Depreciation for Amanda’s fixtures and fittings and van is shown as transaction 22 in Figure 1.1.
Now the assets have been reconciled, the only other matter is to deal with the matching concept and this means dealing with accruals and prepayments, so that in timing terms the sales and the costs associated with those sales match.
The entries for accruals and prepayments are:
Accruals– debit the appropriate expense and credit accruals.
Prepayments– debit prepayments and credit the appropriate expense.
The entries for Amanda’s accruals are shown as transaction 23 in Figure 1.1 and the entries for Amanda’s prepayments are shown as transaction 24 in Figure 1.1. Once these entries are completed, each account is ‘balanced off’, so that only the net balance is showing. This is shown in Figure 1.1. Each of these balances is then listed in the form of a Trial Balance, as shown in Figure 1.2.
Trial Balance at December 31 2004
Debit (£) Credit (£) Capital
Cash at bank Goodwill Samples Loan
Debtor insurance Setting-up costs VAT
Legal costs Stock
Trade creditors Sales
Trade debtors Cost of sales Rent (office) Fixtures and fittings Van
Warehouse rent Delivery costs Stationery
General insurances Wages
National insurance Interest
Bank charges Stock losses Goodwill impairment Depreciation Accruals Prepayments
Accounting and audit expenses
220 25,000 2,000 10,000 12,000 2,380 5,000 95,761
102,500 384,000 10,000 3,750 10,000 6,000 16,500 600 1,500 10,800 1,200 20,000 15,300 239 15,000 6,250 16,000 1,200
50,000
200,000
40,000 480,000
3,200
773,200 773,200
Figure 1.2 Case study – Amanda – Trial Balance
of the Profit and Loss Account and is shown before ‘operating profit’. If the answer to this third question is no, then it will be an extraordinary expense that is shown below the ‘operating profit’ line.
To demonstrate this, we can go down the Trial Balance (Figure 1.2).
Cash at bank. Is it something owned? Yes. Will it be owned for a year or more? No. Therefore, ‘cash at bank’ is a current asset.
Goodwill. Is it something owned? Yes. Will it be owned for a year or more?
Yes again, it must be a fixed asset. Can Amanda see and touch this asset?
The answer to this is no, so goodwill must be an intangible fixed asset.
Goodwill is simply the difference between what has been paid for an asset and the tangible value of that asset based on its book value. In addition to goodwill, other intangible assets might be patents, brands and intellectual property rights.
Samples.Is it something owned? No, then it must be an expense. Did Amanda need to make these samples to demonstrate that the product could be manufactured to the secret formula? If yes, then the expense would appear in the Profit and Loss Account before the ‘gross profit’ line. However, if the samples were made to entice customers to buy the product, they would be a selling expense and would appear below the ‘gross profit’ line. So we are back to this word ‘judgement’ again! What were the samplesreally made for?
Debtor insurance. Is it something owned? No, then it must be an expense.
Why did Amanda take out debtor insurance? Because taking out such insurance was a condition for getting the loan. Therefore, debtor insurance could be regarded as a finance cost and would come below the ‘gross profit’ line.
Setting up costs.Is it something owned? No, then again it must be an expense.
Why were these costs incurred? The answer was that this expense related to the costs Zehin Foods plc would incur in scaling up from Amanda’s jam pan recipe. Here again, some judgement is required. Some would argue that as these setting up costs related to a one-off cost that covered contracts over a 5-year period, they should be capitalised, treated as a fixed asset, and written off over 5 years. Amanda took the prudent view and charged this expense to the Profit and Loss Account, but treated it as
by the business to Revenue and Customs. It is only a debtor here because food is zero rated, which means that Amanda does not charge VAT on sales, but VAT is charged on many of the goods and services she buys. In this case, Revenue and Customs is a debtor and the amount in the Trial Balance represents the amount of VAT that Amanda has paid, but not yet recovered at her year end.
Legal costs. Is it something owned? No, then it must be an expense. What type of expense is it? This is an administrative expense, so it would appear below the ‘gross profit’ line.
Stock. Is it something owned? Yes, as stocks are the goods we are holding with a view to sell later on. Will stock be owned for a year or more?
Hopefully not and if it were, it would have to be written off. Accordingly, stock is a current asset.
Trade debtors. Is it something owned? Yes, as debtors are people or compa- nies who owe us money and we certainly expect these debtors to pay us within a year. Trade debtors are classified as current assets.
