ASSOCIATION OF ACCOUNTING TECHNICIANS

Transcription

1 ASSOCIATION OF ACCOUNTING TECHNICIANS Prepare Final Accounts for Sole Traders and Partnerships Level 3

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3 Published by: Home Learning College 1 Hammersmith Broadway London W6 9DL Home Learning College Ltd 2013 Version 4.0 aac_fstp_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.e Learning College Ltd 2013

4 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 con

5 Contents Introduction... 1 LESSON 1 - Prepare Final Accounts for Sole Traders... 3 Introduction... 4 The process of preparing final accounts... 5 Using the trial balance... 7 The Statement of Profit or Loss (Income Statement) The Statement of Financial Position Drafting final accounts classifying and using balances LESSON 2 - Prepare Final Accounts for a Partnership Introduction The partnership agreement The Partnership Act Financial records and the appropriation of profit or loss The Partnership Appropriation Account The Statement of Financial Position Preparing partnership accounts in extended trial balance format LESSON 3 Account for a Change in the Structure of a Partnership Introduction Goodwill Change in a profit-sharing ratio Appropriation of profit following a change in the profit-sharing ratio Admission of a new partner Admission of a partner, accounting for the sharing of profit or loss Account for the retirement of a partner... 72

6 LESSON 4 Prepare Final Accounts from Incomplete Records Introduction The analysed cash book The opening financial position Calculate sales on credit from incomplete data Calculate purchases on credit from incomplete data Calculate cash sales from incomplete data Calculate receipts and payments from incomplete data Calculate settlement discounts from incomplete data Calculate VAT from incomplete data Calculate expenses from incomplete data Calculate drawings from incomplete data Calculate sales and purchases from incomplete data using mark-up and margin Calculate opening and/or closing cash or bank account balances from incomplete data Prepare a trial balance and final accounts from incomplete records.. 107

7 Prepare Final Accounts for Sole Traders and Partnerships Introduction The AAT Level 3 Diploma in Accounting consists of six separate units which should be completed in the following order: 1. Accounts Preparation (ACPR) 2. Prepare Final Accounts for Sole Traders and Partnerships (FSTP) 3. Costs and Revenues (CSTR) 4. Indirect Tax (ITAX) 5. Spreadsheet Software (SDST) 6. Professional Ethics (PETH) This is the course book for the Prepare Final Accounts for Sole Traders and Partnerships unit. It is written to AAT s AQ2013 syllabus specifications and is designed to be used in conjunction with Home Learning College s Virtual Learning Community (VLC). The Prepare Final Accounts for Sole Traders and Partnerships unit covers the preparation of final accounts for both sole traders and unlimited partnerships, including the appropriation of profits. At the end of the unit, you will be able to draft final accounts and make necessary adjustments according to current financial standards. Throughout the book you will find the icons shown below. These highlight important items, reinforce essential points and provide helpful exam tips. Example this is an illustration of a learning point in the context of a real-life scenario. Key Learning Points the main items to learn and understand in a particular lesson. Exam Tip these call attention to information about potential pitfalls and essential information regarding the AAT assessment. 1

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9 Prepare Final Accounts for Sole Traders and Partnerships LESSON 1 - Prepare Final Accounts for Sole Traders On completing this lesson you should be able to: Identify the financial statements prepared on behalf of sole traders at an accounting period end Describe the format and function of the Statement of Profit or Loss and the Statement of Financial Position Explain the process of preparing final accounts and understand the limitations of using the trial balance for the purpose of preparing final accounts Classify account balances and explain how the balances are used in the preparation of final accounts Prepare final accounts for a sole trader, making adjustments to correct errors and account for closing inventory, prepaid and accrued income and expenses, allowances for doubtful debts and depreciation of non-current assets 3

10 Home Learning College Introduction All business organisations, regardless of their size and type, are required to keep financial records and prepare financial statements. The financial records of a business are the core of its financial information system. Each transaction, as it is processed and recorded in the accounting system, is analysed to provide information that will be used at some point in time for the purpose of preparing financial statements. The financial statements prepared on behalf of a sole trader at the end of each accounting period generally consist of a Statement of Profit or Loss and a Statement of Financial Position. These statements, when prepared at a financial year end, are often referred to as final accounts. You should already be familiar with the form and function of financial statements. In Lesson 6 (Accounting Standards, Concepts and Policies) of Accounts Preparation unit book 2 you were provided with information relating to the purpose of the Statement of Profit or Loss and the Statement of Financial Position, and were given examples of how these statements are presented. In Lesson 13 (Prepare an Extended Trial Balance) of Accounts Preparation unit book 2 you were given the opportunity to draft final accounts from an extended trial balance. The purpose of this lesson is to give you the opportunity to gain the skills required to prepare final accounts for a sole trader from ledger account balances and the trial balance. In so doing you will be required to adjust ledger account balances, where necessary, to take account of: Errors and omissions Closing inventory, and inventory valuations Accruals and prepayments in respect of expenses and income The write-off of irrecoverable debts, and allowances for doubtful debts The depreciation of non-current assets 4

