Chapter 8: Financial statements of a sole trader

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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

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The story so far
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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

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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

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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)

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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

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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

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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)

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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

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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

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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)

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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

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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

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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

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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

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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

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Exercise 2 Cotswold CoolersTrial balance at 30
June 2006
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Solution 1 Cotswold Coolers
Post trial balance adjustments
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Cotswold CoolersProfit and loss account for the
year ending 30 June 2006
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Cotswold CoolersBalance sheet as at 30 June 2006
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Cotswold CoolersBalance sheet as at 30 June 2006
(continued)
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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