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What Do We Do With the Source Documents?

These must be posted onto the "books of original entry." These record on a daily basis every transaction that a business makes. The books are often referred to as "journals" e.g. The Purchases Journal. They record the details of the transaction, the amount of money involved and the date of the transaction. Each transaction will have a folio number. Do you want to see an example? There are seven books of original entry: The Purchases Day Book This records all purchases made by a company.

The Sales Day Book This records all sales made by a company

The Purchases Returns Book This records all items purchased by a company and subsequently returned to the seller.

The Sales Returns Book This records all items sold by a company which were subsequently returned by the buyer.

The Journal Proper This records rarer items such as the purchase of capital items.

The Cash Book This records cash and cheques both issued and received.

The Petty Cash Book This records all items purchased using money from the petty cash account. Where do the books of original entry fit into a basic accounting system? The "Day Books" or "Journals" form the first tier of the system. They record each financial transaction from the source documents. Source Documents

Purchases Returns Book

Purchases Day Book

Sales Day Book

Sales Returns Book

Journal Proper

Cash Book: Cash in / Cash out Cheques in / Cheques Out

Petty Cash Book

What happens to these records then? They are transferred onto the most important books in the accounting system: The "ledgers". There are three ledgers and the cash book: The Creditors' Ledger or in debt. Before you look at these ledgers in more detail we suggest you look at how these accounts are laid out, which column is which, and how they are balanced off. The Debtors' Ledger The Cash Book The General Ledger

All of the ledgers contain "accounts". These "accounts", just like bank accounts are either in credit

Which Column Is Which?


Each of the accounts is separated into two columns. The left hand column is used to show receipts and the right hand side is used to show payments. There is a simple rule to explain which side of the account you should list any particular transaction. Debit - the account that receives the goods, services or money. (The receiver) Credit - the account that gives goods, services or money. (The giver) A local business called Sharp Ltd has an account with Pepe. They often have long business meetings and have pizzas delivered. If we look at their account below we can see that on May 10th they purchased pizzas from Pepe on credit. Sharp Ltd is the receiver of goods and the transaction is therefore entered on the debit side. On June 9th (thirty days later) Sharp Ltd makes a payment for the goods. Sharp Ltd is the giver in this case and so his account is credited. Account of Sharp Ltd DR Debit Side Date May 10 Details Sharp Ltd Purchase pizzas on credit June 09 Payment made for XYZ 200.00 Folio XYZ Amount 200.00 Date Details Folio CR Credit Side Amount

goods At any given day, week or month the account can be balanced off.

How Do We Balance the Account?


On any day, week, month or year accounts can be balanced to see whether any particular account is in credit or debt. To do this we look at which side is larger than the other. In the case of the account of Sharp Ltd, we can see that on the left hand side there are total transactions of 750.00 and on the right the lower amount of 500.00 for the period May 1st to June 30th. To balance off the account, however, both sides must be made to balance, however. To do this the difference between the higher and lower figure is added to the column with the lower total. In this case 250.00 must be added to the right hand column. The figure is entered against "balance carried down (c/d)". This means that the two columns balance. Notice however that the same figure is immediately taken down to the opposite side of the account to begin the list of transactions for the following period. Account of Sharp Ltd DR Debit Side Date Details Folio Amount 550.00 XYZ 200.00 Date Details CR Credit Side Folio Amount

May 01 Balance b/d May 10 Sharp Ltd Purchase goods on credit

June 09 June 15 June 30 750.00 July 01 Balance b/d 250.00

Payment made for goods Payment made for goods Balance c/d

XYZ

200.00

YXY

300.00

250.00

750.00

You now need to understand what sort of accounts each of the ledgers contain.

The Main Ledgers


The Creditors' Ledger The Debtors' Ledger The Cash Book The General Ledger

All of the ledgers contain "accounts". These "accounts", just like bank accounts are either in credit or in debt. For Pepe's Pizza Parlour, when Pepe has money in his bank account then the bank owes Pepe money. In this case Pepe is the bank's creditor and the bank is his debtor. In fact Pepe is overdrawn

and has an arranged overdraft. Pepe owes the bank money. In this case Pepe is the bank's debtor and the bank is Pepe's creditor. Every party with which Pepe's Pizza Parlour has a transaction has an "account" with the business i.e. people who Pepe buys goods from and people who Pepe sells goods to. In addition there are accounts to represent how much equipment the business owns, expense accounts to cover the day to day expenses of the business. If Pepe opens an account with someone new it simply means that he gives them a page in one of the ledgers. Every one of these accounts can be either in credit (where the business is owed money) or in debt (where the business owes somebody else money).

The Creditor's ledger.


