Accounting Basic
Accounting Basic
Accounting Basic
THE ELEMENTS OF
ACCOUNTING
THE ELEMENTS OF
ACCOUNTING
AN INTRODUCTION
GEOFFREY WHITTINGTON
!Em CAMBRIDGE
UNIVERSITY PRESS
www.cambridge.org/978052I424493
ISBN
978-o-52I-41392 -3 Hardback
978-o-52I-42449-3 Paperback
C O N TEN T S
page xi
Preface
Basic concepts
13
29
42
59
85
101
1 27
136
4
5
Solutions to exercises
147
Notes
172
Index
177
ix
P REF A CE
ORIGINS
xii
Preface
Preface
xiii
xiv
Preface
end of chapter 5, but I like to think that this was due to lack of time
rather than lack of interest.
Finally, the whole typescript was prepared under great pressure, and
with equally great patience and skill, by my secretary, Barbara Brewer.
Since I moved to Edinburgh in 1972, I have had only three secretaries,
Debbie Hathorn in Edinburgh (1972-5), Val Harvey in Bristol
(1975-88) and Barbara Brewer in Cambridge (since 1988). They have
all, in their different ways, given me the high level of support which I
needed but probably did not deserve. For this reason, this book is
dedicated to them.
Geoffrey Whittington
Cambridge, January 1991
Chapter 1
BA S I C C O N CEP T S
INTRODUCTION
Basic concepts
Basic concepts
Basic concepts
1 00
2,000
1 ,500
500
600
8
( 1)
(2)
(3)
At the end of the year the firm owed its creditors 1 00.
At the end of the year the firm's debtors owed it 200.
At the end of the year the firm held stock which had cost
200.
For simplicity, we assume that the only initial asset or liability was
1 00 in cash (perhaps because the business was started at the beginning
of the year), so that there is no need to adjust for opening assets and
liabilities.
Accrual accounting is based, in this case, on the following calcu
lation:
( 1)
Cash receipts
Add amounts due from debtors
Total sales
2,000
200
2,200
1 ,500
100
less
1 ,600
200
1 ,400
Basic concepts
Profit and loss account
for the year ended 31 December
2,200
l ,400
Sales
less cost of sales
Profit for the year
800
The profit (800) is, in this case, much larger than the net cash
receipts (500). The difference (300) represents the increase in net
assets other than cash (stocks 200, plus debtors 200, less creditors
1 00). This draws attention to the subjective nature of profit measure
ment: other methods of valuing stocks (e.g., current value rather than
historical cost) or debtors (e.g., applying a discount factor to allow for
lost interest if payment were likely to be received at a significantly
distant date in the future, or applying a 'bad debts' provision ifthe debts
were not likely to be repaid in full) would lead to different measures of
profit.
The relationship of profit measurement to asset valuation is best seen
by looking at another financial statement, the balance sheet. This shows
the assets and liabilities of the firm, with the proprietor's interest in the
business as the residual. At the beginning of the year, the balance sheet
was very simple, with one asset (cash) owned by the proprietor:
Balance sheet
at I January
as
Proprietor's capital
100
Cash
1 00
At the end of the year, the balance sheet includes the assets and
liabilities which have arisen:
10
as
Proprietor's capital
Opening balance, l January
Add profit for the year
Current liabilities
Creditors
Balance sheet
at 31 December
1 00
800
Current assets
Stocks
Debtors
900
Cash
200
200
600
1 00
l,000
1 ,000
The assets listed on the right-hand side are all called current assets,
because they are retained for immediate use in the business and are
unlikely to be held for very long (for, say, longer than twelve months).
They sum to 1 ,000. Deducting the liabilities (described as current
because they are due for payment in the near future) of 1 00 leaves net
assets of 900. This is the amount of the proprietor's capital, made up
of an opening balance of 1 00 and profit for the period of800. It is no
accident that adding profit in this way gives a value of proprietor's
capital which just balances the balance sheet: the profit calculation
presented earlier was based on changes of all of the assets and liabilities
which make up the net assets figure in the balance sheet. This
relationship between profit and the change in net assets is often
described as articulation of the profit and loss account with the balance
sheet. It is the reason why asset (and liability) measurement conventions
affect the profit figure: they are part of the calculation of profit.
Articulation is a logical feature of the accounting system, but it is
sometimes found inconvenient by those who do not like all asset value
changes to affect profit. To avoid this problem, cunning accountants
have devised systems of reserve accounting, which obscure the under
lying relationship. Such systems are at the heart of many 'cosmetic
accounting' schemes, designed to dress up the accounts to look more
pleasing to users, although the motives for reserve accounting are not
always so base. However, these problems are of a more sophisticated
type than need worry us here. For the moment, we shall deal with fully
articulated accounts, in order to understand the fundamental relation
ship between profit calculation and the balance sheet.
In order to complete our picture of the performance of this very
simple firm, it is necessary to introduce one further financial statement,
Basic concepts
11
the flow offunds statement. This shows how the balance sheet has
changed during the period, and its raw material is obtained by
deducting the opening value of each item in the balance sheet from the
closing value. An increase in an item on the left-hand side of the
balance sheet (or a decrease in a right-hand item) will be described as a
source of funds and an increase in an item on the right-hand side (or a
decrease in a left-hand item) will be described as a use of funds. The
relevant changes in our particular example are:
800
1 00
200
200
500
800
1 00
Less: uses
Increase in stocks
Increase in debtors
200
200
900
400
Change in cash balance
500
This has the unfortunate possibility that it will lend credence to the
popular misapprehension that a funds flow statement is a cash flow
statement. In fact, a cash flow statement should, like that given earlier,
be composed entirely of cash flows, not of funds flows which are
calculated on an accruals basis (as is the case here).
This problem is overcome by the second format, which treats the
whole of working capital (stocks, cash and debtors Jess creditors) as
the residual item. In the present case, there are no uses (such as
12
Source offunds
Profit for the period
800
Use offunds
Change in working capital"'
800
Chapter 2
T HE A C C O U N T I N G F R A MEWO RK
INTRODUCTION
14
Liabilities
L,
Net worth
N,
Conventional subdivisions
Fixed
Current
Long-term
Short-term
Capital contributed by proprietors
Retained profits
A 1=L1+N1
where the left-hand side of the equation refers to the right-hand side of
the balance sheet as illustrated in chapter l .
This relationship always holds unless there i s a n error i n recording or
processing, i.e., the balance sheet always balances. It is therefore a sign of
complete ignorance of the elements of accounting to talk about 'making
the balance sheet balance', as if this was a problem of financial
management rather than arithmetic. The relationship is, in fact, an
15
16
Example 2.1
Horizontalformat
Sidgwick industries
Balance sheet
as at 30 September 19..
Capital
Capital subscribed by
proprietors
Fixed assets
Freehold premises
50,000
50,000
Plus accumulated
profits
35,000
85,000
20,000
Motor vehicles: cost
Less depreciation
20,000
1 0,000
1 0,000
80,000
24,000
Long-term investments
1 04,900
20,000
Current assets
Stock and
work-in-progress
Trade debtors and
prepayments
Current liabilities
Trade creditors
and accrued
charges
1 5,000
Bank overdraft 1 0,000
Cash
1 0,000
1 5,000
1 00
25,1 00
25,000
130,000
1 30,000
17
Verticalfonnat
Sidgwick industries
Balance sheet
as at 30 September 19..
ASSETS EMPLOYED:
Fixed assets
Freehold premises
plant and machinery:
50,000
cost
Less depreciation
30,000
1 0,000
cost
Less depreciation
20,000
1 0,000
20,000
Motor vehicles:
1 0,000
80,000
24,900
Long-term investments
1 04,900
Cu"ent assets
Stock and work-in-progress
Trade debtors and prepayments
Cash
1 0,000
15,000
JOO
25, 1 00
1 5 ,000
1 0,000
25,000
1 00
1 05,000
FINANCED BY:
20,000
50,000
35,000
85,000
1 05,000
18
The first thing to note about example 2.1 is that it offers the balance
sheet in two alternative formats. The first is the conventional horizontal
format, used in the illustration in chapter I . This lists the assets on one
side and the claims on the other. Its advantage is that it clearly shows the
working of the balance sheet equation. It also conforms with the format
of traditional ledger accounts (which will be illustrated in later chap
ters), which is why it is the traditional method of presenting a balance
sheet. The alternative format, illustrated second, is the vertical format.
This is more of a narrative form and can be read down the page like a
book. It usually starts by listing and summing the fixed and current
assets and listing, summing and deducting the current liabilities. It thus
arrives at a total for the net assets requiring long-term finance, either
proprietors' equity or long-term loans. This finance is listed and
summed in the final section, the sum equalling the sum of the assets
requiring finance, so that the balance sheet equation holds. This format
is currently the more popular for presenting the balance sheets oflarge
public companies, because there is a belief that it is more easily
comprehended by the casual or non-expert reader.
The detail is the same in both formats. It is worth noting the
convention that assets and liabilities are usually listed in order of their
liquidity, i.e., the length of the period before they are converted into
cash receipts or payments. Thus, fixed assets are listed before current
assets and, within these categories, the most permanent assets are listed
first, e.g., stocks are listed before debtors and cash is listed last. On the
claims side of the horizontal format, the proprietors' equity capital is
listed first (because it will remain in the business for an indefinite
period), long-term liabilities, which are repayable in the relatively
distant future, are listed next, and short-term 'current' liabilities are
listed last. The vertical format slightly disturbs this sequence for the
claims side by putting long-term financing at the bottom of the
statement.
The detailed items give a sample of some of the more common items
appearing in balance sheets. The capital subscribed by the proprietors
is not described as shares, so we may assume that this is an unincorpo
rated business (i.e., not a company). The long-term liability (defined
conventionally as one due more than a year after the balance sheet date)
is secured by a mortgage: in a company, a common legal charge of this
type is called a debenture, and loans protected by it are often referred to
as 'debentures' (the legal charge gives the lenders the right to sell a
particular asset or groups of assets to repay the loan, or interest on it,
19
should the company fail t o d o so). These loans usually have interest
payments attached to them. Trade creditors are an important current
liability in most businesses: they represent amounts owed by the
company to suppliers who have not yet been paid. Accrued charges
include expenses which have accumulated (e.g., rent or electricity
charges) for which a bill has not yet been rendered by the supplier (the
'creditor').
On the assets side, the fixed assets have been recorded at cost,
although many firms now revalue them from time to time, and
depreciation has been deducted from all of the assets which have a finite
life (this is generally accepted practice in the UK). The depreciation
reflects the proportion of assets' potential services which have been
used up. Stock is the raw materials or finished goods held by the
business and work-in-progress represents part-finished products. The
latter can be difficult to value with precision, even within the historical
cost convention. Trade debtors are the mirror image of trade creditors:
they are customers who have not yet paid for goods or services which
they have received. Sometimes, the trade debtors are reduced for a
provision for bad debtors, i.e., those who never pay.2 Equally, pre
payments are the mirror image of accrued charges: they represent
payments in advance for future services, such as advance rental
payments. Finally, cash which is only 1 00, in this business, is probably
what is known as 'petty cash', i.e., the small (petit) quantities of ready
cash which are kept in hand for day-to-day outlays. Larger transactions
are usually carried out through the bank, where this business has a
substantial overdraft.
H OW TRANSACTI ONS AFFECT T H E BALANCE S H E E T
20
flow of funds statement, dealt with changes over a period of time. Thus,
in order to understand the relationship between the balance sheet and
the other two statements, we need to look at the consequences of
transactions, and the changes which these bring about in the balance
sheet.
Assume that, at time t, a business has cash of 1 ,000, which is capital
subscribed by the proprietors. The initial balance sheet is then as
follows:
Balance sheet
at t
Proprietors' capital
1 ,000
Cash
1 ,000
The balance sheet identity holds: cash (A, in our earlier terminology),
being matched by the proprietors' claim (N1).
At time t + 1, the business undertakes its first trading transaction, a
purchase of stock for 1 00 cash. Under the historic cost convention, we
value stock at what was paid for it, so that there is a matching switch of
assets: stock rises by 100 and cash falls by 1 00, leaving aggregate
assets (A,+ 1 ) the same, proprietors' capital (N,) also unchanged, so that
the balance sheet still balances.
Balance sheet
at t+ 1
Proprietor's capital
1 ,000
1 ,000
Stock
Cash
1 00
900
1 ,000
21
claim, so that the 50 of surplus assets belongs to them and their claim
is raised by 50. This also accords with the intuitive interpretation of
the transaction: it resulted in a profit of 50, which goes to the
proprietors. The balance sheet now reads as follows:
Balance sheet
at t+ 2
Proprietors' capital
Add profit
1 ,000
50
1 ,050
Cash
1 ,050
1 ,050
1 ,050
At time t + 3, the business replaces some of its stock by buying stock for
50 on credit, i.e., payment is not immediate. Thus stock rises by 50
on the historical cost convention (an alternative convention would lead
to an immediate profit if the stock were valued higher, or a loss if it were
valued lower), raising aggregate assets '41+3) by 50. This is matched by
the appearance of a liability (L,+ 3), a trade creditor, of 50 on the other
side of the balance sheet, so that the identity still holds:
Balance sheet
at t + 3
Capital
Proprietors' capital
Add profit
Cu"ent assets
Stock
1 ,000
50
1 ,050
Cu"ent liability
Trade creditor
Cash
so
1 ,050
1 , 1 00
50
..
1 , 100
1 , 1 00
22
liabilities are high in relation to assets may wish to carry out a funding
operation of this type). The result is that one type ofliability (long-term)
rises and another (current) falls, so that aggregate liabilities (L,) remain
unchanged and the balance sheet balances without further adjustment:
Balance sheet
at t + 4
Capital
Proprietors' capital
Add profit
Current assets
Stock
1 ,000
so
1 ,050
Long-tenn liability
Loan
Cash
so
1 ,050
1 , 1 00
50
1 , 100
1 , 1 00
--
This gives us our closing balance sheet for the period. We also need
to derive a profit and loss account and a flow of funds statement in order
to appreciate the firm's progress over the period (as opposed to its state
at the end of the period). Of these, the flow of funds statement is the
most easy to assemble: we merely deduct the opening balance sheet
figures from the closing balance sheet figures (although more sophisti
cated flows of funds statements involve more complicated detail than
this):
Calculation of flows of funds
for the period t to t + 4
Sources
Profit (S0-0)
Long-term loan (50-0)
so
so
100
Uses
Stock (50-0)
Cash (lOS0- 1000)
50
so
100
23
Sources offonds
Profit
Long-term loan
so
so
1 00
Total sources
Uses offunds
Investment in stocks
Increase in cash balance
so
so
100
Total uses
Thus, the firm has become (even) more liquid: raising long-term capital
and investing it in current assets.
