Association of Accounting Technicians

Transcription

1 Association of Accounting Technicians Accounts Preparation Level 3 Book 2

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3 Published by: Home Learning College 1 Hammersmith Broadway London W6 9DL Home Learning College Ltd 2013 Version 1.0 aat3_acpr_book2_v2_master_ All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilised in any form or by any other means, electronic, mechanical, photocopying, recording or otherwise without the written permission of the publisher. All product names and services identified throughout this book are trademarks and registered trademarks of their respective owners. They are used throughout this book in editorial fashion only and are for the benefit of such companies. No such usage, or the uses of any trade names, is intended to convey endorsement or other affiliation with the book. Home Learning College course materials are made available in electronic format for use by students of the College. All rights, including copyright and related rights and database rights, in electronic course materials and their contents are owned by or licensed to Home Learning College. In using electronic course materials and their contents you agree that your use will be solely for the purposes of completing a Home Learning College course. Except as permitted above you undertake not to copy, store in any medium (including electronic storage or use in a website), distribute, transmit or retransmit, broadcast, modify or show in public such electronic materials in whole or in part without the prior written consent of Home Learning College or in accordance with the Copyright, Designs and Patents Act 1988.

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5 Contents Lesson 6 - Accounting Standards, Concepts and Policies Introduction 2 Accounting concepts and policies 2 Accounting standards 6 Selecting accounting policies 7 Preparing financial statements 9 The Statement of Profit or Loss 11 The Statement of Financial Position 14 Acounting adjustments 17 Users of Financial Statements 17 Lesson 7 - Account for the Valuation of Inventory Introduction 22 Use of accounting concepts 22 The valuation of inventory at cost price 25 Inventory records 29 Inventory valued at retail selling price 35 Lesson 8 - Account for Prepayments and Accruals Introduction 44 Use of the accruals concept 44 Adjusting for prepayments and accruals 45 Applying year end adjustments 47 Accounting for prepayments and accruals through the income and 56 expense ledger accounts Accounting for opening and closing prepayments and accruals 58

6 Lesson 9 Account for Irrecoverable and Doubtful Debts Introduction 66 Accounting for irrecoverable debts 67 Accounting for the recovery of a debt written off as irrecoverable 70 Making an allowance (provision) for doubtful debts 70 Calculating an allowance for doubtful debts 71 Use of the journal 74 Accounting for an increase in an allowance for doubtful debts 78 Accounting for a decrease in an allowance for doubtful debts 82 Lesson 10 Account for the Acquisition and Depreciation of Non-current Assets Introduction 90 Categorising expenditure 90 Use of the materiality concept 93 Funding the acquisition of non-current assets 94 Authorising capital expenditure 97 Classifying non-current assets 98 Depreciation of non-current assets 98 Record the acquisition and depreciation of non-current assets 105 Lesson 11 Account for the Disposal of Non-current Assets Introduction 122 Calculating a gain (profit) or loss on disposal 122 Recording the disposal of non-current assets 125 Lesson 12 The Non-current Asset Register Introduction 134 The content of the non-current asset register 134 Use of the non-current asset register 136

7 Preparing reconciliations 141 Carrying out physical checks 142 Lesson 13 Prepare an Extended Trial Balance Introduction 148 Preparing the extended balance 149 Preparing final accounts from the extended trial balance 156

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9 Accounts Preparation Book 2 LESSON 6 Accounting Standards, Concepts and Policies On completing this lesson you should be able to: Explain the terms true and fair in the context of preparing and presenting financial statements Explain the terms accounting concepts and accounting policies and identify a range of accounting concepts in general use Explain the use of Accounting Standards in the preparation and presentation of financial statements of sole traders, partnerships and limited companies Explain the use of the qualitative characteristics of relevance, reliability, ease of understanding and comparability in the preparation and presentation of financial statements Explain the form and function of the Statement of Profit or Loss and Statement of Financial Position and recognise the elements of which these financial statements are comprised 1

10 Home Learning College Introduction Different parties interested in the affairs of a business, require different kinds of information about the business. For example, the proprietor(s) of a business, its employees, financiers, customers and suppliers of goods and services all have an interest in its performance and financial standing. Prospective investors in, or buyers of, a business, as well as financial analysts, are also interested in the financial well-being of businesses. Information relating to the financial affairs of a business can be found within its financial statements. However, the various parties referred to above have different needs from the financial statements they read, although they all share a common interest in that they require financial information which is reliable and, therefore, prepared and presented on a consistent basis. To achieve this objective financial statements are prepared and presented to readers on the basis that they reflect a true and fair account of the financial transactions of a business. The term true refers to the objective that the financial statements prepared are factually correct and mathematically accurate. Fair implies that financial information has been prepared and presented in a way that is free from personal bias (neutral). Accounting concepts and policies Accounting concepts have been developed over time from discussion and consensus amongst accounting practitioners and academics, and are regarded as general rules which apply to the preparation and presentation of financial statements. Whereas the concepts of business entity, dual aspect, money measurement and historic cost, which were introduced in Book 1, underpin the activity of financial record keeping, there are also a number of concepts directly associated with formulating accounting policies which are then applied in the preparation of financial statements. Accounting policies are described as the principles, rules and procedures selected and consistently followed by business organisations in preparing and presenting financial statements in accordance with the requirement that they portray a true and fair view. 2

