LECTURE 5 BALANCING OFF ACCOUNTS AND PREPARING FINANCIAL STATEMENTS

1. LECTURE 5BALANCING OFF ACCOUNTS AND PREPARING FINANCIAL STATEMENTS AKUA PEPRAH-YEBOAH DEPARTMENT OF ACCOUNTING AND FINANCE SCHOOL OF BUSINESS

15. Trial balance

16. NOTE: For all expenses and income, balances are transferred to the income statement and so the Bal c/d is not used. Rather a double entry transfer is done. Dr/Cr account in question, Dr/Cr income statement. In the trial balance however, all balances are shown, regardless of whether they are shown in the statement of financial position or transferred to the income statement

17. Example: Post the following into the appropriate accounts, balance them off and prepare a trial balance. Capital contributed is $2,000 cash Bought goods worth $200 for cash Sold goods for $300 for cash Bought furniture for $400 Bought equipment for $300

18. EXAMPLE: INCOME STATEMENT Entity ABCIncome statement for the year ended [date] GHȻ GHȻRevenue 800,000Cost of sales 500,000Gross profit 300,000Other income:Gain on disposal of non‐current asset 10,000 310,000ExpensesEmployees’ salaries 120,000Depreciation 10,000Rental costs 30,000Telephone charges 15,000Advertising costs 30,000Selling costs 40,000General expenses 20,000Interest charges 3,000Bad debts 2,000 270,000Net profit 40,000

19. Entity ABCStatement of financial position as at [date]Assets $ $Non‐current assets:Land and buildings 400,000Plant and equipment 100,000Motor vehicles 80,000 580,000Current assets:Inventory 20,000Receivables 30,000Cash 5,00055,000Total assets 635,000Equity and liabilities Equity:Owner’s capital 440,000Non‐current liabilities:Bank loan 170,000Current liabilities:Bank overdraft 10,000Trade payables 15,00025,000Total equity and liabilities 635,000

20. From trial balance to final accountsAdjustments Inventory Accruals and prepayments Depreciation calculations Provisions

21. InventoryOpening and Closing Inventory and the Cost of Sales In an income statement, the gross profit for a period = Sales – Cost of sales. Theaccruals concept is applied, and sales are matched with the cost of making those sales in order to calculate gross profit. However costs of purchases during a period are not the same as the cost of sales, because of changes in inventory levels. The Cost of Sales = Opening inventory + Purchases – Closing inventory. $Opening inventory APurchases B A + BClosing inventory (C)Cost of sales A + B – C The cost of sales is shown in an income statement, and is used to calculate the gross profit (or loss) earned during an accounting period.

22. Example Here is an illustrative example. $ $Sales 183,000Opening inventory 15,000Purchases 100,000 115,000Closing inventory (20,000)Cost of sales (95,000)Gross profit 88,000Other expenses (80,000)Net profit (or loss) for the period 8,000

23. Recording opening and closing inventory In order to prepare an income statement, it is therefore necessary to obtain values for opening inventory and closing inventory, and to record these in the accounting system. There are two main methods of recording inventory, a continuous inventory system and a period-end system. There is a ledger account (in the main ledger) for inventory. In a period-end system, inventory is normally valued just once each year, at the end of the financial year. The value of inventory at the end of one year (i.e. closing inventory) becomes the opening inventory at the beginning of the next year.Until the end of the year, the balance on the inventory account (a debit balance) is the value of opening inventory at the beginning of the year.At the end of the financial year, the closing inventory is counted and valued. The opening inventory value is replaced in the inventory account by the value of closing inventory, in the way described below.The appropriate book-keeping entries in the main ledger are as follows:

24. Period-end method: accounting procedures For the opening inventory • Credit the inventory account with the value of the opening inventory • Debit the income statement with the value of the opening inventory.The income statement (as well as the inventory account) is an account in the main ledger, and is part of the double entry book-keeping system. • For the closing inventory • Debit the inventory account with the value of the closing inventory • Credit the income statement with the value of the closing inventory.

25. The closing balance on the inventory account is therefore the value of the closing inventory, which is carried forward as the opening balance at the beginning of the next period. The end-of-year adjustments for inventory are shown in the T account below. Inventory accountCurrent year $ $Opening inventory b/f A Income statement AIncome statement B Closing inventory c/f B A + B A + BNext year Opening inventory b/f B In a period-end system, all purchases from suppliers are recorded in a Purchasesaccount: Debit Purchases, Credit Trade payables.

26. Example In Year 2, Bubbles had opening inventory of $10,000. Sales during the year were $80,000 and purchases were $30,000. Closing inventory at the end of Year 2 was $12,000. The entries in the main ledger of Bubbles can be summarised as follows:

29. Carriage inwards and carriage outwards Two expenses that you might come across are carriage inwards and carriage outwards. Even though they are both expenses they are reported differently in the income statement.

30. Carriage inwards This is the cost a business might incur in getting its purchases delivered to its business premises. Sometimes the supplier may pay any delivery costs but if the business has to pay its own delivery costs it records these costs as carriage inwards. The double entry is:Debit Carriage inwardsCredit Bank Cost of carriage inwards is part of the cost of bringing the inventory to its current location and condition. The cost is usually added to the purchase cost of the goods and so this cost is included in the cost of sales and the calculation of gross profit.

31. Carriage outwards Carriage outwards is the cost of delivering goods to customers. This is a normal selling expense, which is treated as an expense in the income statement. The cost of carriage outwards is not included in the cost of inventory or cost of sales and so does not affect gross profit (only net profit).