The creditors ledger will consist mainly of the accounts of businesses with whom goods are purchased on credit. Nearly all goods and services are paid for an agreed number of days after the transaction itself (i.e. 30 days, 60 days, 90 days etc.). When Pepe buys goods and services he is in debt to these businesses during the credit period. They are his creditors. Mr. R. Sandborne DR Debit Side Date Details Folio Amount Date May 01 May 06 May 15 May 31 Payment for goods Balance c/d C909 305.23 64.77 370.00 June 01 Balance b/d What this shows was that on May 01 Mr. Sandborne was owed 320.00 by Pepe's Pizza Parlour. On May 06 Pepe purchased 50.00 worth of eggs from him on credit. Mr. Sandborne is therefore the giver of goods and his account is therefore credited. On May 15 305.23 fell due for payment to Mr. Sandborne and the amount was paid. In this case Mr. Sandborne was the receiver of money and his account is therefore debited. On May 31 the account was ruled off and at this point Mr. Sandborne was owed 64.77 by Pepe's Pizza Parlour. He is Pepe's creditor. The account balance is carried down on the right hand side of the ledger. 370.00 64.77 Details Balance b/d Purchase of Eggs C912 Folio CR Credit Side Amount 320.00 50.00

The Debtor's Ledger

In the case of Pepe's Pizza Parlour the debtor's ledger will consist mainly of the accounts of businesses who purchase goods or services off Pepe i.e. sales. These goods and services are normally purchased on credit. Nearly all goods and services sold are paid for an agreed number of days after the transaction itself (i.e. 30 days, 60 days, 90 days etc.). During this period those parties purchasing the goods would be in debt to Pepe's Pizza Parlour. They are Pepe's debtors. Mr. P. Thompson DR Debit Side Date May 01 May 08 Details Balance b/d Credit sale (outside catering) May 16 May 31 1,350.00 June 01 Balance b/d 650.00 1,350.00 Payment received Balance c/d 650.00 R250 700.00 C812 Folio Amount 850.00 500.00 Date Details Folio CR Credit Side Amount

What this shows was that on May 01 Mr. P.Thompson owed Pepe 850.00. On May 08 Pepe sold an outside catering service to him on credit at a cost of 500.00. Mr Thompson was the receiver of this service and his account is therefore debited. On May 16 700.00 fell due for payment to Pepe from Mr.Thompson and the amount was paid. In this case Mr. Thompson is the giver of money and his account is therefore credited. On May 31 the account was ruled off and at this point Mr. Thompson owed Pepe's Pizza Parlour 650.00 He is Pepe's debtor and so the account balance is carried down on the left hand side of the ledger.

The Cash Book.


The cash book shows the amount of money flowing in and out of a business. It may be made up of several "accounts" i.e. There may be a separate account to show the amount of cash in the business and the amount at the bank. Receipts are shown on the left hand side of the ledger and payments shown on the right. Just like the other ledgers the cash book can be balanced off at any time. Midley's Bank Account No. 7060440 Pepe's Pizza Parlour DR - Receipts Payments - CR

Date

Details

Cheque No.

Amount

Date

Details

Cheque No.

Amount

May 01 May 10 May 15 May 16 Mr. P. Thompson May 18 May 23 7060531 700.00

Balance b/d

1,945.77

Purchase of flour (Mr. Alberto) Mr. R. Sandborne

2030219

200.00

2030220

305.23

>Cook's cash and carry Payment for oven liner (Ovens 'R' Us)

2030221

89.00

2030222

160.00

May 31

Balance b/d

2,000.00

2,700.00 Balance b/d

2,700.00 2,000.00

What this shows was that on May 01 the balance in Pepe's Midley's bank account no. 7060440 was 1,945.77 overdrawn. On May 10 a payment of 200.00 was made to Mr. Alberto. The account was a giver of money and is therefore credited. On May 15 a payment of 305.23 was made from the account to Mr. R. Sandborne. The account was a giver of money and is therefore credited. On May 16 700.00 fell due for payment from Mr. Thompson and the amount was paid into the account. The account was a receiver of money and was therefore debited. On May 23 a payment was made from the account to Ovens 'R' Us. The account was a giver of money and was therefore credited. On May 31 the account was balanced off and was 2,000.00 overdrawn. Pepe's Pizza Parlour owes the account this figure. It is therefore Pepe's creditor and the account balance is carried down to the right hand side of the book.

The General Ledger

The General ledger contains all the other accounts of the business which are not connected with customer sales, purchases from clients or cash and bank accounts. The sort of accounts that would be held in the general ledger would be things such as: Owners capital Asset Accounts (i.e. fixtures and fittings, equipment / machinery, furniture etc.) Drawings accounts - Money taken out of the business by the owner(s)

Expense accounts

Equipment / Machinery Account DR Debit Side Date May 01 May 09 Credit purchase of oven liner (Ovens 'R' Us) May 15 May 31 19,175.00 June 01 Balance b/d 19,100.00 19,175.00 Sale of hotplates Balance c/d 19,100.00 C963 75.00 C950 160.00 Details Balance b/d Folio Amount 19,015.00 Date Details Folio CR Credit Side Amount

What this shows was that on May 01 Pepe's Pizza Parlour owned equipment to the value of 19,015.00. On May 09 Pepe purchased an oven liner on credit for 160.00. Pepe was the receiver of equipment and the account was therefore debited. On May 15 Pepe sold hot-plates on credit to the value of 75.00. Pepe was the giver and the account is therefore credited. On May 31 the account was balanced off and at this point Pepe's Pizza Parlour owned furniture to the value of 20,000.00. The furniture account owes Pepe this figure. It is therefore his debtor and the account balance is carried down to the left hand side of the ledger.

Why Is It Called a "Double Entry" Bookkeeping System?