11 Accounts Preparation Book 2 Four accounting concepts in particular are considered to be fundamental to the formulation of accounting policies. These are: Going concern Accruals Prudence Consistency Two of the above accounting concepts (going concern and accruals) are identified as bedrock accounting concepts and play an influential role in the selection of accounting policies and the preparation of financial statements. The accounting concepts of prudence and consistency are identified as being desirable features relevant to the selection of appropriate accounting policies. The accounting concepts of going concern, accruals, prudence and consistency can be described as follows: Going concern concept This concept requires that financial statements be prepared with the underlying assumption that the business will continue to operate for the foreseeable future. There are no plans to scale-down the operational activities of the business or to liquidate the business. This concept has a significant influence on the valuation of assets. As a going concern the assets of a business will normally be shown on the Statement of Financial Position at cost. However, in circumstances where the going concern concept does not apply, for example, because the business is scaling-down its operations, then a valuation at lower than cost may need to be placed on certain assets. In a forced or liquidation sale some non-current assets and items of inventory may well have a market value which is below their value in the books of the business. Accruals concept This concept is also known as the matching concept and requires that financial statements be prepared on the basis that transactions are shown in the final accounts for the period in which they occur and are not, therefore, merely a reflection of cash received or paid in a particular accounting period. 3

12 Home Learning College As a result of applying the accruals concept, profit is income earned in an accounting period less the costs and expenses incurred in the same accounting period. The application of the accruals concept usually requires several accounting adjustments to be made in the preparation of the Statement of Profit or Loss and the Statement of Financial Position. These include: Adjusting for closing inventories Accounting for prepayments and accruals Providing for the depreciation of non-current assets Accounting for irrecoverable and doubtful receivables Prudence concept The prudence concept, also known as conservatism, requires that a cautious approach be adopted in the treatment of transactions or events for use in the preparation of financial statements. Prudence requires that profits or gains should not be considered for inclusion in the financial statements until they are realised. Losses, however, should be included in the financial statements immediately they are anticipated. The prudence concept is particularly relevant to the valuation of inventories, the depreciation of non-current assets, and in accounting for irrecoverable and doubtful receivables. Not only does the prudence concept determine when profits or losses should be counted and included within the financial statements, the concept also has a significant effect on the treatment of assets and liabilities. The requirement is that assets should not be valued too highly, nor should liabilities (obligations) be understated. Consistency concept This accounting concept applies to the use of accounting policies and procedures. The concept requires that the same policies and procedures be applied uniformly from one accounting period to another. Application of the consistency concept facilitates a valid comparison of financial information from period to period. Once established, accounting policies should only be changed in exceptional circumstances. A change 4

13 Accounts Preparation Book 2 in policy is only acceptable where the resulting outcome is a fairer and more reliable measure of business events. A change in policy should not be introduced merely to present the results of a business in a more favourable light. In addition to the accounting concepts outlined above there are several other concepts that are frequently applied in the preparation of financial statements. We will look at these next. Materiality concept Whilst in processing financial information and preparing financial statements the requirement is that the information we provide is true and fair, there may be a point at which the effort of providing exact and detailed information is out of all proportion to the cost (in terms of time and money) of doing so. Materiality sets the threshold for determining the relevance of financial information contained within the financial statements. An item is deemed to be material if its omission or misstatement will influence the economic decisions of the users of the financial statements. Therefore, materiality allows that in circumstances where ignoring other rules will not significantly affect the financial information provided, then such a course of action is permissible. As a result we do not need to spend valuable time in applying strict rules to transactions where the effect of not doing so would not have a significant impact on the information provided, or the reader s understanding of that information. For example, the cost of purchasing a calculator for use in the office at a cost of 20 should technically be treated as capital expenditure, as the business will benefit from the use of the calculator over several accounting periods. However, rather than including the calculator in the value of non-current assets on the Statement of Financial Position, and accounting for its cost by depreciating it over several years, it is more likely that on the basis of it being an immaterial item (in terms of a oneoff cost to the business) it would be written off as an expense in the Statement of Profit or Loss in the year it was purchased. The treatment of the cost of the calculator in this instance would not have a significant effect on the profit shown within the Statement of Profit or Loss of the business, or on the value of its non-current assets on the Statement of Financial Position. 5

