F3 Financial Accounting 1-4

Financial Accounting (F3/FFA)

July 2012 Session

Main capabilities

On successful completion of this paper, candidates should be
able to:
A. Explain the context and purpose of financial reporting
B. Define the qualitative characteristics of financial information
C. Demonstrate the use of double-entry and accounting systems
D. Record transactions and events
E. Prepare trial balance including identifying and correcting errors
F. Prepare basic financial statements for incorporated and
unincorporated entities
G. Prepare simple consolidated financial statements
H. Interpretation of financial statements

Detailed syllabus

A. The context and purpose of financial
reporting
 The scope and purpose of, financial
statements for external reporting
 Users‟ and stakeholders‟ needs
 The main elements of financial reports
 The regulatory framework
 Duties and responsibilities of those charged
with governance.

Continues…

B. The qualitative characteristics of financial
information

 The qualitative characteristics of financial information

Continues…

C. The use of double-entry and accounting systems
 Double entry bookkeeping principles including the
maintenance of accounting records and sources of
information.
 Ledger accounts, books of prime entry, and journals

Continues…

D. Recording transactions and events
 Sales
 Cash
 Inventory
 Tangible non-current assets
 Depreciation
 Intangible non-current assets and amortisation
 Accrual and prepayments
 Receivables and payables
 Provisions and contingencies
 Capital structure and finance costs

Continues…

E. Preparing trial balance
 Trial balance
 Correction of errors
 Control accounts and reconciliations
 Bank reconciliations
 Suspense accounts

Continues…

F. Preparing basic financial statements
 Statements of financial position
 Income statements and statements of
comprehensive income
 Disclosure notes
 Events after the reporting period
 Statements of cash flows
 Incomplete records

Continues…

G. Preparing simple consolidated financial
statements
 Subsidiaries
 Associates

Continues…

H. Interpretation of financial statements
 Importance and purpose of analysis of financial
statements
 Ratios
 Analysis of financial statements

Examination Approach

The syllabus is assessed by a two hour paper
based or computer-based examination.
Questions will assess all parts of the syllabus
and will include both computational and non-
computational elements. The examination will
consist of 50 two mark questions.

News!!!!

From December 2011, Paper F3/FFA saw two main
new examinable areas added to its syllabus – the
preparation of simple consolidated financial
statements and the interpretation of financial
statements.

Lecture 1 –The scope and purpose of, financial
statements for external reporting

What is Accounting?

 Accounting is the process of collecting, recording,
summarising and communicating financial information.
 There are many purposes of accounting. You may have
considered the following.
 Control over the use of resources
 Knowledge of what the business owes and owns
 Calculation of profits and losses
 Cash budgeting
 Effective financial planning

Objectives of a business - Financial

Profit maximisation
Growth and market
sustainability
Survival
Discourage competitors

Non-financial

 Welfare of employees
 Customer satisfaction
 Welfare of management
 Supplier relationship
 Responsibility to society

User‟s and stakeholders‟ needs
 Users of financial statements need relevant and
reliable information.
 To provide such information, the profession has
developed a set of principles and guidelines called
Conceptual Framework.
 The framework is to be the foundation for building a
set of coherent accounting standards and rules.
 Also to be a reference of basic accounting theory for
solving emerging practical problems of reporting.

User groups of financial Statements
 Accounting information is required for a wide range of users
both within and outside the business.
 Managers
 Shareholders
 Suppliers
 Lenders
 The tax authorities
 Employees
 Government
 The Public

Continues…

User Group Explanation
Manager/Directors Managers/Directors are appointed by the company's
owners to supervise the daily activities of the company
on their behalf. They need information about the
company's current and expected future financial
situation, to make informed decisions.
Shareholders Want to assess how effectively management is
performing and how much profit they can withdraw from
the business for their own use.
Suppliers/Customers Suppliers want to know about the company's ability to
pay its debts; customers need to know that the company
is a secure source of supply and is in no danger of
closing down.
Lenders Lenders will want to ensure that the company is able to
meet interest payments, and eventually to repay the
amounts advanced.

Continues…

User Group Explanation
The Tax authorities Want to know about business profits in order to assess
the tax payable by the company.
Employees Need to know about the company's financial situation
because their future careers and the level of their
wages and salaries depend on it.
Government Interested in the allocation of resources and in the
activities of enterprises. Also require information in
order to provide a basis for national statistics.
The Public Want information because enterprises affect them in
many ways, e.g. by providing jobs and using local
suppliers, or by affecting the environment (e.g.
pollution).

Management accounting and financial accounting
 Management accounts are produced for internal
purposes – they provide information to assist
managers in running the business.
 Financial accounts are produced to satisfy the
information requirements of external users.
 Financial accounting is the preparation of accounting
reports for external use.
 Management accounting is the preparation of
accounting reports for internal use.

Continues…
 Management accountants produce information which is forward-looking,
and used to prepare budgets and make decisions about the future
activities of a business.
 They also compare actual performance with budget and try to take
corrective action where necessary.
 Financial accountants, however, are usually solely concerned with
summarising historical data, often from the same basic records as
management accountants but in a different way. This difference arises
partly because external users have different interests from management
and do not need very detailed information.
 In addition, financial statements are prepared under constraints (such as
International Financial Reporting Standards and company law) which do
not apply to management accounts.

