OTHM LEVEL 5 DIPLOMA IN ACCOUNTING

AND BUSINESS

Financial
Reporting
Table of Contents
1.1. Describe assets within a business organization.
1.2. Apply depreciation to a business organization’s assets.
1.3. Prepare a business organization’s asset register.
2.1. Explain the purpose and functions of control accounts.
2.2. Prepare control accounts for given data.
2.3. Prepare reconciliation statements of control accounts with schedule of
trade payables and trade receivables.
3.1. Prepare, from a given trial balance, financial statements for a single
entity.
3.2. Prepare, from incomplete records, financial statements for a single entity.
Introduction

This revision guide was created to help prepare new trainee accountants for the Financial
Reporting examination. This guide includes worked examples of the different concepts and
principles including different classification of assets, Control accounts, Reconciliations and
Financial Statements.
 Topic

1.1
Describe assets within an organization

A business have something hey own or can be use, this is an Asset.

An Asset is resource owned by a business.

In the other hand, Liability is something owed by the business. Liabilities are all monetary
values owed for assets supplied to the business which had not been paid.

The double entry treatment for purchase of Assets will be:

:
DEBIT Asset Account – cost £X
CREDIT Cash (or payable, if a credit transaction) £X

Note: An increase of an Asset will be Debit in an account, while a reduction of an Asset

value, will be a Credit.

Accounting Equation: Assets = Liabilities + Capital (Equity)

Assets can be classified as:

Currents Assets – Assets consisting of cash, goods for sale and any resources with a short life.
These assets are held for trading, expected to realize in normal operating cycle of business within
one year.

Noncurrent assets – Assets which have a long life and they were bought with the intention to be
used in business but not to be sold. They are used for trading purposes and for investment and
productive purposes. These include both tangible assets (with a physical existence as machinery,
buildings and plant…) and intangible assets (assets without physical existence such as goodwill,
patent and royalties…)
The recognition in the accounts of the business means the integration of the asset in the business's
accounts. The recognition of property, plant and equipment depends on two criteria according
accounting standards:
 It is probable that future economic benefits associated with the asset will flow to the
entity.
 The cost of the asset to the entity can be measured reliably and it will be measured as:
Purchase price, including any import duties paid, delivery, installation, assembly and handling
costs, professional fees from acquisition of the asset and costs associated to ensure asset is
working properly. Smaller items such as tools are often written off as expenses of the period, the
minimum value associated to it will be according business own policy.
Diogo Miranda Page 3
The double entry to record an acquisition of a non-current asset is:
DEBIT Non-current asset – cost £X
CREDIT Cash (or payable, if a credit transaction) £X

The accounting standards, classify noncurrent assets as:

 Tangible assets:
 Are held by an entity for use in the production or supply of goods or services, for rental to
others, or for administrative purposes
 Are expected to be used during more than one period
 Cost is the amount of cash or cash equivalents paid or the fair value of the other
consideration given to acquire an asset at the time of its acquisition or construction.
 Fair value is the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date.
 Carrying amount is the amount at which an asset is recognized after deducting any
accumulated depreciation and impairment losses.

 Intangible assets
 Non-monetary asset without physical substance.
 Controlled by the entity as a result of events in the past
 Something from which the entity expects future economic benefits to flow
 Research is original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding.
 Development is the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices, products,
processes, systems or services prior to the commencement of commercial production or use.
 Amortization is the systematic allocation of the depreciable amount of an intangible asset
over its useful life. Amortization period and amortization method should be reviewed at each
financial year end.

The double entry treatment for the entries for the amortization:
DEBIT Amortization account (statement of profit or loss) £ x
CREDIT Accumulated amortization account (statement of financial position) £x

Note: The Depreciation double entry is similar to Amortization; this will be discussed in
following topic.

Diogo Miranda Page 4

 Topic

1.2
Apply depreciation to a business organization’s assets.

Depreciation is part of the costs of the non-current asset consumed during a period by the
business. It represents the cost of a non-current asset, less its estimated residual value.

Example:
 A non-current asset cost of £8000 which has an expected life of 3 years and an expected
residual value of zero should be depreciated by £8000 in total over the 3 year period.
 A non-current asset cost of £5000 which has an expected life of 3 years and an expected
residual value of £1000 should be depreciated by £7000 in total over the 3 year period.

Depreciation method arises from the accrual assumption which states that revenue and expenses
must be reported in accounting period they were incurred, since the non-current assets consumes
economic benefits over a number of accounting period, then depreciation spread the costs of the
asset over accounting period
In financial statements, Depreciation value will be charged against profit of the period and the
accumulated value of depreciation will be deducted from the value of the non-current assets to
give a clear net value of the non-current asset.

The below are the main definitions regarding the depreciation method:

Useful life - the period over which a depreciable asset is expected to be used by the enterprise
Residual value - the amount that asset could be sold in the end of its useful life after deducting
the expected costs of disposal.
Net Realisable value - the amount the asset could be sold for less the selling costs

The Two main methods of depreciation are:

• The straight line method
• The reducing balance method

The straight line method

The depreciation value is charged in equal amounts to each accounting period over the expected
useful life of the asset – the non-current asset value will be reduced at a fixed rate
.
The annual depreciation charge is calculated as:
Depreciation = (Cost of asset – residual value) / Expected useful life of the asset

Diogo Miranda Page 5

Example of Straight line depreciation:
 A non-current asset costing £10,000 with an estimated life of 10 years and no residual
value would be depreciated at the rate of:

£10000/10 years = £1000 per year

 A non-current asset costing £20000 has an estimated life of 5 years and a residual value
of
£2000. The annual depreciation charge using the straight line method would be:

(£20000 - £2000) / 5 years = £3600

= $10,600 per annum

The carrying amount of the non-current asset would be:

Year 1 = Noncurrent asset £20000 - £3600 = £16400
Year 2 = Noncurrent asset £16400 - £3600 = £12800
Year 3 = Noncurrent asset £12800 - £3600 = £9200
And so on
Depreciation charged in Income Statement in each year would be £3600.

