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LEARNING the
Students learn in different ways. Our accounting text Various pedagogical features make it easier to read
978 1 48512 948 6
Learning path tools have been introduced at the beginning
of each chapter.These include a Business Focus section, where a real life scenario is discussed in the context of the chapter contents, as well as a Dashboard, which guides the student on how to study
the particular chapter.
Examples of a definition
Concepts in context
Add Add
Less
Less
Pause and reflect
The Smart Concepts case study
The transactions in the Smart Concepts case study (that runs from chapters 2 to 7) have
been grouped into distinct sets
to make the case study more manageable and understandable to students. In addition, there is an innovative way of explaining and linking each transaction to the conceptual underpinning: the accounting equation and
the double entry system.
1
Starting the business
bank capital
The statement of changes in equity, which was introduced in Chapter 2, is prepared to provide information to users about the changes in an entity's wealth during the period. You will recall from Chapter 2 that the statement of changes in equity presented line items showing the following:
The income earned and the expenses incurred, as reflected by the profit or loss for the period
Contributions by owners
Distributions to owners.
You should therefore realise that the statement of changes in equity provides information about the four types of transactions that affect equity.
The following is a record of the transactions of Smart Concepts, a computer retailer, for the period from 1 January 20X5 to 31 March 20X5. These are the same transactions that we analysed on a conceptual level in Chapter 2. You must not forget the concepts taught in the previous chapters when analysing transactions using the accounting equation. The explanation which follows this example incorporates the analysis of the transaction on a conceptual level with an explanation of the effect of each transaction on the accounting equation.
External transactions
Starting the business
1. On 2 January, Simon Smart started a business as a computer retailer. He drew
C950 000 from a savings account and opened a bank account in the name of
Smart Concepts into which he paid C950 000.
2. On 2 January, Smart Concepts negotiated a loan from Techno Bank for an
amount of C600 000. The loan is repayable in four equal annual instalments, beginning on 31 December 20X5. The interest rate is 12% per annum, payable quarterly in arrears.
3. On 2 January, Simon located premises from which to operate in Hyde Park. The monthly rent for the premises is C12 000. Smart Concepts paid four months’ rent in advance on 2 January.
4. On 2 January, Simon transferred C120 000 from the bank account into a fixed deposit account earning interest at 5% per annum.
5. On 2 January, Smart Concepts purchased furniture and fittings for C240 000. This was paid for from funds in the bank account. The expected useful life of the furniture and fittings is five years.
bank capital
Assets
Liabilities
Owner’s equity
26
Chapter 2
2
Chapter 3
Starting the business
3
This example introduces you to the activities of Simon Smart, a computer retailer, operating under the name of Smart Concepts. The example will be used throughout parts 1 and 2 of this book to introduce the conceptual aspects of accounting and to explain the accounting process. The following is a record of the transactions of the business for the three-month period from 1 January to 31 March 20X5.
External transactions
Starting the business
1. On 2 January, Simon Smart started a business as a computer retailer. He drew C950 000 from a savings account and opened a bank account in the name of Smart Concepts into which he paid C950 000.
2. On 2 January, Smart Concepts negotiated a loan from Techno Bank for an amount of C600 000. The loan is repayable in four equal annual instalments, beginning on 31 December 20X5. The interest rate is 12% per annum, payable quarterly in arrears.
3. On 2 January, Simon located premises from which to operate in Hyde Park. The monthly rent for the premises is C12 000. Smart Concepts paid four months’ rent in advance on 2 January.
4. On 2 January, Simon transferred C120 000 from the bank account into a fixed deposit account earning interest at 5% per annum.
5. On 2 January, Smart Concepts purchased furniture and fittings for C240 000. This was paid for from funds in the bank account. The expected useful life of the furniture and fittings is five years.
6. On 5 January, Smart Concepts purchased supplies of stationery for C5 000 as well as supplies of computer parts for C12 000. All of these were paid for in cash.
7. On 7 January, Smart Concepts opened an account with Computer World, the
supplier of its inventory.
Trading and operating transactions for January
8. On 10 January, Smart Concepts purchased inventory of 60 computers from Computer World at a cost of C10 000 each. The total amount owing is to be paid by 25 March.
9. On 12 January, Smart Concepts paid a service provider C750 for internet access.
10. On 25 January, Smart Concepts sold 15 computers on credit to a customer for C12 500 each. An amount of C125 000 is due by 15 March and the balance by 15 April.
Trading and operating transactions for February
11. On 1 February, Smart Concepts employed a computer technician at a salary of C8 000 per month.
12. On 8 February, Smart Concepts paid C7 000 for an advertisement in a newspaper, advertising the computers available for sale.
