Section A: Books of original entry

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1 Section A: Books of original entry 1.1 Aims of a business The aim of any business is to make a profit and to ensure it remains in operation for the long term. To achieve these aims the owners of the business must practise sound management techniques. These can include the ability to sell the product/ service, to purchase materials and products wisely, to manage and motivate staff, but crucially, to manage the finances of the business. In setting up the business the owners would have invested money in what they felt was a worthwhile venture. This would normally be referred to as introducing capital in accountancy terms. The capital introduced would be used to enable the business to start trading. In the simplest of terms, this would involve purchasing goods and then selling them at a higher price. The owners would have worked hard to establish good trading relationships with their customers but there can be difficulties if some customers are late paying for the goods or default altogether. To ensure that capital is not put at risk and the trading effort has not been wasted, good financial control is vital. A good control system would inform the owners of the financial status of the business at all times and enable them to make appropriate decisions. Getting started Edexcel specification: Adjustments 4.1 After you have studied this chapter you should be able to: AIMS OF A BUSINESS to make a profit and remain a viable enterprise. 1

2 It is essential to have good financial control. 1.2 Basic concept of financial control All businesses whether small, i.e. sole traders, through to very large organisations use the same concept of financial control as shown in Exhibit 1.1: Exhibit 1.1 The basis of financial control Business is formed Trading with others involves money Control of money is essential to: e a profit w emain in business Good financial control Bad financial control Profit Loss Success Failure This can be further illustrated using the following example: Thomas recently won some money on the lottery and decided that he would like to use some of his winnings to start his own business selling leather goods. He rents a shop, purchases a stock of leather goods and commences trading on 1 July. The cost of the initial stock of leather goods was 14,000 which Thomas sold for 20,000 during the first three months of trading. His expenses for the same period, including the rent for the shop, amounted to 2,800. How successful has Thomas been in his first months of trading? Thomas sells his goods for 20,000 Less Cost Price 14,000 Profit (before expenses) 6,000 Less Expenses 2,800 Profit (after expenses) 3,200 As can be seen from the above example, Thomas has bought his stock of goods wisely and been able to sell them for more than he paid for them, producing a profit before expenses of 6,000. After paying his rent and other expenses, his profit is 3,200. His venture for his first three months of trading is certainly successful. Financial control is a major function of a business but there are other aspects that are equally important if a business is to be successful: a competitive product and/or service a good business strategy a competent workforce. 2

3 None of these would be of any use unless there is a market (people or businesses willing to buy the product and/or service). It is, however, a fact that businesses which practise good recording of financial data will have the information to make sound management decisions with a far better chance of success. 1.3 Importance and need for accounting As stated earlier, businesses must operate profitably otherwise they will cease to exist. The financial statements produced by a business s accounting department aim to show clearly the profit or loss that has been made and the financial position of the business. The two most important statements are: 1. the trading and profit and loss account shows whether the business has made a profit/loss 2. the balance sheet shows the financial position. Both these statements have to be checked and verified by a firm of auditors as part of the legal requirements for correct financial reporting. It is essential that accurate financial information is available to the auditors to enable them to fulfil their functions properly. Financial statements provide management with the means to measure the financial performance of the business. They will have the information to enable them to make rational decisions and to formulate revised plans as necessary. Financial plans are usually known as budgets. There are, however, other groups who are keenly interested in the activities of the business. The main interested parties are shown in Exhibit 1.2. Exhibit 1.2 Interested party HM Revenue and Customs (HMRC) Investors Suppliers Customers Employees Reason Legally required to collect tax such as employees tax, national insurance contributions, business tax, VAT, etc. Could be private individuals, companies, banks, etc. who will want to monitor the performance of the business to ensure it is profitable. They will need to be assured of the viability of the business before accepting orders. Before placing orders with a business they will need to know that it is financially stable. They need to know of a business s financial status, usually via unions or professional bodies. Financial statements consist of a Trading and Profit and Loss Account and Balance Sheet. 1.4 Accounting concepts At the end of a financial year organisations prepare their financial statements, i.e. Trading and Profit and Loss Account and Balance Sheet. There are, however, other issues to consider with the preparation of the financial statements which are known as accounting concepts or rules of accounting. These concepts or rules have evolved over the years for practical as much as theoretical reasons. As a ACCOUNTING CONCEPT the rules which lay down the way the activities of a business are recorded. 3

