets. Both of these consider the relationship between:

 ordinary shareholders’ funds (or equity interest) and,
 fixed return capital – comprising loans and preference share
capital.
DEFINITION
capital and reserves
3.3 Equity gearing

capital and reserves
20X7 20X6
(25 + 40)/(118 – 25) x 100 = 69.9% (25 + 40)/(99 – 25) x 100 = 87.8%
This is sometimes known as the debt/equity ratio.
3.4 Total gearing
Total gearing = Preference share capital plus loans/Total long-term

capital
20X7 20X6
65/158 x 100 = 41.1% 65/139 x 100 = 46.8%
DEFINITION
Total gearing = Preference share capital plus loans/Total long-term
capital
There is no real difference between the two types of calculation as the

components of the numerator remain the same. Some prefer to use the
equity gearing as it shows a more pronounced change if either fixed
return capital or equity capital changes. Most use the second calculation
as it is perhaps clearer to note the relationship of fixed interest finance to
total finance. There is no immediate cut-off between a low-geared
company and a highly- geared company. Gearing is a matter of degree.
3.5 Effect of gearing
Gearing may have an important effect on the distribution of profits. For

example, consider two companies with the same profit record but
different capital structures. The return of the ordinary shareholders can
vary considerably.
A Ltd Rs. B Ltd Rs.

Capital structure:
0% Loan stock 20,000 –
Ordinary share capital and 10,000 30,000
reserves
30,000 30,000

Therefore, A is highly geared, while B has no gearing.
Highly No
geared gearing
Year 1 – Profits Rs.4,000 before
interest
∴ Returns:
10% Loan stock (Rs.20,000 × 10%) 2,000 –
Ordinary shares – balance 2,000 4,000
4,000 4,000
Highly No
geared gearing
Year 2 – Profits double to Rs.8,000
before interest ∴Returns:
10% Loan stock 2,000
Ordinary shares – balance 6,000 8,000
2,000 4,000
8,000 8,000
Therefore, increase in return to ordinary
shareholders 3 times 2 times

Thus, the doubling of the profits in year 2 has the effect of tripling the return to
the equity shareholders in the highly-geared company. The effect would be
even more dramatic if the profits fell below Rs.2,000 because then there would
be no return at all to the ordinary shareholders in A Ltd. Thus an investment in
ordinary shares in a highly-geared company is a far more speculative
investment than a purchase of ordinary shares in a low-geared company.
DEFINITION
Interest cover = Profit before interest and tax/Interest paid
3.6 Interest cover
Interest on loan stock (debenture stock) must be paid whether or not the
company makes a profit. Interest cover emphasises the cover (or
security) for the interest by relating:
Profit before interest and tax/Interest paid.

20X7 20X6
(27+ 2)/2 = 29/2, i.e. 14.5 times (23+2)/2 = 25/2, i.e. 12.5 times
From the point of view of medium and long-term solvency, the company
is in a strong position as regards the payment of interest. Profit would
have to drop considerably before any problem of paying interest arose.

4 Investor Ratios
4.1 With view point of investor following ratios shall be considered to help
him deciding whether he should invest in particular company or not.
EPS
Earning per share=profits attributable to ordinary shareholders/Weighted

average no of ordinary shares
P/E ratio
Current share price

P/E ratio = ––––––––––––––
Latest EPS
• Represents the market’s view of the future prospects of the share.

• High P/E suggests that high growth is expected
Company X
• For the year ended 31 December 20X6, EPS = Rs 0.1

• Overall market P/E ratio = 10.
• P/E ratio for X = 20 (because market expects above average
growth).
• Market price at 30 April 20X7 (date of publication of previous
year’s accounts) = Rs 2.
• During the year, X does even better than expected and by 29
April 20X8, the share price is up to Rs 3, therefore giving a P/E
ratio of 30 (based on EPS for year ended 31 December 20X6).
• Year ended 31 December 20X7, EPS = Rs 0.15, announced on
30 April 20X8. This is in line with expectations so share price is
unchanged and P/E ratio drops again to 20 (Rs 3/Rs 0.15).
The earnings yield is the reciprocal of the P/E ratio, calculated as

earnings as a percentage of market price. For Company X at 30 April
20X8 it is 5% (Rs 0.5 as a % of Rs 3).
Dividend yield
Dividend per share

Dividend yield = –––––––––––––––
Current share price
• can be compared to the yields available on other investment
possibilities
• the lower the dividend yield, the more the market is expecting
future growth in the dividend, and vice versa.