11 Prepare Final Accounts for Sole Traders and Partnerships The process of preparing final accounts The process for preparing final accounts is likely to follow a set routine, which will include all, or some, of the following steps: Step 1 Verify the arithmetic accuracy of the account balances within the double entry system by taking out a trial balance. This does not necessarily mean that at this stage all accounts are balanced off. Sometimes an account balance is calculated and listed on the trial balance without going through the procedure of showing the account balances carried down and brought down, i.e. the accounts are left open until after the trial balance is prepared. This is often the case for income and expense accounts, where balances may have to be adjusted for the purpose of using them in the calculation of profit or loss, by transferring balances, representing income earned and expenses incurred in an accounting period, to the Statement of Profit or Loss. Step 2 This step is only necessary where the trial balance debit and credit column totals fail to agree. In such circumstances a suspense account is introduced to the ledger, the difference in books balance is posted to the suspense account and the suspense account balance is listed on the trial balance. The errors causing the imbalance in the books are identified and journal entries required to correct the errors are prepared, following which the journal entries are processed, thereby eliminating the suspense account balance and correcting any errors within the ledger account balances. Once the errors are amended a corrected trial balance can be redrafted. Step 3 Where final accounts are to be prepared from the trial balance it is important to recognise the limitations of using the balances. The trial balance is a list of account balances as at the date the balances are extracted from the double entry system. It is more than likely that some of the account balances listed do not match the accounting period under review and adjustments to the balances are normally required. 5

12 Home Learning College It is, therefore, necessary to make a list of the period-end adjustments to be accounted for. This list is likely to include the following: Adjustments to account for the valuation of the closing inventory. Adjustments to revenue income and expense accounts to take account of any amounts received in advance, paid in advance, receivable in arrears, or payable in arrears. Adjustments to account for any debts still within the trade receivables balance but which are now deemed to be irrecoverable and are to be written off. Adjustments to account for the introduction of an allowance for doubtful debts, or to account for an increase or decrease in an existing allowance for doubtful debts. Adjustments to account for the depreciation and disposal of noncurrent assets. Step 4 Prepare the journal entries to account for the above adjustments and to transfer income, cost and expense account balances to the Statement of Profit or Loss. Step 5 Prepare the Statement of Profit or Loss and Statement of Financial Position directly from the balances per the trial balance, applying the period-end adjustments to the trial balance figures. Step 6 Return to the ledger accounts and process the journal entries prepared in step 4. It is important to note that in practice income and expense account balances are not only adjusted where necessary, but that account balances are transferred to the Statement of Profit or Loss at the accounting period end. Step 7 Whereas account balances are transferred from ledger accounts to the Statement of Profit and Loss, the preparation of the Statement of Financial Position represents a listing of closing balances remaining on ledger accounts, following the calculation of profit or loss for the year. Where the Statement of Financial Position is prepared directly from the trial balance it is necessary to verify that all accounts within the double entry accounting system have been balanced off and that the Statement of Financial Position balances are in fact representative of balances on accounts within the double entry accounting system. 6

13 Prepare Final Accounts for Sole Traders and Partnerships The Statement of Financial Position proves the accounting equation, i.e. Assets = Capital + Liabilities, and therefore that debit balances in the books of account are equal to credit balances. It follows that if we end one accounting period with debit balances being equal to credit balances and we roll over those same balances to start off the next accounting period we are starting off in the next accounting period with debits = credits. Using the trial balance You should recall from your studies in the unit Processing Bookkeeping Transactions that the trial balance is a periodic listing of balances on accounts within the double entry bookkeeping system. The trial balance does not show the profit of a business or its financial position; its purpose is to verify the arithmetic accuracy of the double entry bookkeeping system. Furthermore, you should recall that its limitations, in addition to those referred to above, include the fact that there are some errors that will not be detected by taking out a trial balance. The types of error that the trial balance will not detect are listed below. These types of error are discussed in detail in Lesson 4 (Prepare a Trial Balance and Correct Errors) of Accounts Preparation unit book 1: Error of omission Error of commission Error of principle Error of original entry Reversal of entries Compensating errors Whilst the trial balance will not identify the types of error listed above, it will of course alert the bookkeeper to instances where there is an imbalance in the books, i.e. that debit balances are not equal to credit balances. Again, Lesson 4 of unit book 1 highlighted these errors, but as they are also relevant to the learning outcomes and assessment criteria covered within this unit, they are repeated below: 7

