July 2011 – accountingexplained

Increase and Decrease in Provision of Doubtful Debts

Increase in Provision of Doubtful Debts

This sub-topic is exceptionally hard for most people but don’t give up, try reading this post!

The previous post was for businesses that start to open up provision account. During the first year, there is no need to worry about an increase or decrease in provision for doubtful debts. However, in any subsequent years, you will need to take note of three possible outcomes:

1) Increase in provision of doubtful debts
2) No change in provision of doubtful debts
3) Decrease in provision of doubtful debts

For e.g. last year, the debtors was $2,000.

Scenario 1: During the year, the debtors are $3,000. If you remember Step 1 in the previous post, we will need to calculate the provision of doubtful debts. In this case,

$3000 x 5% = $150

Now, compare this $150 with previous year of $100. There is an increase in provision for doubtful debts of $50.

Because the amounts of debts have increased, more bad debts will be expected in the future.

Okay, if this blurs you, imagine your friend borrowed $10 from you. You expected your friend to pay you back $8 dollars and as for the remaining $2, you gave up asking for it. Now, what if your friend borrowed $100 from you. You could have expected your friend to only pay you $80! Can you see the difference now? The bigger the amount you lend to your friend, the higher the amount will go to expecting bad debts (in this case, $20.) Can you also see that the increase in provision is $18?

An increase in provision for doubtful debts is an increase in expense. (Imagine that $18 of yours, isn’t that an expense?)

Credit Provision for Doubtful Debts Account.

Debit Profit and Loss Account.

In the Balance Sheet, include the provision for doubtful debts for the year, which is $150.

Decrease in Provision of Doubtful Debts

Scenario 2: The amount of debtors for the year totaled to $1000. The provision for doubtful debts is $50. Note: We are comparing with the $100 previous year, not with $150 in Scenario 1.

You can see that this year provision for doubtful debts have decreased by $50 (100-50.) This decrease is an income for the business.

Blurred? Imagine your friend originally owe you $100, and you expect $20 as bad debts. Now that your friend paid you $50. You will expect that $10 will become bad debts and the other $10 was gone! Let that thoughts sink in for a bit first… can you see that the $10 (that is gone) becomes an imaginary gain because you are not losing that $10!

A reduction in provision for doubtful debts is an income to the business.

Debit Provision for Doubtful Debts Account.

Credit Profit and Loss Account.

In the Balance Sheet, include the current amount of the year.

No change in Provision for Doubtful Debts

This is very unlikely to happen because of the number of sales occurring in a year. You will always get a provision that is either higher or lower than the previous year. However, what if you just happened to get the exact same amount of debtors’ owing as the previous year? Answer is: You do nothing and move on!

Provision for Doubtful Debts

Provisions for Doubtful Debts

Provision (to provide for) is used when you are expecting bad debts. Contrast this with bad debts which are already known to be unpaid.

Because you are expecting what amount of owing will go bad, you will need to have a % to multiply it against the total owing. The estimated percentage that will go bad debts will usually be provided to you.

Example

At any year, the total amount of debtors totaled to $2000. It is estimated that 5% of the debts will become bad debts. You will be required to draw a provision account and post the provision of doubtful debts into the statement of financial position.

Provision for Doubtful Debts

Done!

Bad Debts

It will be easier if I break this down into three different sub-topics. It should be easier to understand if you work out the basic first.

Bad debt is an expense to the business, and is charged to the profit and loss account.

Whenever a debt becomes bad,
1) First, reduce the balance of the respective debtor by crediting it .
2) Open up a bad debt account and debit it.

Note: You will need to total up the bad debts account before posting it to the profit and loss account.

What will happen when bad debts are recovered?
It is possible for customers to repay back their bad debts, when these happen, we reverse back the steps shown above by:
1) Debit debtor account.
2) Credit bad debts account or credit bad debts recovered account (both of them have the same meaning). Choose either one, do not use both.

Important note: We have only reinstated the debtors back to their original in debt position, we have yet to recognise their payment. To do this, we

1) Debit either cash / bank – depending on how debtors pay you.
2) Credit debtor’s account.

Capital and Revenue Expenditure

Capital Expenditure

Capital Expenditure is made when business spends money to buy fixed assets or add value to an existing fixed assets.

In general terms, any costs acquired to bring fixed assets in actions are included as capital expenditure. Such actions should include,
1) acquiring fixed assets.
2) bringing them into the business or firm.
3) legal costs of buying buildings.
4) carriage inwards on machinery bought.
5) any other cost needed to get the fixed asset ready for use.
(Business Accounting, Wood F and Sangster A)

Revenue Expenditure

Revenue Expenditure are paid to run the daily activities of the business.

PS: This topic should not be looked down as something that is not going to come out in the exam.

General Journal

The General Journal

To simply recap a bit on what you have learned so far, you should be able to recognize that all cash sales or cash purchases should be recorded in cash book and that all credit sales or purchases should be recorded in sales journal, purchases journal, return inwards journal and returns outwards journal.