Dividend cover
Profit after tax

Dividend cover = –––––––––––
Dividends
• This is the relationship between available profits and the dividends

payable out of the profits.
• The higher the dividend cover, the more likely it is that the current
dividend level can be sustained in the future.
Example
Given below are the income statements for ABC Ltd for the last two years.
Income statements
20X2 20X1
Rs 000 Rs 000
Sales revenue 1,500 1,000
Cost of sales (700) (300)
–––– ––––
Gross profit 800 700
Administration and distribution expenses (400) (360)
–––– ––––
Net profit before tax 400 340
Income tax expense (200) (170)
–––– ––––
Net profit after tax 200 170
In 20X1 dividends were Rs 100,000 and in 20X2 they were Rs 110,000.
The company is financed by 120,000 Rs 10 ordinary shares and let us suppose

that the market price of each share was Rs 16.4 at 31 December 20X2 and Rs
15.3 at 31 December 20X1.
For each year calculate the following ratios and comment on them briefly:
• EPS
• P/E ratio
• Dividend yield
 Dividend cover.
Solution
20X2 20X1
EPS 200/120 170/120
= Rs 1.67 Rs 1.42
P/E ratio 164/16.7 153/14.2
= 9.8 = 10.77
Dividend yield (110/120)/16.4 (100/120)/15.3
= 5.6% = 5.5%

Dividend cover 200/110 170/100
= 1.8 times 1.7 times
Comment
There has not been a significant amount of change in the investor ratios
over the two years but the following specific comments could be made:
• Both EPS and dividend per share have increased by a small

amount over the two years which is a policy often designed to
satisfy shareholders
• The P/E ratio has declined which indicates that the market does
not think as highly of the shares this year as last year.
• Dividend cover is slightly higher which means that a slightly
higher proportion of the profits for the year have been retained
within the business.
5 Possible drawbacks of ratio analysis
It must be emphasised that accounting ratios are only a means to an

end; they are not an end in themselves. By comparing the relationship
between figures, they merely highlight significant features or trends in
the accounts. Indeed, they may well create more problems than they
solve. The real art of interpreting accounts lies in defining the reasons for
the features and fluctuations disclosed. To do this effectively, the
interested party may need more information and a deeper insight into the
affairs of the business. They should also bear in mind the following:
(a) The date at which the accounts are drawn up. Accurate information
can only be obtained with any degree of certainty from up-to-date
figures. Furthermore, seasonal variations in the particular trade
should be taken into account. Final accounts tend to be drawn up at
the end of seasonal trade when the picture they present is of the
business at its strongest point financially.
(b) The accuracy of the position shown in the statement of financial
position. The arrangement of certain matters can be misleading and
present a more favourable picture, e.g. such ‘window-dressing’
operations as:
(i) making a special effort to collect debts just before the year end
in order to show a larger cash balance and lower debtors than
is normal
(ii) ordering goods to be delivered just after the year end so that
stocks and creditors can be kept as low as possible.
(c) Interim accounts. Whenever possible interested parties should
examine accounts prepared on a monthly basis, as a clearer picture
of the trends and fluctuations will emerge from these than from the
annual financial statements.

(d) Accounting ratios are based on accounting information and are,
therefore, only as accurate as the underlying accounting information.
(e) The accounting ratios of one company must be compared with those
of another similar company in order to draw meaningful conclusions.
These conclusions will only be meaningful if that other company’s
trade is similar.
6 Appraising the position and prospects of a business

Example
A Ltd has been trading steadily for many years as ski shoe
manufacturers. In 20X4 a surge in skiing increased the level of A Ltd’s
turnover significantly. The summarised statement of financial positions of
the last two years is given below
20X4 20X3
Rs.’000 Rs.’000 Rs.’000 Rs.’000
Fixed assets:
Intangible assets 30 40
Tangible assets:
Property 640 216
Plant 174 142
844 398
Current assets:
Stock 540 140
Debtors 440 170
Investments – 120
Cash at bank 4 150
984 580
Creditors – amounts falling
due within one year:
Taxation 70 80
Dividend proposed 60 20
650 350
Net current assets 334 230
Total assets less current 1,178 628
liabilities
Creditors – amounts falling

due
after more than one year:
10% debentures 120
1,058 628
628

Called up share capital:
Ordinary Rs 10 shares 300 250
Revaluation reserve 270 –
Capital redemption reserve – 50
Profit and loss account 488 328
1,058 628
Sales for 20X4 and 20X3 respectively were Rs.1,600,000 and
Rs.1,150,000. Cost of goods sold for 20X4 and 20X3 respectively were
Rs.1,196,000 and Rs.880,000.
Given that this is the only information available, you are required to
comment as fully as you can on A Ltd’s financial position.
Solution
Comments on A Ltd – Financial position