Since this is a fair allocation of the depreciation amount between the different accounting periods,
the depreciation is charged at the rate of x% per annum on the cost of the asset.
£3600 / £2000 = 0.18 * 100% = 18%

So £20000 * 18% = £ 3600

Note: If noncurrent assets are bought part-way through an accounting period, it is reasonable to
charge an amount for depreciation only from the date that the business has owned the asset,
which might be part-way through an accounting period. In example above, if asset had been
bought in part away of the year, the formula would be:

(£3600 x Number of months to be depreciated) / 12 months

Although this is the correct method for calculating depreciation, some business take a simplified
approach in practice and instead of calculating the depreciation from the date the asset is
acquired, the business instead charges a full year's depreciation in the year it is purchased and
then no depreciation in the year it is disposed of.

The reducing balance method

Diogo Miranda Page 6

It a method based on the principle that depreciation is calculated as percentage of the net value of
non-current assets (carrying amount) brought forward at the start of the period.

The formula used Depreciation = (Cost of asset – Residual Value) * Depreciation Factor

The depreciation factor can be determinate by:

1 – (Residual Value/ Cost of Asset) 1/Estimated Useful Life

Example: A business purchases a non-current asset at a cost of £10,000. Its estimated residual
value is $£2500 and 4 years of estimated useful life

Depreciation factor = 1 – (2500/10000) ¼ = 0.7071 (same as 70.71%)

Depreciation for first year = (£10000 - £2500) * 0.7071 = £5303.30

The following years, depreciation will be charged by carry amount multiply by 70.71%.

Comparing to straight method, the reduction method does not deduct the residual value from the
cost before depreciating. Instead, the asset is depreciated using the percentage, until reach the
residual value and then stop depreciate. With this method, the annual charge for depreciation is
higher in the earlier years of the asset's life and lower in the later years.

Note: The method used of depreciation, will be according business policy. A business can
have both methods in place for different categories of Non-current assets. It is important to
mention that Land is not depreciated.

Change of method of depreciation

Businesses must following the same method of depreciation from year to year (consistent
treatment). Although it has been a change in the expected pattern of economic benefit from the
asset, the method of depreciation can be change to meet the new pattern. In this situation, the
remain carrying amount of the non-current asset is depreciated under the new method but in the
financial statements, a note must be added to mention the change of depreciation method and
reasons why.

Example:
Asset purchased for £50000 on year 1, Estimated useful life of 5 years and used Reducing
balance method: 40%. On year 3, it was decided to change the method to straight line.
Depreciation charge for each year will be:
Year 1: £50000 * 40% = £20000
Year 2: £20000 * 40% = £8000
Year 3 to year 5: £8000 / 3 years = £888.88 per year (since the carry amount will be divided by
remain useful life of asset)

Diogo Miranda Page 7

Formula: New depreciation = (Carrying amount – residual value) / Revised useful life

Since Depreciation is not a cash expense. The cash payment for the non-current asset will be
made when the asset is purchased or credit as liability (owed to the supplier of the non-current
asset). For this reason, when processing the double entry, only the value of the purchase of non-
current assets will be credit from bank or from a supplier account.

The accounting entries for depreciation are as follows.

 There is an accumulated depreciation account from all years for each separate category of
non-current assets.
 The depreciation charge for an accounting period is a charge against profit.

Purchase of Non-current Asset as credit

DEBIT Non-current Asset Category (Plant, Machinery, Building…) £X

CREDIT Supplier Account (Accounts Payable). £X

Record of Depreciation

DEBIT Depreciation expense (statement of profit or loss) £X

CREDIT Accumulated depreciation account with the depreciation charge for the
period £X

While a Depreciation expense will be stated in Statement of Profit or Loss or Income Statement,
the Accumulated Depreciation Amount will appear in Statement of financial position or Balance
Sheet.

Net Value of Non-current Asset = Cost of Non-Current Asset – Accumulated Depreciation

Amount

And this is how they would be shown in the statement of financial position.

Statement Financial Position

Non-current assets £X
Accumulated Depreciation (£X)
Net Non-Current Asset Value £X

Statement Profit and Loss

Depreciation Expense £X

Example:
Cost - £20000
Estimated life – 3 years
Estimated residual value - £2000
Straight line method of depreciation to be used
Diogo Miranda Page 8
Calculate the carrying amount of the Non-current Asset for the year 2.

Calculation:

(£20,000 - £2,000) / 3 years = £6000 per year

STATEMENT OF PROFIT OR LOSS

Year 1 – £6000
Year 2 – £6000

STATEMENT OF FINANCIAL POSITION

Noncurrent Asset Total
Asset at cost £20000
Year 1 (£6000)
Year 2 (£6000)
Carry amount of Year 2 = £20000 - £12000 = £8000

Revaluation of non-current assets

When a non-current asset is revalued, depreciation is charged on the revalued amount. This can
be caused due to inflation, since the market value of non-current assets increase. A business can
keep the asset recorded at cost or revaluate to the fair value according accounting standards. If a
non-current value is revaluate, the whole class of non-current assets must be revaluated at the
same time to avoid complication with different costs from different dates. By class of non-current
assets is the group of assets of similar nature and use (such as machinery, building, land,
vehicles…)
If non-current assets are revalued, depreciation must be charged on the revalued amount.