Any other transactions that are NOT related to cash or credit sales or purchases will be recorded on General Journal.

General Journal should contain the following transactions:
1) The date.
2) The name of accounts to be debited and the amounts.
3) The name of the accounts to be credited and the amounts.
4) Narrative, a description and explanation of the transaction.

Generally speaking, any items not related to
1) Cash sales
2) Cash purchases
3) Credit sales
4) Credit purchases
5) Return outwards
6) Return inwards
So any other transactions that are not related to the above will need to be entered into the GENERAL JOURNAL.

Format of General Journal

General Journal

Purchases Journal and Purchases Ledger

Purchases Journal and Purchases Ledger

Definition of Purchases Invoice
– A document received by a purchaser showing details of goods bought and their prices.

Purposes of using Purchases Journal
– To record purchases made through credit purchases
– Act as a record on the creditors’ information on matters regard to their name, date of purchases, amount of purchases and the relevant invoice number.

The Purchases Journal is also known as the purchases book or the purchases day book.

Credit Purchases were first entered in the Purchases Journal, followed by Purchases Ledger.

Example of Purchases Journal

Example of Purchases Ledger

Sales Journal and Sales Ledger

Sales Journal and Sales Ledger

If you know this topic well, you can skip it. If you need quick revision, then you can read through.

Purposes of Sales Journal
– To record sales made through credit sales. NOT cash sales.
– Act as a record on the debtors’ information on matters regard to their name, date of sales, amount of sales and the relevant invoice number.

Definition of Sales Invoice
– A document showing details of goods sold and the prices of those goods.

Credit sales were first entered in Sales journal, followed by Sales Ledger.

Example of Sales Journal

Example of Sales Ledger

Remember that trade discount will NOT be shown in the Double Entry and Sales Journal. Sales Journal only shows the net amount or after deduction amount.

Cash Book

Cash Book

Cash book is a combination of cash account and bank account into one book. Getting the format of cash book correctly is very important in scoring a full mark in this topic.

Three Column Cash Book

Cash Book

In the cash book, the third column (from the left) shows the cash account while the fourth (from the left) shows the bank account.

Contra Entry

A contra entry has almost the same meaning as the double entry system: you will need to enter two transactions into the cash book.

For example,
1) Cash sales banked. *banked means deposited.
Credit the cash account and debit it to your bank account.

2) Withdraw cash from bank for office use.
Credit bank account and debit it to your cash account.

Remember to put C in the folio as an indicator of contra entry, for both side.

Updated on 14/11/2017

Edited grammatical errors.
Amended the content for better understanding.

Statement of Financial Position (Balance Sheet)

Statement of Financial Position (SoFP for short)

SoFP is simply the result of an accounting equation.

Assets = Capital + Liabilities (Please compare this with SOFP’s format below later!)

Before we look at the format, some slight explanations on the definitions of Assets and Liabilities are as follow:

Assets

There are two headings under assets; Fixed Assets and Current Assets.

Fixed Assets are usually long life, are used in the business and are not for resale purposes. Examples: land and buildings, fixtures and fittings, machinery, and motor vehicles.

Current Assets are items that are easily convertible into cash. Examples: cash in hand, cash at bank, stock, and debtors

Liabilities

There are also two headings under liabilities; Current Liabilities and Long term Liabilities.

Current Liabilities – payments that need to be made to creditors within a one year period
Long term Liabilities – payments that need to be made to creditors over a one year period.

Vertical Format

Balance Sheet - Vertical Format

Going back to the accounting equation earlier:

Fixed Assets + Current Assets = Capital + Current Liabilities + Long Term Liabilities

12,000 + 9,200 = 19,200 + 2,000 + 0

21,200 (Assets) = 21,200 (Capital + Liabilities)

Is the format still hard? Clearly not because you can derive the format from the accounting equation! Easy right?

Updated on 14/11/2017

Edited grammatical errors.
Changed ‘Balance Sheet’ to ‘Statement of Financial Position’.
Changed ‘stock’ to ‘inventory’.
Changed ‘debtors’ to ‘trade receivables’.
Changed ‘creditors’ to ‘trade payables’.
Revised the format of Statement of Financial Position to GCSE ‘O’ Level Examination standard.
Removed Horizontal Format style of Statement of Financial Position. (Please learn vertical format instead).

Income Statement (Trading and Profit & Loss Account)

Income Statement
You will need to open up an income statement for sole-proprietorship, partnership, private/public company, and manufacturing company.

Purposes of Income Statement:
1) To calculate the profits or losses of a business;
2) To prepare reports for stakeholders, (stakeholders are people who are interested in your business, it could be creditors or investors); and
3) To calculate tax required by government policies.

Understand Gross Profit

Most people doesn’t know what is the meaning of gross profit, they only know it’s a form of profit! This is the same as knowing nothing at all!
GROSS PROFIT is profit resulting from your sales over cost of goods sold.