14 Home Learning College 1. Posting one-sided entries. The bookkeeper posts only one debit entry, or one credit entry in the books, rather than posting corresponding debit and credit entries. 2. Posting double sided entries. The bookkeeper posts two debit entries, or two credit entries in the books, rather than corresponding debit and credit entries. 3. Errors of addition or subtraction in balancing off ledger accounts, resulting in an incorrect balance on a ledger account. 4. Transposition of numbers (e.g. entering 5,700 as 7,500 or 1,246 as 1,426, when posting amounts to accounts or entering balances on the trial balance. 5. Bringing down the balance incorrectly on an account, or bringing down the balance to the wrong side of an account. 6. Posting entries of unequal amounts to accounts. For example, posting a debit of 1,000 and a credit of Transferring balances incorrectly to the trial balance. For example, listing balances on the incorrect side of the trial balance, or by copying the wrong amount from the ledger account on to the trial balance. 8. Incorrectly calculating the trial balance totals when adding down the debit and credit column figures. The following steps should be considered in an attempt to locate the errors that cause the trial balance to be out of balance: 1. If there is an error of only one digit, the mistake may be one of addition or subtraction, or it may be the result of incorrectly copying a number in the journal, the ledger or the trial balance. 2. If the difference between the debit and the credit totals of the trial balance is divisible by 2: (a) A posting equal to one half of the difference may have been made to the wrong side of an account. (b) The balance of an account equal to one half the difference may have been entered on the wrong side of the trial balance. 8

15 Prepare Final Accounts for Sole Traders and Partnerships 3. If the difference is divisible by 9, the error may be due to a transposition error (all transposition errors are exactly divisible by 9). In practice the trial balance often acts as a starting point for the preparation of the financial statements, in which case it is essential that practitioners have the ability to determine which balances listed on the trial balance are used in preparing the Statement of Profit or Loss and which balances are used in the preparation of the Statement of Financial Position. In preparing financial statements for a sole trader or a partnership it is also necessary that you are able to identify and correct bookkeeping errors and apply accounting adjustments. It is also important to note that the terminology used in presenting some ledger account balances on either the Statement of Profit or loss or Statement of Financial Position may be different to their account title/description per the ledger account and the trial balance. There may also be instances where account balances are combined when they are presented on a trial balance, or within the financial statements. Examples include: The balances on the sales and sales returns accounts may be shown separately on the trial balance, but may be combined and shown as one figure, net sales (sales less sales returns) when entered on the Statement of Profit or Loss. The balance on loan interest paid account when shown on the Statement of Profit or Loss is often described as finance costs. A cost of goods sold balance may be shown on a trial balance. The cost of goods sold figure will be a debit balance and will consist of a netting-off of the balance on the opening inventories account (debit balance), plus the balance on the purchases account (debit balance), plus the balance on the carriage inwards account (debit balance), less the balance on the purchase returns account, less the value of closing inventories. Where a cost of goods sold figure is shown on the trial balance the closing inventories figure (debit balance) for use in preparing the Statement of Financial Position, where closing inventories are listed as a current asset, would also be shown. The balance on the sales ledger control account is described as such when listed on the trial balance. When using the balance in the preparation of the Statement of Financial Position, however, the 9

16 Home Learning College term trade receivables is used and the balance is shown net of the balance on the allowance for irrecoverable debts account (debit balance on sales ledger control account less credit balance on allowance for irrecoverable debts account = net trade receivables). The balance on the purchase ledger control account is described as such when listed on the trial balance, but when using the balance in the preparation of the Statement of Financial Position the balance is referred to as trade payables. The balances on the bank current account and cash account although they may be listed separately on the trial balance are often combined when preparing the Statement of Financial Position and referred to as cash and cash equivalents. The Statement of Profit or Loss (Income Statement) The format of the Statement of Profit or Loss, often referred to as the income statement, depends on the nature of the activities of the business for which it is being prepared. Where a business trades, i.e. buys and sells, the Statement of Profit or Loss will comprise a trading account section and a profit and loss account section. Profit on trading, known as gross profit, is accounted for in the trading account section, the calculation being: 10 Net sales Less Cost of goods sold = Gross profit A combination of account balances is used for the purpose of calculating the net sales and the cost of goods sold figures, for example: Sales income Less Sales returns = Net sales Cost of goods sold (some or all of the following account balances) Opening inventory Add Purchases Less Purchase returns Add Carriage inwards