14 Home Learning College In practice, materiality is extremely subjective. The concept is directly linked to the relevance of financial information. Relevance is one of several characteristics which enhances the usefulness of financial information to user groups. What is material to a sole trader business organisation, for example, is not necessarily material to a large multinational organisation. Materiality is, therefore, concerned with the significance of a particular item in the financial statements in the context of the size of a business organisation. Objectivity concept This concept requires that, where possible, financial statements should be prepared free from personal bias. This is, of course, difficult to achieve in circumstances where the rules allow an element of personal discretion. In general, however, it is suggested that subjectivity should be minimised whilst objectivity should be maximised. Realisation concept This concept determines when a transaction is to be recorded in the books of account. Normally this is when goods or services are delivered, as it is seen as being the point in time at which legal title passes from the supplier to the customer. To process a transaction when an order is placed would not be prudent as the order may be cancelled before it is fulfilled, or the supplier may not be able to meet the order. To process the transaction only when payment is made or received would be over cautious as, following fulfilment of the order, there is a legal requirement to pay for goods or services received. The realisation concept, where credit is given or taken, often results in the transaction being recorded in one particular accounting period with the payment being made or received in a later accounting period. Accounting Standards Concerns about the quality and reliability of information contained within financial statements resulted in the development of accounting standards, devised for the purpose of giving guidance on specific accounting topics and thereby reducing the number of interpretations and treatments being used to prepare and present financial statements. Accounting standards represent the formalising of rules which prescribe the methods by which financial statements are prepared and presented. 6

15 Accounts Preparation Book 2 Many of the accounting concepts referred to above are embodied within accounting standards. Relevant accounting standards must be applied when preparing financial statements on behalf of limited companies. However, although the application of accounting standards is not compulsory when preparing financial statements for sole traders or partnerships, we tend to find that they are in fact used universally by practitioners as it is generally believed they represent best practice, and therefore apply to any set of financial statements designed to present a true and fair view. Accounting standards initially developed for use in the UK were known as Statements of Standard Accounting Practice (SSAP s). From early 1970 to July SSAPs were introduced, each dealing with a specific accounting topic or disclosure requirement relevant to the published accounts of limited companies. However, SSAPs have now been superseded by Financial Reporting Standards (FRSs) and there is currently a combination of SSAPs and FRSs in use. The intention is that eventually all SSAPs will be replaced by FRSs. SSAPs and FRSs form the basis of UK GAAP (Generally Accepted Accounting Principles) and are referred to as domestic standards. In 1973, in an attempt to globalise accounting standards, an International Accounting Standards Committee (IASC) was formed. Its task was to develop and promote the use of International Accounting Standards (IASs). In 2001 the committee was replaced by the International Accounting Standards Board (IASB). The standards developed by the IASB since its formation are known as International Financial Reporting Standards (IFRSs). Since January 2005 all limited companies listed on an EU stock exchange have been required to prepare their financial statements in accordance with IASs/ IFRSs. However, UK companies not yet required to adopt IASs may still prepare their financial statements in accordance with domestic standards. Selecting accounting policies To ensure that financial information is useful to various user groups the appropriateness of accounting policies adopted by a business must be measured against four objectives thought relevant to the preparation and presentation of financial statements. These are known as qualitative characteristics and are referred to as: 7

16 Home Learning College Relevance Reliability Ease of Understanding (understandability) Comparability These characteristics are described in detail within the regulatory and conceptual framework which applies to the preparation of financial statements on behalf of limited companies. However, the following overview of the four qualitative characteristics is appropriate to this textbook where the emphasis is on the preparation of financial statements for sole trader and partnership type organisations. Relevance Financial information is relevant if it has the ability to influence the economic decisions of the users of that information and is provided in time to influence those decisions. Where there is a choice of accounting policies, the one that is most relevant in the context of the financial statements as a whole should be selected. Reliability There are a number of aspects to providing reliable information in the financial statements. These include: The figures should represent the substance of the transactions or events. The figures should be free from personal bias or neutral. The figures should be free from material error. Where there is uncertainty a degree of caution should be applied in making judgment (prudence). Ease of understanding (understandability) Accounting policies should be chosen to ensure ease of understanding by the users of the financial statements, where such users have a reasonable knowledge of business, economic activities and accounting, and demonstrate a willingness to study financial information diligently. Comparability Information provided in the financial statements is much more useful to the various user groups if it is comparable over time, and also comparable with like information provided by other business organisations (of a similar size and nature). 8

