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FINANCIAL ACCOUNTINGLecture 3

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Learning Outcomes

To classified the accruals principles, prepayments and accruals, bad debts, and the provision of bad debts.

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Accruals Basis of Accounting

The income statement for a period is prepared following the accruals concept: the income and expenses are recorded as they happened in the period regardless of whether cash has been received or paid .

Therefore the profit of e.g. Y12 is calculated as following:Sales Y12 ( not only cash sales but also credit sales)

Plus other income - e.g. from interests or rents (paid to the firm and this not paid yet but third parties e.g. banks owe the income to the company because It concerns the specific period)

Less Purchases Y12 (not only cash purchases but also credit purchases)

Less Expenses happened in Y12 ( rent, electricity ,telephone paid and those not paid yet but they concern the period we study and the firm has debt on them)

RESULT : NET PROFIT/LOSS

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1. Accrued Expenditure

• An accrual arises where expenses of the business, relating to the year, have not been paid by the year end.

• In this case the expense not paid it included in the total expenses in the income statement, and therefore deducted from the income so as to calculate the Net Profit, and it also goes to Balance sheet in the current liabilities side and is called Accrued Expenses.

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Example 1:

The electricity bill for the company A Ltd was for the year end 31st Dec Y12 €12000. But in Y12 it was paid only €9000 and the rest €3000 was paid in Jan of Y13.

Required: 1.Prepare the accounts in the General ledger affected from the above transactions and 2.show where each amount finally goes.3.Prepare the extract of B/ce Sheet and the Profit and loss a/c

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Electricity CashCash 9000 Profit & Loss 12000 Electricity 9000Accrued Exp c/d 3000

12000 12000 Accrued exp b/d 3000

Profit & Loss a/c Gross Profit x Less Expenses Electricity 12000 Balance Sheet as at 31st Dec

Y12

Current Liabilities Accrued Expenses 3000

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2. Prepaid Expenditure

• A prepayment arises where some of the following year’s expenses have been paid in the current year.

• In this case, it is necessary to remove that part of the expense which is not relevant to this year, and therefore must not be deducted from the income of this year, and create a corresponding account in the Balance Sheet in the side of assets named Prepaid expenses.

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Example 2:

The insurance bill for the company A Ltd was for the year end 31st Dec Y12 €24000. But in Y12 it was paid €30000 for insurance expenses. The owner of the company wanted to prepaid in this way future charges of insurance.

Required: 1.Prepare the accounts in the General ledger affected from the above transactions and 2.show where each amount finally goes.3.Prepare the extract of B/ce Sheet and the Profit and loss a/c

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Insurance CashCash 30000 Profit & Loss 24000 Insurance 30000 Prepaid Exp c/d 6000

30000 30000Prepaid

B/ce b/d 6000

Profit & Loss a/c Gross Profit x Less Expenses Insurance 12000 Balance Sheet as at 31st Dec Y12

Current Assets Prepaid Expenses 6000

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SUMMARY:

EXPENSE A/C

Prepaid exp b/d x

Prepaid exp c/d x

x x

Accrued exp b/d x

Accrued exp c/d x

Cash payments x Profit & Loss a/c x

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3. Accrued Income

• Accrued income arises where income has been earned in the accounting period but has not yet been received. In this case we mean the income from other sources than the clients for e.g. the bank interest, rents e.t.c)

• In this case, it is necessary to record the whole (paid + unpaid) income in the income statement and create a corresponding asset in the statement of financial position (called accrued income).

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Example 3:

• A business earns income in Y12 from bank interest €300 per month. However during Y12 the business received only €3000 instead of €3600 (300*12).

Required: 1.Prepare the accounts in the General ledger affected from the above transactions and 2.show where each amount finally goes. 3.Prepare the extract of B/ce Sheet and the Profit and loss a/c

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Bank Interest Income BankProfit &Loss 3600 Bank 3000 Bank

Accrued Income c/d 600 Interest 3000

3600 3600Accrued IncomeB/ce b/d 600

Profit & Loss a/c Gross Profit x Add Bank Interest 3600 X

Balance Sheet as at 31st Dec Y12 Current Assets Debtors X Accrued Income 600

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4. Prepaid Income

• Prepaid income arises where income has been received in the accounting period but which relates to the next accounting period.