17 Prepare Final Accounts for Sole Traders and Partnerships Less Closing inventory = Cost of sales The net profit or loss of the business is accounted for in the profit and loss account section. 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 Where a business has no trading activities, but instead generates income by providing a service or services, then the Statement of Profit or Loss will comprise only a profit and loss account section where the net profit/loss for the accounting period is calculated, the calculation being: Income Less Expenses = Net Profit/Loss Where a Statement of Profit or Loss is prepared on behalf of a partnership it will comprise an additional section to account for the distribution of profit or loss between partners. This lesson is concerned only with the preparation of financial statements for a sole trader; the subject of partnership accounting is dealt with later in this text. At this level of your studies you are required to prepare financial statements for sole trader and partnership type entities only. The following are examples showing the format of a Statement of Profit and Loss prepared for a business (sole trader) with trading income, followed by a further example illustrating the format of the Statement of Profit or Loss for a business (sole trader) which generates only nontrading income from providing a service. Statement of Profit or Loss (for a sole trader with trading activities and other non-trading income) 11

18 Home Learning College 12 Direct Building Supplies Statement of Profit or Loss for the Year Ended 30 September 201Y Sales 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 Note: The net profit in the year represents a credit balance, i.e. incomes (credit balances) transferred to the Statement of Profit or Loss exceed costs and expenses (debit balances) transferred to the Statement of Profit or Loss. The net profit would now be transferred back into the ledger, the capital account being credited with the profit. For the purpose of preparing final accounts the net profit is added to capital on the Statement of Financial Position. Of course, if the business made a net loss this would be a debit balance (costs and expenses exceed incomes) and would be debited to the capital account in the ledger and deducted from the owners capital claim when preparing the Statement of Financial Position.

19 Prepare Final Accounts for Sole Traders and Partnerships Income Fares Less Expenses A-2-B Taxis Statement of Profit or Loss for the Year Ended 31 May 201Y Wages 5,200 Office rent and rates 5,400 Insurances 800 Office heat and light 620 Vehicle running costs 8,480 General office expenses 840 Licences 500 Depreciation 7,500 50,660 29,340 Net profit 21,320 The Statement of Financial Position 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. It shows the relationship between the elements that comprise the accounting equation, i.e. Assets = Capital + Liabilities. On preparing the Statement of Financial Position, however, 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 it shows Assets less Liabilities = Capital. The balances are listed on the Statement of Financial Position under several main headings as follows: Non-current assets these are usually listed on the Statement of Financial Position in order of permanence to the business, with the most permanent item being listed first. Without having detailed information about the lifespan of a non-current asset to the business, it is often difficult to decide how to rank them in order of permanence. However, where business premises feature within a list of non-current assets it is recommended that they be listed first. Current assets current assets are usually listed on the Statement of Financial Position in reverse order of liquidity. Liquid 13

20 Home Learning College funds are cash reverse order of liquidity means that the least liquid items (most difficult items to turn into cash) are shown first, with cash always being listed last. It is normally assumed that inventory is the least liquid current asset, with cash obviously being the most liquid. The most common listing of current assets is as follows: Inventory Trade receivables Prepaid amounts Bank deposit account balance Bank current account balance Cash in hand Current liabilities on listing current liabilities on the Statement of Financial Position the least urgent short-term obligation (the one to be met last) is listed first, with the most urgent obligation listed last. Trade payables are usually regarded as being the least urgent current liability and are normally listed first. A typical listing is: Trade payables Accruals Bank overdraft In presenting the Statement of Financial Position the current liabilities are shown beneath the current assets. The total of the current liabilities is deducted from the total of current assets to show net current assets (also known as working capital). Where current assets exceed current liabilities, as is usually the case, then the net current assets balance, i.e. a positive figure, is added to the carrying amount of non-current assets to give a sub-total (total assets less current liabilities). Non-current liabilities in presenting the Statement of Financial Position the non-current liabilities are usually shown directly beneath the current liabilities (after the net current assets and total assets less current liabilities sub-totals). The total of non-current liabilities is then deducted from the sub-total of total assets less current liabilities to give a figure referred to as net assets. Capital/Equity this is the claim of the owner(s) on the assets of a business after deducting its liabilities and is usually summarised on the Statement of Financial Position under the heading of financed by, or represented by. 14

21 Prepare Final Accounts for Sole Traders and Partnerships The capital figure shown on the Statement of Financial Position consists of: the opening capital at the beginning of the financial year, add any further capital introduced in the financial year, add net profit, or less net loss in the accounting period, and less any drawings taken by the owner of the business during the financial year. The following is an example of a Statement of Financial Position prepared from the financial records of a sole trader. Countywide Farming Supplies Statement of Financial Position at 30 June 201Y Non-current assets 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 Prepayments 1,200 Cash and cash equivalents 5,700 Less Current Liabilities Trade payables 18,600 Accruals 1,500 Net current assets Total assets less current liabilities 44,700 20,100 24, ,600 Less Non-current liabilities 10,000 Bank loan (5 years) Net Assets 101,600 Financed By: Capital 100,400 Add Net Profit 25, ,600 Less Drawings 24, ,600 15