17 Accounts Preparation Book 2 Comparability will be improved in circumstances where appropriate accounting policies are adopted and used consistently over successive accounting periods. There are also several accounting principles applied in keeping financial records and preparing financial statements, which have a direct impact on the qualitative characteristics referred to above. These include substance over form (faithful representation), verifiability and timeliness. Substance over form (faithful representation) Information presented in the financial statements should faithfully represent the transaction and events that occur during an accounting period. Faithfull representation requires that transactions and events should be accounted for in a manner which represents their true economic substance rather than the mere legal form. This principle is known as substance over form. Verifiability Verifiability refers to the need for accountants and accounting practitioners to be able to substantiate the transactions recorded and the financial information reported. In practice the verifiability of each transaction is maintained by keeping the source documentation used as the basis of recording the transaction. Timeliness The principle of timeliness is closely related to the qualitative characteristic of relevance and is the term used to describe the need for financial information to be presented to users in good time. Obviously the timeliness of accounting information is highly desirable since information that is presented timely is generally more relevant to users than presenting information which is out of date. A delay in providing information tends to make it less relevant to the decision making needs of the users of the information. Preparing financial statements As suggested earlier in this lesson, although in preparing financial statements for sole traders or partnerships it is not compulsory for practitioners to apply accounting standards, doing so tends to be seen as 9

18 Home Learning College best practice. Therefore, in the lessons in this textbook which apply to the procedures relating to the making of accounting adjustments in the preparation of financial statements, the relevant International Accounting Standards (IASs) currently in use will be referred to. The financial statements prepared on behalf of a sole trader type entity at the end of each accounting period generally consist of a: Statement of Profit or Loss this statement is prepared to show the performance of a business over a given period of time (normally a twelve-month period known as the financial year). In preparing the Statement of Profit or Loss, costs and expenses (revenue expenditure) incurred in the accounting period are deducted from the income (revenue income) earned by the business in the same accounting period, to calculate whether the business has operated at a profit or loss. The Statement of Profit or Loss is also sometimes referred to as the Income Statement. Statement of Financial Position - The Statement of Financial Position is often described as a financial window or snapshot showing the financial position of a business frozen in time. 10 The Statement of Financial Position is prepared using capital balances rather than revenue balances and shows the financial resources (assets) and financial obligations (capital and liabilities) of a business as at a particular point in time (the financial year end). In preparing financial statements it must be recognised that the Statement of Profit or Loss is in fact an account. In order that a business can calculate profit or loss in a particular accounting period the account is debited and credited with account balances which are transferred from the various income and expense accounts within the ledger. The account effectively nets-off the debit balances (cost and expense account balances), against the credit balances (income account balances), to show whether the business has made a profit (credit balances on income accounts exceed debit balances on cost and expense accounts), or a loss (debit balances on cost and expense accounts exceed credit balances on income accounts). By contrast, the Statement of Financial Position, although it is usually presented in vertical format, as is the Statement of Profit or Loss, is not an account. The Statement of Financial Position is a list or sheet of debit and credit balances appearing within the ledgers, showing that, as

19 Accounts Preparation Book 2 at a particular point in time, debit balances on ledger accounts are equal to credit balances (i.e. assets = capital + liabilities). The Statement of Profit or Loss (SPL) The Statement of Profit or Loss prepared on behalf of a sole trader or partnership type entity comprises two sections - the trading account section and the profit and loss account section. Profit on trading, known as gross profit, is accounted for in the trading account section the calculation being: Net sales revenue Less Cost of goods sold = Gross profit A combination of account balances are used for the purpose of calculating the net sales and the cost of gods sold figures, for example: Net sales revenue: Sales income Less Sales returns = Net sales revenue Cost of goods sold (some or all of the following account balances are used in the calculation of cost of goods sold): Opening Stock Add Purchases Less Purchase Returns Add *Carriage Inwards Less Closing Stock = Cost of sales *There are two classifications of carriage on goods these being carriage inwards and carriage outwards, both these balances are debit balances on their respective ledger accounts in the books. However, carriage inwards is paid by businesses to have goods delivered to their place of business and is, therefore, associated with purchasing. As such, 11

20 Home Learning College carriage inwards is charged (debited) to the Statement of Profit or Loss as a cost of sale. However, carriage outward is associated with the selling and distribution of goods as it is paid by businesses to carriers to have goods delivered to customers following their sale. Carriage outwards is charged (debited) to the Statement of Profit or Loss as an expense. You may find that you are presented with a list of balances where you are merely given a sales figure representing net sales. This will be a net credit balance, i.e. sales (an income balance/credit balance less sales returns a debit balance). Similarly, the list of balances may include a cost of goods sold balance i.e. a debit balance. The cost of goods sold balance will be a debit balance representing a netting-off of the various balances which are used in the cost of goods sold calculation (opening stock (debit balance), add purchases (debit balance), add carriage inwards (debit balance), less purchase returns (credit balance), less the value of closing inventory (credited to the Statement of Profit or Loss). The net profit or loss of the business is accounted for in the profit and loss account section of the Statement of Profit or Loss. The net profit/loss calculation is made as follows: Gross profit (from trading account section) Add Other (non-trading) income Less Expenses (incurred in selling, distribution and administration) = Net Profit / Loss Statement of Profit or Loss - overleaf is an example showing a Statement of Profit or Loss prepared on behalf of a sole trader who trades in the name of Direct Building Supplies: 12

