ZNOTES.

ORG

UPDATED TO 2022 SYLLABUS

CAIE AS LEVEL
ACCOUNTING
(9706)
SUMMARIZED NOTES ON THE THEORY SYLLABUS
CAIE AS LEVEL ACCOUNTING (9706)

The accounting Equation is

Assets = Liabilities + Owner’s Equity
1. The Accounting System This Equation will be used throughout the chapters
and the equation will always be true.
Use this equation to cross-check your answers in
1.1. The Double Entry Bookkeeping for
future questions:)
Cash Items Purchases returns always go to a purchases
returns account. They are never entered on the
Accounting system is a process of identifying, analysing, credit side of the purchases account
and recording accounting event of a company to provide
useful information to stakeholders to make decisions
Ex: Selling goods/purchasing raw materials
1.3. Source Documents
Double-Entry Bookkeeping is a process which means that
The information entered into the prime entry books are
there are two sides for each transaction. Golden rule: For
from the source documents these may be
every debit entry in a ledger account there must be an
Invoice: a document that a business issues to its
equal credit entry in another ledger account.
customers, asking the customers to pay for the goods
Ex: You pay $5 for a candy to a shopkeeper (one) and the
and services that the business has supplied to them.
shopkeeper receives $5(second) • Both aspects are
Statement: Issued by the supplier. Checked with other
recorded
documents to ensure that the amount owing is
Ex A cash sale:
correct.
Debit Cash a/c (Increase in Assets)
Credit note: A receipt given to a customer who has
Credit Sales a/c (increase in income)
returned goods, which can be offset against future
Double Entry Book entries are displayed in “T” shape
purchases.
Debit note: Issued by the entity receiving the goods.
Debit Credit
Cross referred to the credit note issued by the
Increase Assets Decrease Assets
supplier.
Increase Expenses Decrease Expenses Receipt: Issued by the selling entity indicating the
Decrease Liabilities Increase Liabilities payment received
Decrease Income Increase Income Cheque counterfoil: this is part of a cheque that is
kept when you give the other part to another entity
Pay in slip: this is used to deposit money into a bank
1.2. Double entry bookkeeping for account
credit transaction Petty cash voucher: used as a receipt whenever cash
is withdrawn from a petty cash box
Credit Transaction:- where there is no exchange of Delivery note: document that accompanies a
payment at the time of the transaction. shipment of goods
In Seller’s books       Purchase order: this is the first official issue to the
Credit Sales a/c seller placing an order
Debit Customer a/c Remittance advice notes: a proof of payment
Debtor: A customer (or other party) that owes the document sent by a customer to a business
business money. Bank statement: document sent by the bank to the
Creditor: Suppliers (or other parties) to whom the account holder every month summarizing all the
business owes money transaction that occurred in that month
Trade discount: A reduction in the selling price of goods
made by one trader to another who are in the same line 1.4. Books of prime entry
of business
Cash (or settlement) discount: An allowance given by a Books of Prime Entry are used to list all transactions of a
seller to a customer to encourage the customer to pay an kind before being posted on ledgers.            
invoice before its due date for payment. Ex. All sales transactions will be posted on a ‘Sales
Discount received: Cash discount received by the Journal’ before being posted on ledgers.
purchaser from the seller of goods, treated as an There are 6 types of Books of Prime Entry:
income Sales Journal
Discount allowed: Cash discount allowed by the seller Sales Returns Journal
to the purchaser of goods, treated as an expense. Purchases Journal
Cash discounts are always recorded in the ledgers while Purchases Returns Journal
trade discounts are only mentioned in the source Cash Book  
documents. Journal

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CAIE AS LEVEL ACCOUNTING (9706)

A book of Prime Entry has its own functions: General ledger – impersonal accounts
Each transaction is recorded chronologically for future Private ledger – owners’ capital and drawings
references. Cash book
Each transaction is analysed into the debit and credit Petty cash book
aspect to learn the effect it has to the business Division of ledgers are essential as it allows staff to be
financially. trained in different aspects of the business, it helps
detect and prevent errors as well as fraud, this is referred
Books Of Prime Entry Use to as internal check.
Record Credit Sales from Accounts are classified in two ways
Sales Journal
invoices. Personal - It is an account which is related to a person
Record goods returned from Accounts for trade receivables
Sales Returns Journal Account for trade payables
Credit Customers.
Accounts of capital and drawings
Purchases Journal Record Credit Purchase
Impersonal accounts - It is every other account other
Record goods returned to than personal account
Purchases Returns journal
suppliers Accounts with debit balance
Record all Cash and Bank Asset’s a/c – non current and current
Transactions (check payments Nominal a/c
Cash Book included) as well as discounts Expense a/c
allowed (dr side) and discount Revenue a/c
received (cr side )
Record Transactions for which Preparation of a ledger
there isn’t any other entry.
Journal Correcting errors, adjustments 2019 Particulars
to the accounts, transfers Mr. Aaron started a business with a capital
March 8
between accounts. on $200000
March 12 He purchased motor vehicles for $40,000
Limitations of Books of Prime Entry: March 15 He purchased goods for $70,000
Huge and Bulky in size - A single journal for a business
March 22 He sold goods for $70,000
would be a lot of work to operate and handle
Balance of accounts not available at a glance - As March 29 He paid salaries amounting to $30,000
there are numerous transactions in a business, it
would take a lot of time to find a particular Transactions → Journal Entry
transaction.
Difficulty in Reconciling Cash Book - If a business has Date Particular Amount Amount
all transactions recorded in journal(s) and no cash March 8 Cash A/c Dr. \n Capital A/c Cr. 200,000 200,000
book maintained then it would be difficult to reconcile Motor Vehicles A/c Dr. \n Cash
daily cash balance. March 12 40,000 40,000
A/c Cr.
Repetitive transactions - A business would have
Purchases A/c Dr. \n Cash A/c
similar kinds of transactions every day and to record March 15 70,000 70,000
Cr.
them would require extra labour.
March 22 Cash A/c Dr. \n Sales A/c Cr. 70,000 70,000
March 29 Salaries A/c Dr. \n Cash A/c Cr. 30,000 30,000
1.5. Balancing accounts
This process includes finding which side has the greater Journal → Ledger
side in a ledger account.
Accounts are usually balanced at frequent intervals as its 1. Cash A/c Ledger
vital for the business to know how much money is in the
Date Particulars Amount Date Particulars Amount
bank, accounts of customers and suppliers are balanced
monthly. 2019 2019
Mar Motor Vehicles
Mar 8 Capital A/c 200,000 40,000
12 A/c
1.6. Classification of Accounts and
Mar Mar
Division of Ledgers 22
Sales A/c 70,000
15
Purchases A/c 70,000

Mar
Types of ledgers. Salaries A/c 30,000
29
Sales ledger – accounts of customers
Purchase ledger – accounts of suppliers Bal c/d 130,000

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CAIE AS LEVEL ACCOUNTING (9706)

Date Particulars Amount Date Particulars Amount A/c Debit Balances Credit Balances
Total 270,000 Total 270,000 Rent Payable 1600  
Wages & Salary 4080  
1. Capital A/c
Heating & Light 960  

Date Particulars Amount Date Particulars Amount Other Operating Expenses 1430  

2019 2019 Cash 500  

Mar 29 Bal c/d 200,000 Mar 8 Cash A/c 200,000 Bank 12600  

Total 200,000 Total 200,000 Loan   2000

Capital   13000
1. Motor Vehicles A/c Drawings 2705  
Total 117575 117575
Date Particulars Amount Date Particulars Amount
2019 2019 If trial Balances do not balance, it can be because of six
12 Mar Cash A/c 40,000 Bal c/d 40,000 things                 
Total 40,000 Total 40,000 Errors of Omission: Transactions which is completely
omitted from the books.
1. Purchases A/c Errors of commission: Transaction which is posted to
a wrong account but which is of the same class such
Date Particulars Amount Date Particulars Amount as telephone bill put into heat & lighting.
2019 2019 Errors of Principle: Transactions posted into a wrong
account and not in the same class.
15 Mar Bal c/d 70,000 Cash A/c 70,000
Errors of Original Entry: A wrong amount is entered
Total 70,000 Total 70,000
into the journal
Complete Reversal of Entries: Account which should
1. Salaries A/c have been debited has been credited
Compensating Errors: Two or more errors cancel each
Date Particulars Amount Date Particulars Amount
other out.
2019 2019 What to do if trial balance does not agree
29 Mar Cash A/c 30,000 Bal c/d 30,000 Check Additions of the trial balance
Total 30,000 Total 30,000 If the difference is divisible by 2 look for a balance
equal to half the difference which may have been
entered on the wrong side
1.7. Trial Balances If the difference his divisible by 9, two figures may
have been transposed in a balance
It is a list of balances on each account to check if the
If its still not agreeing then go back to the start and
Debit side equals the credit side extracted from the ledger check if you have transferred them correctly.
accounts at a particular date

1. Zabine has balanced each account in her ledger, 2. Financial Accounting

together with the cash book at 31 march 2016. She
has then prepared a trial Balance by listing each 2.1. Income Statements
account and balance on it at that date as follows.
Sole trader is the owner of the business who runs the
A/c Debit Balances Credit Balances
business on their own.
  ($) ($) Financial statements (generally):
Premises 70000  
Machinery 10000   Income Trading A/C (give gross profit) and Profit
Statement and Loss A/C (give net profit)
Office Furniture 5000  
Balance
Sales   100000
Sheet/Statement
Sales Returns 700   Show that ASSETS= CAPITAL + LIABILITIES
of Financial
Purchases 6900   Position
Purchases Returns   1000
Trase Receivables 1100   The aim of business is to make a profit; this is calculated
Trade Payables   1575 in the financial statements which are usually prepared at