Imagine you yourself selling one DVD movie to one customer at $4. This is your sale, $4.
The cost of your empty DVD disc is $0.50. This is your cost of goods sold. * People tend to be confused with the term ‘goods’. Goods is a term used to refer to a lot of things, and in this case, it means lots of empty DVDs. But for illustration purpose. I only used one DVD as an example.

Go back to the definition of Gross Profit,
We can rewrite it as
Gross Profit = Sales – Cost of Goods Sold
= 4 – 0.50
= 3.50

Understand Cost of Goods Sold

Now, I wonder if you have realized that the phrase of ‘cost of goods sold’ does seems tricky.

Cost of Goods Sold can be further broken down into it’s part,
Opening Inventory+ Purchases – Closing Inventory = Cost of Goods Sold

You can skip the explanation if you want, but for some reason, I think learning it can actually reinforce your memory. There are cases where people sometimes couldn’t recall their memory due to last minute revising. And this will be the time you apply your understanding.

At the beginning of the year, you have 200 empty DVDs at hand. And during the year, you have purchased 400 empty DVDs. At the end of the year, you are left with 100 empty DVDs. Assume the price of Empty DVDs is $0.50.

If you really concentrate on the word Cost Of Goods Sold, you will see that it means the original cost of empty DVDs that have been sold. Now, this 100 empty DVDs left are ‘unsold’. Therefore, there are not included in the calculation of Cost of Goods Sold.

Now, back to Opening Inventory and Purchases. Why do we have to add it up?

Imagine your shop is selling DVDs, if you don’t buy empty DVDs, how can you sell your final DVDs to customer? Now if you already have 200 empty DVDs at hand, you need to buy more in order to sell enough for your customers. This is the reason why Opening Stock needs to add up with Purchases.

By combining all of this explanation, therefore we arrived at the same formula given earlier of:

Cost Of Goods Sold = Opening Stock + Purchases – Closing Stock

Now we are all done, this is how we can start to draw an income statement.

[Please note that Trading & Profit and Loss Account = Income Statement! For the explanation below, I have retained earlier explanation for ease of understanding.]

Trading Account

Trading Account is simply a calculation of Gross Profit. You will get to see it later. But for now, just know this,

Gross Profit = Sales – Cost of Goods Sold
Gross Profit = Sales – (Opening Stock + Purchases – Closing Stock)

Points to remember:
1) Mark is awarded to title.
2) Use Net Sales instead of Sales*
3) Use Net Purchase instead of Purchase*
*If applicable, I will further explain it later on.

Net Sales / Turnover

Sales need to be net, i.e. after any deduction on sales. If you had been selling 400 DVDs to customers, they are bound to be some customers which would come after you claiming bad DVDs. And in this case, say 30 DVDs were returned to you. This is called Sales Return or Return Inward. You need to memorize both of the terms. Assuming the selling price was at $4. Now we try to compute the Net Sales.

Net Sales / Turnover = Sales – Sales Return / Return Inward
Net Sales = (400 – 30) x 4
= 370 x 4

In exam, sales return was sometimes used instead of return inward, or otherwise. Therefore, it is important to remember their terms.

Net Purchases

Just like Net Sales, Net Purchases are any addition or deduction made to the original purchases. In this case, imagine you purchased 600 empty DVDs. The cost of this purchases may include cost of insurance, freight cost or transportation cost or carriage inwards, purchase return or return outwards and etc. As long as anything that you paid in order to get that 600 DVDs into your shop, you will have to add it. Whilst anything you return back to your suppliers, you deduct it from your original purchases.

Net Purchases = Purchases + Any Cost That You Paid* – Return Outward
* The reason that I put ‘any cost that you paid’ is because there are too many additions that can be included, students should remember the general rule of ‘anything that you paid to get the DVDs into your shop.’

Profit And Loss Account

Inside Profit And Loss Account,

Net Profit = Gross Profit + Revenues/Other Income- Expenses
= A positive amount is called Net Profit
= A negative amount is called Net Loss
In most examination, the answers will always be Net Profit. Unless you are in A Level, then a loss is also possible.

Other Income

Other Income is any amount of money that profits a business. For instance, discount received from purchasing the empty DVDs.

Position on Vertical format, below Gross Profit, above Expenses.

Expenses

Expenses are any amounts that will not profit a business but are necessary to keep the business operating. Example of expenses include rent, wages, salaries, electricity, depreciation, discount allowed and etc.

Position on Vertical Format, below Revenues, above Net Profit.

Income Statement – Vertical Format

Income Statement - Vertical Format (1)

Updated on 12/11/2017

Edited grammatical errors.
Changed ‘Trading and Profit & Loss Account’ to ‘Income Statement’.
Changed ‘stock’ to ‘inventory’.
Revised the format of Income Statement to GCSE ‘O’ Level Examination standard (also the terms used such as ‘stock’ to ‘inventory’).
Removed Horizontal Format style of Income Statement. (Please learn vertical format instead).