Example of the revaluation of non-current assets:

Building cost £30000 with no residual value and 30 years useful life in year 1.
In year 6, building is now worth £75000 and has a further 25 years of useful life.

Annual depreciation for first 5 years = £30000 / 30 years = £1000

Building Purchase
DEBIT Building Account £30000
CREDIT Bank £30000

Depreciation
DEBIT Depreciation Charge £1000
CREDIT Accumulated Depreciation £1000

Year 1 to Year 5, Accumulated depreciation will be: £1000 * 5 = £5000

Diogo Miranda Page 9

Net Value of Non-current Asset = £30000 - £ 5000 = £25000 at end of year 5

Amount of the revaluation is: £75000 – (£30000 - £5000) = £50000

The asset will be revalued by £50000 to £ 75000. According the accounting equation (Assets =
Liabilities + Capital), if any asset value increase, a capital or liability must increase by the same
value. In case of revaluation, the main beneficiary of the revaluation is the owner of the business,
so capital value will increase by the same amount as assets. This revaluation will be credit to a
Revaluation Reserve Account ( included in capital in the statement of financial position) and will
be recognize in the statement of profit or loss and other comprehensive income, as other
comprehensive income (since it is an income from a non-productive activity). The reason for
these entries in the accounts is due to the fact that the gain on revaluation has not been realized
and profits cannot be anticipated before it is realized. If the business is sold for value of the
revaluated amount, then the profit would be realized and could be included in statement of profit
or loss

Following the revaluation, a new depreciation amount must be calculated:

New Depreciation = Revalued amount / Remaining useful life

Follow the above example: £75000 / 25 years = £3000

Then, the annual depreciation charge will by $3,000 per year over the remaining useful life of 25
years.
The main consequence of a revaluation is a higher annual depreciation charge.

The accounting treatment for the revaluation above will be:

Revaluation
DEBIT Building Account (75000-£30000) = £45000 (Revaluation amount – Initial Cost)
Accumulated Depreciation £5000
CREDIT Revaluation Reserve £50000

The effect of these entries is as follows.

BUILDING – COST OR VALUATION

In some situation, due to revaluation of non-current assets, the asset will have an higher
depreciation due to the difference between the new depreciation charge and the old charge – this
is Excessive Depreciation. By accounting standards, a business is permitted to transfer an amount
equal to the excess depreciation from the revaluation surplus to retained earnings in the equity
section of the statement of financial position, if the business wants.
Applying this to the example above gives the following.

Excess depreciation = $3,000 – $1,000 = $2,000

Diogo Miranda Page 10
An amount of $2,000, representing the excess depreciation, can be transferred each year from the
revaluation surplus to retained earnings. This transfer will be stated in the statement of changes in
equity – A statement which do the reconciliation of the opening and closing amount of each
equity type such as reserves, retaining earning.

In case, the market value of the non-current asset had fallen, the process is called Revaluation
Downwards. If building mentioned above, has a market value of £40000 (decreased marked
value of £35000). The carry amount of the building would be £75000 less depreciation £15000 (5
years depreciation) which is £60000.

The accounting entries for Revaluation Downwards would be:

DEBIT Revaluation Reserve (£35000 - £15000) = £20000

= Lost in Revaluation – Accumulated Depreciation
CREDIT Building Account £75000 - £40000 = £35000
= Cost – Revaluation Amount
CREDIT Accumulated Depreciation £15000

Statement of Financial Position

Amount
ASSETS

Non-current assets
Property, plant & equipment x
Accumulated Depreciation (x)
Goodwill x
Intangible assets x

Current assets
Inventories x
Trade receivables x
Cash and cash equivalents x

TOTAL ASSETS x

EQUITY AND LIABILITIES

Equity
Share capital x
Retained earnings x

Diogo Miranda Page 11

Revaluation reserve x
Total equity

Non-current liabilities
Long term borrowings x

Current liabilities
Trade and other payables x
Short-term borrowings x
Current portion of long-term
x
borrowings
Current tax payable x

Total current liabilities x

Total liabilities x
TOTAL EQUITY AND
x
LIABILITIES

Regarding Disposal, Non-current assets can be dispose or sold not in a normal course of trade
but due to age of equipment, incapacity or no longer served the business for their activities.
Comparing to a normal sell of good in the business operation, non-current assets when disposed
will generate a capital gain or capital loss. These gains or losses are recorded as income or
expenses in Profit and Loss Statement, after the Gross Profit. To calculate the gain or loss in a
disposal, the carry amount of the non-current asset must be determinate (cost of asset less
accumulated depreciation value) and value of the sale of the asset minus any costs associated to
the transaction. If price exceeds the carrying amount, then a profit is made, and a loss is made
when the sale price is less than the carrying amount.

Example:
Vehicle Purchase price £30000, 5 years and an estimated residual value of £2000.
Vehicle sold 2 years after by £20500.

Annual depreciation = (£30000-2000) / 5 = £5600 per year (using straight method)

Carry amount at date of disposal = £30000 – (£5600 * 2) = £18800

Disposal = £20500 - £18800 = £1700 Profit on Sale of Vehicle

The amount of profit will appear as Other Income in the Statement of Profit or Loss.