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CAIE AS LEVEL ACCOUNTING (9706)

the end of a financial year. $ $

Financial statements are prepared from the trial balance
revenue
Trading A/C: concerned with buying and selling goods,
Less : return inwards
calculates gross profit (SPOG- COS).
SPOG (of goods sold) = net sales (Sales less returns) Less : cost of sales
COS= total cost of goods only sold, i.e. Not always all Opening inventory
the goods bought. purchases
COS= OS+P (net purchases, less any additional
Less : purchase returns
purchases drawings and/or returns)– CS
P(net)= Purchases - Purchases Returns + Carriage Less : goods for drawings
inwards- goods for own use. Add: carriage inward
Less : closing inventory
NOTE: Cash discount/discount allowed and discount received
Cost of sales
will not be included in the trading A/C as they arise from the
early payment of debts, and are not sales related. Gross profit
Add : other income (discount received, rent received )
The income statement (PNL and Trading A/C) should have
Less : expenses (wages and salaries, rent and rates,
a heading regarding the financial year/period covered
telephone, insurance, etc )
and the name of the business trading.
Operating profit
A trading A/C can be prepared using a horizontal format
(similar to a T Ledger A/C) or a vertical format.
The profit and loss A/C is concerned with profits, loss, 2.2. Statement of financial position
gains and expenses and other income (e.g.
commission)/expenses (running expenses). This gives you A SOFP of a business on a certain date and shows the
the profit for the year/ net profit (Gross profit + other assets of a business (what the business owns/ its
income –other expenses) resources) as being equal to its capital (amount owed to
The expenses/ income A/C have to be credited/debited the owner by the business/owner’s investment/equity)
(respectively) to be transferred to the IS plus any other liabilities (amount owed to any external
Only the expenses & income that pertain to the financial entity other than the owner). i.e. The assets show how the
year end date have to be transferred to the income resources are being used and the liabilities (including the
statement- matching concept capital- for this case) show where these resources come
In the income/expenses A/C, whenever details are not from.
given and only totals are given, they can be entered as Non-current liabilities are those which are not due in the
‘totals to date’ next 12 months (E.g.: long term loans)
Other than the inventory, gross profit and net profit, only Current liabilities are short term ones (due within the
one entry is made (IN THE INCOME STATEMENT) to next 12 months) and arise from the regular trading
transfer the balances to the IS. activities of the business whose values constantly change
The opening stock of one year is equivalent to the closing (E.g.: trade payables)
stock of the previous year. Assets and liabilities are arranged in different groups:
The income statement has 2 entries regarding the Assets are divided into current (Values are constantly
inventory A/C (IN THE INCOME STATEMENT), one to changing, short term assets which arise from the
transfer the balance at the start of the year as the regular trading of the business, E.g.: Inventory) and
opening stock/inventory and at the end of the year from non-current assets (long term assets which are not
the income statement to the inventory A/C to show the used for resale but help the business earn revenue.
closing stock/inventory (indirectly credited from IS as it is E.g.: Motor Vehicles)
shown as a deduction from the expenses) Non-current assets are listed in order of increasing
The net profit is the return received by the owner for liquidity (liquid= least permanent) (The ability to be
their investment (increases amount owed to owner) and converted into cash), typically: Land and buildings,
shall be debited from IS and credited to the capital A/C Machinery, Fixtures and equipment and motor
and vice versa for a net loss (as it reduces the amount vehicles.
owed to the owner.) Current assets are also listed in order of increasing
The income statement of a service business (E.g.: liquidity (furthest away from cash shown first),
accountant) (One who does not buy or sell goods) will not typically: Inventory, Trade receivables, Other
have a trading A/C as no goods are bought and sold/ Only receivables, Bank, Cash. Trade receivables are said to
a PNL is prepared, however the balance sheet stays the be more liquid as compared to the inventory as they
same. There will be only the titles of Income and can be sold to other businesses.
Expenses Current and Non-current liabilities appear in
ascending order of which liability will have to be paid
Income statement for the year ending 31 dec 2020

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first. Note: Other payables will appear after trade $ $

payables.
Non current liabilities
A SOFP should have the heading to the date to which it
relates and must include the trading name of the Loan from Noor
business. Current liabilities
SOFPs can be prepared in the horizontal (2 sided) Trade payables
(typically assets on the left and liabilities on the right, but
Other payables
reverse is acceptable) or a vertical format, which looks
like an arithmetical calculation Bank overdraft
After all the financial statements are prepared every item Total liabilities and capital
on the trial balance must have one effect (either IS or
SOFP) on the financial statements and additional notes 2.3. Accounting Principles and concepts
will have 2 effects on the financial statements (one on the
IS and the other on the SOFP) Accounting principles are rules applied when recording
The balance of the capital A/C will increase in the SOFP if transactions and preparing financial statements.
the business has made a profit or decrease if the Objectives of a set of financial statements is that they
business has made a loss. provide a true and fair view of the profit or loss of the
If a vertical format of a SOFP has been prepared, the company for the year, and that the SOFP likewise gives a
liabilities are shown after the assets to show where the true and fair view of the state of affairs of the company at
resources come from (reverse is OK). the end of the financial year; true indicates if the
If more than one current liability is present it is listed in transaction actually took place, fair implies transactions
the first column and then totalled and taken to the are shown in accordance with accepted accounting rules
second column. of cost and valuation.
The main advantage of a vertical SOFP is that it shows the There are 11 accounting principles and concepts
net current assets/working capital (current assets- Duality is the understanding that there are two
current liabilities) which is very important . aspects of each transaction. Credit and Debit. It also
The non-current liabilities can be listed before or after the involves the accounting equation.
capital. Business Entity - It is when the business and its owner
In the vertical format of SOFP, the Assets-Liabilities = are regarded as separate existence. A clear example
Capital. Other formats keeping in line with the accounting of this concept is when the owner puts in capital into
equation are also acceptable. the business. The credit in the capital a/c shows that
When the business makes a profit, it is added to the the business owes money to its owner.
capital as the amount owed by the business increases Money Measurement - Transactions which can be
and thus it can be concluded that a profit is an increase in measured in monetary terms are recorded in ledgers.
net assets (capital) The limitation is that non-monetary values such as
Amounts to be subtracted are be put in parenthesis to skill/satisfaction cannot be measured.
make sure they are not added. Historic Cost - Transactions are recorded at their cost
to the business. This ensures objectivity but however
Statement of financial position as at 31 dec 2020
doesn’t consider the changing value of money.
$ $
Realisation - Revenue is accounted by the seller when
Non Current asset it is earned whether cash is received or not
Premises Consistency - Transactions of a similar nature must be
Motor van recorded in the same way.
Office furniture Materiality - Businesses might not record some
transactions using the accounting principles as the
Current asset transaction might be considered insignificant.
Closing inventory Matching/accruals  - Revenue and income must not be
Trade receivables earned more or less same applies to expenses which
Cash and cash equivalents must not be more or less.
Prudence - Profits should not be overstated and
Total assets
losses should be provided for as soon as they are
Capital and liabilities recognized
Capital at 1 January Going Concern - It is when there is no intention to
Add : profit for the year stop the business in the coming future.
Less : loss for the year Substance over form - When recording a transaction,
this concept states that the substance of the
Less : drawings
transaction should be recorded rather than its legal
Capital at 31 dec

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CAIE AS LEVEL ACCOUNTING (9706)

form. Ex. Legally, if a company doesn’t fulfil the year, the amount that relates to the next financial year is
payment of a machine it goes back to the seller, but  subtracted from the total amount and this amount is
in substance the machine is the same as the others, entered under the SOFP as other receivables under
its being used in the process, hence substance over current assets.
form. This amount is deducted from the expense amount in the
Goods on sale or return basis – when a trader sells on trial balance while including in the IS.
sale or return basis to a customer, no sale takes place Inventory of stores as an expense accounts – inventories
until the customer informs the seller that he has decided of consumable stores may be unused at the end of the
to buy them year, as per matching concept these should not be
charged against the profit as they are an asset, this is
2.4. Accruals and prepayments (the carried down as a dr balance hence why an expense
account may have both dr and cr balances.
matching concept) Example: In the year ended 31 dec 2020, Mr. Ceyard had
paid 1200 dollars for stationery, at year end he owed 270
Accruals are an expense which is due withing an dollars for stationery and had an inventory of unused
accounting period but which has not been paid, in the stationery of 400 dollars.
statement of financial position, it is known as other
payables. Stationery Account
Prepayments are payments made by the business in 2020 $ 2020 $
advance of the benefits to be derived from them, this is Jan 1 Dec 31 Income statement 1070
entered as other receivables in the statement of financial
Dec 31 Bank 1200 Dec 31 Inventory c/d 400
position.
Accrued expenses – amount owed to a creditor Dec 31 Amt owing c/d 270
1470 1470
Expense account 2021 2021
2020 $ 2020 $
Jan 1 balance b/d 400 Jan 1 Balance b/d 270
Jan bal. b/d (previous Jan Bal b/d (previous
xx xx
year prepaid) year owing)
The amt owing is carried down and it is included under
Dec 31 income current liabilities as other payables in the SOFP while the
Jan-nov bank xxx xxx
statement 400 dollars of unused inventory would be under current
Dec 31 bal c/d (current assets as inventory of unused stationery.
xx
year owing) Adjusting for income prepayments – incomes received in
XXX XXX advance of its due dates is a payable (income prepaid)
Jan 1 bal. b/d xx and is therefore a credit balance and is under current
liabilities in the SOFP. The amount prepaid is misused
from the amount paid in the IS.
Only xxx has been paid but a different amount(amount
Adjusting for income accrued – incomes accrued at the
relevant to the year) will be dr in the Income Statement as
date it is due indicates existence of debtors and is
it is the cost relating to that year, the bal. b/d will be
therefore a debit balance, this is hence under current
shown in the SOFP under current liabilities as accrued
assets as other receivables in the SOFP, and it is added to
expenses.
the amount received in the bank in the IS.
The accrued amount is added to the expense account.
Prepaid expenses – payment in advance (debtor) Income account
expense account $ $

2020 $ 2020 $ Balance b/d (owing Bal b/d (previous year

xxx xx
previous year) prepaid)
Jan bal. b/d (previous Jan Bal b/d (previous
xx xx Income statement xxx Bank account xxx
year prepaid) year owing)
Dec 31 income Balance c/d (prepaid Bal c/d (current year
Jan-dec bank xxx xxx xxx xxx
statement current year) owing)

Dec 31 bal c/d (current XXX XXX

xxx
year prepaid) Balance b/d xxx Balance b/d xxx
XXX XXX
Jan 1 balance b/d xx 2.5. Provision for the depreciation of
The payments during the year add up by the bank but the
non current asset
income statement has been debited with rent for one