21 Accounts Preparation Book 2 Direct Building Supplies Statement of Profit or Loss for the Year Ended 30 September 201Y Sales revenue 560,600 Less Sales returns 9,640 Net sales 550,960 Less Cost of Goods Sold Opening inventory 49,500 Add Purchases 440,400 Add Carriage inwards 6,200 Less Purchase returns 7, ,300 Less Closing inventory 47,800 Cost of sales 440,500 Gross Profit 110,460 Add Other Income Discount received 8, ,060 Less Expenses Wages and salaries 46,200 Discount allowed 5,700 Rates 8,800 Carriage outwards 2,800 Heat and light 2,200 Vehicle expenses 5,400 General expenses 3,500 Insurances 1,200 Depreciation 12,500 88,300 Net profit 30,760 13

22 Home Learning College The Statement of Financial Position (SFP) The Statement of Financial Position is a list of account balances appearing in the financial records at the end of the financial year, following the preparation of the Statement of Profit or Loss. For a sole trader and for partnership entities it depicts the accounting equation Assets = Capital + Liabilities. However, when preparing the Statement of Financial Position we often change the order in which we present the elements within the equation as, quite often, the Statement of Financial Position is presented in a format whereby we show Assets less Liabilities = Capital. The balances are listed on the Statement of Financial Position under several main headings as follows: Non-current assets Non-current assets are acquired by the entity with the intention of using them to generate profit over a number of years, rather than being held for resale. Typical examples of non-current assets include business premises, plant, equipment, machinery, fixtures and fittings and vehicles. Such items are depreciated over their useful life to the business and the Statement of Financial Position will usually show the cost of each category of non-current asset owned by the business, less any depreciation charged against the asset to the date at which the Statement of Financial Position has been prepared. Current assets These are resources in the form of cash or near cash. If an asset is in the form of cash at Statement of Financial Position date, or is expected to be converted to cash within twelve months of Statement of Financial Position date, then it is classified as being a current asset. Common examples of current assets are funds held in a bank deposit account or current account, cash (notes and coins) in hand, trade receivables (amounts owed to the business by its credit customers), prepayments (amounts paid in advance), income receivable in arrears, and inventories. Capital in keeping financial records and preparing financial statements for a sole trader or partnership type entity, the claim of the owner(s) on the assets of a business, after deducting its liabilities, is known as capital. For a sole trader, capital consists of the opening capital at the beginning of the financial year, add any 14

23 Accounts Preparation Book 2 further capital introduced in the financial year, add net profit or less net loss in the financial year, less any drawings taken by the owner of the business during the financial year. For a partnership, each partner s claim on the assets of the business is shown on the Statement of Financial Position. This is made up of the balance on each partner s capital account, add or less the balance on an account, known as a current account, which is kept on behalf of each of the partners within a partnership. In accounting for limited companies the term equity replaces the use of the term capital. Non-current liabilities The non-current liabilities of a business are those financial obligations which it expects to settle more than twelve months after the date to which the Statement of Financial Position is prepared. Non-current liabilities include bank or other loans where the repayment period, at Statement of Financial Position date, is in excess of twelve months. Current liabilities These are financial obligations which must be met quickly. In this context quickly means within twelve months from the date at which the Statement of Financial Position is prepared. Examples of current liabilities include trade payables (amounts owing to credit suppliers), accruals (amounts payable in arrears) and an overdrawn balance on the business bank current account. In preparing the Statement of Financial Position of a sole trader or partnership type entity it is traditional to show the total current liabilities of a business deducted from the total value of its current assets. This calculation provides us with a figure known as net current assets. Statement of Financial Position - the following is an example of a Statement of Financial position prepared from the financial records of a sole trader. The business trades in the name of Countrywide Farming Supplies. 15

24 Home Learning College Non-current assets Countywide Farming Supplies Statement of Financial Position at 30 June 201Y Cost Less Acc d Dep n Carrying Amount Premises 75,000 6,000 69,000 Fixtures and fittings 5,000 2,000 3,000 Vehicles 30,000 15,000 15, ,000 23,000 87,000 Current assets Inventory 25,000 Trade receivables 12,800 Prepaid expenses 1,200 Bank 5,600 Cash in hand ,700 Less Current liabilities Trade payables 18,600 Accrued expenses 1,500 20,100 Net Current assets 24,600 Total assets less current liabilities 111,600 Less Non-current liabilities Bank loan (5 years) 10,000 Net assets 101,600 Financed By: Capital 100,400 Add Net Profit 25, ,600 Less Drawings 24, ,600 16