You have already seen examples of the types of accounts held in each of the ledgers. You now have to think of the business as nothing else but a collection of accounts. Some of these accounts owe the business money and some of them are owed money by the business. All of the accounts must balance. At any one time the total value of the accounts in credit must equal the total value of the accounts in debt. When the business makes any transaction at all money is moved from one account to another. If for example Pepe makes a payment of 200.00 for some flour which he purchased from Alberto's wholesalers then Alberto's account is debited by 200.00. Alberto is the receiver of money and the transaction is therefore entered on the debit side. (Remember the principle; Debit the receiver, credit the giver.) Alberto's Account DR Debit Side Date Details Folio Amount Date Details Balance b/d May 10 Purchase of flour XYZ 200.00 Folio CR Credit Side Amount 500.00

Alberto is one of Pepe's creditors. He supplies Pepe with flour on a regular basis. You can see that at the beginning of the accounting period Pepe owed Alberto 500.00. After the payment was made this figure will be reduced to 300.00. Alberto has received money and his account must be debited. In order that the accounts balance another account must be credited. In this case it is the bank account. Bank Account - Pepe's Pizza Parlour DR Debit Side Date Details Folio Amount Date Details Balance b/d May 10 May 23 May 31 Balance c/d 2,000.00 2,000.00 Balance b/d 2,000.00 2,000.00 Payment for flour Payment for oven liner XYZ C950 Folio CR Credit Side Amount 1,640.00 200.00 160.00

In this case the bank account is already Pepe's creditor by the fact that Pepe has an overdraft. Before the payment was made to Alberto, Pepe owed the bank 1,640. With a 200.00 payment to Alberto and one other payment this figure has risen to 2,000.00. Let's see another example of double entries.

On May 9th Pepe bought an oven liner on credit from Ovens 'R' Us. The equipment account is the receiver and must therefore be debited. (Remember the principle; Credit the giver, debit the receiver.) Equipment / Machinery Account DR Debit Side Date Details Folio Amount 19,015.00 C950 160.00 Date Details Folio CR Credit Side Amount

May 01 Balance b/d May 09 Credit purchase of oven liner (Ovens 'R' Us)

May 15 Sale of hotplates May 31 Balance c/d 20,075.00 June 01 Balance b/d 20,000.00

C963

75.00

20,000.00 20,075.00

The above account has been debited because it is a receiver. There now has to be a credit to another account. In this case it is the account of Ovens 'R' Us. Ovens 'R' Us Account DR Date Details Folio Amount Date May 09 May 23 Payment for oven C950 liner 160.00 Details Credit purchase of oven liner (Ovens 'R' Us) Folio C950 CR Amount 160.00

On May 9th Ovens 'R' Us sold the oven liner on credit. They were the giver and their account is credited. On May 23rd they received payment for the goods and there account was debited. This second transaction (a debit) will require a credit to be made to another account; The bank account. Bank Account - Pepe's Pizza Parlour DR Debit Side Date Details Folio Amount Date Details Balance b/d May 10 Purchase of flour XYZ Folio CR Credit Side Amount 1,640.00 200.00 160.00

May 23 Payment for oven liner C950 May 31 Balance c/d 2,000.00 2,000.00 Balance b/d

2,000.00 2,000.00

Before the payment was made to Alberto, Pepe owed the bank 1,840. With a payment to Ovens 'R' Us this figure has risen to 2,000.00.

Double Entries Assignment


Question 1. Pepe needs to keep his stock levels high as he anticipates a busy Saturday night. He has a regular supplier of fresh anchovies called Toni's Fresh Fish. Pepe buys 25.00 of anchovies on credit. (a.) Is the "stock" account debited or credited? (b.) Is "Toni's fresh fish" account debited or credited? Question 2. Pepe buys a van on credit from "Dodgy Vehicle Sales". (a.) Is "Dodgy Vehicle Sales" account debited or credited? (b.) Is the "Motor Vehicle" account debited or credited? Question 3. Before the payment for the van is due Pepe discovers a major mechanical fault. He returns the van to "Dodgy Vehicle Sales". Mr. Dodgy offers Pepe a 500 discount on the value of the van which Pepe accepts. (a). Is the "Motor Vehicle" account debited or credited? (b.) Is "Dodgy Vehicle Sales" account debited or credited? Question 4. If the payment had already been made, which other account would have to be adjusted?

Answers to Double Entries Assignment


Question 1. Answer: a. b. The "stock" account is debited The "Toni's Fresh Fish" account is credited

Question 2: Answer: a. b. The "Dodgy Vehicle Sales" account is credited. The "Motor Vehicle" account is debited.

Question 3: Answer: a. b. The "Motor Vehicle" account is credited. The "Dodgy Vehicle Sales" account is debited.

Question 4: Answer:

The "Bank" account would be credited.

Remember; Credit the giver, debit the receiver.

What do we do with the balanced accounts?


Let us assume that on a given date we have taken each of our ledgers and balanced all of the accounts within them. What do we do with them now? We put them together to form a "trial balance." All the accounts should have been balanced off correctly and they will all be used. Those accounts which have their balances on the left hand side are our debtors and those balances will appear in the left hand column of the trial balance. Those accounts with their balances on the right hand side of the account are our creditors and those balances will appear on the right hand side of our trial balance. Remember that every transaction that a business carries out is recorded against two accounts (i.e. a double entry). Provided that the accounts were balanced correctly at the beginning of the accounting period then left column (Dr) and the right column (Cr) should total exactly the same. If they do not then a mistake has been made. The creditors' accounts will usually be added together and shown on the trial balance as "Bought ledger control". Similarly, the debtors' accounts will be added together and shown on the trial balance as "Sales ledger control".