4 consequence, this has made the preparation of the financial statements more standardised enabling the information to be more easily understood and reliable, and to enable clearer comparisons between different businesses. Definition A concept may be defined as an idea. Thus, an accounting concept is an assumption that underlies the preparation of the financial statements of the organisation. These are accounting procedures that have developed over the years to form the basic rules of accounting. Fundamental accounting concepts The going concern concept implies that the business will continue to operate for the foreseeable future. In other words, it is assumed that the business will continue to trade for a long period of time and there are no plans to cease trading and/or liquidate the business. The consistency concept requires that the same treatment be applied when dealing with similar items not only in one period but in all subsequent periods. The concept states that when a business had adopted a method for the accounting treatment of an item, it should treat all similar items that follow in the same way when preparing the financial statements. Examples of when the consistency concept is used include: methods of depreciation (see Chapter 19) stock valuation (see Chapters 16 and 17). This concept is important since it assists in analysis of financial information and decision-making, and it is vital that the organisation uses the same accounting principles each year. If the organisation was constantly changing its methods then this would result in misleading profits being calculated and inaccurate analyses, hence the reason why the convention of consistency is used. However, this does not mean that the business must always use a particular method; it may make changes provided it has good reason to do so and each change is declared in the notes to the financial statements. The prudence concept. When preparing financial statements, accountants often have to use their judgement in determining the valuation of a particular asset, i.e. premises, machinery etc., or perhaps deciding whether an outstanding debt will ever be paid. It is the accountant s duty and responsibility to ensure that the financial statements are prepared as accurately as possible in disclosing the appropriate facts about a business. Therefore, the accountant should ensure that assets are not overvalued and similarly all liabilities should be identified. In other words, the accountant should display a certain amount of caution when forecasting a business s net profit or when valuing assets for balance sheet purposes. The prudence concept means that accountants will take the figure that will understate rather than overstate the profit. They must also ensure that all losses are recorded in the books but equally so ensure that profits are not anticipated by recording them before they have been gained. 4

5 The accrual concept (or matching concept) says that net profit is the difference between revenues and expenses rather than the difference between cash received and cash paid. Revenues Expenses Net Profit Sales are revenues when the goods or services are sold and not when the money is received, which can be later in the accounting period. Purchases are expenses when goods are bought, not when they are paid for. In Chapter 22 you will see items such as rent, insurance and motor expenses are treated as expenses when they are incurred, not when they are actually paid. Adjustments are made when preparing financial statements for expenses owing and those paid in advance (prepayments). Other adjustments that are also made include adjusting for depreciation of fixed assets and for probable bad debts, both of which will be discussed later. Identifying the expenses used up to obtain the revenues is referred to as matching expenses against revenues, which is why this concept is also called the matching concept. By showing the actual expenses incurred in a period matched against revenues earned in the same period, a correct figure of net profit will be shown in the profit and loss account. The materiality concept applies when the value of an item is relatively insignificant and as such does not warrant separate recording, for example, the purchase of a box of paper clips, calculator or small clock for the office. Such small expenditures are regarded as not material and their purchase would not be recorded in separate expense accounts but grouped together in a sundry or general expense account. The money measurement concept states that only transactions and activities that can be measured in terms of money and whose monetary value can be assessed with reasonable objectivity will be entered into the accounting records. The business entity concept implies that the affairs of a business are to be treated as being quite separate from the personal activities of the owner(s) of the business. In other words, only the activities of the business are recorded and reported in the business s financial statements. Any transactions involving the owner(s) are kept separate and are excluded. The only time that the personal resources of the owner(s) affect the business s accounting records is when they introduce new capital into the business or take drawings. 1.5 Accounting standards and the legal framework At one time there were quite wide differences in the ways that accountants calculated profits, until the late 1960s when a number of high-profile cases in the United Kingdom led to a widespread outcry against the lack of uniformity in financial reporting. 5