Types of business entity

Sole Trader, Partnership and Limited
Liabilities companies

Sole Trader/Proprietorship
 A sole proprietorship business is owned by one
person who is called a sole proprietor.
 Since the sole proprietor is not a legal entity, the
owner is entitled to all profits generated from the
business.
 However, the owner‟s liability is unlimited, not just
when the business is having financial difficulty, but
also when the business fails and he faces bankruptcy.
 In this case, the creditors may sue him for debts
incurred and also obtain a court order to claim against
his personal assets, including his house.

Continues…
 Normally, a person‟s ability to run a sole
proprietorship business is limited to his area of
expertise, which means he relies mainly on himself.
 He has the freedom to use his entrepreneurial skills to
the maximum, make his own decisions and run the
business as he wishes.
 However, to be a successful entrepreneur, he will
need to get relevant advice from experts in fields he is
unfamiliar with.
 This expertise is sometimes unavailable when one
operates as a sole proprietor.

Advantages
 Easy and cheap to set up since there is a limited
paperwork.
 The owner is in full control of the business
 He/she takes all the rewards alone
 Relax compliance for reporting obligations
 It is usually flexible

Disadvantages
 His capital is limited to the availability of his funds and
the profit generated from the business, this would be
the reason why many sole proprietorship businesses
never take off in a big way.
 In many cases, even when a sole proprietorship
business is successful, all profits generated are taxed
on a personal basis and tax exemptions are limited to
personal and family matters.
 Very often in sole-proprietorship operations, there is
no business succession plan and the business may
no longer operates with the retirement or demise of
the sole proprietor.
 The owner‟s liability is unlimited, in the event of
bankruptcy.

Partnership
 As its name suggests, this form of entity is when two or
more persons come together to carry out a business.
However, the maximum number of persons allowed in a
partnership is 20.
 Examples include an accountancy/audit firm, a medical
practice and legal practice and they are generally formed
by contractual agreement which is legally binding on all
partners.
 In the UK, the provisions of the Partnership Act 1890 apply
where no partnership agreement exists.
 Partnerships are not separate legal entities from their
owners and they have unlimited personal liability for debts
of the business.
 A new form of partnership called Limited liability
partnership (LLP) has emerged in some jurisdictions.

Advantages
 This form of business is cheap, easy to set up, with
minimal documentation and paperwork.
 There are much fewer guidelines and formalities
wherein there is no requirement to appoint auditors,
company secretary or tax agents.
 They do not need to disclose their financial
statements to the general public.
 Access to wider pull of resources – additional capital,
skills and expertise.
 Division of roles and responsibilities.
 Risk is spread among partners.
 No company tax on the business

Disadvantages
 Partners have unlimited liability in the case the
business runs into trouble.
 There are costs to be incurred in setting up the
partnership agreements.
 In the event of the death or illness of partners, the
partnership may cease to exist.
 Consensus between partners are required when
taking decisions and this could lead to slower decision
making.
 In the absence of any agreement to the contrary, the
resignation of one partner automatically terminates
the partnership agreement.

Limited liability companies
 The meaning of limited companies is that the
liabilities of its members are limited to the amount
of shares they hold in the company.
 Members/shareholders are not responsible for
debts of the company unless if there is any
personal guarantee.
 Shareholders may be individuals or other
companies.
 Company Act 2006 is the legislation applicable in
the UK.
 A LLC is a separate entity from its owners.

Agency theory
 The principals (shareholders) appoint some
agents (directors) to run the business on their
behalf.
 Shareholders are the owners – they provide
capital and receive a return usually inform of
dividends.
 Declaration of dividends is at the discretion of the
directors.
 In some cases directors could also be
shareholders.

The reporting requirements for LLCs in the UK

 Must be registered at Companies House
 There must be MoA and AoA deposited with the
Registrar of Companies
 Have at least one director for Private LLC and two for
Public LLC who may also be the shareholder(s)
 Financial statements must be prepared for filing to
Companies House
 Large companies should have audited financial
reports
 The financial should be available to the shareholders

Advantages
 The most obvious advantage is the liability
“protection” to its shareholders which limits their
exposures to the amount of share capital that they
subscribed for.
 Another advantage is the simplicity to transfer existing
shares or issue additional shares to new investors.
 Unlike sole proprietors or partnerships, there is no
need to wind up the company in the event of death of
its shareholders or directors.
 They have access to wider pull of resources
 Tax advantages to being a LLC. The company tax
rate may be lower than income tax rate for individuals.
 LLC is a separate entity from its owners which may
sue or be sued separately.

Disadvantages
 The company‟s financial affairs will be accessible by
the public.
 Compliance with the Companies Act. Although
complying itself is not a disadvantage, the amount of
effort required to comply with the Act is much more
than a sole proprietor/partnership.
 The company had to perform annual audits on its
financial statements.
 At least one company secretary is required to manage
its statutory submissions and returns as well as
attending and preparing minutes for board and
shareholders‟ meetings.
 Incorporation cost is high, and there are yearly
recurring fees to be paid such as audit, accounting,
company secretarial and tax fees.