• In this case, it is necessary to remove the income not relating to the year from the income statement and create a corresponding/resulting current liability in the statement of financial position (called prepaid income).

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Example 4:

A business rents out a property at an income of € 4000 per month. €64000 has been received in the year ended 31 Dec Y12.

Required: What is the year-end liability and what is the rental

income for the year? Show the relevant entries in the ledger

accounts and the financial statements.

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Rent Income BankProfit & Loss 48000 Bank 64000 Rent 64000

(4000*12)Prepaid Income c/d 16000

64000 64000 Prepaid Income b/d 16000

Profit & Loss a/c Gross Profit x Add Rent 48000 X

Balance Sheet as at 31st Dec Y12 Current Liabilities Creditors X Prepaid Income 600

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SUMMARY:

INCOME A/C

Prepaid Income b/d X

Prepaid Income c/d X

x x

Accrued Income b/d X

Accrued Income c/d X

Cash payments XProfit & Loss a/c X

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Irrecoverable DebtsIrrecoverable Debts

• The accruals concept states that when a sale is made, it is recognised in the accounts, regardless of whether or not the cash has been received.

• If sales are made on credit, there may be problems collecting the amounts owing from customers because some may refuse to pay their debt or they may declared bankrupt and unable to pay the amounts owing. At this case the debt is known as an irrecoverable debt or Bad Debt. As it will probably never be received, it is written off by writing it out of the ledger accounts completely.

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Irrecoverable DebtsIrrecoverable Debts

If there is some doubt whether a customer can or will pay his debt, an allowance for receivables (provision for bad debts) is created, these debts are not yet irrecoverable. However the creation of an allowance for receivables means that the possible loss is taking into consideration immediately.

The amount of the original debt will still remain in the ledger account just in case the customer does eventually pay.

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Accounting for Irrecoverable DebtsAccounting for Irrecoverable DebtsThe debtors account is credited so as to reduce them,

and

An account named irrecoverable debts expense or Bad

Debts expense id debited. This expense is treated as all

other expenses and for that reason is included in the

income statement (profit and loss a/c) and is reducing the

net profit.

Double entry:

Dr Bad Debts x

Cr Debtors x

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Accounting for Irrecoverable Debts Accounting for Irrecoverable Debts RecoveredRecovered

• There is a possible situation where a debt is written off as irrecoverable in one accounting period, and later the money, or part of the money, due is unexpectedly received.

Double entry:

Dr Cash / Bank x

Cr ‘Bad Debts Recovered’ x

This account is new, is created later and is not the same as the account ‘Bad Debts’

It goes in the income statement and is added at the gross profit in this way is increasing the net profit

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Example 5:

Celia Ltd had Debtors €3655 at 31st Dec Y12. At that date she wrote off a dept from the client Mr. Smith €699.During the next year Y13 Celia made credit sales €17832 and later received cash from its clients totaling €16936.Also the company received the €699 at the end of the year that was written off in Y12.

Required: show the transactions above in the General Ledger.

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Debtors Bad DebtsB/ce b/d 3655 Bad Debts 699 Debtors 699 Profit & Loss

699

B/ce c/d 2956

3655 3655

B/ce b/d 2956

Sales 17832 Cash 16936

B/ce c/d 3852

20788 20788

Bad Debts Recovered Cash Profit & Loss 699 Cash 699 Debtors 16936

B.D. Recov 699

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Allowance for ReceivablesAllowance for Receivablesor Provision for Bad Debtsor Provision for Bad Debts

• These may be some debts in the accounts where there is some cause for concern but they are not yet definitely irrecoverable-Bad Debts.

• That’s why we make a provision in the profit and loss account for this possible expense of not collecting the debt but the debtors amount remain the same – we are not reducing it as we did in the case of Bad Debts – because the customer may finally pay.

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Provision for Bad DebtsProvision for Bad Debts

• The account ‘Provision fro Bad Debts’ has a credit balance in contrast to the account ‘Bad Debts’ which has debit b/ce.

• The Provision for Bad Debts goes indirectly to the profit and loss through the account Bad Debts.

Double entry: Dr Bad Debts x Cr ‘Provision for Bad Debts’ x

• The balance, at the end of the year, of the a/c ‘Provision for Bad Debts’ goes to balance sheet below Debtors and is deducted there from Debtors to show the net Debtors.