The accounting entries for the above are:

Disposal Vehicle
DEBIT Disposal of Non-current Asset £30000
CREDIT Vehicle Account £30000
Diogo Miranda Page 12
Accumulated Depreciation Transfer
DEBIT Accumulated Depreciation £5600
CREDIT Disposal of Non-current Asset £5600

Sale Value
DEBIT Bank £20500
CREDIT Disposal of Non-current Asset £20500

Vehicle at Cost £30000

Accumulated Depreciation £5600
Carry Amount £18800
Sale of Vehicle £20500
Profit / (Loss) £1700

Note: If instead of selling, a part exchange happened, instead of the vehicle being sold, it was
exchange for a new vehicle; the follow would happen

Vehicle Account
DEBIT with Cost Value of New Machine
DEBIT with any cash amount paid for New machine
CREDIT with Cost of Old vehicle

Depreciation of Old Vehicle

DEBIT Accumulated Depreciation for Old Vehicle
CREDIT Disposal of Vehicle

Disposal Account
DEBIT with Cost of Old vehicle and Profit/Loss associated
CREDIT with Accumulated Depreciation and any cash amount paid for New machine

In case of disposal of a Revaluated Asset, The same process of disposal will happen as below
with exception of the Revaluation Reserve will be closed (DEBIT) with amount for the non-
current asset sold and a double entry will the same amount will be CREDIT to the Disposal
Account. This will realize the profit from the Revaluation of the asset and can will appear as
Other Income in Statement of Profit or Loss.

Finally, the Statement of Financial Position shows the reconciliation of the carrying amount of
non-current assets at the beginning and end of the period. The differences arising from the
beginning and end of the period is due to new purchase or disposal of non-current assets,
revaluations and depreciation charges

Determination of Non-Current Amounts at the end of the period:

Diogo Miranda Page 13

 Topic

1.3
Movements Total Amount

1 Amount at Beginning of Period

2 Purchase of New Non-Current Assets
3 Revaluation Surplus
1 + 2 +3 Total 4
5 Accumulated Depreciation
6 Depreciation of Period
7 Disposal
5+6+7 Total 8
Carry Amount Total 4-8

As mentioned before, the financial statements should disclose the accounting policies used in
depreciation, and specification of how process of revaluation was done for all classes of Non-
Current Assets. It is important for who is reading the financial statements, to understand which
methods were used and be able to compare financial statements with information of the
disclosure, especially for any change in policies by the business and date and value that any asset
was revaluated.

Prepare a business organization’s asset register.

The asset register is an inventory that lists all the information regarding each non-current asset
that is kept by the business. Each non-current asset has their own file - Data Kept – which include
all detailed information about the asset, such as serial number, internal asset identification,
location inside the business, description of asset including cost, depreciation method and carrying
amount. The Asset Register is an internal control which ensures information in non-current
ledgers are accurate and correct since it is possible to reconciliate the value of each Data kept
with carrying value in asset ledger. Comparing with normal stock take in production line, it is
fundamental to maintain an update count of all non-current assets and investigate any discrepancy
between the registers. This can be solely an input error or can be a theft, without investigation and
accurate records; a business will not be available to determinate.

Diogo Miranda Page 14

 Topic

NON CURRENT ASSET RECORD with DEPRECIATION

2.1
DATE:

(Years)Useful Life

Depreciation This
Physical Location

Acquisition Date

Acquisition Cost

Salvage Value
Depreciation

Depreciation

First Year %

Period
Description
Asset Name

Previous
Asset Class

Method
Serial No.
Asset No.
Non-
current 1 A SL 100%
Noncurrent 150%
2 A DDB 100%
Noncurrent
3 B SL 100%

Total £0.00 £0.00 £0.00 £0.00

Explain the purpose and functions of control accounts.

Control Account

A control account is an account in the general ledger, which a record the total amount on each
individual accounts, mostly used for account receivable and account payables, although they can
be used for other items. The purpose of control account is to check the arithmetical accuracy of a
ledger.
The accounts receivable control account will record all transactions of the customers and the
balance must match the total of every individual receivable account. The same way accounts
payable control will records all transactions involving suppliers and other payables and the total
must match the total amount of each payable account.
The entries in book of prime entry will be first record of transactions. These are sales journal,
purchase journal and consecutive return journals. From there the total values in a book of prime
Diogo Miranda Page 15
will be transferred to the Control Accounts and all individual balances will be transferred to the
individual accounts of customers or suppliers.
The control accounts will assist in the location of errors in ledger and individual accounts, allow
management to do internal checks in the accounts department and it is possible to produce a trial
balance much quicker with the full value of the control accounts, instead of adding up all
individual accounts for receivable, payable and other control accounts used by the business.

In case, the control account amount does not much the sum of individual accounts, an error may
have occurred while:
 Transferring the amount from book of original entry
 A missing transaction missing in the control account or in the individual ledger
 A transposition error (where the characters within a number are entered in the wrong
sequence).
To correct the balance of control accounts and ledger, it is require:
 Journal entry be made in general ledger to correct the miscast of the values.
 Correction in the accounts for any transposition error
 Checking the transfer balance and add any missing value.

Accounts receivable has a debit balance, the same way the receivable control account will have
a debit balance. Opening credit balance are not common in account receivable, unless an
overpayment of debts or an advance payments of debts occur for which have not been invoiced.
Accounts payable has a credit balance and following the rule, the payable control account will
have a credit balance. If an account payable account has a debit balance, this can be due to an
overpayment by the business to the supplier or a credit note is awaited for returned goods.
In case a business has both receivable and payable account with another business, it is possible to
offset the balance of both accounts – Contra Entry – with the agreement of the another business.

Example:
A business X buys products from business Y and the same way, business X sells materials to
business Y.
To offset the balance between businesses, the balances of both receivable and payable are
extracted:

Business Y receivable: £1500 debit balance

Business Y payable: £6200 credit balance.