Lecture 2 – The qualitative characteristics of financial
information

Statements of Financial Accounting Concepts
 SFAC No.1: Objectives of Financial Reporting (Business)

 SFAC No.2: Qualitative Characteristics of Accounting Information

 SFAC No.6. Elements of Financial Statements - defines the broad
classifications of items found in financial statements and replaces
SFAC No.3, expanding its scope to include not-for profit
organisations
 SFAC No.4: Objectives of Financial Reporting (Non-Business) –
Guidelines for Non-for-profit and governmental entities
 SFAC No.5: Recognition and Measurement Criteria in Financial
Statements
 SFAC No.7: Using Cash Flows information and Present Value in
Accounting Measurements

Overview of the conceptual Framework
Basic Objectives:
 The basic objectives of financial reporting are to provide
information that is:-

1. Useful to those making investment and credit decisions who
have a reasonable understanding of business and
economic activities
2. Helpful to present and future investors, creditors and other
users in assessing future cash flows
3. About economic resources, the claims on those resources
and the changes in them

Qualitative Characteristics
 The IASB has identified the qualitative
characteristics of accounting information that
distinguish better (more useful) information from
inferior (less useful) information for decision making
purposes
 Primary qualities are relevance and reliability of
accounting information

 Secondary qualities are comparability and
consistency of reported information

Primary qualities - Relevance

 To be relevant, accounting information must be capable of
making a difference in a decision

 For information to be relevant, it should have predictive or
feedback value, and it must be presented on a timely basis

 Predictive value – helps users make predictions about
ultimate outcome of past, present and future events

 Feedback value - helps users confirm or correct prior
expectations

 Timeliness - available to decision makers before it loses its
capacity to influence their decisions

Primary qualities - Reliability
 Information is reliable when it can be relied on to represent the
true situation

 For accounting information to be reliable, it should be verifiable, is
a faithful representation, and it is reasonably free of error and bias

 Verifiability – when given the same information and using the
same measurement methods, independent users can obtain the
same results

 Representational faithfulness - when it represents what really
existed or happened

 Neutrality – when it is factual, truthful and unbiased

Secondary qualities - Comparability
 Comparability and consistency of reported information

 Information about an enterprise is more useful if it can be
compared with similar information about another enterprise
(comparability) and with similar information about the same
enterprise at other points in time (consistency)

 For information to be comparable, it must be

1. Measured and reported in a similar manner for different
enterprises
2. Useful to users in identifying real similarities and
differences between enterprises

Secondary qualities - Consistency

 Entity is considered to be consistent in its use of accounting
standards when it applies the same accounting treatment to
similar events from period to period

 Companies can change methods, if the change results in
better reporting

 Disclosure for change :-
1. Nature of the change
2. Effect of the change
3. Justification for the change

Basic Elements of Financial Statements
Balance Sheet Income Statement
 Assets: Probable future  Comprehensive Income: All
economic benefits resulting changes in equity from
from past transactions non-owner sources
 Liabilities: Probable future  Revenues: Inflows from
sacrifices of economic benefits entity‟s ongoing operations
resulting from past transactions
 Equity/Net assets: Residual  Expenses: Outflows from
interest in assets after entity‟s ongoing operations
deducting liabilities or  Gains: Increases in equity
ownership interest from incidental transactions
 Investment by Owners:
 Losses: Decreases in
Increases in net assets
equity from incidental
 Distributions to Owners:
Decreases in net assets
transactions

Recognition and Measurement in Financial
Statements of Business Enterprises.
Basic Assumptions:
 Economic Entity Assumption - The economic activities of an entity can be
accumulated and reported in a manner that assumes the entity is separate
and distinct from its owners or other business units.
 Going-Concern Assumption - In the absence of contrary information, a
business entity is assumed to remain in existence for an indeterminate
period of time. The current relevance of the historical cost principle is
dependent on the going-concern assumption.
 Monetary Unit Assumption - In the United Kingdom, economic activities of an
entity are measured and reported in pound. These pounds are assumed to
remain relatively stable over the years in terms of purchasing power. In
essence, this assumption disregards any inflation or deflation in the
economy in which the entity operates.
 Periodicity Assumption - The life of an economic entity can be divided into
artificial time periods for the purpose of providing periodic reports on the
economic activities of the entity.

Basic Principles
 Historical Cost Principle - Acquisition cost is the most objective and
verifiable basis upon which to account for assets and liabilities of a business
enterprise. Cost has been found to be more definite and determinable than
other suggested valuation methods.
 Revenue Recognition Principle - Revenue is recognised when the earning
process is virtually complete and an exchange transaction has occurred.
Generally, this takes place when a sale to another individual or independent
entity has been confirmed. Confirmation is usually accomplished by a
transfer of ownership in an exchange transaction.
 Matching Principle - Accountants attempt to match expenses incurred while
earning revenues with the related revenues. Use of accrual accounting
procedures assists the accountant in allocating revenues and expenses
properly among the fiscal periods that compose the life of a business
enterprise.
 Full Disclosure Principle - In the preparation of financial statements, the
accountant should include sufficient information to permit the knowledgeable
reader to make an informed judgment about the financial condition of the
enterprise in question.

The Regulatory framework of accounting
 The main objective of accounting is to present
financial information to users. Users need to be
able to rely on the information provided in those
financial statements to enable them to make
appropriate decisions.
 Accountants need some guidance in the way in
which they prepare the financial statements. We
shall look at some of the ways in which
accountants take decisions on methods of
accounting and valuation for certain items in future
lectures.

Accounting Conventions/concepts/principles
 Going concern - Going concern implies that the
business will continue in operation for the foreseeable
future, and that there is no intention to put the
company into liquidation or to make drastic cutbacks to
the scale of operations.
 Accruals - The accruals concept states that, in
computing profit, amounts are included in the accounts
in the period when they are earned or incurred, not
received or paid.
 Prudence - Prudence is the concept that specifies, in
situations where there is uncertainty, appropriate
caution is exercised in recognising transactions in
financial records.

Continues…
Consistency - The consistency convention is
that the accounting treatment of like items should
be consistently applied from one accounting
period to the next.
Materiality - A matter is material if its omission
or misstatement would reasonably influence the
decisions of a user of the accounts. In preparing
accounts it is important to decide what is material
and what is not, so that time and money are not
wasted in the pursuit of excessive detail.