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Capital income: Capital income is when the sale of an Calculation

asset generates income. Cost 100,000
Revenue incomes: Revenue income is income received by
Year1(20% x 100,000) (20,000)
the sale of goods and services daily; day to day
operations. Net book value 80,000
Capital expenditure: it is the use of funds by a company Year2(20% x 80,000) (16,000)
to purchase non current assets such as machinery which 64,000
benefits the business over more than a year Year3(20% x 64,000) (12800)
Revenue expenditure: it is the use of funds by a company
51,200
to run the day to day operations such as lunch for
employees, fuel. Year4(20% x 51,200) (10,240)
Depreciation is a part of the cost of a non current asset 40,960
that is consumed during the period its used. Year5(20% x 40,960) (8,192)
Ex if a machine which lasts for 5 years is used for 1 year 32,768
then the depreciation is the value of the machine which is
Year6(20% x 32,768) (6,554)
used for a year. Depreciation has 2 methods to calculate
the percentage or value to be reduced. 26,214
Purpose of depreciation: the main purpose of
depreciation is to spread the cost of the non-current Henceforth, the residual value is 26,214 dollars moreover if
asset to the useful life to cover the total cost within the the company sells the machine for more than the residual
period of usefulness. In simpler ways, it’s to cover the value the company makes a profit where as if the company
cost with the money earned using the asset. sells it for lesser than the residual value then the company
Concepts that comply with depreciation: makes a loss.
Prudence concept – to avoid overstating the asset
Revaluation method: Used to calculate the cost of
value
consumption in the accounting period of small non
Matching concept –if cost of using non current asset
current asset such as power tool.
was not included in the income statement or profit
This is used to find how much to charge as an
would be overstated.
expense to the income statement when each tool may
Consistency – the same method is to be applied each
have a different useful life while their total value is
year to reflect the usage of the asset.
large, and it may not cost enough to treat them
Reasons for depreciation
separately.
Wear and tear
Opening valuation + purchase during year – closing
Obsolescence
value = depreciation charge
Passage of time
Using up or exhaustion (physical deterioration) When to choose which Depreciation.
How to calculate depreciation:
Straight line method:  the total amount of Straight line: usually used for assets that are expected to
depreciation is the total cost- the residual value or the earn revenue evenly over useful life. Also for assets
value after it completes its period of usefulness . After whose earning power is uncertain.  This method is used
finding that value ,it is then spread over the years of for assets that have fixed lives (leases); easier to calculate,
usefulness. Calculation formula: less risk of mistakes than reducing balance as the
cost of non current asset - residual value/period of provision doesn’t change annually.
usefulness in years Reducing balance method: used when assets earning
Ex. A machine worth 100,000 dollars has a power will diminish as the asset ages. This is also used
usefulness of 10 years after which it would be sold where assets loses more of its value in the early stages of
for 1000 dollars. The total depreciation is 100,000- life.  Example; motor vehicles, computers. Advancements
1000=99000 which when spread over 10 years in technology affects value. Reducing charges for
comes around 9900 dollars per annum. depreciation compensates for increasing repair costs as it
Reducing Balance method: the depreciation is taken ages.
by a fixed percentage on the net book value (written Accounting for disposal of non current assets:
down value) of assets every year.
1.      Debit: Disposal a/c
Ex. A machine costs 100,000 dollars and has a
Credit: Non current assets a/c( original cost**)
period of usefulness over 6 years. Depreciation is
2.        Debit: Provision for depreciation a/c
used to calculate for 20% per annum on reducing
Credit: Disposal a/c
balance. Therefore, the results are in the table
3.        Debit: Bank a/c
below.
Credit: Disposal a/c
Calculation 4.      A debit balance is a loss on disposal

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A credit balance is a profit on disposal Ex if a machine which lasts for 5 years is used for 1 year
Following are the three accounts when accounting for then the depreciation is the value of the machine which is
disposal. used for a year. Depreciation has 2 methods to calculate
the percentage or value to be reduced.
N on current asset at Cost a/c Purpose of depreciation: the main purpose of
depreciation is to spread the cost of the non-current
2020 $ 2020 $ asset to the useful life to cover the total cost within the
Jan 21 Bal b/d xxxx Dec 2 1 Non current asset disposal xxx period of usefulness. In simpler ways, it’s to cover the
cost with the money earned using the asset.
P rovision f or depreciation f or non current asset account Concepts that comply with depreciation:
Prudence concept – to avoid overstating the asset
2020 $ 2020 $ value
Dec Non current asset Jan Bal Matching concept –if cost of using non current asset
xxx xxx
21 disposal 21 b/d was not included in the income statement or profit
would be overstated.
N on current asset disposal a/c Consistency – the same method is to be applied each
year to reflect the usage of the asset.
2020 $ 2020 $ Reasons for depreciation
Dec Non current asset Dec Provision for Wear and tear
xxx xxx Obsolescence
21 at cost 21 depreciation
Passage of time
Bank(proceeds) xxx
Using up or exhaustion (physical deterioration)
Dec Income statement
xx How to calculate depreciation:
31 (loss on disposal) Straight line method:  the total amount of
xxx xxx depreciation is the total cost- the residual value or the
value after it completes its period of usefulness . After
Part exchange: In part exchange, the company gives the finding that value ,it is then spread over the years of
machinery in exchange for a new machine. In this case, usefulness. Calculation formula:
the exchange value of the asset being disposed will be cost of non current asset - residual value/period of
debited to the non current assets a/c and then credited usefulness in years
to the disposal a/c (in place of the proceedings as per Ex. A machine worth 100,000 dollars has a
usual procedure). usefulness of 10 years after which it would be sold
A business may depreciate its assets either: for 1000 dollars. The total depreciation is 100,000-
A full years depreciation 1000=99000 which when spread over 10 years
Month by month basis comes around 9900 dollars per annum.
Exceptional depreciation : when the amount Reducing Balance method: the depreciation is taken
recoverable on disposal is below it net book value this by a fixed percentage on the net book value (written
asset is said to be impaired, in this case this asset down value) of assets every year.
needs to be immediately written down to the amount Ex. A machine costs 100,000 dollars and has a
which would be received if sold. period of usefulness over 6 years. Depreciation is
used to calculate for 20% per annum on reducing
2.6. Provision for the depreciation of balance. Therefore, the results are in the table
below.
non current asset
Calculation
Capital income: Capital income is when the sale of an Cost 100,000
asset generates income.
Year1(20% x 100,000) (20,000)
Revenue incomes: Revenue income is income received by
the sale of goods and services daily; day to day Net book value 80,000
operations. Year2(20% x 80,000) (16,000)
Capital expenditure: it is the use of funds by a company 64,000
to purchase non current assets such as machinery which Year3(20% x 64,000) (12800)
benefits the business over more than a year
51,200
Revenue expenditure: it is the use of funds by a company
to run the day to day operations such as lunch for Year4(20% x 51,200) (10,240)
employees, fuel. 40,960
Depreciation is a part of the cost of a non current asset Year5(20% x 40,960) (8,192)
that is consumed during the period its used. 32,768

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Calculation 2020 $ 2020 $

Year6(20% x 32,768) (6,554) Dec Non current asset Jan Bal
xxx xxx
26,214 21 disposal 21 b/d

Henceforth, the residual value is 26,214 dollars moreover if N on current asset disposal a/c

the company sells the machine for more than the residual
value the company makes a profit where as if the company 2020 $ 2020 $
sells it for lesser than the residual value then the company Dec Non current asset Dec Provision for
xxx xxx
makes a loss. 21 at cost 21 depreciation
Bank(proceeds) xxx
Revaluation method: Used to calculate the cost of
consumption in the accounting period of small non Dec Income statement
xx
current asset such as power tool. 31 (loss on disposal)
This is used to find how much to charge as an xxx xxx
expense to the income statement when each tool may
have a different useful life while their total value is Part exchange: In part exchange, the company gives the
large, and it may not cost enough to treat them machinery in exchange for a new machine. In this case,
separately. the exchange value of the asset being disposed will be
Opening valuation + purchase during year – closing debited to the non current assets a/c and then credited
value = depreciation charge to the disposal a/c (in place of the proceedings as per
usual procedure).
When to choose which Depreciation. A business may depreciate its assets either:
A full years depreciation
Straight line: usually used for assets that are expected to
Month by month basis
earn revenue evenly over useful life. Also for assets
Exceptional depreciation : when the amount
whose earning power is uncertain.  This method is used
recoverable on disposal is below it net book value this
for assets that have fixed lives (leases); easier to calculate,
asset is said to be impaired, in this case this asset
less risk of mistakes than reducing balance as the
needs to be immediately written down to the amount
provision doesn’t change annually.
which would be received if sold.
Reducing balance method: used when assets earning
power will diminish as the asset ages. This is also used
where assets loses more of its value in the early stages of 2.7. Irrecoverable and doubtful debts   
life.  Example; motor vehicles, computers. Advancements
in technology affects value. Reducing charges for Irrecoverable debt is a debt due from a customer which it
depreciation compensates for increasing repair costs as it is expected will never be paid to them.
ages. When the debtor has become bankrupt and is unable to
Accounting for disposal of non current assets: pay
DR :  Irrecoverable debt account
1.      Debit: Disposal a/c CR : debtor
Credit: Non current assets a/c( original cost**) At end of the financial year, this balance will be
2.        Debit: Provision for depreciation a/c transferred to the income statement as an expense.
Credit: Disposal a/c DR : income statement
3.        Debit: Bank a/c CR : irrecoverable debts
Credit: Disposal a/c
4.      A debit balance is a loss on disposal                       Irrecoverable debts accounts
A credit balance is a profit on disposal 2020 $ 2020 $
Following are the three accounts when accounting for Nov 1 Debtor 1 xxx Dec 31 Income Statement xxx
disposal. Debtor 2 xxx

N on current asset at Cost a/c xxx xxx

2020 $ 2020 $ The irrecoverable debts are deducted from the trade
Jan 21 Bal b/d xxxx Dec 2 1 Non current asset disposal xxx receivables in the SOFP
Irrecoverable debts recovered
A debt that has been written off as irrecoverable may
P rovision f or depreciation f or non current asset account
be recovered at a later date if the customer is able to
2020 $ 2020 $ pay
The debt must first be recorded once more on the
sales ledger via journal entry

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DR customers account What is a bank reconciliation statement?