The profit and loss account is less obviously derived from the balance
sheets. For the moment, we shall adopt the cumbersome and untidy
procedure of analysing each transaction which gave rise to a profit (or
loss). Later, we shall learn more elegant methods of deriving profit and
loss figures.
Fortunately, in our simple example, there was only one transaction
which gave rise to a profit or loss. This was the second transaction
(leading to the balance sheet at t + 2), in which stock costing 1 00 was
sold for 1 50, giving rise to a profit of 50. We can arrange this
information as a profit and loss account as follows:
Profit and loss account
for the period t to t + 4
1 00
so
I SO
Sales
I SO
I SO
24
A GENERALI S ATION
Our numerical illustration has shown clearly how the balance sheet
identity ensures that each transaction involves compensating move
ments in balance sheet items. For example:
and A,
Deducting t from t + 1 ,
A, = L, + N,
25
(2) The flow offunds statement shows how the composition of assets
and claims has changed through a time period t. Algebraically:
1A = 1L + 1N
We have also referred to a third important statement, the profit and
loss account. This fits less obviously into the framework of the balance
sheet identity. However, we can track it down by thinking intuitively
about the role of profit. It will be recalled that profit accrues to
proprietors, i.e., it adds to N and therefore contributes to W It does
not entirely explain W because the proprietors may introduce new
capital or withdraw capital. In order to fully explain W we therefore
need a fourth financial statement which includes profit but also these
other items: in companies this is known as an appropriation account and,
in unincorporated businesses, it is called the capital account.
We are now in a position to define these two statements more
precisely:
.
(3) The profit and loss account is a statement of revenue, expenses and
consequent profits (or losses) over a period of time. Algebraically:
P1 = R1 - E1
where P is profit, R is revenue and E is expenses, of the common
period t.
This relationship is an identity because profit is defined as the
difference between revenue and expenses. It should be noted that P, R
and E are all flows over time, rather than stocks at a point in time.
(4) The appropriation or capital account shows how the equity interest
(ordinary shareholders' stake in a company, or proprietors' net worth in
an unincorporated business) has changed over a period of time.
Algebraically:
,N = P1 + f1 - D1
where 1N is the change in net worth and
P is profit, as defined earlier,
I is capital introduced and
D is capital drawn out, in a common period t.
The relationship is another identity, arising from the definition of the
components, and it is composed entirely of flows over the period.
The third and fourth statements, the profit and loss account and the
26
27
should be aware ofits possible errors and the potentially misleading use
of accounting practices through 'creative accounting'.4
RETROSPECT AND PROS P ECT
Derive a balance sheet from the following list of assets and claims, which
includes everything other than the proprietor's capital.
Adam Ferguson
Assets and claims as at 31 October
Trade debtors
Trade creditors
Cash in hand
Stock in trade
Loan from David Hume (long-term)
Motor vehicle
Bank loan (long-term)
600
450
800
950
l ,200
1 ,000
300
28
2 Derive a balance sheet from the following list of assets and claims and
present it in both the horizontal and the vertical formats.
William Robertson
Assets and claims as at 3 1 October
1 ,900
1 ,200
600
1 00
900
1 ,500
1 ,400
1 ,000
Trade debtors
Bank overdraft
Long-term loan
Cash in hand
Stock in trade
Trade creditors
Freehold buildings
Proprietor's capital
Transactions and the balance sheet
Chapter 3
T HE A C C O U N T I N G S Y S TEM :
ELEMEN T S O F D O U B LE EN T R Y
A C C O UNTING
INTRODUCTION
In this chapter, we shall derive the basic double entry system which
underlies the financial statements described in the previous chapter.
We shall find that the double entry system is logically derived from the
balance sheet identity. It is essentially a means of recording and
marshalling the effect of accounting events (transactions or revalu
ations) in order to enable them to be summarised conveniently in the
form of financial statements. Thus, conceptually, the double entry
system is a logical outcome of the financial statements, although in
practice the financial statements are a product of the double entry
system.
The need for some system of recording and marshalling transactions
may not be obvious from the examples in the previous chapters, where
statements were prepared without the apparent use of such a system.
This appearance was deceptive, because the examples given there had
one extremely unrealistic feature: they were based on very few trans
actions. In practice, even very small businesses may make many
transactions in a single day, and thousands within a year. It would
therefore be very cumbersome for them to reconstruct their balance
sheet after each transaction, as was done in the previous chapter, and
even more so for a multi-national company to reconstruct its balance
sheet every time it purchases a postage stamp! In this chapter, we shall
illustrate a double entry system which can store information about
transactions in a state from which a balance sheet can be readily derived
when required. This will still leave the profit and loss account to be
derived in a relatively cumbersome manner, and, in the next chapter, we
shall see how the double entry system can be adapted to make profit and
loss information more readily retrievable.
29
30
AN ILLUS TRATION
Proprietor's capital
Current liabilities
Trade creditors
115
25
Current assets
Stock
Trade debtors
Cash
50
30
60
1 40
1 40
140
2
3
4
31
Total
Claims
Proprietor's capital
Profit (or loss)
Trade creditors
Total
50
30
60
t+ l
t+2
Time
t+3
t+4
t+ 5
t+ 6
40
30
75
60
30
75
60
15
90
60
15
65
60
15
60
30
65
60
140
1 45
165
1 65
140
1 35
1 55
l l5
1 15
5
25
l l5
5
45
115
5
45
90
5
45
90
90
20
45
25
45
140
145
1 65
165
1 40
135
1 55
--
32
Total
t+ I
t+ 2
Total
t+ 6
Net total
- 30
+50
- 20
+35
0
-5 + 20
+ 15
- 1 0 + 20
-15
+ 1 5 -25
+ 15
+5 + 20
-
Claims
Proprietor's capital
Profit (or loss)
Trade creditors
Period ended
t+3 t+4 t+5
0 -25
-
-5
-
- 5 + 20
- 25
+ 20
+ 20
-5 + 20
+ 15
-25
+5
+ 20
+5 +20
--
0 -25
-
Sources offonds
Profit for the period
Increase in trade creditors
Decrease in stocks
20
20
20
60
Total sources
Uses offonds
Withdrawn by proprietor
Increase in trade debtors
Total uses
25
35
60
33
R. E. Taylor
Example 3.3. Double entry accounts
Stock
Transaaion
Opening balance
I
2
3
4
5
6
50
Trade debtors
-
Cash
+
Trade creditors
-
15
Balance
30
1 15
5
15
25
5
70
Profit
20
20
Total
25
60
15
30
IO
Capital
30
50
40
80
65
25
5
20
15
90
60
30
45
45
25
1 15
90
25
20
35
36
Stock
Trade debtors
Cash
Trade creditors
Capital
Profit
Cr.
45
90
20
155
155
It will be seen that the trial balance is merely a list of the accounts in
the ledger, with the balances entered in the relevant column, Dr.
indicating a debit, and Cr. indicating a credit. It will also be seen that the
trial balance does indeed balance.
The journal entry
The journal entry is a very useful method of recording the debit and
credit effect of a particular transaction. The journal is an old fashioned
'book of prime entry' used to initiate certain records in manual double
entry book-keeping systems. Its wider use need not detain us here,
although we shall return later (in chapter 8) to the concept of a book of
37
Trade debtor
stock
profit
Cr.
30
20
The compact form adopted in example 3.3 can be too cramped for clear
presentation of the information which is needed. Individual accounts
were traditionally recorded on separate pages of a hand-written ledger,
rather than being part of a single complex table, and even in the
computer age it is usual (and desirable) to be able to retrieve data
relating to a single account. In handwritten form, it is usual to write
ledger accounts as 'T' accounts, so-called because their framework can
be thought of as taking the form of a large T written on the page (the
left-hand side of the T recording the debit entries and the right-hand
side the credit entries).
A simple example of a T account is the following, which records
R. E. Taylor's trade creditors account (details as in example 3.3):
38
Balance b/d
t + 2 Stock
t
t + 6 Balance c/d
45
45
25
20
45
t+
6 Balance b/d
45
The first entry is on the credit (right-hand) side. This shows that at
time t (usually a proper date would be given) the balance owed to
creditors was 25 . The expression 'b/d' means 'brought down' from the
previous period: we shall see the significance of this when we consider
the final entries.
The second entry, at time t + 2, is also a credit of 20. This was for
stock purchased, and the corresponding account which was debited was
'stock': this is indicated in the narrative. In practice there might also be
a cross reference to the page or number of the stock account.
The final entries are the 'closing off' of the account at the end of the
period. In example 3.3, we used the crude method of summing both
debit and credit columns and writing the difference between the two on
the row below. In the T account format, we use the more elegant double
entry method of calculating and carrying down the balance. This
involves putting a balancing item 'carried down' (c/d) in order to bring
the debits and credits into equality, thus 'proving' the balance. We then
sum the two columns to close off the account at this point, and the
balance is 'brought down' (b/d) below the summation on the opposite
side to the c/d balance, i.e., the correct side for this balance (the credit
side in the example given). Thus, the 'c/d' balance is really a double
entry item indicating a transfer 'below the line', i.e., below the point
where the account is closed off. The closing balance in the illustration is
a credit balance of 45. We therefore debit the account with a 45 c/d
balance, in order to enable us to close off the account at this point, and
credit the account below the balancing point with a 45 bid balance.
The b/d balance is brought forward and offset against future trans
actions (such as cash repayments) as was the opening b/d balance of
25 at time t. We can now ignore all entries above this point, as the
account has been closed off by double entry.
39
rent 5
From this, we can construct a profit and loss account (in vertical format)
(see next page).
This statement is suitable for presentation to the proprietor as a
statement of performance. It shows how much was sold, how much the
goods (or services) cost to buy or produce, leaving a 'gross profit' or
trading profit of 25 . It then shows how this was reduced by overhead
costs (in this example, only rent) to yield a net profit of 20.
In practice, businesses will have many more revenue and expenditure
headings and many more transactions than appear in this simple
example. It will therefore be extremely cumbersome and expensive to
40
R. E. Taylor
Profit and loss account
for the period t to t+ 6
Sales
Less cost ofsales
65
40
Gross profit
Less rent
25
5
Net profit
20
'unscramble' the profit and loss data as was done above. We would
prefer the double entry system to filter out such categories as sales, cost
of sales and rent, producing separate totals for these rather than a single
net profit figure. This is done by creating revenue and expense
accounts, and the main purpose of the next chapter will be to
demonstrate how this can be done in practice.
One further problem, which also affects the calculation of profit, is
that we have so far concentrated only on recording transactions. We
have not considered how to account for events other than transactions,
notably the passage of time, which may lead to such costs as accrued
expenses or depreciation. These will be considered in chapter 5.
EXER C I S E
David Hume, a trader, has just started business. Listed below are his first ten
transactions. You are required to record these in a double-entry system, using a
simple tabular form, rather than T accounts. Prove your work by drawing up a
trial balance, after recording the final transaction and Hume's closing balance
sheet. Calculate what profit Hume has made during the period. State clearly
any assumptions which you make.
2
3
4
5
6
7
Hume pays 1,000 of his own money into his business bank account to
start up the business.
150 is spent on stock, bought for cash.
20 is paid for rent of business premises.
One third of the stock is sold on credit to William Robertson for 80.
Half of the remaining stock is sold to Adam Ferguson for 40, which is
paid in cash.
Appleton supplies stock on credit for 120.
Hume pays 1 5 rent for his private house out of the business account.
41
Chapter 4
T H E ACCOUNTING SYSTEM:
REVE N U E S A N D EXPE N S E S
I N TRODUCT I O N
The primary purpose o f this chapter is, as indicated in the final section
of the previous chapter, to introduce the method of preparing a detailed
profit and loss account within the double entry system, by the use of
revenue and expense accounts. There are, however, three subsidiary
objectives. Firstly, the appropriation or capital account, which links
profit, P, to change in net worth, tiN, and which was introduced in
chapter 2, will be illustrated. Secondly, the numerical ilhmration will
relate to a manufacturer (R. T. Zan) rather than a retailer (R. E.
Taylor), and this will give us the opportunity of examining how stocks
and work-in-progress are recorded. Thirdly, we shall start to use the
debit (dr.) and credit (er.) notation, rather than the elementary ' + ' and
' - ' used earlier, and balances will now be carried down by the double
entry 'c/d, bid' method. We shall, however, continue to use the tabular
double entry system, because its compactness has particular advantages
in displaying the inter-relationships between accounts which are of
particular importance in the illustrations presented here. In chapter 5 ,
w e shall resort t o the T account format.
A BAS I C I LLUSTRA T I O N
42
43
Trial balance
at t
Dr.
Stocks
Raw material
Work-in-progress
Finished goods
Bank
Trade debtors
Trade creditors
Proprietor's capital
Cr.
50
80
40
20
30
50
170
220
220
--
Example 4.1.
R. T. Zan
Double entry accounts
Raw
materials
Work-inprogress
Transaction
Dr.
Dr.
50
Cr.
Cr.
Bank
Dr.
Cr.
Dr.
20
20
40
40
80
30
20
Finished
goods
Cr.
Trade
debtors
Profit &
loss
Dr.
Dr.
Cr.
Proprietor's Trade
capital
creditors
Cr.
Dr.
Cr.
Dr.
1 70
30
50
20
30
20
30
30
50
30
10
20
5
50
50
10
5
50
30
30
20
20
60
Total
80
60
Cr.
80
1 25
70
25
70
25
1 25
95
25
25
20
95
1 10
1 10
80
20
50
50
80
20
30
1 50
20
5
1 70
1 70
150
80
80
30
45
46
Raw materials
Work-in-progress
Finished goods
Bank
Trade debtors
Profit and loss
Proprietor's capital
Trade creditors
Dr.
60
70
25
Cr.