Continues…
 Substance over form - Substance over form is the
principle that transactions and other events are
accounted for and presented in accordance with their
substance and economic reality and not merely their
legal from.
 Business entity (the entity concept) - This convention
separates the individual(s) behind a business from the
business itself, and only records transactions in the
accounts that affect the business.
 Money measurement - This limits the recognition of
accounting events to those that can be expressed in
money terms.

Continues…
 Historical cost – The historical cost of an asset is the
original amount paid for an asset when it was acquired
and thus non-current assets should be stated in their
historical costs less accumulated depreciation.
 The dual aspect - This convention is the basis of double-
entry bookkeeping and it means that every transaction
entered into has a double effect on the position of the
entity as recorded in the ledger accounts at the time of
that transaction.
 The realisation convention - This convention states that
we recognise sales revenue as having been earned at
the time when goods or services have been supplied and
a sales invoice issued.

The theory of capital expenditure
 Current purchasing power (CPP) accounting - This
method of accounting considers the effects of changing
price levels by reference to an index, for example
movements in the retail price index (RPI) in the UK. It
distinguishes between monetary and non-monetary
items.
 RPI - The RPI is a measure of inflation published each
month. It is based on the prices of items bought by the
average family.
 Monetary items - Examples of monetary items include
cash and bank balances, receivables and payables.
These are valued in a currency – such as dollar, yen or
sterling – regardless of the changes in the price level.

Non-monetary assets
 These are items that do not suffer a loss in value in a
period of changing price levels. They include non-
current assets, inventories and shareholders‟ equity
(ordinary shares and reserves).
 Holding gains/losses - The holding of monetary items
will, in periods of inflation, give rise to holding gains or
losses.

Current cost accounting
 Current cost accounting (CCA) is a method of adjusting
historical cost accounts for the effects of changing
price levels by using indices specific to the
organisation. Thus CCA attempts to measure the
actual rate of inflation experienced by the business
whereas CPP attempts to measure the rate of inflation
experienced by the business owners.
 Fair Value - fair value may be defined as the value of
an asset in an arm‟s length transaction between
knowledgeable buyer and seller of that asset.

Duties and responsibilities of those charged with
governance

Duties
 Those charged with governing a company are
responsible for the preparation of the financial
statements.
 Corporate governance (CG) is the system used in
directing and controlling a company.
 This is necessitated because the management and
ownership of a company reside in the hands of
different people and this could lead to conflicts of
interest.
 The board of directors (BOD) of a company are
usually charged with governance of a company since
they are the top echelons.
 The duties and responsibilities of directors are usually
laid down in law and are wide ranging.

Legal responsibilities of directors
 Directors have a duty of care to show reasonable
competence in the discharge of their duties and
may have to indemnify the company against loss
caused by their negligence.
 Directors also have fiduciary duty to the company
which means that they must act in the best
interest of the company, in utmost good faith and
honesty.
 The Company Act 2006 in the UK sets out 7
statutory duties of directors as shown below:

Directors should:
 Act within their powers
 Promote the success of the company
 Exercise independent judgement
 Exercise reasonable skill, care and diligence
 Avoid conflicts of interest
 Not accept benefits from their parties
 Declare an interest in a proposed transaction or
arrangement

The primary aim is create wealth for the shareholders

Responsibility for the financial statements
 The responsibility to the preparations of financial
statements lies with the directors.
 This preparation must be in accordance with the applicable
financial reporting framework such as IFRS.
 Directors are responsible for the internal controls
necessary to forestall any material misstatement to due to
error or fraud in the preparation of the financial statements.
 They are also responsible for the prevention and detection
of fraud.
 It is also their responsibility to ensure that company
complies with relevant laws and regulations.
 This responsibility should be stated in the financial
statements.
 The company should be reported as going concern unless
if there is any information to the contrary.

Solution
1. C
2. C
3. D
4. A
5. B
6. C
7. C
8. C
9. A
10. B

Lecture 3 – The books of prime entry

Books of prime entry
Books of prime entry are used to list and
summarise the information on source
documents.
 Sales day book - all credit sales are
recorded in the sales day book.
 Sales returns day book – any credit sales
returned by the customers are recorded in the
sales returns day book.
 Purchase day book – all credit purchases
are recorded in the purchase day book.

Continues…
 Purchase returns day book – any credit purchases
returned to the suppliers are record in the purchase
returns day book.
 Cash book – All cash transaction are recorded in the
cash book.
 Petty cash book – lists all cash payments for small
items, and occasional small receipts.
 Journal – is a record of unusual transactions. It is
used to record any double entries made which do not
arise from the other books of prime entry.

Sales and purchase day books
 The sales day book list all invoices sent out to customers.
Sales Day Book

Date Invoice Customer Sales ledger Total amt
ref invoiced
Jan 10 247 Jones & Co SL14 105.00
248 Smith Ltd. SL8 86.40
249 Alex & Co SL6 31.80
250 FTMS College SL9 1,264.60
1,487.80

Continues…
 The column called sales ledger ref is a reference
to the sales ledger which is a record of what each
customer owes the business. It means, for
example, that the sale to Jones & Co for $105 is
also recorded on page 14 of the sales ledger.