CR irrecoverable debts recovered
Once the amount has been received This is a statement that is prepared periodically to ensure
DR : cash book that the bank account in the business cash book matches
CR : customers account the business bank account shown on the bank statement.
The balance of irrecoverable debts recovered account will This may be due to
be credited in the income statement, it must be shown Timing difference – delay between items being
under gross profit added as part of other incomes. entered in the cash book and the entry on the bank
Provisions for doubtful debts statement
a debt due from a customer where it is uncertain Items on the bank statement that have not been
whether or not it will be repaid by them, it may entered in the cash book (bank charges, interest,
eventually be irrecoverable. It would therefore direct debits, standing orders, et).
overstate the assets if this is not removed making the How to prepare a bank reconciliation statement?
SOFP misleading however it may be wrong to write it Compare the entries in the cash book with the bank
off as an expense as its not yet irrecoverable. statement. Check out the ones that coincide with both
When the provision is first created : places
DR : income statement Enter into the cash book the items that remain
CR : provision for doubtful debt unticked in the bank statement and then calculate the
Afterwards in the year following any increase in the updated cash book balance accordingly.
amounts will be DR in the income statement and CR in Prepare the reconciliation statement. First start with
the provision for doubtful debts, (treated as an expense), the balance on the bank statement and adjust for any
while in the case of a decrease in the amount the reverse items that are unticked in the cash book. The result
is followed hence (treated as an income). should equal with the balance in the updated cash
The provision for doubtful debts is deducted from the book.
trade receivables in the SOFP. Therefore this figure will now be able to be recorded In
How to calculate the amount of a provision for doubtful the statement of financial position.
debts : This division of duties is called internal check in which
Specific – the provision will be equal to the total of external auditors rely on to help them verify the accuracy
those doubtful debts, this amount is based on specific of the financial data
knowledge the owner has of the customers financial Unpresented cheques are cheques payments recorded in
position. the cash book but not yet appearing on the bank
General – provision calculated as a percentage of the statement
total trade receivables. Uses of bank reconciliation
Specific and general – provision is made up of debts Reveal the correct amount of cash at bank, without
that are thought to be doubtful plus a % of the the reconciliation the bank statement and cash book
remainder. will be misleading.
Specific provisions must always be deducted from trade Ensure that the correct bank amount is entered in the
receivables first, before the general provision is statement of financial position
calculated. [total receivables – specific ] x general% = They are a crucial system of control – unintended
general provision. drawings can be avoided, surplus of cash at bank can
be highlighted, if reconciliations prepared regularly
              Provision for doubtful debts account errors can be discovered early.
$ $ Since its prepared by someone else, the chances of
Balance c/d (transferred fraud is reduced.
xxx Balance b/d xxx The formats for the reconciliation include
to SOFP)
Income statement Bank reconciliation statement at 31 march 2016
xxx
(increase in provision) $ $
Balance as per bank statement xx
Provisions for doubtful debts and the concepts
Prudence – the trade receivables should not be Add: items not credited in the bank statement xxx
overstated in the SOFP, the IS should hence provide xxx
for the loss and not overstate profit. Deduct: cheques not presented xxx
Matching – the possible loss of revenue should be xxx (xxx)
provided in the relevant period in which the revenue Balance as per cash book xxx
was earned.

Alternative format :
Bank reconciliation statement at 31
2.8. Bank reconciliation statements march 2016

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$ $ only credit purchases are entered in the purchase ledger

Balance as per cash book xx control account. No cash purchases are entered.
The sales ledger and its control account (trade
Add: unpresented cheques xxx
receivables control account).
Deduct: items not credited on the bank
(xxx)
statement                   Sales ledger control account
xxx (xxx) Bal b/d (total of sales ledger credit
Bal b/d
Balance as per bank statement xxx balance)
Credit sales (sales Sales returns (total of sales returns
journal) journal)
2.9. Control accounts
Refunds to credit Cash received from credit
Control accounts contains the totals of all postings made customers (cash book) customers (cash book)
to the accounts in a particular ledger. Dishonoured cheques
Cash discounts allowed (cash book)
These are usually maintained for sales and purchase (cash book)
ledgers, the totals of the books of prime entry are made Interest charged on
to the ledger, hence the balance of the control account overdue acc (sales Irrecoverable debts (journal)
should equal to the total of the balance of the ledger it journal/cash book)
controls. Total of credit balance Sales ledger balances set off
A control checks on the arithmetical accuracy of a single (if any) (journal)
ledger while a trial balance checks the accuracy of all the
Balance c/d to agree with total of
ledgers. Not part of the double entry. c/d
debit balances in sales ledger
A difference between a control account balance and the
total of the balance of the ledger it controls, helps show
Only credit sales should be entered in the sales ledger
where a cause of a difference on a trial balance may be
control account. Never enter cash sales or provisions for
found.
doubtful debts in a sales ledger control account.
The Purchase Ledger and Its Control Account (trade
Reasons why a credit balance may occur in a customers
payables control acc)
account [ if reversed between buyer and seller, reasons
                        Purchase ledger control account why debit balances occur in a suppliers account]
Bal b/d (total of purchase ledger dr Customer may have overpaid their invoice
Bal b/d Customers may have paid in advance
balances from previously if any)
Customer may have paid invoice in full and later
Total credit
returned some or all of the goods
Purchase returns (purchase returns purchases
Uses of control account
journal) (purchase
It alerts possible errors in the ledgers they control if
journal_
totals of the balances
Refunds from May identify the ledger in errors have been made
Cash paid to suppliers (cash book) supplied (cash Totals of trade receivables and trade payables are
book) provided quickly
Interest charged Reduces fraudulent activity as a control account is
on overdue prepared by someone not involved in maintaining
Cash discounts received (cash book) invoices ledgers [internal check].
(purchases When businesses don’t maintain full double entry
journal) systems, control accounts are a vital part of preparing
Total of dr financial statements.
balance (if any) at Limitations of using control account
Purchase ledger bal set off (journal) end of period in Control accounts may contain errors themselves
purchase ledger They don’t guarantee the accuracy of individual ledger
c/d accounts.
Balance c/d (to agree with the total of cr It may add to business costs although a computerised
accounting system will prepare it automatically,
balance in purchase ledger)
individual with specialist knowledge is required to
verify the accuracy.
Debit balances in the purchase ledger must never be
How to reconcile control accounts with ledgers
netted against (deducted from) the credit balances. The
When there’s a difference between the balance on the
credit balances come under current liabilities as trade
control account as well as the total of balance on the
payables while debit balance are under current assets as
ledger it controls, it has to be reconciled
trade receivables In the SOFP.

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Error of omission: If a transaction is omitted from a incorrectly onto a summary of balances for inclusion in
journal, it will be omitted from the personal account the trial balance. The summary of balances should be
in the sales or purchase ledger and from the control amended and a one-sided entry in the journal prepared
account. Both records will be wrong and the control to correct the suspense account. Such errors are not
account will not reveal the error, hence it will be required to be corrected by debit and credit entries
adjusted in both places The types of errors that don’t affect the trial balance and
Error of original entry: if a transaction is incorrectly are hence not corrected by a suspense accounts are;
entered in a journal, this error will be repeated in the error of original entry, error of principle, error of
ledger it controls and hence in the control account. omission, error of commission, error of complete reversal
Both records will be wrong and the control account and compensating errors.
will not reveal the error; both will need to be adjusted. Note whether or not a narrative is required when
If an item is copied incorrectly from the journal to a preparing the journal entries.
personal account in the sales of purchase ledger, the Revised profit or loss is calculated from the nominal
control account will not be affected, and it will reveal account entries in the journal.
the error.
If the total in a day book is incorrect, the control 2.11. Incomplete accounts
account will be incorrect but the sales or purchase
ledger will not be affected. The control account will Incomplete records: Any method of recording
reveal that an error has been made. transactions that is not based on the double-entry model.
Usually maintained by small business owners who lack
2.10. Suspense account sufficient knowledge of double entry hence resort to
single entry bookkeeping.
Suspense account: An account opened to record a Capital is calculated by listing the assets and liabilities in a
difference between the debit and credit totals of the trial statement of affairs. This is similar to a SOFP. However, in
balance. the statement of affairs the assets and liabilities are only
The following checks are useful: listed. Headings such as non-current assets or current
Check the additions of the trial balance liabilities are not included.
If difference is divisible by 2 then look for balance of Profit/(loss)= closing capital + drawing in the period – new
half the difference on the wrong side capital introduced – opening capital
If the difference is divisible by 9 look for balances Capital or net assets = assets – liabilities
where digits have been reversed like 345 dollars When an asset is valued at more or less than cost, it
entered instead of $354 should be included in a statement of affairs at valuation
Check totals of sales and purchase ledger against the Preparing an income statement and a statement of
control accounts financial position from incomplete records
Check extraction of the balances prepare opening statement of affairs, this allows
If the cause of difference has not been found then a opening capital to be calculated
suspense account may be opened in order to temporarily prepare receipts and payment account(similar to a
balance the trial balance. cash or bank account), this is needed to calculate the
A suspense account is opened in the general ledger with closing bank/cash balances for the closing SOFP
the balance on whichever side of the account will make prepare control accounts for trade receivables and
the trial balance agree when the balance is inserted. If the trade payables in order to calculate sales and
total of the debit side of the trial balance is 200 dollars purchases
less than the credit side, the suspense account is opened Adjust the receipts and payments for accruals and
will have a debit balance of $200 prepayments at the beginning and end of the period.
Types of errors that call for a suspense account to be Calculate provisions for doubtful debts, depreciation
opened include: and any other matters not mentioned above.
When it’s a single entry instead of a double entry Prepare the income statement and statement of
When entries have been made on the same side of financial position from the information now available.
two separate accounts Valuing the inventory at selling price goes against three
When the entries have been made on the correct side important accounting principles:
but the figures differ. realisation – profit was shown as realised in the year
An item on the wrong side of an account must be ended 31 December 2015 even though no sale had
corrected by an adjustment equal to twice the taken place.
amount of the original error (once to cancel the error matching – the profit has not been matched to the
and once to place the item on the correct side of the time the sale took place.
account). prudence – the profit was overstated in 2015; it was
Some errors do not affect the double entry; an example not even certain then that the goods could be sold at
would be a balance on a sales ledger account copied a profit.