22 Home Learning College Drafting final accounts classifying and using balances As suggested earlier in this lesson, it is common practice to draft financial statements directly from a trial balance; in doing so, additional information is also required so that appropriate period-end adjustments can be made. The preparation of final accounts from a trial balance (with adjustments) requires a knowledge of what debit and credit account balances represent, and an understanding of how the balances are to be adjusted and where, within the final accounts, the account balances are used. Account balances can be listed in any order on the trial balance, as long as all account balances within the double entry system are listed. However, in practice, the listing of balances is often organised so that there is a listing of balances into two groups, i.e. those which will be used in the preparation of the Statement of Profit and Loss, and those to be used in the preparation of the Statement of Financial Position. The following information provides a key to classifying the account balances extracted from the financial records of a sole trader and also gives an indication of how and where the balances are used in the preparation of the Statement of Profit or Loss and Statement of Financial Position: Classifying debit and credit balances Debits Assets Costs Expenses Drawings ACED Credits Capital Liabilities Incomes Provisions/allowances CLIP 16

23 Prepare Final Accounts for Sole Traders and Partnerships The use of debit balances Item Description Use Financial Statement Assets Resources (Items of value) Statement of Financial position Costs Associated with buying Statement of Profit or Loss trading section Expenses Associated with selling, distribution and administration Statement of Profit or Loss profit and loss section Drawings Reduction in owners claim Statement of Financial Position (deducted from capital) The use of credit balances Item Description Use Financial Statement Capital Owners claim Statement of Financial Position Liabilities Financial obligations Statement of Financial Position Incomes Earned from sales or other non-trading activities Statement of Profit or Loss sales income trading section Statement of Profit or Loss non-trading income profit and loss section Provisions/ allowances Reduction in asset values (estimates of loss in value) *Statement of Profit or Loss and Statement of Financial Position 17

24 Home Learning College Note: *Provisions/allowances Provisions, e.g. a provision for the depreciation of non-current assets, represents an estimate of loss in the value of non-current assets. The provision adjustment accounted for at the end of each financial year appears on the Statement of Profit or Loss. The accumulated provision (the balance on the provision account at the financial year end) is deducted on the Statement of Financial Position from the asset value to which it relates. The treatment of allowances, e.g. an allowance for doubtful debts, is the same as the treatment of provisions. The allowance for doubtful debts made at each financial year end appears on the Statement of Profit or Loss. The balance on the allowance for doubtful debts account at the year end is deducted from trade receivables to give net trade receivables on the Statement of Financial Position. Assessment tip In practice, balances are often listed on a trial balance in two groups, i.e. a group of balances to be used in the preparation of the Statement of Profit or Loss, and a group of balances to be used in the preparation of the Statement of Financial Position. In a CBT, however, you are likely to see account balances listed on a trial balance in random order, or alphabetical order, rather than a grouped list. It is therefore essential that you are able to recognise account balances as being, either debit balances or credit balances and that you know where and how account balances are used in the preparation of the financial statements. It is recommended that you adopt the ACED and CLIP key for determining what account debit and credit balances represent. You also need to know how and where the account balances will be used. The following is a worked example showing the preparation of final accounts for a sole trader. The Statement of Profit or Loss and Statement of Financial Position have been prepared from a trial balance and additional information given at the financial year end. A range of adjustments are dealt with, drawing on knowledge and skill gained in several areas of learning. 18

25 Example Preparation of final accounts Prepare Final Accounts for Sole Traders and Partnerships The following trial balance was extracted from the financial records of Chem Clean, a business owned by Berta Kowalski, as at the financial year end 30 September 201Y: Note: A column has been added to the trial balance in which the classification and use of the account balances (in accordance with the ACED and CLIP key) has been noted. The notes classify each balance and also show how and where within the final accounts the account balance will be used. Where an account balance is to be adjusted, in respect of the additional information provided, this too has been noted. The following abbreviations have been used in classifying the balances on the trial balance: SPL Statement of Profit or Loss SFP Statement of Financial Position A Asset NCA Non-current asset CA Current asset D Drawings CAP Capital L Liability NCL Non-current liability CL Current Liability I Income P Provision/allowance Trade rec bls ledger control Trade receivables ledger control Trade pay bls ledger control Trade payables ledger control Allow ce doubtful debts Allowance for doubtful debts 19