The Purchase day book
 The purchase day book list all invoices from suppliers.
Purchase Day Book
Date Supplier Purchase Total Purchases Electricity
ledger ref amount
invoiced

Mar 15 Abbey PL 31 315.00 315.00
Ahmad PL 46 29.40 29.40
TEN PL 42 116.80 116.80
Emmy PL 12 100.00 100.00
561.20 444.40 116.80

Continues…
 The purchase ledger reference is a reference
to the purchase ledger which is a record of
what each supplier is owed.
 The purchase day book analyses the invoices
which have been received. In this example,
three of the invoices related to goods which
the business intends to re-sell (called
purchases) and the other invoice was an
electricity bill.

Sales and purchase returns day
books

 The sales returns day book lists goods (or services
returned (or rejected) by customers for which credit
notes are issued.
Sales returns day book
Date Customer Goods Sales ledger Amount
ref
30 April Emily 3 pairs of SL 82 135.00
boots

The purchase returns day book
 The purchase returns day book lists goods (or
services) returned to suppliers (or rejected) for
which credit notes have been received or are
expected.
Purchase returns day book

Date Supplier Goods Purchase Amount
ledger ref
29 April Boxes Ltd 300 boxes PL 123 46.60

The cash book
 The cash book lists all money received into and paid
out of the business bank account.
 The cash book records transactions involving the bank
account, such as cheque payments, lodgements of
cash and cheques into the bank account, standing
orders, direct debits and bank charges.
 Some cash, in notes and coins, is usually kept on the
premises in order to make occasional payments for
small items of expense. This cash is accounted for
separately in a petty cash book (which we will look at
shortly).

Lecture example 1
At the beginning of 1 September, Robin Plenty had $900
in the bank. During 1 September 2011, Robin Plenty had
the following receipts and payments.
a) Cash sale – receipt of $80
b) Payment from credit customer Hay $400 less
discount allowed $20
c) Payment from credit customer Been $720
d) Payment from credit customer Seed $150 less
discount allowed $10

Continues…
e) Cheque received for cash to provide a short-term
loan from Len Dinger $1,800
f) Second cash sale – receipts of $150
g) Cash received for sale of machine $200
h) Payment to supplier Kew $120
i) Payment to supplier Hare $310
j) Payment of telephone bill $400
k) Payment of gas bill $280
l) $100 in cash withdrawn from bank for petty cash
m) Payment of $1,500 to Hess for new plant and
machinery

Solution
The receipts part of the cash book for 1 September would look like this.
CASH BOOK (RECEIPTS)
Date Narrative Total
2011 $
1 Sept Balance b/d* 900
Cash sale 80
Receivable: Hay 380
Receivable: Been 720
Receivable: Seed 140
Loan: Len Dinger 1,800
Cash sale 150
Sale of non-current asset 200
4,370
2 Sept Balance b/d* 1,660
* 'b/d' = brought down (i.e. brought forward)

Continues…
 The cash received in the day amounted to $3,470.
Added to the $900 at the start of the day, this comes
to $4,370.
 However this is not the amount to be carried forward
to the next day. First we have to subtract all the
payments made during 1 September.

Continues…
The payments part of the cash book for 1 September would look
like this.
CASH BOOK (PAYMENTS)
Date Narrative Total
2011 $
1 Sept Payable: Kew 120
Payable: Hare 310
Telephone 400
Gas bill 280
Petty cash 100
Machinery purchase 1,500
Balance c/d 1,660
4,370

Continues…
 Payments during 1 September totalled $2,710. We
know that the total of receipts was $4,370. That means
that there is a balance of $4,370 – $2,710 = $1,660 to
be 'carried down' to the start of the next day.
 As you can see this 'balance carried down' is noted at
the end of the payments column, so that the receipts
and payments totals show the same figure of $4,370 at
the end of 1 September.
 And if you look to the receipts part of this example, you
can see that $1,660 has been brought down ready for
the next day.

Lecture example 2 - Two-column cash book
2011 February

1
Opening cash balance RM 10,000. Opening bank balance RM 600.

2 Kong lent us RM 20,000 by cheque.

3 Paid building rent by cash RM 2,300.

4 We paid Mehdi by cheque RM 8,600.

5 Cash sales RM 1,900.

7 Kwai paid us by cheque RM 340.

9 We paid Moore in cash RM 920.

10 Vehicles repairs of RM 460 were paid by cheque.

11 Cash sales paid direct into the bank RM 1,510.

Continues…
15 Hood paid us in cash RM 960.

16 Owner withdrew by cheque RM 1,000.

19 We repaid a previous loan taken from Robertson RM5,000 by cheque.

21 Goods for resale were purchased. This was paid by cash, RM 1,300.

22 Cash sales paid direct into the bank RM 1,220.

25 Paid wages by cash RM 2,760.

26 Paid a fine to the government by cheque RM 750.

30 Withdrew RM 2,000 from the bank account for personal use of the
owner.

31 Paid consultancy fees in cash RM 3,200.

Hood paid us in cash RM 960.

Solution Cash book

Bank Cash Bank Cash
(RM) (RM) (RM) (RM)
Balance b/d 600 10,000 Building rent 2,300
Kong 20,000 Mehdi 8,600
Sales 1,900 Moore 920
Kwai 340 Vehicle repairs 460
Sales 1,510 Drawings 1,000
Hood 960 Robertson 5,000
Sales 1,220 Purchases 1,300
Wages 2,760
Fine 750
Drawings 2,000
Consultancy fee 3,200
Balance c/d 5,860 2,380
23,670 12,860 23,670 12,860

Bank statements
 Weekly or monthly, a business will receive a bank
statement.
 Bank statements are used to check that the balance
shown in the cash book agrees with the amount on
the bank statement.
 This agreement or 'reconciliation' is the subject of a
later chapter.