6 In response, in 1971, the UK accounting bodies formed the Accounting Standards Committee (ASC) who issued many accounting standards known as Statements of Standard Accounting Practice (SSAPs). In 1990 the accountancy bodies replaced the ASC with the Accounting Standards Board (ASB) who issued further accounting standards known as Financial Reporting Standards (FRSs). Both the SSAPs and FRSs are compulsory and enforceable by Company Law. Since SSAPs and FRSs were generally developed for larger companies, the ASB issued a third category of accounting standards in 1997 called Financial Reporting Standard for Smaller Entities (FRSSE). These were issued to make it easier for the small companies to adhere to more manageable standards. Accounting standards are drafted so that they comply with the laws of the United Kingdom and the Republic of Ireland and anyone preparing financial statements for publication must observe the rules laid down in the accounting standards. 1.6 International accounting standards In addition to the accounting standards issued by the ASB for the United Kingdom and Republic of Ireland there is also an international organisation that issues accounting standards. The International Accounting Standards Committee (IASC) was established in 1973 and in 2000 this committee changed its name to the International Accounting Standards Board (IASB). The IASB is an independent body and has 15 full-time members who are responsible for setting accounting standards. The need for such a body is said to have been necessary due to: a) the rapid expansion of global investment, trade and production; b) many companies operating in a number of countries and needing to produce financial statements which are acceptable to all; c) some smaller countries being unable to establish an accounting standards system of their own and adopting the IASB standards. It should be noted that the details provided in Sections 1.5 and 1.6 are a brief explanation of the standards that the accountancy profession is required to operate within. You will not be assessed in this topic at this stage in your studies. 1.7 The accounting equation Accounting is based upon a concept known as the accounting equation, which is simply that, at any point in time, the total amount of resources supplied by the owner equals the resources in the business. Assuming that the owner of the new business supplies all the resources then this can be shown as follows: Resources supplied by the owner Resources in the business CAPITAL the total resources supplied to a business by its owner. In accounting, the various terms have special meanings. The amount of resources supplied by the owner is called capital. As mentioned above, the actual resources 6

7 that are in the business are called assets. If the owner of the business has supplied all of the resources, the accounting equation can be shown as: ASSETS resources owned by a business. Capital Assets In many cases, other people besides the owner of the business will have supplied some of the assets, i.e. money in the form of a loan, or perhaps equipment purchased on credit. The amounts owing to these people are called liabilities (see below). When this is the case the accounting equation changes to: LIABILITIES money owed for assets supplied to the business. Capital Assets Liabilities This is the most common way in which the accounting equation is presented since the two sides of the equation will have the same totals because we are dealing with the same thing but from two different points of view. First, the value of the owners investment in the business and secondly, the value of what is owned by the business, which is ultimately owned by the owners. Unfortunately, with this form of the accounting equation, it is no longer possible to see at a glance what value is represented by the resources in the business. This can be seen more clearly if you change assets and capital around to give an alternative form of the accounting equation: Assets Capital Liabilities This can then be replaced with words describing the resources of the business: Resources: what they are Resources: who supplied them (Assets) (Capital Liabilities) It is a fact that no matter how you present the accounting equation, the totals of both sides will always equal each other, and this will always be true irrespective of the number of transactions. The actual assets, capital and liabilities may change, but the total of the assets will always equal the total of capital + liabilities. Or, reverting to the more common form of the accounting equation, the capital will always equal the assets of the business minus the liabilities. Assets consist of property of all kinds, such as buildings, machinery, equipment, stocks of goods and motor vehicles. Other assets include debts owed by customers and the amount of money in the bank account. Liabilities include amounts owed by the business for goods and services supplied to the business, and expenses incurred by the business but still outstanding. Funds borrowed by the business are also included. 7