25 Accounts Preparation Book 2 Accounting adjustments Whilst the basis of the information used in the preparation of financial statements, whether it be for a sole trader, partnership, or limited company, are the balances on accounts within the main books (where double entry takes place), there is also a need to review account balances and to make adjustments, where necessary, to comply with the requirement that the financial statements provide a true and fair view of an entity s financial performance and financial position. Lessons 8, 9, 10 and 11 in this textbook explain and illustrate the procedures used when making the typical accounting adjustments usually required when preparing financial statements. These include: Valuing and accounting for inventories. Accounting for prepayments and accruals. Accounting for irrecoverable and doubtful receivables. Accounting for the depreciation and disposal of non-current assets. A sound understanding of the above procedures is extremely important as they underpin the process of preparing financial statements for all business entities. Users of financial statements There are a number of different users of financial statements and each user group will be interested in a particular aspect of the business s activities. Some of these interests will overlap. Some of the information of interest to the users of financial statements is produced by analysing the financial statements of the business and calculating a range of accounting ratios to determine such things as its profitability (financial performance), liquidity (the ability of the business to pay its debts), and efficiency (how effectively its resources have been utilised). Users can be categorised as being internal or external users. For a sole trader or partnership type organisation, the main users of its financial statements, and financial information taken therefrom, are its owners and managers, lenders (financiers), suppliers and government agencies. 17

26 Home Learning College Internal Users: Owners and managers Owners and managers of a business use the financial statements as the basis for making decisions and for the purpose of planning and controlling its activities. They will be interested in asking a number of key questions, for example: Key questions How has the business performed? Is the business using its resources efficiently? Can the business meet its financial obligations? Sources of information The Statement of Profit or Loss can be reviewed and appropriate ratios calculated to measure the financial performance of the business in terms of its ability to generate profit. Calculate appropriate ratios to compare efficiency over time and against similar businesses. Review the cash position of the business and use financial information to calculate the liquidity position of the business to ensure that liabilities can be met when they fall due. It should be noted that owners and managers of a business will also use financial information as the basis of planning its future activities. Should the owner of a business approach a bank wanting finance for the purpose of expanding the business, for example, then a business plan, which will include financial forecasts, will be required if it is to convince the bank that its expansion plans are viable and that it represents a sound lending proposition. External Users: Lenders They will use financial statements to assess whether or not a business seeking finance represents a good lending proposition. Before they commit themselves to extending a loan to a business they will want to assess the ability of the business to meet interest and capital repayments on the due date. 18

27 Accounts Preparation Book 2 Key questions Is the business well managed? Does the business generate sufficient profit to meet interest payments? Can the owners and/or managers of the business present plans to underpin loan applications where they are seeking finance? Sources of information Review the past performance of the business. Review the level of profitability shown by Statement of Profit or Loss and using ratio analysis. Review the business plan and financial forecasts prepared by owners/managers. Suppliers Suppliers will use financial statements and financial information to assess the credit risk of a business prior to taking the decision as to whether or not to supply goods on credit. Key question Will the business be able to pay for goods supplied on credit? Sources of information Review the extent of liabilities and the cash position of the business on the Statement of Financial Position. Government agencies Her Majesty s Revenue and Customs (HMRC) will want to determine that the business has met with the statutory requirements of keeping adequate financial records and preparing and presenting financial statements at each financial year end, so that the tax liability of the owner(s) of the business can be assessed and the correct amount of personal tax collected from them. HMRC will also want to ensure that, where appropriate, a business has registered for VAT. Key questions Is the company liable to register for VAT? Sources of information Review the level of sales revenue in the Statement of Profit or Loss. 19

28 Home Learning College Are adequate VAT records kept and does the business submit VAT returns on time? Has the business owner(s) paid the correct amount of tax? Review the accounting system of the business and its VAT records. Monitor its performance in terms of paying or reclaiming VAT on time. Review the profit levels reported in the Statement of Profit or Loss and the tax returns submitted by, or on behalf of, the owner(s) of the business. 20

29 Accounts Preparation Book 2 LESSON 7 Account for the Valuation of Inventory On completing this lesson you should be able to: Identify categories of inventory as referred to within the accounting standard IAS 2 (Inventories) Explain the purpose of valuing inventory, identify the accounting concept on which making an adjustment for closing inventory is based, and process an adjustment to account for the valuation of closing inventory Explain the principle by which inventory should be valued in accordance with the requirements of IAS 2, and identify the accounting concept on which the principle is based Explain the terms cost and net realisable value, make valuations at cost and net realisable value and use the valuations in accordance with the requirements of IAS 2 Adjust a valuation of inventory from retail selling price to cost price given mark-up or margin Maintain an inventory account in the ledger and use inventory valuations in the preparation of final accounts 21