If businesses agree to offset the balances, the double entry would be:

DEBIT Payable Business Y £1500

CREDIT Receivable Business Y £1500

The only Business Y Payable would have a credit balance of £4700 (£6200-£1500).

Diogo Miranda Page 16

 Topic

2.2
Note: In a control account, if we know the opening balance of an account, together with all the
additions and deductions entered in the account, it is possible to calculate the closing balance of
the account.

Total Opening Balance £X

Add Entries which increase the balance £X
Less Entries which decrease the balance (£X)
Total of closing balance should be £X

Prepare control accounts for given data.

As mentioned in previous topic, control accounts record the total amount on each individual
accounts and it is possible to conciliate the amounts from the control account with total of each
individual account, for example receivable or payable accounts. To fully understand which values
are transferred from the prime entry books to the individual account and control accounts, it is
important first to understand what how transactions will be recorded in the sales day book,
purchase day book, cash book and return day books (sales and purchase returns have their own
separate prime entry book).

Diogo Miranda Page 17

 Documents (Invoices, Receipts, Credit Notes...)
Source

Information is classified and enter in books of original entry such as Journal, Cash Book, Sales, Purchase
Original Entry
and Return Day Book

Double entry is posted to each account according amount in each Prime Entry Book
Double Entry

Checked the arithmetical accuracy of double entry account, the Trial Balance is created
Trial Balance

Income Statement is created and calculation of profit or loss for the accounting period is shown
Financial Statement of Financial Position will show all assets, liabilities and capital at the end of the period
Statements

The above graphic shows how the basic accounting cycle works, from first step until production
of the Financial Statements. The below are the main definitions of the accounting cycle.

Sales Day Book – Book of original entry for all Credit Sales.
Sales Ledger – A ledger for customer’s personal accounts.
Sales Return Day Book – Book of original entry for goods returned by customers.
Purchase Day Book – Book of original entry for all Credit Purchases.
Purchase Ledger – A ledger for supplier’s personal accounts.
Purchase Return Book – Book of original entry for goods return to suppliers.
Cash Book – Book of original entry for cash and bank receipts and payments.
Journal – A book of original entry for all transactions which are not contained in the other books
of original entry.

In recording of the transaction in both original entry books and ledgers, it is important to review
some transactions that may occur in our accounts.
Some of most common transactions that a business can have are record of discounts, returns and
interest. However many transactions may happen in the accounts and it is important to understand
how they should be recorded and follow the accounting equation (Assets = Liabilities + Capital)
to ensure all accounts balance in the end of the period.

Definitions and corresponding double entries:

Discount allowed – Deduction from the amount due given to customers who pay their balances
within a specific time establish by the business. This will be recorded in Sales Day Book.

DEBIT Income £X
CREDIT Receivable Account £X

Diogo Miranda Page 18

Discount received – Deduction from the amount due given to the business by its suppliers for
early payment within a specific time. This will be recorded in Purchase Day Book.

DEBIT Inventory £X
CREDIT Payable Account £X

Trade discount – A deduction in price given due to bulk purchase or specific agreement. This
discount does not appear in the account.

Purchase return – Goods returned to suppliers.

DEBIT Payable Account £X

CREDIT Purchase Returns £X

Sales return – Goods returned by customers

DEBIT Sales return £X

CREDIT Receivable Account £X

Carriage inwards – Cost of transport of goods into the business – included in invoices from
suppliers.

DEBIT Carriage Inwards £X

CREDIT Payable Account £X

Carriage outwards – Cost of transport of goods charged to customers – included in the invoices
to the customers.

DEBIT Receivable Account £X

CREDIT Carriage Outwards £X

It is vital to mention the accrual principle of accounting which states that income and expenditure
is allocated to the correct accounting period, this means that the accounting records are completed
on an accruals basis. For this happen, it is necessary to adjust the entries in the account to ensure
revenue is recognize for the period that it is earned but not received yet and expenses incurred are
records even though they are not paid.

 Prepaid expenses are expenses which have been paid and recorded in

advance before they are incurred and need to be allocated to a later accounting period such as
Prepaid Insurance. (recorded as an asset)
DEBIT Prepayment £X
CREDIT Expense £X

Diogo Miranda Page 19

 Unearned revenues are revenues which have been received and recorded before earned
and need to be allocated to a later accounting period such as payment of rent from a rented
premises, the business has annual subscription by a customer (recorded as a liability)
DEBIT Bank £X
CREDIT Unearned Revenue £X

 Accrued expenses are expenses which have been incurred but not paid or recorded and
need to be allocated and accrued (recorded as a liability)
DEBIT Expense £X
CREDIT Accrued Expense (or Accounts Payable) £X

 Accrued revenues are revenues which have been earned by the business but have not yet
been received or recorded (recorded as an asset)
DEBIT Accrued Revenue (or Accounts Receivable) £X
CREDIT Revenue £X

 Interest Expenses are interest accrued but not paid in the loans of business, recorded
same way as accrued expenses and calculated as:
Interest = Principal x Rate x Term
DEBIT Interest Expense £X
CREDIT Interest Payable £X

 Payroll Accrual are wages or salaries at the end of each month where the employee has
worked hours which have not been accounted, recorded same way as accrued expenses.
DEBIT Payroll Expense £X
CREDIT Payroll Payable £X