Assets and Liabilities


What do you understand by the word "Asset?" Assets are items which are owned by a business or money which is owed to the business. If Pepe owned his pizza parlour then the building would be an asset of his business. Assets fall into two groups: Fixed Assets - These are items which have a life span of more than one year. They are usually items that the business expects to keep. Fixed assets include land and buildings, plant and machinery, fixtures and fittings and motor vehicles. These assets fixed because they are necessary for the business to trade but are not affected by the level of trade or the profit made. If a business purchases any fixed assets then this is known as capital expenditure. If Pepe decided to purchase a new delivery van then it would be a new fixed asset of the business. Current Assets - These are items which are much shorter term. The value of these items change in proportion to the amount of trade that a business engages in. If Pepe's business is doing good trade then he would have to purchase more stock (i.e. pizza bases, cheese etc.). This stock would be a current asset of the business.

Current assets include stocks (raw materials, work in progress and finished goods for resale), debtors (money owed to the business), bank balances and cash in hand. Current assets are often described as being more "liquid" or having higher "liquidity". What this simply means is that assets of this type are much easier to turn into cash. What do you understand by the word "Liability?" Liabilities are amounts that are owed by a business. These fall into two groups. Long term liabilities - These are loans that are repayable in more than one year. If the business premises were mortgaged, then that mortgage would be a long term liability. In addition, the capital put into the business by the owner would be looked on as money that is owed by the business to the owner. This again would be a long term liability. Current liabilities - These are amounts which are owed by a business which must be repaid within the next twelve months. Current liabilities include money owed to creditors (for goods purchased but not yet paid for), money owed for services such as the telephone bill (often called accrued expenses) and bank overdrafts. You may think that an overdraft is repayable over a longer term but the bank can demand repayment at any time. If you have worked through each of the sections of background reading you are now ready to learn about trial balances, trading and profit and loss accounts, balance sheets, cash flow statements and solvency / profitability / performance ratios.

The Accounts
You can choose to work through the preparation of Pepe's accounts, starting with the Trial Balance or you can use this as a revision package for the particular Account you need to revise.

The Trial Balance The Trading and Profit & Loss Account The Balance Sheet Depreciation The Profitability, Solvency and Performance Ratios Return to the main menu?

The Trial Balance


Because of the number of entries made in the books, there is a need to check their accuracy. This is called The Trial Balance. It consists of taking and listing every balance in the ledger at that date. The trial balance is an arithmetic check of the double entry system. So it is checking that both aspects of every transaction been recorded accurately; that for every debit entry, is there an equal value for its corresponding credit.

The total debits should equal the total credits. The trial balance will fail to balance if both aspects of a transaction are not recorded. It may at first sight appear that if the trial balance actually balances then the books are correct. This ,however, is quite wrong. It just means that both a debit and credit entry has been made for each transaction. It does not guarantee that the entry itself is correct. If the trial balance does not balance, then you should first check that there are no errors in the addition of each account, check that there is an entry in both a debit and credit account and that the same figure was entered for both the debit and credit entry. There are errors that can be made in accounts which will not be highlighted with a trial balance. For example if a transaction is completely omitted from the books and it was not entered either as a debit entry or credit entry, then the trial balance would still balance. If there were two entries made but one of them was made into the wrong account, the books would still balance. If the entries were made on the wrong side of the account for both entries then, again , the books would still balance.

Pepe's Trial Balance


Dr Capital : Pepe Drawings : Pepe Premises Equipment, machinery Motor Vehicle Mortgage on Premises Stock (opening 1.1.9-) Petty Cash, Float Sales ledger control ( debtors) Bought Ledger Control ( creditors ) Sales Returns inwards Purchases Returns Outwards Wages Light & Heat Telephone Printing & Stationary Advertising Motoring Expenses Interest Payable Bank overdraft TOTALS 201300 8500 1400 600 900 2500 1800 200 2000 201300 800 36800 1300 70000 4000 200 7600 5000 8000 100000 8000 20000 70000 Cr 53000

NOTE: value of closing stock 31.12.9- is 5500. This is the trial balance for Pepe's Pizza Parlour. These figures have been taken from the balances of the "T" accounts. These figures are those from which the Trading and Profit and Loss Account and the Balance Sheet will be calculated. It is good practice to remember if you use a balance from the Trial Balance, tick it off. If you use a figure from the notes at the end of the Trial Balance these should be used twice. This is because the balances in the Trial balance already have an equal and opposite balance within the accounts. The figures given in the notes need to have both a credit and debit entry. So the notes at the foot of the Trial balance should be ticked off twice. The purpose of the Trading and Profit and Loss Account is to determine the business's profit or loss in the accounting period under review, so it would be for the financial year ending 31.12.9-. The preparation of the Balance Sheet represents the business's financial position in terms of its assets, liabilities and capital. So in general terms:

The Trial Balance - Which Balance Goes To Which Account?