Petty cash book
 The petty cash book lists all cash payments for small
items, and occasional small receipts.
 Most businesses keep a small amount of cash on the
premises to make occasional small payments in cash –
e.g. to buy a few postage stamps etc.
 This is often called the cash float or petty cash
account.
 Petty cash can also be used for occasional small
receipts, such as cash paid by a visitor to make a
phone call or to take some photocopies.
 There are usually more payments than receipts and
petty cash must be 'topped up' with cash from the
business bank account.

Continues…
 Under what is called the imprest system, the amount of
money in petty cash is kept at an agreed sum or 'float'
(say $100).
 Expense items are recorded on vouchers as they
occur.
$
Cash still held in petty cash X
Plus voucher payments X
Must equal the agreed sum/float X

Continues…
 The total float is made up regularly (to $100,or
whatever the agreed sum is) by means of a cash
payment from the bank account into petty cash.
 The amount paid into petty cash will be the total
of the voucher payments since the previous top-
up.
 The format of a petty cash book is the same as
for the cash book, with analysis columns for items
of expenditure.

The Journal

 The journal is a record of unusual transactions. It is
used to record any double entries made which do not
arise from the other books of prime entry.
 Whatever type of transaction is being recorded, the
format of a journal entry is as follows.

Date Debit Credit
$ $
Account to be debited X
Account to be credited X
(Narrative to explain the transaction)

Continues…
 A narrative explanation must accompany each
journal entry. It is required for audit and control, to
indicate the purpose and authority of every
transaction which is not first recorded in a book of
prime entry.

Lecture example 3

The following is a summary of the transactions of Abbey beauty salon
1 January Put in cash of $2,000 as capital
Purchased brushes and combs for cash $50
Purchased hair driers from Gilroy Ltd on credit $150
30 January Paid three months rent to 31 March $300
Collected and paid-in takings $600
31 January Gave Mrs Sullivan a perm, highlights etc on credit $80

Although these entries would normally go through the other books of
prime entry (eg the cash book), it is good practice for you to show these
transactions as journal entries.

Solution
JOURNAL
$ $
Dr. Cr.
1 January Cash account 2,000
Capital account 2,000
(Initial capital introduced)
1 January Brushes & combs a/c 50
Cash account 50
(The purchase for cash of brushes &
combs as non-current assets)
1 January Hair dryer asset account 150
Sundry payables account * 150
(The purchase on credit of hair driers as non-current assets)
30 January Rent expense account 300
Cash account 300
(The payment of rent to 31 March)

Continues…
Dr. Cr.
30 January Cash account 600
Sales account 600
(Cash takings)
31 January Receivables account 80
Sales account 80
(The provision of a hair-do on credit)
* Note. Payables who have supplied non-current assets are
included amongst sundry payables. Payables who have supplied
raw materials or goods for resale are trade payables. It is quite
common to have separate payables accounts for trade and
sundry payables.

Lecture 4 – Double entry and accounting system

Bookkeeping
 What is it?
 System of recording financial transactions
 Known as double-entry bookkeeping
 Two sides to every transaction
 Is part of and feeds into the financial reporting
system.

Aims
 This lecture seeks to provide a introduction to
bookkeeping – what it is and how it is carried out.
 To do this we will consider:
 The financial reporting system
 Examine how records are kept
 Explain the transactions and how they are recorded
 Consider how adjustments can be made
 And how the records are used to generate month end
and year end figures

Lecture Content
 The lecture will aim to cover:
 an introduction to financial reporting
 terminology
 the accounting process
 the financial statements

Financial Reporting

Definitions

Financial Reporting
 What is it?
 Financial reporting is the means of reporting what
has happened in the past in an organisation
 It is part of the accountability system
 It relates yesterdays activities in financial terms
 Reports
 Annual Financial Statements
o Annual Report and Statutory Accounts
 Monthly control reports

Example: Monthly Control Report
Current Month As at 30th June Year to date
Budget Actual Variance Expenditure Budget to Actual to Variance
Date Date
Supplies and
General Charges
40,000 43,000 -3,000 Basic pay 230,000 250,000 -20,000
25,000 26,000 -1,000 Part tim e basic 150,000 165,000 -15,000
15,000 14,500 500 Casual pay 90,000 80,000 10,000
20,000 19,000 1,000 Adm inistrative staff 150,000 148,000 2,000
18,000 20,000 -2,000 Photocopy costs 100,000 110,000 -10,000
21,000 24,000 -3,000 Materials 120,000 125,000 -5,000
10,000 6,000 4,000 Books 50,000 56,000 -6,000
6,000 6,000 0 Heating Pow er & Light 39,000 40,000 -1,000
5,000 4,000 1,000 Cleaning 30,000 31,000 -1,000
1,000 1,500 -500 Fax 6,000 5,000 1,000
2,000 1,800 200 Telephone 12,000 10,000 2,000
1,000 2,000 -1,000 Consum ables 6,000 6,000 0
500 500 0 Hospitality 9,000 10,000 -1,000
1,500 2,000 -500 Maintenance 6000 7000 -1,000
800 700 100 Travelling Expenses 5,000 4,500 500
200 500 -300 Stationery 1,000 1,500 -500
700 100 600 Office Expenses 4,000 5,000 -1,000
200 - 2000 Office Equipm ent 1,000 1,500 -500
3,000 3,500 -500 Rent & Rates 20,000 19,000 1,000
1,000 1,000 0 Sundries 6,000 10,000 -4,000
171,900 176,100 -4,200 Sub Total 1,029,000 1,077,500 -48,500

Key Terms

assets liabilities/
capital

expenses revenue
/income

What is an expense?
 An expense is a short term ‘consumable’, which will be
incurred repeatedly, for example the cost of a
telephone call, a days pay, a box of bandages, a litre of
fuel…
 They are items which have a one–off use..once bought
and used…a second must be bought..and a third..etc
 In general, expense items represent day-to-day
operational activity….low value long term items .. such
as a mobile phone will also be included…
 Expenses are recorded and totalled at the end of each
month and each year.