20
50
5
1 50
30
205
205
--
47
Total
Claims
Trade creditors
Proprietor's capital
Total
220
1 85
-35
50
1 70
30
1 55
-20
-15
220
1 85
-3 5
Current assets
Stocks and work-in-progress
Trade debtors
155
50
205
less current liabilities
Trade creditors
Bank overdraft
30
20
50
155
-
Financed by:
Proprietor's capital: opening balance
Add profit for the period
Less Drawings
Closing balance
1 70
5
1 75
20
1 55
-
48
Sources offonds
Reduction in stocks (note 1)
Bank (note 2)
Profit of the period
15
40
15
Total
60
-
Uses offunds
Increase in trade debtors
Increase in trade creditors
Proprietor's drawings
Total
20
20
20
60
-
Note I
The next problem which arises is that of preparing the profit and loss
account, and we might add also the preparation of the proprietor's
capital account: our analysis of the change in the balance on this
account into profit of the period and proprietor's drawings was based on
informal observation and would not have been so easy had there been
many transactions on this account (e.g., including new capital intro
duced also).
We can first proceed to assemble the profit and loss information by
the informal method used at the end of chapter 3. We note that
transactions 1 , 6 and 7 led to changes in profit, and additionally note
that transaction 8 led to the creation of revenue and expense, al
though the two offset one another. We analyse these transactions as
follows:
49
Sales
40
I
6
7
8
50
Total
90
-
10
Sales
less cost of goods sold
Gross profit
less overhead expenses:
Rent
Wages
90
70
20
5
15
15
Net profit
This produces a 'bottom line' figure of net profit (or P in our earlier
notation). In order to reconcile profit to change in net worth (ll.N) on
the balance sheet, we need an appropriation or proprietor's capital
account. In this case, we have already provided a capital account as part
of the balance sheet. This too was based on informal adjustment (the
net change in proprietor's capital between the two balance sheets was a
fall of 1 5 , but we need to look elsewhere to find that this was composed
of profit of 5, less drawings of 20), and it would be convenient if this
information, in addition to profit and loss information, emerged
naturally from the double entry system.
REVENUE AND E X PE NS E ACCOUNTS
In order to adapt the double entry system to give us full details of the
individual revenue and expense items which make up the profit and loss
50
account, we place the analysis which we have just done within the
double entry framework. We thus need a sales account, which will have
credit entries (summing to 90 in our example), because sales increase
profit (and therefore, ultimately, the proprietor's claim). We also need a
cost of sales account (summing to 70 in our example), and overhead
expense accounts for rent (5) and wages (10), all of which will be
debits, because they reduce profit (and therefore, ultimately, the
proprietor's claim).
In order to incorporate these new accounts into the double entry
system, we no longer enter the effect of transactions direct to the profit
and loss account. The new treatments are probably best illustrated by
example. Transaction 1 , it will be recalled, was a sale of goods costing
20 for 40 in cash. Our original double entry was, in journal form:
Bank
Stock
Profit and loss
Dr.
40
Cr.
20
20
Dr.
40
Cr.
40
20
20
-
Dr.
20
1 0
Cr.
30
-
51
It is now:
Work-in-progress
Wages
Bank
Dr.
20
10
Cr.
30
-
Dr.
50
Cr.
50
It is now:
Trade debtors
Sales
Cost of goods sold
Stock of finished goods
Dr.
50
Cr.
50
50
50
-
These transactions are entered in the new format in the upper part of
example 4.3 (above the single horizontal line) which replaces the direct
profit and loss account entries in example 4. 1 . We also introduce a
drawings account, to which the 20 capital withdrawal by the proprietor
is debited rather than being debited direct to the proprietor's capital
account. This clears the way for the capital account to become a
comprehensive summary statement of changes in the proprietor's
interest (tl.N in our formal notation). The need for such a summary is
made less obvious in our simple illustration with only one capital
withdrawal and four transactions affecting profit and loss, than it would
be in a more realistic example, but the reader should be grateful for
being spared the tedious details of a more realistic example.
The above eight accounts replace the existing profit and loss account
and proprietor's account, recorded in example 4. 1 .
Having entered the transactions in their new format in example 4.3,
we have accumulated debits on three expense accounts, wages, rent and
Example 4.3
Transaction
Manufacturing and
trading
account
Profit &
loss
Dr.
Dr.
Cr.
Cr.
Proprietor's Overhead
wages
capital
account
Dr.
Dr.
Cr.
Dr.
Cr.
Dr.
40
20
50
50
Cr.
Dr.
Cr.
5
20
10
1 70
70
T/R P/L
20
90
90
90
10
20
20
70
70
10
T/R P/L
20
155
1 75 1 75
Balance b/d
Cr.
10
Balance c/d
Dr.
Cost of
Drawings
goods sold
1 70
Opening balance
1
6
7
8
10
TiR appropriation
A/C
Cr.
155
20
53
54
The system presented in example 4.3 is not only elegant but is also
extremely efficient in marshalling large numbers of transactions. We
can derive a profit and loss account in horizontal format simply by
copying out the manufacturing and trading account and the profit and
loss account from example 4.3, together with the narrative descriptions
which would attach to each item ('sales', etc.) in a proper T account
format:
R. T. Zan
Profit and loss account
for the period t to t+ 1 1
70
20
Sales
90
90
Overhead wages
Office rent
10
5
Net profit
15
5
20
90
20
20
55
20
1 70
5
155
1 75
1 75
Sales
Less cost of goods sold
Gross profit
Less expenses:
Wages
Rent
90
70
20
IO
5
15
56
1 70
5
1 75
20
155
RE VIEW
In this chapter, we have seen how the rudimentary double entry system
introduced in chapter 3, which recorded changes in balance sheet
items, can be extended to record separately the details of the profit and
loss account and other components of change in proprietor's interest
(AN). The profit and loss detail was obtained by accumulating various
items of revenue and expense in separate accounts, the totals of which
were transferred to the profit and loss account at the end of the period.
The details of the other sources of change in proprietor's interest, such
as capital introduced (a direct increase in N) and capital withdrawn (a
direct decrease in N, described as 'drawings' in our illustration), can
also be accumulated in separate accounts for transfer in total to the
capital account (or appropriation account in the case of a company) at
the end of the period.
As a result of the creation of revenue and expense accounts, we have
a more complicated definition of debit and credit:
A debit is an increase in an asset, a decrease in a claim or an expense.
A credit is a decrease in an asset, an increase in a claim or revenue.
Strictly, these are not new definitions of debit and credit, but
elaborations of the old ones: an expense decreases profit, decreasing
proprietor's net worth (N), which is a claim, and revenue increases
profit, thus increasing the proprietor's claim. It is important to bear this
in mind when faced with the apparent intuitive conflict between a debit
being an increase in an asset or a reduction in a liability (which sound
good things), or an expense (which sounds a bad thing). From the point
57
o f view of the firm, the expense relieves the firm o f part of its residual
obligation to the proprietor, so that it reduces a claim in the same way as
does a reduction in a liability. The double entry system is neutral as to
whether particular changes in balances are good or bad things, and is
instead merely concerned with maintaining the balance sheet identity.
From the proprietor 's point of view, it is, of course, important that his
own stake (N), which is an asset (or debit) in his personal accounts,3
should be as high as possible. It is for this reason that we have paid such
careful attention to assembling the detail necessary to explain how the
proprietor's claim has changed during the period, and, in particular,
how the profit and Joss on the firm's activities has contributed to this.
We have now examined the main accounting statements and the
double entry system from which they are derived. The one remaining
gap in the discussion is the application of the matching system: how
expenses are accrued at the end of a period so that the charge relates to
the revenue earned, and how the cost of fixed assets is allocated as an
expense over their life-time, by the method of depreciation. This is the
main topic of chapter 5 .
E X ER C I S E
58
__
350
250
300
Trade debtors
Trade creditors
Cash at bank
Equipment (at cost)
500
320
390
800
Proprietor's capital
2,270
Transactions
1 00
90
40
200
40
1 20
40
1 20
280
40
20
(a)
(b)
(c)
Chapter 5
T HE A C C O U N T I N G S Y S TEM :
A C C R U A L S , P REP A Y MEN T S A N D
D EP REC I A T I O N
INTRODUCTION
It will often be the case that, at the end of a period, some expenses will
have been paid which bring benefit in a subsequent period. Equally,
some of the benefits derived in the current period may have been paid
for in a previous period. This is a situation involving the prepayment of
an expense, and it is dealt with by treating the prepayment as an asset at
the end of the period in which the payment is made, and then
converting the asset to an expense (both are debits, so this is merely a
matter of classification) in the following period, in which the benefit is
received.
As an example, let us assume that a firm paid an insurance premium
of 1 ,000 in the previous accounting year, half of which related to the
59
60
current year. Half way through the current year, 1 ,200 is paid as the
premium for the next twelve months, only half of which has expired at
the end of the accounting year.
The simplest way to record this is as follows:
Insurance
1 ,700
1 ,700
l January Balance b/d
1 , 1 00
600
600
500
l ,200
1 ,700
600
1 , 1 00
61
January
30 June
1 ,700
1 ,700
Balance b/d
3 1 December T/R insurance
500
600
1 , 1 00
I January b/d
I January
T/R insurance
3 1 December Balance c/d
500
600
1 , 1 00
600
62
300, 400, 250 and 350. The final bill relates to the quarter ended
1 December. The bill rendered for the following quarter (ended 1
March) was for 390. It is considered appropriate to apportion this
equally between months, so that 1 30 related to December. The
electricity account for the accounting year ended 3 1 December1 can be
as follows:
Electricity
February
May
August
December
3 1 December
Bank
Bank
Bank
Bank
Balance cld
300
400
250
3 50
130
1 January
Balance bid
3 1 December Profit and loss
1 ,430
100
1 ,330
1 ,430
1 January
Balance bid
1 30
1 ,300
100
1 ,200
1 30
1 ,330
63
Electricity
February
Bank
May
August
December
31 December
Bank
Bank
Bank
T/R accrued
expenses
300
400
31
250
January
December
T/R accrued
expenses
Profit and loss
1 00
1 ,330
350
1 30
1 ,430
1 ,430
--
--
Accrued expenses
1 January
31 December
T/R electricity
Balance c/d
100
130
230
l January
31 December
l January
Balance b/d
T/R electricity
100
130
230
Balance b/d
130
64
Thus, even in the case of constant benefit, there is a case for allocating a
greater proportion of the cost to the earlier part of the period. However,
these problems are likely to be less important in the case of short-term
accruals because of the short periods over which the accruals take place.
The problem of allocation to time periods is more serious in relation to
the depreciation of fixed assets, which will typically involve allocation
over a span of several periods.
DE PRECIATION
In the case of short-term expenses, the initial assumption was that any
expenditure was an expense of the period. The insurance and electricity
payments were debited initially to expense accounts, where they were
primafacie assumed to be expenses of the period, subject to adjustments
for accrued expenses or prepayments, which were made by creating
closing balances.
By contrast, in the case of fixed assets, the prima facie assumption is
that expenditure gives rise to an asset, rather than an expense. An
adjustment is made at the end of the period by 'writing down' the asset
(creating a credit balance) and charging the profit and loss account (a
debit) with depreciation. The amount of depreciation should represent
an allocation of the total cost to that period, based on the matching
principle.
As a simple illustration, let us assume that a firm pays 20,000 for a
fixed asset on 1 January. It is decided by 3 1 December, when the annual
accounts are prepared, that 20 per cent of the original cost should be
charged as depreciation. The following is the simplest, but not neces
sarily the best, way of recording this:
Fixed asset
1 January Bank
20,000
20,000
20,000
65
31
Bank
December Balance
(depreciation)
c/d
20,000 3 1
31
4,000
20,000
4,000
24,000
I January
Balance (cost)
b/d
20,000
I January
Balance (depreciation)
b/d
4,000
Thus, we can now easily retrieve the type of information given in the
balance sheet in chapter 2.
Fixed asset
Cost
Less depreciation
20,000
4,000
1 6,000
66
January
Bank
20,000
31
20,000
1 January
Balance b/d
20,000
20,000
20,000
Depreciation provision
31
4,000
31
4,000
4,000
4,000
January
Balance bid
4,000
December Depreciation
provision
4,000
4,000
31
4,000
4,000
67
= C-S
L
d= l -
68
nominal scrap value (say 1) for zero, although this is not an entirely
satisfactory solution, given the sensitivity of the depreciation rate to the
arbitrarily chosen scrap value. Secondly, we should note that, for any
given proportionate rate of depreciation, the straight line method will
give the more rapid write off, implying a shorter life or a higher scrap
value, or both. Thus, for similar assets, we would expect the propor
tionate rate to be higher under the reducing balance method than under
the straight line method.
There is a variety of other methods of allocating depreciation costs
between periods, which appear in more advanced texts on accounting
methods. All of them are essentially arbitrary, because depreciation is a
method of allocating a single outlay (the cost of the fixed asset) over a
number of periods, so that depreciation is a joint cost of several
periods.4 A possible resolution of this problem is to revalue the asset at
the end of every period, so that depreciation represents the difference
between opening and closing values, i.e., the loss (or gain, when asset
values appreciate) from holding the asset in the firm during the period.
However, this takes us out of the realm of traditional cost-based
accounting and into the potentially fruitful but not yet practical world of
current value accounting. The same is true of the associated (but not
identical) idea of 'economic depreciation', which bases the valuation of
an asset (and the associated periodic change in value, giving rise to
depreciation or appreciation of the asset) on the present value of the
future benefits to be derived from holding the asset: this idea lay behind
our earlier suggestion that, in accruing prepayments, we might have
regard to the fact that, when the rate of interest is positive, a future
benefit is worth less than an immediate benefit.
We can learn two things from this discussion. Firstly, the assessment
of depreciation within the conventional accounting framework is both
arbitrary (depending on the rule of thumb adopted, such as straight
line) and subjective (depending on estimates of future useful life and
scrap value). This is important because depreciation can be an impor
tant charge in the profit and loss account and depreciated assets can be
a significant element in the balance sheet. Secondly, even a brief
discussion of depreciation brings into question the appropriateness of
the historical cost assumption. We shall return briefly to the subject of
alternative valuation methods in chapter 7. 5
For the moment, we must leave these broader theoretical issues and
return to a concrete example which will enable us to consolidate our
understanding of how prepayments, accrued expenses and depreciation
are recorded in the double entry system.
69
AN ILLUS TRATION
Equipment
Bank
Dr.
1 ,500
Cr.
1 ,500
Rent
Capital introduced
Dr.
300
Cr.
300
Cost of materials
Capital introduced
Dr.
50
Cr.
50
70
Dr.
600
Cr.
600
Dr.
30
Cr.