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It is an important principle that inventory should never be Partnership agreement: An agreement, usually in writing,
valued at more than cost. Valuing inventory at historic setting out the terms of the partnership
cost observes the principles of realisation, matching and Partnership Act 1890: The rules which govern a
prudence. partnership in the absence of a formal partnership
Another important principle is that the method used to agreement
value inventory should be used consistently from one All partners are entitled to contribute equally to the
accounting period to the next. capital
Incorrectly valuing inventory, either by mistake or Partners aren’t entitled to interest on capital
deliberately, will result in the income statement showing Partners aren’t entitled to salaries
the wrong gross profit and profit for the year as well as No interest charged in their drawings o Partners will
the current assets in the SOFP will be incorrect. Which is share profit and losses equally
hence misleading leading to wrong decisions being made. Partners entitled to interest at 5% per annum on
Inventories should be valued at the lower of cost and net loans made to partnership (this will be considered as
realisable value. Cost has already been considered. net an expense and treated as any other loan; debited
realisable value is the price that may be expected to be into the income statement)
received from the sale of the goods, less the cost of Appropriation account: An account prepared after the
putting them into a saleable condition. income statement. It is used to show how the profit for
Margin and mark-up the year is divided between each partner.
Margin is gross profit expressed as a percentage or Partnership salary : a share of the partnership profit
fraction of selling price: for the year paid to one (or more) of the partners in
Profit/selling price x 100 addition to their normal profit share usually for extra
Mark-up is gross profit expressed as a percentage or skill or work undertaken, these are never debited to
fraction of cost of sales. the income statement as expense.
Profit/cost price x 100 Interest on partners capital : A share of the profit for
If margin is 1/3 then markup is 1/(3-1)=1/2 the year (usually) based on a percentage of the
If markup is 1/6 then margin is 1/(6+1)=1/7 amount of fixed capital each partner has contributed
Markup and margin is useful in calculating inventory lost to the partnership
in fire or theft. Interest on drawings: A charge made on the annual
Advantages of keeping full accounting records drawings made by each partner, usually calculated as
Allows financial statements of business to be a percentage of the drawings made.
prepared quickly soon after year end
Allows financial statements to be prepared more than Draft of appropriation account
once a year which may help the manager run more $ $
efficiently PRofit for the year xxx
Helps guard against errors and possible fraud by Add: Interest on drawings - A xxx
employees as inventory or cash loss can be picked up
-B xxx xxx
early
Accuracy of the ledgers can be improved
xxx
May be a legal requirement to keep certain records Less: Interest on capital - A xxx
Disadvantages of keeping full accounting records -B xxx (xxx)
Time taken to set up and maintain them Less: Partners salaries - A (xxx)
Cost of purchasing a computer package along with xxx
training cost
Profit share - A (profit share %) xxx
Business owners may lack expert knowledge on how
to prepare double entry which may lead them to - B (profit share %) xxx (xxx)
employ a specialist which may be costly. 0
How far owners go to keeping financial records for
business depends on Preparing partnership accounts
Accounting knowledge and skill of owner Capital account An account to record the sum of
Time available to write up records money which a partner introduces into the
Cost of employing a member to prepare accounting partnership. It is only adjusted for any further capital
records introduced, any capital withdrawn, any share of
goodwill or any profit on the revaluation of
2.12. Partnership accounts partnership assets.
Partnership capital account

AB AB
A partnership is formed when two or more people carry
on business together with the intention of making profit

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AB AB profit share ratio, afterwards once the change is

Balance b/d (profit from imposed the profit/loss following must be shared in
Capital Withdrawn share from appropriation the new ratio. Hence causing realised or unrealised
profit or losses to occur.
acc)
Realised profit/loss : recognised in the income
:pss share (from
Capital introduced statement such as revenue or expenses these are
appropriation acc)
apportioned on a time basis however exceptional
Revaluation loss Revaluation gain cases such as a change in the interest of a partners
Balance c/d loan would require it to be apportioned on an actual
basis o Unrealised profit/loss : gains/losses arising
Current account: An account which records a partner’s from revaluation of assets and liabilities at the date of
share of profits and any drawings made by them. the change resulting in adjustments to partners
Partners current account capital.
Revaluation of an asset in a partnership : this is done to
A B A B reward the existing partners for their efforts in building
$ $ $ $ up the business over its life. In the case the partner
Drawings x x Balance b/d x x retires it is only fair they are rewarded for their efforts as
Interest on drawings x x Interest on loan x x well
step 1 : DR revaluation account CR asset account(book
Balance c/d xxx xxx Interest on capital x x
value of being revalued)
Partners salary x x step 2 : CR revaluation account DR liability
Share of profit x x account(book value of the liability)
xxx xxx xxx xxx step 3 : CR revaluation account DR asset account(new
Balance b/d xxx xxx value of the asset )
step 4 : DR revaluation account CR liability
account(new value of the liability)
Drawings account
an alternative method could include
If partners do not maintain current accounts, the
Revaluation account
double entry for interest, their salaries and shares of
profit must be completed in their capital accounts Decrease in asset value Increase in asset value
Advantages of partnerships
Increase in liability value Decrease in liability value
The capital invested by partners is often more
than can be raised by a sole trader. Profit on revaluation Loss on revaluation
A greater fund of knowledge, experience and - Partner A - Partner A
expertise in running a business is available to a - Partner B - Partner B
partnership.
A partnership may be able to off er a greater The remaining balance will be the profit or loss on
range of services to its customers (or clients). revaluation which will be shared between the partners in
The business does not have to close down, or be the current profit sharing ratio in the capital account
run by inexperienced staff , in the absence of one If the balance was on the debit side it will be a profit on
of the partners; the other partner(s) will provide revaluation, if the balance was on the credit side it will be
cover. a loss on revaluation.
Losses are shared by all partners. Accounting for goodwill : Goodwill is the amount by which
Disadvantages of partnerships the value of the entity or partnership as a going concern
A partner doesn’t have the same freedom to act exceeds the net value of its assets if they were sold
independently as a sole trader has. individually. It is an intangible asset
A partner may be frustrated by the other There are two types of goodwill : purchased goodwill and
partner(s) in their plans for the direction and inherent goodwill
development of the business. Purchased goodwill arises when one business buys
Profits have to be shared by all partners. another, if the purchaser pays more then the net book
A partner may be legally liable for acts of the other value of the assets the difference is goodwill, IAS allows
partner(s) this to be shown as an intangible non current asset in the
SOFP
2.13. Partnership changes Inherent goodwill is internally generated and is not paid
for and so does not have an objective value.
When partners agree to change the profit/loss share Goodwill is never brought into the revaluation account or
The profits/losses incurred before the change in the current account.
shares must be shared among the partners in the old

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Goodwill is not recorded for two reasons; value placed on After revaluation and goodwill entries in the capital
goodwill is difficult to justify and if goodwill is included it account balance the retiring partners column in the
would be difficult to convince a buyer to pay more for the capital account the missing figure is the amount
business. payable to the retiring partner, shown below
When there’s a change in the partnership (change in A pay cash or cheque DR retiring partners capital
profit sharing ratio or admission/retirement of an existing CR cash/bank
partner) goodwill will need to be adjusted, the following B retiring partner takes asset of the business DR
could be done : retiring partner capital account CR asset account
Goodwill could be opened and maintained: DR C transfer amount payable to a loan account by
goodwill CR old partners capital [old ratio] DR retiring partners capital account CR loan a/c
Or goodwill account can be opened and removed Partnership dissolution
subsequently This is the process by which all the assets of the
Step 1 : CR partners capital account with share of partnership are sold and liabilities paid where the
goodwill in the old profit sharing ratio DR goodwill partnership ceases trading
Step 2 : DR partners capital account with share of Reasons for dissolution
goodwill in the new profit share ratio CR goodwill Partnership is no longer profitable
Capital account Partners disagree on borrowing the partnership
and can no longer work together
X Y X Y Partner has died, retired or being declared
Goodwill (shared in Goodwill (shared in bankrupt and remaining partners agree to close
xxx xxx xxx xxx
new ratio; step 2) old ratio; step 1) down the business
When a partnership business is being taken over
\
by a limited company or by another partnership or
being merged with another business
When apportioning profit while there’s a change in the Steps involved with partnership dissolution
profit share ratio in the middle of the financial year Transfer all assets and liabilities to the realisation
If the profit is assumed to have been earned evenly account except the bank balance. Realisation
throughout the year, it should be divided between the old account: An account prepared when a partnership
and new partnerships on a time basis is ceasing to trade, to record the book value of the
Some expenses may not have been incurred on a time assets and liabilities and how much is received for
basis and must be allocated to the period they belong them if sold, or paid out in respect of liabilities.
these expenses will be specified, this can be done by The result will be a profit or loss on realisation.
splitting the gross profit between the two trading periods Enter the bank balance in the bank account
before and after the change in the terms of agreement Enter the capital balance in the capital account
Admission of a partner/when a partner leaves If there is a current account balance transfer them
When a partner leaves or a new partner joins, it to the capital account
suggests the end of partnership and the start of a new Show all the entries related with the sale of the
one, the following accounts must be taken care of asset settlement by DR bank CR realisation
\ Show the entries of the dissolution expenses by
1. Asset revaluation – calculate the profit/loss on DR realisation account CR cash/bank
revaluation Balance the realisation account and transfer it to
\ the capital account, if the balance is one the debit
1. Adjustments for Goodwill side of the realisation then it is a realisation profit
\ and should be credited to the capital account in
1. Prepare the income and appropriation account the profit sharing ratio.
for the two periods before and after the Balance the partners capital account and transfer
admission the missing figure to the bank account
\ The bank account should balance
1. Changes in the profit share ratio
\ DR realisation CR asset account DR liabilities CR realisation
1. Prepare the current account Realisation Account
Death/retirement of a partner $ $
The following takes place when a partner retires Non current asset (at cost) Trade payables
Revaluation of the assets and liabilities
Inventory Other payables
Goodwill adjustment
Trade receivables
Settlement of retiring partner : transfer the
current account balance of the retiring partner to Other receivables
the capital account

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Shares issued at a premium – this is the excess over the