30 Home Learning College Introduction The accounting term inventory is the term used in international accounting to describe what is referred to in the UK as stock. Inventory represents both an expense (cost), and an asset to a business, therefore, the incorrect treatment and valuation of inventory held by a business will have an impact on the preparation of the Statement of Profit and Loss and the Statement of Financial Position. Due to the fact that Inventory valuation is an important area of accounting it is the subject of an accounting standard - IAS 2 (Inventories). IAS 2 categorises inventories as follows: Finished goods purchased or manufactured for resale. Raw materials or components to be used in the process of manufacturing goods. Products and/ or services in various stages of completion (work in progress). Use of accounting concepts Several accounting concepts are applied in valuing and accounting for inventories, the concepts of accruals, prudence and consistency being of particular relevance. Accruals concept The accruals concept requires that in calculating profit or loss for an accounting period (financial year), the costs and expenses incurred in the accounting period should be deducted from the income earned in the same accounting period. Consider the following example: Example Applying the accruals concept During its financial year ended 31 May 201X Direct Tiles purchased goods for resale at a cost of 600,000. Sales to customers during the same period were 800,000. The gross profit was therefore calculated in the Statement of Profit or Loss (trading section) as follows: 22

31 Accounts Preparation Book 2 Direct Tiles Statement of Profit or Loss (extract) for the Year Ended 31 May 201X Sales 800,000 Less Purchases 600,000 Gross Profit 200,000 Let us now assume that Direct Tiles did not, in fact, sell all the goods it purchased during the year to 31 May 201X. At the year end the business had goods, which cost 80,000, remaining as inventory. It would clearly be unfair to charge the cost of all goods purchased in an accounting period against income earned from selling only some of them. In such circumstance the accruals concept must be applied and an adjustment made to account for closing inventory. The adjustment would result in the closing inventory being valued and deducted from this year s expenses in the Statement of Profit or Loss and carried forward as an asset to the next accounting period. The closing inventory adjustment would be supported by an entry in the journal as follows: Journal 201X Details DR CR 31 May Closing inventory Statement of Financial Position (SFP) 80,000 Closing inventory Statement of Profit or Loss( SPL) 80,000 Closing inventory as at financial year end 31 May 201X The closing inventory valuation as at 31 May 201X would be used in the preparation of the financial statements as follows: 23

32 Home Learning College Direct Tiles Statement of Profit or Loss (extract) for the Year Ended 31 May 201X Sales 800,000 Less Cost of Goods Sold Purchases 600,000 Less Closing inventory 80,000 Cost of Sales 520,000 Gross Profit 280,000 Direct Tiles Statement of Financial Position (extract) as at 31 May 201X Current assets Inventory 80,000 Of course the closing inventory of one period end becomes the opening inventory of the following accounting period. This has further implications when calculating gross profit. Consider now that in its financial year ended 31 May 201Y Direct Tiles purchased goods for resale costing 700,000. Sales in the year were 940,000, and inventory remaining at the year end was counted and valued at its cost to the business of 100,000. When we now calculate gross profit in applying the accruals concept we must take into account both the opening and closing inventory. The Statement of Profit or Loss (trading section) would now be prepared as follows: 24

33 Accounts Preparation Book 2 Direct Tiles Statement of Profit or Loss (extract) for the Year Ended 31 May 201Y Sales 940,000 Less Cost of Goods Sold Opening inventory 80,000 Add Purchases 700, ,000 Less Closing inventory 100,000 Cost of Sales 680,000 Gross Profit 260,000 Assessment tip remember the rule, the accruals concept requires the cost of unsold goods at the end of an accounting period should be carried forward to a future accounting period in the anticipation of future sales revenue. The valuation of inventory at cost price For the purpose of using an inventory valuation in the financial statements, initially a valuation of inventory at its cost price is required. IAS 2 specifies what represents cost in arriving at a valuation of inventory at cost. The standards describe cost as all costs incurred in bringing inventory to its present location and condition. Such costs are likely to include: Cost of purchase, production and conversion. Import duties. Cost of transportation (delivery). Direct labour costs incurred by a business when its own employees are used in an assembly or conversion process. 25