30
71
Cost of materials
Trade creditors
Dr.
700
Cr.
700
Trade creditors
Bank
500
500
-
There are two stages in this transaction (or, more strictly, series of
transactions). Firstly, the goods are bought on credit, so that the
expense account, cost of materials, is debited (in confonnity with the
treatment of transaction (3)) and the liability (trade creditors) is
credited. Secondly, the liability is paid (in part), so that trade creditors
are debited and the bank credited, i.e., a liability has fallen and an asset
has fallen (or, ifthe bank account is overdrawn at the time, a liability has
risen).
Transaction (7): Fees charged to patients during the year were 4,000,
of which 3,500 was received during the year:
Debtors
Fees earned
Dr.
4,000
Cr.
.4,000
Bank
Debtors
3,500
3,500
--
Dr.
95
Cr.
95
72
Transaction (9): During the year, Rythe drew 1 ,950 out of the
business for personal use:
Drawings
Bank
Dr.
1 ,950
Cr.
1 ,950
Dr.
1 0
Cr.
1 0
We could, alternatively, use the c/d, b/d balance method. The method
illustrated is clearer if, as here, we wish to make the adjustment before
(rather than simultaneously with) the transfer of the expense to profit
and loss.
( 1 1) : The accumulated liability for electricity at the end of the year was
25.
Electricity
Accrued liabilities
Dr.
25
Cr.
25
73
Dr.
1 50
Cr.
150
Dr.
80
Cr.
80
74
Bank
3,SOO
(7) Debtors
Balance c/d
(I)
(l)
(4)
(S)
(6)
(8)
(9)
l , l 7S
Equipment
Wages
Insurance
Trade creditors
Electricity
Drawings
l,SOO
600
30
soo
9S
l ,9SO
4,67S
4,67S
l , l 7S
Bank
Balance b/d
Equipment (cost)
Balance c/d
l ,SOO
Balance bid
l ,SOO
Balance c/d
Accumulated depreciation
I SO
( 1 2) Depreciation charge
Balance b/d
l ,SOO
ISO
I SO
Depreciation charge
I SO
300
Cost ofMaterials
(13) Stock
so
T/R Profit and loss
700
80
670
7SO
7SO
( 1 2) Accumulated d'ciation
l 0
300
Rent
75
Wages
(4) Bank
600
-
(5) Bank
(8) Bank
(1 1) Accrued liabilities
600
-
Insurance
(10) Prepayments
30
T/R Profit and loss
10
20
30
30
Elearicity
95
25
1 20
1 20
1 20
Fees earned
4,000
(7) Debtors
-
4,000
--
Stocks
( 1 3) Cost of materials
80
Balance c/d
Balance b/d
(6) Bank
Balance c/d
80
Trade creditors
500
(6) Cost of materials
200
700
700
700
Balance b/d
Balance c/d
80
Accrued liabilities
25
( 1 1) Electricity
-
200
25
-
Balance b/d
25
76
Balance b/d
( 1 0) Insurance
Balance b/d
Debtors
4,000
(7) Bank
Balance c/d
3 ,500
500
4,000
4,000
500
Prepayments
10
Balance c/d
10
Capital introduced
350
(9) Bank
IO
Drawings
1 ,950
350
T/R Proprietor's
capital
4,000
300
50
1 ,950
4,000
4,000
T/R Drawings
Balance c/d
77
350
2,140
2,490
2,490
Balance bid
540
The trial balance, taken before transfers to profit and loss and
proprietor's capital, is as follows:
Dr.
Bank
Equipment (cost)
Accumulated depreciation
Depreciation charge
Rent
Cost of materials
Wages
Insurance
Electricity
Fees earned
Stocks
Trade creditors
Accrued liabilities
Debtors
Prepayments
Capital introduced
Drawings
Cr.
1 ,175
1 ,500
1 50
150
300
670
600
20
1 20
4,000
80
200
25
500
10
350
1 ,950
--
5,900
5,900
--
The trial balance, after making transfers to the profit and loss account,
consists of the balances which are brought down after balancing off
each account:
78
Cr.
l , 1 75
l ,500
I SO
80
200
25
500
10
540
---
2,090
2,090
This provides the data from which the closing balance sheet can be
assembled: the detail of the proprietor's capital account is obtained
from the account in the ledger.
Dr Seatham Rythe
Balance sheet
as at (end of period)
Fixed assets
Equipment (cost)
less accumulated depreciation
1 ,500
1 50
l ,350
Current assets
Stocks
Debtors and prepayments
80
5 10
590
225
l , 1 75
1 ,400
(8 1 0)7
540
-
79
350
2, 1 40
2,490
l ,950
Closing balance
540
The income statement (as the profit and loss account might be
described in this case) can be obtained by rearranging the details of the
profit and loss account which appeared in the ledger:
Dr Seatham Rythe
Income statement
for the period ( )
Fees earned
less: Expenses
Materials
Wages
Electricity
Depreciation
Insurance
Rent
4,000
670
600
1 20
1 50
20
300
1 ,860
2, 140
--
80
Item
Equipment (cost)
Depreciation
Stocks
Debtors and prepayments
Trade creditors and accrued liabilities
Bank overdraft
Capital introduced
Net income for the period
Drawings for the period
Total
Use
1 ,500
1 50
80
510
225
1 , 1 75
350
2,140
1 ,950
4,040
4,040
--
81
82
Dr Seatham Rythe
Flow of funds statement
for the period ( )
Sources offunds
Net income for the period
Add increase in depreciation provision
2,140
1 50
2,290
Uses offunds
Purchase of equipment
Net drawings by the proprietor
Increase in net working capital
1 ,500
1 ,600
365
3,465
1 ,175
2,290
83
EXER C I S E
__
George Square
Trial balance at I January 19 ..
Dr.
Trade creditors
Stocks of raw materials
Work-in-progress
Stocks of finished goods
Machinery, at cost
Accumulated depreciation
Bank overdraft
Trade debtors
Proprietor's capital
Cr.
2,300
1 ,200
1 ,400
700
2,500
500
1 ,250
1 ,500
3,250
---
7,300
7,300
---
---
2
3
4
5
6
7
8
9
IO
11
12
84
Required
Chapter 6
T H E I N T E R P R E T AT I O N O F
AC C O UNTS
INTRODUCTION
(1)
(2)
A good answer requires a good question. To see this, the reader need
85
86
87
and claims, whereas many uses of accounts are concerned with the
future. In assessing the future, we must take a view as to the likely state
of the economic environment in which the firm operates and the firm's
position within that environment, e.g., which markets it sells in and
obtains its factors of production from.
In assessing the state of the firm itself, there is much relevant
information about the firm which does not appear in the main accounts
but may appear by way of a note or, in the case of a company, in the
Directors' Report or the Chairman's Statement. For example, the firm
may have undergone a re-structuring process, which has temporarily
depressed reported profits or other performance measures, but will
improve future performance. Changes of senior management may also
be important, as will be take-overs and mergers, which not only affect
future performance but can have considerable distortionary effects on
the way in which the accounts reflect performance: take-overs and
mergers are a fruitful area for the creative accountant. A particularly
useful source of information can be the Chairman's Statement, which
usually reviews recent performance, outlines current plans and some
times even gives informal forecasts. This statement is not audited or
regulated by accounting standards, and this makes it a useful vehicle for
'soft' information which, although not very reliable, may be highly
relevant to the user's assessment of the company.
Another source of company-specific information comes from
stockbrokers and other analysts who visit companies listed on the stock
exchange and investigate their current state and future plans. This
relationship is restrained by 'insider trading' rules, which forbid the use
in the stock market of information which is not publicly available. If
rules ofthis type did not exist, senior managers of companies, who have
access to privileged, price-sensitive information, could profit greatly, at
the expense of other shareholders, by acting upon it. For this reason,
great care is taken that information about such matters as interim or
annual profits, dividends, take-over offers or major new contracts is
made public in a prompt and systematic way, so that the alert
shareholder who uses public information sources should be able to
trade on the basis of the best available current information.
There are, of course, many sources of information relating to the
economic environment which are not company-specific but which will
affect the assessment of different companies in different ways, e.g., a
rise in the price of crude oil is likely to affect the profits of oil
companies, and those which produce relatively more crude oil
88
89
90
-
profit
Sales
91
Gross
profit
Constant
Sales
term
Gross
profit
92
Profitability
The ratio is thus designed to show the effectiveness with which assets
are used in generating profits. Apart from the obvious limitations of
accounting measurement, some more precise definitional problems
deserve mention.
Firstly, profits must be defined for the particular purpose which we
have in mind: gross profit may be used as a measure of trading and
operating success, and net profit (after deducting overhead costs} as a
measure of overall success. Net profit before deducting interest
payments may be relevant to loan stock holders (long-term lenders to
companies), who wish to see the 'cover' for their interest payments, but
net profit after interest payments may be of more interest to proprietors
(or shareholders in companies) whose claims are limited to this measure
of profit.
Having defined profit, we need to define assets in such a way as to be
consistent with it. Thus, profit before interest payments should be
related to a measure of net assets which includes interest bearing
liabilities (i.e., proprietors' net worth plus interest-bearing liabilities),
whereas profit after interest payments should be related to proprietors'
(or shareholders') net worth. Another small, but potentially important
aspect of asset measurement is that assets are measured at a point in
time, whereas profit is measured over a period of time. Thus, we should
ideally like to relate profit to average assets employed, not closing assets
(as appearing in the closing balance sheet which accompanies the profit
and loss account) or opening assets. An approximation to average assets
which is often used and may be useful is to average opening and closing
assets. This can be misleading when there is a large discrete jump in
assets employed, e.g., due to a take-over . . . but take-overs involve many
other potential pitfalls for the interpreter of accounts. 3
A potentially useful decomposition of profitability is the following
identity:
Profit
Assets -
Profit
Sales
Sales
Assets
93
94
assessment of the current state of the firm, and one obvious measure is
the current asset ratio:
Current assets
Current liabilities
Clearly, if this ratio is less than one, when all existing current assets and
liabilities have matured, the proceeds of the assets will be inadequate to
pay off the liabilities, so that there must be a prospect of a net cash
inflow from other sources, if the firm is to avoid insolvency. However,
current assets typically include stocks and work-in-progress, which the
firm must continue to hold (or replace) ifit is to remain in business and
which may not be readily saleable even in those cases in which the firm
would not wish to replace them. This suggests a narrower definition of
liquid (rather than current) assets, and the corresponding liquid asset
ratio:
(Current assets - stocks)
Current liabilities
Sales are normally measured over a year and debtors as at the end of the
year. To obtain the average credit period in weeks, we multiply this ratio
by fifty-two. It must be remembered that closing debtors may not be
typical of the firm's position, either because the business is seasonal or
because the firm has deliberately 'window-dressed' its balance sheet by
collecting an unusual proportion of debts at the balance sheet date.
95
An analogous ratio showing the credit period which the firm obtains
from its creditors is the creditor/purchases ratio:
Trade creditors
Purchases
This tells us how many times existing stock would be expected to 'turn
over' during the period, e.g., if stock costing 1 .2 million (cost of sales)
is produced during the year and stocks costing 1 00,000 are held at the
year end, annual production is twelve times stock, so we would expect
stock to be replaced twelve times during the year. The inverse of this
ratio is the stock holding period: one month (-ri x 1 2) in our example.
The higher is stock turnover (or the lower the stock holding period) the
less capital is tied up in stocks. This may also be taken as an indicator of
the strength of demand, although extremely low stock levels can lead to
supply failures (through 'stockouts' occurring) and, ultimately, loss of
business. Like the two credit ratios, the stock ratios are vulnerable to
'window-dressing' of the closing balance sheet.
Capital strncture
96
97
Profit
Net worth
Retentions
Net worth
This assumes that all of the elements are defined consistently, in terms
of post-tax profits attributable to shareholders (or proprietors) and net
worth attributable to the same group. Multiplying the retention ratio by
98
This is a 'times covered' ratio, which shows exactly how many times
current dividends are covered by current profits (although tax can
introduce complications into this calculation, in practice). A similar
ratio can be calculated for interest payments, as an alternative to the
profit and loss account measure of gearing discussed earlier.
Finally, there are certain ratios which are important in the evaluation
of companies whose shares are listed on a stock exchange, so that a
market price is available. The most basic is perhaps earnings per share:
Earnings available for ordinary shareholders
Number of shares
/E
99
The higher the P/E ratio, the more expensive are current earnings,
indicating that the market believes them to be of higher quality in terms
of future growth prospects or immunity from risk. 4
The shareholder who has a particular interest in immediate cash
returns may wish to look at the dividend yield:
Dividend per share
Price per share
The higher the dividend yield, the higher will be immediate returns, but
dividends in the longer term are likely to depend on future earnings
more than on current dividend levels.
CONCLUSION
EXERCISES
(1)
1 00
(2)
You have just received a legacy from your late uncle with which you have
purchased a tennis court and pavilion and have started a private tennis club.
Listed below are the transactions in your first year of trading. You are required to
record these in a double entry system. Prove your work by drawing up a trial
balance and your closing balance sheet. Calculate your profit for the year and
arrange the profit and loss account in a form which would reveal which aspect of
your business appeared to be most profitable. Discuss any problems which may
arise in determining the overall profit or loss and in judging the most profitable
area.
2
3
4
5
6
7
8
9
10
11
12
You purchase with your own money the court and the pavilion for
3,000.
As the pavilion has been derelict for two years, you pay 500 with your
own money on repairs to make the structure sound.
You purchase, on credit, 1 ,000 of bar fittings and equipment.
100 members join the club, each paying 20 cash, which entitles them to
use the tennis court and pavilion facilities for one year.
You pay 500 cash for wines and spirits.
Wines and spirits sold during the year amount to 1 ,850 (cash) (cost
price 400).
Groundsman's wages amount to 1 ,250 (cash).
Part-time barman's wages total 250 (cash).
You draw out 300 cash to pay rates on your own house.
Food fo r the restaurant costs 500, o f which 300 i s paid i n cash and
200 is still owing. No food stock remained at the end of the period.
Catering wages amount to 450 (cash).
Restaurant takings amount to 1 ,600.