26 Home Learning College Chem Clean Trial Balance at 30 September 201Y DR CR Classification and Use Premises (cost) Fixtures and fittings (cost) 75,000 5,000 A = SFP (NCA) A = SFP (NCA) Vehicles (cost) 40,000 A = SFP (NCA) Office equipment (cost) 4,000 A = SFP (NCA) Accumulated depreciation 30 September 201X: Premises 3,000 P = SFP (deduct from NCA) Adjust Fixtures and fittings 1,000 P = SFP (deduct from NCA) Adjust Vehicles 14,400 P = SFP (deduct from FA) Adjust Office equipment 2,000 P = SFP (deduct from NCA) Adjust Capital 134,600 Cap = SFP (CAP) Drawings 30,000 D = SFP (deduct from CAP) Bank loan payable (5 years) 12,000 L = SFP (NCL) Sales 575,650 I = SPL (trading income) Sales returns 4,550 Cost = SPL (treat as negative income reduce sales) Purchases 420,700 C= SPL (trading cost) Carriage inwards 5,600 C= SPL (trading cost) Purchase returns 6,650 I = SPL (treat as negative cost reduce purchases) Opening inventory 50,160 C = SPL (trading cost) Discount received 6,300 I = SPL (non-trading income) Wages and salaries 73,200 E = SPL (expense) Discount allowed 7,350 E = SPL (expense) Rates 14,800 E = SPL (expense) adjust Carriage outwards 3,600 E = SPL (expense) Heat and light 2,560 E = SPL (expense) adjust Vehicle expenses 8,400 E = SPL (expense) General expenses 5,200 E = SPL (expense) adjust Bank 9,750 A = SFP (CA) Cash 200 A = SFP (CA) Sales ledger control 46,550 A = SFP (CA) Purchase ledger control Closing inventory (SPL) Closing inventory (SFP) Allow ce for doubtful debts 48,600 50,270 48, Totals 855, ,220 Additional information at 30 September 201Y A =SFP (CL) C = SPL (trading less costs) adjust A = SFP (CA) adjust P = SFP (deduct from trade rec bls) adjust (a) Inventory at close of business on 30 September 201Y was valued at 48,600 and has been entered on the trial balance above at this valuation. However, since the original valuation was made it has been discovered that one item of inventory has been valued at its selling price of 1,200 (which includes a mark-up of 50%). 20

27 Prepare Final Accounts for Sole Traders and Partnerships (b) Rates of 7,600 were prepaid at 30 September 201Y. (c) The last gas and electricity bills received and paid by Chem Clean totalled 900 and were for the quarter (three-month period) ended 31 July 201Y. It is expected that gas and electricity bills for the next quarter will be 10% lower than those of the previous quarter and an accrual needs to be made in respect of gas and electricity outstanding as at the year end. (d) General expenses at 30 September 201Y include certain items prepaid by 1,500. An accrual of 1,800 also needs to be accounted for in respect of general expenses incurred in the year but unpaid at the year end. (e) Depreciation for the year ended 30 September 201Y is now to be provided for as follows: Premises 2% per year, straight line method. Fixtures and fittings 10% per year, straight line method. Vehicles 20% per year, diminishing balance method. Office equipment 25% per year, straight line method. (f) The allowance for doubtful debts is to be adjusted to represent an amount equivalent to 2% of trade receivables at 30 September 201Y. 21

28 Home Learning College Chem Clean Statement of Profit or Loss for the Year Ended 30 September 201Y Sales 575,650 Less Sales returns 4,550 Net sales 571,100 Less Cost of goods sold Opening inventory 50,160 Add Purchases 420,700 Add Carriage inwards 5,600 Less Purchase returns 6, ,810 Less Closing inventory (see workings) 48,200 Cost of sales 421,610 Gross profit 149,490 Add Other income Discount received 6, ,790 Less Expenses Wages and salaries 73,200 Discount allowed 7,350 Rates (see workings) 7,200 Carriage outwards 3,600 Heat and light (see workings) 3,100 Vehicle expenses 8,400 General expenses (see workings) 5,500 Depreciation (see workings 8,120 Allowance for doubtful debts adj t ,651 Net profit 39,139 22

29 Prepare Final Accounts for Sole Traders and Partnerships Chem Clean Statement of Financial Position at 30 September 201Y Cost Less Acc d Carrying Non-current assets Dep n amount Premises 75,000 4,500 70,500 Fixtures and fittings 5,000 1,500 3,500 Vehicles 40,000 19,520 20,480 Office equipment 4,000 3,000 1, ,000 28,520 95,480 Current assets Inventory 48,200 Trade receivables (see workings) 45,619 Prepayments (see workings) 9,100 Cash and cash equivalents 9,950 Less current liabilities Trade payables 50,270 Accruals (see workings) 2, ,869 52,610 Net current assets 60,259 Total assets less current liabilities Less non-current liabilities Bank loan 155,739 12,000 Net assets 143,739 Financed by: Capital 134,600 Add net profit 39, ,739 Less drawings 30, ,739 Workings: Closing inventory adjustment Original valuation 48,600 Less mark-up on inventory at selling price (reduce value to cost price) 400 SPL deduct from cost/sfp (current asset) 48,200 23