32. PURCHASES AND SALES RETURNS In the calculation of Cost of Sales, Sales and Purchases are adjusted for any returns made during the year. Therefore, Revenue = Sales – Return Inwards And Purchases = Purchases – Return Outwards

33. Thus, gross profit is calculated as follows:

34. OTHER INCOME After gross profit is calculated, income from other sources (gains from disposal of non current assets and income from other investments) are added to it. Gains on disposal are calculated as: Sales price of asses xxxx Cost of asset xxx Less depn(xxx) (xxx) Profit/Loss xxx Other income include: Rent receivable Decrease in provisions Interest on investments All other incomes from sources other than the core business of the entity

35. EXPENSES

36. Accruals and prepayments According to the accrual concept, expenses should be matched against revenue for a particular accounting period. Thus, expenses should be fully charged for a particular year irrespective of how much has been actually paid. For example, if in a year GHȻ 3,000 is paid as electricity but the electricity bill shows GHȻ4,000, an electricity expense of GHȻ4,000 is recognised in the income statement. Likewise if the bill showed GHȻ2,000, still an expense of GHȻ4,000 would be showed. This is because, the amount of electricity consumed this year in order to earn revenue is GHȻ4,000. An expense/income owing is said to be ACCRUED whiles an expense/income paid in advance is said to be PREPAID.

37. Effect on profit Effect on the statement of financial position Accrued income and Prepaid expenses are treated as part of receivables. Accrued expenses and prepaid income are treated as part of payables.

38. Example In an accounting year, an entity paid GHȻ3,500 as electricity and GHȻ5,600 as rent. At the end of the year, the electricity bill showed an owing of GHȻ300 and the rent for the year is GHȻ5,000. For the same year, interest income received was GHȻ4,000 with GHȻ2,000 still outstanding and the entity received fees for other jobs to the tune of GHȻ5,420 when jobs executed was worth GHȻ2,800. Show the rent, electricity, interest income and other income in the income statement and statement of financial position.

39. WORKINGS Electricity consumed in the year = GHȻ3,500+GHȻ300 =GHȻ3,800 Rent expense incurred = GHȻ5600 (even though onlyGHȻ5,000 has been paid for) Interest received = GHȻ4,000 + GHȻ2,000 Other Income = GHȻ2,800

40. INCOME STATEMENT EXTRACT Gross Profit XXX Add other income: Interest received 6,000 Other income 2,800 8,800 Less expenses Electricity 3,800 Rent Expense 5,0008,800

41. BALANCE SHEET EXTRACT Current Assets: Receivables XXXX Add Prepaid expenses: Rent (5,600-5,000) 600 Add accrued income: Interest income owing 2,000 Current Liabilities Add Accrued expenses Electricity owing 300 Other income repaid 2,620

42. DEPRECIATION Deprecation is defined as that part of the original cost of a non-current asset that is consumed during its period of use by the business. Each year, an amount is charged to the profit and loss account that represents the amount consumed in earning revenue (in accordance with the matching concept). Thus depreciation reduces profit.

43. METHODS OF CALCULATING DEPRECIATION CHARGESSTRAIGHT LINE METHOD • In this method the number of years of use is estimated. The cost is then divided by the number of years. This gives the deprecation charge for each year. For instance if a van is bought for Ghc22,000 and we think that it will last for 4 years, and will be sold for Ghc2,000 the depreciation to be charged each year would be:

44. METHODS OF CALCULATING DEPRECIATION CHARGES REDUCING BALANCE METHOD In this method, a fixed percentage for depreciation is deducted from the cost in the first year. In the second year, and later years the same percentage is taken of the reduced balance (i.e. cost less depreciation already charged). • The method is also known as diminishing balance method or the diminishing debt balance method. If a machine for Ghc10,000 and deprecation is to be charged at 20%, the calculation for the first three years would be as follows:

45. Depreciation and the final accounts • The calculation of depreciation for the accounting period is Debited to the Income statement as an expense and Credited to the accumulated depreciation account. Dr Income statement Cr Accumulated depreciation account The balance of the accumulated depreciation account is sent to the statement of financial position as a reduction in value of assets.

46. EXAMPLE Trial balance extract Depreciation is calculated on a straight line basis for 12 years with no scrap value. Show the income statement and balance sheet extracts.

47. Workings: • Depreciation charge for year 2 = = = 2,500 Dr Income statement 2,500 Cr Accumulated Depreciation 2,500 Therefore accumulated depreciation becomes (5000+ 2500) = 7500

48. INCOME STATEMENT EXTRACT Gross profit xxxx Add other income xxx Less expenses: Depreciation (2,500) STATEMENT OF FINANCIAL POSITION Non Current Assets: Cost AccDepn NBV Motor Van 30,000 7,500 22,500

49. PROVISIONS FOR DOUBTFUL DEBT A provision is an amount set aside for probable contingencies that might occur. One provision made is for debts that are likely to become bad. This is referred to as the provision for doubtful debt. The key thing to note here is that only increases or decreases in the provision are considered. Increase in provision: Dr Income statement Cr Provision for doubtful debt account Decrease in provision: Dr Provision for doubtful debt account Cr Income statement Thus, increases are treated as expenses whiles decreases are treated as gains (under other income). The balance of the doubtful debt account is sent to the SOFP as a reduction in receivables.

50. EXAMPLE AAM ltd made a provision for doubtful debts of 360 last year. It is their view that a larger provision is necessary for this accounting year. Therefore, the provision is increased to 420. The receivables balance for the year is 45,000. Show the treatment in the income statement and statement of financial position.