Chapter 7
INTRODUCTION
1 02
1 03
A S I M P L E I L L U S T R A T I O N2
150
100
50
1 50
125
25
1 04
Sales
less historical cost of goods sold, in current
's (1 00 x 1 . 1)
Constant purchasing power profit
1 50
1 10
40
Thus, we have seen that, even in a business which holds only cash in its
opening and closing balance sheets, thus avoiding the valuation
problem (since cash is, by definition, denominated in unambiguous
cash terms), there are still three concepts of accounting profit: one
based on historical money amounts determined by past transactions,
one on the current cost of specific assets as determined by the market
(but not confirmed by a transaction), and one on historical money
amounts adjusted by subsequent changes in the general purchasing
power of money. We can add to these three concepts another, which
combines the second and the third and, in this case (but not in general),
yields the same result as the third. This calculates profit initially on the
current cost basis, to give a figure for 'operating profit', but then adds
the real gain which Old Fred made by buying early (when the cost was
1 ) rather than later (when cost had risen to 1 .25). This is sometimes
described as a 'holding gain' (i.e., gain on holding assets while the
market price rises), and in the present case it is a 'real' holding gain
because we measure the extent to which the gain exceeded general
inflation (i.e., 1 .25 - (1 x 1 . 1), or 1 5p. per unit, which amounts to
1 5 in aggregate). Moreover, the stock has now been sold, so that the
gain is a 'realised' real holding gain. 5 The resulting profit calculation is
sometimes described as the real tenns method:
1 05
Sales
Less current cost of goods sold
1 50
125
25
15
40
T H E B A LA N C E S H E E T
Proprietor's capital
1 00
1 00
Cash
Under the historical cost system, the closing balance sheet would be:
Closing balance sheet
Proprietor's capital:
Opening balance
Add profit for the period
Closing balance
Cash
1 50
1 00
50
1 50
1 50
1 50
1 06
Cost of sales
Revaluation reserve
Dr.
25
Cr.
25
1 07
We can now complete our current cost (CC4) closing balance sheet:
Closing balance sheet
Proprietor's capital
Opening balance
Revaluation reserve
1 00
25
125
25
Cash
1 50
1 50
1 50
1 50
The constant purchasing power (CPP) profit and loss account also
had an adjustment to profit. This was based on a general index, to
reflect pure inflation, rather than the specific index used in CCA, but
the double entry implementation of the adjustment is similar to that
used for CCA. The debit to profit and loss is matched by a credit to a
reserve (re-statement of opening capital), as follows:
Dr.
1 0
Cr.
1 0
Thus, under the CPP method, we have the following closing balance
sheet:
Closing balance sheet
Proprietor's capital
Opening balance
Add capital re-statement
1 00
10
1 10
40
Cash
1 50
150
1 50
1 50
1 08
Cr.
15
10
25
25
This shows the initial current cost adjustment to cost of sales in the
profit and loss account (25) and the subsequent credit of real holding
gains (15 ) to arrive at the final profit figure of 40. If required, the
credit of the real holding gains would be made to a separate reserve in
the balance sheet, rather than to the profit and loss account. The credit
to the capital re-statement reserve is made in the balance sheet. Thus,
the 'real terms' closing balance sheet is, either the same (in this
particular case) as for CPP, or, with real holding gains shown separ
ately, it is:
Closing balance sheet
Proprietor's capital
Opening balance
Add capital re-statement
Cash
1 00
IO
1 10
15
125
25
1 50
1 50
150
-
1 50
1 09
R E V A L U A T I O N O F A S S ETS
Sales
Less cost of goods sold
1 50
1 00
Trading profit
Less depreciation
50
5
Net profit
45
1 10
Proprietor's capital
Opening balance
Add profit for the period
150
45
Closing balance
1 95
Fixed asset
Barrow, at cost
Less accumulated depreciation
50
5
45
Current asset
Cash
150
1 95
195
The changes resulting from the revised assumptions are the higher
initial capital balance, matched by the cost of the barrow, and the
subsequent depreciation of the barrow, which reduces profit (a debit)
and increases the depreciation provision against cost, (a credit) in the
balance sheet.
The cu"ent cost (CCA) accounts are as follows:
Current cost profit and loss account
Sales
Less current cost of goods sold
150
125
25
6
19
Proprietor's capital
Opening balance
150
Add current cost revaluation
35
reserve
Fixed asset
Barrow, at current cost
Less accumulated
depreciation
1 85
Add current cost profit
19
204
-
60
6
54
Current asset
Cash
1 50
204
111
There are two differences between current cost and historical cost in
this example. The first, which we encountered before, is the adjustment
to eliminate stock appreciation, i.e., the difference between the his
torical cost of goods sold and their current cost at the time of sale. In
journal entry form, this adjustment is:
Cost of goods sold
Revaluation reserve
Dr.
[J.5
Cr.
25
Dr.
10
Cr.
10
Dr.
1
Cr.
1
The net result of these adjustments is that the balance sheet shows a
higher asset valuation than historical cost but a lower balance of profit,
the net difference being accounted for by the current cost revaluation
reserve.
The constant purchasing power (CPP) approach, like the current cost
approach (CCA), involves re-stating the fixed asset and the depreciation
figure and creating a capital reserve. However, whereas CCA did this
on the basis of specific asset prices, CPP does it on the basis of general
price level indices. The CPP accounts are as follows:
1 12
1 50
1 10
Sales
Less cost of goods sold
Less
Trading profit
depreciation
40
5.50
Net profit
34.50
Opening balance
1 50
15
165
34.50
Fixed asset
Barrow, at cost
accumulated
depreciation
Less
Current asset
Cash
1 99.50
55
5.50
49.50
1 50
1 99.50
In the profit and loss account, the historical cost of goods sold is
increased by 10 per cent, reflecting general inflation, to 1 1 0 in current
purchasing power terms. The historical cost depreciation charge is
similarly raised by 10 per cent to 5 .50. In the balance sheet, initial
capital (1 50) is supplemented by a 1 0 per cent reserve ( 1 5) to reflect
the maintenance of general purchasing power over the period, and the
cost of the barrow is raised by 1 0 per cent to 55, with accumulated
depreciation rising by the same proportion.
The journal entries necessary to translate historical cost into CPP are
the same, in debit and credit terms, as those necessary to translate
historical cost into CCA, but the index used to calculate amounts is the
general index, which rose by 1 0 per cent over the period, rather than the
specific price changes used in the CCA translation. The CPP journal
entries are:
1 13
Dr.
1 0
Cr.
10
5
5
-
0.50
0.50
--
--
Thus, the choice between CCA and CPP in a case like this, which
involves accounting for non-monetary assets (note that, during the
period, it is assumed that only stocks and the barrow were owned),
depends upon whether we regard specific price adjustment or general
price level adjustment as the more appropriate. The former (CCA) tries
to capture the current costs of the specific assets used by or held by the
business, whereas the latter (CPP) attempts to up-date historical costs
in terms of the purchasing power of money. Although CPP has the
advantage of relative objectivity, avoiding the problem of assessing the
current prices of specific assets, CCA does have the advantage of
expressing the values of assets held and used by the business at prices at
which they might be expected to change hands currently.
The fourth method of accounting was real terms accounting. The
accounts on this basis are:
Real terms profit and loss account
Sales
less current cost of goods sold
1 50
1 25
25
6
19
25
1
9
35
15
20
39
1 14
Proprietor's capital
Opening balance
Add capital re-statement reserve
1 50
15
Fixed asset
Barrow, at current cost
Less depreciation to date
1 65
Add total real gains for the period
39
60
6
54
Current asset
Cash
150
204
204
The real terms system now yields a different profit figure from the CPP
system. The reason for this is that we now have a non-monetary asset
(the barrow) in the closing balance sheet. When this is revalued at
current cost, an unrealised holding gain (9) is created, and, to the extent
that this 'beats the index', it is recorded as a gain (unlike the CCA
system, in which any such gain is credited direct to a capital reserve).
The extent to which the gain beats the index (and is therefore a real
gain) is 4.50 (a money gain of 9, less 1 0 per cent of original cost, less
depreciation, of the asset, 4.50). This is precisely the difference
between the 'total real gains' in the real terms system and the net profit
in the CPP system.
Thus, relative to the CPP system, the 'real terms' system has the
advantage of showing assets at current prices, rather than indexed
historical prices. Like CPP, it uses the general index to re-state opening
capital on the grounds that the proprietor will wish to judge gain or loss
in terms of whether the general purchasing power of his capital has
increased or decreased. The difference between non-monetary assets
valued at current prices and a capital balance re-stated by means of a
general index gives rise to real holding gains and (potentially) losses (as
shown in the lower part of the real terms profit and loss account), the
unrealised element in these gains (or losses) accounts for the difference
between CPP 'net profit' and real terms 'total real gains'.
Relative to CCA, the real terms approach is differentiated by the
recognition of any holding gains, whether realised or unrealised, as
shown in the lower part of the real terms profit and loss account. CCA
regards all such gains as being growth of the capital to be maintained,
not part of profit, and they are therefore credited direct to the current
cost revaluation reserve.
1 15
Dr.
[).5
Cr.
[).5
,,
10
1
9
10
(3) Depreciation charge
Accumulated depreciation
10
I
1
-
Dr.
15
Cr.
15
We have seen, in this more elaborate example, that our four methods of
accounting for charging prices all give different measures of profit or
total gain for the period. Historical cost accounting (HCA) which
reflects only prices paid in past transactions, shows a net profit of 45 .
Current cost accounting (CCA), which reflects only current prices and
does not recognise any gains which took place in the holding period
when the asset was bought and when it was used, shows a net profit of
19, reflecting the higher current cost charges. Constant purchasing
power accounting (CPP) up-dates historical cost by means of a general
index. Like CCA, it does not show any holding gains on the assets,
because they are revalued by the same general index as the capital.
Because we have assumed that the general index (used in CPP) rose by
less than the specific prices (used in CCA), the increases in costs are
less in the CPP case, so that the CPP net profit of 34.50 lies between
1 16
its HCA (45) and CCA (1 9) counterparts. Finally, the real terms
system first calculates CCA profit and then adds in the real holding
gains, i.e., the holding gains on assets between purchase (historical cost)
and use (current cost), less an adjustment for general inflation. In the
present example, this raises Total Real Gains to 39, although in
practice there can be holding losses as well as gains, especially when a
loss is defined as failure to beat the general price index.
M O N ETARY A S S ETS A N D L I A B I L I T I E S
The final complication which has been avoided so far is the problem of
monetary assets and liabilities. We have avoided this by the somewhat
unrealistic assumption that Old Fred does not hold money during the
period and does not borrow: instead he simply carries a stock of
pineapples which are converted to cash (i.e., sold) at the instant before
the final balance sheet is drawn up. This was an unrealistic assumption
which served the useful purpose of not having to deal with monetary
assets and liabilities, which might have complicated the exposition too
much. However, the time has now come to explore monetary items and,
in particular, the 'loss on holding money' and the 'gain on borrowing'
which occur in a period of inflation (i.e., decline in the general
purchasing power of money).
As a prelude to looking further at monetary items, we shall revert to
the algebra used in chapter 2. It will be recalled that the balance sheet
identity was:
A 1 = L1 + N1
and that, over a period of time, the corresponding flow identity was:
!!,,. 1N = /!,,. 1A - /!,,.1 L,
or
!!,,. 1N was
In the example of Old Fred, as we have so far considered it, there were
no liabilities and all of the assets were of a 'non-monetary' type, i.e.,
they did not have a fixed cash value. In this system, we had the following
profit measures:
1 17
where s is the specific price change of each asset held over the
relevant period. 9 In our example A r- 1 was measured at historical cost
because the assets were acquired at that time: in a more realistic
situation, they would have been acquired earlier and would therefore
be measured at current cost at the start of the period (historical cost
adjusted by the change of specific price from the time of acquisition
to t- 1).
Constant purchasing power profit:
PcPPr=Ar.g-Ar - l g
1 18
Historical
General index
Specific price
General index
Specific price
CPP
RT
CCA
HC
1 19
1 20
THE
'
'
G A I N O N B O RROW I N G : A N U M E RI C A L
ILLUSTRATION
Dr.
50
Cr.
50
121
The closing balance sheet will record this revised attribution of net
worth, but the change in the proprietor's interest will be unchanged, an
equal amount (50) being deducted from both the opening and the
closing balances.
The same result will obtain for cu"ent cost (CCA): 50 of net worth
will now be attributed to the Joan, rather than the proprietor, at both the
beginning and the end of the period. In the case of constant purchasing
power (CPP), we do show a gain on borrowing, as follows:
CPP profit and loss account
150
1 10
Sales
Less cost of goods sold
Trading profit
Less depreciation
40
5.50
Net profit
34.50
5.00
39.50
CPP closing balance sheet
100
10
1 10
39.50
Interest-free loan
149.50
50.00
1 99.50
Fixed asset
Barrow, at cost
Less accumulated
depreciation
55
5.50
49.50
Cu"ent asset
Cash
1 50.00
1 99.50
---
1 22
Sales
Less current cost of goods sold
1 50
1 25
25
6
19
25
I
9
less
35
15
less
20
5
25
44
-
1 23
Proprietor's capital
Opening balance
Add capital re-statement reserve
l 00
10
Fixed asset
Barrow, at current cost
Less depreciation to date
54
1 10
Add total real gains for the period
Interest-free loan
44
1 54
50
60
6
Current asset
Cash
204
1 50
204
As in the CPP case, the gain on borrowing is added to the 'gains' section
of the profit and loss account. It should be noted that the gains on assets
still have an adjusunent of 1 5 (=1 50 x 0. 1 ) to reduce them to 'real'
gains: this is because 1 50 was the recorded value of those assets at the
start of the period. The gain on borrowing arises from the fact that a
liability did not increase in money amount (remaining constant at 50),
whereas it would have had to rise by 1 0 per cent to be a constant real
burden.
The real terms balance sheet, like the CPP balance sheet, shows the
proprietor's capital re-stated by 1 0 per cent but the loan constant in
money terms.
AN OVERVIEW
1 24
1 25
1 2,000
20,000
5 ,000
37,000
Assume the following further information:
(i)
(ii)
(iii)
(iv)
The plant will last for five years, losing value by a constant amount and
having no scrap value.
During the year from l January l 9x l to 3 1 December l 9x l work is
carried out on only half of the stock. The wages for this work, amounting
to 6,000, are paid on the last day of the year. On the same day, the entire
finished stock is sold for 25,000, which is paid in cash, and is replaced by
equivalent unprocessed raw material costing 1 5 ,000, which is paid for in
cash.