2.14. Limited companies
nominal or par value of a share when it is issued, this is
A limited company is a separate legal entity whose known as a capital reserve and is hence non distributable:
DR bank/cash account (with the total cash received for
existence is separate from its owners; the liabilities of the
the issue)
members are limited to the amounts paid (or to be paid)
CR share capital account (with the nominal value of the
on the shares issued to them i.e. limited liability
when a company is formed certain documents are share)
CR share premium (with the premium received)
registered by people who are the founders with the
Revenue reserves – The profits made by a company which
registrar of companies and various fees and duties are
have not been distributed to shareholders, these are
paid to the registrar
created by transferring an amount from profit for the
the two documents needed are the articles of association
(this is the main constitutional document of a company year. These may be created for a specific purpose
(replacement of non current asset, planned expansion,
that defines the existence of the company and regulates
etc) or general reserve to strengthen the financial
the structure and control of the company and its
position of the company. These are usually distributable
members ) and the memorandum of association ( this
forms part of the article and defines the relationship of and used to pay dividends; retained earnings and general
reserve come under this class of reserve
the company to the rest of the world )
the main difference between private and public Capital reserve - Gains which (usually) arise from non-
trading activities, such as the revaluation of a company’s
companies is that public companies are allowed to offer
non current assets, they represent gains that haven’t
their shares to the public and may arrange for the shares
been realised yet, these may include
to be bought and sold on the stock exchange while
private companies cannot. Share premium – usually to pay up unissued shares to
existing shareholder as fully paid bonus issue, to write
Capital structure of a limited company
off expenses arising on new share issue at premium
Authorised share capital – the share capital the
and to write off any commission paid on new share
company is allowed by law to issue to the public.
issue at premium
Issued capital – total amount the company has issued
on the stock exchange Capital redemption reserve – created when a
company redeems or buys back shares from existing
Called up capital – the amount of shares taken up by
shareholders without using the proceeds from issue
shareholders without having to pay the entire
of new shares created by DR retained earnings CR
amount, usually in instalments
Paid up share capital – part of share capital for which capital redemption
Revaluation reserve - A company may revalue its non-
the company has actually received cash from
shareholders current assets and any gain on the revaluation must
be credited to a revaluation reserve; it is an
Classes of shares
unrealised profit and must not be credited to the
Ordinary share capital – also known as equity of the
income statement. May be used in bonus issues.
company, they are entitled to attend the AGM and
vote on propositions, they are paid a dividend on the Income statement for a limited company as per IAS 1
profit that remains after preference dividend id paid, X’s income statement for the year ended ………
they are hence the risk takers as they may not receive
     $
dividends at all, all the reserves also belong to them
Preference share capital – a share which doesn’t give
Revenue
the owner any ownership rights in the company, (-) cost of sales
dividends are normally received at a fixed rate, Gross profit
payable before dividends to ordinary shareholder. (+) operating income
These may be redeemable of non redeemable, if its (-) distribution costs
redeemable companies can buy back the shares and
(-) administrative expenses
hence will appear under non current liabilities. Non
redeemable would mean the company cannot buy Profit/loss from operations
them back and will appear as equity along with (+) finance income
ordinary shares. (-) finance cost
Non cumulative preference share – not entitled to Profit before tax
have any arrears of dividends carried forward to
(-) taxation
future years if profits are insufficient to pay
dividends in full Profit for the year
Cumulative preference shares – entitled to have
arrears of dividends carried forward to future The statement of financial position as per IAS 1
years If profits are insufficient 
X Limited’s statement of financial position as at ……….

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  $   SHARECAPITAL SHAREPREMIUM GENERALRESERVE

Non current asset (net book value):   BONUS
X (X)
Plant Property Equipment  ISSUE
Intangible assets (goodwill) TRANSFER
TO
Long term investments X
GENERAL
Current assets:
RESERVE
Inventory
TOTAL
Trade receivables (BAL C/D)
Other receivables
Short term investments Any dividends that proposed will not be shown in the
Cash and cash equivalents financial statements
Provisions are an amount set aside out of profits to
Total assets
reduce the recorded value of an asset or to cover an
Equity:
expected liability even if the exact amount or timing of
Ordinary share capital the liability is uncertain.
Retained earnings Dividends of two types, interim dividends and final
Share premium dividends, interim dividends are paid to existing
General reserve shareholders during the year given the directors are
satisfied with the profits and cash resources are
Non current liabilities:
sufficient while final dividends are paid after the end
Bank loans of the financial year while director can only
Debentures recommend the amount of dividend to be paid,
Current liabilities: shareholders must approve the payment
Trade payables Distributable profits consists of accumulated realised
profits which has been undistributed and its
Other payables
accumulated realised loss which haven’t been
Tax payable previously written off.
Bank overdraft Difference between shares and debentures
Total equity and liabilities
Share Debentures
The above format is for accounts which will be published Shareholders are members §  Debenture holders are
by the company and available for the general public to of the company. creditors to the company
look at, internal accounts will be in much more detail Shown in the statement of
Shown in the SOFP under
than this. financial position under
non current liability
IAS 1 allows for alternative ways of setting out the equity
statement of changes in equity. One such alternative is to Shareholders are the last Debenture holders are
prepare a statement of recognised income and expenses. people to be repaid when a entitled to be repaid before
This is much less detailed, as it includes such things as company is wound up shareholders are wound up
the profit for the year and gains on revaluation of non-
Dividends can only be paid if Interest on debentures must
current assets. But no dividends paid or share issue
distributable profits are be paid even if no profits are
Statement of changes in equity
available made
This is a statement prepared to show the changes in a
company’s share capital, reserves and retained earnings They receive an interest
over a reporting period. Dividends are an which is shown under finance
appropriation of profit. cost as an expense in the
Statement of changes in equity for the year ended … income statement
  SHARECAPITAL SHAREPREMIUM GENERALRESERVE RETAINEDEARNING TOTAL
OPEN BAL X X  X Bonus
X share issue
X – this is an issue of free shares to
existing shareholders from the accumulated reserves of
PROFIT X X
the company usually in proportion to the existing
DIVIDEND (X) (X)
ordinary shares using their reserves with no payment
SHARE The capital reserves are used for this (share premium)
X X X
ISSUE Share capital will increase on the SOFP
RIGHTS Reserves will decrease
X X X
ISSUE

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Example : if directors made a bonus issue of shares on the  Internal stakeholders Reasons for interest
basis of three for every five shares held To assess business
3/5 x the number of issued shared x par value  Owner [in the case of a sole performance. \n To identify
DR reserves                           CR share capital
trader or partnership]   areas of problem and take
If its in the most flexible form the least flexible reserves are corrective action.
used first the least being share premium and most flexible
Assess overall performance.
being general reserve.
Consider the security of their
Rights issue – the purpose of rights issue is to raise Existing shareholders investment. Return in terms
finance further for the company, this offers existing of dividends and capital
shareholders opportunity to purchase additional shares growth
at a price below the current market price, the Salary and bonus often linked
Managers and directors
shareholders can either take up the shares and pay for it with business performance.
or sell the rights on the stock market. To see if future pay or salary
Workers increases will be made and if
Example, the company made a rights issue of one new share
they have job security
for every five shares already held. Then
1/5 x no. of issued shared x selling price External stakeholders Reasons for interest
DR cash/bank  [total amount received ] Assess if loan overdraft
CR share capital [rights issue x par value] should be granted. Interested
CR share premium [rights issue x share premium ] Banks to see if the business can be
           Rights and bonus issues compared able to pay back existing
Rights issue Bonus issue loans
§  Shareholders don’t pay for Comparing several returns
Subscribers pay for shares
shares Future shareholders from several businesses and
The company net assets The net assets of the decide which to invest in
increased by cash received company are unchanged Investors [an individual who Determine the return they
Shareholders do not have to All the ordinary shareholders has been asked by the owner will receive and the security
exercise their right to will receive their bonus to invest fund] of any investment
subscribe for the new shares shares Whether or not to supply to
Shareholders may sell their Shareholders may sell their the business. To check if the
Supplier of the business
rights if they do not wish to bonus shares if they do not business is liquid enough to
exercise them wish to keep them pay back
Assess performance to see if
Other sources of finance for a limited company may Customers of the business business will be able to
include supply to them In the future
Bank loans Level of tax charged on profit.
Bank overdrafts To decide whether or not to
Hire purchase - Hire purchase enables a purchaser to Government give a grant. Check if
have the beneficial use of an asset while the business is in compliance
ownership of the asset remains with the hire with laws and regulations
purchase company, at the end of the agreement the
If the business will provide
company may own the asset Local community
employment
Leasing – the asset is leased to the company for a
rental charge by a leasing company who will own the
Assess their profitability to
asset, the asset will never be owned by the company Trade unions see if their members pay
Long term capital could increase
Trade payables Whether or not the business
General community
Working capital is operating ethically

2.15. Analysis and communication of The purpose of financial statements, such as the income
statement and statement of financial position, is to
accounting information to stakeholders present information in a meaningful way. To be useful,
information must be clear, complete, reliable and timely.
Stakeholder concept : individuals who are interested in Limitations of published accounts
the decisions taken by the business and are as a result Not clear to people who have insufficient knowledge
affected by it on accounting

