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Chapter 8: Financial statements of a sole trader

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Title: Chapter 8: Financial statements of a sole trader


1
Chapter 8 Financial statements of a sole trader
  • On completion of this topic you should be able to
  • Differentiate between accruals and prepayments
  • Calculate depreciation using the straight line
    method or reducing balance method
  • Differentiate between bad debts and doubtful
    debts
  • Construct financial statements with post trial
    balance adjustments
  • Independent study
  • Study Chapter 8
  • Progress test and practice question(s) as set

2
The story so far
3
Post trial balance adjustments
  • Although the records in the accounting system may
    be up to date, some last minute adjustments to
    the ledger accounts are always necessary at the
    end of the accounting period
  • This means that some of the figures in the trial
    balance will need to be amended (post means
    after in Latin, hence the term post trial
    balance adjustments)
  • There are four main adjustments
  • Stock
  • Accruals and prepayments
  • Depreciation of tangible fixed assets
  • Doubtful debts

4
Exercise 1Accounting principles revisited
  • Post trial balance adjustments are guided by UK
    GAAP and in particular by the following
    accounting principles
  • Historical cost concept
  • Accruals concept
  • Prudence concept
  • Consistency concept
  • Required
  • Jot down a brief explanation of each principle

5
Solution 1Accounting principles revisited
  • Historical cost concept values of assets are
    based on their original acquisition cost,
    unadjusted for subsequent changes in price or
    value
  • Accruals concept revenue and costs are
    recognised as they are earned and incurred, and
    they are matched with one another and dealt with
    in the profit and loss account of the period to
    which they relate, irrespective of when cash is
    received or paid
  • (Continued)

6
Solution 1 (continued)Accounting principles
revisited
  • Prudence concept - revenue and profits are not
    anticipated, but are included in the profit and
    loss account only if there is reasonable
    certainty that they will be received. However,
    provision for all known expenses and losses must
    be made, whether the amount is known with
    certainty or is only a best estimate in the light
    of the information available
  • Consistency concept - there is uniformity of
    accounting treatment of items of a similar nature
    within each period and from one period to the next

7
Adjustments for stock (inventory)
  • Stock refers to unsold goods
  • In a manufacturing business, it includes raw
    materials, work-in-progress and finished goods
  • Stocktaking is the process of counting the stock
    at the end of the accounting period to confirm
    the actual quantities support the figures
    recorded in the ledger accounts
  • Under UK GAAP, stock must be shown at the lower
    of historical cost or net realisable value (NRV)
  • NRV is the price the business expects to get for
    the stock, less any costs incurred in selling it

8
Closing stock and opening stock
  • In a continuing business, the closing stock at
    the end of one accounting period is the opening
    stock at the beginning of the next
  • The values of opening stock at the start of the
    period and closing stock at the end of the next
    are needed to calculate the cost of sales in the
    profit and loss account
  • Closing stock is also shown under current assets
    in the balance sheet
  • It is listed first, as it is the most permanent
    (it takes the longest to
    turn into cash)

9
Accruals
  • An accrual is an estimate of a liability that is
    not supported by an invoice or a request for
    payment at the time when the accounts are
    prepared (Collis and Hussey, 2007, p. 136)
  • It belongs to the financial period and must be
    added to the trial balance figure for that
    expense
  • In the profit and loss account, show the expense
    (including the accrued amount)
  • In the balance sheet, show total accruals under
    current liabilities

10
Prepayments
  • A prepayment is revenue expenditure made in
    advance of the accounting period in which the
    goods or services will be received (Collis and
    Hussey, 2007, p. 137)
  • It belongs to the next financial period and must
    be deducted from the trial balance figure for
    that expense
  • In the profit and loss account, show the expense
    (excluding the prepaid amount)
  • In the balance sheet, show total prepayments
    under current assets

11
Depreciation of tangible fixed assets
  • UK GAAP requires all tangible fixed assets with a
    finite life to be depreciated
  • Tangible fixed assets are non-monetary in nature
    and have a physical form (Collis and Hussey,
    2007, p. 138)
  • Depreciation is the systematic allocation of the
    cost (or revalued amount) of a tangible fixed
    asset, less any residual value, over its useful
    economic life (Collis and Hussey, 2007, p. 138)
  • The residual value is an estimate of the net
    proceeds from the sale of the asset on disposal
    (ie the amount for which it can be sold less any
    costs of sale)

12
Calculating the annual provision for depreciation
  • Straight-line method
  • Cost Residual value
  • Useful economic life
  • The useful economic life is an estimate of the
    number of years the asset is expected to provide
    economic benefits
  • Reducing balance method
  • Year 1 (Cost Residual value) ? Depreciation
    rate
  • Subsequently Net book value at start of year ?
    Rate
  • The net book value (NBV) is Cost ? Depreciation
    to date

13
Depreciation
  • In the profit and loss account, the provision for
    depreciation is shown under expenses
  • Straight-line method spreads charge evenly over
    the period the asset is used
  • Reducing balance method gives a lower charge in
    later years, which offsets higher maintenance
    costs as the asset ages, so the overall cost is
    smoothed
  • In the balance sheet, the accumulated
    depreciation is shown as a deduction from cost to
    give the net book value (NBV) under fixed assets
  • NBV represents the remaining proportion of the
    cost

14
Doubtful debts
  • A doubtful debt is money owed to an
    organization, which it is unlikely to receive. A
    provision for doubtful debts may be created,
    which may be based on specific debts or on the
    general assumption that a certain percentage of
    debtors amounts are doubtful (Hussey, 1999, p.
    138).
  • Do not confuse them with bad debts, which are an
    amount owed by debtors that is considered to be
    irrecoverable (Collis and Hussey, 2007, p. 141)
    that are written off immediately as
    an expense in the profit and loss
    account

15
Adjustments for doubtful debts
  • In the profit and loss account
  • Year 1 Show the provision for doubtful debts
    under expenses
  • In subsequent years, show only the increase or
    decrease in the provision (last years provision
    less this years provision) under expenses
  • In the balance sheet
  • Show the provision for the current year as a
    separate deduction from debtors under current
    assets
  • In the profit and loss account for Year 1, show
    the provision for doubtful debts under expenses

16
Exercise 2Post trial balance adjustments
  • Cotswold Coolers bookkeeper has drawn up the
    following trial balance from the records at 30
    June 2006
  • However, you can see that Ros has provided some
    additional year-end information regarding
    expenses which is not reflected in the trial
    balance
  • Required
  • Using the relevant figures from the trial balance
    and the additional information provided, draw up
    a final list of all the expenses for the year
    showing the adjusted amounts

17
Exercise 2 Cotswold CoolersTrial balance at 30
June 2006
18
Solution 1 Cotswold Coolers
Post trial balance adjustments
19
Cotswold CoolersProfit and loss account for the
year ending 30 June 2006
20
Cotswold CoolersBalance sheet as at 30 June 2006
21
Cotswold CoolersBalance sheet as at 30 June 2006
(continued)
22
Conclusions
  • Post trial balance adjustments are necessary to
    deal with outstanding matters at the end of the
    accounting period
  • In exercises and exams these adjustments are
    provided as additional information to the trial
    balance
  • If you tick every item as you use it in the
    financial statements you will have one tick
    against every item in the trial balance and two
    ticks against each adjustment, because these are
    shown once in the profit and loss account and
    once in the balance sheet
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