The Retail Price Index was 1 00 on l January and 1 20 on 3 1 December
l 9xl .
The replacement cost of new plant identical to that owned by the firm
rose to 1 8,000 by 3 1 December l 9x l .
Required
(a)
Prepare a balance sheet and profit and loss account for the year ended 3 1
December l 9xl on each of the following four bases: historical cost (HC),
constant purchasing power (CPP), replacement cost (RC), and real terms
1 26
Chapter 8
INTRODUCTION
1 28
obvious temptation for the bus conductor to keep a share of the fares
and under-state the amount collected. The total cash collected, as
verified by the tickets issued, will be the amount registered by the
accounting system as cash received: this will be debited to cash (an asset
in the balance sheet) and credited to receipts (the sales figure in the
profit and loss account) . The ticket issuing system may, additionally, be
a means of gathering management accounting data. Modem electronic
ticket machines can record detailed information about number, length
and time of journeys, which is valuable in assessing the profitability of
different services and in planning adjustments to services.
In practice, most business transactions are associated with the issue
of a record of some type: to an increasing extent, the record may be of
an electronic type, recorded instantaneously in a computer, as, for
example, when a bank customer withdraws cash from a bank using an
ATM cash dispenser. Traditional paper records include orders,
delivery notes, receipts and invoices. All of these can serve the dual
purpose of initiating accounting records and of protecting the business
against error or fraud. Such records usually enter the accounting
system by being listed in what is traditionally called a book ofprime entry,
although the prevalence of computers means that, in practice, this is
more likely to be a computer listing than a bound ledger.
DATA P R O C E S S I N G
1 29
A control account is one o f the oldest and most basic forms of internal
checks. Essentially, it is an aggregate account, prepared from the total
of individual entries, and provides a total check on the individual
accounts in a ledger. Often there will be a complete system of control
accounts, dealing with such items as debtors, creditors, stock and cash.
To illustrate how such a system works, we shall use a simple example of
a creditors' control account.
Suppose that a company has four suppliers, A, B, C and D, and
purchases two types of goods, Y and Z. When the company buys goods
this will be recorded by means of various documents, such as written
orders (possibly recorded in an order book) and delivery notes (record
ing the delivery of goods into stock). These will be used for day-to-day
management (e.g., in chasing up suppliers who fail to deliver on time) as
well as for checking whether the transaction should be recorded in the
accounting system. The most important document from an accounting
point of view is the invoice, which is received from the supplier and (after
checking that it is justified by an order and delivery) will be used to
initiate the purchase records.
An invoice contains information of the following type:
(Units)
4
1 30
"
"
Supplier Units
4
A
B
6
c
3
D
8
Amount ()
4
12
6
8
Type
y
z
z
y
Total
30
Dr.
30
Cr.
30
The two accounts are called 'cor.trol accounts' because they represent
the total transactions for the month. In order to keep track of individual
stocks and creditors for day-to-day management, we shall need more
detailed accounts, contained in personal or subordinate ledgers, to tell us
what items are in stock and what amounts are owed to particular
suppliers. These records are not part of the main double entry system,
but provide a dis-aggregation of the control account data which are part
131
y
10 Oct. Purchases
3 1 Oct.
4
8
z
17 Oct. Purchases 12
24 Oct. "
6
A
l 0 Oct. Purchases
1 7 Oct. Purchases
12
24 Oct. Purchases
3 1 Oct. Purchases
132
15
22
October
October
Supplier
A
B
Discount receii-ed
1
2
Cash payment
3
10
13
1 33
A
1 5 Oct. Cash payment
Discount received
l 0 Oct. Purchases
3
1
B
22 Oct. Cash payment
Discount received
10
2
1 7 Oct. Purchases
12
12
12
Oct.
Cash payments
Discounts received
3 1 Oct. Balances c/d
30
30
30
l l'ov. Balances b/d
14
The balances are, o f course, those owed t o C and D (6 and 8), so that
the control account is the sum of the individual accounts.
S U M M A RY A N D O V E R V I E W
This chapter has drawn the reader's attention to the importance of the
system of data collection and processing which is a necessary foun
dation for accounts. The system is initiated by some form of documen
tation of the transaction (e.g., an invoice), followed by some form of
listing (prime entry) which in turn gives rise to the double entry system
('posting'). The double entry system itself can contain parallel records
(personal ledger accounts) which provide detail not available in the
aggregate records (control accounts). These parallel records are useful
1 34
135
EXERCI S E
A list o f individual suppliers' balances was prepared from the purchases (i.e.
trade creditors) ledger of the Widget Wholesaling Company. These balances
were added together, and the total, of 8,506 differed from the balance on the
purchase ledger control account at that date.
Further investigation revealed the following errors:
A purchases invoice for 52 had not been posted to (i.e., entered in) the
supplier's account, although it had been entered in the purchases day
book.
2 A purchases invoice for 80 had been entered in the purchases day book
twice and posted to the supplier's account twice.
3 A sum of 39 paid to a supplier and correctly entered in the cash book
had been posted to his account as 93.
4 There was a casting (i.e., addition) error in the purchases day book,
which meant that the total was over-stated by 100.
5 A supplier's account had the credit side overcast by 99.
6 A supplier's balance of 64 had been omitted from the list of balances.
After these errors were corrected, the total of the list of balances agreed with the
balance on the control account.
Required
Chapter 9
INTRODUCTION
In this final chapter, we touch upon some important areas which have
not been dealt with at all so far and whose proper treatment is beyond
the modest aims of this book. We set out to explore what was described
as the 'hard core' of the accounting framework. We did not intend to
explore the wide range of applications of accounting which exists in the
real world, or the wide variety of accounting research. However, this
book would be incomplete without the briefest of allusions to other
aspects of accounting. In particular, we have not referred to corporate
financial reporting, although it is by far the most important area in
which financial accountants operate, and we have not discussed the
scope of management accounting. The next two sections give the
briefest of introductions to these two areas. Finally, there are sug
gestions for further reading in these areas and the wider field of
accounting.
C O R P O RA T E F I NA N C I A L R E P O R T I N G
137
1 38
139
1 40
141
not yet fulfilled the high hopes o f some o f its earlier protagonists who
hoped that empirical research would resolve or avoid the intellectual
squabbles of the deductive theorists. Nevertheless, much has been
learned from empirical research. It is, for example, comforting to know
that accounting information does appear to be reflected in share prices.
In summary, accounting theory is still in its infancy, but it is making
progress. It has gone substantially through the initial stages of naive
optimism, comparable with that of early natural scientists who hoped to
find the philosopher's stone3 or the elixir of life. It is now in a more
mature stage, in which we are, at least, becoming aware of what we do
not know.
MANAG E M E NT A C C O U N T I N G
1 42
fixed (i.e., not incremental) in the short term. There has also been much
debate on the allocation of joint costs (such as a shared production
facility) and joint revenues between processes or activities which are
being appraised independently (as in the exercise at the end of chapter
6). Finally, there are a variety of techniques available for the identifica
tion and measurement of costs, including statistical estimation
methods.
Another important area of management accounting is budgeting, i.e.,
estimating future financial flows. This can be done either for decision
making purposes, to demonstrate the probable future consequences of
decisions, or for control purposes, comparing the actual outcome with
the budget in order to assess the extent to which past decisions are
being carried out successfully. The most fundamental form of budget is
a cash budget, which estimates future cash flows and therefore gives a
view of the firm's liquidity and solvency over a future period. The term
'budgeting' is also used in the context of investment appraisal, which is
commonly known as 'capital budgeting'. This is because investment
involves the outlay of cash (or foregoing the opportunity to receive cash)
in exchange for future receipts of cash (or saving of cash expenditure).
Thus, an appraisal of whether the investment is worthwhile depends
upon estimating future returns, which is a budgetary process.
The methods and theory of management accounting have changed
greatly over recent years, although it is possible that academics, who are
responsible for developing new methods and theories, over-estimate
the extent to which new ideas percolate into practice. Traditional
methods are based upon elaborate book-keeping techniques and
typically involve the detailed allocation of full costs, as in standard
costing systems. These methods were challenged from the nineteen
twenties onwards by ideas derived from economic theory, which sought
to identify those costs which were relevant to particular purposes. Thus,
concepts such as marginal cost, avoidable cost and opportunity cost
crept into the literature (and, more slowly, into practice), supplement
ing the traditional belief that an elaborate enough system could identify
'true cost', and replacing it with the more flexible principle of'different
costs for different purposes'. The economist's approach also offered
insights into the measurement of divisional performance in large,
divisionalised companies, where it might be considered important to
have divisional performance measures and targets which are consistent
with those appropriate for the firm as a whole.
Another source of new approaches to management accounting,
1 43
which has been important in the period since the Second World War is
operational research, the broad collection of mathematical and statis
tical techniques concerned with maximising operational efficiency. A
notable example of operational research techniques which have a place
in management accounting is mathematical programming. Many
simple resource allocation problems can, for example, be characterised
as linear programming problems. Linear programming provides
optimal solutions to such problems, thus avoiding the need for an
internal price system, but there is a large literature on how 'shadow
prices' derived from linear programming4 can be used for internal
resource allocation decisions, where continuous resort to an optimi
sation programme is infeasible. Another example of an operational
research model is the optimal inventory control model, which attempts
to calculate the optimal stock-holding level, given the level and degree
of uncertainty of demand, the lag in supply, and the costs of holding
stock (e.g., interest on capital tied up) and of running out of stock (lost
sales). Statistical methods of estimating cost relationships (e.g., by
regression analysis of the relationship between output and various
components of cost), which have already been referred to, can also be
classified broadly as operational research techniques.
Following the impact of economics and then of operational research,
described in the previous two paragraphs, there has been a third wave of
new ideas and approaches to management accounting. This could be
characterised as being associated with a sociological perspective on
management accounting. It views management accounting as a human
activity arising out of and influencing human relationships within the
context of an organisation, or the wider context of society. It is
sometimes characterised as a 'behavioural' approach to accounting, and
it affords some important insights into management accounting.
A mundane example which is nevertheless of considerable practical
importance is the impact of budgeting within an organisation. The
traditional attitude of the accountant to budgets was authoritarian: once
a budget was set it should be complied with, and typically that meant
that it would impose an upper limit on expenditure. The budget was
therefore (in addition to its role in planning and decision-making) a
device for controlling expenditure, and, in particular, reducing it below
the level to which it might rise in the absence of the budget constraint.
However, in practice, even casual observation suggests that the
budgetary process can actually increase expenditure. The accountant
setting the budget may regard the budgetary target as a maximum but
1 44
the person who is given the budget may regard it as a minimum, if the
system offers no rewards for saving on the budget level. There are at
least two possible reasons for this: firstly, the rewards of a high level of
expenditure (a more comfortable working environment), and secondly
the possible 'knock-on' effect of not spending the full budget, if the next
period's target is based on the previous period's expenditure. This
suggests that the budgetary process should be approached in a
thoughtful manner which takes account of organisational structure and
human relations, rather than as a mechanical process of minimising the
cost of a given output in a system with known fixed parameters.
A whole range of approaches has been developed for analysing the
human and organisational factors in management accounting. One of
these is the agency theory approach, derived from neoclassical
economic theory, which considers the design of reward structures
which will bring the aims of the agent (the person managing the budget
in our example) into line with those of the principal (top management,
which sets the budget). Other approaches rely more on sociological,
political or historical analysis and include contingency theory (relating
the form of the management accounting system to the characteristics of
the particular organisation), historical critiques (such as the notable
work of Professors Kaplan and Johnson,5 which shows how manage
ment accounting practices have evolved from historical needs and may
therefore tend to lag behind new needs), and 'critical theories' which
tend to regard accounting as an expression of and vehicle for power
relationships between different groups in society. This rich variety of
ideas takes us very far from the popular image of the dull, conventional
accountant whose sole concern is with the numerical accuracy of
historical records of transactions.
S O M E S U G G E S T I O N S F O R F U RT H E R R E A D I N G
In this final section o f the book, there are suggestions for further
reading, both to reinforce the basic techniques covered in the book and
to introduce the reader to more advanced and wider aspects of
accounting.
The basic techniques of accounting have been introduced in this book
using essentially the same approach as that adopted by Prof. H. C. Edey
in his Introduction to Accounting (Hutchinson, 4th edition, 1 978). 6 This
can be recommended particularly for more detailed treatment of some
1 45
issues and a good set of worked examples and exercises. A more lengthy
and comprehensive first-year text-book on financial accounting is
John Arnold, Tony Hope and Alan Southworth, Financial Accounting
(Prentice Hall, 1 985) and its sister text-book, Arnold and Hope's
Accountingfor Management Decisions (Prentice Hall, 2nd edition, 1 990)
can be recommended as an introductory management accounting
text. Another introductory management accounting text, with a greater
organisational and behavioural emphasis, is David Otley, Accounting
Control and Organisational Behaviour (Heinemann, 1 987).
More advanced expositions of accounting systems and financial
accounting are provided in many text-books. One book which can be
particularly recommended is A. D. Barton, The Anatomy ofAccounting
(3rd edition, University of Queensland Press, 1 984).
In the area of company accounting, two excellent introductions to
UK company accounts and their interpretation arc R. H. Parker's
Understanding Company Financial Statements (3rd edition, Penguin,
1 988) and P. Bird and B. Rutherford's Understanding Company Accounts
(3rd edition, Pitman, 1 989) . Both of these books reproduce and
interpret real examples of company accounts, although readers must
bear in mind that UK companies represent only one example of a
variety of international practice. An advanced text on the interpretation
of financial accounts which is American in origin but travels well
internationally is George Foster, Financial Statement Analysis (2nd
edition, Prentice Hall, 1 986). This book also introduces some more
advanced technical ideas and the results of empirical research in the
area of financial reporting.
More advanced treatments of price change accounting, including
discussion of theoretical issues which were avoided in chapter 7, will be
found in W. T. Baxter's Inflation Accounting (Philip Allan, 1 9 84) and in
a book by the present author, G. Whittington, Inflation Accounting, An
Introduction to the Debate (Cambridge University Press, 1 983). An
introductory survey of wider aspects of accounting theory is provided by
the present author's paper in The British Accounting Review, Autumn
1 986.
The regulation and reform of financial accounting has recently been
a topic of considerable interest in most advanced market economies.