What is income?
 Income is the sum earned for providing goods or
service, whether or not any payment has been
received.
 It too represents monies from operational activity
and, items which are frequently repeated for
example, the sale of a chocolate bar or the price of
a bus ticket.
 Income is totalled monthly and annually to reflect
what has been earned during that time period.

What is an asset?
 An asset is an item owned by the organisation, it has
value and can be ‘fixed’ or ‘current’.
 Fixed assets provide benefit beyond a year and
current assets have a life less than one year.
 Fixed assets are made up of physical and financial
assets. Land, buildings, equipment, vehicles and
furniture and fittings make up the physical fixed
assets, which put in place the infrastructure through
which operational activity is conducted.
 Stock, debtors and cash make up the current assets.

What is a liability?
 Liabilities are sums owed from the organisation.
They can be short-term such as overdraft or sums
owed to suppliers, known as creditors, or long-term
such as loans, leases and mortgages.
 These latter items contribute to long term funding,
without which, the organisation would not be able to
purchase assets.
 All liabilities carry with them the obligation to repay
and many of them carry interest payments.

What is capital?
 Capital is the owners’ original investment
 although it is rarely repaid, it is ‘technically’ a debt.

 Without this money the organisation would not exist.
Further investment from the ‘owners’ increases this
sum. A key way this sum is increased is through the
Income and Expenditure account. Any excess income
over expenditure belongs to the ‘owners’ and can be
left in the organisation by way of an increase in capital.

 Without capital an organisation cannot begin its’ life nor
grow, as without money new assets cannot be
purchased.

……key terms…..

assets liabilities/ balance
capital sheet

revenue income
expenses
/income statement

The statement of financial position
 Is a position statement which evaluates wealth at a
point in time.
 It considers capital costs.
 Consists of assets and claims on those assets

Assets (owned) Claims (owed)
Current Current liabilities
Non-Current Long-term Loans
Owners capital

But, as Claims = Liabilities + Capital
then, Assets = Liabilities + Capital

Income Statement
 The difference between costs & income
 Profit & loss account / Income & expenditure
account
 Shows where the resource was spent
 Covers a period of time
 Matches expenses and income to time period
 Expenses represent the cost INCURRED, resource
used or consumed in providing the service during
the accounting period
 Income is that which is EARNED from and related
to the service provided

Basis of Preparation

 = Accrual Accounting
 Income and expenditure based system
 Income and expenditure are matched so that they are
allocated to the period in which the benefit /expense is
incurred
 Starting point: Transactions must be recorded….
 Basis of gathering accounting information is double-
entry bookkeeping

The double entry system
 Records transactions - two sides to each
 debit and credit side
 Separate accounts – uniquely identified
 called ledger accounts
 based on chart of accounts

 Ledgers - books of record
 general/nominal
 accounts payable
 accounts receivable
 Trial balance

…..etc…...
 Trial Balance
 Adjustments
 stock/inventory
 depreciation
 bad debts
 accruals and prepayments

 Annual Financial Statements

 ... but it begins with recording transactions….

The ledgers
 General /nominal
 Main list of all accounts
 Total balances maintained on this ledger

 Accounts payable
 Records purchases
 Links to suppliers / creditors / payables
 Also called purchase or bought ledger

 Accounts receivable
 Records „sales‟ or income
 Links to customers / debtors /receivables
 Also called sales ledger

Ledger Accounts
 Each item (asset, expense, liability, capital or income) has its
own ledger account
 It records the details of transactions relating to the
particular item
 Original paper system was „T‟ accounts
 Each account is identified by a unique code

Debit Credit

Lecture example 1

 The accounts of MSU
reveal the following:  Consider how the following
 Capital 18 900 transactions will affect the
Fixtures 3 500 accounts;
Loan 2 000  MSU buys stocks of goods on
Stocks 4 950 credit for £770.
Debtors 3 280  One of the debtors pays £280
Creditors 1 600 in cash.
Vehicles 4 200  New fixtures are purchased
Cash - bank 6 450 with a cheque for £1000.
Cash - hand 120

Double Entry Book-Keeping

asset liabilities/capital

expenses income

= =
debit credit

Rules of Debit & Credit

 Every transaction effects two accounts

 A debit
 increases an asset or expense account
 decreases an income or liability account
 A credit
 increases an income or liability account
 decreases an asset or expense account

Types of accounts
 Asset and liability accounts – are ongoing
accounts
 Non Current (fixed) assets, loan and capital accounts once
established – remain..
 Current assets and liability accounts also remain but move
very regularly up and down as, for example, cash at bank
 Income and expenditure accounts differ in that
each year we start with a zero balance and
record all income and all expenditure into its
own separate account. The aim is to establish
a total amount for each item, e.g. telephone

An exception… purchases/stock
 Purchases …are an expense item
 For example – chocolate bars in a shop