When processing the bank transaction or even following the bank reconciliation process (ensures
that the cash book of the business is reconciled to the bank statement sent be the bank), one
transaction that can appear and must be processed it is dishonored cheques (a cheque from a
customer’s bank has refused to make payment of it). First, it is important to contact the customer
and notify it of restriction of payment and ensure customer takes action upon it and they are
aware of possible increase of fees. The same way can happen if the business gives a dishonor
cheque to a supplier, the supplier will notify the business and fees will be charged by supplier.
This situation must be reflected in the accounts as:
Return the amount of the dishonored cheque credit previously from customer account back.
DEBIT Customer account £X
CREDIT Bank £X

The same way, any fees charged by bank for the dishonored cheques must be posted:
DEBIT Customer account £X
CREDIT Bank £X

Diogo Miranda Page 20

 Topic

2.3
The last two adjustments needed regarding customers, happens when customers due to financial
problems will not be paid their amounts due and the business will need to have a process in place
to record these bad debts – Irrecoverable debts written off – which involve remove
uncollectible amount from accounts receivable and recording this as a bad irrecoverable debt
expense in the income statement of the business.

DEBIT Irrecoverable Debts £X

CREDIT Accounts Receivable £X

The other adjustment is Allowance for Doubtful Debt – is an allowance created for estimate and
record of uncollectible amounts when a customer fails to pay. The estimation is calculated using a
percentage of the accounts receivable at the end of the accounting period (the percentage is based
on the amount of irrecoverable debt experienced by business).

 Allowance Doubtful Debt = Accounts receivable at the end of the accounting period x
Estimated % uncollected
 Bad debt expense = Ending allowance for doubtful accounts - Current allowance for
doubtful accounts
DEBIT Bad Debts Expense £X
CREDIT Allowance for Doubtful Debt £X

Prepare reconciliation statements of control accounts with schedule of trade payables and
trade receivables.

Schedule of Accounts Payable is a detailed list of all the suppliers which business owes money.
The schedule of accounts payable is prepared to show all the outstanding accounts payable, who
are owed the money, and how much is owed. this allows business and the accounts payable
department to track and organize the supplier accounts which need to be paid in the near future.

Diogo Miranda Page 21

Schedule of Accounts Receivable is similarly to accounts payable schedule, the schedule of
accounts receivable shows you how much income you can expect to receive from outstanding
invoices. This report may indicate then necessity to do collection calls or for the reduction of
extended credit, if a customer is falling behind in payments to the business.
Accounts Payable Schedule
Due Pay Notes Recipient(s) Amount Jan Fe Mar
On On b
1st 1st Rent Property £1,150.00 x
owner
5th 1st Invoice 2546 Supplier 1 £500.00 x
10th 5th Invoice 3664 Supplier 2 £200.00 x

Total £1,850.00

£
A
Accounts Receivable Schedule Total Due:
26,900.00 reconciliation
of accounts
Invoice Balance involves
Invoice Date Number Customer Total Amount Due Date Due
£ matching two
03/28/20 s1648 Customer 1 £ 20,000.00 05/02/20 13,000.00 sets of records
£ to see if there
04/01/20 s649 Customer 2 £ 1,000.00 05/06/20 450.00 are any
£
          -
discrepancies,
£ such as:
        Total  - 13450  Comparin
g a bank
statement to the cash book of the business.
In here it is possible to find:
Items which affect the bank statement
 Receipts in the cash book not on bank statement.
 Payments in the cash book not on bank statement.
 Errors on the bank statement
Diogo Miranda Page 22
 Items which affect the cash book
 Receipts on bank statement not in the cash book.
 Payments on bank statement not in the cash book.
 Errors in the cash book

Adjust bank Statement

Bank statement balance x
Add Receipts in the cash book not on the bank x
statement
Deduct Payments in the cash book not on the bank x
statement
Add or deduct Errors on the bank statement x
 Adjusted bank statement balance x

Adjusted cash book balance

Cash book balance x
Add Receipts in bank statement not in the cash book x
Deduct Payments in bank statement not in the cash book x
Add or deduct Errors in the cash book x
 Adjusted cash book balance x

 Comparing a customer statement to receivable accounts and in same way, comparing a

supplier statement to payable accounts. Steps to follow:
 Check that the opening balances agree between statement and the amount in the
receivable account
 Record the difference of the closing balances
 Adjust entries with any missing transaction due to timing differences
 Review the closing balance and, if necessary, produce a reconciliation report to
justify any discrepancies in the accounts.

Diogo Miranda Page 23

 Topic

3.1
Prepare, from a given trial balance, financial statements for a single entity.

After all transaction had been posted, it is time to balance all the accounts and determinate which
accounts have a debit or a credit side. Picking the accounting equation, it is possible to extend to:

Assets + Expenses + Dividends + Losses = Liabilities + Capital + Revenue + Gains

This shows that all items in left side will have a debit balance while all the items in right side will
have a credit balance.

Note: A Contra Account is one which is offset against another account and it follows that the
normal balance on the contra account will be the opposite of the original account such as an
purchase is normally a debit balance so a contra expense account will be purchase returns that has
a credit balance

After all accounts in ledgers are balanced, the Trial Balance appears as is a list of all the account
balances in the accounting records on a particular date. Following the double entry bookkeeping
method for every debit there should be a credit so a list of all the balances in the accounting
records should balance and it is possible to test accuracy of the accounts.