Some of the current problems of financial accounting in the UK are
described and illustrated in a very readable manner in Ian Griffiths'
best-selling book Creative Accounting, or how to makeyourprofits whatyou
want them to be (Sidgwick and Jackson, 1 986). Proposals for the reform
1 46
S OLUTIONS TO EXERC I S E S
2 T H E A C C O U NT I NG FRA M E W ORK
(1)
Capital
Proprietor's capital
long-term loans
David Hume
1 ,200
Bank
300
Fixed assets
Motor vehicle
Current assets
Stock in trade
Trade debtors
Cash in hand
1 ,400
1 ,000
950
600
800
1 ,500
Current liabilities
Trade creditors
2,350
450
3,350
3,350
--
--
1 47
1 48
Solutions to exercises
(2)
Horizontal fonnat
William Robertson
Balance sheet
as at 3 1 October
Capital account
Proprietor's capital
1 ,000
600
Long-tenn loan
Freehold buildings
1 ,500
1 ,200
1 ,400
Current assets
Stock in trade
Trade debtors
Cash in hand
Current liabilities
Trade creditors
Bank overdraft
Fixed assets
900
1 ,900
1 00
2,700
2,900
--
--
4,300
4,300
Vertical fom1at
William Robertson
Balance sheet
as at 3 1 October
Fixed assets
l ,400
Freehold buildings
Current assets
Stock in trade
Trade debtors
Cash in hand
900
1 ,900
1 00
2,900
Trade creditors
Bank overdraft
1 ,500
1 ,200
2,700
200
1 ,600
1 49
Solutions to exercises
FINANCED BY:
Capital account
Proprietor's capital
long-term loan
1 ,000
600
1,600
Fixed assets
Freehold buildings
Office equipment
l ,400
300
1 ,700
Current assets
Stock in trade
Trade debtors
Cash in bank
Cash in hand
300
1 ,000
350
1 00
l ,750
l ,050
700
2,400
FINANCED BY:
Capital account
Proprietor's capital
Plus profit for period
Less drawings
long-term loans
1 ,000
600
l ,600
200
1 ,400
l ,000
2,400
150
Solutions to exercises
(4)
William Robertson
Flow of funds statement
for November
Sources
Profit
Additional long-term loans
Reduction of stock
Received from debtors
600
400
600
900
2,500
Uses
Proprietor's drawings
Purchase of office equipment
Net payments to trade creditors
Increase in cash in bank
200
300
450
1 ,550
2,500
Solutions to exercises
151
T H E A C C O U N T I N G S Y S T E M : E L E M E NT S O F D O U B L E
ENTRY ACCOUNTING
Duvid Humt
Double entry
Transaction
Debtors
Bank
Stock
Creditors
Profit
Proprietor
and loss
Dr.
Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr.
1
2
3
4
5
6
7
8
9
10
1,000
Total
1,1 1 5 185 1 65
1,000
150
150
20
35
Balance
930
20
120
15
35
50
30
50
50
80
40
40
125
120
15
40
40
10
20
20
50
30
270 180
90
120 30
70
120
40
1,000
15
985
Cr.
Cr.
930
125
90
120
Creditors
40
985
Proprietor
1 ,145
1 ,145
Solutions to exercises
1 52
Balance Sheet
after transaction I 0
Current assets
Bank
Trade debtors
Stocks
930
1 25
90
1 , 1 45
Less current liabilities
Trade creditors
1 20
1 ,025
985
40
1 ,025
The profit for the period, according to the balance on the profit
and loss account, is 40.
This is made up as follows:
Trading profits (less loss)
60
Less rent
20
Net profit
40
There are various assumptions behind this calculation. Each arises out of the
valuation of an item in the Balance Sheet. The obvious assumptions are:
Solutions to exercises
153
Another assumption, which again arises out of the valuation of an asset, is the
possibility of bad debts. If Robertson or Ferguson is unable to pay his debt, the
item 'Trade debtors' is over-stated, and a provision for bad debts should be
deducted from this asset, a corresponding charge being made to the Profit and
Loss Account.
4 T H E A C C O U N T I N G SYST E M : R E V E N U E S A N D E X P E N S E S
Grantchester Gaskets
Trial balance as at 1 January 19
__
Dr.
Stocks
Cr.
350
250
300
Raw materials
Work-in-progress
Finished goods
500
Trade debtors
Trade creditors
Cash at bank
Equipment
Proprietor's capital
320
390
800
2,270
--
2,590
2,590
[.
1 Jan. Balance bid
6"
Trade creditors
Raw Materials
31 Jan. Work in progress
350
90
31 "
Balance c/d
440
-
Balance b/d
420
[.
20
420
440
===
Solutions to exercises
1 54
l Jan.
7"
14 "
21 "
28 "
31 "
31 "
Balance bid
Cash
Cash
Cash
Cash
Cash
Raw materials
Work in Progress
16 Jan. Finished goods
250
Balance cld
31 "
20
20
20
20
10
20
240
Finished goods
3 Jan. Cost of sales
300
1 20
24 "
Cost of sales
Balance cld
31 "
1 40
Cost ofsales
80
3 1 Jan. Trading account
200
280
280
280
Trade debtors
500
1 1 Jan. Cash
1 00
280
31 "
Balance cld
880
Balance bid
3 1 Jan. Trading account
200
680
880
680
Sales
380
380
80
200
1 40
420
420
Balance bid
1 20
240
360
360
Balance bid
Equipment
800
1 00
280
380
Solutions to exercises
Trade debtors
Balance b/d
23 Jan. Cash
31 "
Balance c/d
Cash
390
200
Cash
Cash
Cash
Cash
3 1 Jan. Cash
40
40
1 20
40
20
290
590
590
-
290
Trade creditors
1 20
1 Jan. Balance bid
290
6"
Raw materials
320
90
410
410
Wages
20
3 1 Jan. Profit and loss
20
20
20
290
80
80
80
Rent
10
3 1 Jan. Profit and loss
-
40
Balance b/d
7 Jan.
14 "
21 "
28 "
155
Trading account
3 1 Jan. Sales
280
1 00
10
-
380
380
380
Solutions to exercises
1 56
3 1 Jan. Wages
31 "
Rent
31 "
Proprietor's capital
1 00
100
1 00
Proprietor's capital
2,280
1 Jan. Balance b/d
Profit and loss
31 "
2,270
10
2,28 0
2,280
2,280
Balance b/d
Trading and
Profit and loss account
for January 1 9
__
Sales
Less: Cost of sales
Gross profit
less: Expenses
Wages
Rent
380
280
1 00
80
10
90
Net profit
10
Solutions to exercises
1 57
Balance sheet
as at 3 1 January
Fixtd asstts
Equipment (at cost)
Currmt asstts
Stocks and work-in-progress
Trade debtors
Cash
800
800
680
290
1 ,770
Less
currmt liabilitits
Trade creditors
290
1 ,480
--
2,280
Net assets
Financed by:
Proprietor's capital
Add profit for the month
2,270
10
2,280
-
5 T HE A C CO U NTING S Y ST E M : A C C R U A L S , P RE P A Y MENTS
A N D DEPRECI ATION 0 0 R O S Q UA RE
Out/int solution
Journal mtrits (ledger accounts can be derived from these, and are not given
here)
Transaction Account
Office premises
Long-term mortgage loan
Raw materials
Bank
Trade creditors
Wages
Bank
Work-in-progress
Wages
Dr.
4,000
Cr.
4,000
3,000
2,200
800
4,000
4,000
2,500
2,500
1 58
Solutions to exercises
Transaction Account
4
Work-in-progress
Raw materials
Finished goods
5
Work-in-progress
Factory rent
6
Bank
Work-in-progress
Factory rent
Drawings
7
Bank
8
Insurance
Bank
Work-in-progress
Insurance
Electricity
9
Bank
Electricity
Accrued charges
Work-in-progress
Electricity
Cost of sales
10
Finished goods
Trade debtors
Sales
Bank
Trade debtors
Depreciation expenses (machinery)
11
Accumulated depreciation (machinery)
Depreciation expenses (office)
Accumulated depreciation (office)
Interest
12
Bank
Dr.
2,700
Cr.
2,700
3,000
3,000
300
300
300
300
400
400
600
600
200
200
900
900
100
1 00
750
750
2,500
2,500
6,000
6,000
7,000
7,000
250
250
500
500
400
400
No trial balance is given here, but the ledger balances all appear in thl! accounts,
and the fact that they balance proves that the trial balance would have balanced.
Solutions to exercises
1 59
George Square
Trading and profit and loss account
for the year ended 3 1 December
Cost of sales
Gross profit
2,500
3,500
Sales
6,000
6,000
6,000
--
Depreciation
Insurance
Electricity
Wages
Interest
750
400
250
1 ,500
400
Net profit
3,300
200
3,500
Gross profit
3,500
3,500
--
1 60
Solutions to exercises
George Square
Balance sheet
as at 31 December
Cost
Fixed assets
Office premises
Machinery
Aggregate
depreciation
(I Jan . . . )
500
750
3,500
1,750
(2,000)
6,500
1 ,250
5,250
4,000
2,500
Current assets
Stock-raw materials
Work-in-progress
Stock-finished goods
Trade debtors
1 ,500
4,850
1 ,200
500
(1 ,200)
(1 ,400)
( 700)
(1 ,500)
8,050
Trade creditors
Sundry creditors
Bank overdraft
(2,300)
3 , 1 00
1 00
3,050
(1,250)
6,250
1 ,800
7,050
-
(3,250)
--
Financed by:
Proprietor's capital
Balance at January
Plus profit for year
3,250
200
less drawings
3,450
400
3,050
4,000
(3,250)
7,050
(3,250)
--
Solutions to exercises
161
(1)
Sources
Profit
Plus depreciation
200
750
950
4,000
1 ,000
900
6,850
less uses
Purchase of office premises
Increase in stocks: raw materials
Work-in-progress
Finished goods
4,000
300
3,450
500
4,250
Drawings
400
8,650
Increase in bank overdraft
1 ,800
--
Solutions to exercises
1 62
(2)
Profit
Plus depreciation
200
750
950
4,000
4,950
less uses
4,000
400
4,400
550
Net increase in working capital
Increase in stocks: Raw materials
Work-in-progress
Finished goods
300
3,450
500
1 ,000
900
1 ,800
4,250
3,700
550
The assessment of performance appears below, under chapter 6.
6
T H E I N T E R P R E T A T I O N OF A C C O U N T S
(l)
Solutions to exercises
1 63
firm is involved in, the past record of the firm, current plans and future
prospects.
Looking at the financial statements gives us the following initial facts:
Profit and loss account
Sales seem rather low in relation to assets employed and the profit margin is
handsome (3,500/6,000). However, we would like to know the nature of the
business before making a final judgement. The net profit margin is much lower
and so is the rate of return on assets employed, partly because of depreciation
and interest charge on the new office premises. This could mean that there is
scope for increasing sales without much increase in overheads (i.e., the firm
may not be at the lowest cost point of its short-run average cost curve), e.g., an
optimistic suggestion would be that sales could double without overheads
increasing, in which case gross profit would rise to 7,000, and net profit to
3,700 (more than twelve times the present level).
Balance sheet
This adds a dynamic element to the static position portrayed by the balance
sheet. Both formats show modest net funds generated by operations (950,
including 750 from the adding back of depreciation) which are more than
absorbed by the increase in stocks and work-in-progress. The big increase in
the latter item emphasises the crucial importance of the firm being able to make
future sales at a profitable price. The purchase of premises is a large use of
funds which can be expected not to recur, but this was financed by the loan
which is also unlikely to be repeated, given the firm's high gearing ratio and the
consequent limited liability to cover interest payments. The increase in the bank
overdraft is large for a firm of this size (and would, in practice, give rise to high
interest charges which have not been specified here), so that the overall flow of
funds picture is one of an unhealthy drift towards illiquidity.
1 64
Solutions to exercises
Summary
There are signs of potential profitability (in the gross profit margin) and the
increased output which will be necessary to realise it (the increase in work-in
progress). However, current net profits are poor and the firm is in a dangerously
illiquid position. Everything depends upon future sales, prices and costs. This
firm is a decidedly risky proposition.
(2)
Dr.
1
2
3
4
5
6
7
8
9
10
11
12
Proprietor
Bank
Cr.
Dr.
Land and
buildings
Cr.
Dr.
3000
500
3000
500
Cr.
Bar
equipment
Dr.
Cr.
Profit
and loss
Dr.
Cr.
Stock
wines
Dr.
Cr.
Creditors
Dr.
1 000
1 000
2000
2000
500
500
400
1250
250
1 850
1 250
250
300
300
450
5450
Balance
2400
400
1 850
300
500
450
200
1 600
1 600
Total
Cr.
3050
300
3500
3500
3200
3500
1 000
1 000
2850
5450
500
2600
1 00
400
1 200
1 200
Solutions to exercises
166
12
Bank
Proprietor
Land and buildings
Bar equipment
Profit and loss
Stock (Wines)
Creditors
Dr.
2,400
Cr.
3,200
3,500
1 ,000
2,600
100
1 ,200
--
7,000
7,000
--
12
3,500
1 ,000
4,500
Current assets
Stock
Bank
100
2,400
--
2,500
Less current liabilities
Trade creditors
1 ,200
1 ,300
5,800
NET ASSETS
--
Financed by:
Proprietor's interest
Proprietor's account
Plus profit for year
Less drawings
3,500
2,600
6, 1 00
300
5,800
--
Solutions to exercises
1 67
Gross revenue
400
500
1 ,250
250
450
Net profit
2,850
2,600
5,450
5,450
5,450
Tennis court
Fee income
Less groundsman's wages
2,000
1 ,250
Net profit
Bar
750
l ,850
400
1 ,450
250
1,200
NET PROFIT
Restaurant
Restaurant takings
Less cost of food sold
l ,600
500
1 , 1 00
450
650
NET PROFIT
--
2,600
Should the bar equipment be charged against bar profits? If so, how
should we decide on the appropriate depreciation rate?
2 Is all the stock saleable? If some deterioration has occurred, by how
much should the value of stock be reduced?