Profitability and growth
Profit and loss accounts have not been given but laying these out as far
as they are available:
20X4 Rs. 20X3 Rs.
Sales 1,600,000 1,150,000

Cost of sales 1,196,000 880,000
Gross profit 404,000 270,000
Profit margin:
Gross profit/Sales x 100 25.25% 23.48%
Return on capital employed:
Gross profit/Share capital + 404,000 270 , 000
Reserves +
Debt x 100 1,178,000 898,000
= 34.30% = 30.07%
Average capital employed should be used but year-end figures have
been taken so that a figure for 20X3 can be computed. It is assumed that
the property was worth Rs.270,000 more than its book value in 20X3
also, therefore Rs.270,000 has been added to the 20X3 book value of
Rs.628,000.
The ROCE figures have been computed in a rough and ready fashion
but they indicate an improvement in 20X4 compared with 20X3. The
gross profit/sales also shows a (slight) improvement. This would appear
to be encouraging as the sales have grown considerably.
20X4 Sales Rs.1,600,000
20X3 Sales Rs.1,150,000
Percentage increase 39.13%

Solvency: long-term
Gearing
There was no debt in 20X3. The 10% debentures issued in 20X4 were to
enable the investment to be made to finance growth. The year-end gearing is:
Debt/Capital employed (as above) x 100
= 120,00/1,178,000 x 100
= 10.19%
In absolute terms this is a low figure.
Solvency: short-term
20X4 20X3
Current ratio
Current assets/Current 984,000/650,000 = 1.5 580,000/350,000 = 1.7
liabilities
Quick ratio
Current assets – 444,000/650,000=0.7 440,000/350,000=1.3
Stock/Current Liabilities
Both ratios have shown a decline – particularly the quick ratio.

Conventional opinion states that for many businesses an ideal current
ratio is 2 and an ideal quick ratio is 1. However, the ideal ratio will
depend on the type of business concerned. More important is the
constancy of the ratio over time (assuming that the ratios reflect the
efficient use of working capital). The decline should not be viewed with
alarm, particularly as the 20X3 figures include current assets that were
surplus to the working capital requirements of the business at that time,
i.e. the investments and cash. Both these items have been spent in
purchasing new fixed assets. The quick ratio is, however, now low and
should be watched carefully.
Short-term solvency: working capital efficiency

20X4 20X3
Stock turnover
Cost of sales/Year-end 1,196,000/540,000 = 2.2 880,000/140,000 = 6.3

stocks times pa times pa
Year-end stock has been taken so that the 20X3 figure can be
computed.
A very significant fall in stock turnover. This may indicate that:

 the growth in sales has been made by offering many more types
of shoes, some of which are not selling quickly, or
 further growth in sales is expected so that the company has
stepped up production to anticipate this.

A closer look at this area is required.
20X4 20X3
Debtor collection period
Year-end trade debtors/Sales x 365 440,000/1,600,000 365 = 54.0 days
Year end debtors have been taken so that the 20X3 figure can be
computed. 54 days to collect debts is not very impressive – 100 days is
potentially disastrous. Immediate action is required to ensure prompter
payment although the situation may not be as bad as it appears if it is
the case that the growth in sales took place shortly before the year end
rather than throughout the year. Debtors at the yearend would then not
be typical of the sales throughout the whole year.
Summary
The number of ratios that can be calculated may easily lead to

confusion. Try to organise your thoughts in this area by mentally using
the categories into which this chapter is broken down: operating ratios;
liquidity, working capital and solvency. Remember above all that the
ratios are not an end in themselves. Calculating a ratio is not the same
as drawing a conclusion, but it can point you towards a conclusion.
 Calculate and explain basic ratios
Self-test questions
Analysis of accounting statements and use of ratios

1 Name three different user groups of financial statements and state the
particular interests of each group. (1.2)
2 How do you calculate the return on capital employed for a company?
(1.5)
3 Show how two important ratios can be multiplied together to give the
return on capital employed. (1.8)
Liquidity, working capital and solvency

4 What are the two key ratios to assess a company’s liquidity? (2.1)
5 How is the stock turnover ratio computed? (2.2)
6 How would you assess whether a company’s debt collection procedures
were improving or deteriorating? (2.2)
Financial gearing
7 What is the definition of equity gearing? (3.3)
8 Which is the more risky investment: in a highly geared company or a
company with low gearing? (3.5)
Practice questions
The following information relates to questions 1 to 8.
You are given summarised information about two firms in the same line of
business, A and B, as follows:
Statement of financial positions at 30 June
A B
Rs.’000 Rs.’000 Rs.’000 Rs.’000 Rs.’000 Rs.’000
Land 80 260
Buildings 120 200
Less: Depreciation (40) 80 - 200
80
Plant 90 150
Less: Depreciation (70) 20 (40) 110
180
Stocks 80 100
Debtors 100 90
Bank – 10
180 200