30 Home Learning College Rates adjustment Balance per trial balance 14,800 Less rates prepaid 7,600 SPL (expense) 7,200 Heat and light adjustment Balance per trial balance 2,560 Add heat and light accrued (900 x 90% = 810 divide 3 x 2) SPL (expense) * 540 3,100 Note: * Accrue for two months gas and electricity bills at year end (August and September months) General expenses adjustment Balance per trial balance 5,200 Add general expenses accrued 1,800 Less general expenses prepaid 1,500 SPL (expense) 5,500 Depreciation Depreciation adjustment(s) Land and buildings: cost 75,000 x 2% = 1,500 Fixtures and fittings: cost 5,000 x 10% = 500 Vehicles: cost 40,000 14,400 x 20% = 5,120 Office equipment: cost 4,000 x 25% = 1,000 Depreciation charge (SPL) 8,120 Accumulated depreciation at 30 September 201Y Dep n at 30/9/1X Dep n in Year Acc d Dep n 30/9/1Y Premises 3, ,500 = * 4,500 Fixtures and fittings 1, = * 1,500 Vehicles 14, ,120 = * 19,520 Office equipment 2, ,000 = * 3,000 * see SFP Non-current assets section at 30 September 201Y 24

31 Prepare Final Accounts for Sole Traders and Partnerships Allowance for doubtful debts adjustment Trade receivables as at 30 September 201Y 46,550 x 2% = 931 (allowance to be): Allowance to be (SFP deduct from trade receivables) 931 Less Allowance brought forward per trial balance 750 Allowance adjustment increase (SPL expense) 181 Trade receivables Statement of Financial Position Sales ledger control per trial balance 46,550 Less allowance for doubtful debts 931 Net trade receivables (SFP current asset) 45,619 Prepayments Rates prepaid Operating expenses prepaid SFP (current asset) Accruals Heat and light accrued Other operating expenses accrued SFP (current liability) 7,600 1,500 9, ,800 2,340 25

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33 Prepare Final Accounts for Sole Traders and Partnerships LESSON 2 - Prepare Final Accounts for a Partnership On completing this lesson you should be able to: Define the term partnership and explain the advantages and disadvantages of forming a partnership Explain the purpose of a partnership agreement and describe the key components of such an agreement Explain the circumstances in which the Partnership Act 1890 would apply, and identify the main provisions of the Act Describe the key components of partnership accounts, i.e. capital accounts, current accounts, Statement of Profit or Loss, Appropriation of Profit or Loss, and Statement of Financial Position Accurately determine the profit or loss to be allocated to partners after accounting for interest on drawings, interest on capital and partnership salaries Prepare capital accounts, current accounts, a Statement of Profit or Loss, an Appropriation Account, and a Statement of Financial Position 27

34 Home Learning College Introduction The term partnership is used to describe a form of business ownership. A partnership is defined as follows: the relationship which subsists between persons carrying on a business in common with a view to profit. A partnership is a relatively simple way for a number of individuals to establish and run their own business. In a partnership two or more people share the risks, rewards and responsibilities of being in business. A partnership has several advantages over the sole trader type entity. For example: As a number of individuals contribute capital to the business there is greater potential for raising the finance necessary to set up and/or expand the business. It is possible to have sleeping partners, i.e. individuals who contribute capital to the partnership but are not involved in the dayto-day running of the business. The partners themselves will normally manage the business and make important decisions, although they can delegate some responsibilities to employees of the business. Individuals from the same, or different, backgrounds, can work together and there is a pooling of qualifications, skills and talent, as well as a sharing of responsibility. If, in any trading period, the business trades at a loss, the loss is shared between the partners. Of course, being in partnership with others can have its drawbacks, these include: The sharing of decision making and the control of the business can lead to disputes between partners. Profits generated by the partnership have to be shared between partners. All partners are bound by a commitment made by a single partner. 28

35 Prepare Final Accounts for Sole Traders and Partnerships Each partner has unlimited personal liability for all of the debts and obligations of the partnership. The partnership agreement In a partnership we may find that each partner may not be able to contribute an equal amount of capital to the business. They may each bring a different level of skill to the business, not be able to take on an equal share of responsibility, or devote the same amount of time to the partnership as other partners. We might also find that because of different lifestyles, or personal financial commitments, they may need to take different amounts from their business in the form of drawings. It is often matters of this nature that, in time, result in disputes between partners. Such matters can, however, be addressed by the partners, usually with the help of a solicitor and accountant, by drawing up a Partnership Agreement. This is a document that sets out the important terms and conditions that will determine the relationship of the partners with each other. The key components of a partnership agreement will normally include such matters as: Capital contributions The amount of capital each partner has agreed to contribute to the partnership will be stated in the partnership agreement. Interest on drawings the partnership agreement may be used to control partners drawings, for example to discourage partners from withdrawing large amounts from the business early in the year, or taking amounts as drawings in excess of what the business is earning for them. It is also used to penalise those partners who need to withdraw more from the business than their fellow partners. In practice any interest on drawings would probably be calculated on a monthly basis, but in an assessment question, for ease of calculation, it is often based on the balance on each partner s drawings account at the financial year end. Partners are charged (debited with) interest on drawings and the amount charged is added to net profit prior to it being shared between partners. However, the charge is a notional charge, the partners do not make a payment to the business; instead, the 29