Dr balance sheet Capital : Pepe balance sheet Drawings : Pepe balance sheet Premises balance sheet Equipment, machinery balance sheet Motor Vehicle balance sheet Mortgage on Premises trading & P&L balance sheet Petty Cash, Float balance sheet Sales ledger control ( debtors) balance sheet Bought Ledger Control ( creditors) trading & P&L Sales 200 7600 5000 70000 Stock (opening 1.1.9-) 4000 8000 100000 8000 20000 70000 53000 Cr

trading & P&L trading & P&L trading & P& trading & P&L trading & P&L trading & P&L trading & P&L trading & P&L trading & P&L trading & P&L

Returns inwards Purchases Returns Outwards Wages Light & Heat Telephone Printing & Stationary Advertising Motoring Expenses Interest Payable

800 36800 1300 8500 1400 600 900 2500 1800 200 2000

balance sheet bank overdraft

TOTALS 201300 201300 NOTE: value of closing stock 31.12.9- is 5500. trading & P&L and balance sheet

The Trading and Profit & Loss Account


One of the most important uses of the Trading and The Profit and Loss account is to compare the results obtained with the results expected. There are two profit measures:

The Gross Profit. This is calculated in the Trading Account and is the excess of sales over the cost of goods sold during the period.

The Net Profit. This is calculated in the Profit and Loss Account and is what remains after all other costs used up in the period have been deducted from the Gross Profit.

It is now usual for the trading and the Profit and Loss accounts to be shown under one combined heading, The Trading Account being the top section and the Profit and Loss account being the lower section. It would be unusual for a trader to have sold all the goods at any particular date. So in most cases there would be stock in hand at the end of the trading period. So it is normal practice for this stock to be counted and valued at the price for which it could be sold. The figure for this is normally called

the closing stock and the details are given as a note at the end of the Trial Balance. This amount is in fact entered as a debit in a new account called the Stock account, which is an asset account and as a credit in the Trading account. The Trading Account also shows any items of expenditure which can properly be allocated to expenses connected with the purchase, manufacture or stage of goods, i.e. rent of warehouse, wages of store men, carriage inwards, etc. Other considerations: Returns Outwards - Goods returned to suppliers, so this reduces the cost of purchases. Returns Inwards - Goods returned to the company by the customers who bought them, so this reduces the sales figure. Carriage Inwards - Is the cost of transport of goods into the firm and are therefore added to the purchases figure. Carriage Outwards - Is the cost of transport of goods out of the firm to its customers, it is not part of the firm's expenses in buying the goods and is always entered in the Profit and Loss Account as an expense not the Trading Account. Depreciation - This is discussed later, but generally the provision for depreciation for the accounting period is considered an expense to the business is entered on the Profit and Loss Account. ( The total depreciation of the asset is taken account of on the Balance Sheet).

The Trading and Profit & Loss Account


This is the basic outline of a Trading and profit and Loss Account: SALES minus Returns Inward MINUS COST OF SALES opening Stock plus Purchases minus Returns Outward plus Carriage Inwards minus Closing Stock GROSS PROFIT LESS EXPENSES wages light and heat printing and stationary telephone carriage outwards

advertising overheads discount allowed motoring expenses interest payable PLUS OTHER INCOME commission received discount received NET PROFIT

Let's complete the Trading and Profit & Loss account


So lets start filling in the figures from the Trial balance to complete Pepe's Trading & Profit and Loss Account. The first figure is the Sales. If you look at the Trial Balance you will find this figure of 70,000. We have filled this in for you. Now complete the rest, Don't forget to tick off the figure on the Trial Balance as you use it for this account. SALES minus Returns Inward MINUS COST OF SALES opening Stock plus Purchases minus Returns Outward plus Carriage Inwards minus Closing Stock GROSS PROFIT LESS EXPENSES wages light and heat printing and stationary telephone carriage outwards advertising overheads discount allowed motoring expenses interest payable __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ __________________ 70,000 __________________ __________________

PLUS OTHER INCOME commission received discount received NET PROFIT This is the correct version of Pepe's Trading and Profit and Loss Account for the year ending 31.12.9 SALES minus Returns Inward MINUS COST OF SALES opening Stock plus Purchases minus Returns Outward plus Carriage Inwards minus Closing Stock GROSS PROFIT LESS EXPENSES wages light and heat printing and stationary telephone carriage outwards advertising overheads discount allowed motoring expenses interest payable PLUS OTHER INCOME commission received discount received NET PROFIT -------------19,300 8,500 1,400 900 600 ----2,500 --------1,800 200 (15,900) 19,300 --------------39,500 (5,500) (34,000) 35,200 36,800 (1,300) 35,500 4,000 70,000 (800) 69,200 __________________ __________________ __________________ __________________

The Balance Sheet

The Balance Sheet is a list of the balances remaining on the Trial Balance after the Trading & Profit & Loss account has been done. The balances are arranged according to whether they are asset balances or liability or capital balances and gives the business's financial position at any given point in time. The Balance sheet is normally described " as at ". It is a snapshot at one particular point in time. The balance sheet can be prepared in two formats: Vertically, emphasising Assets - Liabilities = Capital or Horizontally, emphasizing Assets = Capital + Liabilities For the purposes of this exercise we will be using the vertical format, as this is most widely used in all types of businesses and its form of presentation makes comparisons with other years easier. To re-cap: ASSETS - There are two types of assets: Fixed assets are the more or less permanent assets of the business. They are not normally for resale, e.g. premises, motor vehicles, fixtures and fittings, equipment and furniture. Current assets are the types of assets used for trading purposes. These assets are usually more liquid than the fixes assets. In other words they are more readily converted into cash. They include cash, bank, debtors and stock. LIABILITIES - There are two main types of liabilities: Long term liabilities and are the creditors payable after 12 months. They include mortgages, loans, hire purchase repayments longer than 12 months and debentures. Current liabilities represent the debts of the business which have to be paid in less than 12 months. These include trade creditors, bank overdrafts, and short-term loans that are repayable within 12 months. CAPITAL Capital represents what is known as " the net worth" of the owner(s). It is the difference between the assets and the liabilities. In the Balance Sheet it is listed under the "Financed By:" section. It includes capital introduced into the business, (which could be personally from the owners if a sole trader or partnership, or from the shareholders if a limited company), the net profit for the accounting period, less any owners drawings.