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Information given isn’t complete, crucial data may be have had to reduce its mark up because of more
confidential. competition.
Comparability is limited as accounting policies used Expenses to revenue ratio
differ Formula:
Historic nature; information relates to past and operating expenses/revenue *100
circumstances may have changed. Comment: how effective are the managers in
Accounting ratios controlling business expenses. In some cases.
Profitability ratios overheads may increase as a percentage of sales,
Return on capital employed but the increase may not match the increase in
Formula: gross margin. The reason is that most overheads,
Operating profit/capital employed*100 such as rent, do not vary as a result of an increase
Comment: how much profit was generated per in sales. Other overheads may vary although not
100 dollars invested in the form of equity, reserves in proportion to sales.
and long term liabilities. This measures the overall Liquidity ratios
efficiency of a company in employing the Current ratio
resources available to it, this should be compared Formula:
with the previous years ROCE, with competitors Current assets/current liabilities : 1
and the industry average. The higher it is the Comment: shows the relationship between
better, this indicates the business is efficiency current assets and current liabilities, if the
managing its equity. business is liquid enough to pay creditors. A
Gross margin higher ratio may indicate the business has enough
Formula: funds to pay the current liabilities. A favourable
gross profit/operating profit*100 range for this ratio would be 1.5-2 : 1. But this
Comment:  how much gross profit was generated depends on the kind of business, a low ratio could
per 100 dollars in sales, how efficient the trading mean danger, a high ratio could mean the
activities of the business. The higher the figure the resources aren’t put to efficient use and capital is
greater the business is at converting revenue to lying idle as a result instead of being used
gross profit. A lower gross profit would indicate profitably.
that Liquid ratio [acid test ratio]
A rise in the price of goods purchased which Formula:
weren’t passed onto customers. current assets - inventory/current liabilities : 1
Purchase of goods from a difference supplier Comment: excludes inventory from the calculation
at a higher price. and shows liquid assets that is available to pay the
Selling price may have been cut to increase current liabilities. A good range would be 1-1.5 : 1.
volume of sales, to fight competition, as an Businesses like supermarkets  would expect their
introductory offer for a new product, as a sales on a daily basis having a constant inflow of
result of seasonal sales, to get rid of old cash, while they enjoy a period of credit to pay
inventory, to increase cash flow. suppliers their ratio may not exceed 0.8:1. A motor
The cost of sales may have increased by the manufacturer on the contrary would have more
theft of inventory. current assets then current liabilities making it
Profit margin: seem unfavourable without knowing the business,
Formula: hence making acid test ratio more suitable.
profit for the year/sales X 100 Efficiency ratio
Comment: how much profit is generated from Non current asset turnover
revenue, this indicates how efficiently the business Formula:
can convert revenue to profits, a lower percentage  net revenue/total net book value of non
would indicate that the business has not been current assets
able to control its expenses. Comment: number of times the non current
Mark up assets are turned over, how well the non current
Formula: assets are used to generate revenue. The main
gross profit/cost of sales * 100 reason for purchasing a non-current asset is for it
Comment: how much business has marked up to either generate revenue for the business or
costs before arriving at the selling price. A fall in reduce cost, both of which will hopefully increase
this ratio is bad for the company as it indicates the profit. The higher the ratio is better.
they may have has to buy from more expensive Trade receivables turnover [in days]
suppliers and unable to pass the full increase in Formula:
purchase price to its customers. A business may trade receivables/credit sales * 365

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Comment:  how long it takes credit customers to Cost accounting is a method of accounting where all costs
pay back (credit period). The longer customers relating to a certain activity are grouped together,
take to pay, the company may be losing control classified and recorded
over its customers and deteriorating cash flow, Management accounting is the process of preparing
the risk of incurring irrecoverable debts is higher. reports and accounts to be used by internal parties such
Trade payables turnover [in days] as managers for decision making on future performance
Formula: of the business
trade payables/credit purchases*365 Direct costs are costs incurred with directly relate to the
Comment:  length of time the business takes to production of the good or service example: raw materials,
pay its creditors. The longer it takes to pay its carriage inwards, royalties.
creditors would mean that cash outflow would be Indirect costs are costs that aren’t directly linked with the
less, however this may result in suppliers may production of goods and services example: cleaning
withdraw their credit facilities in the future. materials, supervisor salary, factory managers.
Inventory turnover [in days] Fixed costs are costs that remain unchanged while the
Formula: level of output or activity increases or decreases,
average inventory/cost of sales * 365 example: rent
Comment: how it takes for the inventory to be Stepped fixed cost is cost that does not change within
sold. The quicker the inventory is sold, the sooner certain high or low threshold of the activity but which will
the profit is realised and the more times profit is change once these thresholds are breached
earned. A slow turnover would mean excessive
inventory is held and risk of obsolete or spoiled
inventory increases, hence inventory being locked
up would mean it is not earning revenue. Days
must be rounded up.
Rate of inventory turnover times
Formula:  
cost of sales/average inventory
Average inventory is found by adding up the
opening and closing inventory divided by 2.
Comment: the number of times a year the
inventory is turned over. Businesses like
supermarkets would have a higher turnover than
a for instance a business like a diamond retailer.
Working capital cycle Variable costs are costs that varies on the level of output
Formula: of activity, example: direct costs that vary in proportion to
inventory days + trade receivables days - trade the number of units produced
payables days Cost unit is the unit of output of a business to which costs
Comment: The working capital cycle measures the can be charged
time it takes for cash to circulate around the IAS 2 allows two different methods for valuing direct
working capital system. It calculates the interval material inventory.
that occurs between the time a business has to LIFO is another inventory costing method where the most
pay its creditors (trade payables) and the time it recently produced items are sold first; opposite to FIFO.
receives cash from its customers. This is appropriate for businesses that mainly deal with
Limitations of ratio seasonal demand.
Some useful information may not be disclosed First In First Out (FIFO) – assumes that the first goods
Information may not be timely available only available received by the business will be the first one to be
at year end delivered to the final customer of the department
Ratios don’t explain the cause of the change in results requisitioning the good; goods used in the order they
Ratios don’t recognise seasonal factor were purchased.
The benefits of using FIFO;
Based on most recent prices
3. Elements of costing and Generally realistic, sales made from the oldest
item of inventory first especially if perishable
management accounting Acceptable under IAS 2
Issued prices based on prices actually paid for
3.1. Costing for materials, labour and purchase
Relatively simple system to use
overheads The drawbacks of using FIFO;

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In times of inflation, closing inventory will be Cost centres are any location in a department to
priced at the latest prices causing a lower cost of which costs may be attributed.
sales and higher gross profit. Production cost centres are locations which are
Identical items from batches bought at different directly involved in producing goods
times for similar jobs will be charged at a different Service cost centre are locations which are not
price, making it unreliable. involved in the production of goods but provide
Average cost (AVCO) – requires calculation each time new services for the production cost centres eg, stores.
goods are received, when materials are returned to stock Allocation of costs is charging costs directly to the cost
they should be valued at price of issue, this is a perpetual centres which can be directly identified with them, for
inventory system this is valued by adding the new instance wood, metal, plastic, components and
purchased invoice to the present inventory and dividing it chemicals are allocated to the production
by the purchased quantity and the existing number department. Packing materials are allocated to the
quantity to obtain weighted average. packing department.
The benefits of using AVCO; Apportionment of cost is the process of charging
Avoids inequality of identical items being charged costs to cost centres using a suitable basis, these
differently for similar jobs. costs cannot be directly identified with a single cost
Smoothen variation in production costs making centre.
comparisons more meaningful.
Closing inventory valued fairly close to latest price Overhead Basis of apportionment
Acceptable under IAS 2. Rent and rates, heating and
Weighted average price recognises all issues have lighting, building
Floor area
equal importance. depreciation, insurance,
The drawbacks of using AVCO; building expenses, rent 
Average price must be calculated after every Actual consumption Power
purchase.
Depreciation, insurance of Cost or replacement value of
Average price does not represent any price
plant and other machinery asset
actually paid for inventory.
Periodic inventory system is where the business
Storekeeping costs, material
Store requisition
calculates the value of the closing inventory at the end of
handling costs
a period instead of prior to each receipt. Closing Welfare costs, canteen costs,
inventory is calculated by opening inventory + purchased administration costs, No. of employees
qty – issued qty supervision
If its FIFO per unit will be the last purchased price and if Machines repairs Machine hours
its AVCO per unit of closing inventory will be:
Opening inventory (amount) + purchases(amount) / Steps to absorption costing
opening inventory (units) + purchases(units) if a manufacturer has four production cost centres;
Ways in which labour is paid moulding, machining, painting and packaging, Given
Hour rate – common method direct workers basis for each department for rent is floor area of
Piece rate – based on the level of output 1000m2 , 700m2 , 500m2 and300m2 respectively. If
Annual salary – usually for office staff or managers as rent was 45000 dollars, the cost will be apportioned
an indirect labour cost. as  below
Employees may also receive additional amount such
as overtime and bonus payments Expense Moulding  machining Painting Packaging
Using overtime and bonus payments are beneficial as; Rent 18000 12600 9000 5400
Increase productivity
Greater number of units, maybe increase total
This is known as primary apportionment Overhead
profits.
analysis sheet
However,
Rush workers at the expense of quality.
If Extra production cannot be sold, inventory
holding cost will increase.
May not be able to pass the extra cost to
customers

3.2. Absorption costing

Apportionment of overheads to cost centres.

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If absorbed overheads was however greater than actual

overheads then this will result in over absorbed
Reasons for under absorption
Actual expenditure is greater than budgeted
Production is less than the planned level, not enough
overheads has been charged to production.
Reasons for over absorption
Actual expenditure is less than budgeted expenditure
Actual production is more than the planned level, too
much overhead was charged to production.
Benefits of absorption costing
Acceptable under IAS as well as GAAP
Accounting for all production cost not just direct cost
hence giving a complete picture of the cost per unit,
After apportionment, If the service cost centres provided more realistic selling price as a result
services to the production cost centres they will need to Gives a better view on profitability then variable cost
be reapportioned to the production centres on suitable especially if not all products are used during the same
bases, the simplest and quickest method is the period.
elimination method (this is where the service costs are Better suited for companies which have constant
apportioned using bases which don’t involve the service demand for products
sot centre in question). Drawbacks of absorption costing
Another method is the reciprocal method as shown As this is based on both fixed and variable costs, this
below where the cost centres are apportioned until they method cannot be used for management decision
reach immaterial values making or planning further actions like budgeting
Absorption makes It difficult to do cost volume profit
analysis, as with additional fixed cost, the variations in
the variable cost becomes difficult to determine.
Making it difficult to assess efficiency and
effectiveness.
Profits are needed to be adjusted for over and under
absorption of fixed costs, this can make the
calculation of profits difficult and complicated
especially when the company has too many products.