36 Home Learning College interest on drawings charge is offset against other items relevant to their share of profit. Example Charging interest on drawings Let us consider that on 1 June 201X Dave and Nick decide to go into partnership and a partnership agreement is drawn up on their behalf. The agreement contains the arrangement that each partner will be charged interest on drawings at the rate of 4% based on the balance on their drawings account at each financial year end. At the end of the first year of trading, 31 May 201Y, let us assume that the partnership generated a net profit of 64,000 and that Dave s drawings account carried a balance of 30,000 at that date and Nick s drawings account carried a balance of 24,000. In sharing out the profit earned by the business each partner would be charged (debited with) interest on drawings as follows: Dave 1,200 (30,000 x 4%) Nick 960 (24,000 x 4%) The interest on drawings charged to the partners would be added to the net profit and 66,160 (64, , ) would now be available for sharing between the partners. Interest on capital This enables partners who have contributed greater amounts to the business in terms of capital than other partners to receive financial recognition in respect of their additional investment. For example, partners may agree that they each be paid a rate of interest on their capital equivalent to what it might earn them if it were invested outside the business, say in a bank or building society. The interest on capital that partners receive is not a business expense but a way of sharing (appropriating) the profit of the partnership. 30

37 Prepare Final Accounts for Sole Traders and Partnerships Example - Interest on capital On entering into partnership on 1 June 201X, let us assume that Dave contributed 150,000 as capital to the business and Nick contributed capital of 100,000, and that each partner transferred their capital contribution from their private bank accounts into a bank account opened on behalf of the partnership business. Their partnership agreement contains the arrangement that they will each receive interest on their capital at the rate of 3% per year. At the year end 31 May 201Y, Dave will be given (credited with) 4,500 as interest on capital, and Nick will be given (credited with) interest on capital of 3,000. Profit remaining for sharing between partners after accounting for interest on drawings will now be 58,660 (66,160 4,500 3,000). Partnership salaries Partners who are involved in the running of a partnership, particularly where they commit more time to the business than fellow partners, take on more responsibility, or bring different qualifications or levels of skill to the business than other partners, may be paid a partnership salary in recognition of their additional commitment. In this context the term salary can be misleading as partners are not in fact employed by the partnership, they are its joint owners. Any payment of a salary to an individual partner is not therefore classed as a business expense, but is an agreed share of profit. Let us now consider that Dave is to work full-time in the partnership business, whilst Nick, who has other business commitments, will work part-time. Their partnership agreement, therefore, contains an arrangement that Dave will receive a partnership salary of 10,000 per year and Nick will receive a partnership salary of 5,000 per year. As a result of this arrangement, at the year ended 31 May 201Y Dave will receive (be credited with) a salary of 10,000 and Nick will receive (be credited with) a salary of 5,000 before remaining profits are shared between partners. 31

38 Home Learning College Profits remaining to be shared between the partners following the giving of salaries are 43,660 (58,660 10,000 5,000) Profit-sharing ratio The partners will agree upon what they consider to be an equitable division of profit/loss and the partnership agreement will specify the profit-sharing ratio agreed upon. The share of profit/loss is the distribution of remaining profit/loss after the above items have been accounted for. Example Sharing remaining profit Let us now assume that the partnership agreement drawn up on behalf of Dave and Nick contains the arrangement that remaining profit (after accounting for other items agreed upon) will be shared equally between the partners. As a result of this agreement each partner will receive (be credited with) 21,830. Interest on loans Occasionally a partner may make a loan to the partnership. Loans are separate to the agreed capital contribution of the partners and are treated as such. Loan capital should be covered by a loan agreement between the partnership business and the individual partners concerned. Partners who loan money to the business will expect to be paid interest on the amount of the loan. Loan interest is payable to a partner whether the business generates a profit or a loss and is a business expense and not a share of profit (appropriation of profit). Loan interest will therefore be charged as an expense to the Statement of Profit or Loss at the year end. The loan itself is a liability of the partnership business and will be listed under the heading of liabilities on the Statement of Financial Position. 32