AAT LEVEL 3 ACCOUNTS PREPARATION
Chapter 1
Chapter coverage:
This chapter gives an overview of the financial statements that are produced at the end of the financial year. It explains how each account can be classified into one of only four basic types which determine whether the balance will appear on the Income Statement or the Statement of Financial Position. It then explains the foundation on which every accounting system is built - the Accounting Equation - and how an understanding of how the equation works will help with the fundamental understanding of how accounting systems operate.
DIFFERENT TYPES OF ACCOUNT A business can have many accounts in which transactions are recorded, but there are only 4 basic types of account:
ASSETS
LIABILITIES
These are items that the business owns
These are amounts that the business owes
e.g. property, vehicles, equipment, stocks, cash, debtors (they owe money to us) etc.
e.g loans, creditors (we owe money to them) capital ( the money invested by the owners is owed to them by the business)
EXPENSES
REVENUES
These are the day to day running costs
These are the incomes from activities
e.g. rent, wages, electricity, telephone, vehicle running costs, stationery etc.
e.g. sales, interest received, dividends received
The type of account you are dealing with at any one time is important, because at the end of the period you need to classify each account into one of those types so that you can prepare the financial statements which will determine how much profit the business has made and what the financial position of the business is. These statements are called The Income Statement and the Statement of Financial Position respectively. In Accounts Preparation you will be producing all 3 of these statements.
This is an example of how an Income Statement will look and what you are ultimately going to prepare. For now please do not worry about the format of this statement – this is an introduction to the ultimate goal of preparing it. Essentially what it does is determine the total of revenues (money coming in to the organisation) and it deducts from that the total of expenses incurred in earning those revenues. From this you can determine whether the firm has made a profit on its activities (there is money left over after deducting the expenses) or a loss (the expenses were greater than the revenues).
Revenues – Expenses = Profit (or Loss) PROFIT AND LOSS ACCOUNT For the year ended ……………… £ Sales Less Cost of sales Opening stock Add Purchases Less Closing stock
10,000 45,000 (15,000) (40,000) 60,000
GROSS PROFIT Less expenses: Wages & salaries Rent & rates Telephone Heat & Light Vehicle running expenses Stationery Depreciation Bad debts NET PROFIT
£ 100,000
10,000 1,000 500 1,200 400 200 1,000 100 14,400 45,600
This is an example of how a Statement of Financial Position might look at the end of the year:
STATEMENT OF FINANCIAL POSITION AS AT …………………………… Cost
Fixed Assets
Office furniture Vehicles
£ 12,000 18,000 30,000
Stock Debtors Bank
15,000 5,000 12,000
Depreciation
Net Book
To Date £ 500 2,000 2,500
Value £ 11,500 16,000 27,500
Current Assets
32,000 Current Liabilities Creditors
(2,000)
NET CURRENT ASSETS
30,000
NET ASSETS
57,500
Financed by: Capital Add profit for year Less Drawings
21,900 45,600 (10,000) 57,500
The Statement of Financial Position is a list of all the assets and liabilities of the business at the end of the year and gives an estimate of the business’s worth – it shows how the assets have been funded.
Assets (Fixed + Current) – Liabilities = Capital
If you look back at the diagram on page 3 you will see that these four types of account have been set out in that particular format to try to help you remember which account to debit and which to credit. There are a number of methods students use to try to remember which side of an account to enter a transaction – you should use the method which you find easiest until one day you will find that you don’t even need to think about which side the entry goes. The whole thing will simply fall into place. Assets and expenses must be paid for, therefore either the cash account, bank account or a creditor must be credited. It follows that the asset or expense account must have a debit entry. Revenues are monies coming in, therefore the bank or cash or a debtor must be debited. It follows that the revenue account must be credited. Liabilities are amounts which are due to be paid, therefore either the bank, an asset account or purchases has been debited. The liability account must therefore be credited. It might also help you to remember that assets and liabilities are opposites, which means that entries into those accounts will always be into the opposite side. For example, if you buy a new computer for the office on credit you have increased the value of your assets but you have also created a liability – someone you now owe money to. The double entry for the transaction would therefore be: Dr Computers
Cr (Name) creditor Expenses and revenues are also opposites, so entries into those accounts will be to opposite sides. For example, if you rent your premises from a landlord the rent you pay will be treated as an expense. The double entry would be: Dr Rent paid
Cr Bank If on the other hand you rent out part of your premises to another firm they will pay you and the money you receive will be treated as a revenue. The double entry would be: Dr Bank Cr Rent received
Aspects of transactions To operate effectively a business needs to own a variety of assets and they are classified as either fixed assets or current assets. Fixed assets (But for limited company accounts these are now referred to as non-current assets)
Fixed assets are retained within the business in order to generate income and make profits. They are assets that are to be used within the business for normally a period of at least a year. Examples are: Motor Vehicles Office Equipment Land and Buildings They are for use in the business rather than for resale. ****************************************************
Current assets Current assets are money or other items owned by the business that will be converted into money as part of everyday trading. Examples are: Stock of goods for Resale Cash at the Bank Cash in Hand Debtors (people/companies who owe the business money) The term current implies that conversion to money would normally take place within twelve months, but it is frequently much sooner than that. *************************************************** During trading businesses will build up liabilities and they can be classified as current liabilities or long term liabilities.