A B
Rs.’000 Rs.’000 Rs.’000 Rs.’000 Rs.’000 Rs.’000
Creditors 110 120
Bank 50 -
160 120
20 80
200 650
Capital b/d 100 300

A B
Rs.’00 Rs.’00 Rs.’000 Rs.’000 Rs.’000 Rs.’000
0 0
Profit for year 30 100
130 400
Less: Drawings (30) (40)
100 360
Land 160
Revaluation Loan 100 130
(10% pa)
200 650
Statement of profit or loss for the year ended 30 June

Sales 1,000 3,000
Cost of sales 400 2,000
Gross profit 600 1,000
Expenses 560 887

Interest 10
Net Porfit 30
Choose the correct answer for ratios:

1 Gross profit margin
A 67%
B 33%
C 52%
D 25%
2 Net profit margin
A 6%
B 3%
C 5%
D 2%
3 Return on capital employed
A 16%
B 23%
C 51%
D 18%
4 Gearing
A 16%
B 21%
C 51%
D 18%
Answer of MCQs
1 B
2 B
3 D
4 B


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Fundamentals of Financial Accounting (Study Text)

Fundamentals of Financial Accounting (Study Text)

Institute of Cost and Management Accountants of Pakistan

Institute of Cost and Management Accountants of Pakistan

First Edition 2014

This document has been developed to serve as a comprehensive study and

Fundamentals of Financial Accounting (Study Text)

ACCOUNTING CONVENTIONS AND REGULATORY

THE ACCOUNTING EQUATION

4 DOUBLE ENTRY BOOKKEEPING 45

5 BOOKS OF PRIME ENTRY AND CONTROL ACCOUNTS 68

6 ACCOUNTING FOR SALES TAX 88

7 ACCRUALS AND PREPAYMENTS 97

8 BAD DEBTS AND ALLOWANCES OR RECEIVABLES 110

Fundamentals of Financial Accounting (Study Text)

11 BANK RECONCILIATIONS 159

12 NON-CURRENT ASSETS 171

13 PAYROLL ACCOUNTING 203

14 PAYABLES, PROVISIONS AND CONTINGENCIES 211

15 JOURNAL ENTRIES AND SUSPENSE ACCOUNTS 221

16 FROM TRIAL BALANCE TO FINANCIAL STATEMENTS 232

17 INCOMPLETE RECORDS 247

18 COMPANY ACCOUNTS 271

Fundamentals of Financial Accounting (Study Text)

20 INCOME AND EXPENDITURE ACCOUNT 312

21 STATEMENT OF CASH FLOWS 334

22 FINANCIAL RATIOS 358

Fundamentals of Financial Accounting (Study Text)

 Step-by-step topic coverage. This is the heart of each chapter, containing

 Examples. Most chapters are illustrated by more practical elements, such as

 Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an

Fundamentals of Financial Accounting (Study Text)

Prepare a written schedule summarizing the above and stick to it.

Tips for effective studying

Fundamentals of Financial Accounting (Study Text)

Fundamentals of Financial Accounting (Study Text)

 Explain the objectives of financial accounting.

Fundamentals of Financial Accounting (Study Text) 2|Page

There are two main financial accounting statements:

 The statement of financial position – a statement of assets and

 The statement of profit or loss – this summarises income and

 Note that the statement of financial position is a ‘position’ statement, i.e.

1.2 Statement of financial position

Both formats will be shown here.

Fundamentals of Financial Accounting (Study Text) 3|Page

The capital of a business entity is a special liability of the business. It is the

This illustration is not as difficult as it looks. First of all, consider what

The assets used in the business amount to Rs 8,390. The individual

As regards the listing of assets in the statement of financial position,

Looking at assets and starting with the least liquid assets:

(ii) The remaining assets are classified as current assets. Current

A fixed asset is any asset, tangible or intangible, acquired for retention

Liabilities are claims on the business by outsiders.

Fundamentals of Financial Accounting (Study Text) 4|Page

Capital: The total of resources invested and left in a business by its

Capital Expenditure: When a business spends money to buy or add

Revenue Expenditure: Expenses needed for the day-to-day running

Accounting Equation: Accounting equation describes that the total

(a) At the beginning of the year the amount owing to the

The statement of financial position is a statement of the financial

It is important to appreciate that the balance, i.e. the amount that is

Fundamentals of Financial Accounting (Study Text) 5|Page

This is known as the accounting equation.

In the present example the respective totals are Rs 8,390.