The Balance Sheet


This is the basic outline of a Balance Sheet :

FIXED ASSETS Premises Equipment Machinery

CURRENT ASSETS Stock Debtors Bank Petty Cash

LESS CURRENT LIABILITIES Creditors Bank Overdraft TOP TOTAL

CAPITAL EMPLOYED less mortgage

FINANCED BY: net profit capital less drawings BOTTOM TOTAL

The Balance Sheet


So lets start filling in the figures from the Trial balance to complete Pepe's Balance sheet. The first figure is the premises. If you look at the Trial Balance you will find this figure of 100,000. We have filled this in for you. Now complete the rest. Don't forget to tick off the figure on the Trial balance as you use it for this Balance Sheet.

FIXED ASSETS Premises Equipment Machinery Motor Vehicle CURRENT ASSETS Stock Debtors Bank Petty Cash __________________ __________________ __________________

100,000 __________________ __________________ __________________ __________________

__________________ __________________

LESS CURRENT LIABILITIES Creditors Bank Overdraft __________________ __________________ __________________ __________________

CAPITAL EMPLOYED less mortgage TOP TOTAL

__________________ __________________ __________________

FINANCED BY: capital net profit less drawings __________________ __________________ __________________ __________________

BOTTOM TOTAL

__________________

The Balance Sheet


This is the correct version of Pepe's Balance Sheet as at 31.12.9

FIXED ASSETS Premises Equipment Machinery Motor Vehicle CURRENT ASSETS Stock Debtors Bank Petty Cash LESS CURRENT LIABILITIES Creditors Bank Overdraft CAPITAL EMPLOYED less mortgage 5,000 2,000 (7,000) 6,300 134,300 70,000 64,300 FINANCED BY: capital net profit less drawings This is the simplest form of Balance Sheet. However for most businesses there is an item called DEPRECIATION that has to be accounted for. Lets see how this would affect both the Trading & Profit and Loss Account as well as the Balance Sheet. 53,000 19,300 72,300 (8,000) 64,300 5,500 7,600 ---200 13,300 100,000 8,000 ------20,000 128,000

Depreciation
Fixed assets are those assets of the business that have a long life, are used in the business and are not for re-sale or for conversion to cash, e.g. motor vehicles, machinery, buildings, land, office equipment, etc. However, usually, except for land, most fixed assets have a limited number of years of useful life. Depreciation can be defined, in its simplest terms, as the difference between the original cost of the asset and the amount received when the asset is sold, for example, if Pepe buys a motor vehicle for 20,000 and then sells it for 8,000, then the total depreciation is 12,000. If an asset is bought and sold within one accounting period, (normally one trading year) then the depreciation can be accounted for within one accounting period. However difficulties arise because most assets are used for more than one accounting period. Pepe is planning to keep his vehicle for four years. In this instance there are two main methods of calculating the provision for depreciation, straight line and reducing balance. The choice of which method to use depends upon whether the

main value to the business of the asset is gained evenly throughout the life of the asset or whether it is gained mainly in the early years of the asset when it is newer and the repairs and maintenance costs are lowest.

The Straight-Line Method of Calculating Depreciation


This allows an equal amount to be charged as depreciation for each year of the expected use of the asset. The basic formula is: ORIGINAL COST - ESTIMATED COST WHEN SOLD / NO. OF YRS OF EXPECTED USE PROVISION PER YR. = DEPRECIATION In Pepe's case, he paid 20,000 for a motor vehicle. He expects to use it for four years before he replaces it. He estimates that when he sells it in four years time he will get 8,000 for it. So, for Pepe, the calculation for the provision for depreciation would be: 20,000 - 8,000 = 3,000 per year 4 The figures from which to calculate the depreciation are normally given as a note at the end of the Trial Balance. This means that within the accounts there must be both a credit and debit entry. So the Provision for depreciation FOR THAT YEAR is added as an expense on the Trading & Profit & Loss Account. On the Balance Sheet, the total amount of depreciation, (the provision for depreciation for this year plus any other provision from previous years) is deducted from the original value of the motor vehicle and so reduces the value of the fixed assets.