 Inventory/Stock is an asset…
 Unsold chocolate bars in a shop

 We record all purchases as expenses..
 At year end…we measure if we have any items
left…
 What remains = stock/inventory to carry forward, i.e.: closing
stock/inventory
 What‟s used = purchases
 Purchases are the only expense item where we cannot simply
look to the balance on the account

But…

 Through the year we record all the purchases of each
stock item… at the end we then see how much we
have left…this determines how much of the item we
have used..i.e. the expense incurred
 But we may have
 had stock/inventory at the beginning…opening
stock/inventory
 sent goods back…returns outwards
 been charged for delivery…carriage in
 All the above help determine the value of the items
used

Returns..
 When we send something back…
 returns outwards

 When something comes back to us…
 returns inwards

 Set up separate accounts for each…
 For a return outwards:
 reduce supplier account
 increase returns outwards account

 For a return inwards:
 reduce customer account
 increase returns inwards account

..and how much did we use?
£
Opening Stock/Inventory X
+ Purchases X
- Returns outwards (X)
+ Carriage inwards X
- Closing Stock/Inventory (X)
= Cost of Goods Used X

Lecture example 2
 A hospital is trying to establish the cost of
cleaning materials used in a year.
 Opening stock/inventory value £ 12,400
 Purchases £ 87,300
 Returns £ 7,600
 Carriage inwards £ 1,200
 Closing stock/inventory £ 14,250
 What is the cost of the cleaning materials
used?

Balances on Accounts
 Each ledger account is „balanced off‟
 all debit balances are assets or expenses
 all credit balances are liabilities or income
 Balance sheet = asset & liability accounts
 The balances on these accounts are „ongoing‟ ie
closed and re-opened for the next accounting
period
 Income statement = income & expenses
 The closing balances on these accounts are
transferred out and the new accounting period
starts with zero balances.

Balancing off accounts

Supplier A

10/5 Returns out 40 1/5 Purchases 690
24/5 Paid cash 300 4/5 Purchases 66
bal c/d 416 756
756
1/6 bal b/d 416

A balance on a supplier account is a ‘credit’ balance which means
we have a ‘creditor’ (payable).
For customer accounts, a ‘debit’ balance means we have a ‘debtor’
(receivable).

Trial Balance

 List of balances on ledger Dr Cr
accounts Income 155
 Total debit entries Purchases 60
= total credit entries Expenses 25
 Starting point for the Wages 30
derivation of the financial Vehicle 120
statements Fittings 70
 Adjustments to the trial Capital 150
balance lead to the creation
of the operating statement 305 305
and the balance sheet

Preparing accounts
 From trial balance we prepare year end and
month end figures..
 Accrual basis – 4 main adjustments
 Stock/inventory
 Depreciation of fixed assets
 Bad debts
 Accruals & prepayments

Fixed Assets
 Capital expenditure
 buildings, equipment, vehicles, fixtures and fittings
 Provide benefit beyond the accounting period
 Accruals system - match cost to benefit
- by depreciation

Depreciation
 Allocation of the cost of an asset to the years in
which benefit is gained
 Key
 historic cost
 useful life
 residual value
 method
 main - straight line or reducing balance

 Assets recorded at :
 Net Book Value = cost - accumulated depreciation

Lecture example 3
 An asset is bought for £100,000
 It has an estimated useful life of 4 years
 The residual value will be £20 000.
 What depreciation - assuming the straight line
basis is appropriate - will be charged to the
I&E accounts in each of the years and what is
shown in the balance sheet?
 Using a reducing balance of 33% recalculate
the above.

Entering the transactions

 Cost of asset is recorded when purchased
 Only removed when asset disposed of

 Two accounts record depreciation
 Depreciation expense
 Income Statement account

 Depreciation provision (accumulated depreciation)
 Balance sheet account
 Carry forward each year of assets life
 Offsets cost to give NBV on balance sheet

Bad Debts
 Debtors are sums owing to us – but not yet paid
 Bad debt - money owed which is unlikely to be received
 Treatments
 specific debts are written off
 Dr bad debts expense account
 Cr debtor account
 general provision is established as policy
 Dr bad debts expense
 Cr bad and doubtful debt provision
 Provision is a balance sheet account – it offsets the debtors in
the BS – the account is carried forward and is adjusted each
year based on debtors balance – any movement in the provision
is treated as an expense on the income statement.

The Month – End result
 Management accounts
 On-going figures on a monthly basis
 Current month and year to date
 Reports on individual cost centres
 Line items included

 Compared to budgets - variances
 Basis is accruals – prepayments and accruals
included

The Year- End Result
 Accounting statements
 Operating Statement
 Income and Expenditure
 Profit and Loss Account
 Income Statement
 Balance Sheet
 Accounting policies
 Additional notes

Reports…content in brief
 Balance Sheet
 Own
 Income Statement
 Assets
 Income  Non-Current
 Current
 Less
 Owe
 Expenses  Liabilities
=  Long term
 Current
 Profit/Loss
 Capital
 Original
 Accumulated surplus‟s

Basic Income Statement
£ £
Income 1000
Cost of goods sold (750)
Gross Profit 250

Expenses (50)
Net Profit to be retained 200 Balance
Sheet

The Balance Sheet - format
£
Non-Current Assets 1000
Current Assets
Inventory 150
Receivables 250
Cash 200
600
Total Assets 1600
Current Liabilities
Payables 150
Overdraft 250
400

Long Term Liabilities 300
Net Assets 900

Capital
Owners Share Capital 700
Retained profit 200
900

F3 Financial Accounting 1-4

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