13. On 12 February, Smart Concepts sold 30 computers to customers for C12 500 each. The customers paid cash for them.
14. On 25 February, Smart Concepts received cash of C48 000 in respect of technical support contracts taken out by customers. The contracts are for a two- year period.
15. On 28 February, Smart Concepts paid the computer technician his salary for February.
Chapter 4
Assets
Liabilities
Owner’s equity
increase in assets on the left side
increase in owner’s equity on the right side
Debit debit
Credit credit
bank borrowings
Dr Cr
Assets
Liabilities Owner’s equity
increase in assets on the left side
increase in liabilities on the right side
rent paid in advance bank
73 79
bank borrowings
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b -
A business entity is an organisation that uses economic resources for the primary goal of
maximising profit. A non-business entity is concerned with providing a service to members.
Accounting contributes to these decisions by identifying what information will assist the various decision makers, how it should be recognised and measured, and how it should be communicated to them. Accounting provides information about an entity to users for decision-making purposes.
Users of financial information may be broadly categorised as primary users or as management. Primary users are sometimes referred to as external users and management is sometimes referred to as internal users.
Primary users, for example investors or lenders, are not involved in the management
of an entity’s activities but require financial information about the entity for decision making. They lack the ability to prescribe all the financial information they need from an entity and therefore must rely on information provided in financial reports.
Management, who is responsible for the entity’s activities, is also interested in financial information about the entity. Management, however, does have access to detailed information relating to the entity and is responsible for preparing financial information for the primary users. Management therefore does not need to rely only on the information provided in financial reports.
The relationship between internal and external users and their information needs is shown in Diagram 1.2. A more detailed discussion of users is provided in section 1.5.1.
Interested in information about the entity for decision making
Also interested in information about the entity, but has access to all information it needs
Provides information
information
Prepares
Financial Financial
(about the entity)
Accounting thought and practice can be classified according to the user group to whom it is directed.
Financial accounting is concerned with providing useful information about business
entities for primary users.
Management accounting is concerned with providing useful information related to the
deployment of resources and the exploitation of opportunities for management. The emphasis in this text is on financial accounting for primary users.
5
Chapter 5
Recording Internal Transactions
Dashboard
Look at the Learning outcomes so that you
Learning outcomes
Read the Business focus to place this chapter’s contents in a real-world context.
and explain the impact of each on the
Accounting scandals, creative accounting and fraud are recurrent. They range from the South Sea Bubble in 1720 to Parmalat, Enron and Worldcom today. They occur in all eras and in all countries. As accounting forms a central element of any business success or failure, the role of accounting is crucial in understanding such business scandals.
Preview In this chapter to focus your mind on the contents of the chapter.
accounting equation.
3. Record internal transactions in the journal,
Accounting enables businesses to keep a set of records to give investors and other users a picture of how well or badly the entity is doing. However, sometimes when businesses are doing badly, management are tempted to use accounting to enhance the apparent performance of the firm in an unjustified way. In addition, management may use ‘creative accounting’ to exploit the flexibility within accounting to serve a range of managerial interests legally, such as to boost profits or increase assets.
Focus on Diagram 5.2, which identifies and classifies the four main adjusting entries. Use this classification as you read the explanation of each adjustment.
5.1
Adjusting entries in the context of the accounting process
Alternatively, management may engage in false accounting or fraud. Here management will step outside the principles that govern accounting. Often this will be because management has gotten into serious financial difficulties and is looking for any way to postpone corporate collapse. Management may use prohibited accounting techniques, falsify records or even document fictitious transactions. In some cases, companies start with creative accounting, but end up committing fraud.
5.2
period concept Classification of the adjustments
The inappropriate use of internal transactions or adjusting entries is one of the ways to perpetuate creative accounting or commit fraud. Management intent on creative accounting could recognise cash received in advance as income before it has been earned, thus increasing profit. Similarly, the recognition as an expense of cash paid in advance could be deferred, also increasing profit. This chapter will give you a good understanding of the authentic use of adjusting entries.
(expenses paid in advance) 5.2.4 Cash payment outstanding
5.4.1 Recording of receipts into income accounts
5.4.2 Recording of payments into
Life for an accountant could be easy if the work for an accounting period was done after processing the data for that period. However, at the end of a period, most entities have received some cash in advance of earning the income and have also earned some income where the cash receipt is outstanding. Similarly, most entities have paid some cash in advance of the incurral of expenses and have also incurred some expenses where the cash payment is outstanding. This chapter explores these issues in detail.
expense accounts Revision example
know what you should be able to do after studying this chapter.
After studying this chapter, you should be able to do the following:
1. Explain the objective of internal transactions. 2. Identify the four main types of adjustments
Prepare solutions to the examples as you read through the chapter.