Trading and Profit & Loss Account


This is the revised TRADING and PROFIT & LOSS account, including the PROVISION FOR DEPRECIATION, calculated using the Straight-Line Method. 70,000 (800) 4,000 36,800 (1,300) -------35,500 39,500 (5,500) 69,200

SALES minus Returns Inward MINUS COST OF SALES opening Stock plus Purchases minus Returns Outward plus Carriage Inwards minus Closing Stock GROSS PROFIT LESS EXPENSES wages light and heat printing and stationary telephone

(34,000) 35,200

8,500 1,400 900 600

carriage outwards advertising overheads discount allowed motoring expenses provision for depreciation interest payable PLUS OTHER INCOME commission received discount received NET PROFIT

----2,500 --------1,800 3,000 200

(18,900) 16,300

---------

-----16,300

This is the revised version of Pepe's Balance Sheet as at 31.12.9- using the Straight-line Method of calculating Depreciation. Premises Equipment Machinery Motor Vehicle CURRENT ASSETS Stock Debtors Bank Petty Cash LESS CURRENT LIABILITIES Creditors Bank Overdraft CAPITAL EMPLOYED less mortgage FINANCED BY: capital net profit less drawings cost depreciation 100,000 ------8,000 -----------------20,000 3,000 5,500 7,600 ---200 5,000 2,000 100,000 8,000 -----17.000 125,000

13.300

(7,000)

6,300 131,300 70,000 61,300

53,000 16,300

69,300 (8,000) 61,300

The Reducing Balance Method of Calculating Depreciation


This method calculates the Provision for Depreciation annually on the balance of the asset from the previous year. It is normal for the percentage to be used to be specified in the notes at the end of the Trail Balance. This method is particularly useful for assets where the repair and maintenance costs increase as the asset gets older, for example on a motor vehicle. By reducing the Provision for Depreciation as the repair and maintenance cost rise, means that the total usage costs each year are kept fairly constant.

So, if Pepe's Accountant recommends using the Reducing Balance Method for calculating the Provision for Depreciation for his motor vehicle, assuming 20%, the figures would be: YEAR 1 - 20,000 (purchase price)

less 4,000 ( 20% of 20,000) Provision for Depreciation Year 1

16,000 (asset value at the end of year 1)

YEAR 2 - 16,000 ( asset value at the end of year 1)

less 3,200 ( 20% of 16,000) Provision for Depreciation Year 2

12,800 ( asset value at the end of year 2)

YEAR 3 - 12,800 ( asset value at the end of year 2)

less 2,560 ( 20% of 12,800) Provision for Depreciation Year 3

10,240 ( asset value at the end of year 3)

YEAR 4 - 10,240 ( asset value at the end of year 3)

less 2,048 ( 20% of 10,240) Provision for Depreciation Year 4

8,192 ( asset value at the end of year 4)

So again there needs to be a credit and debit entry in the accounts. The Provision for Depreciation, JUST FOR THIS ACCOUNTING PERIOD, is an expense on the Trading & Profit and Loss Account. On the Balance Sheet, the Provision for Depreciation for this period is added to the Provision for Depreciation made in previous years, and then this total is taken from the original cost of the asset to give the value of that asset in this trading period.

This is the revised TRADING and PROFIT & LOSS Account using the reducing balance method of calculating Depreciation SALES minus Returns Inward MINUS COST OF SALES opening Stock plus Purchases minus Returns Outward plus Carriage Inwards minus Closing Stock 36,800 (1,300) -------35,500 39,500 (5,500) (34,000) 4,000 70,000 (800) 69,200

GROSS PROFIT LESS EXPENSES wages light and heat printing and stationary telephone carriage outwards advertising overheads discount allowed motoring expenses provision for depreciation interest payable 8,500 1,400 900 600 ----2,500 --------1,800 4,000 200

35,200

(19,900) 15,300

PLUS OTHER INCOME commission received discount received NET PROFIT -------------15,300

This is the revised version of Pepe's Balance Sheet as at 31.12.9- using the Reducing Balance Method to calculate the depreciation cost Premises Equipment Machinery Motor Vehicle CURRENT ASSETS Stock Debtors Bank Petty Cash LESS CURRENT LIABILITIES Creditors Bank Overdraft CAPITAL EMPLOYED less mortgage 5,000 2,000 7,000 6,300 130,300 70,000 60,300 5,500 7,600 ---200 13.300 100,000 8,000 -----20,000 depreciation ------------------4,000 100,000 8,000 -----16.000 124,000

FINANCED BY: capital net profit less drawings 53,000 15,300 68,300 (8,000) 60,300

Profitability, Solvency and Performance Ratios


Once the accounts have been done, and are ready to be published. A number of people might want to compare them with other companies operating in the same financial sector. How do they do this? The answer is to use profitability, solvency and performance ratios. These are quite simple formulae which help to create a picture of the company. This worksheet identifies the name of the ratio, the formula, where we should be looking in the accounts and what it means. These ratios are not by themselves the answer to all questions, but an indicator of areas requiring further examination. Try some out! Have a go with the figures from Pepe's Pizza Parlour. Please note: The / symbol means divide by.

Profitability
How successful a company is depends upon its profitability. The key ways in which we work out these are called the Return on Capital Employed and the Gross and Net Profit Margins.

Return on Capital Employed (ROCE)


This is expressed in percentage terms and is often called "return on owner's equity". It represents the profit earned from the money invested in the business by it's owner. It can be worked out by the following equation: (Net Profit (before Interest and tax) / Capital Employed) x 100 So a company generating a net profit of 250,000 before deduction of interest and tax which has an opening balance on it's capital account 1M would have a Return on Capital of 25%.

Gross and Net Profit Margins


These are the most commonly used profitability ratios. They express the comparison between sales and profit in percentage terms, and are worked out by the following equations: (Gross Profit Margin = Gross Profit /Sales) x 100 (Net Profit Margin = Net Profit / Sales) x 100

So, if the company which generated a net profit of 250.000 had achieved sales of 750.000 the profit margin would be 33%.