Current liabilities Current liabilities are items that a business owes that would normally be payable within 1 year. Examples:Short term loans Overdrafts Creditors (people or companies we owe money to) *********************************************************
Long Term Liabilities Long term liabilities are monies owed that businesses will not pay within the next twelve months. Examples: Long term loans. Mortgages ******************************************************* During the life of a business and especially in the beginning an owner will pay money into the business from his own monies or leave profits in the business at the end of each financial year. Monies paid into the business by the owner are called ‘Capital introduced’ ***************************************************** Profits of the business are simply called ‘Profit’. If an owner does draw monies from the business or pays their own bills from the business funds this is referred to as ‘Drawings’
‘Profit’ The profit of a business is simply the sales of the business minus the expenses of the business.
THE ACCOUNTING EQUATION AND THE BALANCE SHEET During the Foundation stage in Basic Accounting 1 and Basic Accounting 2 we were concerned only with the RECORDING of transactions, that is, the BOOK-KEEPING. However, accounting is not only about recording transactions. It is concerned with using these records to best effect by analysing and interpreting the results so that the accountant is in a position to answer the questions put to him by the managers and owners of the business. The two main questions we need to provide answers to are: Can the business meet its commitments as they fall due? (What is its net worth?) Is the business making a profit? We are going to use the accounting records to answer these questions. THE ACCOUNTING EQUATION Financial accounting is based on the ACCOUNTING EQUATION. Essentially, in order to operate a firm needs resources (ASSETS), and these resources must be supplied to the firm by some-one. In its simplest form the resources of a business are supplied by the owner and this is known as the owner’s CAPITAL. In this case the accounting equation is simply; ASSETS = CAPITAL Frequently, however, some ASSETS are provided by someone else. The firm is then indebted to someone for these resources which must, logically, be LIABILITIES. (i.e. OWED by the firm to someone else) The accounting equation then becomes: ASSETS = CAPITAL + LIABILITIES THE EQUATION IS ALWAYS TRUE regardless of how many transactions are entered into, although the actual assets, capital and liabilities will change.
HOW DOES THE EQUATION ALWAYS HOLD TRUE? Assets might include; Buildings
Machinery
Stocks of goods
Motor vehicles
Money in the bank
Debtors (monies owed TO the firm)
Liabilities might include: Monies owing for goods supplied to the firm (Creditors) Monies owing for expenses Loans made to the firm Capital might include: Owner’s equity Retained profits Sometimes a transaction has the effect of changing two assets by increasing one while at the same time decreasing the other: e.g. Buying a car for cash The asset MOTOR VEHICLES increases The asset CASH reduces by the same amount e.g. A debtor pays what he owes: The asset BANK increases The asset DEBTORS reduces by the same amount In both cases there has been NO EFFECT ON THE OTHER SIDE OF THE EQUATION.
Sometimes a transaction has the effect of changing an asset and a liability or capital: e.g. Paying a creditor what we owe: The asset BANK is reduced The liability CREDITORS is reduced by the same amount e.g. Taking a loan from the bank: The asset BANK is increased The liability LOAN is increased by the same amount e.g. Addition of capital: The asset BANK is increased CAPITAL is increased by the same amount.
In each case BOTH SIDES OF THE EQUATION HAVE BEEN AFFECTED IN THE SAME WAY.
You can try this with any transaction you can think of and you’ll see that the equation will always hold true.