3.3. Unit, job and batch costing

Continuous operations are typically those in which a
single type of good is produced and the cost units are
Calculating the Overhead Absorption Rate [OAR] : rate at identical. Production may involve a sequence of
which costs are apportioned to a cost centre are charged continuous or repetitive operations such as oil refining.
to the cost unit passing through it, OARs are used to Continuous costing is used to find the cost of a single unit
calculate overhead attributed per unit, it is calculated by: of production[ unit costing=total cost/output]
budgeted production overheads/budgeted activity Specific order operations are those which are performed
level (labour hours or machine hours)    in response to special orders received from customers,
Usually both direct labour and machine hours are this may be job or batches
given**, always** choose the greatest and never add the Job costing is a costing method that calculates the cost of
two sets together meeting a specific customer order or job such as re
Once the OAR rate is found this will be multiplied by the painting a house
number of hours used to make the product to obtain the
A job quotation may look like
amount of overhead absorbed per unit
Job no.282
Under/over absorption is calculated by:
Installation of central heating at xxx
Actual overheads XXX Estimated costs $ Actual cost $

(less) absorbed overhead (OAR * actual hours) (xxx) Materials 2800 2670

Under absorbed xxx Labour 1800 2150

Overhead 3500 3380
Total cost 8100 8200

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Estimated costs $ Actual cost $ equation can also be used; total f

c
ixed cost
ratio ​

s ​

Add: profit 25% of cost If there the business has a target profit set the breakeven
Amount of quotation 2025 1925 level of output will be calculated by:
10125 10125 \frac{fixed\ cost + target\ profit}{contribution\ per\
unit}
Breakeven charts are diagrammatic representation of
Once the quotation is accepted the costs will be recorded
profit or loss to be expected from the sale of a product at
on the job card as incurred, the actual costs may however
various levels of activity.
differ from the quoted amount, in that case the business
is only charging the quoted selling price hence causing
profit to either increase or decrease
Job cards would provide useful information the next time
the business receives a request for a similar job, directors
can identify areas of overspend and take corrective action
for future jobs since they are focused on a specific area.
Batch costing is where the costing procedure to find the
cost of a number of identical items produced
Similar to job costing the selling price on the quotation
will be agreed and fixed, if everything goes as per plan
the same profit may be made however if costs prices or
labour hours deviate this might cause profits to fall
This allows the business to plan for its future.
Cost volume profit analysis is a way of finding out how
Costs for a batch of 500 chairs changes in variable and fixed cost affect a firms profit.
$ $ These are used by companies to see how many units they
need to sell to breakeven or reach a certain minimum
Direct materials X
profit margin.
Direct labour : Machining x Margin of safety  is the difference between the breakeven
Finishing x point  and the level of sales , this is found by total units
Assembly x sold - breakeven level of output or the following equation
prof it
Prime cost x is used to calculate margin of safety rate c
s ratio
​

Production overhead recovered (no of hours * OAR) x Profit volume chart is a type of breakeven chart which
Machining x only shows the profit of loss at each level of output.
At 1000 units of output the business incurs neither a
Finishing x
profit nor a loss, the units exceeding the BEO is the
Assembly x margin of safety which is 1000 units.
Cost of production x
Add: administration costs x
Total cost of batch of 500 chairs
Profit x
Selling price xx

3.4. Marginal costing

Marginal costing is the cost of making an extra unit of
output.
Contribution is the difference between the selling price Limitations of breakeven charts
and the variable cost of a unit of output. it assumes there are no changes in the level of
selling price - variable cost per unit inventory, everything produced is assumed to be sold
Contribution to sales ratio (C/S ratio) is the ratio of during that period which is unrealistic.
contribution to the selling price, calculated by; It doesn’t allow for a mix of products and is usually
contribution
sales ​ × 100 calculated for a single product which.
Break even point is the level of output in which the Cost behaviour is assumed to be either fixed or
business makes neither a profit nor a loss, total variable, so semi variable costs are not considered.
contribution is exactly equal to total fixed costs. Similarly stepped costs are also not included
total f ixed costs
contribution per unit  to find the breakeven sales this is
​ Variable costs are assumed to be perfectly linear with
multiplied by the selling price or the following the level of production so changes in costs such as

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bulk purchase discounts or overtime rates aren’t Step 4: based on the answer, state the rank in
considered. descending order
The selling price is assumed to remain fixed Step 5: calculate the optimum production capacity,
throughout the year so seasonal sales or discounts produce a revised production plan considering the
aren’t considered, this is misleading. shortage
Advantages of breakeven analysis Marginal costing VS absorption costing
Charts are easy to construct and understand Marginal costing: using this method, fixed costs are
Provides useful guideline for managers like breakeven treated as period costs and written off each period.
points, safety margins when taking decisions such as Finished goods and work in progress are valued at
on ordering raw materials and budgeting. marginal cost only i.e. variable costs.
Comparison between different options and draw a In inventory valuation, when using marginal costing
new chart to show changing situations such as a price the closing inventory will only include the variable
increase. cost. While, in absorption the variable as well as some
Acceptance of orders below normal selling price of the fixed overhead will be included hence giving a
When the order results in a contribution to cover greater gross profit for absorption as closing
fixed costs, the selling price must exceed marginal inventory is valued more than marginal. This
cost of production difference arises purely due to the way the fixed
To maintain production and avoid laying off skilled overheads are treated.
workforce during off season
To promote a new product. Format of an operating statement (marginal costing)
To dispose of slow moving or redundant inventory $ $
The business should consider if they have the Sales x
available spare capacity. (-) variable cost:
Make or buy decisions
Materials x
if the marginal cost of production is below the price
Labour x
quoted by the supplier then the offer should be
rejected. Overheads x
The business should consider (+) opening inventory x
Will the price offered by the suppliers change? (-) closing inventory \n
The quality of the supplies offered by the external total variable production cost (x) (x)
total units produced ​ × closing inventory
supplier.
x
Will there be delays in delivery?
Is there an alternative use for the resources? (-) selling variable expenses (x)
Will the business lose the services of skilled Contribution x
workers which may be difficult to replace at a later (-) fixed costs
date?
Admin costs x
dropping a product
Production costs x (x)
if a business is dealing with a range of products and
one of which is deemed to be unprofitable, it may Profit for the year X
consider dropping the item from its range.
When the contribution is negative, but if the product Absorption costing uses all costs which are absorbed into
has a positive contribution and a negative profit, it is production and thus operation statements do not
favourable to continue the production as it would still distinguish between fixed and variable cost. Valuation of
be covering some of the fixed cost. both finished and work in progress inventory contain
choice of product where a limiting factor exist both fixed and variable costs.
a limiting factor is anything that limits the quantity of
Format of an operating statement (absorption)
goods that a business may produce. This may include
the shortage of materials, labour and demand for a $ $
particular product. Sales x
When making the best use of limited resources the (-) production costs
product must be ranked according to the amount of materials x
contribution they make from each unit of the scarce
labour x
resource.
Step 1: calculate the contribution per unit
fixed overheads x
Step2: identify the limiting factor and limiting (+) opening inventory x
factor per unit (-) closing inventory
total variable production cost
×
total units produced (x) x
​

contribution
Step 3: find limiting f actor per unit ​

closing stock units

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highest cost−lowest cost
$ $ highest activity−lowest activity ​ =
gross profit x variable cost per unit
(-) fixed and variable operating expenses
admin expenses (x) 3.5. The application of accounting to
selling and distribution expenses (x) business planning
profit for the year x
A budget is a short term financial plan of standard cost
Uses of marginal costing and revenue prepared for the future to control resources
Clear distinction between variable and fixed costs so that the business objectives can be achieved.
which is helpful in short term decision making. Budgeting is the preparation of the budget for each
Sees costs allocated to a time period so that it may be budget centre.
argued that profits for the time period is more The planning process includes
accurate.
It is prudent to write off costs in the time period
incurred and therefore marginal costing methods
include accurate inventory valuation of and as well as
profits.
Easy to operate but relied upon cost being split into
fixed and variable. No arbitrary apportionment of
fixed costs.
Shows clearly the impact on profit of fluctuations in
the volume of sales.
Under and over absorption is not a problem hence no
need to calculate and OAR
Can also be used with standard costing.
Shows relative contributions to profit that are made
by each product and shows where the sales effort Planning – managers are responsible for planning and
should be contracted. controlling a business and budgets are an essential
Disadvantages of marginal costing tool for planning and controlling
Not all costs can be split into variable and fixed Rolling budgets is where as each year passes it is
Fixed costs don’t in reality remain constant and deleted from the budget and a budget for another
variable costs do not vary according to levels of year is added, making one year detailed and the
output, in the long run all costs are variable following years less precise. Top down budgets are
Assumes production method remains constant which prepared by top management and handed down to
isn’t the case in reality. departmental managers. Bottom up budget is
Contribution may vary if new techniques are followed prepared by departmental managers and although
in the production process. they tend to reflect local conditions better, they may
It isn’t useful for business with a range of products as be set easily achievable and may not fit with overall
allocating fixed costs to each product will be difficult plan.
with any degree of accuracy, making difficult to Managers should concentrate their attention on items
calculate the breakeven point. with adverse variance (where the actual performance
Uses of absorption costing deviates negatively from the budgeted) management
Includes all costs to product there it could be useful accounts may report only the items with adverse
for management when fixing prices or reviewing of a variance this is known as management by exception
product has been profitable. or exception reporting.
It could be said that profit gives a true and fair view The need for budgeting
according to absorption costing A forecast of income and expenditure ( thereby
Helps set prices. profitability) helps figure out long term goals and
Used in the long run rather than short run. works towards them.
More acceptable and realistic for financial statements. A tool for decision making
High low method : this technique uses the units and total A means to monitor business performance
cost at one level of activity compared to the units and Ensure the business doesn’t spend money they don’t
total costs incurred at another level to calculate the have.
variable cost per unit. This is used to split and find the Helps build investment contribution into your budget
fixed element and the variable element of a semi variable Helps the business be prepared in unforeseen
costs. Once variable cost is found, fixed costs can be instances
found by deducting the variable cost from the total cost.

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Helps identify unnecessary expenditure and cut down Helps in decision making.
on these Helps identify areas where improvement is required
Ensure the business has money for future projects before start of a financial period.
Budgetary control refers to the responsibility that each May help in securing finance as banks and lenders
budget centre has to justify the use of resources, control requires budget information.
costs, achieve activities set by the budget in accordance Disadvantages of budgeting and budgetary control.
with the business objectives. May demotivate staff if targets are set too challenging.
Budgetary control delegates financial planning to manage Time consuming and costly, requires specialist
it evaluates managers performance by comparing actual knowledge.
results with those set in the budget. Can cause conflicts between department about
Advantages of budgeting and budgetary control resource allocation.
Facilitates long term planning, leads managers to Can discourage innovation – budgets restrict activity
think about the future and the direction in which the managers fail to take advantages of unexpected
business is heading. opportunities as actions are restricted.
Promotes coordination between department. If managers are paid on their performance against the
Enables monitoring and control. budget, they may build extra costs and reduce the
Acts as a motivator for employees. revenue from the expected target to ensure they
Helps allocation and use of resources. always beat it, this is referred to as budgetary slack.
May provide a framework for delegation.

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Accounting (9706)

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