8 Capital is often called the owner s equity or net worth. This comprises the funds invested in the business by the owner plus any profits retained for use in the business less any share of the profits paid out to the owner by the business. SOLE TRADER a business owned by one person. PARTNERSHIP a business owned by two or more people. LIMITED COMPANY an organisation owned by its shareholders. This topic is covered more fully in Chapter Types of organisations Organisations are classified according to their structure and financial make-up and are mainly classified as follows. The classification will determine an organisation s legal status and what financial reporting is required of it: A sole trader is an individual trading alone in his or her own name, or under a recognised trading name. He or she is solely liable for all business debts, but when the business is successful can take all the profits. A partnership is a group of a minimum of two people up to a maximum of 20 who together carry on a particular business with a view to making a profit. This topic will be covered in Chapter 26. Limited companies, both private and public: A private limited company is a legal entity with at least two shareholders. The liability of the shareholders is limited to the amount that they have agreed to invest. A public limited company is also a legal entity with limited shareholder liability, but unlike a private company it can ask the public to subscribe for shares in its business. See Chapter 27. 8

9 Non-trading organisations include clubs, associations and other non-profitmaking organisations which are normally run for the benefit of their members to engage in a particular activity rather than to make a profit. Their financial statements will take the form of income and expenditure accounts, to be covered in Chapter Accounting definitions Accounting is the skill of maintaining accounts and preparing financial statements and reports for use by the management and owners of a business to aid financial control, management and budget forecasts. Assets are resources owned by the business, i.e. premises, machinery, motor vehicles etc. Auditors are a specialist firm of accountants appointed by an organisation to examine and verify that its financial statements have been presented fairly, comply with accounting practice and meet legal requirements. Book-keeping is the process of recording, in the book accounts or on computer, the financial effect of business transactions and managing such records. The process of recording the financial information is the initial stage in the preparation of financial statements. Budgets are financial plans produced by an organisation. Capital is the total resources supplied to a business by its owner(s), i.e. money. Financial statements are formal documents prepared by an organisation to show the financial position of the business at a specific date. They include a Trading and Profit and Loss Account and a Balance Sheet. See later chapters for more details. Liabilities are amounts owed for assets supplied to the business. Owner s equity is another name for the capital supplied by the owner of the business, also referred to as net worth. 9

10 End of Chapter Checklist Summary The basis of any business is trading with others and providing good products and/ or services to meet customer requirements; to manage the business well, ensuring costs are controlled and cash flow maintained, resulting in a successful and profitable business. Financial statements are prepared by a business to show the profit/loss made and the financial position; these are known as the Trading and Profit and Loss Account and the Balance Sheet. These financial statements enable management to measure the performance of the business and make appropriate decisions and financial plans known as budgets. Various groups/organisations are interested in the financial performance of a business, i.e HMRC, investors, suppliers, customers, employees. An accounting concept is an accounting procedure developed over the years to form the basic rules of accounting. The fundamental accounting concepts are: going concern, consistency, prudence, accruals (or matching concept), materiality, money measurement and business entity. The whole of accounting is based on the accounting equation, namely, that the resources supplied by the owner (the capital) will always equal the resources in the business (the assets). There are various types of business organisations, including: sole traders, partnerships and limited companies, which may be either a private limited company or a public limited company, plus non-trading organisations. There are many terms which are used when dealing with accounting and financial matters. Some of these are: accounting, assets, auditors, book-keeping, budgets, capital, financial statements, liabilities, owner s equity. Reminder: A glossary of accounting terms can be found in Appendix A at the end of the book. Questions X X a) Going concern concept b) Accrual concept c) Consistency concept d) Prudence concept 1.7X a) The purchase of a waste-paper basket for use in the office. b) Tom has just purchased a set of golf clubs for his own personal use but wonders if he could charge them to his business. c) Alice, who runs her own hairdressing business, considers her staff to be worth several hundred pounds to her business yet nothing is entered in her books of account. d) A debt has been written off as a bad debt even though there is still a chance that the debtor may eventually be able to pay it