34 Home Learning College Specifically excluded from cost are abnormal wastage (materials, labour and overheads), the cost of storing finished goods and selling expenses. Cost is assigned to each unit of inventory separately which causes problems in practice as it is often difficult for a business to ascertain the actual cost of items remaining in inventory at the period end. This is due to the fact that most businesses take numerous deliveries of identical goods during an accounting period, often paying a different purchase price for each consignment. At the end of the accounting period it is often impossible to match individual units of a particular line of inventory to their actual purchase price. The accounting standards allow the following methods of valuing inventory at cost. First in First Out (FIFO) this is a method of inventory valuation whereby inventory items received first are costed out first, resulting in the most recent quantities of inventory in hand being valued at the most recent cost of production or purchase price. This method of inventory valuation is widely used as it appears logical, in that most businesses would wish to issue and price out their oldest goods first to safeguard against deterioration or obsolescence. Continuous Weighted Average (AVCO) inventory is valued at its average cost. This involves dividing the total value of inventory in hand by the total quantity of finished units or partly finished units of inventory to arrive at the average cost price, which is then applied to the issue of inventory. A new average price must be calculated every time there is a receipt of goods into inventory at a price which is higher or lower than the prevailing average price. The AVCO method of inventory valuation is commonly used in practice as it is easy to apply and the valuation which results is thought to be a fair representation of the cost of inventory held. Last in First Out (LIFO) - the last in first out (LIFO) method of inventory valuation, where goods received last are priced out first using the most recent cost prices, whilst widely used in cost and management accounting, is not an acceptable method of inventory valuation for the purpose of financial accounting and the preparation of financial statements. 26

35 Accounts Preparation Book 2 Example The use of FIFO and AVCO Inventory valuation methods A company trades in a single product. At I July 201Y the inventory of the company consisted of 20,000 units of the product at a cost of 10 per unit. During the month of July 201Y purchases and sales of the product were: Date Purchases Sales 2 July 12,000 units 4 July 5, each 8 July 7,000 units 10 July 10, each 15 July 6,000 units 18 July 5, each 26 July 10,000 units 31 July 10, each Note: All sales in the month of July 201Y were at 25 per unit. If the company valued their inventory using the FIFO method, closing inventory would be 15,000 units valued at 220,000 calculated as follows: Closing inventory units Units Opening inventory 20,000 Add purchases 30,000 50,000 Less sales 35,000 Closing inventory 15,000 27

36 Home Learning College Closing inventory valuation 10, = 150,000 (purchased 31 July 201Y) 5, = 70,000 (purchased 18 July 201Y) 220,000 Gross profit on trading in the product for the month ended 31 July 201Y would be: Revenue 875,000 (35, each) Less Cost of Sales Opening inventory 200,000 (20, each) Purchases 430,000 (20, each + 10,000 units 15 each) Closing inventory (220,000) (10, each + 5,000 Cost of Sales 410,000 Gross profit 465, each) If an AVCO method of inventory valuation were used (continuous weighted average), then closing inventory would consist of 15,000 units at a value of 189,000, with the valuation calculated as follows: Opening inventory 200,000 + Purchases 430,000 = 630,000 = per unit Opening inventory 20,000 units + Purchases 30,000 units = 50, x 15,000 (closing inventory units) = 189,000 28

37 Accounts Preparation Book 2 Gross profit on trading in the product for the year ended 31 July 201Y would be: Revenue 875,000 (35, each) Less Cost of Sales Opening inventory 200,000 (20, each) Purchases 430,000 (20, each + 10, each) 630,000 Closing inventory (189,000) (15, each) Cost of Sales 441,000 Gross profit 434,000 Consistency concept In practice an inventory valuation method which is fair and suitable should be selected. The management of a business is expected to choose a method of inventory valuation which provides the fairest possible approximation of the expenditure incurred in bringing a product to its present location and condition. Once a particular method of inventory valuation has been selected it then becomes the business s policy in respect of inventory valuation and should be applied consistently from accounting period to accounting period. The consistency concept prevents a change in policy being introduced just to show information in a more favourable light. Inventory records Various records are used to enable us to calculate the value of inventory. These include: The Bin Card The Inventory Record Card 29

38 Home Learning College The bin card is a document which provides a record of the quantities of items held in stock. Normally a bin card would be kept for each different item held in inventory. The inventory record card is used to record not only quantities of inventory but also to provide us with a valuation of items held in inventory. It should be noted that whilst the above records have been referred to as cards, they are most probably nowadays a computerised version of the original cards. Checking inventory In practice, regular checks need to be made to ensure that the physical inventory held corresponds to the book inventory (quantity of inventory held as per the bin card and inventory record card). Discrepancies between physical inventory and book inventory need to be investigated. Reasons for discrepancies will normally include: Arithmetic errors in recording receipts and/or issues on the bin card/inventory record card. Arithmetic errors in counting the inventory. Differences due to time lags: o Inventory delivered and counted but not entered on the bin card/inventory record card. o Inventory issued but not entered on the bin card/stock record card. Inventory disposed of without notification to those keeping the bin cards/inventory record cards. Inventory stolen. Prudence The accounting standard (IAS 2) requires that in the valuation of inventory the prudence concept be applied. Therefore, a business must not account for profit on goods in its inventory until the goods are sold and the profit is earned. However, the business should account for any loss in the value of its inventory immediately a loss is anticipated. 30