Solvency
The solvency or liquidity of a company tells us whether a company can pay its debts. We work how solvent companies are by using the Liquidity Ratios.

Liquid Ratio (or Acid test)


This ratio is calculated as follows: Liquid assets / Current liabilities. Liquid assets are those assets which can be turned into cash quickly such as debtors, cash and short term investments such as bank deposits. Stock is not considered a liquid asset. Current liabilities are those liabilities which must be paid shortly such as creditors and bank overdrafts. A bank overdrafts is considered to be a current liability because it can be recalled without notice. The ideal ratio should be around 1:1. If, for example, a company had liquid assets of 60,000, and debts of 40,000 the ratio would be: 60,000 / 40,000 : 1 Expressed as 1.5 : 1 This means that the company has more assets (1.5) than liabilities (1). This company is solvent but may not be managing it's money very well. If the figures were reversed then the ratio would change as follows: 40,000 / 60,000 : 1 Expressed as 0.66 : 1 This would mean that the company is in serious trouble since it would not have sufficient funds to meet its liabilities.

Current or Working Capital ratio


This is the other test of a companies liquidity. It takes a longer term view of the company's position since unlike the Acid test it includes stock and work in progress ( this is termed Current assets). This is due to the fact that it is deemed that both of these will at sometime be turned into debts and eventually into cash. The ratio is worked out as follows: Current assets / Current liabilities therefore a company with current assets of 80,000 with the current liabilities of 40,000 would equate as follows: 80,000 / 40,000 = 2 and would be expressed as 2 : 1.

There is no "ideal" ratio but a figure of 2:1 is often quoted. Most businesses operate with a ratio lower than this but it is important to maintain a healthy figure because bank overdrafts can in theory be recalled without notice at any time.

Performance
These ratios provide information on how well a business is being run.

Rate of Stock turnover


Businesses try to have as high a rate of stock turnover as possible. The rates can be expressed in two ways. (Average stock / Cost of goods sold) x either 12, 52 or 365 This tells a business how long on average an item remains in stock. The figure can be expressed in terms of months, weeks or days. For Pepe's Pizza Parlour, this would result in the following: 4,750 / 39,500 x 365 = 44 days (on average) Cost of goods sold / Average stock This tells a business how many times in each year the stock rotates. For Pepe's Pizza Parlour, this would result in the following: 39,500 / 4,750 = 8.3. i.e. The stock is cleared 8.3 times a year. Note! In both cases the average stock can be calculated from the Trading and Profit and Loss account by: Opening stock + Closing stock / 2. For Pepe's Pizza Parlour this is 4,000 + 5,500 / 2 = 4,750.

Debtors collection period


Most businesses sell goods on credit. Credit is usually given for periods of 30, 60 or 90 days. No business wishes to extend the credit period given and so it is important to monitor just how long customers are taking to pay for credit sales. The following ratio can be used: Debtors / Average daily sales (Sales divided by 365)

Creditors payment period


It is important for a business to monitor how long it takes to pay it's creditors. Persistent late payment may result in a supplier cutting off credit facilities! The following ratio can be used: Creditors / Average daily purchases (Purchases divided by 365)

Gearing (income gearing)

Gearing is the name given to the ratio which measures how much of a company's profits are taken up by interest payments. It is expressed as a percentage, and is worked out by: (Interest / Profit) x 100 Therefore a company with interest payments of 35,000 whilst earning 50,000 would have the following gearing ratio: (35,000 / 50,000) x 100 = 70% This company would be susceptible to changes in the interest rate. Whereas a company with a gearing ratio of 40% could absorb any increases in the interest rate with greater ease.

Profitability, Solvency and Performance Ratios Test


The test is based upon the information held in Pepe's Pizza Parlour. The test is of your understanding of the performance ratios. If you want to refresh your memory go back to the profitability, solvency and performance ratios page

Return on Capital Employed (ROCE) Net Profit (before interest & tax) / Capital Employed x 100 = ROCE __________________ __________________ __________________

Gross Profit Margin Gross Profit / Sales x 100 = Gross Profit margin __________________ __________________ __________________

Net Profit Margin Net Profit / Sales x 100 = Net Profit margin __________________ __________________ __________________

Liquidity Ratio (or Acid test) Liquid assets / Current liabilities = Acid test __________________ __________________ __________________

Current Ratio Current assets / Current liabilities = Current ratio

__________________

__________________

__________________

Gearing (income gearing) Interest / Profit = Income gearing (%) __________________ __________________ __________________

Answers

Return on Capital Employed Net Profit (before interest and tax) 19300 + 200 (interest)

/ Capital Employed 134300

x 100 =

ROCE 14.5%

Gross Profit Margin Gross Profit 35200 / Sales 69200 x 100 = Profit margin 51%

Net Profit Margin Net Profit 19300 / Sales 69200 x 100 = Profit margin 28%

Liquidity Ratio (or Acid test) Liquid assets 7800 / Current liabilities 7000 = Acid test 1.1 : 1

Current Ratio Current assets 13300 / Current liabilities 7000 = Current ratio 1.9 : 1

Gearing (income gearing)

Interest / Net Profit (before deducting interest 200 and tax) 19300 + 200 (interest)

Income gearing (%) 0.01(1%)