5.2.1 Cash received in advance of earning income (income
Read the text in detail.
adjustment trial balance.
4. Explain the accounting procedure when
Pay attention to the definitions, and apply your mind to the Pause and reflect scenarios.
receipts and payments of cash are recorded into income and expense accounts.
Look back at the relevant internal transaction of the Smart Concepts case study in chapters 2, 3 and 4 as you come across each one in sections 5.2 and 5.3 of this chapter.
5.1.1 The accrual basis of accounting and internal
Prepare a solution to the Revision example at the end of the chapter without reference to the suggested one. Compare your solution to the suggested solution provided.
received in advance) 5.2.2 Cash receipt outstanding
post to the ledger and prepare a post-
5.3 5.4
adjustments
Processing of internal transactions at the end of the accounting period Recording receipts and payments into income and expense accounts
transactions
5.1.2 The accrual basis of
accounting and the time-
and income already earned
(income receivable) 5.2.3 Cash paid in advance of
incurral of expenses
and expense already
incurred (expenses payable) 5.2.5 Other period-end
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Dr Cr
You have learnt in the previous sections about the principles of the double-entry system as well as the format of a general journal and general ledger. We have analysed each transaction showing its effect on the accounting equation, the resultant double entry as well as the applicable journal entry and ledger posting.
It is important that you are able to process a set of transactions using a manual bookkeeping system; in other words, record the transactions in a journal, post the transactions to a ledger and prepare a trial balance. We examine this process in the sections and examples that follow.
It is very important to be able to identify accounts either as an asset, liability, owner’s equity, income or expense as this determines the debit or credit in the double-entry system. In this book, we include either an ‘A’, ‘L’, ‘OE’, ‘I’ or ‘E’ behind the account name to identify it as an asset, liability, owner’s equity, income or expense respectively. This helps you identify the account as a statement of financial position account or a statement of profit or loss account when preparing the financial statements. It is also essential to distinguish accounts of the same or similar name that appear as statement of financial position accounts and as statement of profit or loss accounts.
For example, if an entity pays insurance in advance, we debit an asset account that we have called ‘Insurance paid in advance (A)’. When the entity recognises the insurance used for the period, we debit an expense account ‘Insurance (E)’ and credit the ‘Insurance paid in advance (A)’. Similarly, if an entity receives fees in advance, we credit a liability account that we have called ‘Fees received in advance (L)’. When the entity recognises the fees earned for the period, we debit the liability account ‘Fees received in advance (L)’ and credit an income account ‘Fees (I)’.
Think of ‘rent’. Is ‘rent’ an asset, a liability, income or an expense? Could it be all of these?
Rent is recognised as an asset if the entity is a tenant and pays rent in advance to a landlord. At the end of the period, the entity recognises the rent incurred for the period as an expense.
Rent is recognised as a liability if the entity is a landlord and receives rent in advance from a tenant. At the end of the period, the entity recognises the rent earned for the period as income.
This emphasises the importance of identifying an account as an asset, liability, income or expense.
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Purchase of goods from wholesaler (Design for You)
Sale of goods to customer
Cost of goods sold
What concepts in context can you see here?
Remember that there is no VAT effect when recognising cost of sales as the inventory has already been recorded net of the input VAT paid at the time of purchase.
Marks and Spencer Group plc
Extract from revenue note
Revenue comprises sales of goods to customers outside the group, less an appropriate deduction for
actual and expected returns, discounts and loyalty scheme vouchers, and is stated net of value added
tax and other sales taxes.
You have learnt in this chapter that VAT is collected by an entity on behalf of the tax authority and
therefore income earned from sales must exclude the VAT component of the selling price. Marks and
Spencer accounting policy note for revenue is typical of most business entities, informing users that
revenue from sales is stated net of VAT.
Marks and Spencer plc is a major British multinational retailer headquartered in the City of Westminster,
London. It specialises in the selling of clothing, home products and luxury food products.
Source: http://corporate.marksandspencer.com/investors/b73df1d3e4f54f429210f115ab11e2f6 (Accessed 28 June 2014)
It is important to note that not all supplies of goods and services are taxable supplies that attract VAT at the standard rate.
Certain supplies are zero-rated and attract VAT at a rate of 0%. Common examples of zero-rated supplies are exports and the supply of certain basic foodstuffs such as milk and fresh vegetables. A registered vendor who makes zero-rated supplies may still deduct the input VAT it paid when preparing its VAT return even though it did not charge any output VAT on its sales of these items.
Certain other supplies are exempt supplies and also attract no VAT. Examples typically include financial services such as the payment of interest on a loan, residential rentals and the supply of educational services by a school or university. When preparing its VAT return, a vendor who makes exempt supplies may not deduct the input VAT paid on goods or services used in making the exempt supply.
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