1 68
Solutions to exercises
1 69
Solutions to exercises
7 A C C O U NT I NG FOR PRI C E C H A NGES
Sales
less expenses
Cost of materials
Wages
Depreciation
(1)
(2)
(3)
(4)
HC
CPP
RC
Real tmns
25,000
25,000
18,400
20,880
24,600
24,600
6,600
4, 1 20
400
400
6,000
10,000
3,600
6,000
( l ,000)
(1000)
(1 ,000)
1 5,000
6,000
3,600
15,000
6,000
3,600
1 2,000
6,000
2,880
1 0,000
6,000
2,400
6,600
3, 1 20
16,000
8,600
1 6,400
9,000
Notes
Depreciation charges
25,000
25,000
Solutions to exercises
170
Balance sheels
(I)
(2)
(3)
(4)
HC
CPP
RC
Real
terms
Assets
9,600
1 1 ,520
1 4,400
1 4,400
25,000
27,000
30,000
30,000
9,000
Cash
9,000
9,000
43,600
47,520
53,400
53,400
37,000
37,000
37,000
37,000
37,000
44,400
37,000
44,400
9,000
--
--
Financed by:
Opening capital
7,400
adjustment
7,400
--
--
Holding gains
Operating profit
1 6,000
4, 1 20
6,600
6,600
8,600
400
400
3 , 1 20
--
--
1 6,400
9,000
43,600
47,520
53,400
53,400
Notes
Closing cash balance: 5,000 - 6,000 (wages) + 25,000 (sale) - 1 5,000 (stock)
Plant values before depreciation
HC: 1 2,000
!'\ott that under RC a capital maintenance adjustment of 1 6,000 (equal to the nominal holding
gains on physical assets) would be made if it were intended to maintain physical capital.
Comment
The various profit figures show that the method of price change accounting can
have a significant effect on reported profit, although the differences are
amplified by the rather dramatic price changes assumed in the example.
If we are using operating profit as our profit measure, historical cost (HC)
produces the largest profit in this case, followed fairly closely by constant
Solutions to exercises
171
purchasing power (CPP), with replacement cost (RC) and real terms (RT)
lagging behind. This is because HC profit bears only the historical cost of
materials and depreciation. CPP, on the other hand, bears these costs increased
by a general index, and RC and RT both charge the costs at the current
replacement price (which, in this example, has risen faster than the general
price index). Thus HC operating profit can be said to include nominal holding
gains on physical assets used (i.e., the difference between replacement cost at
the time of use and money cost paid on acquisition). CPP operating profit
includes only real holding gains (the difference between replacement cost and
cost of acquisition adjusted by a general price index). RC and RT operating
profit, on the other hand, charge replacement cost and so eliminate all holding
gains on assets used up ('realised' holding gains).
If we look at holding gains, we obtain a very different picture. HC, by
definition, reports no separate holding gains (although we have seen that
realised holding gains are included in HC operating profit). CPP, by definition,
shows no holding gains on physical assets (stock and plant) because these are
assumed to increase by the general index, and cost adjusted by the general index
is also the capital maintenance benchmark which we use in measuring gain or
profit. However, CPP does show a holding loss on money, which has failed to
rise in value to equal the capital maintenance benchmark. RC shows the largest
holding gains, because it compares the current replacement costs of the
physical assets with their historical money costs. RT also shows large holding
gains on physical assets but these are lower than in the RC case because the
capital maintenance benchmark is now indexed HC rather than money HC.
Finally RT also reports a loss on holding money, the same as that in CPP, and
for the same reason, i.e., the capital maintenance benchmark is adjusted by the
general index.
The relative merits of the different measures depend on what qualities we are
seeking. HC reports only realised profits, and it includes realised holding gains
in operating profits. It makes no adjustment for the effects of general inflation
on the measurement of capital. CPP does allow for the effect of inflation on
capital and thus shows the loss on holding money, but it makes a somewhat
artificial assumption that the cost of physical assets has moved in direct line with
inflation. RC makes a strict separation between operating profit and holding
gains on physical assets, and holding gains include unrealised gains (the
difference between RC and HC of assets held at the end of the period). It does
not make any allowance for the effects of general inflation, which might be
thought to exaggerate the holding gains. RT remedies the latter deficiency: it
calculates operating profit on a RC basis, but the holding gains are calculated
after removing the effects of general inflation during the year. This adjustment
for general inflation means that RT, like CPP, reports a loss on holding money.
In summary, HC has two possible deficiencies: it does not take account of
general inflation or of changing prices of specific assets. CPP adapts HC to take
account of the former (general inflation) and RC takes account of the latter
Solutions to exercises
1 72
(specific price changes). RT takes account of both. It should be noted that the
distribution between realised and unrealised holding gains is sometimes
thought to be important (because unrealised gains do not meet the realisation
criterion). If this is the case, it might be better to report the unrealised gains (or
losses) separately.
8
T H E C O L L E C T I O N A N D P R O C E S S l 1' G O F A C C O U N T I N G
DATA
(a)
8,506
52
54
64
1 70
less
80
99
(1 79)
8,497
Correct balance
Note that Item (4) is an error confined to the Day Book and does not affect the
individual account balances, which we are correcting here.
(b)
80
100
1 80
None of the other items affects the total of the purchases day book. Hence, the
corrections reduce purchases by 1 80 and increase profit by 1 80.
NOTES
BASIC CONCEPTS
T H E A C C O t.: N T I N G F R A M E W O R K
1 73
1 74
3
The reader who i s familiar with computers will realise that example 3 . 1
could be generated by using a spread sheet system, which would make i t less
laborious to prepare. However, the accounting system which is developed
subsequently (example 3.2) would still be more efficient and store more
relevant information than the up-dated balance sheet and could equally well
be implemented by using a computer.
2 In the next chapter, we shall take a more sophisticated view of this type of
transaction, by splitting profit into its two basic components, sales and cost
of sales.
3 This convention is violated by the British, but not by the American, method
of presenting a horizontal format balance sheet.
4
T H E A C C O U N T l !'i G S Y S T E M : R E V E N U E S A N D E X P E N S E S
I f the business were purely a trading concern, this would simply b e called a
trading account.
2 The peculiarities of company accounting practice in the UK mean that the
appropriation section of the profit and loss account deals only with a limited
part of shareholders' funds. Thus, whereas dividends (the company
equivalent of drawings) are debited to the appropriation account, capital
raised by issue of shares (the company version of capital introduced) is
credited direct to the balance sheet. Various other gains, losses and
adjustments (such as those resulting from revaluations of fixed assets) are
also debited or credited direct to reserves (which are part of shareholders'
funds) in the balance sheet, by-passing the profit and loss account. Such
adjustments are a source of some of the creative accounting devices
described in Ian Griffiths' Creative Accounting.
3 Another well-known intuitive conflict is that banks speak of 'crediting' the
customer's account when money is paid in. The reason for this is that it
is the bank which is keeping the account, and it is therefore recorded as a
liability to the customer (a credit). From the customer's point of view, the
bank account is an asset (a debit).
5
T H E A C C O U N T I N G S Y S T E M : A C C R U A L S , P R E P AY M E N T S
A N D D E P RE C I AT I O N
Note that accounting years do not have to coincide with calendar years,
although 3 1 December is, in fact, a popular date on which to end the
accounting year.
2 In general, substituting C = 20,000 and D 4,000 into the equation, and
rearranging terms, gives us S = 20,000 - 4,000 l.
=
1 75
= l -d
Douglas Adams, The Hitchhiker's Guide to the Galaxy, Pan Books, 1 979,
p. 1 36.
2 Liquidation is the selling up of a company's assets to pay its debts when it
becomes insolvent. Insolvency is inability to repay debts as and when they
become due: it does not preclude the possibility of ultimate (delayed)
repayment of all debts.
1 76
3 See, for example, the relevant sections of Ian Griffiths' Creative Accounting.
Risk is evaluated in the context of a portfolio of shares, i.e., variable returns
may be very desirable, improving immunity from risk, if they vary inversely
with the returns of other shares held. The principles of portfolio theory are
explained in the book by Foster, Financial StatementAnalysis and in any good
introductory textbook on finance.
2
3
4
10
11
Notes to pages 1 3 1 - 1 44
8
1 77
T H E C O L L E C T I O N A N D P RO C E S S I N G O F A C C O U N T I N G
DATA
S O M E E X T E N S I O N S A N D S U G G E S T I O N S F O R F IJ R T H E R
READING
4
5
6
The description derives from the fact that the residual profits o f equity
shareholders are made more volatile (i.e., 'geared' or 'levered' up) by the
fact that the fixed claim element (loan stock and preferred stock) takes a
fixed slice out of profits.
In particular in 'Financial Accounting Theory: An Overview', The British
Accounting Review, Autumn 1 986, pp. 4-4 1 , which gives a much more
extensive treatment of the issues which are touched upon here.
Before natural scientists are allowed to mock this, they should be reminded
that Newton was one of many who looked for the philosopher's stone (which
would turn base metals to gold). If he had studied economics instead, he
would have realised that in the likely event that such a technology could not
be kept secret, the effect of the discovery would be to drive down the price
of gold.
These are the so-called dual values, which represent the opportunity cost of
the resources which are in short supply.
H. T. Johnson and R. S. Kaplan, Relevance Lost: The Rise and Fall of
Management Accounting, Boston, 1 987.
This book is at present out of print.
I N DEX
accounting
theory see financial accounting theory
see also individual forms and concepts,
e.g., accrual accounting: cash flow
accounting: constant purchasing
power accounting
Accounting Standards Board 3, 1 37
accounts
interpretation see interpretation of
accounts
notes 87
see also individual accounts, e.g.,
appropriation account: insurance
account
accrual accounting 7-8, 1 3 9
accrued charges 1 9
accrued expenses 40, 6 1 -4, 7 1 -2
rate of accrual 63-4
agency theory 1 44
apportionment of expenses 63-4
appropriation account 25, 26
articles of association 13 7
articulation I O
assets 33
current I O
definition for profitability ratio 92
fixed 6
cost of 57
depreciation see depreciation
revaluations at end of each period 68
monetary, price change accounting
1 1 6-20
ownership of 1 5
revaluation o f see revaluation o f assets
audit 3
Audit Practices Committee 1 3 7
auditing 1 34
company accounts 1 3 7
auditors
external 1 3 4
internal 1 34
1 78
Index
cash flow accounting 6-7
cash flow statement l l
cash payment control 1 3 2
Chairman's Statement 8 7
changes i n price see price change
accounting
claims 1 3- 1 4, 33
companies see corporate financial
reporting
consistency concept 4, 5
consolidated accounts 1 38--9
constant purchasing power accounting
I O I , 1 04
balance sheet 107, 1 1 2, 1 2 1-2
capital maintenance 1 1 8
capital re-statement reseive I 07
gain on borrowing 1 2 1-2
profit adjustment 1 07
profit calculation 1 1 7, 1 1 8
profit and loss account 1 2 1
revaluation of assets l l l-1 3, I I 4, l l 5 ,
1 16
contingency theory 1 4 1
continuous inventory method 73
control accounts 1 29-33
cash control account 13 2
cash payments 1 3 2
discounts received 1 3 2
goods returned 1 32
invoices 1 29-30
personal ledgers 1 3 0
purchases day book 130
subordinate ledgers 1 30-- 1
trade creditors' control account 1 32,
133
conventions see individual concepts, e.g.,
consistency and prudence concept
corporate financial reporting 1 3 6-9
auditors 1 3 7
capil structure 1 3 7
Chairman's Statement 87
consolidated accounts 1 38--9
directors' report 87, 13 7
groups 1 3 8-9
incorporation 1 36-7
memorandum and articles 1 3 7
public and private companies 1 3 8
regulatory bodies 1 3 7-8
stock exchange financial requirements
138
subsidiary companies 1 38--9
cost accounting 14 1-2
cost of sales account 50
1 79
Index
1 80
discounting 7
discounts received, control accounts
1 32
dividend cover 98
dividend vield 99
double e trv svstem 29-41
earnings yield 98
'economic' depreciation 68
electricity account 63, 72
empirical inductive method 1 3 9-40
equity interest/stake 1 4, 25, 1 3 7
European Commission Directives 1 3 8
expense account 40, 49-54, 70
electricity account 63, 72
insurance account 60-1 , 72
overheads 49, 50
expenses
accrued 40, 6 1 -4, 7 1 -2
rate of accrual 63-4
allocation of time periods 63-4
apportionment of 63-4
depreciation see depreciation
prepayments 5 9-6 1 , 70-1
short-term 59-64, 70-2
financial accounting 2, 3
Financial Accounting Standards Board
(CS) 1 37
financial accounting theory 1 39-41
deductive method 1 40
empirical inductive method 1 3 9-40
new empiricism 1 40-1
fixed assets 6
cost of 57
depreciation see depreciation
revaluations at end of each period 68
flow of funds calculation 22
flow of funds statement 1 1 , 1 2, 23, 25,
32, 48
depreciation and 80-2
funds flow see flow of funds statement
Ill
imperfections of information 89
see also data collection: data processing
insider-trading rules 87
insurance account 60-1 , 72
International Accounting Standards
Committee 1 37
interpretation of accounts 85-100
accounts as system 88
economic context 86--8
imperfections of information 89
liquidity measures see liquidity ratios
other information 86--8
purpose 85-6
ratio analysis see ratio analysis
intra-group transactions 1 3 9
invoices 1 29-30
iournal entry 35, 36--7
Index
ledger accounts 68
ledgers 35
personal ledgers 1 30
subordinate ledgers 1 30-1
leverage 1 3 7
see also gearing
liabilities
long-term 1 8
price change accounting 1 1 6-20
linear programming 1 43
liquid asset ratio 94
liquidity ratios 88, 93-5
average credit period 94
credit/purchases ratio 95
current asset ratio 94
debtor/sales ratio 94
liquid asset ratio 94
stock turnover ratio 95
loss on holding during inflation 1 1 6, 1 1 9
management accounting 2-3, 14 1-4
agency theory approach 1 44
budgeting 2, 1 42, 1 43-4
contingency theory of 1 4 1
cost accounting 1 4 1 -2
data collection 1 28
divisional performance measures 142
monitoring decision consequences 1 4 1
'moral hazard' problem 1 3 7, 1 4 1
operational research 1 43
sociological perspective 1 43-4
manufacturing and trading account 53,
54
matching principle 6, 8, 57, 59, 1 3 9
mathematical programming I 43
memorandum of association 1 3 7
mergers 87
'moral hazard' problem 1 3 7, 1 4 1
mortgage, in balance sheet 1 8
net worth 1 4, I 5
proportionate growth of 97-8
proprietor's 5 6
new empiricism 140-1
notes 87
operational research 1 4 3
overhead expense account 49, 50
performance statement 39
preference shares I 3 7
prepayments 70- I
in balance sheet I 9
181
1 82
Index