Account Trial Balance

  Debit Credit
Plant & Machinery x
Motor vehicles depreciation x
Inventory x
Work in progress x
Finished goods x
Accounts Receivable Control x
Accounts Payable Control x
Accruals x
Sales Tax Control x
Purchase Tax Control x
VAT liability x
PAYE x
Mortgages x
Preference shares x
Reserves x
Total Debits = Credits

Diogo Miranda Page 24

If both columns of the list do not balance, there must be an error in recording the transactions in
the accounts. Some errors may have occurred such as:
 Error of omission - Transaction not posted in system
 Error of Commission - Transaction recorded in the wrong account
 Compensating error arise from an error of a certain amount been cancelled by another of
the same amount
 Errors of principle (debit and credit side posted in wrong order in both accounts
 Error of Transposition – when digits are recorded in the wrong way.
While Transposition, Omission and Commission errors can be detected by a trial balance, the
other two remain errors (Compensation and Principle) will only be detected through
reconciliation.

Once the error has been detected, it is required to balance the accounts through a journal entry or
in case that error breaks the rule of double entry, then a suspense account (an account in which
the amount equal to the difference in the trial balance is enter until the error causing the
imbalance is detected) must be used as well as a journal entry to rectify accounts. The suspense
account is a temporary account only to be used to help balance the trial balance.

The double entries to correct the error are as follow:

Transposition error: Invoice of £393 but posted as £339

DEBIT Suspense account £54
CREDIT Sales £54

Error of omission: expense invoice of £660 entered only in cash account

DEBIT Expenses £660
CREDIT Suspense account £660

Error of commission: Customer payment of £320 entered as debit in receivable account. Amount
to be correct is £640, duo to debit exceed credit by 2 x £320
DEBIT Suspense account £640
CREDIT Sales £640

After Trial Balance is complete and amount are balancing. It is time to produce financial
statements. And the first step is to open up a Profit or Loss account which will gather together all
the ledger account balances relating to the statement of profit or loss.
As part of the double entry system, the Profit or Loss Account must follow the basic rule of
double entry (every debit must have an equal and opposite credit entry). In trial balance there are
two types of accounts – Permanent and Temporary. A temporary account is an account which
last only for the accounting period and at the end of the accounting period will be closed with a
zero balance; these accounts belong to the income statement. While a permanent account which
are not closed at the end of period, will be carried over to the next accounting period and belong
to Statement of Financial Position.
Diogo Miranda Page 25
 Income Statement (or Profit & Loss Statement) – it is a financial statement in which the
calculation of the gross profit and then net profit are presented.

Balance Sheet (or Statement of Financial Position) – is a statement which shows all the assets,
liabilities and capital of a business.

The Trial Balance is created, after that the necessary adjustment for depreciation, accruals,
prepayments, closing inventory, irrecoverable debts and allowances for doubtful debts are
calculated as mentioned previously, this will created a Adjusted Trial Balance, from where all the
information from the financial statements are taken. Firstly, the Income Statement must be
completed to arrive to the profit of the period, after that the remaining balances in Trial balance
will go to the Balance Sheet plus the net profit obtained from the Income Statement.

Account Trial Balance Adjusting Entries Adjusted Trial Balance

Debit Credit Debit Credit Debit Credit
Plant & Machinery
Plant & m/cy depreciation
Inventory
Accounts Receivable Control
Prepayments
Bank current account
Accounts Payable Control
Accruals
VAT liability
Net wages control
Loans
Undistributed reserves
Profit & Loss Account
Discounts allowed

To determinate the cost of goods sold for the Income Statement, closing inventory will be
evaluate according FIFO or AVCO (weighted average costing). The gross profit will be
determinate through the use of a Trading Account (An account which gross profit is calculated
and it is part of income statement)

Note: If Goods are taken by owner of the business for own use, this must be posted in account of
the business at their cost price.

DEBIT Drawings £X
CREDIT Inventory £X

The same way, any drawings from the owner of the business must be posted in accounts of the
business as:

DEBIT Drawings £X

Diogo Miranda Page 26

CREDIT Bank £X

If there is a difference between the physical count of inventory and amount registered as closing
inventory in system. Then, that shortage must be written off as an expense for the period as:

DEBIT Loss on Inventory £X

CREDIT Inventory £X

The trading account shows the gross profit which is determined by deducting the cost of goods
sold from the net sales revenue of the business. Net sales are sales less any sale returns and
discounts, and represent the true value of the customer sale to the business

Net Sales = Sales – Sales Returns – Discounts Allowed

Net Sales – COGS = Gross Profit
Cost of goods sold (COGS) = Opening Inventory + Net purchases– Ending inventory
Net Purchases = Purchases – Purchase Return – Discount Received + Carriage Inwards

Trading Account
Debit Credit
Sales returns x Sales x
Purchases x Purchase returns x
Beginning
x Ending inventory x
inventory
Gross Profit x
Total Total
Gross Profit x

After Gross Profit calculation, it is time to calculate the Net Profit of the business. The Gross
Profit will be debited from Trading account as per above and credited to the Profit & Loss
Account, to calculate the Net Profit.

Net profit = Gross profit – Expenses + Other income

Note: Carriage outwards will be charged as expense for the period

Diogo Miranda Page 27

 Simplified profit and loss Statement
Net sales x
Net purchases x
Beginning inventory x
Ending inventory (x)
Cos t of goods s old (x)
Gros s profit x
Expenses (x)
Other income x
Net profit/ (Los s ) x

Upon the end of the Income Statement, the remain balances in the Trial Balance, will go to the
Balance Sheet including the closing inventory value and Net Profit calculated in the Income
Statement. As mentioned before, the Balance sheet shows a snapshot of the assets, liabilities and
equity of the business at the end of an accounting period or in another specific time. The
accounting equation must balance in Balance sheet, in case some discrepancies are found, it is
necessary to check the values of the accounts.