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Example 6: Stamp Ltd has opening balances at 1ST Jan Y12 Debtors

€68000. During the year the company made credit sales €354000 and received cash later from the clients €340000. At 31st Dec Y12 the company find out that €2000 of the clients are Bad Debts and also believes that 5% of the remaining clients will might not pay and since this is not sure the accountant makes a provision for Bad Debts.

Required: 1. find the amount of Provision for Bad Debts that will added to Bad Debts amount. 2.find the amount of Bad Debts which will go to Profit and Loss 3. Show how Debtors will be presented in the Balance

Sheet

Lecturer: Chara Charalambous

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Provision for Bad DebtsProvision for Bad Debts

• If there is already an opening amount in the account ‘Provision for Bad Debts’ then only the movement in the provision is charged to the Profit & Loss through ‘Bad Debts’ (closing provision less opening provision)

• If an exercise with trial balance is given to you and you have the amount of Debtors and the amount of Bad Debts in the trial balance it means that bad debts have already been deducted from debtors and so you should not deduct it.

• What you have to do is to find the new provision for bad debts : 1 .Debtors* provision % and then

2 . deduct from the new provision the old and then

3 . add the difference in the bad debts amount.

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Example 7:

Stamp Ltd has opening balances at 1ST Jan Y12 Debtors €68000 and Provision for Bad Debts €3400. During the year the company made credit sales €354000 and received cash later from the clients €340000. At 31st Dec Y12 the company find out that €2000 of the clients are Bad Debts and also believes that 5% of the remaining clients will might not pay and since this is not sure the accountant makes a provision for Bad Debts.

Required: show the transactions above in the General Ledger

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Debtors Bad DebtsB/ce b/d 68000 Bad Debts 2000 Debtors 2000 Profit & Loss 2600

Sales 354000 Cash 340000 Provision 600 B/ce c/d 80000 2600 2600 422000 422000

Provision for Bad Debts Cash B/ce c/d 4000 B/ce b/d 3400 Debtors 340000 Bad Debts 600

4000 4000

80000*5%=4000

B/ce b/d 80000

B/ce b/d 4000

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Balance Sheet as at 31st Dec (extract)

€ €Current Assets

Debtors 80000

Less Provision 4000 76000

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Carriage Inwards and Carriage Outwards

• Carriage refers to the costs of transporting goods to and from the firm.

• From the buyer’s point of view, the delivery charge would he referred to as “carriage inwards”. Any such carriage charges should be debited to the carriage inwards account in the general ledger.

• The carriage inwards account is written off to the trading account at the end of the accounting period.

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• When the buyer sells the goods to his customer, he incurs further delivery charges. This cost is referred to as ‘carriage outwards”. These costs are debited to the carriage outwards account in the general ledger.

• Any carriage outwards charges are usually included in an item called ‘selling and distribution costs”.   Since this cost is incurred after the goods have been made ready for sale, the account is written off to the profit and loss account at the end of the accounting period.

• Each type of carriage will be an expense and therefore will have a debit balance in the trial balance. However, these two carriages will appear in different sections of the trading and profit and loss account.

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Accounting Treatment of Carriage Inwards and Carriage Outwards

• Journal  Entry for Carriage Inwards:Debit   Carriage Inwards Credit    Bank• Journal  Entry for Carriage Outwards:Debit   Carriage Outwards Credit    Bank• Treatment in Trading, Profit and Loss

Accounts: Carriage inwards Trading account expense Carriage outwards Profit & loss account

expense

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Summary:• Carriage inwards is connected with the cost of getting goods into

the business and ready for sale. As a result, it will be added on in the calculation for the cost of goods sold. Carriage outwards does not have anything to do with the cost of getting goods into saleable condition. Therefore it will appear with all the other overhead expenses in the profit and loss account.

• Good to know: Nowadays, the price quoted for goods being purchased will

usually be inclusive of any delivery charge, and so a separate charge for carriage inwards (or outwards) is not very common. In cases where separate carriage inwards charges are incurred, the cost should be added on to the cost of purchases in the trading account. Consequently, a proportion of carriage inwards charges should be added to the purchase cost when determining the cost of closing stock.