Cost of sales. Is it something owned? No, because ‘cost of sales’ is the direct cost associated with the sales Amanda has made in the period. Cost of sales is always the first item in the Profit and Loss Account after sales.
Rent (office). Is it something owned? No, then it must be an expense. Amanda does not own her office, but pays the owner to be able to use it.
Fixtures and fittings. Is it something owned? Yes. Will it be owned for a year or more? Yes. Can fixtures and fittings be seen and touched? Yes, then they must be a tangible fixed asset. What has happened is that Amanda has rented an unfurnished office and has had to furnish it. She could take her fixtures and fittings with her if she moves to another office.
Van. Owned for over a year, can see and touch, so a tangible fixed asset.
Warehouse rent. Like ‘office rent’, but this time the rented space is a store for Amanda’s finished products. Because this expense is incurred before the goods are delivered to customers, it would come above the ‘gross profit’
line in the Profit and Loss Account.
Delivery costs. These are the costs associated with delivering the goods to customers and would come under the heading of ‘distribution’ that fall below the ‘gross profit’ line.
Stationery. Paper, envelopes, etc. might be something that Amanda owns at the year end, but the value would be so immaterial that the full cost would be expensed and being an administrative expense would come below the
‘gross profit’ line.
General insurances. This is another administrative expense.
Wages. Here it is related to the warehouse manager who organised the trans- port and is, therefore, an expense that comes above the ‘gross profit’
line.
National Insurance. It is the employer’s contribution of this tax, relating to wages paid and accordingly falls into the same category. Employers deduct income tax and national insurance from their employees and each month they have to pay the sum of the amount they have deducted, plus their contribution, to Revenue and Customs. It is the employer’s contribution that appears in the Profit and Loss Account.
Interest. It is the amount paid to a lender, to compensate the lender for the money he has loaned the business. In the Profit and Loss Account, interest is charged after all other expenses, including extraordinary items, with the exception of tax. But as Amanda is a sole trader, we are not accounting for tax in the example shown.
Bank charges. It is the amount that the bank has charged for providing banking services and is treated as an ordinary administrative expense.
Stock losses. It is the amount that has been lost because stock has gone missing or lost value for whatever reason. It is usually charged above the
‘gross profit’ line.
Goodwill impairment. It is the amount that goodwill has had to be written down, because its valuation cannot be justified based on the predicted future earnings. Given ‘goodwill impairment’ is often an unexpected event that does not regularly happen, it is treated as an extraordinary item in the Profit and Loss Account.
Depreciation. It is a book entry having no impact on cash, which indi- cates how much the assets have been written down in the financial year.
Depreciation on assets to do with production would be charged above the ‘gross profit’ line, while all other depreciation would be regarded as a distribution or administrative expense and would be charged below the line.
Prepaymentsare payments made in advance and are regarded as debtors and are accordingly classified as current assets.
Accounting and audit expensesare yet another administrative expense com- ing below the ‘gross profit’ line.
generating and will appear in the Profit and Loss Account. We can now go down the Trial Balance on the credit side.
Capital. Is this something the business owes? Yes, capital is what the busi- ness owes to the owner of the business. Remember that although a sole trader as a person and his or her own business are treated as the same entity, the books of the business will not record any transactions that are for personal use. A sole trader is not paid a wage or a salary, but rather is taxed on the profits his or her business makes, but will still get the per- sonal and other allowances given to salaried or waged employees based on their personal circumstances. However, a sole trader has unlimited liability, which means that if the business cannot meet all its debts, then the sole trader will have to sell personal assets to make good. Will the business owe capital to the owner of the business for a year or more?
Well, the owner of the business will certainly hope to stay in business for a year or more, so capital is a fixed liability.
Loan. This is the amount that the business owes to the bank and as the intention is to pay it off over 5 years, it is another fixed liability.
Trade creditors. Is it something the business owes? Yes, so it must be a liability. Will the business still owe what will appear in the Balance Sheet in a year’s time? No, because creditors are people the business owes money to and they will certainly expect to be paid within 12 months. Therefore, creditors are classified as current liabilities.
Sales. Is it something the business owes? No, so sales must be income generating and therefore will appear in the Profit and Loss Account.
Accruals. They relate to goods and services received by the Balance Sheet date, but not put through the books as a permanent entry at the Balance Sheet date. Accruals are regarded as creditors and are therefore classified as current liabilities.
So, now we have classified each item in the Trial Balance as either going to the Profit and Loss Account or Balance Sheet; we can prepare these two statements.