Assets = Liabilities + Equity

Balance Sheet
Cash x Accounts payable x
Accounts receivable x Other liabilities x
Inventory x Current liabilities x
Short term Investments x
Current assets x Long-term debt x
Goodwill x Total liabilities x
Amortization x Capital x
Retained earnings (will
Plant, Machinery & Vehicles x include Net Profit of Period) x
Accumulated Depreciation x Total equity x
Non Current assets x
Total assets x Total liabilities and equity x

Retained earnings at the end of the period = Retained earnings at beginning + Net Profit -
Dividends

The movement in Equity is stated in another financial statement - Retained Earnings

Statement which is one of the four main financial statements and is the link between the
Diogo Miranda Page 28
 Topic

3.2
income statement and the balance sheet, which refers to the net income retained by a
business after any distribution (dividends) to the equity holders.

Prepare, from incomplete records, financial statements for a single entity.

Incomplete records occur when a business does not have all the accounting records due to
negligence of the owner of the business or records were accidentally lost or destroyed. Here rise
the issue of prepare the financial statement for the business, since the business does not have all
information posted in the accounts, it is not possible to close the accounts and transfer the
balances to the profit or loss account, or have full detail of assets, liabilities and capital in the
statement of financial position. To prepare the final steps of the accounts, it is necessary to
establish sales of the period, cost of goods sold and expenses, and establish the amounts for
accounts payable, accounts receivable, accruals, depreciation and prepayments for the period.
But before that, it is important to understand which records are incomplete, especially:
 Credit sales and trade receivables
 Purchases and trade payables
 Purchases, inventory and the cost of sales
 Stolen goods or goods destroyed
 The cash book
 Accruals and prepayments
And focus in the relationship between:
 The accounting and business equation
 Cash received and paid for every item
 Sales and accounts receivable
 Purchase and accounts payable
 Cost of goods sold formula

The following formulas will help to reach the missing figures in incomplete records, it is
important to understand the relationship between them.

Diogo Miranda Page 29

The business equation:
Closing net assets = opening net assets + capital introduced + profit – drawings

Profit/ (Loss) = Movements in net assets – capital introduced + drawings

Net assets = (Noncurrent Assets + Current Assets) – (Current Liabilities + Noncurrent

Liabilities)

Cash Received = Sales + Opening Receivables – Closing Receivables

Cash payments = COGS + Closing inventory - Opening Inventory + Opening Payable –

Closing Payable

Purchases = Payment to Payables + Closing Payable – Opening Payable

Payment for Expenses = Expenses + Closing prepaid expenses - Opening prepaid expenses
+ Opening accrued expenses - Closing accrued expenses

Payroll Payments = Payroll expense + Opening Payroll Payable – Closing Payroll Payable

Tax Payment = Tax expense + Opening Tax Payable – Closing Tax payable

Calculation of profit:
Mark-up is the profit as a percentage of cost.
Gross profit margin is the profit as a percentage of sales.

Exercise:
Suppose that the inventory of Diogo on end of January has a value of £9000, and an inventory
count at beginning of January showed inventory to be valued £10500. Sales for the month are
£78000, and the business uses a mark-up of 10% on cost for all the items that it sells. What were
the purchases during the year?

The cost of goods sold can be derived from the value of sales:
Sales (110%) £78000
Gross profit (mark-up) (10%) £7090.9
Cost of goods sold (100%) £70909.1
So using formula: Purchase = COGS + Closing inventory – Opening Inventory
Cost of goods sold £70909.1
Plus closing inventory £9000
Less opening inventory (£10500)
Purchases £69409.1

Exercise:

Diogo Miranda Page 30

Miranda does not have full records of the business, but the following information is available in
respect of his accounting year ended 2019.
Cash purchases in year £5000
Cash paid for goods supplied on credit £32000
Opening Accounts Payable £2500
Closing Accounts Payable £3200
What is the figure for Purchases?

Credit Purchases = (32000 + 3200-2500) = 32700.

So, total purchases = 32700 + 5000 = 37700.

Exercise:
Net assets at the beginning of 2018 were £100500. The owner of the business introduced new
capital of £12000 during the year and took drawings of £5000. Net assets at the end of 2019 were
£120000.
What was the profit earned by the business?
Profit = movement in net assets – capital introduced + drawings
Profit = (120000 – 100500) – 12000 + 5000
Profit = £12500

Exercise:
Albertino opens his business on 1 January 2019, from rented premises, with £2000 inventory and
£4000 in the bank. All sales are in cash and no records of his drawings. At the end of the year he
has the following:
Inventory worth £8000, £3400 in the bank, owes £2500 to suppliers, New capital £5000 and
drawings £2000. He has been taking drawings of £150 per week. What is the profit at 31
December 2019?

Opening net assets = £2000 + £4000 = £6000

Closing net assets = £8000 + £3400 - £2500 = £8900
Movement in capital (net assets) = £2900
Drawings ((150× 52) + 2,000) = £9800
Profit for year = £2900 - £5000 + £9800 = £7700

Exercise:
Silva’s trial balance has the following items: non-current assets £50000, inventory £10000,
accounts payables£8000, accounts receivables £4000, current bank account £22000, allowance
for doubtful debts are £1500. What is the amount of current assets?

Current assets = £10000+£22000+ (£4000-£1500) = £34500

Diogo Miranda Page 31

Conclusion
Through this manual, you should have a clearer idea of the context in which Financial Reporting
is set. You should also be aware of accounting definitions for diverse accounting adjustments as
accruals and prepayments, suspense accounts and calculation of incomplete figures using
different accounting formulas. The Balance Sheet and Income Statement allows you to
understand the basic structure of the financial statements. Hopefully you learn and were able to
refresh some concepts of accounting methods.

Diogo Miranda Page 32